The Securities and Exchange Commission (SEC) has finalized independence rules for compensation committees of public companies and their advisers. The new rules implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and require the New York Stock Exchange, NASDAQ and the other self-regulatory organizations (SROs) to develop listing standards that:
- Require that compensation committee members (or board members performing similar functions) be independent;
- Require that (a) compensation committees have the authority to obtain or retain the advice of a compensation consultant, independent legal counsel or other adviser (collectively, “compensation adviser”) and to oversee and direct their work, and (b) issuers provide sufficient funding to compensation committees to enable them to do this;
- Require that compensation committees, in selecting a compensation adviser, consider certain factors relating to the independence of the adviser, and
- Provide certain exemptions from these requirements.
The SROs are required to propose listing standards by Sept. 25, 2012, and must finalize those standards by June 27, 2013.
In addition, the SEC has modified an existing proxy disclosure rule that applies to all public issuers, whether or not listed on an SRO. The modified rule requires issuers to disclose in their annual proxy statements whether the compensation committee has retained or obtained the advice of a compensation consultant, whether the consultant’s work has raised any conflict of interest and, if so, how that conflict is being addressed. The modified requirement applies for annual meetings occurring after Jan. 1, 2013.
Compensation Committee Independence
Under the final rules, each member of an issuer’s compensation committee, or other committee performing executive compensation oversight functions (collectively, “compensation committee”), must be a member of the board of directors and must be “independent” under rules to be developed by the SROs. The final rules do not require that issuers have a compensation committee, but do require that if an issuer does not have a compensation committee, the members of the board of directors who, in the absence of a compensation committee, oversee executive compensation matters on behalf of the board, must be “independent” as well.
In developing standards for “independence,” the SROs must consider relevant factors, including, but not limited to:
- A director’s source of compensation, including any consulting, advisory or other compensation paid by the issuer to the director; and
- Whether a director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.
The SEC contemplates that the standards developed by SROs may not be uniform and has emphasized that SROs have more discretion to develop independence standards for compensation committee members than they previously did in developing independence standards for audit committee members under the Sarbanes-Oxley Act of 2002.
Although no particular standard or relationship automatically results in a director failing to qualify as independent, the SEC states that it expects the SROs to consider whether the independence standards and relationships that result in disqualification for audit committee members should also apply to compensation committee members. However, the SEC has been careful to suggest that at least one prohibited affiliation under the audit committee independence rules – i.e. the prohibition on directors who represent large shareholders from serving on audit committees – may not be appropriate for compensation committees.
The NYSE and NASDAQ independence standards for audit committee members are generally the same, and most compensation committee members would already meet the audit committee standards as a result of having to comply with the existing SRO independence requirements, the Internal Revenue Code Section 162(m) independence requirements and/or the Securities Exchange Act Section 16(b) independence requirements for compensation committees. However, the audit committee standards include a requirement that no audit committee member may be an “affiliated person” of the issuer or any subsidiary of the issuer. An “affiliated person” may include any 10 percent or more shareholder, and any officer, inside director, general partner or managing member of such a shareholder. The SEC has suggested that this requirement may not be appropriate for compensation committees. If the SROs nevertheless decide to apply this standard to compensation committees, then it could prevent some existing compensation committee members from continuing to serve.
In addition, both NASDAQ and the NYSE require that audit committee members meet certain “financial literacy” requirements, and that at least one member of the audit committee have accounting or related financial management expertise. It is unclear whether the SROs may use the current mandate to develop additional independence standards for compensation committee members as an opportunity to impose similar compensation literacy or expertise requirements on compensation committee members as well.
Authority to Retain Compensation Advisers
Part of the Dodd-Frank effort to promote independence of the compensation committee is to give the committee explicit authority to obtain the advice of a compensation consultant, legal counsel and other advisers. The final rules use the term “compensation adviser” to include a compensation consultant, counsel and any other adviser on compensation matters. Primarily for the disclosure rules, there are distinctions between a compensation consultant and any other compensation adviser. We use the term “compensation adviser” to include any of these types of advisers.
Under the new listing standards, a compensation committee:
- May retain or obtain advice of a compensation adviser, at its sole discretion;
- May select a compensation adviser only after taking into consideration a set of independence factors (but the compensation adviser does not have to be independent);
- Will be directly responsible for the appointment, compensation and oversight of any compensation adviser retained; and
- Must have adequate funding from the issuer to pay reasonable compensation to any compensation adviser.
The rules are clear that a compensation committee does not have to:
- Retain a compensation consultant or any other compensation adviser;
- Follow the advice of any compensation adviser that is retained; or
- Retain or obtain advice only from a compensation adviser that is independent.
The SEC was careful to note that a compensation committee may obtain advice from in-house counsel, outside counsel retained by management or a nonindependent compensation consultant engaged by management. The compensation committee would not have responsibility for any of these compensation advisers that are not retained by the committee.
Independence of Compensation Advisers and Related Requirements
The statute includes five independence factors that must be taken into consideration when a compensation committee selects a compensation adviser. The rule adds one additional required factor. The six independence factors are:
- The provision of other services to the issuer by the employer of the compensation adviser (the “employer”);
- The amount of fees from the issuer paid to the employer as a percentage of the employer’s total revenue;
- The policies and procedures of the employer that are designed to prevent conflicts of interest;
- Any business or personal relationship of the compensation adviser with a member of the compensation committee;
- Any stock of the issuer that is owned by the compensation adviser; and
- As added in the rules, any business or personal relationship between the compensation adviser or employer and the executive officers of the issuer.
The SEC has provided some guidance on how these factors should be applied. For example, the SEC has cautioned that no single factor is determinative of independence. The stock ownership factor would apply to any individual (and their immediate family members) who provides services to the compensation committee. The compensation committee does not have to look at these independence factors when receiving advice from in-house counsel, who would never be independent. However, the independence analysis will be required for any outside counsel providing advice to the compensation committee. There are no materiality or numerical tests to be applied. The process for selecting compensation advisers will not need to be disclosed in a proxy.
Exemptions from the New Requirements
Some limited classes of issuers will be exempt from certain of these requirements. The following issuers are exempt from the compensation committee independence standards:
- Limited partnerships;
- Companies in bankruptcy proceedings;
- Registered open-end management investment companies;
- Foreign private issuers that provide annual disclosure to shareholders of why they do not have an independent compensation committee;
- Controlled companies, defined as where more than 50 percent of the voting power for election of directors is held by an individual, group or another company;
- Smaller reporting companies as defined in Exchange Act Rule 12b-2; and
- Any category of issuer exempted by the SRO, as the SRO determines appropriate.
Disclosure Regarding Use of Compensation Consultants
Dodd-Frank added a new requirement that issuers disclose in their annual proxy statements (1) whether the compensation committee has retained or obtained the advice of a compensation consultant and (2) whether the consultant’s work raised any conflict of interest and, if so, how that conflict is being addressed.
It was unclear how the SEC would interpret this requirement, because it has an existing requirement that issuers disclose in their annual proxy statements any role played by a compensation consultant in determining or recommending the amount of executive or director compensation, subject to certain limited exceptions relating to consulting on broad-based, nondiscriminatory plans, or consulting that was limited to providing noncustomized information without giving any advice. The existing SEC disclosure requirement also generally requires disclosure of the fees paid to the consultant, if the consultant provided both compensation consulting services and other services, and if the fees for the other services exceeded $120,000.
The SEC has taken the approach of retaining the existing disclosure requirement and adding a new component to that requirement. Under the revised disclosure requirement, in addition to the disclosures described above, the issuer must disclose any conflict of interest raised by the work of a compensation consultant who provided advice on the compensation of executives or directors, and must describe how that conflict of interest was addressed. As a result, conflicts of interest must be disclosed regardless of whether the compensation consultant was retained directly by the committee or by management, and without regard to the amount of fees received for its services.
Only actual conflicts of interest must be disclosed. The same six factors as described above under the heading “Independence of Compensation Advisers and Related Requirements” are relevant to the determination of whether there is a conflict, although other factors may also be relevant. Even if an issuer concluded that no conflict of interest existed, the SEC staff may expect to see some discussion in the proxy statement regarding the process the issuer went through to reach that conclusion, similar to the staff’s expectations regarding discussion of the process issuers go through in analyzing the risks presented by their compensation policies (as indicated in SEC staff comments on issuer proxy statements after that disclosure requirement became effective).
Effective Dates and Implementation Considerations
As noted above, the SROs will be required to propose their new independence standards by Sept. 25, 2012, and adopt final standards by June of 2013. Because the SEC’s modified disclosure requirement regarding consultant conflict of interest will be in effect for the 2013 proxy season, it is anticipated that the SROs may attempt to finalize their independence standards well before next June so that those standards also will be effective for the 2013 proxy season. As a result, issuers should closely follow the actions of their respective SROs on this issue in the next few months.
Implementing the new listing standards will likely require substantial work. First, committees will need to be educated on the specific independence standards adopted by the issuer’s SRO. Next, the committee will need to consider appropriate procedures for evaluating the independence of existing advisers, adopt such procedures and then engage in an evaluation process. Such an evaluation may cause a committee to determine that it should have access to additional advisers, which would typically involve a separate vetting procedure to select those other advisers. Consequently, issuers should begin considering what processes will be appropriate for preparing their compensation committee to implement the new independence standards when they are finalized.
For more information regarding these rules and the ongoing development of the SRO standards described above, please contact the authors or any other members of McGuireWoods’ executive compensation group or securities law group.