The Securities and Exchange Commission (SEC) has issued proposed rules to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which contains new independence requirements for compensation committees of public companies and their advisors.
The proposed rules would implement the new requirements by:
- Requiring the New York Stock Exchange, NASDAQ and the other self-regulatory organizations (SROs) to adopt a listing standard that compensation committee members (or members of board committees performing similar functions) be independent, and by directing the SROs to develop minimum independence standards that would apply to compensation committee members of any company listed on the exchange;
- Requiring the SROs to adopt a listing standard that (a) compensation committees have the authority to obtain or retain the advice of a compensation consultant, independent legal counsel or other advisor (collectively, “compensation advisor”) and to oversee and direct their work, and (b) issuers provide sufficient funding to compensation committees to enable them to do this;
- Requiring the SROs to adopt a listing standard that compensation committees, in selecting a compensation advisor, consider certain factors relating to the independence of the advisor, and giving the SROs authority to develop any additional independence factors that compensation committees should have to consider in making this selection; and
- Adopting a new proxy disclosure rule that would apply to all public issuers, whether or not listed on an SRO, that would require the 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.
New Independence Standards for Compensation Committee Members
Neither Dodd-Frank nor the proposed rules would require a public company to have a compensation committee. However, as a practical matter, most public companies already do have compensation committees in order to comply with existing SRO listing requirements, Section 16(b) of the Securities Exchange Act of 1934 and Section 162(m) of the Internal Revenue Code.
While the proposed rules require compensation committee members (or members of board committees performing similar functions) to be independent, the proposed rules do not mandate specific independence standards that compensation committee members must meet. Instead, the proposed rules leave it up to the SROs to develop minimum independence standards, based on factors such as the source of a committee member’s compensation and any affiliations the committee member has with the issuer. SROs are required to develop and submit these standards for SEC approval within 90 days after the proposed rules have been finalized.
Compensation committee members already must meet a variety of existing independence requirements pursuant to the same SRO listing requirements, securities and tax laws that have prompted most public companies to have a compensation committee in the first place. It is unclear what additional independence standards the SROs will choose to impose on compensation committee members, but one possibility that many commentators expect, and which the SEC acknowledges in the release regarding the proposed rules, is that the SROs will borrow from the restrictions that currently apply to audit committee members by virtue of Section 301 of the Sarbane-Oxley Act of 2002.
Among other things, the independence standards for audit committee members prohibit a director from serving on the audit committee if the director “controls” the issuer. A director who does not own more than 10% of the voting interests of the issuer (and who is not a director, executive officer, partner or manager of an entity that owns more than 10% of the voting interests of the issuer) is deemed not to be in “control” of the issuer for this purpose. None of the existing compensation committee independence standards, including the SROs’ standards or the applicable securities and tax-related standards, specifically prohibit a compensation committee member from owning stock in the issuer, or from serving as an executive, director, partner or manager of an entity that owns stock in the issuer, regardless of the amount. Thus, if the SROs were to adopt independence standards for compensation committee members that were the same as the independence standards for audit committee members, this may bar certain directors who currently own substantial voting interests in the issuer or who work for entities that do.
Compensation Committee Authority to Retain Compensation Advisors
The proposed rules would give compensation committees the authority to retain and supervise their own compensation consultants, independent legal counsel and other advisors, and would require issuers to provide compensation committees with adequate resources with which to do so.
While Dodd-Frank and the proposed rules specifically refer to “independent” legal counsel, the SEC makes clear in the preamble to the proposed rules that nothing in Dodd-Frank or the proposed rules (1) requires a compensation committee to retain its own legal counsel, (2) prevents a compensation committee from retaining non-independent legal counsel or (3) prevents a compensation committee from obtaining advice from in-house legal counsel or from outside legal counsel retained by management.
Thus, as a practical matter, compensation committees may continue (as is currently generally the case) to be advised on routine compensation-related matters by their in-house counsel or management-retained outside counsel. At the same time, there may be circumstances—such as a special investigation, a merger or acquisition transaction, a matter in which in-house or management-retained outside counsel has been forced to recuse itself because of a potential conflict of interest, a matter that relates to the compensation committee’s own specific duties or obligations, or a matter on which the compensation committee simply wishes to get a second opinion—in which the compensation committee would feel the need to seek its own separate counsel, and in those circumstances Dodd-Frank and the proposed rules give it the authority and resources to do so.
The proposed rules would also require a compensation committee, prior to selecting its own compensation consultant, legal counsel or other advisor, to consider several factors relating to the advisor’s independence. The proposed rules would not actually require a compensation advisor retained by the compensation committee to be independent—only that the compensation committee consider the specified independence-related factors before selecting the advisor. The factors that the proposed rules would require a compensation committee to consider are:
- Whether the person who employs the advisor provides other services to the issuer;
- The amount of fees paid by the issuer to the person who employs the advisor as a percentage of that person’s total revenues;
- Any policies or procedures of the person who employs the advisor designed to prevent conflicts of interest;
- Any business or personal relationship the advisor has with any compensation committee member; and
- Whether the advisor owns any stock of the issuer.
In addition, the SEC has given the SROs the authority to add any additional factors that the SROs may feel are relevant, but has prohibited the SROs from including any factors that would involve any “materiality” or “bright-line” numerical thresholds or cut-offs for independence. Nothing in Dodd-Frank or in the proposed rules would require any public disclosure relating to the committee’s consideration of the independence-related factors prior to selecting a compensation advisor.
New Compensation Consultant-Related Disclosures
The proposed rules would add new public disclosure requirements relating to compensation consultants and any potential conflicts of interest posed by their work. These requirements would apply only to compensation consultants, not to legal counsel or other compensation advisors.
Prior to Dodd-Frank, the SEC already required issuers to publicly disclose in their annual proxy statements any role played by a compensation consultant in determining or recommending the amount of executive or director compensation, with certain limited exceptions relating to consulting on broad-based, non-discriminatory plans, or consulting that was limited to providing non-customized information without giving any advice. The existing disclosure requirements also generally require 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.
Dodd-Frank and the proposed rules expand on the existing disclosure requirements in two material respects: (1) by removing the two exceptions for consulting on broad-based plans and providing only non-customized information, and (2) by requiring, in addition to the fee disclosure already required under the existing rules, disclosure regarding whether the compensation consultant’s work presents any conflicts of interest and, if so, the nature of those conflicts and how they are being addressed.
Disclosure in the second case is only required to the extent the issuer determines that a conflict of interest exists. In determining whether there is a conflict of interest for this purpose, the issuer would be required to consider, at a minimum, the same five independence-related factors discussed above, plus any additional factors specified by the SROs. However, neither the existence of any of these factors, nor the fact that the issuer is required to disclose any fees paid to the consultant, would by itself be determinative of whether there is a conflict of interest. Instead, this would depend on all the facts and circumstances surrounding the engagement.
Even if an issuer concluded that no conflict of interest existed, we note that the SEC staff would likely 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.
Applicability and Effective Dates
Controlled companies are exempted by Dodd-Frank from all of the proposed new listing standards. In addition, limited partnerships, companies in bankruptcy, registered open-end management investment companies and foreign private issuers that provide certain additional disclosures are exempted by Dodd-Frank from the first listing standard discussed above relating to the independence requirements for compensation committee members. Finally, the SEC has given the SROs the authority (subject to SEC approval) to exempt any other category of issuer, including smaller reporting companies, from any or all of the proposed listing standards. The proposed rules relating to compensation consultant disclosures would apply to all public issuers, including smaller reporting companies, controlled companies and companies not listed on an exchange.
The proposed rules relating to listing standards would not become effective until the SROs adopt final standards. The SROs would be required to propose listing standards within 90 days after the SEC issues final rules and to finalize the listing standards within one year after the SEC issues final rules. The proposed rules relating to compensation consultant disclosures would be effective for proxy statements filed after the later of July 21, 2011 or the date on which the SEC issues final rules. The SEC has disclosed that it is planning to issue final rules between August and December of this year.