On June 20, 2012, the Securities and Exchange Commission adopted final rules implementing Section 952 of the Dodd-Frank Act.1 The rules were adopted with some changes from the proposal2 and direct national securities exchanges, including the NYSE and Nasdaq, to adopt rules addressing:
- The independence of compensation committee members;
- Compensation committee authority to retain advisers;
- Compensation committee consideration of the independence of advisers; and
- Compensation committee responsibility for the appointment, compensation and oversight of advisers.
The exchanges are directed to file their rules with the SEC within 90 days after publication in the Federal Register of the SEC’s final rules, and to adopt them within one year of that date. Accordingly, the new rules might be in effect in time for the 2013 proxy season.
The SEC also amended its existing proxy disclosure rules to require, for all companies subject to the proxy rules with annual meetings on or after Jan. 1, 2013, new disclosure about conflicts of interest of compensation consultants.
Independence of Compensation Committee Members
The SEC’s final rules on compensation committee member independence were adopted largely as proposed, except that the SEC directs exchanges to extend the independence rules to members of a listed company’s board of directors who oversee executive compensation matters for companies that do not have a formal compensation committee.3
Exchanges are directed to establish listing standards to require that members of a listed company’s compensation committee be board members and be independent, as defined by the exchange.4 This will be a new definition of “independence” specifically for compensation committees, although what the exchanges propose may resemble their existing definitions for boards in general and for audit committees. Exchanges have flexibility to establish their own definitions of independence, as long as they consider relevant factors in creating their definition, including, but not limited to:
- A director’s source of compensation, including any consulting, advisory or compensatory fee paid by the company; and
- Whether the director is affiliated with the company, a subsidiary or an affiliate of a subsidiary.
Factors the SEC suggests exchanges might also consider include personal and business relationships between members of the compensation committee and the listed company’s executive officers.
One point left open in the proposing release was whether the SEC would require exchanges to make “affiliate” status of a director a bar from service on a compensation committee, as is the case under Sarbanes-Oxley’s audit committee independence rules. Such a rule would have barred directors associated with large stockholders from serving on the company’s compensation committee. While the SEC does direct the exchanges to consider “affiliate” status as a possible factor in devising their independence definitions, no such bar is required and the adopting release notes strong arguments against such a bar.
Compensation Committee Engagement of Advisers
These rules direct exchanges to require that (i) the compensation committee of a listed company may, but is not required to, retain or obtain the advice of a compensation adviser,5 (ii) the compensation committee will be responsible for the appointment, compensation and oversight of services provided by advisers it retains, and (iii) the company must provide funding to compensate advisers retained by the committee. These requirements do not apply to advisors, such as the company’s regular outside counsel, that are engaged by management or the board, rather than the committee, even if they give advice to the committee.
Under the new rules, compensation committees are required to consider the following six “independence” factors when engaging or obtaining advice from compensation advisers:
- Other services to the company provided by the adviser’s firm;
- The amount of fees received from the company by the adviser’s firm, as a percentage of the firm’s total revenue;
- The firm’s policies and procedures designed to prevent conflicts of interest;
- Any business or personal relationship between the adviser and any member of the compensation committee;
- Any company stock owned by the adviser; and
- Any business or personal relationship between the adviser or his or her firm and an executive officer of the company.
The SEC gives two examples of relationships that compensation committees should consider, including the adviser having a familial relationship with the CEO, and the adviser or his or her firm and the CEO being business partners.
The rules do not require a compensation committee to give any weight to any of these factors, and the committee is free to take advice from any adviser, whether or not independent. The compensation committee must consider these factors when engaging both compensation consultants and outside legal advisers, and also when receiving advice from consultants or legal advisers engaged by management. Advice provided by
in-house legal staff, however, is not covered. This new rule will require many law firms who advise compensation committees to provide information to public company clients that they have not provided before.
New Proxy Disclosure Rule Regarding Compensation Consultant Conflict of Interest
Existing proxy rules require a company to disclose whether its compensation committee retained or obtained the advice of a compensation consultant in setting executive and director compensation, along with additional information about such a consultant.
The SEC has added to that requirement an obligation to disclose whether the work of any compensation consultant (which does not include legal counsel) raised any conflict of interest, and, if so, what the conflict is and how it is being addressed. The compensation committee must consider at least the six factors identified above in determining whether a consultant’s work has raised a conflict of interest. The new requirement applies to all companies subject to the proxy rules, including controlled companies, non-listed issuers and smaller reporting companies.
Consistent with the existing disclosure rules, the final rules exempt consultants who provide only advice on broad-based plans or non-customized benchmark data.
The final rules are in many respects consistent with the SEC’s March 2011 proposal, the impact of which many companies have been considering over the past year. While final details will be clarified by the exchanges, companies that have not already done so should begin to consider the independence of their compensation committee members and its advisers, as well as the new disclosure requirements.