Compensation committees remain on the hot seat. Stemming from the Dodd-Frank Act, the SEC has adopted rules directing each national securities exchange to require companies with listed equity securities to comply with new compensation committee and compensation advisor requirements. Among other things, these new rules require national securities exchanges to implement listing standards that require :
- each member of a listed company’s compensation committee to be an “independent” director;
- the issuer to consider relevant factors (to be determined by the national securities exchange) including, but not limited to, the source of compensation of a member of the compensation committee member and whether a compensation committee member is “affiliated” with the issuer, subsidiary of the issuer, or an affiliate of the subsidiary;
- an issuer’s compensation committee to have the authority and responsibility to retain compensation advisers and consider the independence of compensation advisers; and
- require issuers to include specified disclosure about the use of compensation consultants and any related conflicts of interest in the proxy materials for their annual shareholders’ meetings.
As we noted when these rules were originally proposed, the SEC has not infringed on the traditional rights of states to define corporate law because these new rules do not require an issuer to have a compensation committee. Rather, the new rules require that the independence rules be applied to committees performing functions typically performed by a compensation committee regardless of the name of the committee (compensation committee, human resource committee, etc.). Under the final rules, the SEC has broadened the independence requirement to apply also to the members of the listed issuer’s board of directors who, in the absence of a compensation committee, oversee executive compensation matters.
The final definition of “independence” for a compensation committee will largely depend on the final rules of each national securities exchange. While each national securities exchange must take into account the factors listed above, each exchange may layer further requirements. It is also critical to note that while the independence requirements for compensation committees under Dodd-Frank are largely similar to the independence requirements for audit committees under Sarbanes-Oxley, there is one significant difference. An audit committee member may not accept certain advisory compensation; however, the exchanges need only consider relevant factors such as certain advisory compensation and whether the director is “affiliated.” I would expect NASDAQ and the NYSE to have somewhat different definitions of independence, particularly with regard to what it means to be “affiliated” with an issuer and how any such affiliation would impair independence. Something critical to many smaller issuers with large shareholders will be whether the large shareholder will be precluded from serving on the compensation committee.
Compensation committees must also have the ability and funding to engage independent advisors. This does not mean that a compensation committee must only engage independent advisors or that it engage any independent advisors at all. Merely the requirement will be that the compensation committee (or the members of the listed issuer’s board of directors who, in the absence of a compensation committee, oversee executive compensation) direct the advisors who they engage and that they consider whether the advisors are independent based on these five factors (in addition to any additional factors required by the exchange):
- whether the advisor provides other services to the issuer;
- amount of fees received from the issuer as a percentage of total revenue of the advisor;
- the policies and procedures of the advisor to prevent conflicts of interest;
- any business or personal relationship of the advisor with a member of the compensation committee or its executive officers; and
- any stock of the issuer owned by the advisor.
These factors will need to be reviewed in their totality; no single factor is determinative. There is no requirement to disclose how the compensation committee selected an advisor.
Lastly, listed issuers will be required to disclose in its proxy statement any conflicts of interest identified by its compensation committee with regard to any advisor regardless of whether the advisor was engaged by the compensation committee, by management, or by any other committee of the Board. The disclosure will need to include how the conflicts of interest are being addressed.
Smaller reporting companies, limited partnerships, companies in bankruptcy proceedings, and controlled companies are exempt from the new requirements. Each exchange may exempt other categories such as for newly listed issuers. In addition, there are some cure periods for compensation committee members who lose their independence for reasons beyond a member’s control.
Exchanges are expected to propose rules within 90 days and implement final rules within one year. Given that timing, it is possible that the new disclosure rules would be in effect before next proxy season. Once the rules are in effect, an issuer must comply with the new rules to maintain its listing.
In practice, these new rules will likely have a minimal impact on issuers. Most issuers with compensation committees will likely already meet the independence requirements. Nevertheless, I would recommend that issuers, if they haven’t done it already, to immediately review their compensation committee composition to determine whether there are any expected problems with complying with the new independence requirements (with the understanding that an issuer’s exchange may strengthen the independence requirements). Compensation committee advisors need to be reviewed for their independence and whether any advisors for compensation matters have conflicts of interest. Compensation committee charters need to be reviewed to ensure that the charter provides the compensation committee the authority to engage independent advisors. Issuers need to be proactive because executive compensation continues to be a hot button item for investors and proxy advisors.