Issuers listed on the NYSE or Nasdaq should pay close attention to the rules proposed by the exchanges last week because the proposed rules will impact compensation committees; however, the impact may be a “tale of two exchanges” because the impact is more significant to Nasdaq-listed companies. As you may recall, Congress included several provisions in the Dodd-Frank Act to combat perceived public concerns over excessive executive compensation. One provision, say-on-pay, has been implemented, but other more controversial provisions such as executive compensation clawbacks and executive compensation pay ratios have not been implemented. Last week, the exchanges proposed rules to implement the independence requirements for compensation committees required under Dodd-Frank.
As we have mentioned before, Section 952 of the Dodd-Frank Act does not infringe on traditional state corporation law by requiring an issuer to have a compensation committee or to have a compensation committee actually approve executive compensation. Instead, it directs the exchanges to design and implement their interpretations of corporate governance best practices based on the parameters of Section 952. The NYSE and Nasdaq proposed rules are different, and I highlight some of the most important aspects of each of the set of rules below. In general, NYSE-listed companies are impacted significantly less than Nasdaq-listed companies.
The SEC rules implementing Section 952 require that the exchanges’ definition of independence consider relevant factors such as (i) the source of the director’s compensation, including any consulting, advisory, or other compensatory fees paid by the listed company and (ii) whether the director has an affiliate relationship with the company. The two exchanges interpreted the SEC’s rules vastly different.
The NYSE merely maintains its current definition of “independence” and requires the issuer to consider the two additional factors set out by the SEC. In practice, it would be highly unlikely that the two additional factors set out by the SEC would impact a board’s assessment of a particular director’s independence.
Nasdaq’s current definition of “independent director” remains in effect; however, Nasdaq has elected to overlay a separate independence requirement for members of compensation committees in line with the heightened independence standard for audit committees required by Sarbanes-Oxley. This means that for Nasdaq-listed companies, no compensation committee member may accept “directly or indirectly any consulting, advisory, or other compensatory fee” from the issuer. For smaller issuers, particularly community banks where many of the directors may have some business ties with the issuer, aligning the independence definition for compensation committees with the definition for audit committees is problematic. To me, it seems as if Nasdaq was attempting to “out corporate governance” the NYSE by layering on this extra independence requirement, which just makes it more difficult for small- and mid-cap public companies to find qualified directors. The burden simply outweighs any limited improvement in corporate governance.
Both NYSE and Nasdaq have determined that stock ownership, by itself, would not preclude a board from determining that a director was independent, which puts to rest a concern some had raised that large shareholders may have been precluded from participating on the compensation committee. An issuer still must determine whether the director has an affiliation that would impair the director’s judgment.
Committee Composition, Authority of the Committee, and Charter Revisions
Nasdaq-listed companies will now be required to have compensation committees consisting of at least two independent directors. Previously, Nasdaq-listed companies could have a compensation committee or have a majority of its independent directors determine executive compensation (although the latter approach of having independent directors determine executive compensation was not used regularly.) Further, now that issuers are required to maintain compensation committees, those committees must now have formal written charters. At a minimum, the charter must set forth the committee’s responsibilities, including for determining (or recommending to the full board for determination ) executive compensation, prohibiting the CEO from being present during voting or deliberations of his or her own compensation, and providing authority to engage consultants, legal counsel, and other advisors. Again, most Nasdaq-listed issuers already have compensation committees and written charters, but issuers should make sure that the existing charter contains the minimum requirements.
Because the NYSE already required independent compensation committees and mandated certain minimum requirements in formal written charters, there is no impact on NYSE-listed companies.
Compensation Committee Advisors
Neither the exchanges nor the SEC actually requires the compensation committee to retain an independent compensation advisor, but all three will require that the compensation committee conduct an independence analysis beforehand if it does decide to engage an advisor. The factors for the independence analysis for both exchanges is verbatim from what the SEC set forth in its proposed rules, namely the following six factors:
- Whether the compensation consulting company employing the compensation adviser is providing any other services to the company;
- How much the compensation consulting company who employs the compensation adviser has received in fees from the company, as a percentage of that person’s total revenue;
- What policies and procedures have been adopted by the compensation consulting company employing the compensation adviser to prevent conflicts of interest;
- Whether the compensation adviser has any business or personal relationship with a member of the compensation committee;
- Whether the compensation adviser owns any stock of the company, and
- Whether the compensation adviser or the person employing the adviser has any business or personal relationship with an executive officer of the issuer.
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 their proxy statement any conflicts of interest identified by their 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 will need to have a compensation committee of independent directors with a formal written charter, but do not need to comply with the heightened independence requirements or consider the independence of compensation advisors. Any other issuers not subject to the exchange’s compensation committee standards (e.g., controlled companies) continue to be exempt and are exempt from these new rules.
For NYSE-listed companies, the proposed rules would be effective at the earlier of the first annual meeting after January 15, 2014 or October 31, 2014. For Nasdaq-listed companies, the proposed rules would be effective at the first annual meeting in 2014 (and not later than December 31, 2014); however, compensation committees must consider the independence of its compensation advisors immediately upon adoption of the final rules.
What you should do now
If you are a NYSE-listed issuer, this is much ado about nothing. Double check to make sure your directors remain independent under the enhanced independence rules and create a process that ensures that your compensation committee evaluates the independence of the compensation committee. I would suggest adding the independence analysis to the compensation committee charter.
If you are a Nasdaq-listed issuer, there is greater potential impact:
- Review the independence of your directors serving on the compensation committee. Ensure that the committee members do not accept any consulting or other advisory fees from the company. Consider adding this to your year-end D&O questionnaire and your related persons transaction procedures.
- If you are one of the handful of Nasdaq-listed companies without a compensation committee, create one.
- Review your compensation committee charter (or adopt one if necessary) and consider adopting revisions, including adding the required independence analysis to the compensation committee charter.