04/11/2011

SEC Proposes Rule Regarding Compensation Committees and Compensation Consultants to Implement Provisions of the Dodd-Frank Act

On March 30, 2011, the Securities and Exchange Commission (the SEC) proposed new rules (the Proposed Rule) that would require national securities exchanges to adopt listing standards governing listed issuers’ compensation committees and the use of compensation consultants. The Proposed Rule would also impose certain additional disclosure requirements relating to the use of compensation consultants and conflicts of interest that would apply to all registrants subject to SEC proxy rules, whether listed or not. The Proposed Rule would implement Section 952 of the Dodd-Frank Wall Street Reform Act of 2010 (the Dodd-Frank Act).

The SEC voted unanimously in favor of the Proposed Rule, the full text of which is available here. A brief summary of the Proposed Rule follows below.

Background
The SEC issued the Proposed Rule to implement Section 952 of the Dodd-Frank Act. Section 952 added Section 10C to the Securities Exchange Act of 1934, as amended (the Exchange Act), which requires the SEC to issue rules by July 16, 2011, providing for certain listing standards and disclosure requirements relating to compensation committees and compensation advisers. Section 10C requires the SEC to direct the exchanges¹  to prohibit the listing of any equity security of an issuer, subject to certain exemptions, that does not comply with certain compensation committee and compensation adviser requirements. In addition, Section 10C(c)(2) requires the SEC to adopt new disclosure rules concerning the use of compensation consultants and conflicts of interest.

Under the Proposed Rule, the SEC would:

• Adopt new Exchange Act Rule 10C-1 to implement the listing standards requirements of Section 10C(a)-(g); and
• Adopt rule amendments to Regulation S-K of the Exchange Act to implement the disclosure requirements of Section 10C(c)(2), including revisions to current disclosure requirements relating to the retention of compensation consultants to reflect the Regulation S-K amendments.

The listing standards requirements and disclosure requirements are each summarized separately below.

Listing Standards Requirements
In accordance with Section 10C of the Exchange Act, the Proposed Rule would require exchanges to adopt listing standards to address the independence of the members on an issuer’s compensation committee, the committee’s authority to retain compensation advisers, and the committee’s responsibility for the appointment, payment and work of any compensation adviser.

Scope
In its proposing release, the SEC notes the discrepancy in Section 10C of the Exchange Act with respect to references to issuers subject to the required listing standards. One subsection of Section 10C specifies that the listing requirements apply to issuers with listed equity securities, while another subsection suggests that they apply to issuers with any listed securities. Due to the discrepancy, it is unclear whether Section 10C is intended to apply to issuers with only listed debt securities. Based on legislative history, and the historical treatment of such issuers by the SEC and the exchanges, the SEC believes that the required listing standards in Section 10C are intended to only apply to issuers with listed equity securities and, therefore, the listing standards required under the Proposed Rule would only apply to this type of issuer.

SEC rules currently do not require, nor would the Proposed Rule require, that a listed issuer establish a compensation committee. The SEC notes in the proposing release, however, that current exchange listing standards generally require listed companies either to have a compensation committee or to have independent directors oversee certain executive compensation matters. In light of the foregoing, the listing standards requirements in the Proposed Rule would apply to the compensation committee of a listed issuer, or in the absence of such committee, any other board committee that performs functions typically performed by a compensation committee. The listing standards would not apply to independent directors who perform such functions in the absence of a formal committee structure. The SEC is requesting comments as to whether, among other things, the Proposed Rule should require exchanges to only list issuers with compensation committees.

Independence of Compensation Committee Members
In accordance with Section 10C(a) of the Exchange Act, the Proposed Rule would require exchanges to adopt listing standards that require each member of the compensation committee of the listed issuer to be a member of the board of directors of the issuer and to be independent. Consistent with Section 10C(a), the Proposed Rule would allow exchanges to determine the definition of independence for this purpose, subject to SEC approval.

In determining independence requirements for members of compensation committees, the Proposed Rule would require exchanges to consider relevant factors, including, but not limited to:

• The source of compensation of a member of the board of directors of a listed issuer, including any consulting, advisory or other compensatory fee paid by the issuer to such member of the board of directors; and
• Whether a member of the board of directors of a listed issuer is affiliated with the issuer, is a subsidiary of the issuer or is an affiliate of a subsidiary of the issuer.

In its proposing release, the SEC notes the similarities and differences between the foregoing factors and the factors specified in Section 10A(m)(1) of the Exchange Act used in determining the independence of audit committee members. Although the factors in both situations are similar, the SEC notes that for compensation committees, exchanges are only required to consider the relevant specified factors in developing independence standards for compensation committee members, as compared to audit committees in which the factors listed are relationships that preclude independence of audit committee members. As a result, for compensation committees, exchanges have greater flexibility in establishing their minimum independence requirements after considering the relevant factors listed in Section 10C(a)(1). The SEC declined to propose any additional factors that must be considered in determining such independence requirements, but the SEC is requesting comments as to whether any such additional factors should be included in the final rule. 

Additional Requirements Relating to the Compensation Committee and Compensation Advisers
As required by Section 10C(f) of the Exchange Act, the SEC has proposed rules directing the exchanges to prohibit the listing of any security of an issuer that is not in compliance with the following requirements relating to compensation committees and compensation advisers:

• Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of compensation consultants, independent legal counsel and other advisers (collectively referred to herein as the “compensation advisers”);
• Before selecting any compensation adviser, the compensation committee must take into consideration specific factors (listed below) that affect the independence of compensation advisers;
• The compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser; and
• Each listed issuer must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to compensation advisers.  

In its proposing release, the SEC notes that the Proposed Rule would not require compensation committees to engage compensation advisers, but rather only requires listed issuers to provide such committees with the power to do so, which is consistent with the requirements of Section 10C of the Exchange Act. The Proposed Rule would also provide that the requirements listed above would not require the compensation committee to implement or act consistently with the advice or recommendations of the compensation advisers or otherwise affect the ability or obligation of the compensation committee to exercise its own judgment in fulfillment of its duties.

With respect to independence, the Proposed Rule would require the listing standards to require that compensation committees consider the following independence factors prior to selecting a compensation adviser: 

• The provision of other services to the listed issuer by the person that employs the compensation adviser;
• The amount of fees received from the listed issuer by the person that employs the compensation adviser as a percentage of total revenue of the person that employs the compensation adviser;
• The policies and procedures of the person that employs the compensation adviser 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 listed issuer owned by the compensation adviser; and
• Any other factors identified by the Exchange in its listing standards.

The foregoing independence factors were those factors specified in Section 10C(b) of the Exchange Act. In its proposing release, the SEC notes that Section 10C of the Exchange Act does not require compensation advisers to be independent, but rather only requires the compensation committee to consider factors that may bear upon independence. Under Section 10C(b), these factors must include, at a minimum, the factors listed above, which the SEC believes are generally comprehensive. Given the foregoing, the SEC declined to propose any additional factors or any materiality or bright-line thresholds for applying such factors. However, the SEC is requesting comments as to whether, among other things, additional factors or any thresholds should be included in the final rule.

The Proposed Rule also requires exchanges to adopt listing standards requiring the disclosures discussed below under “Disclosure Requirements,” with respect to compensation consultants and conflicts of interest. As discussed below, although these listing standards would only apply to listed issuers, the disclosure requirements would apply to all Exchange Act registrants subject to SEC proxy rules, whether listed or not.

The Proposed Rule also requires exchanges to establish procedures providing listed issuers with an opportunity to cure any violations of the listing standards.

Exemptions
The Proposed Rule would provide for certain exemptions from all or some of the above requirements as provided in Section 10C of the Exchange Act. The Proposed Rule would exempt “controlled companies” (as defined under the Proposed Rule) from all of the above requirements. In addition to controlled companies, the Proposed Rule would exempt the following categories of issuers from the compensation committee independence requirements listed above: limited partnerships; companies in bankruptcy proceedings; open-end management investment companies registered under the Investment Company Act of 1940; and any foreign private issuer that discloses in its annual report the reasons that the foreign private issuer does not have an independent compensation committee. In addition to these issuer exemptions, exchanges would be allowed to exempt: (i) particular relationships from the independence requirements applicable to compensation committee members, as the exchanges deem appropriate, taking into account the size of an issuer and any other relevant factors; and (ii) any category of issuer from all the above requirements, taking into account the potential impact of the requirements on smaller reporting companies. Any of the foregoing exemptions adopted by the exchanges would be subject to SEC approval.

Disclosure Requirements
Section 10C(c)(2) of the Exchange Act requires that, in any proxy or consent solicitation material for an annual meeting (or a special meeting in lieu of the annual meeting), each issuer must disclose, in accordance with SEC rules, whether the compensation committee retained or obtained the advice from a compensation consultant, and whether the compensation consultant’s work raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

Item 407 of Regulation S-K currently requires Exchange Act registrants that are subject to SEC proxy rules to provide certain disclosures concerning their compensation committees and the use of consultants. Specifically, Item 407(e)(3)(iii) imposes a general requirement on registrants to disclose “any role of compensation consultants in determining or recommending the amount or form of executive and director compensation,” including:

• The identity of the consultant;
• Whether the consultant was engaged directly by the compensation committee or other person; 
• A description of the nature and scope of the consultant’s engagement, and instructions given relating thereto; and
• The aggregate fees paid to the consultant for advice on executive compensation and the aggregate fees for additional services, if the consultant provided both and the fees for the additional services exceeded $120,000 during the fiscal year.

Item 407 does not require disclosures relating to any role of compensation consultants limited to advising on broad-based plans that do not discriminate in favor of executive officers or directors and that is generally available to all employees, or limited to providing information that either is not customized for a particular registrant or is customized based on parameters that are not developed by the consultant, and about which the compensation consultant does not provide advice.

Given the overlap in disclosure requirements between Section 10C(c)(2) and current Item 407, the Proposed Rule would implement the new disclosure requirements under Section 10C(c)(2) by integrating those requirements with existing disclosure requirements under Item 407(e). The requirements would apply to all proxy and information statements for annual meetings (or a special meeting in lieu of an annual meeting) at which directors are to be elected. Furthermore, the requirements would apply to all Exchange Act registrants subject to SEC proxy rules, whether listed or not, and whether they are controlled companies or not.

As compared to the current requirements, the Proposed Rule would result in the following changes:

• The Proposed Rule would change the disclosure trigger from whether a compensation consultant played “any role” in the process of determining or recommending the amount of executive compensation to whether the compensation committee has “retained or obtained” the advice of a compensation consultant;
• The Proposed Rule would require disclosure of whether the work of the consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed; and
• The Proposed Rule would eliminate the current exemptions for advice on broad-based plans or the provision of only non-customized benchmark data (the exemptions would be retained for purposes of fee disclosure). 

The Proposed Rule includes an instruction providing guidance with respect to whether the compensation committee “obtained the advice” of a compensation consultant as contemplated under the Item.  The instruction would clarify that the phrase relates to whether advice was requested or received from a compensation consultant, without regard to whether there is a formal engagement or any payment of fees to the consultant for the advice. The Proposed Rule also includes an additional instruction that references the factors described above with respect to determining the independence of compensation advisers as factors to consider in determining whether the compensation consultant’s work has raised any conflict of interest.

The SEC is requesting comments with respect to the integrated approach described above.

Timing on Final Rule
Comments to the Proposed Rule must be submitted by April 29, 2011. In addition, Section 10C of the Exchange Act requires the SEC to issue rules directing the exchanges to prohibit the listing of issuers not in compliance with Section 10C by July 16, 2011. Although Section 10C does not establish a deadline by which the listing standards adopted by the exchanges must be in effect, the SEC is proposing that exchanges meet certain deadlines to facilitate timely implementation of the final rule. The SEC is requesting that exchanges provide the SEC with proposed rules or rule amendments complying with the final rules within 90 days after publication of the final rule in the Federal Register, and the exchanges would need to have final rules or rule amendments approved by the SEC no later than one year after publication of the SEC’s final rule in the Federal Register. Under the Proposed Rule, the new disclosure requirements would not be required for proxy or information statements filed in definitive form before the effective date of the final rule implementing the requirements imposed by Section 10C(c)(2) of the Exchange Act.

For more information regarding this alert, contact any one of our Corporate Finance attorneys. 

¹The required listing standards under the Proposed Rule would apply to “national securities exchanges” and “national securities associations.” A “national securities exchange” is an exchange registered as such under Section 6 of the Exchange Act. There are currently fifteen such national securities exchanges and they include, most notably, the New York Stock Exchange and The NASDAQ Stock Market. A “national securities association” is an association of brokers and dealers registered as such under Section 15A of the Exchange Act. The Financial Industry Regulatory Authority (“FINRA”) is currently the only registered national securities association. However, FINRA does not list securities. Accordingly, the Proposed Rule would not apply to FINRA. Section 10C of the Exchange Act specifically references national securities associations and, therefore, the listing standards would apply to any registered national securities associations that list equity securities in the future. References in this summary to “exchanges” refer to both national securities exchanges registered under Section 6 of the Exchange Act and any national securities associations registered under Section 15A of the Exchange Act that list equity securities in the future.