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SEC Adopts Final Rule Under Dodd-Frank Act Regarding Listing Standards for Compensation Committees

June 26, 2012

SEC Adopts Final Rule Under Dodd-Frank Act Regarding Listing Standards for Compensation Committees

On June 20, 2012, the SEC adopted final rules implementing provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”) requiring stock exchanges to adopt listing standards for Compensation Committees. While these rules will not formally affect listed companies until the stock exchanges adopt the necessary listing standards, companies should begin reviewing their compensation committee charter, membership and adviser team to ensure compliance with the new rules.

Similar to the manner in which Sarbanes-Oxley heightened independence and process requirements for audit committees and auditors, the new Dodd-Frank rules will now lead to similar heightened standards for compensation committee members and their advisers.

Applicability of Listing Standards

The final rules do not mandate that stock exchanges require separate committee structure. Certain issuers, usually smaller issuers, will still be free to have executive compensation supervised by independent directors acting on behalf of the full board. However, certain of the standards set forth in the rules, including independence requirements, will apply to any such independent directors as if they were, in fact, a committee.

Independence of Compensation Committee Members

Stock exchanges will be required to adopt listing standards requiring that an issuer’s compensation committee consist solely of independent directors. The final rules require that the stock exchanges consider relevant factors, including:

  • the source of compensation of a board member, including any consulting, advisory, or other compensatory fee; and
  • whether a board member is affiliated with the issuer or its subsidiaries or affiliates of subsidiaries.

As we initially noted when Dodd-Frank was passed, the two major U.S. stock exchanges, the NYSE and Nasdaq, already require members of a compensation committee to meet general independence standards. This new rule will likely lead to a heightened independence standard for compensation committee members.

Authority to Retain Advisers and Counsel

Under the final rules, the exchanges must adopt listing standards providing that:

  • the compensation committee has sole discretion to retain the advice of a compensation consultant, independent legal counsel and other advisers;
  • the compensation committee shall be directly responsible for the appointment, compensation and oversight of the work of any consultant, counsel or other adviser retained by the compensation committee; and
  • the listed company must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation adviser retained by the committee.

Presumably, these powers should be explicitly stated in the committee’s charter.

There is no requirement to retain such advisers, only that committees have the express authority to do so. Further, the rules clarify that the committee retains authority to use its own discretion in making any decision.

Independence of Compensation Committee Advisers

Compensation committees of listed companies must consider several independence factors before engaging an adviser, such as counsel or consultants. At a minimum, committees must evaluate the following six factors:

  • The provision of other services to the issuer by compensation consulting firm, law firm or other adviser;
  • The amount of fees received from the issuer by the compensation consulting firm, law firm or other adviser, as a percentage of the total revenue of such firm;
  • The policies and procedures of the consulting firm, law firm or other adviser that are designed to prevent conflicts of interest;Any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee;
  • Any stock of the issuer owned by the compensation consultant, legal counsel or other adviser (at the individual level, as opposed by the consulting firm or law firm); and
  • Any business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an executive officer of the issuer.

In addition, the stock exchanges may add other factors to be considered in evaluating the independence of advisers to the compensation committee.

Some of the above factors apply to the individuals providing the advice or counsel (stock ownership and personal relationships) and some of the factors apply to the firm employing the adviser (the revenue factor). Some of the key terms, such as “business or personal relationship” or “provision of other services,” are not defined and are potentially very broad.  Obviously, committees will need to add periodic evaluations of adviser independence to their dockets.

Committees should note that these rules do not require that the advisers actually be independent, only that the committee evaluate the enumerated factors when considering an engagement. However, any conflict of interest by a consultant will need to be disclosed in the proxy with an explanation of how the conflict of interest is being addressed.

Cure Periods for Listing Standard Compliance

The exchanges’ listing standards must provide reasonable opportunity for a company to cure noncompliance with this requirement. Among other things, exchanges may (but are not required to) provide that if a member of a compensation committee ceases to be independent for reasons outside the member’s reasonable control, that member, upon notice to the applicable exchange, may remain a committee member until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the member to be no longer independent.

Proxy Disclosures Concerning Consultants and Advisers 

The new rules slightly alter the disclosure requirements related to compensation consultants in an issuer's proxy. Most importantly, as noted above, companies must now disclose in their proxies any conflict of interest by a consultant with an explanation of how the conflict of interest is being addressed. In addition, whereas companies have been subject to requirements to disclose whenever a compensation consultant plays “any role” in determining or recommending the amount or form of executive or director compensation, they must now disclose whether the “compensation committee retained or obtained the advice of a compensation consultant.” For most companies, this will probably be a distinction without a difference.

Implementation Timeline

Exchanges are required to submit their proposed rules within 90 days of the publication of the SEC’s rules.