On March 30, 2011, the U.S. Securities and Exchange Commission proposed listing standards and disclosure rules to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The proposed rules are available at http://www.sec.gov/rules/proposed/2011/33-9199.pdf.
In seeking to implement the Dodd-Frank Act, the SEC did not take a prescriptive approach but instead deferred to the exchanges to develop (within the Dodd-Frank parameters) their own standards for compensation committee independence and other required matters. The SEC's approval will be required before the listing standards become effective.
The proposed rules:
Section 10C of the Securities Exchange Act of 1934, which the Dodd-Frank Act added, requires the SEC to adopt rules requiring the stock exchanges to prohibit the listing of any equity security of an issuer - other than a controlled company or an issuer in certain other exempt categories - that does not comply with Section 10C's requirements regarding compensation committees and their advisers. To implement Section 10C, the SEC has proposed Rule 10C-1 under the Exchange Act and certain amendments to Regulation S-K Item 407(e)(3)(iii).
The comment period for the proposed listing standard and disclosure rules ends on April 29, 2011, and final rules are expected no later than July 16, 2011.
The exchanges must propose listing standards within 90 days, and adopt them within one year, after publication of the SEC's final rules in the Federal Register. Whether the new listing standards will be in place for the 2012 proxy season depends on how quickly the exchanges propose, and how quickly the SEC approves, the listing standards.
The disclosure requirements regarding compensation consultants and their conflicts of interest will be applicable to proxy statements filed in connection with the election of directors in definitive form after the effective date of the SEC rules.
The listing standards will apply only to companies that have listed equity securities (subject to exemptions for, among others, controlled companies). However, the disclosure amendments regarding compensation consultants and their conflicts of interest will apply to all companies subject to the SEC proxy rules (whether or not listed).
Compensation Committee Independence
Proposed Rule 10C-1(b)(1) requires the exchanges to adopt a listing standard requiring that each member of the compensation committee be (1) a member of the board of directors and (2) independent. The proposed rule also requires the exchanges to develop a standard for determining the independence of compensation committee members. The SEC did not mandate any heightened independence criteria for compensation committee members and has instead left the exchanges to develop the standard. The only requirement of the proposed rule is that, in developing the standard, the exchanges must consider the following factors:
• The source of compensation of the director, including any consulting, advisory, or other compensatory fees paid by the company to such director; and
• Whether the director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.
The SEC is seeking comment on whether the exchanges should be required to consider additional factors, including, for example, business or personal relationships between a compensation committee member and an executive officer.
Applicability Beyond the Compensation Committee
Under Proposed Rule 10C-1(b), the independence standards adopted by the exchanges will apply not only to the compensation committee, but also to any committee of the board "performing functions typically performed by a compensation committee," even if the committee is not designated as a compensation committee or performs other functions as well. Note, however, that the listing standard would not be required to apply to a committee that addresses only director compensation.
Independence Of Consultants And Other Advisers
Neither the Dodd-Frank Act nor the SEC's proposed rules require that compensation consultants, legal counsel or other compensation advisers be independent. However, proposed Rule 10C-1(b)(4) requires the exchanges to develop various factors bearing on the independence of advisers that the compensation committees must consider prior to selecting such advisers. These factors must include the following:
• whether the firm employing the adviser is providing any other services to the company;
• the amount of fees received from the firm employing the adviser, as a percentage of that firm's total revenue;
• what policies and procedures have been adopted by the firm employing the adviser designed to prevent conflicts of interest;
• any business or personal relationship of the adviser with a member of the compensation committee; and
• whether the adviser owns any stock of the company.
The exchanges may adopt additional factors.
Committee Authority Over Consultants And Other Advisers
Proposed Rule 10C-1(b)(2) requires the exchanges to adopt a listing standard requiring that compensation committees have direct and express authority to appoint, compensate and oversee the work of their advisers, in their sole discretion. In addition, the proposed rules require that each company must provide appropriate funding for the payment of reasonable compensation to such advisers as determined by the compensation committee.
Amended Disclosure Regarding Consultants And Conflicts
In addition to proposing Rule 10C-1, the SEC proposed amendments to existing disclosure rules concerning fees paid to and serivices provided by compensation consultants and their conflicts. The proposed amendments are designed to integrate the disclosure requirements of the Dodd-Frank Act with the requirements of Item 407(e) (3)(iii), adopted in December 2009 as part of the SEC's proxy disclosure enhancements.
Disclosure Of Conflicts; Factors To Consider
Under the proposed amendments, once disclosure is required under the new trigger, the scope of the required disclosure will broaden somewhat. The current rules focus on the conflicts that arise when a compensation consultant also receives fees for providing other services to a company, whereas the proposed amendments are more open-ended about conflicts of interest and require companies to disclose "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." In order to provide some guidance to companies as to how to assess whether a conflict of interest exists, a proposed instruction provides that companies should consider, among other things, the same five factors identified above for compensation committees to consider prior to selecting advisers.
The proposed rules also broaden the scope of the disclosure required under Item 407(e)(3)(iii) by eliminating the exclusion applicable to compensation consultants that provide only advice on broad-based plans or non-customized benchmark data.
How To Prepare
• Consider Adopting Adviser Retention Procedures . Companies should consider establishing specific procedures for the compensation committee to follow when retaining its advisers in order to ensure that, when the standard is adopted, the required independence factors are considered. (Five of these factors are already identified and mandatory under the Dodd-Frank Act.) Companies should also consider obtaining, in engagement letters, representations and agreements from their "independent" compensation consultants addressing the five factors.
• Consider Changes to Compensation Consultant Disclosures in Annual Proxy Statements. A company expecting to file its definitive proxy statement for a meeting in connection the election of directors after the effective date of the final SEC rules (expected to be no later than July 16, 2011) should focus on the proposed changes to required disclosures regarding the retention of compensation consultants and conflicts of interest.
• Review Compensation Committee Composition . While it is possible that the exchanges' independence standards will not be in place in time for the 2012 proxy season, companies should begin to review the composition of their compensation committees (and those board members or other committees overseeing compensation functions).
• One issue to be resolved by the exchanges is whether (by analogy to audit committee independence standards) directors who are greater than 10 percent shareholders or who are executive officers of greater than 10 percent shareholders, including private equity funds, will no longer be eligible for compensation committee membership. In the proposing release the SEC expressly recognized that directors who are affiliated with significant investors (such as private equity funds) may be highly motivated to rigorously oversee compensation and that such directors' interests are usually aligned with those of shareholders generally. The SEC gave the exchanges the freedom to determine that, even though affiliated directors are not permitted to serve on audit committees under Rule 10A-3, such a blanket prohibition may be inappropriate for compensation committees, and that certain affiliates, such as representatives of significant shareholders, could be permitted to serve.
• Companies should also review and evaluate the functions of other committees to determine whether the enhanced standards could apply to such directors. The proposing release suggests that only oversight of executive compensation is covered, so that a governance committee that is only responsible for setting director compensation policies would not be subject to the heightened independence standards.
• Nasdaq companies that authorize independent directors to provide oversight of executive officer compensation without being constituted as a compensation committee may wish to consider establishing a compensation committee.
• Review D&O Questionnaires. Once the exchanges' independence standards are adopted, review D&O Questionnaires to determine whether any revisions are required to capture information about relevant relationships.
• Review and Amend Compensation Committee Charters. Once the exchanges' standards are adopted, compensation committee charters should be amended to reflect: (1) any heightened independence requirements as part of committee membership criteria; (2) the authority of the compensation committee, in its discretion, to appoint, compensate and provide oversight of the work of compensation consultants, independent legal counsel and other advisers, and the obligation of the company to provide reasonable compensation to such advisers; and (3) any established policy governing the independence or retention of advisers.
Weil Gotshal & Manges Public Company Advisory Group consists of Howard Dicker, Catherine T. Dixon, Holly Gregory, P.J. Himelfarb, Robert L. Messineo and Ellen J. Odoner. The Group thanks Lyuba Gottser for her contribution to this article. This article is an excerpt from a longer client advisory that can be found at www.weil.com/pubdetail.aspx?pub=10240.