The New York Stock Exchange (NYSE) and the NASDAQ Stock Market (NASDAQ) recently filed with the U.S. Securities and Exchange Commission (SEC) proposed changes1 to their listing standards relating to compensation committees as required by SEC Rule 10C-1.2 In general, neither exchange proposes to (i) significantly alter the minimum listing requirements set forth in Rule 10C-1 or (ii) add any additional factors to be considered in determining director independence for compensation committee purposes or the independence of compensation advisers beyond those in Rule 10C-1.
Among other things, SEC Rule 10C-1 required each U.S. stock exchange to develop its own definition of “independence” for serving as a member of a compensation committee after considering all relevant factors, including the following (together, the Rule 10C-1 Independence Factors):
the source of a director’s compensation, including any consulting, advisory or other compensatory fee paid by the issuer to such director; and
whether a director is affiliated with the issuer, an issuer’s subsidiary or an affiliate of an issuer’s subsidiary.
Existing NYSE and NASDAQ director independence requirements, including the existing “bright line” prohibitions for director independence, will continue to apply to the determination of the independence of compensation committee members, although the board will also be required to consider the Rule 10C-1 Independence Factors in making such determination. However, the NASDAQ proposal, in contrast to the NYSE proposal but consistent with the NASDAQ requirements for audit committee member independence, would establish a “bright line” prohibition for determining director independence for compensation committee purposes that the director not receive, directly or indirectly, any consulting, advisory or other compensatory fees from the issuer, other than fees received as a member of the compensation committee, the board of directors or other board committee or the receipt of fixed amounts under a retirement plan.
The NASDAQ proposal also includes additional changes to its compensation committee requirements not directly required by SEC Rule 10C-1, including a requirement that NASDAQ listed companies, including smaller reporting companies, have a separate compensation committee composed of at least two independent directors to determine compensation of the CEO and all other executive officers. The NASDAQ and NYSE proposed rules are subject to public notice and comment and final listing standards must be approved by the SEC no later than June 27, 2013. To comply with the proposed new listing requirements, listed issuers should consider the action items detailed below.
Implications for Canadian Issuers
Both the NYSE and NASDAQ proposals maintain their existing exemption for foreign private issuers. Accordingly, as with most other NASDAQ and NYSE governance listing standards, Canadian foreign private issuers will be allowed to follow their home country practice in lieu of the revised listing rules relating to compensation committees. Canadian foreign private issuers relying on this exemption must disclose in their annual report filed with the SEC (or if not required to file a Form 20-F with the SEC, disclose on their web site) the ways in which their practices differ from the applicable exchange’s requirements.
However, where a Canadian foreign private issuer does not comply with the revised compensation committee composition and independence requirements, under the NASDAQ proposal but not the NYSE proposal, the Canadian foreign private issuer will be required to disclose the reasons why it does not have an independent compensation committee.3 In addition, Canadian foreign private issuers that intend to comply with the new listing requirements will likely need to amend their compensation committee charters in order to comply with the new rules and implement procedures and processes to comply with the compensation adviser independence assessment requirements of Rule 10C-1 and the new listing standards.
NASDAQ Proposed Listing Standards
Compensation Committee Composition, Independence and Size; Exception and Cure Period
Under the NASDAQ requirements, the compensation of executives must be determined, or recommended to the board of directors by a compensation committee comprised solely of independent directors. Although current NASDAQ requirements also permit the compensation of executives to be determined by independent directors constituting a majority of the board’s independent directors in a vote in which only independent directors participate, the proposed rule changes would eliminate this alternative, thereby requiring all NASDAQ listed companies to have a standing compensation committee. In addition, under the proposal, NASDAQ will now require that the compensation committee be comprised of at least two independent directors.
In determining independence, the proposed rules will continue the current requirements that the director not fail any of the independence “bright line” prohibitions set forth in NASDAQ Rule 5605(a)(2) which remain unchanged and that the board of directors make an affirmative determination that the independent director does not have any relationships that, in the opinion of the board, would interfere with the director’s exercise of independent judgment in carrying out its responsibilities as a director.
In response to the first of the Rule 10C-1 Independence Factors, the NASDAQ proposal would, like its audit committee requirements, prohibit compensation committee members from receiving, directly or indirectly, any consulting, advisory or other compensatory fees from the issuer or any subsidiary, other than fees received as a member of the compensation committee, the board of directors or other board committee or the receipt of fixed amounts under a retirement plan (including deferred compensation) for prior service provided that such compensation is not contingent in any way on continued service.4 This prohibition on receipt of consulting, advisory or other compensatory fees begins when the director’s term of service on the committee begins and does not contain any look-back period as are contained in the “bright line” prohibitions.
With regard to the second Rule 10C-1 Independence Factor relating to affiliation considerations, no bright line test is proposed but the board of directors will be required to consider a compensation committee member’s affiliations with the company, a subsidiary of the company or an affiliate of the subsidiary of the company in determining the eligibility of that member to be on the compensation committee.5 In performing this analysis, the board’s consideration of affiliation begins when the director’s term of service on the committee begins and does not contain any look-back period as are contained in the “bright line” prohibitions.
Under the proposed rules, NASDAQ would retain the existing “exceptional and limited” exception that allows one non-independent director to serve on the compensation committee for up to two years if the compensation committee consists of at least three members and the non-independent director is not currently an executive (or family member of an executive) of the company and the board determines that it is in the best interests of the company and its shareholders to have that director serve on the compensation committee. The exception will be available even for a director who fails to meet the Rule 10C-1 Independence Factors. The current disclosure requirements will continue to apply to a company relying on this exception.
NASDAQ proposal provides companies with an opportunity to cure defects in the composition of compensation committees. If a company fails to comply with the compensation committee composition requirements due to one vacancy, or one compensation committee member ceases to be independent due to circumstances beyond the member’s reasonable control, the company is required to regain compliance by the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the noncompliance. However, if the annual shareholders meeting occurs no later than 180 days following the event that caused the noncompliance, the company shall instead have 180 days from such event to regain compliance.
Compensation Committee Charter; Compensation Adviser Requirements
NASDAQ will require each listed company to certify that it has adopted a formal written compensation committee charter. Companies must also certify that their compensation committees will review and reassess the written charter on an annual basis. These requirements are similar to the current requirements imposed on audit committees. The written charter must now specify:
the scope of the compensation committee’s responsibilities including how it will carry out its functions, the structure of the committee, the committee’s processes and membership requirements;
the compensation committee’s responsibility for determining, or recommending to the board for determination, the compensation of the chief executive officer and all other executive officers of the company;
that the chief executive officer may not be present when the committee deliberates or votes on his or her salary; and
the specific compensation committee responsibilities and authority required by SEC Rule 10C-1 relating to the (i) authority to retain compensation consultants, independent legal counsel and other compensation advisers; (ii) authority to fund such advisers; and (iii) responsibility to consider the six independence factors specified in Rule 10C-16 before selecting such advisers, other than in-house legal counsel (the “Compensation Adviser Requirements”).7
Like the SEC, NASDAQ emphasized that a compensation committee is not required to retain an independent compensation adviser; rather, a compensation committee is required only to conduct the independence analysis described in Rule 10C-1 before selecting a compensation adviser.
General Exemptions; Modified Rules for Smaller Reporting Companies
The applicability of the proposed rule and disclosure requirements to foreign private issuers is described above. NASDAQ is also proposing to continue to exempt controlled companies, asset-backed issuers and other passive issuers, cooperatives, limited partnerships and management investment companies from the compensation related listing rules.
In order to lessen the burden on smaller reporting companies, NASDAQ is proposing to exempt smaller reporting companies from complying with the Rule 10C-1 Independence Factors of its revised compensation committee rules. Further, smaller reporting companies are allowed to include the content of their compensation committee charters in a board resolution. While smaller reporting companies must still specify the same content in their charters as other companies, they are exempted from having to include the Compensation Adviser Requirements in their committee charters.
Phase in Schedules
NASDAQ’s existing phase-in schedules for companies listing in connection with an initial public offering, companies emerging from bankruptcy, companies ceasing to be controlled companies and companies transferring from other markets for compliance the requirements relating to compensation committee composition remain generally unchanged under the proposed rule. However, none of the phase-in schedules apply to the requirement to adopt a formal written compensation committee charter. NASDAQ also proposes to apply the same phase-in schedule for a company ceasing to be a smaller reporting company that it applies to a company listing in conjunction with its initial public offering.
The proposed rule relating to compliance with the Compensation Adviser Requirements would be effective immediately following SEC approval of the rule. The remaining provisions of the proposed rule, including compensation committee independence requirements, would become effective on the earlier of the company’s second annual meeting held after the date of approval of the proposed rules, or December 31, 2014.
NYSE Proposed Listing Standards
Compensation Committee Member Independence; Cure Period
In determining independence, the proposed rules will continue the current requirements that the director not fail any of the independence “bright line” prohibitions set forth in Section 303A.02 (b) of the NYSE Listed Company Manual which remain unchanged and that the board of directors make an affirmative determination that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). In addition, in affirmatively determining the independence of any director who will serve on the compensation committee, under proposed new Section 303A.02(a)(ii), the board of directors must consider all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to, the Rule 10C-1 Independence Factors.
New commentary to be added in the proposed rules states that when considering the sources of a director’s compensation in determining independence for compensation committee purposes, the board should consider whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the listed company’s executive compensation.8 Similarly, when considering affiliate relationships in determining independence for compensation committee purposes, the board should consider whether the affiliate relationship places the director under the direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair his ability to make independent judgments about the listed company’s executive compensation. The rule filing confirms the NYSE’s existing position that ownership of even a significant amount of stock, by itself, does not act as a bar to an independence determination.
The proposed rules include a cure period if a listed company fails to comply with the compensation committee composition requirements but, in contrast to the NASDAQ proposal, limits the use of the cure period only to situations in which a member of the compensation committee ceases to be independent for reasons outside the member's reasonable control. In such situations, upon prompt notice to the NYSE and only so long as a majority of the members of the compensation committee continue to be independent, such director may remain a member of the compensation committee until the earlier of the next annual shareholders' meeting of the listed company or one year from the occurrence of the event that caused the member to be no longer independent. This cure period only applies with respect to compensation committee independence.
Compensation Committee Charter; Compensation Adviser Requirements
Current NYSE rules already require that the compensation committee adopt a formal written charter covering specified matters and the NYSE noted that the required powers of the compensation committee under Rule 10C-1(b) relating to authority to retain compensation consultants, independent legal counsel and other compensation advisers and authority to fund such advisers are in significant part already required by NYSE Rule 303A.05(b). For clarity and emphasis, the NYSE proposes to adopt all of the Compensation Adviser Requirements specified in Rule 10C-1(b) verbatim as part of a new Section 303A.05(c) and amend Section 303A.05(b) to remove the comparable requirements and require that the committee charter contain all the rights and responsibilities set forth in new Section 303A.05(c).
Accordingly, new Section 303A.05(c) would also require that, before engaging a compensation committee adviser, the compensation committee must consider “all factors relevant to the person’s independence from management,” including the six compensation adviser independence factors set forth in SEC Rule 10C-1 which would be included in the new section without any changes or addition of other factors. Like SEC Rule 10C-1, the proposed NYSE rule would indicate that a compensation committee is not required to hire an independent adviser or follow the advice of any adviser it does hire. The committee also does not have to analyze independence when obtaining advice from in-house counsel to the company, consistent with the Rule 10C-1.
General Exemptions; Modified Rules for Smaller Reporting Companies
The applicability of the proposed NYSE rule and disclosure requirements to foreign private issuers is described above.9The NYSE is also proposing to continue to exempt from all of its compensation committee listing requirements the existing classes of exempt companies: controlled companies, limited partnerships and companies in bankruptcy, closed-end and open-end funds, passive business organizations in the form of trusts, derivatives and special purpose securities, and issuers whose only listed equity security is a preferred stock.
The NYSE is proposing to exempt smaller reporting companies from compliance with the compensation committee member independence requirements set forth in proposed Section 303A.02(a)(ii), including the Rule 10C-1 Independence Factors. In addition, smaller reporting companies will be exempt from the compensation adviser assessment requirements of proposed Section 303A.05(c). Smaller reporting companies must comply with all other compensation committee requirements in the amended rules.
Phase in Schedules
The NYSE’s existing phase-in schedules for companies listing in connection with an initial public offering, spin-off or carve-out, companies emerging from bankruptcy, companies ceasing to be controlled companies or a foreign private issuer and companies transferring from other markets for compliance with the compensation committee composition requirements remain generally unchanged under the proposed rule. To the extent a company ceases to qualify as a smaller reporting company, it will be required (i) to have a compensation committee in which all of the members meet the independence standard of proposed Section 303A.02(a)(ii) within six months of its ceasing to be a smaller reporting company under SEC rules and (ii) to comply with compensation committee independent adviser assessment requirements as of the date it ceases to be a smaller reporting company under SEC rules.
Subject to SEC approval, the final NYSE rules will become effective on July 1, 2013. NYSE listed companies will have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new compensation committee director independence standards contained in Section 303A.02(a)(ii). The proposed rule relating to compliance with the Compensation Adviser Requirements would be effective immediately following SEC approval of the rule.
Action Items Relating to New Compensation Committee Requirements
In preparation for the new compensation committee listing standards and potential proxy statement disclosures required by Rule 10C-1, amendments to Regulation S-K Item 407(e) and the proposed new NASDAQ and NYSE listing standards, companies and their board of directors should consider the following action items.
1. Revise Director and Officer Questionnaires to:
obtain information regarding the Rule 10C-1 Independence Factors.
capture information about business or personal relationships with compensation advisers (compensation consultants, legal advisors and other advisors) for purposes of complying with the new compensation adviser independence assessment, as well as to assess whether conflict of interest disclosure under new Item 407(e)(iv) of Regulation S-K10 is required with respect to compensation consultants. For example, the questionnaire should elicit responses regarding (1) any business or personal relationship of the compensation adviser with a member of the compensation committee and (2) any business or personal relationship of the compensation adviser or the firm employing the adviser with an executive officer of the company.
2. Review Compensation Committee Charter and revise as necessary to:
include as a part of the duties and responsibilities of the compensation committee, the evaluation of conflicts of interest with any compensation consultant in accordance with new Item 407(e)(iv) of Regulation S-K.
include the Rule 10C-1 Independence Factors as part of the compensation committee member independence determination.
provide that, as a part of the duties and responsibilities of the committee, the committee will undertake the independence assessment of compensation advisers who provide advice to the committee.
include the authority of the compensation committee to appoint, compensate and oversee the work of compensation advisers, and the obligation of the company to provide reasonable compensation to such advisers.
reflect that the chief executive officer must not be present when the committee discusses or votes on his or her compensation.
3. Dealing with Compensation Advisers
As part of a company’s disclosure controls and procedures, companies should establish specific policies and procedures for the compensation committee to follow prior to retaining or receiving advice from a compensation consultant, legal counsel or other advisor. Some possible approaches to the foregoing would be to:
prior to obtaining advice from a new compensation adviser, and annually for each existing compensation adviser, gather information using a questionnaire covering the six independence factors and, with respect to compensation consultants, requiring a description of any conflicts of interest policies of the compensation adviser’s employer, and consider the responses at a compensation committee meeting.
require compensation advisers to conduct an independence assessment and, in the case of compensation consultants conflict of interest assessment, and to report on the results of such assessment and any facts considered in the course of that assessment to the committee, either in the engagement letter or a separate report to the committee for consideration at a compensation committee meeting.
obtain representations and agreements from compensation advisers addressing the independence factors in engagement letters; or
discuss directly with each compensation adviser what processes are already in place to assess the six independence factors identified in Rule 10C-1 and consider whether additional information is needed from compensation consultants in order to be able to perform the conflicts of interest assessment.
With respect to compensation consultants, companies should put procedures such as one or more of those discussed above in place as soon as possible so that the compensation committee can assess whether any conflict of interest exists and take any remedial actions, if desired, prior to when proxy disclosure is first required in connection with its 2013 stockholders meeting. In that connection, the compensation committee should discuss with legal counsel how disclosure of any conflicts of interest will appear in its 2013 proxy statement and the committee should consider whether that conflict rises to a level that would necessitate (or cause the company to consider) engaging a different compensation consultant.
The disclosure controls and procedures referred to above should include documenting the evaluation process, including detailing in committee minutes the independence factors considered and determinations made for each compensation adviser or, in the case of potential Item 407(e)(iv) disclosure, the factors considered and determinations made for each compensation consultant in respect of a conflicts of interest.
4. Review Compensation Committee Composition and Consider Independence
Companies should evaluate the independence of current members of the compensation committee under the proposed revised standards and begin to make preparations, subject to the final NYSE and NASDAQ listing rules, to replace members who are determined to not be independent under the new standards.
1 New York Stock Exchange, Form 19b-4 Proposed Rule Change by New York Stock Exchange (Sept. 25, 2012), amended by New York Stock Exchange, Amendment No. 1 to Form 19b-4 Proposed Rule Change by New York Stock Exchange (Oct. 1, 2012); The NASDAQStock Market LLC, Form 19b-4 Proposed Rule Change by NASDAQStock Market (Sept. 25, 2012).
2 Rule 10C-1 was adopted by the SEC under the Securities and Exchange Act of 1934 (Exchange Act) in June 2012 to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Exchange Act Section 10C). For a detailed discussion of the requirements of Rule 10C-1 and related changes to Regulation S-K Item 407(e), see our July 2012 Corporate Review update entitled SEC Adopts Final Rules on Listing Standards for Compensation Committees.
3 The NYSE will not require foreign private issuers to explain why their company does not have an independent compensation committee as the NYSE believes the company will likely reiterate that they are not required to under the laws of their home country.
4 In this regard NASDAQnoted that two of the “bright line” tests would prohibit a finding of independence if the director received compensatory fees in excess of certain thresholds. See NASDAQ Rule 5605(a) (2) (B) and (D). Thus, under current rules, receipt of compensation below these amounts would not prohibit a finding of independence for compensation committee purposes but would have for audit committee purposes. NASDAQ determined that there was no compelling reason to have different independence standards for audit and compensation committee purposes with respect to the acceptance of compensatory fees.
5 NASDAQconsidered whether compensation committee members should meet the same standard applicable to audit committee members under SEC Rule 10A-3 and NASDAQlisting standards which prohibit a director from serving on the audit committee if he or she is an affiliate of the company, subject to certain exception. However, NASDAQ concluded that such a blanket prohibition would be inappropriate for compensation committees, specifically noting that “it may be appropriate for certain affiliates, such as representatives of significant stockholders, to serve on compensation committees since their interests are likely aligned with those of other stockholders in seeking an appropriate executive compensation program.”
6 The independence criteria specified in Rule 10C-1(b)(4) are:
the provision of other services to the company by the firm employing the compensation adviser;
the amount of fees received from the company by the firm employing the compensation adviser, as a percentage of that firm’s total revenue;
the policies and procedures adopted by the firm employing 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;
the compensation adviser’s ownership of the company’s stock; and
any business or personal relationships between the company’s executive officers and the compensation adviser or the firm employing the adviser.
7 NASDAQconsidered whether to adopt other independence factors that a compensation committee would be required to consider before retaining a compensations committee adviser, but concluded that the six independence factors enumerated in Rule 10C-1 provided compensation committees with a broad and sufficient range of facts and circumstances to consider in making an independence determination.
8 Existing commentary which remains unchanged states that boards of directors should broadly consider all relevant facts and circumstances and that in assessing the materiality of a director's relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation.
9 Foreign private issuers that follow home country practice and rely on the exemption from the proposed new compensation committee requirements will still be required to comply with Section 303A.11 which requires foreign private issuers to disclose any significant ways in which their corporate governance practices differ from those followed by domestic companies under NYSE listing standards. Foreign private issuers that are required to file an annual report on Form 20-F must include their statement of significant differences in that annual report. All other foreign private issuers may either (i) include the statement of significant differences in an annual report filed with the SEC or (ii) make the statement of significant differences available on or through the listed company’s website.
10 For a discussion of this new requirement, see our Osler Corporate Review referred to in footnote 2.
11 The instruction to SEC Rule 10C-1 clarifies that the independence assessment should occur for any compensation adviser “that provides advice to the compensation committee, other than in-house counsel.” Furthermore, the SEC in the adopting release to Rule 10C-1 stated that it does not matter who retained the compensation adviser and that it could apply to outside legal counsel, compensation consultants or other advisers retained by management or the issuer. In addition, the new Regulation S-K Item 407(e)(3)(iv) disclosure requirements relating to compensation consultants conflicts of interest are required with respect to any compensation consultant for which disclosure is required under Item 407(e)(3)(iii) of Regulation S-K which requires specified disclosures with respect to compensation consultants who had any role in determining or recommending the amount or form of executive and director compensation, whether such consultants were engaged directly by the compensation committee or any other person. Accordingly, the new Item 407(e)(3)(iv) disclosure also applies to compensation consultants retained by the compensation committee or management of the issuer.