[authors: Wayne A. Wald and Palash Pandya]

On September 25, 2012, the New York Stock Exchange ("NYSE") and the NASDAQ Stock Market ("NASDAQ") each filed proposed changes to their respective listing standards as required by the final rules issued by the Securities and Exchange Commission on June 20, 2012.¹ The final SEC rules were issued pursuant to Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 which directed national securities exchanges to establish listing standards for the independence of compensation committees and compensation advisers. Our Practice Update on the final SEC rules can be found here.

The NYSE's and NASDAQ's proposed listing standards for compensation committee and compensation adviser independence generally reflect the final rules issued by the SEC, although there are certain differences from the final SEC rules, as well as differences between the proposed NYSE listing standards and the proposed NASDAQ listing standards. The proposed NYSE listing standards can be found here. The proposed NASDAQ listing standards can be found here.

Timing

The NYSE and NASDAQ proposed rules must be approved by the SEC by June 27, 2013. NYSE. The proposed NYSE rule changes become effective on July 1, 2013. However, listed companies would have until the earlier of their first annual meeting after January 15, 2014 or October 31, 2014 to comply with the compensation committee independence standards.

NASDAQ. The proposed NASDAQ rule changes relating to (i) a compensation committee's authority and funding to retain advisers and (ii) consideration of independence of a compensation adviser prior to its selection will be effective immediately upon approval of the proposed rules by the SEC. Compliance with the remaining proposed NASDAQ rule changes, including the compensation committee independence requirements, will be required by the earlier of the second annual meeting held after the date of approval by the SEC or December 31, 2014. Listed companies must certify compliance with the applicable requirements no later than 30 days after the applicable implementation deadlines.

Compensation Committee Independence Standards

The final SEC rules require the national securities exchanges to adopt independence standards for compensation committee members considering the following factors: (i) a director's source of compensation, including any consulting, advisory or compensatory fee paid by the issuer, and (ii) whether a director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of an issuer.

NYSE. The current NYSE rules require a director to meet five "bright line" tests for independence.2 Additionally, the board of directors must affirmatively determine that a director has no material relationship with listed company, either directly, as a partner, shareholder or officer of an organization that has a relationship with the listed company. The NYSE proposed rules would add an additional test that would require the board of directors to consider "all factors specifically relevant to determining whether a director has a relationship" to the listed company that is "material to the director's ability to be independent from management" which include the two factors stated above from the final SEC rules.

NASDAQ. The current NASDAQ rules require a director to meet certain tests for independence3, and the board of directors must make an affirmative determination that the independent director does not have a relationship that would interfere with the exercise of independent judgment in carrying out his or her responsibilities. The proposed NASDAQ rules would require listed companies to have a compensation committee consisting of at least two "independent" directors as determined in accordance with the rules described below (rather than the current NASDAQ rules which provide that that executive officer compensation can be determined by either (i) a committee consisting of one or more independent directors or (ii) a majority of the independent directors of the board of directors). The proposed NASDAQ rules also modify one of the tests for independence by requiring that a director cannot receive any consulting, advisory or other compensatory fee from the listed company (other than fees for service as a member of the board of directors or any board committee), which conforms to current audit committee independence requirements. Similar to audit committee independence standards, there is no "look back" period for this prohibition on the receipt of fees.

The proposed NYSE and NASDAQ rules would allow a board of directors to determine that a director with a large equity ownership in the listed company could still meet the independence requirements and serve on the compensation committee as long as such relationship is evaluated as part of the independence requirement.

Compensation Advisers

The final SEC rules provide that the compensation committee of a listed company may, in its sole discretion, retain or obtain the advice of a compensation consultant, independent legal counsel or other advisers (collectively, "compensation advisers"). A compensation committee that retains or obtains the advice of a compensation adviser is directly responsible for the appointment, compensation, and oversight of that adviser. A listed company must provide appropriate funding as determined by the compensation committee to ensure the compensation committee has the necessary funds to pay reasonable compensation to compensation advisers.
The final SEC rules further provide that exchanges must establish listing standards that require a compensation committee to select a compensation adviser only after considering six independence factors.⁴

The NYSE and NASDAQ proposed rules include the six independence factors set forth in the final SEC rules and do not add any additional factors which listed companies must consider when selecting a compensation adviser.

Compensation Committee Charters

NASDAQ. The current NASDAQ rules do not require listed companies to adopt a written compensation committee charter. The proposed NASDAQ rules require each listed company to certify that it has adopted a written compensation committee charter and must specify the following:

• The scope of the compensation committee's responsibilities and how it carries them out;
• The committee's responsibility for determining, or recommending to the board of directors for determination, the compensation of the chief executive officer and the other executive officers;
• That the chief executive officer may not be present during voting or deliberations on his or her compensation; and
• The compensation committee's (i) authority to retain compensation advisers, (ii) authority to fund such advisers and (iii) responsibility to consider the six independence factors mentioned above before selecting such advisers, other than in-house counsel.

A compensation committee must also review and reassess the charter's adequacy annually.

NYSE. The current NYSE rules require compensation committees to have a written charter. The proposed NYSE rules require that the charter must also contain the rights and duties relating to compensation committee advisers described in the final SEC rules.

Opportunity to Cure Defects

The final SEC rules require national securities exchanges to provide appropriate procedures for listed companies (if existing procedures are not adequate) to have a reasonable opportunity to cure any noncompliance with the new listing requirements based on the new rules before they are delisted. The final SEC rules also state that NYSE and NASDAQ rules may provide that if a compensation committee member ceases to be independent for reasons outside the member's reasonable control, that person may remain a compensation committee member until the next annual meeting or one year form the occurrence of the event that caused the member to no longer be independent.

NASDAQ. The proposed NASDAQ rules provide that if a listed 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 listed company will regain compliance by the earlier of the next annual meeting of stockholders or one year from the occurrence of the event that cause noncompliance. If the annual meeting of stockholders occurs no later than 180 days following the event that cause noncompliance, the listed company will instead have 180 days from such event to regain compliance. Therefore, the proposed NASDAQ rules provide a listed company with a period of at least 180 days to cure noncompliance and would typically allow a listed company to regain compliance in connection with its next annual meeting.

NYSE. The proposed NYSE rules would adopt the cure period set forth in the final SEC rules with respect to noncompliance with the proposed compensation committee requirements that are outside of the director's reasonable control, but would limit its use to circumstances where the compensation committee has a majority of independent directors as this would ensure that the committee could not take any action without the agreement of one or more independent directors.

Exemptions

The final SEC rules exempted smaller reporting companies and controlled companies from all of the requirements of the new listing standards. Additionally, a listed company in the following categories cannot be prohibited from listing on an exchange for noncompliance with the compensation committee independence standards:
• Limited partnerships;
• Companies in bankruptcy proceedings;
• Open-end management investment companies registered under the Investment Company Act of 1940; and
• Foreign private issuers that disclose in their annual reports the reasons why they do not have an independent compensation committee.

The final SEC rules also authorized national securities exchanges to exempt a particular relationship from the compensation committee independence requirements as each exchange determines is appropriate, taking into consideration the size of the issuer and other relevant factors.

NASDAQ. The proposed NASDAQ rules relating to compensation committees would also not apply to asset-backed issuers and other passive issuers, cooperatives, limited partnerships, management investment companies and controlled companies. While smaller reporting companies would generally be exempt from the compensation committee requirements under the proposed NASDAQ rules, they must certify that they have a compensation committee comprised of at least two independent directors and that they have adopted a written compensation committee charter or board resolution having the same effect.

NYSE. The proposed NYSE rules relating to compensation committees would also not apply to closed-end and open-end funds registered under the Investment Company of 1940, passive business organizations in the form of trusts, derivatives and special purpose securities and issuers whose only listed equity security is preferred stock. The proposed NYSE rules would not require smaller reporting companies to comply with the modified definition of "independent director". All other proposed rules would apply other than the independence test for the selection of compensation advisers.

What Companies Should Do Now

Listed companies should reevaluate the independence of their compensation committee members and compensation advisers in light of the new rules. Listed companies should consider whether changes to the composition of their compensation committee may be necessary once the final NYSE and NASDAQ listing standards are adopted and become effective. Listed companies will also need to develop or modify procedures to determine relationships between issuers and compensation committee members and compensation advisers, including modifications to director and officer questionnaires. Listed companies should also develop procedures to identify conflicts of interest between issuers and compensation advisers, including with the use of a questionnaire that includes the six independence factors mentioned above. Listed companies should also review their existing compensation committee charter to determine if modifications may be required to the charter. In most instances, some modification will be necessary to a compensation committee charter. Listed companies without compensation committee charters that are listed on NASDAQ should approve a charter prior to the implementation deadlines.

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1. The NYSE amended its proposal on October 2, 2012 to correct an error in the text of its proposed rules relating to transition periods for compensation committee requirements.
2. The tests are: (i) the director is, or has been within the last three years, an employee of the listed company, or an immediate family member is, or has been within the last three years, an executive officer, of the listed company, (ii) the director has received, or has an immediate family member who has received, during any 12-month period within the last three years, more than $120,000 in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service), (iii)(A) the director is a current partner or employee of a firm that is the listed company’s internal or external auditor, (B) the director has an immediate family member who is a current partner of such a firm, (C) the director has an immediate family member who is a current employee of such a firm and personally works on the listed company’s audit, or (D) the director or an immediate family member was within the last three years a partner or employee of such a firm and personally worked on the listed company’s audit within that time, (iv) the director or an immediate family member is, or has been within the last three years, employed as an executive officer of another company where any of the listed company’s present executive officers at the same time serves or served on that company’s compensation committee, (v) the director is a current employee, or an immediate family member is a current executive officer, of a company that has made payments to, or received payments from, the listed company for property or services in an amount which, in any of the last three fiscal years, exceeds the greater of $1 million, or 2% of such other company’s consolidated gross revenues.
3. These include: (i) an executive officer of the company, (ii) a director who is or was in the past three years employed by the company, (iii) a director who accepted or had a family member who accepted compensation from the company exceeding $120,000 during any period of 12 consecutive months within the three years preceding the independence determination, (iv) a director who is a family member of an individual who is or was in the past three years an executive officer of the company, (v) a director who is, or has a family member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three years that exceed the greater of 5% of the recipient’s gross revenues for that year or $200,000, (vi) a director of the company who is, or who has a family member who is, an executive officer of another entity where at any time during the prior three years any of the executive officers of the company serve on the compensation committee of the other entity, or (vii) a director who is, or has a family member who is, a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during the prior three years.
4. The six independence factors are: (i) the provision of other services to the issuer by the person that employs the compensation adviser, (ii) the amount of fees received from the issuer by the person that employs the compensation adviser, as a percentage of the total revenue of the person that employs the compensation adviser, (iii) the policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest, (iv) any business or personal relationship of the compensation adviser with a member of the compensation committee, (v) any stock of the issuer owned by the compensation adviser and (vi) any business or personal relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer.

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