This past January, the Securities and Exchange Commission (the SEC) approved new corporate governance listing rules proposed by each of the New York Stock Exchange (the NYSE) and the Nasdaq Stock Market (the NASDAQ) pursuant to the Dodd-Frank Act. The rules pertain to the composition and activities of the compensation committees of NYSE- or NASDAQ-listed companies and begin to take effect as early as July 1, 2013. The new listing rules, which generally exempt controlled companies, smaller reporting companies and certain other companies, as discussed below, govern two principal areas:
• Composition – the NASDAQ rules impose structural compensation committee requirements (which already apply to NYSE-listed companies) and the rules of each exchange impose enhanced independence requirements for compensation committee members; and
• Advisers – the rules require committees to have specific authority to retain advisers and impose responsibilities to evaluate the independence of potential advisers.
COMPENSATION COMMITTEE COMPOSITION
Compensation Committees Required for NASDAQ Companies
The new NASDAQ rules require that each listed company must have a compensation committee comprised of at least two directors, each of whom meets the enhanced independence requirements discussed below. The NASDAQ rules retain the current exception that allows a non-independent director to serve on the compensation committee in exceptional and limited circumstances. Compensation committees of NASDAQ-listed companies now must also have a formal written charter that reflects certain responsibilities and authority enumerated in the NASDAQ rules, including those with respect to advisers discussed below, and must review and assess the adequacy of such charter annually. These structural requirements are effective on the earlier of (1) October 31, 2014 or (2) a company’s first annual meeting after January 15, 2014. NASDAQ-listed companies must certify to the exchange that they have complied with all of the new compensation committee rules no later than 30 days after the applicable deadline. Previously, NASDAQ rules allowed independent directors to oversee compensation matters whether or not organized as a committee.
Enhanced Independence Requirements
Effective on the earlier of (1) October 31, 2014 or (2) a company’s first annual meeting after January 15, 2014, a NYSE- or NASDAQ-listed company must comply with heightened compensation committee independence requirements.
NYSE-listed companies already are required to have compensation committees composed of members that satisfy objective independence criteria applicable to all directors. Pursuant to the new rules, they must now also conduct a subjective evaluation of 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. The NYSE rules provide that such factors include, but are not limited to, (1) the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the listed company to such director, and (2) whether such director is affiliated with the listed company, a subsidiary of the listed company or an affiliate of a subsidiary of the listed company. Commentary to the NYSE rules explains that the subjective analysis should be broad and provides that material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. The commentary notes, however, that the NYSE does not view ownership of even a significant amount of the listed company’s stock, by itself, as a bar to independence. Stock ownership generally is thought to align a director’s interest with shareholders.
NASDAQ-listed companies currently evaluate independence for directors generally pursuant to both objective independence requirements and a subjective determination that the director has no relationship that, in the opinion of the board, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The new NASDAQ rules add two criteria for compensation committee members. First, no member of a compensation committee of a NASDAQ-listed company may accept, directly or indirectly, any consulting, advisory or other compensatory fee from the listed company or any subsidiary of the company, excluding fees for board and committee service and fixed, non-contingent amounts of compensation under a retirement plan for prior service. This prohibition applies only during the director’s term of service on the compensation committee and, unlike the NYSE rules, does not allow any room for the exercise of discretion. Second, like the NYSE rules, the new NASDAQ rules provide that a compensation committee must consider whether a director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company in such a way as would impair the director’s judgment as a compensation committee member. Similar to the NYSE rules, commentary to the NASDAQ rules acknowledges that significant share ownership alone is not necessarily a prohibitive affiliation, as it may be appropriate for certain affiliates, such as representatives of significant shareholders, to serve on the compensation committee where their interests align with other shareholders in seeking an appropriate executive compensation program.
Each of the NYSE and NASDAQ has established a cure period for having an independent compensation committee. If a NYSE-listed company fails to comply with compensation committee composition requirements because a committee member ceases to be independent for reasons outside that member’s reasonable control, that person may generally remain a member of the compensation committee until the earlier of the company’s next annual shareholders’ meeting or one year from the occurrence of the event that caused the failure to comply. Similarly, if a NASDAQ-listed company fails to comply with the compensation committee composition requirements due to one vacancy or due to one member ceasing to be independent due to circumstances beyond the member’s reasonable control, the company must regain compliance by the earlier of its next annual shareholders’ meeting or one year from the occurrence of the event that caused the failure to comply with the rules. However, if the annual shareholder meeting of the NASDAQ-listed company will occur within 180 days of the event that caused the failure to comply, then then company instead will have 180 days from the date of such event to regain compliance.
COMPENSATION COMMITTEE ADVISERS
Authority to Retain Advisers
By July 1, 2013, the compensation committees of a NYSE- or NASDAQ-listed company must have the right and responsibility to (1) in their sole discretion, retain or obtain advice from a compensation consultant, legal counsel or other adviser (a compensation adviser), and (2) be directly responsible for the appointment, compensation and oversight of the work of any such compensation advisers that they retain. The charters of NYSE- and NASDAQ-listed companies must reflect these rights and responsibilities, as well as the related responsibility to evaluate potential conflicts of interest discussed below, though in the case of NASDAQ-listed companies, companies need not update their charters until the earlier of (1) October 31, 2014 or (2) the company’s first annual meeting after January 15, 2014. In addition, NYSE- and NASDAQ-listed companies must provide for appropriate funding, as determined by the compensation committees, for payment of reasonable compensation to a compensation adviser retained by the compensation committee.
Evaluation of Independence of Advisers
Before selecting any compensation adviser, each compensation committee of a listed company must evaluate the following six independence criteria and, in the case of a NYSE-listed company, all other factors relevant to that compensation adviser’s independence from management:
• the provision of other services to the listed company by the person that employs the compensation adviser (the firm);
• the amount of fees received from the listed company by the firm, as a percentage of the firm’s total revenue;
• the policies and procedures adopted by the firm 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 listed company’s stock; and
• any business or personal relationship between an executive officer of the company and the compensation adviser or the firm.
The new rules are clear that compensation committees are free to retain any adviser they choose, regardless of whether such adviser is independent. The NASDAQ rules and the commentary to the NYSE rules both highlight that they do not require actual independence of compensation advisers, only that the compensation committee consider the enumerated independence factors before selecting or receiving advice from a compensation adviser. In fact, the new rules do not require compensation committees to reach an actual conclusion about independence.
Furthermore, neither the NYSE nor the NASDAQ rules require compensation committees to conduct the independence assessment when obtaining advice of in-house legal counsel (or with respect to any compensation adviser whose role is limited to providing advice on broad-based plans or providing non-customized information or customized information not developed by the adviser and about which the adviser does not provide advice). However, if the compensation committee plans to obtain advice from outside legal counsel engaged by management, the compensation committee should perform the independence evaluation with respect to such counsel.
Finally, note that the new rules do not require a company to disclose in its proxy statement or otherwise whether or not legal counsel used by the compensation committee is independent or has an actual or potential conflict of interest, unless the legal counsel has a role in determining or recommending the amount or form of executive and director compensation (typically beyond the scope of legal advice), in which case SEC rules that became effective earlier this year would require proxy statement disclosure of the nature of any actual conflicts of interest raised by the work of legal counsel and how the conflicts are being addressed.
Controlled companies, foreign private issuers and certain other companies remain generally exempt from compensation committee related listing rules of the NYSE and NASDAQ, including the new rules discussed above. Applicable phase-in periods for certain companies, such as those listing in connection with their initial public offerings or emerging from bankruptcy, also continue to apply under each of the NYSE and NASDAQ rules.
Smaller reporting companies are generally exempt from the enhanced independence standards and the responsibility to evaluate the independence of compensation advisers under the new NYSE and NASDAQ rules. In addition, smaller reporting companies listed on the NASDAQ are generally exempt from requirements relating to the retention of compensation advisers and the structural requirement to have a formal compensation committee of at least two members with a written charter.