Background and Timing

The SEC adopted the new rules in response to the mandate of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC first proposed rules under Section 952 in March 2011.²

This is not the final action relating to the new listing standards. The final SEC rules will become effective 30 days after they are published in the Federal Register, and the national securities exchanges must propose the listing standards that the SEC rules mandate within 90 days after the rules become effective. Listing standards under the new rules must receive SEC approval within one year after the SEC rules become effective. The exchanges’ listing standards will supply additional details and address some questions that remain under the final SEC rules. For example, the listing standards will presumably address how often a committee must consider the factors as to any adviser.

The only new rule that requires additional disclosure applies to annual meetings occurring on or after January 1, 2013.

Highlights of the Final Rules

Independence of Compensation Committee Members
The rules direct national securities exchanges to adopt listing standards that require each member of a listed company’s compensation committee to be “independent.” The rules do not define the term “independent.” Rather, each national securities exchange is to define the term in the listing standards that it adopts after considering relevant factors, including but not limited to the following:

• The source of compensation of a director, including any consulting, advisory, or other compensatory fee paid by the company to such member of the board of directors
• Whether a director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company

Five categories of companies are exempt from this requirement, including controlled companies, limited partnerships, companies in bankruptcy proceedings, open-end management investment companies registered under the Investment Company Act of 1940, and any foreign private issuer that discloses in its annual report the reasons that the issuer does not have an independent compensation committee. The rules also permit the exchanges to exempt particular relationships from the independence requirements.

The rules will apply to board committees that are labeled as “compensation committees,” but they also will apply to other board committees performing functions typically performed by compensation committees, as well as to independent directors who determine the compensation of executive officers even if they are not designated a committee.

There may be a grace period under the exchanges’ listing standards for a director who ceases to be independent, as the SEC rules permit the listing standards to provide that a director who ceases to be independent for reasons outside of the director’s reasonable control may, upon notice to the exchange, remain a member of the committee until the earlier of the company’s next annual shareholders’ meeting or one year from the event that caused the loss of independence.

The requirement to consider compensation of a compensation committee member may not have a significant effect on some listed companies, due to the requirement that currently exists for “outside directors” to approve certain compensation awards to executive officers to preserve tax deductions under Section 162(m) of the Internal Revenue Code. A director is an “outside director” under Section 162(m) if, among other requirements, the director does not receive “remuneration” from the listed company, directly or indirectly, in any capacity other than certain de minimis remuneration. However, for companies that use a subcommittee of the compensation committee to satisfy the requirements of Section 162(m) or are not concerned with the Section 162(m) limitation on tax deductions, new limitations on compensation of compensation committee members may be problematic.

For example, it is possible that the listing standards will preclude a compensation committee member from continuing to serve on the compensation committee if he or she would not satisfy the more stringent independence rules that now apply to audit committee members under Rule 10A-3 of the Securities Exchange Act of 1934, Listing Standards Relating to Audit Committees. This would prohibit a director from serving on the compensation committee if the director’s employer provides professional services to the company due to the prohibition in Rule 10A-3 on audit committee members receiving any consulting, advisory, or other compensatory fee. On the other hand, the SEC made it clear in the release adopting the new rules that it did not believe that the compensation committee independence test that each exchange will outline in its listing standards needs to be as restrictive as the audit committee test.

The requirement to consider whether a member of the compensation committee is an affiliate of the listed company may be problematic for some companies because large shareholders and their representatives could be deemed affiliates by virtue of the size of their shareholdings. Rule 10A-3 prohibits any person who is an affiliated person of the company or any its subsidiaries from serving on the audit committee. It is possible that the national securities exchanges will promulgate listing standards relating to compensation committees that are similar to Rule 10A-3, which would result in “affiliates” and others being deemed to be not independent and, therefore, ineligible to serve on the compensation committee. Since controlled companies will not be subject to this requirement, the problem of compensation committee members being deemed not independent by virtue of their affiliation with large shareholders would likely apply only to compensation committee members who are associated with shareholders who own less than 50 percent of the company’s voting securities. However, the SEC noted that the new rules do not require that the exchanges prohibit all affiliates from serving on a compensation committee. In establishing their standards, exchanges may determine that a prohibition of the type that applies to audit committees is not necessary for compensation committees such that the exchanges would permit certain affiliates, such as representatives of significant shareholders, to serve.

Compensation Committee Authority to Retain Advisors
The rules direct national securities exchanges to adopt listing standards that require the following with respect to a compensation committee’s ability to retain advisers:

• Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, independent legal counsel, or other advisers (collectively, Committee Retained Advisers), although the listing standards need not require a committee to retain its own advisers
• The compensation committee must be directly responsible for the appointment, compensation, and oversight of the work of any Committee Retained Adviser that the committee elects to retain
• Each listed company must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to Committee Retained Advisers that the committee elects to retain

The rules state expressly that they should not be construed to require the compensation committee to implement or act consistently with the advice or recommendations of Committee Retained Advisers or to affect the ability or obligation of the compensation committee to exercise its own judgment in fulfillment of its duties.

As noted, the final rules do not require a committee to retain its own advisers or obtain advice only from “independent” advisers. The SEC expressly acknowledged that a committee may receive advice from non-independent counsel, such as in-house counsel or outside counsel that management has retained, or from a non-independent compensation consultant or other adviser, including those that management engaged. The final rules do not require a committee to be directly responsible for the engagement of compensation advisers that the committee has not retained, such as compensation consultants or legal counsel that management retained. A committee’s direct responsibility to oversee compensation advisers applies only to those advisers that the committee retained.

Compensation Committee Reviews of Factors Impacting Compensation Adviser Independence
The rules also direct national securities exchanges to adopt listing standards that require a compensation committee to take into consideration specified factors before it “selects” any compensation consultant, legal counsel, or other adviser (Compensation Advisers), including any Committee Retained Adviser and any adviser that management or the company has retained, although there is no requirement that a compensation committee only use Compensation Advisers that are in fact independent in the sense that they do not present questions under any of the factors. Neither the rules nor the adopting release defines the term “select,” but the release suggests that, in the SEC’s view, it includes the committee taking advice from the adviser in any way. In addition, neither the rules nor the release indicates how often a committee will need to consider the factors as to any particular adviser. Presumably, final listing standards will add clarity on these subjects.

Compensation committees will be required to consider the following six factors, together with any other factors that an exchange chooses to include in its final listing standards, before selecting a Compensation Adviser:

• The provision of other services to the company by the employer of the Compensation Adviser
• The amount of fees received from the company by the Compensation Adviser’s employer as a percentage of the total revenue of the employer
• The policies and procedures of the Compensation Adviser’s employer that are designed to prevent conflicts of interest
• Any business or personal relationship of the Compensation Adviser with a member of the compensation committee
• Any stock of the company owned by the Compensation Adviser (but not by the employer of the Compensation Adviser)
• Any business or personal relationship of the Compensation Adviser or the Compensation Adviser’s employer with an executive officer of the company

The factors are the same as in the SEC’s proposed rules except for the last factor (any business or personal relationship between a Compensation Adviser or the Compensation Adviser’s employer and executive officers of the company), which was added to the final rules in response to comments on the proposed rules. The potential large size of employers of Compensation Advisers is likely to provide challenges to these employers in addressing this factor. Depending on the content of the forthcoming listing standards, there is likely to be a need to develop processes to generate the information that is necessary for compensation committees to consider the specified factors.

The final rules add an instruction indicating that, while compensation committees need not consider the factors relative to in-house legal counsel, committees must apply the analysis to any other Compensation Adviser (including outside legal counsel) that provides advice to the committee. The adopting release indicates that the SEC expects the analysis to be applied to Compensation Advisers that provide advice to the compensation committee regardless of whether the Compensation Advisers are Committee Retained Advisers or engaged by the company or by management.

The adopting release reiterates and emphasizes that there is no requirement that a compensation committee only use Compensation Advisers that are in fact independent, so long as the committee considers the factors before selecting each Compensation Adviser. The requirement under the rules is merely that the committee must consider the listed factors and any others that are in final listing standards. The rules, moreover, do not include any required weighting of the six factors or any numerical thresholds. The rules also do not require disclosures in any way concerning the independence analysis or conflicts of interest with respect to outside legal counsel or other Compensation Advisers other than compensation consultants.

The SEC’s approach to in-house counsel in this context is telling: “We agree ... that, as in-house counsel are company employees, they are not held out to be independent.” Thus, as to in-house counsel, the SEC believes a compensation committee is on notice that the Compensation Adviser is not disinterested. Forcing the committee to consider the factors as to each other Compensation Adviser ensures that the committee will have the facts to understand up front the level of independence that the committee should expect from that Compensation Adviser so that it can take that understanding into account when it receives the Compensation Adviser’s advice or, if the circumstances warrant, seek an additional or alternative opinion. We do not believe the new rules and forthcoming listing standards will necessarily change how compensation committees use a company’s regular outside legal counsel or other Compensation Advisers (other than compensation consultants). We believe committees have likely understood the extent to which regular outside legal counsel is independent in this context just as they do for in-house counsel. Because the rules do not require independence and, as noted above, there is no related disclosure obligation for Compensation Advisers other than compensation consultants, we believe committees may decide that the independence of their compensation consultants is sufficient and the cost and complexity associated with retaining other Compensation Advisers that are completely independent are not worthwhile except in unusual circumstances. Among other things, the work that a company’s regular outside legal counsel does on compensation matters is often connected in various ways to other work that such counsel does for the company.

Compensation Consultant Conflicts of Interest Disclosure
The rules expand Item 407(e) of Regulation S-K to require additional disclosure in proxy statements for the election of directors regarding any compensation consultant conflicts of interest. Under the final rules (as in the proposed rules), the disclosure requirements will not apply to in-house or outside legal counsel or other Compensation Advisers other than compensation consultants.

Prior to the new rules, companies have been required to disclose, among other things, any role of compensation consultants in determining or recommending the amount or form of executive and director compensation and, under certain circumstances, information about the fees paid to such consultants. As amended, Item 407(e) will require companies to also disclose whether the work of any such consultant raised any conflict of interest. This new requirement will apply to any consultant whose work a company must disclose under the prior disclosure requirements, regardless of who retained the consultant. If a conflict of interest has been raised, the company will need to disclose the nature of the conflict and how the conflict is being addressed. The rules do not define the concept of conflict of interest, but they provide that the six factors cited above are among the factors that should be considered in determining whether a conflict of interest exists. The SEC considered but rejected comments to the effect that the new disclosure requirement should not apply in respect of a consultant with a role only in director compensation.

The final rules will not otherwise expand the disclosure already required of companies under Item 407(e). The proposed rules would have eliminated exceptions to the general disclosure requirements available under the current rules for any role of a compensation consultant that is limited to consulting on certain broad-based plans or to providing non-customized information about which the consultant does not provide advice. This feature of the proposed rules was not included in the final rules, so these exceptions to the disclosure requirements remain available.

Exemption for Controlled Companies and Smaller Reporting Companies
The final rules exempt two categories of companies from the requirements of the new rules (other than the disclosure requirements with respect to compensation consultant conflicts of interest under item 407(e)):

• Controlled companies, defined generally as companies in which more than 50 percent of the voting power for the election of directors is held by an individual, a group, or another company
• Smaller reporting companies, generally including companies with a public float of less than $75 million

Differences From the Proposed Rules

As described above, the final rules are generally similar to the proposed rules, but with some notable differences, including the following:

• Under the final rules, smaller reporting companies are exempt from the independence requirements for committees and the mandatory inquiry into specified factors applicable to the selection of Compensation Advisers
• The rules will apply to board committees performing functions typically performed by compensation committees, as well as to independent directors who determine the compensation of executive officers even if they are not designated a committee
• The final rules add a new factor to the list of factors that listing standards must require compensation committees to consider in respect of their compensation advisers; the new factor is any business or personal relationships of the adviser or the adviser’s employer with any executive officer of the company
• The proposed rules would have eliminated certain exceptions, described above, to the proxy statement disclosure requirements concerning the role played by compensation consultants in setting compensation; the final rules do not eliminate these exceptions

Actions Companies Should Take Now

Companies should begin taking steps now to ensure that they will be able to comply with the required disclosures on compensation consultant conflicts under Item 407(e) in their proxy statements for annual meetings on or after January 1, 2013 and with the new listing standards promptly after they are finalized.

1. Review current compensation committee membership. If they have not done so already, companies should review the current members of their compensation committees to determine if any member would not satisfy the more stringent independence rules that now apply to audit committee members under Rule 10A-3. While the listing standards that the national securities exchanges ultimately adopt may not be as stringent as those under Rule 10A-3, such a review would highlight potential issues now and provide companies with sufficient time to address any concerns.

The new SEC rules require the listing standards that the exchanges ultimately adopt to provide appropriate procedures for a company to have a reasonable opportunity to cure defects before the exchange prohibits the listing of, or delists, a company not in compliance with the new listing standards, so that a company will have time after the listing standards are effective to shuffle committee assignments or appoint a new independent director if necessary. Still, we do not suggest a complacent approach, and in some circumstances a listed company may want to start its process of curing identified issues before the exchange listing standards go into effect.

2. Review current arrangements with compensation consultants for conflicts of interest. Given the disclosure implications, when a company considers its Compensation Advisers, the initial focus should be on the compensation consultants. A company should review its arrangements with its current compensation consultants and any compensation consultants that the committee, the company, or management intends to use in the future to determine the implications of the new SEC disclosure requirement to disclose whether a consultant’s work has raised, or could raise, any conflict of interest (taking into account at least the six factors noted above), the nature of the conflict and how the conflict is being addressed, and the impending new listing standards (based on the SEC mandates to the exchanges). As noted, existing rules already require companies to disclose any role of compensation consultants in executive and director compensation and information about fees to such consultants.

• As an initial matter, a compensation consultant should provide a company with adequate information to facilitate a determination as to whether a conflict exists.
• Once sufficient information has been received, the compensation committee will need to evaluate the information and determine whether a conflict exists in light of the six required factors. Each company and compensation committee should consider whether any disclosure of conflicts will be required in the proxy statement and whether any supplemental disclosures or other actions are desirable to address any conflict involving the consultant. For example, under some circumstances, a company may want to change consultants or add a consultant. However, it is too late to avoid disclosure in the 2013 proxy statement of a conflict as to a consultant that a company used in 2012.
• Going forward, a compensation committee may have as its objective engaging any compensation consultants in a way that will avoid the need to make a disclosure under the new disclosure requirement.

3. Review current arrangements with Compensation Advisers other than consultants to consider on a preliminary basis what might result when the committee reviews the specified factors. A company should review its arrangements with its Compensation Advisers other than compensation consultants to consider on a preliminary basis what the compensation committee might conclude when it reviews the specified factors as to each Compensation Adviser. For many companies, an easy example of a Compensation Adviser that is not a consultant is the company’s regular outside legal counsel, who often assists management and the committee on compensation matters. At this point, it is premature to attempt to have a compensation committee formally consider the specified factors as they relate to a Compensation Adviser because the listing standards to implement the SEC rules are not available. However, as an initial matter, Compensation Advisers should attempt to provide adequate information to facilitate the analysis that the listing standards will require. A company and/or its committee may then consider whether there is information as to any Compensation Adviser that the committee did not already know that is likely to trouble the committee, keeping in mind that there is no requirement that a compensation committee only use Compensation Advisers that are in fact independent in the sense that they do not present questions under any of the factors. If its committee is not involved in this preliminary work, then a company should nonetheless advise the committee of the new rules and perhaps seek preliminary feedback. Of course, if the preliminary work raises valid concerns, then a company and its committee will need to consider what actions to take to address the situation.

4. Review compensation committee charter on authority, responsibility, and funding with respect to advisers. Companies should review their compensation committee charters to determine whether any amendments will be required to satisfy the new requirements for committee authority, responsibility, and funding with respect to Committee Retained Advisers described above. Current NYSE rules already provide that if a compensation consultant is to assist in the evaluation of director or executive officer compensation, then the compensation committee charter should give the committee sole authority regarding engagement of the consultant. Current NASDAQ rules do not require this.

5. Review engagement arrangements with Committee Retained Advisers. As noted, the compensation committee must be directly responsible for the appointment, compensation, and oversight of the work of any Committee Retained Adviser that the committee elects to retain. A company should review the engagement arrangements with any consultant or other Committee Retained Adviser that the committee has elected to retain to ensure the proper level of committee involvement. It is likely that companies have already taken the necessary action with respect to a consultant that is a Committee Retained Adviser. As was also noted, the final rules do not require a committee to retain its own advisers or obtain advice only from “independent” advisers.

¹ See http://www.sec.gov/rules/final/2012/33-9330.pdf.

² See http://www.sec.gov/rules/proposed/2011/33-9199.pdf.