Final NASDAQ Rule on Disclosure of Third-Party Compensation for Directors and Nominees Includes Important Clarifications and Highlights Related Considerations for All Public Companies

August 4, 2016

On August 1, 2016, the new rule on disclosure of third-party compensation for directors and nominees adopted by The NASDAQ Stock Market LLC ("NASDAQ") took effect. Disclosure will be required in connection with annual shareholder meetings after August 1. Accordingly, for NASDAQ companies with a calendar-year end, no action is immediately required, but they should have the rule on their radar screens as they begin preparations for the next annual meeting season. In addition, we anticipate that third-party compensation will continue to be a focal point for both NASDAQ and New York Stock Exchange (NYSE) companies due to current levels of shareholder activism and as public companies continue to adopt proxy access bylaws, which typically address these arrangements.

The final rule includes a number of welcome clarifications to NASDAQ’s proposal that address important aspects of the rule, including the timing of required disclosures and the rule’s application to directors designated by private equity firms, hedge funds and similar firms. The final rule also includes a new section of commentary that supplements the rule text. A copy of the final rule, which has been added as Rule 5250(b)(3), and the commentary, which is found in Interpretive Material (IM)-5250-2, appears at the end of this alert. NASDAQ filed several versions of the rule proposal with the Securities and Exchange Commission (SEC), and the SEC release approving the final proposal is available here.

Overview of the Final NASDAQ Rule

New NASDAQ Rule 5250(b)(3) requires companies to disclose "the material terms of all agreements and arrangements between any director or nominee for director, and any person or entity other than the Company (the "Third Party"), relating to compensation or other payment in connection with such person’s candidacy or service as a director of the Company." Disclosure must be made no later than the date on which the company files its definitive proxy statement for the next shareholder meeting at which directors are to be elected. The disclosure must be made in the proxy statement or via the company’s website.

Companies need not disclose:

reimbursement of expenses in connection with serving as a nominee; and
compensation paid to employees of private equity funds, hedge funds and other investment firms who routinely serve on the boards of portfolio companies as part of their job duties, if the compensation predates their appointment to a company’s board and the relationship with the firm has been publicly disclosed. Disclosure is required if an individual’s compensation is "materially increased" specifically in connection with the person’s candidacy or service as a director of a NASDAQ company, and in that situation, the difference between the new and previous level of compensation must be disclosed.

Consistent with the proposed rule, the required disclosure must be made until the earlier of the director’s resignation from the board or one year after termination of the agreement or arrangement. The final rule also incorporates a "safe harbor" that protects companies if third-party compensation is not disclosed because a company is not aware of it. Companies would not be in violation of the rule if: (a) they make "reasonable efforts" to identify third-party compensation, including asking each director or nominee in a manner designed to allow timely disclosure; and (b) they disclose any compensation promptly upon discovering it "by filing a Form 8-K . . . where required by SEC rules, or by issuing a press release."

Important Clarifications in the Final NASDAQ Rule

The final rule includes a number of clarifications that were made over the course of several months during which the proposed rule was revised and subject to public comment.

Timing of required disclosures. The final rule provides clarity on several aspects of the timing for disclosure. Specifically:

Under the proposed rule, there was some question about the timing of the initial disclosure, and in particular, whether companies could wait until the next proxy statement to disclose third-party compensation arrangements where the board appointed a director during the year. The final NASDAQ rule clarifies that it does not separately require disclosure of new arrangements at the time they are entered into. Disclosure is required at least annually, no later than the filing of the company’s definitive proxy statement for the next shareholder meeting at which directors are to be elected. The disclosure can be included in the proxy statement or (as discussed below) made via the company’s website. This timing is intended "to provide shareholders with information and sufficient time to help them make meaningful voting decisions," according to IM-5250-2.
However, under SEC rules, for directors appointed outside of a shareholder meeting, Item 5.02(d)(2) of Form 8-K requires disclosure of "any arrangement or understanding between [a] new director and any other persons, naming such persons, pursuant to which such director was selected as a director." Where a company provides the 8-K disclosure, Rule 5250(b)(3)(A) states that separate additional disclosure "in the current fiscal year" is not necessary under the rule. This provides companies with one-time relief from the requirement to provide proxy disclosure, for the fiscal year in which an Item 5.02(d) 8-K announcing the appointment of a new director is filed, if the third-party compensation arrangement was disclosed in the Form 8-K. However, this relief may prove to be largely technical. In this regard, it seems likely that companies would repeat the information in the proxy statement because of the likelihood that shareholders would view it as relevant to the director’s election. Moreover, disclosure would be required in future years because the NASDAQ rule imposes an annual disclosure obligation thereafter.
The final rule contains a similar, one-time disclosure exemption for third-party compensation disclosed during the course of a proxy contest. That is, if a compensation arrangement has already been disclosed "in the current fiscal year" under Item 5(b) of Schedule 14A in the proxy materials distributed by the parties running the proxy contest, the NASDAQ company need not disclose the arrangement in its own proxy materials filed in that fiscal year. Company disclosure would be required the following year if the director is elected to the board and renominated because the disclosure requirement applies for one year after termination of any arrangement. If the compensation arrangement is ongoing, it would be subject to annual disclosure in subsequent years when the director is renominated.

"Material terms" of compensation arrangements. The text of final Rule 5250(b)(3) explicitly limits the disclosure requirement to the "material terms" of third-party compensation or "other payment." IM-5250-2 states that "[t]he terms ‘compensation’ and ‘other payments’ . . . are not limited to cash payments and are intended to be construed broadly." In this regard, the rule applies to any "agreements and arrangements that provide for non-cash compensation and other payment obligations, such as health insurance premiums or indemnification, made in connection with a person’s candidacy or service as a director," as NASDAQ clarified in its final rule proposal filed with the SEC.[1]
Application to directors designated by private equity firms, hedge funds and similar firms. In response to comments asking that NASDAQ clarify the application of the rule to directors designated by investment firms, in part because of the complex arrangements that can exist between these firms and individuals appointed to portfolio company boards, the final rule contains some helpful language clarifications. First, it clarifies that disclosure of arrangements that existed prior to a nominee’s candidacy need not be disclosed if "the nominee’s relationship with the Third Party" (emphasis added) has been publicly disclosed in a proxy statement or annual report (for example, in the individual’s biography). Thus, details of an individual’s employment compensation with an investment firm need not be disclosed in order for this exemption to be available. Second, IM-5250-2 clarifies that disclosure is only required if an individual’s compensation is materially increased "specifically in connection with" candidacy or service as a director of the NASDAQ company. In that case, only the difference between the new and previous level of compensation or other payment obligation needs to be disclosed. Despite the clarification (noted above) that the rule covers indemnification, it is unlikely this will lead to significant disclosure about indemnification arrangements provided by investment firms. Many investment firms grant their director appointees indemnification as an additional layer of protection beyond the indemnification in place at the portfolio company level. However, these arrangements would be part of an appointee’s pre-existing relationship with an investment firm and it is unlikely they would be materially increased in connection with appointment to a specific board.
Website disclosure. The final rule clarifies the timing and substance of disclosure about third-party compensation arrangements if companies choose to make these disclosures via their websites. To the extent disclosure is not required in a company’s proxy statement under SEC rules, Rule 5250(b)(3) permits website disclosure, as long as the disclosure is posted no later than the date on which a company files its definitive proxy statement in connection with the relevant shareholder meeting at which directors are to be elected. Companies can provide disclosure on their own website or by hyperlinking to another website. The disclosure must be continuously accessible. If the website hosting the disclosure becomes inaccessible or the hyperlink becomes inoperable, the company must promptly restore it or make other disclosure in accordance with the rule. The one instance in which the rule does not appear to permit website disclosure is where a company must make remedial disclosure after becoming aware of third-party compensation that it should have disclosed but did not. As noted above and discussed in Rule 5250(b)(3)(C), that disclosure must be made through a Form 8-K "where required by SEC rules" or by issuing a press release.
Foreign private issuers. Existing NASDAQ rules permit a foreign private issuer to follow its home country practices, in lieu of NASDAQ’s corporate governance requirements, if the foreign private issuer fulfills certain conditions in the rules. These include providing disclosure about each NASDAQ requirement a foreign private issuer does not follow and briefly describing the home country practice it follows instead. This approach will also apply to Rule 5250(b)(3).

Relationship to SEC Rules

The overlap between new Rule 5250(b)(3) was discussed at some length by the SEC in its release approving the rule,[2] by NASDAQ and by those who commented on the rule proposal. Both the SEC and NASDAQ noted that there may be some overlap with existing SEC disclosure requirements. These requirements include:

Regulation S-K Item 401(a) (requiring disclosure identifying directors, and arrangements or understandings with any other person (naming the person) pursuant to which they were selected as a director or nominee));
Regulation S-K Item 402(k) (requiring disclosure of all compensation paid to directors "by any person" for all services rendered in all capacities for the company’s last fiscal year);
Item 5(b) of Schedule 14A (discussed above, and requiring proxy disclosure, in contested solicitations, of "any substantial interest, direct or indirect, by security holding or otherwise," of certain persons, including each director nominee and each other participant in the solicitation); and
Item 5.02(d)(2) of Form 8-K (requiring, as discussed above, disclosure of "any arrangement or understanding between [a] new director and any other persons, naming such persons, pursuant to which such director was selected as a director" for a director appointed outside of a shareholder meeting).

In spite of this overlap, in a July 1 letter to the SEC,[3] NASDAQ noted that the "nature, scope and timing of these required disclosures may not in all cases be the same" as the disclosure that would be required by NASDAQ Rule 5250(b)(3). The SEC, in its release approving Rule 5250(b)(3), observed that it is "not unusual" for national securities exchanges to adopt disclosure requirements that supplement or overlap with those applicable under the federal securities laws, and that "it is within the purview of a national securities exchange to impose heightened governance requirements." The SEC also observed that Rule 5250(b)(3) does not require separate disclosure when a company has made NASDAQ-compliant disclosure in its proxy statement under SEC rules.

Relationship to Director Independence

During the period when proposed Rule 5250(b)(3) was under consideration, NASDAQ also conducted a survey and sought feedback on whether to propose additional rules on various aspects of third-party compensation arrangements, including how they may impact independence. NASDAQ officials have since indicated that the exchange has no current plans to proceed with additional rulemaking in this area. However, in the rule proposal, NASDAQ reminded companies about its definition of "independence" for directors, noting that the definition excludes any director with any relationship that, in the opinion of the board, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. Accordingly, boards that are not already doing so should be sure to consider any third-party compensation arrangements in assessing the independence of directors and director candidates. NASDAQ’s rule on compensation committee independence (found in Rule 5605(d)(2)(A)) also specifically requires that boards consider this compensation in assessing whether directors meet the heightened independence criteria applicable to service on the compensation committee.

Conclusion

For NASDAQ companies, preparations for the next annual shareholder meeting will need to include consideration of how Rule 5250(b)(3) may be relevant for them and their directors. It remains to be seen whether the NYSE will follow NASDAQ’s lead and adopt its own rule on third-party director compensation arrangements. However, of relevance to all public companies, in the release approving the NASDAQ rule, the SEC observed that, in addition to certain line-item disclosure requirements of the federal securities laws that may apply (as listed above), the anti-fraud provisions of the proxy rules and Rule 10b-5 under the Securities Exchange Act of 1934 may mandate disclosure of third-party compensation in order to make statements included an SEC filing not misleading in light of the circumstances in which they were made.

In light of the new NASDAQ rule and the cautionary language in the SEC’s release, public companies should review their D&O questionnaires to confirm that the questions are appropriately drafted to obtain potentially relevant information required under both SEC rules and, for NASDAQ companies, new Rule 5250(b)(3). This includes non-cash arrangements and items such as indemnification. In addition, both NYSE and NASDAQ companies that have adopted proxy access, or that have advance notice bylaws or other bylaw provisions addressing third-party compensation, will want to confirm that their D&O questionnaires cover any information addressed in these bylaws.

NASDAQ Rule 5250(b)(3)

Changes are operative on August 1, 2016

5250. Obligations for Companies Listed on The Nasdaq Stock Market

* * * * * *

(b) Obligation to Make Public Disclosure

* * * * * *

(3) Disclosure of Third Party Director and Nominee Compensation

Companies must disclose all agreements and arrangements in accordance with this rule by no later than the date on which the Company files or furnishes a proxy or information statement subject to Regulation 14A or 14C under the Act in connection with the Company’s next shareholders’ meeting at which directors are elected (or, if they do not file proxy or information statements, no later than when the Company files its next Form 10-K or Form 20-F).

(A) A Company shall disclose either on or through the Company’s website or in the proxy or information statement for the next shareholders’ meeting at which directors are elected (or, if the Company does not file proxy or information statements, in its Form 10-K or 20-F), the material terms of all agreements and arrangements between any director or nominee for director, and any person or entity other than the Company (the "Third Party"), relating to compensation or other payment in connection with such person’s candidacy or service as a director of the Company. A Company need not disclose pursuant to this rule agreements and arrangements that: (i) relate only to reimbursement of expenses in connection with candidacy as a director; (ii) existed prior to the nominee’s candidacy (including as an employee of the other person or entity) and the nominee’s relationship with the Third Party has been publicly disclosed in a proxy or information statement or annual report (such as in the director or nominee’s biography); or (iii) have been disclosed under Item 5(b) of Schedule 14A of the Act or Item 5.02(d)(2) of Form 8-K in the current fiscal year. Disclosure pursuant to Commission rule shall not relieve a Company of its annual obligation to make disclosure under subparagraph (B).

(B) A Company must make the disclosure required in subparagraph (A) at least annually until the earlier of the resignation of the director or one year following the termination of the agreement or arrangement.

(C) If a Company discovers an agreement or arrangement that should have been disclosed pursuant to subparagraph (A) but was not, the Company must promptly make the required disclosure by filing a Form 8-K or 6-K, where required by SEC rules, or by issuing a press release. Remedial disclosure under this subparagraph, regardless of its timing, does not satisfy the annual disclosure requirements under subparagraph (B).

(D) A Company shall not be considered deficient with respect to this paragraph for purposes of Rule 5810 if the Company has undertaken reasonable efforts to identify all such agreements or arrangements, including asking each director or nominee in a manner designed to allow timely disclosure, and makes the disclosure required by subparagraph (C) promptly upon discovery of the agreement or arrangement. In all other cases, the Company must submit a plan sufficient to satisfy Nasdaq staff that the Company has adopted processes and procedures designed to identify and disclose relevant agreements or arrangements.

(E) A Foreign Private Issuer may follow its home country practice in lieu of the requirements of Rule 5250(b)(3) by utilizing the process described in Rule 5615(a)(3).

IM-5250-2. Disclosure of Third Party Director and Nominee Compensation

Rule 5250(b)(3) requires listed companies to publicly disclose the material terms of all agreements and arrangements between any director or nominee and any person or entity (other than the Company) relating to compensation or other payment in connection with that person’s candidacy or service as a director. The terms "compensation" and "other payment" as used in this rule are not limited to cash payments and are intended to be construed broadly.

Subject to exceptions provided in the rule, the disclosure must be made on or through the Company’s website or in the proxy or information statement for the next shareholders’ meeting at which directors are elected in order to provide shareholders with information and sufficient time to help them make meaningful voting decisions. A Company posting the requisite disclosure on or through its website must make it publicly available no later than the date on which the Company files a proxy or information statement in connection with such shareholders’ meeting (or, if they do not file proxy or information statements, no later than when the Company files its next Form 10-K or Form 20-F). Disclosure made available on the Company’s website or through it by hyperlinking to another website, must be continuously accessible. If the website hosting the disclosure subsequently becomes inaccessible or that hyperlink inoperable, the company must promptly restore it or make other disclosure in accordance with this rule.

Rule 5250(b)(3) does not separately require the initial disclosure of newly entered into agreements or arrangements, provided that disclosure is made pursuant to this rule for the next shareholders’ meeting at which directors are elected. In addition, for publicly disclosed agreements and arrangements that existed prior to the nominee’s candidacy and thus not required to be disclosed in accordance with Rule 5250(b)(3)(A)(ii) but where the director or nominee’s remuneration is thereafter materially increased specifically in connection with such person’s candidacy or service as a director of the Company, only the difference between the new and previous level of compensation or other payment obligation needs be disclosed.

All references in this rule to proxy or information statements are to the definitive versions thereof.

Adopted July 1, 2016 (SR-NASDAQ-2016-013), operative Aug. 1, 2016.

[1] See File No. SR-NASDAQ-2016-013, Amendment No. 2 (June 30, 2016), available at http://nasdaq.cchwallstreet.com/NASDAQ/Filings/.

[2] See SEC Release No. 34-78223, 81 Fed. Reg. 44400 (July 7, 2016), available here.

[3] See July 1, 2016 Letter from A. David Strandberg III of NASDAQ to Brent J. Fields of the SEC, available at https://www.sec.gov/comments/sr-nasdaq-2016-013/nasdaq2016013-12.pdf.

Gibson Dunn lawyers are available to assist in addressing any questions you may have about these developments. To learn more about these issues, please contact the Gibson Dunn lawyer with whom you usually work, any lawyer in the firm’s Securities Regulation and Corporate Governance practice group, or any of the following practice leaders and members:

Ronald O. Mueller – Washington, D.C. (202-955-8671, [email protected])
James J. Moloney - Orange County, CA (949-451-4343, [email protected])
Elizabeth Ising – Washington, D.C. (202-955-8287, [email protected])
Lori Zyskowski – New York (212-351-2309, [email protected])
Gillian McPhee – Washington, D.C. (202-955-8201, [email protected])
Dennis Friedman – New York (212-351-3900, [email protected])
John F. Olson - Washington, D.C. (202-955-8522, [email protected])

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