July 2, 2012
On June 20, 2012, the United States Securities and Exchange Commission (the "SEC") adopted rules under Section 10C of the Securities Exchange Act of 1934, as mandated by Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). As mandated by Dodd-Frank, the SEC rules require stock exchanges to adopt listing standards that (1) impose independence requirements on compensation committee members; (2) require companies to authorize compensation committees to retain compensation consultants and other advisers; and (3) require compensation committees to assess the independence of any consultant, legal counsel or other adviser selected by the committee. Stock exchanges have until September 25, 2012, to propose listing standards under these requirements, and must adopt final listing standards no later than June 27, 2013.
The SEC also implemented one provision of Section 10C by amending the corporate governance disclosure rules under Item 407 of Regulation S-K. The new provision requires companies to disclose in their proxy statements whether a conflict of interest was raised by any work performed by a compensation consultant required to be identified under the SEC’s rules, and, if so, to disclose the nature of the conflict and how it was addressed. This disclosure obligation applies to proxy and information statements for annual meetings at which directors will be elected occurring on or after January 1, 2013.
The SEC’s 124-page adopting release is available here.
I. Listing Standards Related to Compensation Committees
As adopted by the SEC, new Rule 10C-1 requires U.S. stock exchanges to adopt listing standards that: (1) establish heightened independence requirements for compensation committee members; (2) require issuers to grant compensation committees the authority to retain, be directly responsible for and pay for compensation advisers; and (3) require the compensation committee to assess the independence of any compensation adviser that provides advice to the committee.
For purposes of the listing standards, the SEC’s rules define the compensation committee as being the committee of a company’s board of directors (in the case of a foreign issuer with two-tier board system, the company’s supervisory or non-management board) that is designated as the compensation committee. In the absence of a committee that is designated as the compensation committee, the rules apply to a committee that performs the functions typically performed by a compensation committee, including the oversight of executive compensation. We expect the NYSE and NASDAQ to interpret this standard to mean the committee or group of independent directors who satisfy the exchanges’ existing requirements with respect to approving or determining executive compensation. If director compensation is set by another committee of the board, it does not appear that the new listing standards will apply to that other committee.
Consistent with Dodd-Frank’s mandate, Rule 10C-1 also requires the stock exchanges’ listing standards to provide issuers an opportunity to cure non-compliance with any of the new listing standards adopted pursuant to these rules.
A. Independence of Compensation Committee Members
Rule 10C-1 requires the stock exchanges to develop a definition of compensation committee member independence, taking into account the following two statutory factors in Exchange Act Section 10C: (1) the source of compensation of compensation committee members; and (2) whether a member of the board of directors of the issuer is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer. In the adopting release, the SEC declined to define the term "affiliate." After hearing conflicting views from commentators as to whether large stock holdings align the interests of compensation committee members with shareholders, the SEC indicated that it would permit the exchanges to determine to what extent affiliates would be able to serve on compensation committees. Rule 10C-1 also permits the exchanges to consider additional factors in developing their definitions of independence.
Although the factors to be considered by the stock exchanges in adopting these listing standards parallel the standards that Sarbanes-Oxley applied to board audit committees, the Dodd-Frank provision and Rule 10C-1 provide greater flexibility. They specify only that the two factors must be considered in establishing compensation committee members’ independence, whereas the Sarbanes-Oxley provision states that audit committee members may not accept any advisory or compensatory fee from an issuer and may not be an affiliated person.
As noted above, the stock exchanges’ listing standards are required to provide procedures for a listed issuer to have a reasonable opportunity to cure any defects that would be the basis for prohibiting the company’s initial or continued listing. The rule adopted by the SEC specifically provides that the listing standards may provide that, if a compensation committee member ceases to be independent for reasons beyond the member’s reasonable control and the company informs its stock exchange, that member may remain on the compensation committee until the earlier of (1) the next annual meeting, or (2) one year from the occurrence of the event that caused the member to be no longer independent.
B. Authority to Retain Compensation Advisers
Rule 10C-1 also requires the stock exchanges to adopt listing standards specifying that a company’s compensation committee must have the authority and sole discretion to retain or obtain the advice of compensation consultants, independent legal counsel, and other advisers (together, "compensation advisers"). In addition, a compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser retained by the committee, and each issuer must provide its compensation committee appropriate funding, as determined by the compensation committee, to reasonably compensate compensation advisers retained by the committee. As adopted by the SEC, the oversight and funding rules apply only to advisers "retained by" the compensation committee, whereas the SEC had originally proposed that these requirements apply to any adviser to the committee.
C. Assessing the Independence of Compensation Advisers
Under Rule 10C-1, the stock exchanges’ listing standards must require that a compensation committee may receive advice from a compensation consultant, legal counsel or other adviser only after it has assessed the compensation adviser’s independence. The adopting release makes clear that a compensation committee is not required to select independent advisers and instead may receive advice from compensation advisers that it determines are not independent.
Section 10C lists five independence factors that must be considered in assessing the independence of compensation advisers, and requires that any other factors specified by the SEC in implementing this provision must be "competitively neutral." Under the rule adopted by the SEC, the stock exchange listing standards will require that a compensation committee may receive advice from a compensation adviser only after it has assessed the adviser’s independence taking into consideration the following six factors:
(1) the provision of other services to the issuer by the person that employs the compensation adviser;
(2) 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;
(3) the policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest;
(4) any business or personal relationship of the compensation adviser with a member of the compensation committee;
(5) any stock of the issuer owned by the compensation adviser; and
(6) any business or personal relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer.
Rule 10C-1 also permits the stock exchanges to identify additional factors for a compensation committee to consider in assessing compensation adviser independence. In the adopting release, the SEC confirmed that all six factors are to be considered in their totality and that no one factor should be viewed as a determinative factor of independence.
The sixth factor was added to the final rule in response to comments because, in the SEC’s view, relationships between an executive officer and a compensation adviser "may potentially pose a significant conflict of interest that should be considered by the compensation committee" in selecting the compensation adviser. In the adopting release, the SEC stated that it did not include materiality or numerical thresholds and did not define the phrase "business or personal relationship" used in factors four and six because it intended compensation committees to consider the facts and circumstances of all business and personal relationships, not just those that meet certain criteria.
The rule requires compensation committees to perform the independence assessment with respect to any compensation adviser that provides advice to the committee, including compensation advisers engaged by management. In the adopting release, the SEC stated, after hearing conflicting views from commentators, that requiring compensation committees to assess the independence of compensation advisers retained by management will be useful to compensation committees in considering the recommendations of management-retained compensation advisers. Compensation committees are not required to conduct an independence assessment of "in-house legal counsel."
The independence assessment requirements of the rules are likely to be the most burdensome and controversial aspect of the SEC’s rulemaking under Section 10C. They require that a review and assessment of independence be conducted by the compensation committee prior to receiving advice from a compensation adviser, and that review must encompass relationships of both the individual providing advice to the committee and the entity that employs that individual. We expect significant interpretive issues to arise under this standard, some of which we expect will be addressed in the context of the stock exchanges’ proposal, review and adoption of listing standards implementing Rule 10C-1. Among those issues are the following:
D. Certain Exemptions
Controlled companies and smaller reporting companies are exempt from the new listing standards. In addition, limited partnerships, companies in bankruptcy proceedings, open-end management investment companies registered under the Investment Company Act of 1940, and certain foreign private issuers are exempt from the compensation committee independence listing standards. The rules also allow the stock exchanges to exempt other categories of issuers from the compensation committee independence requirements, and in the adopting release the SEC specifically noted that the rules will permit the stock exchanges to decide whether any exemptions are appropriate for "emerging growth companies" as defined under the Jumpstart Our Business Startups (JOBS) Act.
II. Proxy Rule Amendment Requiring Disclosure of Compensation Consultant Conflicts
Exchange Act Section 10C(c)(2) requires that, in proxy statements for annual meetings, companies must disclose (1) whether the compensation committee has retained or obtained the advice of a compensation consultant, and (2) whether the work of the compensation consultant has raised any conflicts of interest and, if so, the nature of the conflict and how the conflict is being addressed. Existing Item 407(e)(3)(iii) of Regulation S-K already requires companies to identify any compensation consultants who had a role in determining or recommending the amount or form of executive and director compensation, to state whether such consultants were engaged directly by the compensation committee or by management or any other person and in specified circumstances to provide certain fee and other information with respect to such consultants. The SEC initially proposed combining the two requirements of Exchange Act 10C(c)(2) into the existing Item 407(e)(3)(iii) disclosure requirements. However, after considering comments, the SEC determined instead to retain Item 407(e)(3)(iii) of Regulation S-K and adopt a separate standard under new Item 407(e)(3)(iv) of Regulation S-K that applies to any compensation consultant identified under Item 407(e)(3)(iii). Specifically, new Item 407(e)(3)(iii) requires that companies (1) assess whether the work of any compensation consultants identified pursuant to Item 407(e)(3)(iii) raises any conflicts of interest, and (2) if so, disclose the nature of that conflict and how it was addressed. Notably, the SEC did not define or describe what might be considered to constitute an actual conflict of interest. Senior staff from the SEC Division of Corporation Finance have informally stated that they would not expect these proxy statement disclosures to be common.
In determining whether the work of compensation consultants raises any conflicts of interest, the rule specifies that among the factors to be considered are the six factors, discussed above, required to be considered in assessing the independence of compensation advisers. The conflicts of interest provision does not raise some of the interpretive issues raised under the independence assessment rule discussed above, as it is clear that the conflicts of interest standard applies only for compensation consultants otherwise identified in a company’s proxy statement under existing Item 407(e)(3)(iii), which among other things excludes consultants that only provide advice on broad-based compensation arrangements or that provide certain types of survey data. However, some issues may arise in light of the fact that the six independence factors address relationships of individuals providing advice to a compensation committee, whereas the Item 407(e)(3)(iii) disclosure requirements have been interpreted to apply only to compensation consulting firms.
New Item 407(e)(3)(iv) will apply to any proxy or information statement for any annual meeting at which directors are to be elected occurring on or after January 1, 2013. This disclosure requirement is not dependent on the stock exchanges adopting new listing standards.
III. What Companies Should Do Now
The compensation consultant conflicts of interest disclosure is effective automatically for annual meeting proxy statements filed after January 1, 2013. We suggest that companies begin to:
All of the other provisions addressed in this alert are effective only once the stock exchange on which a company’s stock is listed has adopted listing standards under the new rules. While some of the requirements under Rule 10C-1 for new listing standards are fairly prescriptive and unlikely to be significantly changed in the course of the stock exchanges’ listing standards proposal and adoption process (such as the requirement for compensation committee direct oversight and funding authority), the SEC rules provide the stock exchanges greater flexibility in establishing independence standards, and interpretive issues exist with respect to the independence assessment requirements. Accordingly, companies should evaluate whether to await final stock exchange action on new listing standards before implementing any new procedures or revising relevant documents such as committee charters and director and officer questionnaires, or to start implementing changes before then. That said, companies should plan for a number of actions they need to be ready to take:
 Listing Standards for Compensation Committees, Release No. 33-9330 (June 20, 2012). The rules adopted by the SEC to implement Section 952 of Dodd-Frank were proposed on March 30, 2011 and are described in our March 31, 2011 client memorandum, available here.
 Although the SEC solicited comment on whether to adopt a listing standard requiring boards to have a compensation committee, the SEC did not adopt such a requirement.
 Although Dodd-Frank only requires independence assessments of any compensation adviser selected by the compensation committee, the SEC adopted an instruction interpreting the term "select" more broadly than the term "retained by" the committee, and instead requiring that an independence assessment be conducted "with respect to any compensation consultant, legal counsel or other adviser that provides advice to the compensation committee, other than in-house legal counsel." Instruction to Paragraph (b)(4) of Rule 10C-1(b)(4).
 "Compensation committees may select any compensation adviser they prefer, including ones that are not independent, after considering the six independence factors outlined in the final rule." Release No. 33-9330, text at note 127.
 According to the adopting release, the "competitively neutral" provision required the SEC to address both potential conflicts from large, multi-service compensation consultants that provide "other services" to companies and potential conflicts from boutique compensation consultants that are dependent on revenue from a small number of clients.
 In the adopting release, the SEC states that it considers this factor "to include shares owned by the individuals providing services to the compensation committee and their immediate family members." Release No. 33-9330, text following note 125.
 Rule 10C-1(b)(4). Any such additional factors, however, would have to be approved by the SEC when it approves the exchange’s listing standards and would have to satisfy the "competitively neutral" standard.
 Notably, in the context of the compensation consultant conflicts of interest disclosure provision under Section 10C, discussed below, the SEC had proposed to define the term "obtained the advice," but did not adopt the standard in response to comments noting that the proposed definition was too broad and as stated by the SEC, could result in "unnecessary, and potentially costly, adjustments by issuers and consulting firms." Instead, the SEC determined that its existing disclosure requirement applicable to any compensation consultant that has "any role . . . in determining or recommending" the amount or form of executive or director compensation is consistent with the meaning of the words "retained or obtained" the advice of a compensation consultant in Section 10C. Release No. 33-9330, at part II.C.3.a.
 Again, these factors are: (1) the provision of other services to the issuer by the person that employs the compensation adviser; (2) 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; (3) the policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest; (4) any business or personal relationship of the compensation adviser with a member of the compensation committee; (5) any stock of the issuer owned by the compensation adviser; and (6) any business or personal relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer.
 As noted above, in the adopting release the SEC stated that, in the context of independence assessments, the fifth factor (any stock of the issuer owned by the compensation adviser) applies only to the individual providing advice to a compensation committee and not to the entity that employs that person.
Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you work, or any of the following:
John F. Olson – Washington, D.C. (202-955-8522, email@example.com)
Brian J. Lane - Washington, D.C. (202-887-3646, firstname.lastname@example.org)
Ronald O. Mueller – Washington, D.C. (202-955-8671, email@example.com)
Amy L. Goodman – Washington, D.C. (202-955-8653, firstname.lastname@example.org)
Stephen W. Fackler - Palo Alto, CA (650-849-5385, email@example.com)
Michael J. Collins – Washington, D.C. (202-887-3551, firstname.lastname@example.org)
James J. Moloney - Orange County, CA (949-451-4343, email@example.com)
Elizabeth Ising – Washington, D.C. (202-955-8287, firstname.lastname@example.org)
Sean C. Feller - Los Angeles, CA (213-229-7579, email@example.com)
Gillian McPhee – Washington, D.C. (202-955-8201, firstname.lastname@example.org)
© 2012 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.