SEC Proposes Guidance to Stock Exchanges on Compensation Committee and Adviser Independence

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1 SEC Proposes Guidance to Stock Exchanges on Compensation Committee and Adviser Independence Exchanges Will Be Responsible for Details, Including Whether Significant Stock Ownership Will Impact Committee Member Independence Timing of Implementation Depends on Stock Exchange Rulemaking SUMMARY On Wednesday, the Securities and Exchange Commission proposed rules to implement Section 952 of the Dodd-Frank Act, under which the SEC must direct national securities exchanges to incorporate compensation committee and compensation adviser independence requirements into their equity listing standards. Hewing closely to the text of Section 952, the SEC proposal leaves most of the important details, including the definition of independence, to the exchanges to propose. The SEC does, however, propose guidance on some interpretive issues. In particular, the SEC proposes that an exchange may conclude that significant stock ownership or affiliation with a significant stockholder does not preclude independence for purposes of compensation committee membership even though it would preclude audit committee membership. The SEC must approve any final listing standards proposed by the exchanges. The SEC also proposed rules implementing the Section 952 disclosure requirements relating to the use of, and conflicts of interests of, compensation consultants, which would slightly expand existing disclosure requirements for companies that are subject to the U.S. proxy rules. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 Comments on the SEC s proposed rules are due by April 29, Under the Dodd-Frank Act, the SEC must issue final rules by July 16, The SEC has proposed that once these final rules are issued, the national securities exchanges will have 90 days to submit their own proposed listing standards to the SEC and one year to issue final listing standards. BACKGROUND Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010 (the Dodd-Frank Act ), directs the SEC to issue rules requiring national securities exchanges to prohibit the listing of any equity security unless each member of the issuer s compensation committee is independent. The exchanges must also require compensation committees to actively consider the independence of any compensation advisers, such as consultants and lawyers. Listed companies must also disclose any conflicts of interest of compensation consultants providing advice to their compensation committees and give their compensation committees authority and appropriate funding to engage independent advisers. U.S. listed companies are already subject to exchange and SEC rules that address much of what Section 952 covers. The New York Stock Exchange and the NASDAQ Stock Market, for example, already require that executive compensation decisions be made by directors who are independent under their listing standards, which take into account compensation from the listed company and employment, business, familial and other relationships with the company and its auditors. 2 (NYSE rules actually require a formally chartered independent compensation committee of the board, whereas Nasdaq permits oversight of executive compensation by the independent directors as a group, outside a committee structure.) Under existing SEC rules, Exchange Act reporting companies generally must disclose their determinations of director independence, any role of consultants in determining executive compensation and, in some cases, the fees paid to consultants. 3 One important question, then, has been whether Section 952 would be interpreted as a mandate to toughen existing independence requirements for compensation committees where existing standards already potentially meet the requirements of Section 952. IMPACT ON NON-U.S. ISSUERS The compensation committee independence standards would not apply to foreign private issuers under SEC rules that disclose in their annual reports the reasons why they do not have an independent compensation committee. As a practical matter, this would seem to require foreign private issuers listed The SEC s proposing release, Listing Standards for Compensation Committees, Rel. Nos , (Mar. 30, 2011), is available at See NYSE Listed Company Manual 303A, Nasdaq Rule See Item 407 of Regulation S-K (17 CFR ). -2-

3 on U.S. exchanges to determine whether they have independent compensation committees under the standards developed by the relevant stock exchange in order to appropriately formulate the disclosure. Foreign private issuers listed on U.S. exchanges that have a compensation committee would be subject to the requirement that the committee consider the independence of consultants and other advisers. 4 Because foreign private issuers are exempt from the U.S. proxy rules, they would not be subject to the revised proxy disclosure requirements relating to compensation consultants and conflicts of interest. DETAILS OF THE SEC S PROPOSED RULES The SEC proposal parallels Section 952 itself and does not specify minimum requirements or additional factors for the exchanges to consider in formulating their standards for independence of compensation committee members. In taking this approach, the SEC notes that Section 952, unlike the audit committee independence requirements of the Sarbanes-Oxley Act of 2002, does not itself impose minimum independence requirements and instead provides factors for the exchanges to consider. Coverage of the proposed rules. Listing standards under Section 952 apply to the compensation committee of a company with an equity security listed on a national securities exchange, with certain exceptions noted below. The SEC has defined these terms for purposes of its proposal as follows: Compensation committee. A committee of the board of directors that oversees executive compensation is a compensation committee under the proposed rules, even if it is called something else or has additional responsibilities. On the other hand, because Section 952 refers only to compensation committees, the listing rules will not apply to independent directors who oversee executive compensation in lieu of a board committee. The SEC notes that Section 952 does not, and its proposal would not, require a listed company to have a compensation committee, though the exchanges may require this, as the NYSE currently does. Equity security. The SEC uses its existing broad definition of equity security 5 but has proposed that security futures and standardized options issued by a registered clearing agency be excluded for purposes of its rules under Section 952. In addition, although Section 952 uses the phrase any security in place of equity security in one instance, the SEC has concluded that Congress did not intend for Section 952 to apply to issuers that list only debt securities. 4 5 The SEC s proposing release notes that some non-u.s. issuers have a two-tier board, with one tier designated as the management board and the other tier designated as the supervisory or nonmanagement board. The rules would apply to any compensation committee of the supervisory or non-management board. See Exchange Act 3(a)(11) ( The term equity security means any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security.... ). -3-

4 National securities exchange. National securities exchanges are those that are registered as such under Section 6 of the Exchange Act. 6 If an exchange is registered solely for trading security futures, however, its listed securities might all be excluded security futures. Independence of the compensation committee. Under Section 952, compensation committee members must be members of the full board and must be independent. In formulating a definition of independence for these purposes, the national securities exchanges must consider: the source of the director s compensation, including any consulting, advisory or other fees paid by the listed company; and whether the director is affiliated with the listed company or a subsidiary or affiliate. The SEC proposal does not propose specifying any additional factors. The SEC notes that, although Section 952 essentially provides the compensation committee counterpart to the audit committee requirements of Section 301 of the Sarbanes-Oxley Act, Section 301 provides categorical prohibitions, whereas Section 952 provides factors for consideration. The SEC proposal therefore takes a fundamentally different approach for purposes of the compensation committee independence rules than was taken in implementing the Sarbanes-Oxley Act audit committee rules. In particular, the reference in Section 952 to a director affiliated with the listed company has raised concerns that a director who is, or is associated with, a significant stockholder of the listed company would be prohibited from being a compensation committee member, as is the case under Exchange Act Rule 10A-3 for audit committee membership. The SEC has proposed, in response to a number of comments it received, that an exchange may determine that affiliation with a significant investor is not a bar to independence for compensation committee purposes. 7 This approach would be consistent with the existing rules of the NYSE and Nasdaq, each of which expressly provides that ownership of a significant amount of stock is not, by itself, a bar to independence (other than for audit committee members), because the independence that is needed in the compensation committee context is independence from management. The SEC requests comment with respect to this aspect of its proposal. 6 7 Section 952 applies to national securities associations as well as national securities exchanges, but FINRA is currently the only national securities association, and it does not list securities for trading. The audit committee prohibition is designed to prevent the conflict of interest that could occur if a representative of a major stockholder has influence on the company s financial statement reporting, but the same conflict may not arise in the compensation committee context because the major stockholder s interest in having well-designed executive compensation programs is not necessarily different from other stockholders interest. -4-

5 Under Section 952, listed companies must be given a reasonable opportunity to cure any defects before being subject to delisting. The SEC notes that most exchanges, including the NYSE and Nasdaq, already have procedural protections that are likely to be satisfactory for this purpose. 8 Compensation adviser independence factors. Under Section 952, a compensation committee will be able to select a compensation consultant or other adviser, such as legal counsel, only after considering specified independence factors determined by the SEC, although the committee does not need to conclude that the adviser is actually independent. The independence factors set forth in Section 952, and duplicated in the SEC proposal, are: the provision of other services to the listed company by the consultant or other adviser; the amount of fees received from the listed company by consultant or other adviser, as a percentage of the total revenue of the consultant or other adviser; the policies and procedures of the consultant or other adviser that are designed to prevent conflicts of interest; any business or personal relationship of the consultant or other adviser with a member of the compensation committee; and any stock of the listed company owned by the consultant or other adviser. The SEC has not proposed any changes to the statutory independence factors and has not proposed to introduce any bright-line tests or numerical thresholds. 9 Authority and funding to engage compensation consultants and other advisers. Under Section 952, the compensation committee must have sole discretion to retain or obtain the advice of a compensation consultant, independent legal counsel or another adviser, and the listed company must provide appropriate funding as determined by the compensation committee for this purpose. The SEC proposal confirms that the authority to hire independent counsel is not a requirement to do so and does not preclude a compensation committee from retaining legal counsel that is not independent or 8 9 In addition, the SEC has proposed that national securities exchanges cure rules may provide that if a member of a compensation committee ceases to be independent... for reasons outside the member s reasonable control, that person... may remain a compensation committee member of the listed issuer until the earlier of the next annual shareholders meeting of the listed issuer or one year from the occurrence of the event that caused the member to be no longer independent. This tracks the equivalent SEC rule that applies to audit committees. See Exchange Act Rule 10A-3(a)(3) (17 CFR A-3(a)(3)). Section 952 requires that the independence factors be competitively neutral. The SEC, like most commentators, assumes that this means not biased against larger consulting firms, which were unhappy with 2009 amendments to Item 407(e) of Regulation S-K that required disclosure of fees for firms that provided significant services to management in addition to the board. Those firms countered that, because of their size, while they were more likely to provide services to both management and the board, they were less likely to be dependent on revenues from any particular client. The second and third independence factors in the list above appear to have been written in response to these concerns. The SEC has requested comment on whether the listed factors are competitively neutral. -5-

6 obtaining advice from in-house counsel or outside counsel retained by the issuer. The SEC also proposes to provide expressly that compensation committees are not required to follow the advice of any adviser retained and that the authority to retain independent advice does not affect the ability or obligation of the committee to exercise its own judgment. Exemptions from coverage. Section 952 provides that the requirement to have an independent compensation committee need not apply to companies in five specific categories: controlled companies, which are companies that hold board elections in which more than 50 percent of the voting power is held by an individual, a group or another company; 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 why it does not have an independent compensation committee (as discussed above). The SEC proposal would retain these exemptions without modification. The national securities exchanges may also exempt other categories of issuers from the independence requirements or from Section 952 as a whole; they are specifically directed to consider the effects of their listing standards on smaller reporting companies. Controlled companies are exempt from all listing requirements under Section 952, other than the disclosure requirements discussed below. Additional disclosure requirements. Section 952 provides that listed companies disclose in their proxy statements whether: the compensation committee retained or obtained the advice of a consultant; and the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed. The first requirement is similar to an existing SEC disclosure rule, 10 and the second is closely related. Accordingly, the SEC intends to make these disclosure requirements applicable to all Exchange Act reporting companies that solicit proxies for a meeting at which directors are elected, even though these requirements will then go beyond the statute by applying to controlled companies and unlisted reporting companies. 11 Consistent with Section 952, the proposed disclosure rule would apply only to compensation consultants, not to legal counsel or other advisers See Item 407(e)(iii) of Regulation S-K (17 CFR (e)(iii)). The SEC believes that this approach, which will involve amending Section 407(e)(iii) of Regulation S-K, is preferable to having subtly different disclosure requirements for listed companies, on the one hand, and for unlisted companies and controlled companies, on the other hand. -6-

7 The SEC proposal would revise the threshold for compensation consultant disclosure, requiring disclosure if the compensation committee has retained or obtained the advice of a compensation consultant for any purpose, not only if the consultant played a role... in determining or recommending the amount or form of executive and director compensation, which is the language used in the current rule. The proposal would also eliminate the existing exception for disclosure of a compensation consultant engaged solely in connection with non-discriminatory, broad-based plans or engaged to provide non-customized benchmark data. In that case, under the proposal, the company would now be required to identify the consultant, describe the nature and scope of the assignment and instructions given and discuss whether the work raised any conflicts of interest and, if it did, the nature of the conflict and how the conflict is being addressed. The SEC proposal would, however, preserve the existing exception for disclosure of the fees of the consultant engaged solely in connection with broad-based plans or to provide benchmark data. Timing and implementation of final rules. Comments on the SEC s proposed rules are due by April 29, Under the Dodd-Frank Act, the SEC must issue final rules by July 16, The SEC has proposed that once these final rules are issued, the national securities exchanges will have 90 days to submit their own proposed listing rules to the SEC, and one year to issue final listing rules. * * * Copyright Sullivan & Cromwell LLP

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