As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the Securities and Exchange Commission (SEC) adopted on June 20, 2012 new and amended rules regarding the compensation committees of exchange listed public companies. According to SEC Chairman Mary L. Schapiro, "[the new rules] will help to enhance the board’s decision-making process on executive compensation matters, particularly the selection, engagement and oversight of compensation advisors, and will provide more transparency with respect to conflicts of interest of consultants engaged by boards.”

In effect, the new rules will impose requirements with respect to the composition and function of compensation committees not unlike those imposed on audit committees pursuant to the Sarbanes-Oxley Act of 2002. For the most part, the new rules direct the stock exchanges to implement new listing standards. As a result, the ultimate impact of these rules cannot be determined until the new listing standards are established. The new SEC rules take effect 30 days after publication in the Federal Register and require that the exchanges provide to the SEC their proposed new rules within 90 days after such publication date, with  final standards to be in place one year after such publication date.

Summary of the New Rules

The new listing rules, set forth in new Rule 10C-1 under the Securities Exchange Act of 1934, as amended (Exchange Act) and adopted under new Section 10C of the Exchange Act as added by Section 952 of Dodd Frank, require exchange listing standards for issuers of listed equity securities to address:

• The independence of the members on a compensation committee. The exchanges must establish independence requirements for compensation committee members. While neither Dodd Frank nor the new rules specify particular independence standards, the exchanges must consider relevant factors, including but not limited to:
  • the source of compensation of a board member who is to serve on the compensation committee, including consulting, advisory or compensatory fees paid by the issuer to such member; and
  • whether the such board member is affiliated with the issuer.

In response to comments from the venture capital and private equity community, the SEC specifically noted that the new rules are not intended to prevent per se a director affiliated with a shareholder of the issuer from serving on a compensation committee; within the broad limits described above, the exchanges are free to adopt their own compensation committee independence standards that could conceivably permit a board member affiliated with significant shareholder to serve on a compensation committee. The SEC expects, however, that because of the similar statutory and policy objectives, the exchanges may consider adapting their audit committee independence standards to the compensation committee arena.

Under Dodd Frank, controlled companies¹ are generally exempted from Section 10C of the Exchange Act and the new rules. In addition, the new rules exempt from the independence requirements certain other issuers including any foreign private issuer that discloses in its annual report the reason why it does not have an independent compensation committee. The exchanges are also permitted to exempt particular relationships with respect to compensation committee members, taking into account the size of the issuer and other relevant factors.

• The committee’s authority to retain compensation advisors. Exchange listing standards must provide that a compensation committee has the sole discretion to retain or obtain advice from a compensation consultant, independent legal counsel or other advisor. In addition, a compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any such professionals. In addition, the new listing standards must require each listed issuer to provide appropriate funding, as determined by the compensation committee, to pay the reasonable compensation of the advisors retained by the compensation committee. The new rules state that they are not to be construed to require that compensation committees act consistently with advice from their advisors or to limit compensation committees from acting in their own judgment. Moreover, there is nothing in Section 10C or the new rules that requires a compensation committee to utilize any external advisor.
• The committee’s consideration of the independence of any compensation advisors. Exchange listing standards must require a compensation committee to select its external advisors only after taking into consideration certain factors specified in the new rules (most of which are set forth Section 10C(b)(2) of the Exchange Act) and other factors identified by the exchanges. The specified factors include other services provided to the issuer by the advisory entity which employs the advisor; the amount of fees as a percentage of total revenue received from the issuer by such advisory entity; the conflict of interest policies of such advisory entity; any business or personal relationship of the advisor with a member of the compensation committee; any stock of the issuer owned by the advisor; and any business or personal relationship of the advisor or the advisory entity with an executive officer of the issuer.

The exchanges are authorized under the new rules to exempt certain categories of issuers as they determine to be appropriate. In addition, Rule 10C-1 exempts controlled companies and smaller reporting companies (as defined in Exchange Act Rule 12b-2), as well as certain listed security futures products and standardized options from the new listing standards.

Once an exchange’s new listing standards are in effect, a listed company must meet the standards in order for its shares to continue trading on that exchange. The new rules, however, require the exchanges to provide appropriate procedures for listed issuers to have a reasonable opportunity to cure defects that would cause delisting under the compensation committee standards.

The new rules also make a minor change to existing compensation committee disclosure requirements set forth in Item 407 of Regulation S-K to enhance disclosures regarding conflicts of interest raised by the work of any compensation consultant that is identified as having had a role in determining or recommending executive or director compensation.

The new rules do not require a listed company to have a compensation committee or to use compensation consultants, although, as noted by the SEC, current listing standards generally require listed companies to maintain a compensation committee or to have independent directors oversee senior executive compensation.

Existing SEC rules also mandate disclosures about the role of compensation consultants in the setting of executive and director pay. As a result, the ultimate impact of the new rules should not cause a dramatic change in how executive compensation decisions are made. Notwithstanding, depending upon the standards adopted by the exchanges, the new rules are likely to affect investors’ and directors’ views on best governance practices, create or influence investor expectations and could cause a reshuffling of existing relationships between compensation committees and their current independent advisors. As is usually the case, the devil will be in the details.

_{1 Defined in Section 10C(g) of the Exchange Act to include a listed issuer in which a majority of the voting power is held by an individual, group or another issuer.}