On June 20, 2012, the Securities and Exchange Commission (SEC) adopted rules to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act,^[1] which added Section 10C to the Securities Exchange Act of 1934 (Exchange Act). 

The final rules adopted are (1) Exchange Act Rule 10C-1, which directs the national securities exchanges to develop listing standards requiring each member of a listed issuer’s compensation committee to be independent, establishing independence standards for compensation committee members, requiring the compensation committee to have authority to retain compensation advisers and listed issuers to fund the engagement of those advisers and requiring the compensation committee to assess the independence of compensation advisers, and (2) an amendment to Item 407(e)(3) of Regulation S-K to require disclosures regarding certain compensation consultant conflicts of interest. The rules will be effective on July 27, 2012. 

The adoption of Rule 10C-1 starts the clock for the exchanges to propose for SEC review and approval listing standards that comply with the rule’s requirements. The exchanges have until September 25, 2012 to propose listing standards, which must be approved by the SEC by June 27, 2013. As a result of this timing, listed issuers will be unable to assess the full impact of the rule’s independence and other requirements on their compensation committees and compensation advisers until the exchanges propose, and the SEC approves, the listing standards required by the rule. Depending on how quickly the exchanges and SEC act and the length of any transition period included in the new listing standards, those listing standards could be in effect for the 2013 proxy season. 

While the new compensation consultant conflict of interest disclosure rule will be effective on July 27, 2012, issuers will only be required to comply with the disclosure rule in any proxy or information statement for an annual shareholder meeting (or special meeting in lieu of an annual meeting) where directors will be elected occurring on or after January 1, 2013. Thus, an issuer that files a proxy or information statement in 2012 related to an annual meeting to be held on or after January 1, 2013 must comply with the compensation consultant conflict of interest disclosure rule.

This client alert briefly summarizes the SEC’s final rules and provides practical considerations for issuers to consider in light of the final rules.    

Listing Standards for Compensation Committees

Subject issuers. The requirements of Rule 10C-1 will generally apply to issuers, including foreign private issuers, with equity securities listed on a national securities exchange. 

Exemptions from all requirements. 

The requirements of Rule 10C-1 will not apply to:

• issuers that only have listed debt securities;
• issuers whose equity securities are quoted only on the OTC Bulletin Board or by the OTC Markets Group;
• smaller reporting companies (generally issuers with less than $75 million of public equity float);
• controlled companies (i.e., listed issuers where more than 50% of the voting power for the election of directors is held by an individual, a group or another issuer);
• the listing of a security futures product cleared by a registered clearing agency or a clearing agency exempt from registration; and
• the listing of a standardized option issued by a registered clearing agency.

Exchanges may exempt from their listing standards any category of issuer that the exchanges deem appropriate after taking into consideration the potential impact of the requirements on smaller reporting issuers and other relevant factors. For example, the exchanges may consider whether to exempt emerging growth companies (a new class of issuer added by the JOBS Act) from the new listing standards. This exemptive authority will also allow the exchanges to prepare limited exceptions for newly listed and other categories of listed issuers.

Exemptions from the compensation committee independence requirement. 

The following listed issuers will not be subject to the compensation committee independence requirement discussed below:

• limited partnerships;
• issuers 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 it does not have an independent compensation committee.

Scope of requirements.

 The listing standards will apply to “compensation committees,” which is defined to include:

• a designated compensation committee;
• in the absence of a designated compensation committee, any board committee performing functions typically performed by a compensation committee, including oversight of executive compensation, even if the committee performs other functions (for example, corporate governance oversight) or is not formally designated as a compensation committee (for example, the human resources committee); or
• those directors who, in the absence of a board committee, oversee executive compensation matters on behalf of the entire board. 

The listing standards discussed below relating to the compensation committee’s authority to retain compensation advisers and an issuer’s funding requirement for the payment of the compensation advisers retained by the compensation committee will not apply to directors who oversee executive compensation matters outside of a formal committee structure.

The rule does not require listed issuers to establish a compensation committee or a committee performing functions typically assigned to a compensation committee, unless otherwise required by the applicable exchange. A Nasdaq staff member recently noted that he expected Nasdaq to eliminate the ability of its listed issuers to have compensation decisions overseen by independent directors meeting in executive session as few issuers rely on the accommodation. If this change occurs, Nasdaq-listed issuers would be required to have an independent compensation committee. However, the staff member did note that Nasdaq may allow a compensation committee to be composed of fewer than three members otherwise required for the audit committee.

Compensation committee independence requirement. 

The new listing standards must require each compensation committee member to be an independent member of the issuer’s board of directors. The exchanges must develop compensation committee independence standards after considering relevant factors, including:

• the source of director compensation, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
• whether a director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.^[2]

The exchanges are not required by the rule to consider any other factors when developing their independence standards, but may add other independence factors as they deem appropriate. The exchanges may exempt particular relationships with an issuer that might impair a compensation committee member’s independence after taking into consideration an issuer’s size and any other relevant factors.

Unlike the audit committee rules adopted by the SEC pursuant to the Sarbanes-Oxley Act, Rule 10C-1’s independence factors are not intended to be bright-line prohibitions but merely factors for the exchanges to consider in developing independence standards. However, the SEC noted in its adopting release that because the relevant factors set forth in Rule 10C-1 are similar to its audit committee rules, it expects the exchanges to consider whether the bright-line prohibitions found in the SEC’s audit committee independence rule should also apply to compensation committee members. 

As a result, exchanges will have discretion in developing their independence standards and determining how boards should consider them, including whether or not the standards should serve as blanket prohibitions. For example, the SEC noted in its proposing release that exchanges could permit directors affiliated with a significant shareholder, such as a private equity fund or venture capital firm, to serve on the compensation committee even though these directors may not be considered independent for audit committee purposes. However, in response to commentators’ concerns that significant shareholders may have other relationships with listed issuers that would result in the shareholders’ interest differing from those of other shareholders, the SEC stressed in its adopting release the importance for exchanges to consider other ties between a listed issuer and a director (for example, personal or business relationships with an issuer’s executive officer) that could impair the director’s judgment as a compensation committee member.

Authority to retain compensation advisers. 

Compensation committees will be required to have the authority, in their sole discretion, to retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser (collectively referred to throughout this alert as “compensation advisers”). Despite the rule’s reference to “independent legal counsel” (which is not defined in the rule), the rule does not require compensation committees to retain or obtain advice only from independent advisers. A compensation committee may receive advice from non-independent counsel, including in-house counsel and outside counsel retained by management, or from a non-independent compensation consultant or other adviser, including those engaged by management.    

Committee responsibilities for compensation advisers. 

Compensation committees will be required to be directly responsible for the appointment, compensation and oversight of any compensation adviser they retain, but not a compensation adviser retained by management or the issuer. This responsibility does not require the compensation committee to implement or follow a compensation adviser’s advice or recommendations and does not affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.  

Issuer funding obligation. 

Listed issuers will be required to provide appropriate funding (as determined by the compensation committee) for the payment of reasonable compensation to any compensation adviser retained by the compensation committee, whether or not independent. This funding obligation does not extend to any compensation adviser retained by management or the issuer.

Independence factors to consider before engaging compensation advisers.

 Before engaging or receiving advice from a compensation adviser other than in-house counsel, the compensation committee will be required to consider the following independence factors, along with any additional independence factors identified by the applicable exchange in its listing standards:

• the provision of other services to the issuer by the employer of the compensation adviser;
• the amount of fees received from the issuer by the employer of the compensation adviser as a percentage of the employer’s total revenue;
• the policies and procedures of the employer of the compensation adviser that are designed to prevent conflicts of interest;
• any business or personal relationship between the compensation adviser (i.e., the individuals providing services to the compensation committee, but not their employer) and a compensation committee member;
• any issuer stock owned by the compensation adviser (i.e., stock owned by the individuals providing services to the compensation committee and their immediate family members, but not stock owned by the employer of the individuals providing services); and
• any business or personal relationship between either the compensation adviser or the employer of the compensation adviser and an issuer’s executive officer.

After considering the six independence factors, along with any additional factors identified by the exchanges, compensation committees will be entitled to select any compensation adviser they prefer, even those that are not independent. The SEC noted that the independence factors should be considered in their totality and that no single factor should be viewed as a determinative factor of independence. 

The rule does not include, and does not permit the exchanges to include in their listing standards, materiality or bright-line numerical thresholds for the six enumerated independence factors.  However, any additional independence factors identified by the exchanges could include materiality or bright-line thresholds or cutoffs. 

The rule’s limited exclusion of in-house counsel from the requirement to conduct an independence assessment does not extend to outside counsel or compensation consultants or other advisers retained by management or the issuer, including the issuer’s regular outside counsel.

Opportunity to cure defects. 

Exchanges must provide listed issuers a reasonable opportunity to cure any defects that would be the basis for a prohibition on the initial or continued listing of an issuer’s equity securities as a result of the issuer’s failure to satisfy the rule’s requirements.    

Practical considerations. 

While listed issuers and their compensation committees must await final listing standards from their respective exchanges to determine the rule’s full impact, listed issuers and their compensation committees that are subject to the rule should:

• Track the developments of their exchange’s compensation committee listing standards until approved by the SEC.
• Assess the independence of their compensation committee members in light of the rule and, as issued, their exchange’s listing standards, and develop contingency plans in the event one or more of the members is no longer deemed independent.
• Consider what changes to their director and officer questionnaires will be necessary to address their exchange’s new compensation committee independence definition.
• Consider what changes to the compensation committee independence policies included in their compensation committee charter or other issuer policies will be necessary to address their exchange’s new compensation committee independence requirements.
• Consider what changes to their compensation committee charter will be necessary to address the rule’s retention authority, the compensation adviser independence assessment requirement, compensation adviser appointment, compensation and oversight responsibility and funding requirements.
• As specifically noted by the SEC in its adopting release, create policies and procedures for collecting and analyzing information about potential compensation advisers, including questionnaires, before their compensation committee can engage or receive advice from those advisers and ensure that those policies and procedures are consistent with the compensation committee charter and other issuer procedures.
• Assess the independence of existing compensation advisers, other than the issuer’s in-house counsel, that provide advice to the compensation committee, even those advisers retained by management or the issuer. The assessment should likely be conducted this year after determining whether their exchange will add any additional independence factors to be considered in order to uncover any issues should the listing standards be in effect for the 2013 proxy season.

Compensation Consultant Conflict of Interest Disclosure Rule

Subject issuers. 

Pursuant to new Item 407(e)(3)(iv) of Regulation S-K, all issuers subject to the SEC’s proxy rules, including unlisted issuers, controlled companies and smaller reporting companies, must provide specific compensation consultant conflict of interest disclosure in their proxy and information statements for annual meetings (or special meetings in lieu of an annual meeting) where directors are to be elected.^[3]  Master limited partnerships will not be required to provide the disclosure unless they elect directors at unitholder meetings.

Disclosure requirement. 

Subject issuers will be required to provide disclosure in their proxy statements regarding any conflict of interest raised by the work of any compensation consultant, but not other compensation advisers such as lawyers, whose work must be disclosed pursuant to Item 407(e)(3)(iii) of Regulation S-K, regardless of who retained the compensation consultant.  Disclosure is not required for potential conflicts of interest or an appearance of a conflict of interest. Item 407(e)(3)(iii) currently requires subject issuers to provide specific disclosures if compensation consultants played “any role” in determining or recommending the amount or form of an issuer’s executive and director compensation.   

New Item 407(e)(3)(iv) expressly requires that, “[w]ith regard to any compensation consultant identified in response to Item 407(e)(3)(iii) whose work has raised any conflict of interest,” an issuer must disclose the nature of the conflict and how the conflict is being addressed. In its adopting release, however, the SEC noted that forany compensation consultant identified pursuant to Item 407(e)(3)(iii) as having played a role in determining or recommending the amount or form of executive and director compensation, an issuer must disclose whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed. Issuers should take the SEC’s broader characterization of the new disclosure requirements into account in complying with the disclosure requirement, not just the literal language of the new item.

Conflict of interest assessment. 

Neither the new disclosure rule nor the adopting release defines “conflict of interest,” but the adopting release indicates that in determining whether a conflict of interest exists issuers should, at a minimum, consider the six independence factors identified above under “Independence factors to consider before engaging compensation advisers.”  While only issuers with listed equity securities will be required to consider the six independence factors before engaging a compensation consultant, all issuers subject to the SEC’s proxy rules should consider the factors when assessing potential compensation consultant conflicts for disclosure. 

Practical considerations. 

To prepare for compliance with the new disclosure rule, issuers subject to the SEC’s proxy rules and their compensation committees should:

• Determine whether existing disclosure controls and procedures need to be modified, or whether disclosure controls and procedures need to be established, to collect and analyze information relevant to whether their compensation consultants required to be disclosed pursuant to Item 407(e)(3)(iii) have a conflict of interest, which may involve the creation of questionnaires to be completed by the compensation consultants and updates to director and officer questionnaires to elicit information on any business or personal relationships between executive officers or compensation committee members and any compensation consultant. 
• Determine, and include in relevant procedures, what factors, in addition to the six independence factors and any additional independence factors that exchanges may include in applicable listing standards, should be considered when analyzing whether a conflict of interest exists.  
• Consider what changes to the compensation committee charter will be necessary to address the compensation committee’s responsibility to evaluate compensation consultant conflicts of interest.
• Evaluate their compensation consultants using the established factors and the specific facts and circumstances relating to a consultant’s engagement to determine if their work currently gives rise to any conflicts of interest. If conflicts of interest are determined to exist, consider how to address such conflicts of interest, when and how to implement the measures to address them and how to disclose them.

The new disclosure rule does not specify if the conflict of interest raised by a compensation consultant’s work must have been raised or have existed during any particular look-back period and the adopting release provides no clarity on the matter. Subject issuers may wish to consider providing disclosure of compensation consultant conflicts of interest existing during the fiscal years covered by their compensation tables appearing in the proxy statements in which the conflict of interest disclosure appears.

_{1. See Listing Standards for Compensation Committees, Securities Act Release No. 33-9330, Exchange Act Release No. 34-67220 (Jun. 20, 2012), 77 Fed. Reg. 38,422 (Jun. 27, 2012), available at http://www.gpo.gov/fdsys/pkg/FR-2012-06-27/pdf/2012-15408.pdf .}

_{2. Unlike Exchange Act Rule 10A-3, the SEC’s rule directing the exchanges to adopt listing standards for audit committees, Rule 10C-1 does not define “affiliate” or provide a safe harbor for affiliate status.} 

_{3. Registered investment companies will not be subject to the amendment as they will continue to provide disclosure as required by Item 22 of Schedule 14A.}