On March 30, 2011, the Securities and Exchange Commission (SEC) proposed rules to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), which added Section 10C to the Securities Exchange Act of 1934. Section 10C requires the SEC to:

• adopt rules directing the national securities exchanges to prohibit the initial or continued listing of any equity security of an issuer (subject to certain exceptions) that is not in compliance with Section 10C’s compensation committee and compensation adviser requirements; and  
   
• adopt new disclosure rules regarding the use of compensation consultants and conflicts of interest.   

The proposed rules are substantially similar to Section 10C’s provisions and delegate to the exchanges the task of developing listing standards that, among other things, require each compensation committee member to be independent and define the term “independent.” 

The SEC’s delegation of rulemaking to the exchanges means that the proposed rules are merely the first step in the development of compensation committee and compensation adviser requirements. After the SEC adopts final rules, the exchanges must propose and adopt listing standards in accordance with the SEC’s final rules. As a result, the proposed rules will not impact disclosure during the current proxy season but issuers will be unable to assess the full impact of the proposed independence and other requirements on their compensation committees and advisers until the exchanges propose and adopt listing standards. Depending on the effective date of the SEC's final rules, the new disclosure rules regarding the use of compensation consultants and conflicts of interest (which are not subject to exchange rulemaking) could be required in annual meeting proxy and information statements filed later this year.

The proposing release can be found here. Because the proposing release contains numerous requests for comment, the SEC’s final rules may vary from the proposed rules. Comments on the proposed rules must be submitted to the SEC by April 29, 2011. 

This client alert summarizes important aspects of the proposed rules.

Compensation Committee and Compensation Adviser Requirements

Subject Issuers. The compensation committee and compensation adviser rules discussed below will be implemented through exchange listing standards that are subject to SEC approval. Accordingly, the rules would generally apply to issuers (including foreign private issuers) with equity securities listed on a national securities exchange. The rules would 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; 
• controlled companies (i.e., companies where more than 50% of the voting power 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.

The exchanges may also exempt any category of issuers that they deem appropriate after taking into consideration the potential impact of the requirements on smaller reporting issuers.

In addition to controlled companies, the following listed issuers would not be subject to the compensation committee independence requirement discussed below:

• 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 that it does not have an independent compensation committee.

Scope. The proposed rules would require the listing standards to apply to any board committee responsible for executive compensation even if the committee performs other functions (for example, corporate governance) or is not formally designated as a compensation committee (for example, the human resources committee). Independent directors responsible for executive compensation in lieu of a board committee would not be subject to the listing standards. Issuers would not be required to establish a compensation committee or a committee that performs functions typically associated with a compensation committee, unless otherwise required by the applicable exchange.

Compensation Committee Independence Requirement. Each compensation committee member would be required to be an independent member of the issuer’s board of directors. The exchanges would be required to 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. 

Unlike the audit committee membership rules adopted by the SEC pursuant to the Sarbanes-Oxley Act, these independence factors are not intended to be bright-line prohibitions but merely factors for the exchanges to consider in developing independence standards. Further, the proposed rules do not define “affiliate” or provide a safe harbor for affiliate status. The exchanges may add other independence factors as they deem appropriate and exempt particular relationships with an issuer that might impair the compensation committee member’s independence after taking into consideration the issuer’s size and any other relevant factors, in each case subject to SEC approval.

Accordingly, the exchanges will have discretion in developing their own independence standards and determining how boards should consider them, including whether or not the standards should serve as blanket prohibitions. For example, the exchanges could permit directors affiliated with a significant stockholder, 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. 

Authority to Engage Compensation Advisers. The compensation committee would be granted the authority, in its 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 reference to “independent legal counsel” in the proposed rules, the compensation committee would not be required to retain independent legal counsel or be precluded from retaining non-independent legal counsel or obtaining advice from in-house counsel or outside counsel retained by the issuer or management. The compensation committee would be directly responsible for the appointment, compensation and oversight of any compensation adviser but would not be required to follow the adviser’s advice or recommendations and must continue to exercise its own judgment in fulfilling its duties.  

Independence Factors to Consider before Engaging Compensation Advisers. A compensation adviser would not be required to be independent. However, the compensation committee would need to consider the following independence factors (as well as any additional independence factors identified by the applicable exchange in its listing standards) before engaging a compensation adviser:

• 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 its 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 the employer of the individuals providing services) and a compensation committee member; and
• 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).

The proposed rules do not include, and would not permit the exchanges to include in their listing standards, materiality or bright-line numerical thresholds for these factors.

Issuer Funding Obligation. Issuers would be required to provide appropriate funding (as determined by the compensation committee) for the payment of reasonable compensation to any compensation adviser to the compensation committee.

Opportunity to Cure Defects. Exchanges would be required to provide 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 securities as a result of the issuer’s failure to satisfy the listing standards. The listing standards may provide that if a compensation committee member ceases to be independent for reasons outside that member’s reasonable control, the member may, with notice by the issuer to the exchange, remain a member until the earlier of the next annual stockholders meeting or one year from the occurrence of the event that caused the member to cease to be independent.

Compensation Consultant and Conflict of Interest Disclosure Rules

Subject Issuers. Under proposed amendments to Item 407(e)(3) of Regulation S-K, all issuers subject to the SEC’s proxy rules (including unlisted issuers and controlled companies) would be required to provide specific compensation consultant and conflict of interest disclosures in their proxy and information statements for annual meetings where directors are to be elected. MLPs would not be required to provide the disclosures unless they elect directors at unitholder meetings or the final rules provide otherwise.

Disclosure Requirements. Issuers that are subject to the SEC’s proxy rules are currently required by Item 407(e)(3)(iii) of Regulation S-K to provide specific disclosures concerning their use of, and the payment of certain fees to, compensation consultants. Under current rules, compensation consultant disclosure is triggered if compensation consultants played “any role” in the issuer’s process for determining or recommending the amount or form of executive or director compensation. Under the proposed amendments, disclosure would be triggered if the compensation committee “retained or obtained the advice” of a compensation consultant (but not other compensation advisers such as lawyers) during the issuer’s last completed fiscal year. A compensation committee would be deemed to have “obtained the advice” of a compensation consultant if the committee requested or received advice from the consultant, even if the committee did not formally engage the consultant, form a client relationship with the consultant or pay any fees to the consultant for its advice.

If disclosure is required, an issuer must disclose, in addition to the existing disclosure requirements, whether the compensation consultant’s work raised any conflicts of interest. If a conflict exists, an issuer would be required to provide a clear, concise and understandable description of the specific conflict and how the conflict was addressed. A general description of the issuer’s policies and procedures to address conflicts or the appearance of conflicts would not satisfy the disclosure rules. 

The proposed amendments would also broaden the scope of the current disclosure rules by removing the disclosure exceptions for compensation consultants that consult only on broad-based plans that are generally available to all salaried employees or that provide information that is not customized. However, the current exemption from certain fee disclosures for these consultants would be retained.

Conflict of Interest Assessment. The proposed amendments do not define “conflict of interest,” but they indicate that in determining whether or not a conflict exists issuers should consider the five independence factors identified above under “Independence Factors to Consider before Engaging Compensation Advisers.” In addition to those factors and any additional independence factors that exchanges may include in applicable listing standards, issuers would still need to consider the specific facts and circumstances relating to a consultant’s engagement when assessing potential conflicts for disclosure. The presence or absence of any of the five independence factors would not be determinative of a conflict that must be disclosed but would need to be analyzed on a facts-and-circumstances basis. While only listed issuers would be required to consider the five independence factors before engaging a compensation consultant, all issuers subject to the proxy rules should consider the factors when assessing potential conflicts for disclosure. 

Timing

Compensation Committee and Compensation Adviser Requirements. Dodd-Frank requires the SEC to adopt final rules by July 16, 2011. However, the SEC recently indicated that it would adopt final rules between August and December 2011. The proposed rules would require the exchanges to propose listing standards within 90 days, and the SEC to approve the listing standards within one year, after publication of the SEC’s final rules in the Federal Register. Based on these proposed deadlines, the compensation committee and compensation adviser requirements may not be in effect for the 2012 proxy season. 

Compensation Consultant and Conflict of Interest Disclosure Rules. Despite Dodd-Frank’s requirements that the compensation consultant and conflict of interest disclosure rules apply to any proxy or consent solicitation material for an annual stockholders meeting occurring on or after July 21, 2011, the SEC noted that the disclosure would not be required for proxy or information statements filed in definitive form before the effective date of the SEC’s final rules.