Compensation Committee Independence and Consultants

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New SEC Rule 10C-1 directs the national stock exchanges and associations (“FINRA”) to adopt rules requiring listed companies to comply with rules regarding the following:

  • Independence of compensation committee members,[1]
  • Compensation committee authority to retain consultants, independent legal counsel and other compensation advisers at company expense,[2] and
  • Compensation committee consideration of independence of consultants, independent legal counsel and other compensation advisers.[3]
General

It should be noted at the outset that the SEC does not provide much in the way of how the exchanges and associations must implement the SEC directives.  For example, the SEC does not require companies to have an actual compensation committee.  The Rule defines compensation committee as that committee so designated by the board, or in the absence of a designated committee, a committee which performs the functions “typically” performed by a compensation committee, “including oversight of executive compensation” even if it performs other functions.[4]If there is no separate committee at all, then the compensation committee is deemed to be those directors with executive compensation oversight on behalf of the board.

The SEC also does not provide a definition of independence.  The SEC discussed the fact that in the case of an audit committee, Section 301 of Sarbanes Oxley[5]precludes a member from being independent if that member “[a]ccepts any consulting, advisory or other compensatory fee from the issuer…”  However, the SEC noted that the Dodd Frank Section 952 requirements regarding compensation committees permit more discretion.[6]

As noted below under “Independence of Compensation Committee Members,” the SEC exempts certain companies from that particular aspect of new Rule 10C-1.  Other companies are exempted from Rule 10C-1 in its entirety.[7]  The SEC authorizes the exchanges and associations to exempt from the listing requirement imposed by Rule 10C-1 certain categories of issuers as the exchanges and associations deem appropriate, taking into account relevant factors such as the size of the issuer.[8]   The Rule expressly exempts any “controlled company,”[9] smaller reporting companies,[10] the listing of a securities futures product cleared by an agency registered under Section 17A of Dodd Frank, and the listing of a standardized option also cleared by an agency registered under Section 17A of Dodd Frank. Thus, the new rules expressly do not apply to companies which are controlled 50% by one person or a group acting in concert, although the exchanges are certainly free to impose their own rules on a broader class.  Nasdaq, for example, similarly exempts controlled companies from its compensation listing standards.[11]

Independence

New Rule 10C-1 prohibits the stock exchanges and associations from listing any company that does not meet the independence provisions of Rules 10C-1.[12]  Thus, each member of the “compensation committee” as defined above, must be a board member who is also independent.[13]  In defining independence, the exchanges and associations must take into account “relevant factors,”   including the statutory factors:

  • The source of the compensation of a board member, including “any consulting, advisory or other compensatory fee paid by the issuer” to the board member, and
  • Whether the board member is affiliated with the issuer or any subsidiary or affiliate of a subsidiary.[14]

The SEC declined to expressly require the exchanges to consider any additional factors noting, however, that because the “relevant factors” cover the same matters as under the Sarbanes Oxley audit committee prohibitions, the SEC indicated it expects the exchanges to consider whether those prohibitions should apply to compensation committee members.[15]  While the SEC has not provided much substantive guidance as to what factors are “relevant”, they did cite with approval the NYSE comment that “the concern is independence from management.”[16]  Thus, while the SEC noted and did not dispute that a director’s company stock holdings or alliance with larger shareholders or private equity firms may be a good thing in aligning board and shareholder interests, Rule 10C-1 leaves it to the exchanges to determine what affiliations might be a problem—such as relationships between a board member and executives.

 

Authority to Retain Compensation Consultants, Independent Legal Counsel and Other Compensation Advisers at Company Expense

Reg. §10C-1(b)(2) requires that the compensation committee[17] have authority to retain “compensation consultants, independent legal counsel and other compensation advisers” and Reg. §10C-1(b)(3) requires that the company pay appropriate and reasonable compensation for such services.   The rule expressly states that the compensation committee shall be directly responsible for the appointment, compensation and oversight of the work, and that nothing should be construed to require that the compensation committee “implement or act consistently with the advice or recommendations” of any such advisers or to “affect the ability or obligation of a compensation committee to exercise its own judgment” in fulfilling its duties.

An obvious observation is that the Rule acknowledges that the compensation committee likely has the ultimate role in deciding what actions are in the best interest of the company.  While the courts have often upheld the decisions of a board under state “business Judgment” standards, this does not mean a company or its board will not be sued in shareholder or derivative actions.  Board or committee failure or refusal to adopt recommendations of a consultant or other adviser are common but to the hands of the typical plaintiff lawyer such an observation often shows up in court filings to serve as proof of some malfeasance regardless of whether such a claim has any validity.

It should also be pointed out that the compensation committee’s discretion to appoint its own consultants or other advisers is just a right, not an obligation.[18]  For example, there is no reason the board as a whole, or even management, could engage a compensation consultant for use by the compensation committee.  Likewise, compensation committees often only receive legal advice through in-house legal counsel (who in turn may or may not consult the company’s outside corporate counsel).  This is all perfectly acceptable.  However, if a compensation committee—comprised as it is of independent directors—determines that it needs the assistance of its own compensation consultant, legal counsel or other adviser (for example, an adviser to calculate the accounting expense under pronouncements of Financial Accounting Standards Board), then the company must permit such retention.

Consideration of Independence of Compensation Consultants and Other Advisers

Rule §10C-1(b)(4) provides that a compensation committee may select a compensation consultant, independent legal counsel or other adviser only after taking into account six enumerated factors and such other factors added by the national exchanges or associations.  Note this requirement, which again, is a directive to the national exchanges and associations, applies to any consultant, counsel or other adviser “that provides advice to the compensation committee.”[19]  This excludes in-house legal counsel.  Thus, while the compensation committee’s authority to retain consultants, counsel or advisers is discretionary, and does not prohibit the company hiring  only a consultant hired by management, for example, if any consultant provides advice to the compensation committee, regardless of who retains the adviser, the compensation committee must assess the independence factors with regard to that adviser.

The SEC requires the consideration of at least six factors, the first five of which are taken directly from new §10C of the Exchange Act:

  • The provision of other services to the company by the adviser’s employer;
  • The amount of fees paid by the company to the adviser’s employer, as a percent of the employer’s total revenue;
  • The policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • Any business or personal relationship between the adviser and a member of the compensation committee;
  • Any company stock owned by the adviser and
  • Any business or personal relationship between the adviser or the adviser’s employer and a company executive officer.

Rule §10C-1 does not prohibit the compensation committee from actually hiring an adviser which is not independent and the compensation committee is not required to describe its process for selecting its advisers. Expressing its concern for competitive neutrality, the SEC also does not require bright line, materiality or numerical tests (for example, with respect to adviser stock ownership of the company), and the SEC concurs with commentary that no single factor should be determinative in assessing independence, but rather the compensation committee’s determination in choosing an adviser should be based on the totality of factors considered.[20]

Opportunity to Cure a Failure to Satisfy the Listing Standards Required by SEC Rule §10C-1

Pursuant to new §10C(f)(2) of the Exchange Act, the exchanges are required to establish “appropriate procedures” for any listed company to cure any  lack of compliance with the director independence or retention of a compensation adviser rules.  SEC Rule §10-1(a)(3) specifically provides that if a compensation committee member ceases to be independent for reasons outside the director’s control, the exchanges and associations may permit the director to remain on the compensation committee until the earlier of the next annual meeting or one year from the occurrence of the event which caused the lack of independence.  Obviously any such relief will not help in certain other contexts—such as independence for purposes of Section 162(m) of the Internal Revenue Code (the “million dollar cap” rules) or SEC Rule 16b-3 (regarding insider trading).

 

SEC Revision to Proxy Disclosure Rules

In addition to its guidance to the exchanges, the SEC beefed up its disclosure rules under Item 407 of SEC Reg. S-K. Prior to the adoption Reg. §10C-1, Item 407(e) has required registrant companies to describe in their annual proxies certain information with respect to compensation committees and their use of consultants.  Specifically, if the company does not maintain a compensation or similar committee, it must state the basis for its view that it is appropriate not to have such a committee and identify each director who participates in the consideration of executive and director compensation.[21]  It should be noted that implicit in this requirement, of course, is that the neither the SEC, nor Dodd Frank actually requires that a compensation committee be established.  While the exchanges themselves may require a listed company to maintain a compensation committee—as Nasdaq does and as NYSE effectively  does—companies may in fact operate without such a committee.  Few companies do in fact operate without a compensation committee, for a variety of reasons, including the tax and securities requirements.

In addition, the SEC requires the company to state in its annual proxy whether or not the compensation committee has a charter.[22]  Again, implicit in this statement is the observation that neither Item 407(e) nor Dodd Frank requires that a company have a charter, though again, certain exchanges, as NYSE and Nasdaq do, may have a charter requirement.  If the company does have a charter, the company must disclose whether a current copy is available on the company’s website, and if so, the web address of the charter.[23]  If the charter is not available to stockholders on the company’s website, a copy must be provided in the proxy at least once every three years and an identification of which year the charter was most recently included in a proxy.

In addition,  with regard to executive compensation consultants, their relationship to the board and the nature of their assignments, companies must describe their processes and procedures for the consideration and determination of executive compensation, including the scope and authority of the compensation committee of any similar body,[24] the extent to which and to whom any such committee delegates authority and what  has been delegated[25] and with respect to compensation consultants (other than consultants advising on broad based plans and other services that in general are not customized), companies must:

  • Identify the consultant,
  • State if the consultant is engaged directly by the compensation committee or anyone else,
  • The nature and scope of the engagement,
  • Any instructions given to the consultant,
  • Aggregate fees paid to the consultant for services regarding executive and director compensation, and
  • Aggregate fees for additional services provided by a consultant who also advised with regard to executive and director compensation, if the fees for such additional services exceed $120,000 during the year.[26]

As a result of Dodd Frank, new §10C(c)(2)(A) of the Exchange Act statutorily requires that a company disclose in its proxy whether “the compensation committee retained or obtained the advice of a compensation consultant.”  At first blush this seems to just statutorily confirm the Reg. S-K Item 407(e)(3)(iii) requirement that companies disclose whether  a compensation consultant has been involved with executive or director compensation. However, as the SEC noted, this language is actually in conflict with Item 407(e)(3)(iii) which requires a company to disclose its processes and procedures regarding executive compensation for “[a]ny role of compensation consultants in determining or recommending the amount or form of executive and director compensation”  except for those specifically excluded in Item 407(e) (i.e., those consulting on broad based or non-tailored projects).[27]

This language conflict raises several distinct problems.  First, the statutory requirement of §10C(c)(2)(A) makes no exception for broad based or non-tailored projects.  Second, the Item 407(e) requirement applies without regard to who hires the consultant (e.g., management, the compensation committee or the board), while the statute applies only if the compensation committee “retains or obtains” the advice of the consultant.  In it’s the preamble to its proposed regulation, the SEC indicated that because the language was so similar, and because they found it unlikely that any consultant would have a role with regard to executive compensation without the compensation committee either retaining or obtaining the advice of the consultant, the SEC’s proposed rule would have integrated the two disclosures by essentially defaulting to the statutory language, thereby wiping out the broad based and non-tailored project exceptions so long as the compensation committee retained or obtained the advice of the consultant.[28]  In addition, the SEC proposed a definition for the phrase “obtained the advice.”[29]

In adopting the final regulation, the SEC acknowledged the concerns of several commenters suggesting that the time and expense to change to the SEC’s proposed language was not justified, especially, as the SEC acknowledged, given the similarity of the statutory and Item 407 language and the unlikelihood that a consultant would have a role if the compensation committee had not retained or obtained the advice of the consultant.  Accordingly, the SEC scrapped its plans to integrate Item 407(e) and the express language of the statute.[30]  The SEC also pulled back its suggested instruction as to the meaning of the phrase “obtained the advice.” Instead, Item 407(e)(3) has been left intact and new (iv) has been added to provide as follows:

“(iv) With regard to any compensation consultant identified in response to Item 407(e)(3)(iii) whose work raised any conflict of interest, disclose the nature of the conflict and how the conflict and how the conflict is being addressed.”[31]

The final regulation adds a new instruction for interpreting when the consultant’s advice raises a conflict of interest.  Specifically, the instruction refers to the Dodd Frank Exchange Act §10C requirement that the exchanges require their listing companies in assessing any conflicts involving compensation consultants, advisers and independent legal counsel, as discussed in above.[32]

Nasdaq

General

On September 14, 2012, the board of directors of The NASDAQ Stock Market LLL (“Nasdaq”) approved changes to its listing rules (“Nasdaq Rule Change”) in compliance with compensation committee requirements under SEC Rule 10C-1.[33]Unlike the NYSE rule changes pursuant to SEC Rule §10C-1, Nasdaq’s changes represent a significant departure from previous practice.  The heart of the Nasdaq changes are in revised Nasdaq Listing Rule 5605(d).[34]

Nasdaq proposes no changes to companies which are currently exempt from its compensation listing standards.  Thus, the proposed changes will not apply to asset-backed issuers and other passive issuers,[35] cooperatives,[36] limited partnerships,[37] management investment companies[38] and controlled companies.[39]

Charter Requirement

Proposed Nasdaq Listing Rule 5605(d)(1) requires each listed company to certify it has adopted a “formal written compensation committee charter” that the company must review and reassess annually.  The charter must address:

  • The scope of the compensation committee’s responsibilities, and it must address how those responsibilities are carried out including the committee’s structure, processes and membership requirements;
  • The committee’s responsibility for determining, or the committee’s responsibility for recommending to the board for determination, the compensation of all company executive officers, including the CEO;
  • That the CEO may not be present for deliberation of or voting on the CEO’s compensation; and
  • The compensation committee’s responsibilities and authority under SEC Rule 10C-1(b)(2)-(4) as discussed in this section above under “SEC Directive to Stock Exchanges.”[40]

The charter requirement, similar to other changes in the Nasdaq Rule Change, takes its cue from the pre-existing charter rule for the audit committee.  Like the SEC, Nasdaq does not expand upon the independence factors the compensation committee must consider in assessing the independence of any compensation consultant, independent legal counsel or other adviser retained by the compensation committee and Nasdaq does not require that any such adviser be independent.

Compensation Committee Requirement

Nasdaq’s current rules require that compensation of company executive officers be determined by either a compensation committee comprised solely of independent directors or independent directors constituting a majority of the board’s independent directors.  Although this would have been permissible under SEC Rule §10C-1, Nasdaq has chosen in its proposed rule change to require that compensation of executive officers be determined by a compensation committee comprised solely of at least two independent directors.[41]  In doing so, Nasdaq explains:

“Since responsibility for executive compensation decisions is one of the most important responsibilities entrusted to a board of directors, Nasdaq believes there are benefits from a board having a standing committee dedicated solely to oversight of executive compensation.  Specifically, directors on a standing committee may develop expertise in a Company’s executive compensation program in the same way that directors on a standing audit committee develop expertise in a Company’s accounting and financial reporting processes.  In addition, a formal committee structure may help promote accountability to stockholders for executive compensation decisions.”[42]

Nasdaq considered whether requiring companies to have a two or more person compensation committee would pose a hardship on its listed companies but noted only a small number of companies function without a separate compensation committee, no doubt because of similar compensation committee requirements for Internal Revenue Code Section 162(m) (the “million dollar cap” rule) and SEC Rule 16b-3 (dealing with insider trading).

While Nasdaq’s current Listing Rule permits a one person compensation committee member, and although not required by SEC Rule §10C-1, Nasdaq has proposed a compensation committee of at least two independent directors.  This is a departure from its rules regarding audit committees, which requires at least three independent directors, but Nasdaq believes that two three member board committee requirements would impose too much a burden on listed companies.  As for requiring more than one member, Nasdaq noted only a small number of companies have one person compensation committees, which again is likely to tax and SEC requirements with regard to the million dollar cap rule and the SEC insider trading rules. [43]

Definition of Independence

The compensation committee under the proposed Nasdaq rule must be comprised of at least two persons, each of whom is in independent board member.  While Nasdaq leaves unchanged its definition of independence in current Listing Rule 5605(a)(2), Nasdaq adds additional requirements for compensation committee members.  The basic rule for Nasdaq independence in Listing Rule 5605(a)(2), provides a two part requirement:

  • First, a director is not independent if any of the following is true:
    • The director is an executive officer[44] or employee of the company, presently or at any time in the preceding three years;
    • A director who has accepted or has a family member[45] who has accepted compensation from the company of more than $120,000 during any twelve consecutive month period in the preceding three years;[46]
    • A director who has a family member who has been employed as an executive officer of the company within the preceding three years;
    • A director who is or has a family member who is a partner or a controlling shareholder of any entity that paid to or was paid by the company in the current fiscal year or any of the preceding fiscal years more than the greater of 5% of the recipient’s consolidated gross revenues or $200,000;[47]
    • A director who is or has a family member who is employed as an executive officer of another entity where during the preceding three years any company executive officers have served on the compensation committee of such other entity; or
    • A director who is or has a family member is either a partner in the company’s outside accounting firm, or was a partner or employee of the accounting firm who worked on the company’s audit at any time during the preceding three years.
    • Second, the board as a whole must make an affirmative determination the director has no relationship that would interfere with the exercise of independent judgment as a director.

As noted in this chapter above, SEC Rule 10C-1expressly requires the exchanges to adopt rules requiring listed companies to consider the independence of a compensation committee by assessing the source of the director’s compensation, including any advisory or other compensation paid to the director from the listed company. [48] In considering this requirement, Nasdaq noted that two of its general requirements for disqualifying a director from being independent nonetheless permit the [49]director to earn a certain amount of money from the company. However, Nasdaq notes this permitted level of income is in contrast to the fact that Nasdaq forbids audit committee members from accepting, directly or indirectly, “any consulting, advisory or other compensatory fee from an issuer or any subsidiary, with certain exceptions.”[50]  Nasdaq concludes there “is no compelling justification to have different independence standards for audit and compensation committee members” on this point, and accordingly will not permit any such compensation, directly or indirectly.  However, this prohibition applies only during the period of the compensation committee service.  Thus, earnings under either of the above provisions up to the maximum amount that may be earned during the three year look back period, but before the director has begun serving on the compensation committee, will not disqualify the director from compensation committee service.[51]

SEC Rule §10C-1 requires the exchanges to require listed companies to address compensation committee independence by considering whether a director is “affiliated with the issuer or an affiliate of the issuer.”[52] In this regard, Nasdaq concluded it was not appropriate to require compensation committee members to meet the same independence rules as audit committee members.  SEC Rule §10A-3(e)(1) provides that “affiliate” means a person who directly or indirectly controls or is controlled by the company, but excludes any person who is not the beneficial owner of more than 10% of the company’s voting securities or an executive officer.  SEC Rule §10A-3(b)(1) prohibits an affiliate from serving on an audit committee.[53]  As noted, the general Nasdaq independence rules preclude an executive officer of company from being an independent director.  Thus any individual who is either an officer or a 10% owner of the company’s voting securities is disqualified from being an audit committee member.

As noted, SEC Rule 10C-1 does not prohibit an affiliate from being a compensation committee member, only that such affiliate status be considered.  Like the SEC, Nasdaq feels that stock ownership for a compensation committee can be a good thing:

“In fact, Nasdaq believes it may be appropriate for certain affiliates, such as representatives of significant stockholders, to serve on compensation committees since their interests are likely aligned with those of other stockholders in seeking an appropriate executive compensation program.”[54]

Thus, even if a director holds more than 10% of the voting securities of a company, that person likely can sit as a member of the compensation committee, provided the director is not an executive officer or otherwise disqualified.  Once again, in making this analysis regarding affiliate status, no three year look back is required, except if affiliate state arises as a result of having been an employee within the last three years or in any other way is disqualified for failure to satisfy the express prohibitions under Nasdaq’s general director independence requirements.

For not longer than two years, provided the compensation committee has at least three members, one of those directors may be excused from meeting the Nasdaq independence requirements, so long as the person is not a company executive officer (or the family member of a company executive officer) and the board, “under exceptional and limited circumstances, determines that such individual’s membership on the committee is required by the best interests of the Company and its Shareholders.”[55]  If this exception is used, the company must explain the nature of this relationship and the reasons for this determination on its website or its next annual proxy (or if the company does not file a proxy, on its form 10-K or 20-F). This Nasdaq Listing Rule also requires compliance with Item 407(a) of SEC Reg. S-K and Instruction 1 thereto which requires identification in the proxy of any board or committee member who does not satisfy the independence requirements for the board or committee, the reason for the exemption and the basis for the company’s conclusion the exemption is applicable.

If the compensation committee falls out of compliance with Nasdaq’s proposed rule on compensation committee independence, either because of one (and only) vacancy, or because one (and only one) director ceases to be independent for circumstances beyond the member’s control, the company has a minimum of 180 days to become compliant or if later, the earlier of the date of the next annual shareholder meeting or one year from the occurrence of the event that causes the noncompliance.[56]

A Smaller Reporting Company[57] is exempt from the Nasdaq compensation committee requirements provided it has a compensation committee of at least two members, each of whom satisfies Nasdaq general independence standards and the company has either a compensation committee charter or board resolution that specifies all requirements of a Nasdaq compensation committee charter except that such document does not have to address compensation committee retention or compensation of a compensation consultant, independent legal counsel or other adviser and does not have to address the independence of such advisers.[58]

Compensation Consultants, Independent Legal Counsel and Other Advisers

Nasdaq does not propose to add to the SEC Rule §10C-1 requirements regarding compensation committee retention of compensation consultants, independent legal counsel and other advisers, and assessing the independence of such persons, except to require that such requirements be addressed in the compensation charter as noted above.[59]  Nasdaq’s only other statement is as follows:

“The Compensation committee must have specific compensation committee responsibilities and authority necessary to comply with Rule 10C-1(b)(2)[authority to retain a consultant, independent legal counsel, or other adviser], (3) [company obligation to pay appropriate and reasonable compensation of such persons] and (4)(i)-(vi) [the six independence factors to be considered with respect to such persons, other than outside legal counsel]…”[60]

Thus, Nasdaq, added little gloss to the SEC requirements which are discussed in detail in “SEC Directive to Stock Exchanges” above, [61] though Nasdaq did confirm its agreement with the SEC that companies are under no obligation to retain independent consultants and other advisers.[62]

 

Effective Dates

As for the effective date of the changes, Nasdaq wastes no time.  The compensation consultant, independent legal counsel and other adviser provisions become effective immediately upon the finalization of the Nasdaq change.[63]  All other changes are applicable as of the earlier of the second annual meeting after finalization of the proposed changes or December 31, 2014. Nasdaq does not accelerate the timetable for certain companies such as initial public offerings (“IPOs”), companies emerging from bankruptcy or companies which cease to be controlled companies.[64]  Those companies generally have to have one independent board member at the time of listing, a majority of independent members within 90 days of listing and all independent board members within one year of listing.  Thus, in general, [65]  after the effective date of the compensation committee rule, the compensation committee must have at least one qualifying independent director at listing, two qualifying members within 90 days and everyone must be a qualifying independent director within a year.   Once the proposed compensation committee rules become effective, Nasdaq indicates the IPO etc. transition rule will integrate with the compensation committee as follows:

To provide an illustration of how the compensation committee composition requirement will interact with the minimum size requirement, consider a Company that at the time of listing has a compensation committee consisting of two members, both of whom are Independent Directors [as defined under Nasdaq’s independence rules for directors at large], but one of whom accepts compensatory fees of $50,000 annually[66] from the Company pursuant to a consulting agreement. Although only one of these directors is fully eligible to serve on the compensation committee, the committee meets the requirements of Nasdaq’s phase-in schedule because it has one fully eligible member at the time of listing. By the 90th day from listing, the committee must have a majority of fully eligible members, so the Company could: (i) remove the ineligible member and temporarily have a committee of one fully eligible member; (ii) replace the ineligible member with a fully eligible member so that the committee consists of two members, all of whom are fully eligible; or (iii) add a second fully eligible member so that the committee consists of three members, a majority of whom are fully eligible. By one year from listing, the Company’s compensation committee must consist of at least two members, and all members must by fully eligible under Nasdaq’s compensation committee composition requirement.[67]

 

 


[1] SEC Rule §10C-1(b)(1).

[2] SEC Rule §10C-1(b)(2)-(3).

[3] SEC Rule §10C-1(b)(4).

[4] SEC Rule §10C-1(c)(2).

[5] Pub. L. 107-2014, 116 Stat 745 (2002).

[6] SEC Rel. No. 33-9330, (June 20, 2012), 77 FR 38422, 38426.  As discussed, below however, Nasdaq puts compensation committees on the same footing as audit committees, and thus on its own precludes any discretion in this instance.

[7] Rule 10C-1(b)(5)(ii)-(iv).

[8] SEC Rule §10C-1 (b)(5)(i).

[9] Defined as an issuer that is listed on a national exchange or by a national association and of which more than 50% of the voting power for directors is held by an individual, a group or another company.

[10] Defined in SEC Rule 12b-2 generally as companies with a public float of less than $75 million.  SEC Rel. No. 33-9330, FN 179, (June 20, 2012), 77 FR 38422, 38438.

[11] Nasdaq Listing Rule 5615(c).

[12] SEC Rule §10C-1 (a)(1)-(2).

[13] There are certain exemptions from the compensation committee independence requirements: limited partnerships, companies in bankruptcy, open ended mutual funds, foreign private issuers that disclose they do not have independent compensation committees, and such issuers as determined by the exchanges or associations, taking into account factors deemed relevant, including size of the issuer.  SEC Reg. §10C-1(b)(iii).

[14] SEC Rule §10C-1 (b)(1)(ii)(A)-(B).

[15] SEC Rel. No. 33-9330, (June 20, 2012), 77 FR 38422, 38428.

[16] SEC Rel. No. 33-9330, FN 71 (June 20, 2012), 77 FR 38422, 38428 [emphasis added].

[17] This Rule makes a peculiar, though as a practical matter, largely irrelevant distinction.  The requirements granting authority to retain a compensation consultant or other adviser and that the company pay for such persons, apply only to a compensation committee or other committee which performs similar functions.  Thus, this requirement does not apply to board level oversight of executive compensation in the event no such committee exists.  Reg. §10C-1(c)(2)(iii). However, in the absence of any committee, if an adviser is retained, board members with board level oversight have the right under Reg. §10C-1(b)(2)(ii) regarding “appointment, compensation and oversight” of any retained adviser.  Not only is this distinction rare in practice because the compensation committee usually does hire and oversee the work of its advisers, but Nasdaq and NYSE in fact will require each company to maintain a separate compensation committee comprised solely of independent directors—thus there will be little opportunity for a company to operate without a compensation committee—and while such a committee is in place, there is little application of the rules at the board level outside of the compensation committee.

[18] SEC Rel. No. 33-9330, (June 20, 2012), 77 FR 38422, 38429.

[19] Instruction to paragraph (b)(4) of SEC Rule 10C-1, SEC Rel. No. 33-9330, (June 20, 2012), 77 FR 38422,38433, 38455.

[20] SEC Rel. No. 33-9330, (June 20, 2012), 77 FR 38422, 38432-38433.

[21] SEC Reg. S-K, Item 407(e)(1).

[22] SEC Reg. S-K, Item 407(e)(2).

[23] Instruction 2 to Reg. S-K, Item 407.

[24] SEC Reg. S-K, Item 407(e)(3)(i)(A).

[25] SEC Reg. S-K, Item 407(e)(2)(ii).

[26] SEC Reg. S-K, Item 407(e)(3), which provides the proxy must disclose

“ [a]ny role of compensation consultants in determining or recommending the amount or form of executive and director compensation (other than any role limited to consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the registrant, and that is available generally to all salaried employees; or providing information that either is not customized for a particular registrant or that is customized based on parameters that are not developed by the compensation consultant, and about which the compensation consultant does not provide advice) during the registrant’s last completed fiscal year, identifying such consultants, stating whether such consultants were engaged directly by the compensation committee (or persons performing the equivalent functions) or any other person, describing the nature and scope of their assignment, and the material elements of the instructions or directions given to the consultants with respect to the performance of their duties under the engagement:

“(A) If such compensation consultant was engaged by the compensation committee (or persons performing the equivalent functions) to provide advice or recommendations on the amount or form of executive and director compensation (other than any role limited to consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the registrant, and that is available generally to all salaried employees; or providing information that either is not customized for a particular registrant or that is customized based on parameters that are not developed by the compensation consultant, and about which the compensation consultant does not provide advice) and the compensation consultant or its affiliates also provided additional services to the registrant or its affiliates in an amount in excess of $120,000 during the registrant’s last completed fiscal year, then disclose the aggregate fees for determining or recommending the amount or form of executive and director compensation and the aggregate fees for such additional services. Disclose whether the decision to engage the compensation consultant or its affiliates for these other services was made, or recommended, by management, and whether the compensation committee or the board approved such other services of the compensation consultant or its affiliates.

“(B) If the compensation committee (or persons performing the equivalent functions) has not engaged a compensation consultant, but management has engaged a compensation consultant to provide advice or recommendations on the amount or form of executive and director compensation (other than any role limited to consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the registrant, and that is available generally to all salaried employees; or providing information that either is not customized for a particular registrant or that is customized based on parameters that are not developed by the compensation consultant, and about which the compensation consultant does not provide advice) and such compensation consultant or its affiliates has provided additional services to the registrant in an amount in excess of $120,000 during the registrant’s last completed fiscal year, then disclose the aggregate fees for determining or recommending the amount or form of executive and director compensation and the aggregate fees for any additional services provided by the compensation consultant or its affiliates.”

[27] SEC Rel. No. 33-9330 (June 12, 2012), 77 FR 38422, 38439.

[28] SEC Rel. No. 33-9199 (March 30, 2011), 76 FR 18966, 18979

[29] SEC Rel. No. 33-9199 (March 30, 2011), 76 FR 18966, 18989, Proposed Instruction 1 to SEC Reg. S-K, Item 407(e)(3).

[30] The SEC also headed off a suggestion that because of its proposed language regarding the “advice retained or obtained by the compensation committee,” the SEC had intended to exclude from the disclosure rule any consultant hired exclusively for director compensation.  Often, companies have committees other than the compensation committee determine the compensation of directors—e.g., the nominating committee.  The SEC declined to make such an interpretation.  Thus, in retaining current Reg. S-K item 407(e)(3), the SEC retains the disclosure requirement with respect to any compensation consultant who has any role “in determining or recommending the amount or form of executive and director compensation.”  This issue does provide however, a difference in the extent of proxy disclosure of compensation consultants—which applies to director and executive compensation—and the directive to the exchanges—which applies to “compensation committees” and consultants, advisers and legal counsel who advise them.  Thus, the exchanges are essentially without direction as to committees other than a compensation committee which determines the compensation of non-employee directors.

[31] SEC Reg. S-K, Item 407(e)(3)(iv).

[32] Those factors are: (1) other services provided by the consultant’s employer to the company, (2) the amount of fees received from the company by the consultant’s employer, as a percentage of total revenue of the employer, (3) the policies and procedures of the consultant’s employer with regard to potential conflicts, (4) any business or personal relationship of the consultant and a member of the compensation committee, (5) (6) ) any business or personal relationship of the consultant or consultant’s employer, and an executive officer of the company.

[33] The text of the Nasdaq rules can be found at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[34] Proposed Nasdaq Rule Change at p. 83, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[35] Nasdaq Listing Rule 5615(a)(1), because these issuers commonly do not have boards and their activities are passive in holding the interests of others.

[36] Nasdaq Listing Rule 5615(a)(2), who do not have publicly traded stock and who are owned by their members,

[37] Nasdaq Listing Rule 5615(a)(4), because limited partners do not expect a voice in management.

[38] Nasdaq Listing Rule 5615(a)(5), which are registered under the Investment Company Act of 1940 and which are thus subject to extensive regulation.

[39] Nasdaq Listing Rule 5615(c).  Controlled companies have more than 50% of voting power held by an individual, group or another company, similar to the SEC Rule 10C-1 definition.

[40] To recap, (1) SEC Rule 10C-1(b)(2) requires that the compensation committee have the authority to retain a consultant, independent legal counsel or other adviser and have the responsibility to appoint, compensate and oversee such adviser(s);  (2) SEC Rule 10C-1(b)(3) requires that the company must pay the appropriate and reasonable compensation payable to any such adviser retained by the compensation committee; and (3) SEC Rule 10C-1(b)(4) requires that with respect to any such adviser who provides advice to the compensation committee, regardless of who retains such adviser (with the exception of in-house legal counsel), the compensation must consider the independence of such adviser by taking into account at least the following six factors: (a) the provision of other services to the company by the adviser’s employer;  (b) the amount of fees paid by the company to the adviser’s employer, as a percent of the employer’s total revenue; (c) the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest; (d) any business or personal relationship between the adviser and a member of the compensation committee; (e)  any company stock owned by the adviser and (f) any business or personal relationship between the adviser or the adviser’s employer and a company executive officer.

 

[41] Proposed Nasdaq Listing Rule 5605(d)(2), http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[42] Proposed Nasdaq Rule Change at p. 9, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[43] Proposed Nasdaq Rule Change at p. 10, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[44] Defined in Nasdaq Listing Rule 5605(a)(1) by reference to the definition of what officers must file transaction reports under SEC Rule 16a-1(f).

[45] Family member is any person who is a spouse, parent, child or sibling of the director, by blood, marriage or adoption, or anyone residing in the director’s home.  Nasdaq Listing Rule 56-5(a)(2).

[46] This excludes payments for board service, compensation paid to a family member who is an employee but not an executive officer and benefits under a tax qualified retirement plan on non-discretionary compensation. As noted below, this permitted amount of compensation will not be allowed during the term of a compensation committee member, although compensation paid within the three year look back period but before the director became a member of the compensation committee will not disqualify the director from compensation committee service.

[47] This excludes payments arising solely from investments in company securities and non-discretionary charitable matching contributions. As noted below, this permitted amount of compensation will not be allowed during the term of a compensation committee member, although compensation paid within the three year look back period but before the director became a member of the compensation committee will not disqualify the director from compensation committee service.

[48] SEC Rule §10C-1(b)(1)(ii)(A).

[49] Specifically, as indicted above, a director may be independent even if that director accepts from the company no more than $120,000 (with certain exclusions, including for board service) in any consecutive twelve months in the preceding three years or that director is a partner in or controlling shareholder in any entity which is paid by, or pays to, the Company an amount in any current or preceding three fiscal years less than the greater of 5% of the recipient’s revenues for that year or $200,000.

[50] Nasdaq Listing Rule 56-5(c)(2)(A)(ii), as discussed at Proposed Nasdaq Rule Change, p. 14, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[51] Proposed Nasdaq Listing Rule 5605(d)(2)(A). Excluded from this blanket prohibition are fees for board service and compensation from a retirement or deferred compensation plan (apparently, regardless of whether tax qualified).

[52] SEC Rule 10C-1 (b)(1)(ii)(B).

[53] The obvious concern from an audit committee perspective is that significant company stock ownership might influence a director’s assessment of audit compliance because of its potential effect on the company’s stock value and thus the director’s holdings.

[54] Proposed Nasdaq Rule Change, p. 17, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[55] Proposed Nasdaq Listing Rule 5605(d)(2)(B).

[56] Proposed Nasdaq Listing Rule 5605(d)(4).

[57] As generally defined in SEC Rule §12-b as a company with less than $75 million in public float.

[58] Proposed Nasdaq Listing Rule 5605(d)(5).

[59] Proposed Nasdaq Listing Rule 5605(d)(1)(D).

[60] Proposed Nasdaq Listing Rule 5605(d)(3).

 [61] Specifically, see subsections entitled “Independence,” “ Authority to Retain Compensation Consultants, Independent Legal Counsel and Other Compensation Advisers at Company Expense” and “Consideration of Independence of Compensation of Consultants and Other Advisers.”

[62] Proposed Nasdaq Rule Change, p. 24, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[63] Proposed Nasdaq Listing Rule 5605(d)(6).

[64] Proposed Nasdaq Rule Change, p. 64, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

[65] Assuming there are no other exemptions or exceptions, such as the exception “exceptional and limited circumstances.”

[66] Which would satisfy the Nasdaq rule for independent directors at large, but not for compensation committee members under the proposed change.

[67] Proposed Nasdaq Rule Change, p. 64, FN 66, at http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

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