On June 20, 2012, the U.S. Securities and Exchange Commission (SEC) adopted new Rule 10C-1 under the U.S. Securities Exchange Act of 1934 (Exchange Act) to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).¹ The new rule directs U.S. national securities exchanges, including the New York Stock Exchange and the NASDAQ Stock Market, to adopt listing standards regarding the independence of compensation committee members and the retention of compensation advisers. The SEC also adopted amendments to the proxy disclosure rules requiring additional disclosure regarding compensation consultants and related conflicts of interest.

The new rule and disclosure amendments will become effective on July 27, 2012. By September 25, 2012, each national securities exchange is required to submit proposed listing standards to the SEC, with final listing standards to be approved by the SEC by July 27, 2013. We anticipate, however, that the exchanges will act expeditiously so that the new listing standards are effective for purposes of the 2013 proxy season. The amendments to the proxy disclosure rules will apply to proxy statements for annual meetings at which directors will be elected on or after January 1, 2013.

Implications for Canadian Issuers

1. Canadian foreign private issuers whose equity securities are listed on U.S. exchanges will be required to comply with the new compensation committee member independence requirements unless they disclose in their annual reports the reasons why they do not have an independent compensation committee.
2. Canadian foreign private issuers whose equity securities are listed on U.S. exchanges will be required to comply with the new compensation adviser retention, funding and independence assessment requirements absent further exemption by the exchanges.
3. As Canadian foreign private issuers are generally exempt from the SEC proxy rules, they are not required to comply with the new compensation consultant conflict of interest disclosure requirements.  However, Canadian foreign private issuers may voluntarily decide to make such disclosures as a developing best practice. 

Exchange Listing Standards

Compensation Committee Member Independence

Under the new rule, U.S. national securities exchanges (exchanges) must establish listing standards requiring that each member of a listed issuer’s compensation committee (or other body of directors overseeing compensation)² be an “independent” member of its board of directors. As neither the new rule nor Dodd-Frank specifically defines the term “independent”, each exchange must develop its own definition of “independence” after considering relevant factors, including, but not limited to:

• the source of a director’s compensation, including any consulting, advisory or other compensatory fee paid by the issuer to such director; and
• whether a director is affiliated with the issuer, an issuer’s subsidiary or an affiliate of an issuer’s subsidiary.³

While the exchanges must consider affiliate relationships in establishing a definition of independence, the new rule does not require the adoption of listing standards which preclude compensation committee membership based on specific relationships. And while the SEC considered the issue of whether a director affiliated with a significant shareholder, such as a private equity or venture capital firm, could be sufficiently independent for compensation committee purposes, it declined to reach a view, thereby leaving the determination up to the exchanges in establishing their listing standards. Instead, the new rule requires the exchanges to consider other ties between an issuer and a director, in addition to share ownership, that could impair the director’s independence, such as, for example, personal or business relationships between compensation committee members and the issuer’s executive officers.

Compensation Committee Authority to Retain Compensation Advisers and Funding

The new rule also requires the exchanges to adopt or amend listing standards to provide that:

• the compensation committee may, in its sole discretion, retain or obtain the advice of a “compensation adviser,” defined to include compensation consultants, independent legal counsel and other advisers;
• the compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation advisers retained by the compensation committee; and
• the issuer must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation advisers (whether or not they are independent) retained by the compensation committee.⁴

Compensation committees are not required to implement or act consistently with the advice or recommendation of any compensation adviser, but must exercise their own judgment in fulfilling their duties.  Similarly, compensation committees are not required to retain or obtain advice solely from independent advisers; they are free to receive non-independent advice, including from in-house counsel or outside counsel retained by management or from a non-independent compensation consultant or other adviser, including those retained by management. In addition, these listing standards only apply to advisers hired by compensation committees and not those retained by management.

Compensation Adviser Independence

Under the new rule, exchange listing standards will also need to provide that before obtaining advice from any compensation adviser (other than in-house legal counsel), the compensation committee must consider the following six independence criteria, as well as any additional criteria specified in the listing standards adopted by the exchanges:

• The provision of other services to the issuer by the entity that employs the compensation adviser;
• The amount of fees received from the issuer by the entity that employs the compensation adviser, as a percentage of the total revenue of the entity that employs the compensation adviser;
• The policies and procedures of the entity that employs the compensation adviser that are designed to prevent conflicts of interest;
• Any business or personal relationship of the compensation adviser with a member of the compensation committee;
• Any stock of the issuer owned by the compensation adviser, including his or her immediate family (but not for this purpose by the entity that employs the adviser); and
• Any business or personal relationships between the executive officers of the issuer and the compensation adviser, or the entity employing the adviser.⁵

In adopting the new rule, the SEC indicated that the foregoing independence factors should be considered in their totality and that no factor should be viewed as determinative of independence. Furthermore, the SEC emphasized that it is not necessary that compensation consultants, legal advisers or other advisers be independent; but only that compensation committees consider the six independence factors before choosing a compensation adviser, except that compensation committees need not consider these factors before consulting with or obtaining advice from in-house counsel. Accordingly, listed issuers will need to put into place procedures for collecting and analyzing information about the independence of their compensation advisers, including information specified in the above criteria as well as any other criteria adopted by the exchanges, before they can obtain advice from those advisers.  Finally, listed issuers are not required to describe in their proxy materials the compensation committee’s process for selecting compensation advisers, as the SEC was sensitive to concerns that adding such disclosure would increase the length of proxy statement disclosures on executive compensation without necessarily providing additional material information to investors.

New Proxy Disclosure Regarding Compensation Consultants’ Conflicts of Interest

The SEC amended Item 407 of Regulation S-K to require new disclosure regarding compensation consultants’ conflicts of interest. Under existing Item 407(e)(3)(iii) of Regulation S-K, U.S. registrants must currently provide in proxy material for annual meetings the following information with respect to compensation consultants who had “any role in determining or recommending the amount or form of executive and director compensation”: 

• identify the compensation consultants;
• state whether such consultants were engaged directly by the compensation committee or any other person;
• describe the nature and scope of the consultant’s assignment and the material elements of any instructions given to the consultants under the engagement; and
• disclose the aggregate fees paid to a consultant for advice or recommendations on the amount or form of executive and director compensation and the aggregate fees for additional services if the consultant provided both and the fees for the additional services exceeded U.S.$120,000 during the fiscal year.

While the above requirements will remain in effect, under newly adopted Item 407(e)(3)(iv) of Regulation S-K, U.S. issuers will also be required to disclose whether 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.⁶ In determining whether or not a conflict of interest exists, issuers must consider the six independence-related factors listed above under “Compensation Adviser Independence”. The new conflict of interest disclosure requirements will apply to any compensation consultant whose work must be disclosed pursuant to Item 407(e)(3)(iii), regardless of whether the compensation consultant was retained by management, the compensation committee or any other board committee.

The new disclosure requirements will require issuers to implement disclosure controls and procedures to collect and analyze information relevant to whether their compensation consultants have a conflict of interest.

The requirements apply to disclosure in proxy and information statements for meetings at which directors are elected held on or after January 1, 2013, and apply to controlled companies, non-listed issuers and smaller reporting companies.

Exemptions

The applicability of the new rule and disclosure requirements to foreign private issuers is described above.  Controlled companies (defined as a listed company in which more than 50% of the voting power for the election of directors is held by an individual, a group or another company) and smaller reporting companies (generally, companies with a public float of less than $75 million) are exempt from both the compensation committee member independence requirements and the compensation adviser independence assessment requirements, but not from the new proxy statement compensation consultant conflicts of interest disclosure requirements. Limited partnerships, companies in bankruptcy proceedings and open-end management investment companies registered under the U.S. Investment Company Act of 1940 are exempt from the compensation committee member independence requirements but not from the compensation adviser independence assessment requirements, absent further action by the exchanges, or from the new proxy statement compensation consultant conflicts of interest disclosure requirements. The exchanges are also expressly permitted to consider whether any additional exemptions are appropriate for any other category of issuer, such as “emerging growth companies” under the recently enacted JOBS Act or other newly listed issuers.

Opportunity to Cure Defects

The final rule requires exchanges to provide reasonable opportunity and appropriate procedures for listed issuers to cure any non-compliance with the compensation committee listing requirements that could lead to the delisting of an issuer. In addition, the exchanges may provide that if a member of a listed issuer’s compensation committee ceases to be independent for reasons outside the member’s reasonable control, that person, upon notice by the issuer to the applicable exchange, may remain a compensation committee member of the listed issuer for up to a year, or until the next annual shareholders’ meeting of the issuer if earlier.

For more information about these developments, please contact the authors.

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¹ See “Listing Standards for Compensation Committees,” SEC Release No. 33-9330 (June 20, 2012).

² The new rule defines “compensation committee” as either (i) a board committee designated as the compensation committee, (ii) in the absence of such a committee, the board committee performing functions typically performed by a compensation committee, including oversight of executive compensation, even if not designated as the compensation committee or also performs other functions; and (iii) in the absence of either of the foregoing, the members of the board who oversee executive compensation on behalf of the board.

³The factors to be considered in determining the independence of compensation committee members are similar to those applicable under the Exchange Act to audit committee members; however, unlike the independence requirements for audit committee members, the new rule does not establish any standards or relationships that will automatically preclude a finding of independence. Thus, the new rule provides more discretion to the exchanges to determine the independence standards for compensation committee members than they are provided with respect to audit committee members. However, the new rule would permit the exchanges in adopting their listing standards to make these considerations actual prohibitions.

⁴ The listing standards relating to the compensation committee’s authority to retain compensation advisers and required funding for payment of such advisers do not apply to directors who oversee executive compensation outside of the structure of a formal board committee.

⁵ The final rule does not include any materiality, numerical or other thresholds that would narrow the circumstances in which a compensation committee is required to consider the independence factors specified in the rule.

⁶ The final rule does not require disclosure of potential conflicts of interest or an appearance of a conflict of interest, nor does it require disclosure with respect to compensation advisers other than compensation consultants.