New SEC Compensation Committee Rules

Background

On June 20, 2012, Section 10C was added to the Securities Exchange Act of 1934 by the U.S. Securities and Exchange Commission (the “SEC”) to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The new rules to the Securities Exchange Act of 1934 will require:

• National securities exchanges to establish listing standards that require each member of a listed issuer’s compensation committee to be a member of the board of directors and to be independent; and

• All issuers that are subject to SEC proxy rules to disclose conflict of interest in their use of compensation consultants

Independence Requirements

The new rules require that a member of the issuer’s compensation committee be a member of the board of directors of the issuer and must also be independent. For the purpose of this article, the compensation committee is, in absence of a board committee, the committee of independent directors of the board who are charged with oversight of executive compensation. It will be the exchanges’ responsibility to determine the definition of independence which considers “relevant factors” including, but not limited to the following:

• A director’s source of 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, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer

Under the new rules, the exchanges will establish the definition of independence. The exchanges are not required to establish a uniform definition. This provides the exchanges with some flexibility in determining what they believe are the relevant factors in determining the definition of independence. The final rules do not provide any specifics that must be considered or establish any relationships that will preclude a determination of independence. The final definition will still be subject to the SEC’s review and approval. It should also be noted that the definition of independence under the Sarbanes-Oxley Act of 2002 does not offer this flexibility. As a result, a director that has been determined not to be independent under the independence rules related to audit committees could be determined to be independent under the compensation committee rules.

The new rules recognize that a compensation committee member, through no fault of their own, may cease being independent. If this circumstance arises, the member, with notice by the issuer to the exchange, may remain a member of the compensation committee until the earlier of the following:

• Issuer’s next annual meeting

• One year from the occurrence of the event the caused the impairment of independence

Compensation Consultants and Advisers

The new rules allow compensation committees, at their sole discretion, to obtain the services of a compensation consultant. This also includes the services of independent legal counsel and other advisers. Although the rules allow the compensation committee to retain a compensation consultant, it does not make it a requirement that the compensation committee do so. In addition, if the compensation committee does retain the services of a consultant, the compensation committee is not required to implement or act on the advice or recommendations of the consultant. The compensation committee is responsible for the appointment, compensation and oversight of the compensation consultant’s work. The issuer is responsible to provide appropriate funding, which will also be at the discretion of the compensation committee, to retain a compensation consultant.

While the new rules do not call for the compensation consultant to be independent, it does provide that the compensation committee should consider certain factors that may affect the independence of the consultant. The following factors should be considered by compensation committees prior to engaging a compensation consultant:

• The provision of other services to the issuer by the employer of the compensation advisor;

• The amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser;

• The policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest;

• Any business or personal relationship between the compensation consultant, legal counsel or other adviser with a member of the compensation committee;

• Any stock of the issuer owned by the compensation consultant, legal counsel or other adviser; and

• Any business or personal relationship between the compensation consultant, legal counsel or other adviser with the issuer’s executive officers.

In considering these six factors, the compensation committee should not include any threshold amount (i.e. materiality, numerical or other threshold amounts) that would narrow any circumstances that are required to be considered. The compensation committee does not have to consider these factors when consulting with the issuer’s in-house counsel.

Exemption and Timing – Listing Standards for Compensation Committee Independence and the Retention and Independence of Compensation Consultants

The final rules relating to the listing standards for compensation committee independence and the retention and independence of compensation consultants apply to all issuers of equity securities with the following exceptions:

• Issuers not subject to compensation committee independence requirements:
  • Limited partnerships
  • Companies in bankruptcy proceedings
  • Open ended management investment companies registered under the Investment Company Act of 1940, and
  • foreign private issuers that disclose in their annual reports the reasons that they do not have independent compensation committees

• Issuers exempt from all of the new rules relating to compensation committee independence and the retention and independence of compensation advisers:
  • Clearing agency issuers of security futures products and standardized options
  • Controlled companies – a company in which more than 50% of the voting power for the election of directors is held by an individual, group or another company
  • Smaller reporting companies, as defined in Exchange Act Rule 12b-2

The exchanges must provide their proposed rule listing standard changes to the SEC no later than September 25, 2012 and each exchange must have final rules that are approved by the SEC by June 27, 2013. Issuers must comply with the disclosure changes in Item 407 of Regulation S-K in any proxy or information statement at which directors will be elected occurring on or after January 1, 2013.

Disclosure Items Related to Compensation Committee

Section 10(c)(2)(A) under the Securities Exchange Act of 1934 requires an issuer to disclose whether its compensation committee retained or obtained the advice of a compensation consultant. Rather than integrating a new disclosure requirement, a new subsection was added. Under Item 407(e)(3)(iii) of Regulation S-K issuers will continue to be required to:

• Identify the consultants;
• State whether the 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 consultant under the engagement; and
• Disclose the aggregate fees paid to a consultant for advise or recommendations on the amount or form of executive and director compensation and the aggregate fees for additional services of the consultant provided both and the fees for the additional services exceeded $120,000 during the fiscal year.

A new subparagraph was added to Item 407(e)(3) of Regulation S-K. This was to address disclosures mandated by Section 10(c)(2)(B) of the Securities Exchange Act of 1934 which required disclosure of whether: (1) the compensations committee has retained or obtained the advice of a compensation consultant, and (2) 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. This information should be disclosed in a proxy or information statement related to an annual meeting of shareholders.

The new subparagraph, Item 407(e)(3)(iv) of Regulation S-K, requires disclosures of the nature of any conflict of interest arising from the work of any compensation consultant and how that conflict is being addressed. This new disclosure requirement applies to compensation consultants that are required to be identified in the proxy statement under existing Item 407(e)(3)(iii). As such, this disclosure requirement will pertain to all compensation consultants regardless if they were retained by management or the compensation committee.

The new conflict of interest disclosures under Item 407(e)(3) of Regulation S-K apply to all issuers that are subject to the SEC proxy rules and will be required in any proxy or information statement for an annual shareholder meeting at which directors will be elected on or after January 1, 2013.