The Commission’s Final Rules Requiring Listing Standards for Compensation Committees and Advisers

Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act amended the Securities Exchange Act of 1934 by adding new Section 10C which requires that the Securities and Exchange Commission adopt rules directing the national securities exchanges and national securities associations to prohibit the listing of a company’s equity securities if that company does not comply with certain compensation committee and compensation adviser requirements.^*

The Commission first released proposed rules and amendments to implement Section 10C in March 2011, and, thereafter, in response to a request from the Center for Capital Markets, extended the comment period through May 2011.

Last week the Commission adopted new Rule 10C-1 and amended Item 407 of Regulation S-K.

Compensation Committees Listing Standards

New Rule 10C-1 requires that, to the extent a national securities exchange lists equity securities, that exchange must adopt listing standards that address the independence of a company’s compensation committee members as well as such members’ authority to select, oversee and pay for the services of compensation advisers.

Rule 10C-1 defines a “compensation committee” to include not only board committees formally designated as compensation committees, but also any board committee that performs functions typically performed by a compensation committee (e.g., a human resources committee or corporate governance committee), and, for certain aspects of Rule 10C-1, in the absence of either a compensation or other committee that performs functions typically performed by a compensation committee, the members of a company’s board of directors who oversee executive compensation matters on behalf of the board.

The exchanges’ listing standards must prohibit the initial or continued listing of any company’s equity securities unless each member of the company’s compensation committee, as defined by Rule 10C-1, is a member of the company’s board of directors and is otherwise independent.

Subject to the Commission’s review and approval, each exchange may develop its own definition of independence, provided they take into consideration relevant factors including, without limitation:

• a director’s source of compensation, including any consulting, advisory or compensatory fee paid by the company; and

• whether a director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.

There is, however, no requirement that the exchanges adopt listing standards prohibiting compensation committee membership based on any specific relationship, such as affiliate status, and they may exempt certain relationships or categories of companies as deemed appropriate.

Compensation Advisers Listing Standards

New Rule 10C-1 also requires that the exchanges adopt listing standards providing that:

• a formally designated compensation committee or other board committee that performs functions typically performed by a compensation committee may, in its sole discretion, retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser (each a “Compensation Adviser”);

• a formally designated compensation committee, other board committee that performs functions typically performed by a compensation committee or, in the absence of a committee, members of a company’s board of directors who oversee executive compensation matters, are directly responsible for the appointment, compensation and oversight of any Compensation Adviser retained; and

• each company must provide appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any Compensation Adviser.

Moreover the compensation committee will not be required to implement or act consistently with the advice or recommendations of any  Compensation Adviser, but rather will retain the ability and obligation to exercise its own judgement in fulfilling its duties.

Compensation Adviser Independence

Prior to selecting a Compensation Adviser, a compensation committee must consider six independence factors set forth in Rule 10C-1 and any other factors prescribed by the listing standards of the exchanges. The factors enumerated in Rule 10C-1 include consideration of:

• other services provided to the company by the Compensation Adviser’s employer;

• the fees received from the company by the Compensation Adviser’s employer as a percentage of such employer’s total revenues;

• the policies and procedures of the Compensation Adviser’s employer 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 company owned by the Compensation Adviser; and

• any business or personal relationship of the Compensation Adviser or the Compensation Adviser’s employer with an executive officer of the company.

The factors should be considered in their totality, with no one factor being viewed as determinative of independence. What’s more nothing in Rule 10C-1 requires a Compensation Adviser to be independent, only that the compensation committee consider the independence factors prior to selecting a Compensation Adviser.

Exemptions

Certain categories of companies are exempt from Rule 10C-1’s independent compensation committee requirements, including limited partnerships, companies in bankruptcy, open-end management investment companies and foreign private issuers that disclose in their annual report the reason why they do not have an independent compensation committee.

In addition controlled companies and smaller reporting companies are altogether exempt from new Rule 10C-1.

What’s Next for the Exchanges

The exchanges will have until September 25, 2012 (90 days from Rule 10C-1’s publication in the federal register) to propose listing rules and amendments to implement Rule 10C-1, and until June 27, 2013 (one year from Rule 10C-1’s publication in the federal register) to have final listing rules and amendments approved by the Commission.

Disclosure of Compensation Consultant Conflicts of Interest

Section 10C of the Dodd Frank Act also requires that in any proxy or consent solicitation materials for an annual meeting (or special meeting in lieu of an annual meeting), a company disclose whether its compensation committee has retained the advice of a compensation consultant and 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.

In implementing Section 10C the Commission notes that Item 407 of Regulation S-K already requires companies to disclose the role of compensation consultants in determining or recommending executive and director compensation. As such, a new subsection has been added to Item 407 requiring disclosure with regard to conflicts of interest and how those conflicts are being addressed. Also, in implementing Section 10C, the Commission is only requiring disclosure in proxy or consent solicitation materials for an annual meeting (or special meeting in lieu of an annual meeting) at which directors are to be elected.

Unlike the requirements of new Rule 10C-1, the new subsection of Item 407  is applicable to controlled companies, non-listed companies, smaller reporting companies and any other companies subject to the Commission’s proxy rules.

Companies must begin complying with the new disclosure requirements in any proxy or information statement for an annual meeting (or special meeting in lieu of an annual meeting) at which directors are to be elected occurring on or after January 1, 2013.

Update July 13, 2012:

Yesterday the Commission released a brief small entity compliance guide summarizing the rules related to compensation committee listing standards, from which smaller reporting companies are exempt, and the disclosure requirements related to compensation consultants conflicts of interest.

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*At present FINRA is the only national securities association and it does not list equity securities, so new Rule 10C-1 only applies to national securities exchanges like the NYSE, Nasdaq and NYSE Amex. In addition new Rule 10C-1 will not apply to over-the-counter markets like the OTC Bulletin Board or OTC Markets Group, which are interdealer quotation systems that quote rather than list securities.

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