SEC Proposes Dodd-Frank Compensation Committee and Consultant Rules

On March 30, 2011, the SEC proposed rules¹ that would implement Section 952 of the Dodd-Frank Act. The proposed rules would require U.S. stock exchanges to adopt new corporate governance requirements as to compensation committees² of listed issuers of equity securities. The rules would also require new disclosures in annual proxy statements regarding advice obtained by compensation committees from compensation consultants, which would apply to all public companies, not just listed companies. In general, the proposed rules add little to the provisions of Section 952, which is more detailed and prescriptive than other provisions of the Dodd-Frank Act dealing with corporate governance.

Neither Section 952 of the Dodd-Frank Act nor the proposed rules mandate that any stock exchange require listed companies to have a compensation committee, or have executive compensation approved by independent directors. Current NYSE rules require an independent compensation committee, while NASDAQ Stock Market Rules permit, in the alternative, executive compensation to be determined or recommended by a majority of the board’s independent directors, in a vote in which only independent directors participate.

Comments on the proposed rules are due by April 29, 2011.

Proposed Listing Requirements

“Independence” of Committee Members

Proposed new Rule 10C-1 under the Securities Exchange Act of 1934 would require stock exchanges to establish specific independence requirements for members of compensation committees and to consider relevant factors in adopting those requirements, including:

• Compensation of the member, including any consulting or advisory fees; and
• Whether the member is affiliated with the issuer.

These two factors, which track Section 952, closely resemble criteria established by the Sarbanes-Oxley Act in 2002 for members of audit committees. The proposing release notes, however, that while the SOX provision barred directors from the audit committee if either of those factors applied, Section 952 merely requires stock exchanges to consider them in adopting their rules. Significantly, the release notes strong arguments that have been advanced against barring from compensation committees directors associated with significant stockholders, such as a venture capital fund, even if the stockholder is an “affiliate” of the issuer.

When stock exchanges implement this new independence requirement for compensation committee members, many companies will need to consider three different definitions of “independence” for compensation committee members, in addition to the relevant exchange’s general definition of independence:

• This new Dodd-Frank definition;
• The definition under IRC Section 162(m), in order to preserve the tax-deductibility of performance-based awards by the committee; and
• The definition in SEC Rule 16b-3, in order for the committee to approve equity compensation that is exempt from the Section 16(b) short-swing profit rules.

Certain categories of issuers would be exempted from this requirement, including:

• Controlled companies (which would be exempted from all of the listing requirements);
• Open-end management investment companies (e.g., mutual funds and most exchange-traded funds)³; and
• Any foreign private issuer that discloses in its annual report why it does not have an independent compensation committee.

In addition, exchanges would be permitted to exempt particular relationships with respect to compensation committee members or particular categories of issuers (perhaps including smaller reporting companies, which would not otherwise be exempt).

Authority to Engage Consultants and Independent Legal Counsel

Under the stock exchanges’ rules, the compensation committee must have sole discretion to retain or obtain the advice of a compensation consultant, independent legal counsel or other advisor, and direct responsibility for oversight of any such advisors. The issuer must provide appropriate funding for reasonable compensation to such a consultant, counsel or advisor. The committee would not, however, be required to seek the advice of a compensation consultant, independent legal counsel or any other advisor, and would be free to obtain advice from a “non-independent” consultant, counsel or other advisor, including in-house counsel.

Independence of Compensation Consultants and Other Advisors

Under the stock exchanges’ rules, a compensation committee selecting a compensation consultant, legal counsel or other advisor must consider the following factors (as well as any others that a stock exchange identifies in its listing standard):

• Provision of other services to the issuer by the employer of the consultant, legal counsel or other advisor;
• What percentage fees received from the issuer represent of total revenue of the employer of the consultant, legal counsel or other advisor;
• Policies of the employer of the consultant, legal counsel or other advisor to prevent conflicts of interest;
• Any business or personal relationship of the consultant, legal counsel or other advisor with any member of the compensation committee; and
• Any stock of the issuer owned by the consultant, legal counsel or other advisor (but not stock owned by his or her employer, or by its other employees).

No particular weight need be given to any of these factors, since a committee would be free to engage a consultant, counsel or other advisor even if all factors suggested a potential conflict of interest.

Disclosure Requirement

Section 952 of Dodd-Frank requires proxy statement disclosure whether:

• The compensation committee retained or obtained the advice of a compensation consultant, and
• The work of the consultant raised any conflict of interest and, if it did, the nature of the conflict and how it is being addressed.

Rather than simply adding a new requirement to its proxy disclosure rules, the SEC proposes to combine this requirement with its existing requirements in Regulation S-K, Item 407(e)(3)(iii) regarding compensation committee use of compensation consultants. In harmonizing these requirements, the SEC proposes to delete the current total exemption from disclosure of a consultant whose services were limited to broad-based plans, or were not customized for the company. The exemption from disclosure of fees paid to those types of consultants would, however, be retained.

Effective Dates

The SEC is required by Section 952 to adopt these rules by July 16, 2011, although their effective date could be later. The proposed rules would require the exchanges to submit their proposed rules within 90 days after publication of the final SEC rules and to have final rules approved no later than one year after publication of the final SEC rules. Thus, final stock exchange rules implementing the listing requirements could be approved as late as July 2012.

The disclosure rules would take effect on the date specified in the release adopting final SEC rules, which, as noted above, are required to be adopted by July 16, 2011.

Conclusion

By sticking closely to the text of Section 952 of Dodd-Frank, the SEC has left it to the exchanges to supply the details on important concepts such as the new definition of “independence” for compensation committee members. Since the exchange rules will be subject to SEC approval, however, the SEC may yet play a significant rule in the shaping of those rules, in addition to its suggestions and hints in the proposing release.

For additional information concerning this alert, please contact your regular Bingham contact or the following lawyers:

Michael P. O’Brien
michael.obrien@bingham.com
617.951.8302

Laurie A. Cerveny
laurie.cerveny@bingham.com
617.951.8527

Charles A. Sweet
charles.sweet@bingham.com
202.373.6777

Barry N. Hurwitz
barry.hurwitz@bingham.com
617.951.8267

¹ The proposed rules can be found at: http://www.sec.gov/rules/proposed/2011/33-9199.pdf

² “Compensation committee” would include any other committee that performs functions typically performed by a compensation committee, which might include certain corporate governance or human resources committees. The rules would not, however, apply to independent directors approving executive compensation not as a committee, as permitted by NASDAQ Stock Market rules.

³ Although the five categories of exempted issuers do not include closed-end management investment companies (or “closed-end funds”), these companies are generally exempt from current exchange listing standards that require executive compensation determinations to be made by a compensation committee or independent directors. As noted above, neither Section 952 of the Dodd-Frank Act nor the proposed rules compel stock exchanges to change their rules in this regard. Whether any exchanges would do so cannot be determined at this time.