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January 17, 2013

SEC Approves NYSE and NASDAQ Rules on Independent Compensation Committees

By Jim Hamilton, J.D., LL.M.

The SEC has approved rule changes by the NYSE and NASDAQ on independent compensation committees as ultimately required by the Dodd-Frank Act. Implementing Section 952 of the Dodd-Frank Act, the SEC adopted regulations directing the exchanges to establish listing standards requiring each member of a company’s compensation committee to be an independent member of the board of directors. The regulations also direct the exchanges to adopt listing standards providing that the compensation committee may, in its sole discretion, retain or obtain the advice of a compensation adviser.

As approved by the SEC, NYSE rules will require each listed company to have a compensation committee composed entirely of independent directors, as defined in NYSE rules. The NYSE will also require that a listed issuer adopt a formal written compensation committee charter that specifies the scope of the committee’s responsibilities and how it carries out those responsibilities, including structure, operations, and membership requirements (Release No. 34-68639, January 11, 2013).

No director qualifies as independent unless the board of directors of the listed company affirmatively determines that the director has no material relationship with the company. The board of directors is required, in affirmatively determining the independence of any director who will serve on the compensation committee of the board, to consider all factors specifically relevant to determining whether a director has a relationship to the company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to: (1) the source of compensation of such director, including any consulting, advisory, or other compensatory fee paid by the listed company to such director; and (2) whether such director is affiliated with the listed company, a subsidiary of the company, or an affiliate of a subsidiary of the company.

The board should consider whether the director receives compensation from any person or entity that would impair his or her ability to make independent judgments about the company’s executive compensation. With respect to the affiliation factor, NYSE rules provide that the board should consider whether an affiliate relationship places the director under the direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair his or her ability to make independent judgments about the company’s executive compensation

NASDAQ

Separately, the SEC approved the NASDAQ rule proposal that each listed company be required to have a compensation committee of at least two independent directors. NASDAQ dropped the current alternative to a formal compensation committee under which a company could use a majority of the board’s independent directors in a vote in which only they participate (Release No. 34-68640, January 11, 2013).

The compensation committee must have a formal charter, and the company must certify that it has adopted such a charter and that its compensation committee will annually review and reassess the adequacy of that charter. The charter must specify the scope of the committee’s responsibilities and how it carries out those responsibilities, including structure, processes, and membership requirements.

NASDAQ adopted a provision stating that each member of a compensation committee of a listed company must not accept, directly or indirectly, any consulting, advisory, or other compensatory fee from the company or any of its subsidiaries. As currently permitted under the rules for audit committee members, however, the rules would permit a compensation committee member to receive fees for his or her membership on the committee, on the company’s board, or on any other board committee. In addition, a compensation committee member would be permitted to receive fixed amounts of compensation under a retirement plan for prior service with the company, provided that such compensation is not contingent in any way on continued service.

In determining whether a director is eligible to serve on the compensation committee, the company’s board also must consider whether the director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company to determine whether such affiliation would impair the director’s judgment as a member of the compensation committee.

NASDAQ has retained an exception allowing a director who is not an independent director to be appointed to the compensation committee under exceptional and limited circumstances, so long as that director is not currently an executive officer, an employee, or the family member of an executive officer. The exception applies, however, only if the committee comprises at least three members and the company’s board determines that the individual’s membership on the committee is required by the best interests of the company and its shareholders. A compensation committee member may not serve longer than two years under this exception. In addition, a company relying on the exception must disclose on its website or in its proxy statement the nature of the relationship and the reasons for the determination.

While some commenters objected to retention of the exception, NASDAQ explained that the exception is consistent with SEC Rule 10C-1, which expressly permits a national securities exchange to exempt from these requirements a particular relationship with respect to members of the compensation committee, as each national exchange determines is appropriate, taking into consideration the size of an issuer and any other relevant factors. Further, the exception has been in place since 2003, noted NASDAQ, has been used infrequently, and has not been abused.

Moreover, NASDAQ said that it is appropriate to allow a company some flexibility as to board and committee membership and composition under exceptional and limited circumstances. This is particularly important for a smaller company that may have relationships that require such flexibility.

Compensation Consultants

Under both NYSE and NASDAQ rules, the compensation committee may select or receive advice from a compensation consultant, legal counsel, or other adviser to the compensation committee, other than in-house legal counsel, only after taking into consideration all factors relevant to that person’s independence from management, including the six factors set forth in Rule 10C-1 regarding independence assessments of compensation advisers.

The six factors, which are set forth in full in the approved rules, are: (1) the provision of other services to the listed company by the person that employs the compensation consultant, legal counsel, or other adviser; (2) the amount of fees received from the listed company 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; (3) 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; (4) any business or personal relationship of the compensation consultant, legal counsel, or other adviser with a member of the compensation committee; (5) any stock of the listed company owned by the compensation consultant, legal counsel, or other adviser; and (6) any business or personal relationship of the compensation consultant, legal counsel, other adviser, or the person employing the adviser with an executive officer of the listed company.

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