Comp Committee Standards Arrive

Forget the Fourth of July—for companies listed on the New York Stock Exchange and Nasdaq, July 1 is independence day.

That's the deadline for compliance with new listing standards for board directors serving on compensation committees. No compliance with those new standards for director independence means no trading on those exchanges any longer.

The listing standards are the last regulatory domino to fall for the independence standards. First came the Dodd-Frank Act of 2010, which directed the Securities and Exchange Commission to call for enhanced independence standards; the SEC in turn passed a rule last year directing the exchanges to adopt those standards, which the exchanges did, and now the changes are here.

The standards state that all members of the board's compensation committee must be independent; independence metrics include director compensation and affiliations with the company or a subsidiary.

The amendments also require that compensation committees hire pay consultants only after considering: whether the firm employing the compensation adviser is providing any other services to the company; how much the compensation consulting firm has received in fees from the company; whether the adviser has any business or personal relationship with a member of the compensation committee; and whether the adviser owns any company stock or has any business or personal relationship with an executive officer.

The SEC also required disclosure of whether the work of a compensation consultant raised any conflicts of interest, and if so, how they were addressed. Rather than impose a uniform standard, specifics were left to the discretion of the exchanges. With the Commission's approval, new rules crafted by NYSE and Nasdaq for their companies begin to go into effect on July 1.

“The first thing public companies listed on either exchange should do is review the applicable new standards and discuss these changes, so that they are aware of the new requirements and when they will apply,” says Peter Wolf, an associate with the law firm Drinker Biddle & Reath.

All companies listed on the NYSE or NASDAQ will need to grant the compensation committee the authority and responsibility to retain and oversee compensation advisers, he explains. For NYSE companies, this requires amending the compensation committee charter. Nasdaq companies have the option to adopt board resolutions granting the compensation committee this authority and responsibility by the July 1 deadline and then amend their charter prior to the earlier of the company's first annual shareholders' meeting after Jan. 15, 2014, or Oct. 31, 2014.

Among the requirements in the listing standards:

Nasdaq will impose a bright-line prohibition on any payments to compensation committee members. This is the same independence standard that applies to audit committee members. There is, however, no bright-line test regarding affiliate status, which alone does not necessarily prevent a director from also being a committee member.

Unlike Nasdaq, the NYSE does not adhere to a bright-line test for compensation. A director may still be considered independent even if he or she receives compensation, or has a company affiliation, if his or her ability to make independent judgments is not impaired.

Nasdaq companies are required to have a separate compensation committee, consisting of at least two members, each of whom is an independent director. The new standards eliminate the current option for a majority of independent directors to act in lieu of a compensation committee.

The NYSE's director independence standards specify that ownership of even a significant amount of company stock does not, by itself, mean that a director is not independent.

“You can have all the rules you want about who should be on your committee, but if you don't have competence and integrity the rules won't matter much.”

—Margaret Farrell,

Hinckley, Allen & Snyder

Wolf says many Nasdaq companies have already started to amend their compensation committees to reflect the new standards. “This has the advantage of being a one-step process, as opposed to passing a board resolution now and amending the charter later,” he says. An initial step is to review the current compensation committee charter to determine how extensive the required amendments will be.

Margaret Farrell of the law firm Hinckley, Allen & Snyder says that because many companies are already focused on compensation best practices, the new standards shouldn't be a “big leap” for them. Aside from heeding the advice of their legal counsel to get ahead of the issue, companies were also pushed toward the standards detailed in the listing standards by proxy advisory firms, especially through their use corporate governance scores and proxy recommendations.

“All of that was already part and parcel of the governance world,” she says. “If you cared about any of that, you were already thinking about compensation committee independence.”

Farrell has seen many of her clients adopt measures for compensation committees that hew closely to existing (and exhausting) standards for audit committees. One potential issue that may arise, she says, is that Nasdaq's bright-line stance may mean that someone otherwise deemed independent because of the lack of materiality of any compensation arrangements, would no longer qualify, even if the payment was relatively insignificant.

Complying with new listing standards will be most challenging for Nasdaq-listed companies that do not already have a standalone compensation committee in place, Wolf says. Fortunately, he explains, they do not have to establish a separate compensation committee to comply with the standards until their company's first annual shareholders' meeting after Jan. 15, 2014, or Oct. 31, 2014, whichever is sooner.

“Companies should not lose focus on the second deadline, as it could cause some headaches if they wait to assess compensation committee member independence and later determine that some members do not meet the new standards,” he says.

ACTION ITEMS

The following is from a client advisory by the law firm Gibson, Dunn & Crutcher.

Action Items for NYSE Companies

By July 1, NYSE companies will need to amend the compensation committee charter to include the following additional responsibilities and authority:

Having the authority, in the committee's sole discretion, to retain or obtain the advice of compensation consultants, outside counsel or other advisers;

Being directly responsible for the appointment, compensation and oversight of the work of any compensation consultants, outside counsel or other advisers retained by the committee;

Receiving appropriate funding from the company, as determined by the committee, for payment of compensation to any compensation consultants, outside counsel or other advisers retained by the committee; and

Assessing the independence of any compensation consultants, outside counsel or other advisers that provide advice to the committee, before selecting or receiving advice from them, based on the factors set forth in the listing standards.

Action Items for NASDAQ Companies

By July 1, NASDAQ companies, like NYSE companies, will need to provide their compensation committees with the additional responsibilities and authority set forth above. We anticipate that NASDAQ companies will address these new requirements by amending their charters. Although the NASDAQ listing standards also allow companies to satisfy these requirements on an interim basis by adopting a board resolution, we expect this approach will be useful only for those few NASDAQ companies that do not yet have a compensation committee charter.

Because the NASDAQ listing standards require the charter “to specify . . . the specific compensation committee responsibilities and authority” described above, questions have been raised about whether the charter must set forth the specific factors that the committee will have to consider in assessing the independence of advisers. According to informal guidance we received from the NASDAQ staff, the charter need not include these factors. A cross-reference would be sufficient. The NASDAQ rules also require the charter to specifically address the existing NASDAQ requirement that the chief executive officer may not be present during voting or deliberations on his or her compensation.

Adviser Independence Assessment

Beginning July 1, compensation committees will need to have conducted an assessment of adviser independence before receiving advice from an outside adviser or retaining a new adviser. This requirement applies to any compensation consultant, outside counsel or other adviser that “provides advice” to the committee, including advisers retained by management. This requirement applies only to advisers to the compensation committee, but is not limited to advisers providing advice on executive or director compensation matters. There are interpretive questions about what it means to “provide advice,” and this may depend on the facts and circumstances. Because of this uncertainty over what may constitute the provision of advice to the committee, in many cases it may be best for the compensation committee to review the independence factors with respect to any consultants, outside counsel or other advisers that work regularly with management or the committee on executive compensation matters and other matters that fall within the committee's areas of responsibility. Compensation committees may conduct the assessment at a meeting prior to July 1, or at the first regularly scheduled meeting after July 1 provided that they do not receive advice from advisers in the interim. After the initial assessment, compensation committees should conduct a similar assessment at least annually. Importantly, the listing standards do not require that the compensation committee use only independent advisers or that the committee make a determination about whether the advisers are independent after reviewing the relevant factors.

Source: Gibson Dunn.

A concern for Ronald Mueller, a partner with the law firm Gibson, Dunn & Crutcher, is the annual process companies will need to endure as the compensation committee evaluates the independence of anyone who provides advice.

Mueller offers a reminder that this review extends to any advisers to the committee. “So that could include actuaries, outside counsel, and management's compensation consultant, not just the committee's consultant,” he says. “Not only do they need to have this charter amendment approved, it could affect the committee's operations because these assessments are required to be done in advance of receiving advice.”

Both the NYSE and Nasdaq included language that under “exceptional and limited” circumstances companies can appoint a non-independent director to the compensation committee. This is allowed if the board can make the case that doing so is in the best interests of shareholders. Left up to interpretation is just what sort of arrangement would qualify.

Mueller says there likely won't be many situations where this exemption would come into play. One example: A past executive, despite not satisfying independence standards, nevertheless offers valuable expertise and his tenure was far back enough that he has little connection to current operations. Another situation, Mueller says, might be a sudden, unexpected executive vacancy necessitates a quick temporary appointment.

For companies that haven't yet made progress toward the new listing standards, Mueller says they first need to review their existing charter to make sure it complies with the rules. Then they should determine who the advisers to the committee are, as well as who is likely to advise the committee in the coming year. “Frankly, there is still a lot of uncertainty about what it means to be advising the committee,” he says. “Since it has to be done in advance, it's better to be overly broad and err on the side of caution when you bring your potential adviser's information in front of the committee.”

“I don't think these changes materially impact the ability to have the right people on your committee,” Farrell says. If there is any debate, it is whether the new rules will ensure both “competence and integrity.”

“You can have all the rules you want about who should be on your committee, but if you don't have competence and integrity the rules won't matter much,” she says. Some advisers with a conflict might, in fact, “work extra hard to be fair, even-handed, and look out for shareholder interests,” holding themselves to a higher standard.

She agrees with some research that indicates having non-affiliates on the board actually has the opposite effect, and those who are perceived to have a vested interest in the company “are often very good watchdogs.”

“Their interests may actually align with those of the shareholders,” she says. “A director with some de minimus interest who is knowledgeable and capable may be much more valuable than someone who has no such potential conflict, but doesn't have the competencies and is basically a tool of management.”