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 do not require that exchanges establish a uniform definition of independence. Given the wide variety of issuers that are listed on exchanges, said the SEC, exchanges were given the flexibility to develop independence requirements appropriate for the issuers listed on each exchange. Although this provides the exchanges with flexibility to develop the appropriate independence requirements, the Commission reminded that the independence requirements developed by the exchanges will be subject to review and final SEC approval pursuant to Section 19(b) of the Exchange Act.
In addition, when developing their own definitions of independence applicable to compensation committee members, the exchanges must consider relevant factors, including a director’s source of compensation, including any consulting, advisory or compensatory fee paid by the issuer; and whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.
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. The compensation committee will be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser retained by the committee. Further, each listed issuer must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation adviser retained by the committee. According to the SEC, the regulations may not be construed to require the compensation committee to implement or act consistently with the advice or recommendations of any adviser to the compensation committee or to affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of its duties.
Moreover, SEC regulations do not require compensation committees to retain or obtain advice only from independent advisers. The committee may receive advice from non-independent counsel, such as in-house counsel or outside counsel retained by management, or from a non-independent compensation consultant or other adviser, including those engaged by management. Nor do the regulations require a compensation committee to be directly responsible for the appointment, compensation or oversight of compensation advisers that are not retained by the compensation committee, such as compensation consultants or legal counsel retained by management.
Section 10C(b) of the Exchange Act, added by Dodd-Frank, provides that the compensation committee of a listed issuer may select a compensation adviser only after taking into consideration the five independence factors specified in the statute as well as any other factors identified by the Commission. In accordance with Section 10C(b), these factors would apply to the selection of compensation consultants, legal counsel and other advisers to the committee. The statute does not require a compensation adviser to be independent, only that the compensation committee of a listed issuer consider the enumerated independence factors before selecting a compensation adviser.
The SEC regulations require a compensation committee to take into account the five factors enumerated in Section 10C(b)(2), as well as one added by the Commission, which is any business or personal relationships between the executive officers of the issuer and the compensation adviser or the person employing the adviser. This would include, for example, situations where the chief executive officer of an issuer and the compensation adviser have a familial relationship or where he chief executive officer and the compensation adviser (or the adviser’s employer) are business partners. The SEC agreed with commentators who stated that business and personal relationships between an executive officer and a compensation adviser or a person employing the compensation adviser may potentially pose a significant conflict of interest that should be considered by the compensation committee before selecting a compensation adviser.
The five statutory factors are the provision of other services to the issuer by the person that employs the compensation adviser; the amount of fees received from the issuer by the person that employs the compensation adviser, as a percentage of the total revenue of that person; the policies of the person that employs the compensation adviser that are designed to prevent conflicts of interest; any business or personal relationship of the compensation adviser with a member of the compensation committee; and any stock of the issuer owned by the compensation adviser.
The SEC believes that these six factors, when taken together, are competitively neutral, as they will require compensation committees to consider a variety of factors that may bear upon the likelihood that a compensation adviser can provide independent advice to the compensation committee, but will not prohibit committees from choosing any particular adviser or type of adviser. The factors should be considered in their totality, said the SEC, and no one factor should be viewed as a determinative factor of independence
Neither Dodd-Frank nor the implementing regulations require a compensation adviser to be independent, only that the compensation committee consider the enumerated independence factors before selecting a compensation adviser. Compensation committees may select any compensation adviser they prefer, including ones that are not independent, after considering the six independence factors.
Changes to Item 407(e)(3) of Regulation S-K will require issuers to disclose in their proxy statements whether the work of any compensation consultant that has played any role in determining or recommending the amount or form of executive and director compensation has raised a conflict of interest, and if it had, disclose the nature of the conflict and how it is being addressed.