The Securities and Exchange Commission has approved changes to the rules of the New York Stock Exchange (NYSE) and the NASDAQ Stock Market (NASDAQ) regarding compensation committees for listed companies. The revised rules implement Rule 10C-1 which required the exchanges to adopt new standards for independent compensations committees and mandated that compensation committees be given new authority and responsibility for the engagement of compensation advisers.

Independent Compensation Committees

The exchanges took similar but slightly different approaches to satisfy the requirement in Rule 10C-1 that listed companies must have compensation committees comprised solely of independent directors. Under Rule 10C-1, each member of the compensation committee of a listed company must be determined to be “independent” based on a consideration of (a) the source of compensation to a director, including “any consulting, advisory or other compensatory fee paid by the issuer” to the director (the Fee Factor); and (b) whether the director is “affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer” (the Affiliate Factor). Each exchange retained its current standards for director independence which continue to apply to members of the compensation committee and then added new independence criteria that apply only to members of the compensation committee.

The NYSE rules directly incorporated both the Fee Factor and the Affiliate Factor from Rule 10C-1 into its new requirements for independent compensation committees without revision or addition of any bright-line tests or other specific factors. In contrast, the NASDAQ rules implement the Fee Factor by prohibiting members of the compensation committee from receiving any consulting, advisory or other compensatory fees from the company in the same manner as current NASDAQ rules apply to audit committee members. The new rules of both exchanges treat the Affiliate Factor as a determination of whether an affiliation would impair a director’s ability to make independent judgments about the company’s executive compensation, and each exchange rejected a bright-line cap on share ownership by a member of the compensation committee or the member’s affiliates.

The new NASDAQ rules included additional revisions in order to conform to Rule 10C-1. NASDAQ listed companies will now be required to have a compensation committee composed of at least two independent directors with a written charter, eliminating the option for executive compensation to be set by a separate vote of the board’s independent directors. In addition, the compensation committees must conduct an annual review of the committee’s charter. The NYSE retained its current requirement that listed companies establish a compensation committee with a written charter.

Authority of Committees to Engage Compensation Advisers

Rule 10C-1 mandates that the compensation committees of listed companies must have the authority to hire compensation consultants, independent legal counsel and other compensation advisers (collectively, “compensation advisers”) and exercise the sole responsibility to oversee the work of any compensation advisers retained to advise the committee. Listed companies must provide adequate funding to pay reasonable compensation to compensation advisers retained by a compensation committee. In addition, before engaging a compensation adviser, a compensation committee must consider at least six factors listed in Rule 10C-1 that could potentially impact the independence of the compensation adviser. The new rules of both the NYSE and NASDAQ effectively adopt these elements of Rule 10C-1 without modification and require that listed companies include these elements in their compensation committee charters.

Consistent with Rule 10C-1, the new exchange rules provide that the compensation committee is not required to follow the advice or recommendations of any compensation advisers and that the committee may exercise its own judgment “in fulfillment “of its duties. The new rules are also clear that a compensation committee may receive advice from an adviser that is not independent as long as the committee considers the six independence factors prior to engaging the adviser. Both sets of new rules do not require an independence assessment under the six factors for in-house legal counsel or an adviser whose role is not required to be disclosed in the proxy statement because such adviser is consulting only on broad-based plans or providing information that is not customized for the listed company.

Exemptions and Transition Rules

The new listing standards will not apply to (a) limited partnerships, (b) companies in bankruptcy proceedings, (c) open-end investment companies registered under the Investment Company Act of 1940, (d) foreign private issuers that disclose that they do not have an independent compensation committee, (e) controlled companies, or (f) smaller reporting companies. The new standards also provide transition rules for companies that cease to qualify as smaller reporting companies and for IPO companies. Both new listing standards provide a cure period if a company fails to comply with the compensation committee composition requirements because a member of the committee ceases to be independent for reasons outside the member’s reasonable control. The NASDAQ rules provide a further exemption that a listed company may have one director who does not meet the independence test so long as the committee has at least three members, the non-independent director is not any executive officer, employee or family member of an executive office and the board determines, under exceptional and limited circumstances, that director’s membership on the committee is required by the best interests of the company and its shareholders. A NASDAQ company may use this exemption for no more than two years and must disclose its reliance on this exemption.

Effective Dates

The new rules for compensation committee charters and the authority of compensation committees will be effective for NYSE and NASDAQ listed companies on July 1, 2013. Listed companies must comply with the new standards for compensation committee director independence upon the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.

Game Plan

Listed companies should develop a plan to:

  • Educate their boards and compensation committee on the new exchange rules; 
  • Revise compensation committee charters for the new exchange rules; 
  • Update policies and procedures for engaging compensation advisers in line with the six independence factors;
  • Engage compensation advisers in a discussion of the six independence factors and plan for an evaluation of any compensation advisers under the six independence factors by the compensation committee; 
  • Examine and revise timelines and responsibility charts with respect to the compensation process in light of the new rules; and 
  • Evaluate the membership of the compensation committee under the new independence standards and plan for any adjustments to the committee memberships that may be required to comply with the new rules.