(The following post originally appeared on ONSecurities, a top Minnesota legal blog founded by Martin Rosenbaum to address securities, governance and compensation issues facing public companies.)
On June 20, 2012, the SEC adopted final rules (PDF) under Section 952 of the Dodd-Frank Act (Section 10C of the Securities Exchange Act of 1934), covering independence standards for compensation committees of listed companies and their advisers. In themselves, the new rules are not too exciting. Consistent with Section 10C, the rules require the national securities exchanges, such as the New York Stock Exchange and Nasdaq, to adopt listing standards on these topics. The final rules raise some intriguing questions, including whether the listing standards will push public companies’ compensation committees to engage independent counsel.
Timing. New Rule 10C-1 requires the exchanges to issue proposed rules on independence standards by September 25, 2012. Therefore, in the next few months, we will know a lot more about the approaches taken by the exchanges, and whether the exchanges’ standards will vary from each other. The exchanges must each adopt final listing standards that comply with Rule 10C-1, which must be approved by the SEC no later than June 27, 2013.
Independence of compensation advisers. Rule 10C-1(b)(4) requires the exchanges to adopt standards requiring listed companies’ compensation committees to consider the independence of outside advisers, such as compensation consultants and legal counsel. The rule does not require that the advisers be independent, only that before engaging them, the committee consider their independence by taking six factors into consideration: (i) other services provided to the company by the advisory firm, (ii) amount of fees received by the advisory firm as a percentage of its total revenues, (iii) the advisory firm’s procedures for preventing conflicts of interest, (iv) business or personal relationships of the adviser with a member of the committee, (v) stock ownership by the adviser, and (vi) business or personal relationships of the adviser with an executive officer of the issuer. The exchanges may also require consideration of other factors.
The requirements of Rule 10C-1(b)(4) are mostly lifted directly from Section 10C(b)(2) of the Exchange Act. However, there were a few interesting changes under the Rule. First, in the final rules the SEC added the last of the six factors (relationships of the adviser to executive officers); surprisingly, that was not one of the factors listed in the Dodd-Frank Act. Second, the Instruction to Paragraph (b)(4) clarifies that the independence assessment is required for an adviser, including counsel, that “provides advice to the compensation committee.” Third, that Instruction clarifies that in-house counsel are not covered by the independence assessment requirements.
What outside law firms are covered? The new rule leaves some questions open to discussion. In what circumstances does outside legal counsel “provide advice” to the compensation committee so as to be covered by the assessment requirement? The answer is obvious where the law firm is engaged directly by the committee, in which case a partner of the law firm would be likely to attend committee meetings and would be available to answer questions of committee members. But what about a law firm that has little or no direct contact with the committee, given that the Instruction does not require that the advice be direct? Do the standards apply to outside counsel that provides compensation or governance advice to in-house counsel, who in turn incorporates that advice into her advice to the committee? What about outside counsel that provides compensation disclosure advice (or tax advice, or drafting or negotiation of agreements) to management where the work product is shared with and reviewed by the committee?
The answers may or may not be clarified by the exchanges’ listing standards. The independence assessment does not seem very relevant or important where the law firm has no direct contact with the committee, but the language of the Instruction seems broad enough to encompass this situation.
Will Committees Retain Independent Counsel? Mike Melbinger, in Melbinger’s Compensation Blog on CompensationStandards.com (subscription site) also raises the question: Will the new assessment requirement cause compensation committees to engage independent counsel? Rule 10C-1(b)(4) allows the committee to continue to engage non-independent advisers after considering the six factors in the rule. But he points out:
Committees have retained independent legal counsel in recent years, but certainly not the majority of them. Those Compensation Committees who have not retained independent legal counsel will need to grapple with questions/factors 1 and 2 [of the six factors] . . . , just as they once did for their compensation consultant. . . . We all have seen this movie before – only starring the compensation consultants instead of legal counsel, and we all know how it ends. . . . [June 25, 2012 post.]
. . . [W]hen the SEC mandates a process such as this new independence assessment, it usually wants companies to reach – or at least consider – a certain result. Thus, the issue is one of following best practices. . . . [June 26, 2012 post]
Well stated, and if a law firm providing advice directly to the committee does derive a large percentage of its revenues from the company and has a very close relationship with the executives, the committee may feel pressure to engage independent counsel. Even though the independence assessment need not be publicly disclosed, the committee may still be concerned about exposure to liability in such cases, especially given the increased incidence of compensation-related litigation in recent years.
On the other hand, I’m not sure that compensation committees will be compelled to hire independent counsel in many cases. Given the size of many law firms, it may be rare for the fees to the individual client to represent a very large percentage of the law firm’s revenues. Also, if the law firm’s role is limited or does not involve direct contact with the committee, the committee probably will not feel much pressure to engage independent counsel. Once we see the exchanges’ proposed listing standards in September, we may know more about the likelihood of such engagements.
Dodd-Frank Rulemaking Timetable Delayed
In adopting the final rules under Section 952 of the Dodd-Frank Act as described above, the SEC got in just under the wire – the SEC’s Dodd-Frank rulemaking timetable listed those rules as being scheduled for January-June 2012. Several other sets of rules were not completed in June but are still listed under that schedule:
- Propose rules regarding disclosure of pay-for-performance, pay ratios, and hedging by employees and directors (Dodd-Frank Sections 953 and 955).
- Propose rules regarding recovery of executive compensation (i.e., clawbacks) (Dodd-Frank Section 954).
- Adopt rules regarding disclosure related to “conflict minerals” and disclosures by resource extraction issuers (Dodd-Frank Sections 1502 and 1504).
Of course, the SEC now includes the following disclaimer at the beginning of the timetable: “This is an estimated timeline and may be subject to change.”