Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The SEC has proposed new rules to implement the provisions of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which adds Section 10C to the Securities Exchange Act of 1934, or the Exchange Act. Section 10C requires the SEC to direct the national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer, with certain exemptions, that does not comply with Section 10C’s compensation committee and compensation adviser requirements.

The proposed rules of the SEC and those to be adopted by the exchanges are unlikely to impose significant additional burdens on issuers since many topics are already addressed by listing standards. However, care must be taken to identify a compensation consultant’s conflicts of interest. Given the nuances between the rules of the various exchanges, there will probably be greater confusion as to what one exchange requires versus another. Drawing an analogy to listing requirements established to approve equity compensation plans in the wake of Sarbanes-Oxley, we expect the SEC will push the exchanges to adopt similar rules. That process is likely to take some time.

The SEC ducked a significant hot button question regarding whether it would establish rules regarding compensation consultants that are “competitively neutral.” The SEC left it to the exchanges to sort this one out, if they want to.

The proposed rules do not require a compensation committee to retain independent legal counsel or preclude a compensation committee from retaining non-independent legal counsel or obtaining advice from in-house counsel or outside counsel retained by the issuer or management. However, certain enumerated items must be considered before the compensation committee engages legal counsel.

Other highlights include:

• The rules only apply to issuers with listed equity securities.

• The SEC left it to the exchanges as to whether they should exempt smaller reporting issuers.

• Incremental disclosure requirements are modest.

It is important to recognize the two prongs of the proposed rule. One requires the exchanges to implement certain governance matters. That has one timeline. The second is additional disclosure about compensation consultants and conflicts of interest. That is not dependent on exchange rulemaking and implementation will be set by the SEC.

The SEC is proposing that the exchanges have final rules in place no later than one year after publication of the final SEC rules. As to disclosure regarding whether the issuer’s compensation committee retained or obtained the advice of a compensation consultant and conflict of interest matters, disclosure is not required before the SEC determines its final rules should take effect. The Dodd-Frank Act alludes to a July 21, 2011 deadline for disclosure implementation, but the SEC believes it can extend this deadline by rule.

More specifics are included below.

Compensation Committees

Neither the Dodd-Frank Act nor the Exchange Act defines the term “compensation committee.” The SEC rules do not currently require, and the proposed rules would not mandate, that an issuer establish a compensation committee. However, current exchange listing standards generally require listed issuers either to have a compensation committee or to have independent directors determine, recommend or oversee specified executive compensation matters. Proposed Rule 10C-1(b) would direct the exchanges to adopt listing standards that would be applicable to any committee of the board that oversees executive compensation, whether or not the committee performs multiple functions and/or is formally designated as a “compensation committee.”

Independence

In order to implement the requirements of Section 10C(a)(1) of the Exchange Act, proposed Rule 10C-1(b)(1)(i) would require each member of a listed issuer’s compensation committee to be a member of the issuer’s board of directors and to be independent. As required by Section 10C(a)(1), proposed Rule 10C-1(b)(1)(ii) would direct the exchanges to develop a definition of independence applicable to compensation committee members after considering relevant factors, including, but not limited to, the source of compensation of a director, including any consulting, advisory or other compensatory fee paid by the issuer to such director, and whether the director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer. Other than the factors set out in Section 10C(a)(1), the SEC did not propose to specify any additional factors that the exchanges must consider in determining independence requirements for members of compensation committees.

Authority to Engage Compensation Advisers

Section 10C(c)(1) of the Exchange Act provides that the compensation committee of a listed issuer may, in its sole discretion, retain or obtain the advice of a “compensation consultant,” and Section 10C(d)(1) extends this authority to “independent legal counsel and other advisers” (collectively, “compensation advisers”). Both sections also provide that the compensation committee shall be directly responsible for the appointment, compensation, and oversight of the work of compensation advisers. Sections 10C(c)(1)(C) and 10C(d)(3) provide that the compensation committee’s authority to retain, and responsibility for overseeing the work of, compensation advisers may not be construed to require the compensation committee to implement or act consistently with the advice or recommendations of a compensation adviser or to affect the ability or obligation of the compensation committee to exercise its own judgment in fulfillment of its duties. To ensure that the listed issuer’s compensation committee has the necessary funds to pay for such advisers, Section 10C(e) provides that a listed issuer shall provide “appropriate funding,” as determined by the compensation committee, for payment of “reasonable compensation” to compensation consultants, independent legal counsel and other advisers to the compensation committee.

Proposed Rule 10C-1(b)(2) implements Sections 10C(c)(1) and (d)(1) of the Dodd-Frank Act by repeating the provisions set forth in those sections regarding the compensation committee’s authority to retain or obtain a compensation adviser, its direct responsibility for the appointment, compensation and oversight of the work of any compensation adviser, and the related rules of construction. In addition, proposed Rule 10C-1(b)(3) implements Section 10C(e) by repeating the provisions set forth in that section regarding the requirement that listed issuers provide for appropriate funding for payment of reasonable compensation to compensation advisers.

The SEC noted that while the statute provides that compensation committees of listed issuers shall have the express authority to hire “independent legal counsel,” the statute does not require that they do so. Similar to the SEC’s interpretation of Section 10A(m) of the Exchange Act, which gave the audit committee authority to engage “independent legal counsel,” the SEC does not construe the requirements related to independent legal counsel and other advisers as set forth in Section 10C(d)(1) of the Exchange Act as requiring a compensation committee to retain independent legal counsel or as precluding a compensation committee from retaining non-independent legal counsel or obtaining advice from in-house counsel or outside counsel retained by the issuer or management.

Independence Factors

Section 10C(b) of the Exchange Act provides that the compensation committee may select a compensation adviser only after taking into consideration the factors identified by the SEC. In accordance with Section 10C(b), these factors would apply not only to the selection of compensation consultants, but also to the selection of legal counsel and other advisers to the committee. The statute does not require a compensation adviser to be independent, only that the compensation committee consider the enumerated independence factors before selecting a compensation adviser. Section 10C(b) specifies that the independence factors identified by the SEC must be competitively neutral and include, at minimum:

• The provision of other services to the issuer by the person that employs the compensation consultant, legal counsel or other adviser;

• The amount of fees received from the issuer 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;

• 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;

• Any business or personal relationship of the compensation consultant, legal counsel, or other adviser with a member of the compensation committee; and

• Any stock of the issuer owned by the compensation consultant, legal counsel or other adviser.

Because Exchange Act Section 10C does not require compensation advisers to be independent – only that the compensation committee consider factors that may bear upon independence – the SEC does not believe that this provision contemplates that the SEC would necessarily establish materiality or bright-line numerical thresholds that would determine whether or when the factors listed in Section 10C of the Exchange Act, or any other factors added by the SEC or by the exchanges, must be considered germane by a compensation committee. Therefore, proposed Rule 10C-1(b)(4) would require the listing standards developed by the exchanges to include the independence factors set forth in the statute and incorporated into the rule without any materiality or bright-line thresholds or cut-offs.

Disclosure

Section 10C(c)(2) of the Exchange Act requires that, in any proxy or consent solicitation material for an annual meeting (or a special meeting in lieu of the annual meeting), each issuer must disclose, in accordance with regulations of the SEC, whether:

• the compensation committee has retained or obtained the advice of a compensation consultant; and

• the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

Given the similarities between the disclosure required by Section 10C(c)(2) and the disclosure required by Item 407 of Regulation S-K for registrants subject to SEC proxy rules, the SEC proposes to integrate Section 10C(c)(2)’s disclosure requirements with the existing disclosure rule, rather than simply “tacking on” the new requirements to the existing ones.

The trigger for disclosure about compensation consultants under Section 10C(c)(2) of the Exchange Act is worded differently from the trigger for disclosure under the amendments to Item 407 that the SEC adopted in 2009. Specifically, Section 10C(c)(2) states that the issuer must disclose whether the “compensation committee retained or obtained the advice of a compensation consultant.” By contrast, the current rule refers to whether compensation consultants played “any role” in the registrant’s process for determining or recommending the amount or form of executive or director compensation. Once disclosure is required, the specifics of what must be disclosed are also different. With regard to conflicts of interest, the current rule requires detailed disclosure about fees in certain circumstances in which there may be a conflict of interest, whereas Section 10C(c)(2) is more open-ended and requires disclosure of any conflict of interest, the nature of the conflict and how the conflict is being addressed, which existing rules do not require.

As proposed, revised Item 407(e)(3)(iii) would have a disclosure trigger that is consistent with the statutory language and would, therefore, require the registrant to disclose whether the compensation committee has “retained or obtained” the advice of a compensation consultant during the registrant’s last completed fiscal year. The practical effect of the proposed change is minimal.

Consistent with Section 10C(c)(2) of the Exchange Act, disclosure of whether the compensation committee obtained or retained the advice of a compensation consultant during the registrant’s last completed fiscal year and whether the consultant’s work raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed, would be required without regard to the existing exceptions in Item 407(e)(3). For example, disclosure about the compensation consultant would be required even if the consultant provides only advice on broad-based plans or provides only non-customized benchmark data. In this regard, the proposed rules broaden the scope of disclosure currently required by Item 407(e)(3)(iii).

The other existing disclosure requirements of Item 407(e)(3) would remain the same, aside from amending the fee disclosure requirements to link the disclosure of fees to the compensation committee “retaining or obtaining the advice of a compensation consultant” and to management “retaining or obtaining the advice of a compensation consultant.”

To provide guidance to issuers as to whether the compensation committee or management has “obtained the advice” of a compensation consultant, the SEC is proposing an instruction to clarify the statutory language. This instruction would provide that the phrase “obtained the advice” relates to whether a compensation committee or management has requested or received advice from a compensation consultant, regardless of whether there is a formal engagement of the consultant or a client relationship between the compensation consultant and the compensation committee or management or any payment of fees to the consultant for its advice.

Conflicts of Interest

Currently, Item 407(e)(3) focuses on the conflicts of interest that may arise from a compensation consultant also providing other non-executive compensation consulting services to an issuer, which may lead the consultant to provide executive compensation advice favored by management in order to obtain or retain such other assignments. Section 10C(c)(2) of the Exchange Act is more open-ended about conflicts of interest in that it requires issuers to disclose whether the work of a compensation consultant raised “any conflict of interest” and, if so, the nature of the conflict and how the conflict is being addressed. The term “conflict of interest” is not defined in Section 10C(c)(2), and the proposed rules do not supply a definition.

In light of the link between the requirement that the compensation committees of listed issuers consider independence factors before retaining compensation advisers and the disclosure requirements about compensation consultants and their conflicts of interest, the SEC believes it would be appropriate to provide some guidance to issuers as to the factors that should be considered in determining whether there is a conflict of interest that would trigger disclosure under the proposed amendments. Therefore, the SEC proposes to include an instruction that identifies the factors set forth in proposed Rule 10C-1(b)(4)(i) through (v) as among the factors that issuers should consider in determining whether there is a conflict of interest that may need to be disclosed in response to proposed amendments to Item 407(e)(3)(iii).

The SEC has not concluded that the presence or absence of any of these individual factors indicates that a compensation consultant has a conflict of interest that would require disclosure under the proposed amendments, nor has the SEC concluded that there are no other circumstances or factors that might present a conflict of interest for a compensation consultant retained by a compensation committee.

If a compensation committee determines that there is a conflict of interest with the compensation consultant based on the relevant facts and circumstances, the issuer would be required to provide a clear, concise and understandable description of the specific conflict and how the issuer has addressed it. A general description of an issuer’s policies and procedures to address conflicts of interest or the appearance of conflicts of interest would not suffice.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

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