In accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”) for adopting regulations required by section 952 of the Reform Act, the Securities and Exchange Commission (the “SEC”) on June 20, 2012 issued a press release and published final rules (Release No. 33-9330) (the “Final Rules”) for compensation committee and compensation adviser independence requirements.

As we have previously commented (see our blog from July 26, 2010 “The Regulatory March to Reform Executive Compensation Practices Takes Another Step Forward”), the Reform Act implemented numerous new laws affecting executive compensation and corporate governance at publicly-held companies. Section 952 of the Reform Act added Section 10C to the Securities Exchange Act of 1934 (the “Exchange Act”). Among other things, Section 10C required the SEC to adopt rules directing the national securities exchanges and national securities associations (the “Exchanges”) to prohibit the listing of any equity security of an issuer that is not in compliance with Section 10C’s compensation committee and compensation adviser independence requirements.

Section 10C essentially provides that limited partnerships, companies in bankruptcy proceedings, registered open-end management investment companies registered under the Investment Company Act of 1940, and foreign private issuers that provide annual disclosures to shareholders of the reasons why the foreign private issuer does not have an independent compensation committee will not be subject to the Exchanges’ listing requirements regarding compensation committee member independence. Section 10C further expressly provides that controlled companies are exempt from its requirements. The Final Rules provide a slightly modified definition of a "controlled company" for purposes of these rules and which more closely tracks the definition currently used by the NYSE and Nasdaq.

In response to the requirements of Section 10C, the SEC over one year ago on March 30, 2011 released the Proposed Rules (see our blog on the Proposed Rules from April 25, 2011 “SEC Proposes New Rules Calling For Greater Independence Standards for Compensation Committees and Their Advisors”) which are the foundation for the adopted Final Rules.

Below is a brief overview of the Final Rules (which are contained in new Rule 10C-1 of the Exchange Act which provides the listing standards related to compensation committees and in new Item 407(e)(3)(iv) to Regulation S-K which provides the disclosure requirements related to compensation consultant conflicts of interest).

Compensation Committee – Independence Requirements

The Final Rules will compel the Exchanges to establish listing standards that require each member of a listed issuer’s compensation committee to be: (i) a member of the board of directors and (ii) “independent.”  The term “independent” is not defined in the Final Rules  Instead, the Final Rules provide that “independent” is to be defined by the Exchanges after taking into consideration “relevant factors” which shall include, but are not limited to:

  • the source of compensation of a director of an issuer, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
  • whether the director of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

The Exchanges are given the flexibility to establish their own minimum independence criteria for compensation committee members after considering the relevant factors enumerated above.  An Exchange may add other factors subject to approval by the SEC.  The Final Rules authorize the Exchanges to establish listing standards that exempt particular relationships between members of the compensation committee and listed issuers that might otherwise impair the member’s independence, taking into consideration the size of an issuer and any other relevant factors.  The listing standards adopted by the Exchanges shall generally apply to any committee of the board of directors that performs functions typically performed by a compensation committee, including oversight of executive compensation, whether or not such committee also performs other functions or is formally designated as a "compensation committee".

The existing independence requirements for audit committee members under Exchange Act Rule 10A-3 and the Final Rules’ requirements for compensation committee members are generally similar.  However, with respect to defining compensation committee member independence, the Exchanges will only have to consider the above relevant factors.  In contrast, the SEC’s rules for audit committee independence prescribe specific minimum criteria and permit the Exchanges to adopt even more stringent independence requirements if desired.  Thus, an audit committee member cannot accept any consulting, advisory or other compensatory fee and cannot be an affiliated person of the issuer or its subsidiaries.  With respect to compensation committee member independence, the Exchanges will have more flexibility in determining whether or not to impose any specific criteria that would per se preclude compensation committee membership.

Compensation Committee – Authority and Funding

The Final Rules include a number of requirements that are intended to ensure that the compensation committee has the requisite authority and autonomy to perform its role.  These include the following:

  • Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of compensation consultants, independent legal counsel and other advisers who are retained by the compensation committee (collectively, “compensation advisers”);
  • Each compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser; and
  • Each issuer must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to compensation advisers.

Compensation Advisers – Independence Requirements

The Final Rules require that the Exchanges’ listing standards provide that the compensation committee may select a compensation adviser only after taking into consideration the competitively neutral independence factors set forth below.  Moreover, the Exchanges may add other independence factors that must be considered by the compensation committees of their listed issuers in addition to the mandatory independence factors.  The Final Rules do not require a compensation adviser to be independent, only that the compensation committee consider the below six factors before selecting a compensation adviser (whether it is a compensation consultant, legal counsel or other adviser).  Such independence factors are listed below.  The Proposed Rules only had contained the first five factors but the Final Rules added the last item listed below as an additional factor that must be considered.  The Final Rules contain a specific instruction that compels the compensation committee to conduct an independence assessment of any compensation adviser (other than in-house legal counsel) that provides advice to the committee including, for example, outside legal counsel.  This would also include performing an independence assessment on outside legal counsel or other compensation advisers who are retained by management or the issuer and who may also provide advice to the compensation committee.  The six 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 consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation adviser;
  • The policies and procedures 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;
  • Any stock of the issuer owned by the compensation adviser; and
  • Any business or personal relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer.

Opportunity to Cure Defects Before Delisting

Consistent with the requirements of Section 10C, the Final Rules require the Exchanges to establish procedures (if their existing procedures are not adequate) before the Exchange can prohibit the listing of, or delist, any security of an issuer.  Moreover, the Exchanges’ rules may provide that if a member of a compensation committee ceases to be independent for reasons outside the member’s reasonable control, that person, with notice by the issuer to the applicable Exchange, may remain a compensation committee member of the listed issuer until the earlier of the next annual meeting of the listed issuer or one year from the occurrence of the event that caused the member to no longer be independent. 

Exemptions From Listing Standards

In addition to the exemptions from the compensation committee independence rules provided by the Reform Act and which are mentioned above, the Final Rules provide some additional exemptions from the listing standards as shown below. In addition to controlled companies, the Final Rules expressly exempt smaller reporting companies from the listing standards.

  • The listing standards are intended to apply only to issuers with listed equity securities. Accordingly, listed issuers with only debt securities would not be subject to these listing rules.
  • Issuers of security futures products and standardized options are exempted from the listing standards.
  • The Exchanges may exempt a category of issuers from the listing requirements as each Exchange determines is appropriate.  In April 2012, the Jumpstart Our Business Startups Act (JOBS Act) was enacted and which created a new category of issuer called the "emerging growth company" and it will be interesting to see if the Exchanges exempt emerging growth companies from some or all of these listing standards.

Compensation Consultants – Disclosure and Conflicts of Interest

Amendment to Item 407(e)(3) of Regulation S-K.  Under existing Item 407(e)(3)(iii) of Regulation S-K, companies are required to make certain disclosures regarding any role of a compensation consultant in determining or recommending the amount or form of executive and/or director compensation.  The Final Rules add a new disclosure requirement under new Item 407(e)(3)(iv) that will compel companies to disclose the nature of any conflict of interest, and how the conflict is being addressed, with respect to any compensation consultant who is identified under existing Item 407(e)(3)(iii).  The Final Rules include a specific instruction that identifies the six factors set forth above in assessing compensation adviser independence as among the factors that issuers should consider in determining whether there is a conflict of interest for the compensation consultant that may need to be disclosed.  This new disclosure rule of Item 407(e)(3)(iv) will apply to all issuers (including without limitation, controlled companies, non-listed issuers and smaller reporting companies) subject to the SEC’s proxy statement reporting requirements.  Consulting work on broad-based plans and/or providing non-customized benchmark data will be exempted from the disclosure requirements of Item 407(e)(3).


To facilitate timely implementation of the Final Rules, within 90 days after publication of the Final Rules in the Federal Register, the Exchanges must propose to the SEC rules or rule amendments that comply with the Final Rules. Further, each Exchange will need to have final rule or rule amendments that comply with the SEC’s Final Rules no later than one year after publication of the Final Rules in the Federal Register.

The new disclosure requirements of Regulation S-K Item 407(e)(3)(iv) will become applicable in any proxy or information statement for annual (or special) meeting of shareholders at which directors will be elected on or after January 1, 2013.

What Next?

Listed companies may wish to review the independence and potential conflicts of interest for each of their compensation committee members, compensation consultants, compensation committee legal counsel and any other advisers in light of the relevant factors cited in the Final Rules.  Listed companies may also wish to monitor the rulemaking proposals which will be proffered in the near-term by the Exchanges so that they will be better prepared for the implementation of the new listing standards and with respect to making any needed modifications in their practices and/or governing documents such as the compensation committee charter.

In any event, while the Final Rules may not technically require compensation advisers to be independent, a company’s ability to affirmatively disclose that all advisers to the compensation committee are independent may be more favorably received by investors and proxy voting advisers and may potentially assist a company with obtaining a more positive Say-on-Pay vote in future years.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.


This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.