When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, one of the problems it aimed to address was the failure of companies to adequately tie compensation to company performance. Section 952 of Dodd-Frank mandated that the Securities and Exchange Commission (SEC) issue rules requiring the national exchanges to adopt listing standards related to the independence of listed companies' compensation committees and compensation committee advisers. The SEC adopted final Rule 10c-1 pursuant to Section 952 in June, and on Sept. 25, both the New York Stock Exchange (NYSE) and Nasdaq filed proposed listing standards with the SEC.

The NYSE proposal and Nasdaq proposal largely stick to the SEC requirements, with a few exceptions. Their basic impact is to heighten independence standards for compensation committees and their advisers. They offer few surprises, and experts say that any additional requirements they do impose are unlikely to have much of a practical effect on most listed companies.

“The SEC had a pretty light touch in terms of just following what Dodd-Frank required and didn't require, and it's the same thing with the exchanges,” says David Scileppi, a shareholder at Gunster, Yoakley & Stewart. “This is a pretty issuer-friendly release.”

Committee Independence

The SEC mandated that the exchanges add at least two factors to their required assessment of the independence of compensation committee members: the source of compensation of a member of the board of directors, including any consulting, advisory or other compensatory fee paid by the company to such director; and whether a member of the board of directors of a company is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.

Nasdaq responded by proposing a new requirement that listed companies must have a compensation committee comprising at least two members and that all of the compensation committee's members must be independent. Previously, Nasdaq required that executive compensation be determined either by a compensation committee comprising solely independent directors or by independent directors in a majority vote. Now, Nasdaq has proposed to eliminate the latter option, a choice it made “given the heightened importance of compensation decisions in today's corporate governance environment.”

That was something of a surprise, says Alan Dye, a partner at Hogan Lovells. “The Nasdaq historically left the governance structure, at least on compensation issues, to the company's discretion, so that companies didn't have to have compensation committees,” he says.

The Nasdaq proposal notes that based on June numbers, this change will impact only 25 of 2,636 Nasdaq-listed companies that did not have a standing compensation committee. In assessing the independence of members of the compensation committee, Nasdaq-listed companies now will have to consider the two new factors that the SEC proposed, in addition to the considerations that (as the SEC mandates) the exchanges require. If compensation committee members are found not to meet the first new standard—if they are found to receive any compensation from the company for acting as a consultant, for instance—they are automatically disqualified from being independent. If previously a director was deemed independent despite his or her consulting relationship with the company, for example, under the newly proposed listing standards, Nasdaq-listed companies would no longer have this freedom. However, the new “affiliation” factor is not an automatic disqualifier.

NYSE-listed companies will not see a major change: The NYSE currently requires that its listed companies have compensation committees comprising at least three independent directors (and all the compensation committee members must be independent). Under current rules, the directors meet five bright-line tests to determine their independence. If compensation committee members do not meet the standards, they are automatically disqualified from being considered independent. The NYSE's Sept. 25 proposal adds the SEC's additional two new factors.

“It does leave the NYSE-listed companies free to take a look at those two new factors that have to be taken into account and conclude, even if the director is an affiliate of the company [for example], that the director is still independent,” Dye says. “Maybe the director is being paid $50,000 a year for being a consultant to the company—the board can take that into account and determine whether it thinks the relationship is or isn't enough to compromise his independence, but the factor at least has to be taken into account.”

Adviser Independence

Dodd-Frank mandated that compensation committees selecting a compensation consultant must consider five factors; the SEC added one. There is no requirement for compensation committees only to hire independent consultants, but they must make the assessment and disclose conflicts of interest (see “Consultant Disclosures”). The SEC's rule required that listing standards mandate that compensation committees consider:

• Whether the compensation consulting company employing the compensation adviser is providing any other services to the company
• How much the compensation consulting company who employs the compensation adviser has received in fees from the company, as a percentage of that person's total revenue
• What policies and procedures the compensation consulting company employing the compensation adviser has adopted to prevent conflicts of interest
• Whether the compensation adviser has any business or personal relationship with a member of the compensation committee
• Whether the compensation adviser owns any stock of the company
• Whether the compensation adviser or the person employing the adviser has any business or personal relationship with an executive officer of the issuer

Both the NYSE and Nasdaq stuck with those six factors, and both specified that such an assessment is not required for the compensation committee to consult with in-house counsel.

If the SEC approves them, the proposed Nasdaq rules on compensation committee independence would take effect Dec. 31, 2014, and the proposed NYSE rules on compensation committee independence would take effect on the earlier of the company's 2014 annual meeting or Oct. 31, 2014. The Nasdaq adviser independence consideration rules would take effect upon SEC approval, and the NYSE rules would take effect July 1, 2013.

Practical Advice

Experts advise that although they still have time, boards of directors begin the process of assessing compensation committee members' independence, incorporating the two new factors. Robin Struve, a partner at Latham & Watkins, says that most companies will just add the additional factors to the D&O (director and officer) questionnaires that directors fill out every year to determine their independence.

“There are not really clear lines; you just have to go through the practice of making the assessment—but I don't think it will significantly change the actual results of who's on the compensation committee in many instances,” Struve says.

Determining whether there is a conflict of interest with compensation consultants will be a more involved process that may require more information-gathering than what's being done now, Struve says. But even here, she says, most companies already are required to report whether they are, for instance, paying the compensation consultant for other consulting services.

Dye says that given the timeframe, companies have the opportunity to engage in a dry run of their updated processes for determining adviser independence. He recommends companies immediately begin gathering information so that compensation committees are in a position to make that assessment and address any conflicts of interest. Many of the major consulting firms, he says, have been preparing their own internal assessments of potential conflicts within their firms—for instance, two separate consultants advising different parts of the company—and addressing them. In preparation for these long-expected listing standards, many consulting firms have put in place processes to prevent conflicts of interest within the firm.

If a conflict of interest with the compensation consultant is uncovered, the compensation committee should either obtain new advisers who are independent, or address the conflict by stating that it is immaterial, or that the committee recognizes the conflict is there but takes it into account when considering their opinion.

“I would suspect that the best practice for most people, given the environment we're in, would be that they would either get a new compensation consultant or there would be some disclosure about why they don't think it's a problem,” Struve says. “I suspect you'll see a lot of disclosure about how [companies] undertook a review, looked at the six factors and determined there was no conflict.”

The question more pressing than the details of how Nasdaq- and NYSE-listed companies plan to implement these new listing standards is whether they will have the intended impact of achieving better alignment between executive compensation and pay-for-performance, Dye says.

“We won't know that in the first proxy season,” Dye says. “It will take time to see if, over time, as we get more objective compensation consultants and independent compensation committee members, what impact that will have on either the amount or the form of executive compensation.”

Consultant Disclosures

In implementing Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission (SEC) also issued a rule requiring that listed companies make potential disclosures in their annual meeting proxy statement regarding the independence of any consultants advising compensation committees. Unlike the New York Stock Exchange- and Nasdaq-proposed listing standards, the SEC disclosure rule will be in effect in time for 2013 proxy season.