July 31, 2012

KEEPING CURRENT: SEC Final Rule on Independence, Outside Consultants

The SEC has released its final rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 concerning listing standards for equity securities (i.e., publicly traded companies) related to compensation committees.

The rule, published in the Federal Register on June 27, is divided into three key areas:

  • the independence of compensation committee members;
  • their role in retaining and supervising outside compensation consultants and legal counsel; and
  • evaluation of potential conflicts of interest for outside compensation consultants and legal counsel, and disclosure of such conflicts in a company's annual proxy statement.

Timing Milestones

The rule will be effective on July 27. Within 90 days of June 27, the national securities exchanges (such as NYSE and NASDAQ) must propose changes to listing standards to the SEC for review. Such listing standards must be finalized and adopted by the national securities exchanges by June 27, 2013.

Disclosure changes under Item 407 of Regulation S-K (described below) shall apply to any proxy or information statement for a meeting at which directors are elected occurring on or after January 1, 2013.


The cumulative effect of the changes to is to begin to apply similar, though less rigid, standards that are already applicable to audit committees and company auditors (evaluating auditor independence and compensation) to compensation committees, including their retention of advisers.

Compensation committee members not only must be independent, but further must meet heightened independence tests, be vested with the authority to retain outside advisers, and evaluate the independence of such advisers. However, there is no mandate per se that such advisers meet any specific independence test. Certain companies, such as those in bankruptcy, controlled companies, and foreign private issuers who do not maintain a compensation committee, are exempted from one or more of the various provisions of the rule.

Compensation Committee Member Independence

In addition to independence standards that already apply under NYSE and NASDAQ listing standards, the rule requires exchanges to maintain listing standards that require compensation committee members to meet heightened independence requirements that exchanges must develop based on relevant factors, including but not limited to:

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

While we wait to see what heightened standards exchanges elect to adopt, for the majority of public companies, such standards may not materially impact them. As these mandatory factors cover the same matters as the heightened independence standards for audit committees, it seems possible that exchanges may apply the same heightened standards to compensation committee membership. Accordingly, companies may wish to consider whether their compensation committees include any members who are "affiliates" of the company or who receive fees that would prohibit them from audit committee service, as such persons may also find themselves ineligible to serve on compensation committees.

Compensation Consultants and Outside Counsel

The rule requires that the compensation committee has full discretion and authority to retain outside compensation consultants as well as independent legal counsel, although there is no mandate to retain either set of advisers. Compensation committees "shall be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser retained by the compensation committee; and each listed issuer must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation adviser retained by the compensation committee." The compensation committee does not need to be directly responsible for compensation consultants, outside counsel, or other advisers retained by management.

Considering Compensation Consultant Independence

The rule requires exchanges to adopt rules requiring compensation committees to consider Dodd-Frank's five enumerated factors in evaluating the independence of a compensation consultant or other adviser, plus one additional factor. However, it is important to note that there explicitly is no requirement that the compensation consultant or other adviser to actually be independent. As a result, none of the enumerated factors constitute a "bright line test" for retaining a compensation consultant or other adviser. The six factors are:

  • 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;
  • Any stock of the issuer owned by the compensation consultant, legal counsel, or other adviser; and
  • Any business or personal relationship of the compensation consultant, legal counsel, or other adviser or the person employing the adviser with an executive officer of the issuer.

Proxy Disclosure

Item 407(e)(3)(iii) of Regulation S-K already now requires disclosure:

  • identifying the consultants;
  • stating whether such consultants were engaged directly by the compensation committee or any other person;
  • describing the nature and scope of the consultants' assignment, and the material elements of any instructions given to the consultants under the engagement; and
  • disclosing the aggregate fees paid to a consultant for advice or recommendations on the amount or form of executive and director compensation and the aggregate fees for additional services if the consultant provided both and the fees for the additional services exceeded $120,000 during the fiscal year.

The final rule adds an additional disclosure obligation: "With regard to any compensation consultant identified in response to Item 407(e)(3)(iii) whose work has raised any conflict of interest, disclose the nature of the conflict and how the conflict is being addressed."

The enumerated factors that the compensation committee must consider in retaining a compensation consultant or other adviser are among the factors that must be considered in determining whether a conflict of interest exists.