In a welcome bow to more transparency around executive compensation, the SEC approved a new exchange listing standards rule (Rule 10C-1) relating to public company boards of directors and compensation advisers. The new rule, adopted on 20 June, was required by the Dodd-Frank Wall Street Reform and Consumer Protection Act and requires listing standards to address:
- Independence of the members on a compensation committee
- Committee’s authority to retain compensation advisers
- Committee’s consideration of the independence of any compensation advisers
- Committee’s responsibility for the appointment, compensation, and oversight of the work of any compensation adviser.
According to the rule, exchanges must adopt listing standards that require each member of a company’s compensation committee to be a non-executive, independent member of the board of directors. In developing a definition of independence, the exchanges will have to consider relevant factors, including, but not limited to:
- 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
- Whether a member of the board of directors is affiliated with the company, a subsidiary, or an affiliate of a subsidiary
Once an exchange adopts these new standards, a listed company must meet the standards if its shares are to continue trading on that exchange.
The SEC also amended its proxy disclosure rules to require new disclosures from companies about their use of compensation consultants and conflicts of interest. Exchanges now have to implement listing standards permitting compensation committees to independently hire compensation consultants, legal counsel, or other advisers — other than in-house legal counsel — after considering these independence factors:
- Whether the hired consulting firm is providing other services to the company
- How much the consulting firm has received in fees from the company, as a percentage of that firm’s total revenue
- The consulting firm’s policies and procedures related to preventing 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 adviser or the consulting firm has any business or personal relationship with an executive officer of the issuer.
Based on this consideration, the new rules will require companies to disclose any potential conflicts of interests with the compensation consultant, the nature of the conflicts, and how the conflicts are being addressed.
The rule exempts controlled and smaller companies from the new compensation committee standards and authorizes exchanges to exempt other categories of issuers. To do so, exchanges would have to seek SEC approval.
We welcome the increase in transparency, as it should give investors a better understanding of the independence of compensation committees and compensation consultants. This will enable investors to decide for themselves what to make of the Compensation Discussion and Analysis in the corporate proxy.
These issues echo some of the best practices CFA Institute published last year in the Compensation Discussion and Analysis Template (CD&A Template).
Some of the language from the CD&A Template concerning the independence of compensation consultants is listed below for your reading pleasure. We are pleased to see that some of the efforts of the CD&A Template working group we assembled may have influenced the SEC in asking for increased transparency.
The CD&A should clearly illustrate the process undertaken to link compensation, corporate strategy, and performance and answer the question, Why is this compensation framework right for the company? A company should discuss the process the compensation committee undertook with management, the board, and compensation consultants in setting and implementing executive compensation. This section should allow the investor to obtain a clear sense of how and why compensation targets are determined and awards made. A company also should discuss the level of discretion exercised by the compensation committee, both on the upside and downside, in setting executive compensation. Items covered in the narrative should include
a. The role of compensation consultants and management in the determination of compensation. The discussion should focus on how any advice from the compensation consultants is reflected in the compensation committee’s decisions setting executive compensation.
b. A statement addressing the independence of the compensation consultants from company management and a discussion of, or cross-reference to, the information concerning how consultants are compensated for this work and other work for the company unrelated to the specific executive compensation engagement.