The Dodd-Frank Wall Street Reform Act and the Preemption of Delaware Law (Compensation Committee Reform, Part 2)

So how has the compensation process been preempted?  

A new Section 10C of the Exchange Act mandates the use of a compensation committee for listed companies.  That step does not alter the existing landscape.  Stock exchanges already require a compensation committee, although now they will lose any discretion (and exemptive authority) over application of the requirement. 

Section 10C, however, gives to the committee the authority to pick its own consultants and determine their compensation.  In effect, as with the audit committee in SOX, the Dodd-Frank Act cleaves off a committee of the board and gives it board like authority. 

Section 10C, however, goes much further than SOX.  Dodd-Frank has extended to the Commission broad authority to define critical terms.  Thus, while the directors on the compensation committee must be independent, it is the Commission that gets to determine the "factors" that must be considered in determining independence.  In effect the stock exchange lost its authority to control the definition of director independence.  Moreover, Congress instructed the Commission in defining those factors to take into account: 

• the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors;

While not entirely clear, this suggests that the Commission will need to require consideration of the fees paid to directors for their service on the board.   Of course, the provision will potentially result in three different definitions of independent:  one for audit committee members, one for compensation committee members, and one for other non-management members.  Nonetheless, it is likely that the Commission will eventually craft together a unified definition of director independence that is not committee specific. 

WIth repect to compensation consultants (and counsel to the committee), the Commission is charged with identifying factors that must be considered by the compensation committee when selecting the consultant.  Among the factors that must be considered include: 

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

• (B) 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;

• (C) 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;

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

• (E) any stock of the issuer owned by the compensation consultant, legal counsel, or other adviser.

In other words, it is the Commission that effectively has the authority to define "independence" with respect to compensation consultants (and counsel) and directors.  As the Summary to the Conference Report described, the requirements give the committee the “authority to hire compensation consultants in order to strengthen their independence from the executives they are rewarding or punishing.”

While Congress specifically required consideration of fees in connection with director independence, it specifically required, with respect to compensation consultants, consideration of any “personal relationship” among the consultants and the members of the compensation committee.  The provision is narrow in the sense that it applies only to personal relationships with the members of the compensation committee.  Nonetheless, it makes explicit for the first time that personal relationships matter with respect to a determination of independence.  (The NYSE takes the position that personal relationships among directors matters for purposes of determining independence but the listing standard merely applies to  material relationships "with the listed company."  For a discussion of this language and the NYSE's interpretation, go here).   

As for payment, Section 10C specifically requires the company to “provide for appropriate funding, as determined by the compensation committee” for counsel or any consultants.  While the requirement to provide funding was imposed on the company and, perforce, the entire board, it is bound by the decisions of the committee. 

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  We have included Section 952 below.

SEC. 952. COMPENSATION COMMITTEE INDEPENDENCE.

(a) IN GENERAL.—The Securities Exchange Act of 1934 (15 U.S.C. 78 et seq.) is amended by inserting after section 10B, as added by section 753, the following:

SEC. 10C. COMPENSATION COMMITTEES.

(a) INDEPENDENCE OF COMPENSATION COMMITTEES.—

(1) LISTING STANDARDS.—The Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer, other than an issuer that is a controlled company, limited partnership, company in bankruptcy proceedings, open-ended management investment company that is registered under the Investment Company Act of 1940, or a foreign private issuer that provides annual disclosures to shareholders of the reasons that the foreign private issuer does not have an independent compensation committee, that does not comply with the requirements of this subsection.

(2) INDEPENDENCE OF COMPENSATION COMMITTEES.—The rules of the Commission under paragraph (1) shall require that each member of the compensation committee of the board of directors of an issuer be—

(A) a member of the board of directors of the issuer; and

(B) independent.

(3) INDEPENDENCE.—The rules of the Commission under paragraph (1) shall require that, in determining the definition of the term ‘independence’ for purposes of paragraph (2), the national securities exchanges and the national securities associations shall consider relevant factors, including—

(A) the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors; and

(B) whether a member of the board of directors of an issuer is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.

(4) EXEMPTION AUTHORITY.—The rules of the Commission under paragraph (1) shall permit a national securities exchange or a national securities association to exempt a particular relationship from the requirements of paragraph (2), with respect to the members of a compensation committee, as the national securities exchange or national securities association determines is appropriate, taking into consideration the size of an issuer and any other relevant factors.

(b) INDEPENDENCE OF COMPENSATION CONSULTANTS AND OTHER COMPENSATION COMMITTEE ADVISERS.—

(1) IN GENERAL.—The compensation committee of an issuer may only select a compensation consultant, legal counsel, or other adviser to the compensation committee after taking into consideration the factors identified by the Commission under paragraph (2).

(2) RULES.—The Commission shall identify factors that affect the independence of a compensation consultant, legal counsel, or other adviser to a compensation committee of an issuer. Such factors shall be competitively neutral among categories of consultants, legal counsel, or other advisers and preserve the ability of compensation committees to retain the services of members of any such category, and shall include—

(A) the provision of other services to the issuer by the person that employs the compensation consultant, legal counsel, or other adviser;

(B) 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;

(C) 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;

(D) any business or personal relationship of the compensation consultant, legal counsel, or other adviser with a member of the compensation committee; and

(E) any stock of the issuer owned by the compensation consultant, legal counsel, or other adviser.

(c) COMPENSATION COMMITTEE AUTHORITY RELATING TO COMPENSATION CONSULTANTS.—

(1) AUTHORITY TO RETAIN COMPENSATION CONSULTANT.—

(A) IN GENERAL.—The compensation committee of an issuer, in its capacity as a committee of the board of directors, may, in its sole discretion, retain or obtain the advice of a compensation consultant.

(B) DIRECT RESPONSIBILITY OF COMPENSATION COMMITTEE.—The compensation committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of a compensation consultant.

(C) RULE OF CONSTRUCTION.—This paragraph may not be construed—

(i) to require the compensation committee to implement or act consistently with the advice or recommendations of the compensation consultant; or

(ii) to affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee.

(2) DISCLOSURE.—In any proxy or consent solicitation material for an annual meeting of the shareholders (or a special meeting in lieu of the annual meeting) occurring on or after the date that is 1 year after the date of enactment of this section, each issuer shall disclose in the proxy or consent material, in accordance with regulations of the Commission, whether—

(A) the compensation committee of the issuer retained or obtained the advice of a compensation consultant; and

(B) 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.

(d) AUTHORITY TO ENGAGE INDEPENDENT LEGAL COUNSEL AND OTHER ADVISERS.—

(1) IN GENERAL.—The compensation committee of an issuer, in its capacity as a committee of the board of directors, may, in its sole discretion, retain and obtain the advice of independent legal counsel and other advisers.

(2) DIRECT RESPONSIBILITY OF COMPENSATION COMMITTEE.—The compensation committee of an issuer shall be directly responsible for the appointment, compensation, and oversight of the work of independent legal counsel and other advisers.

(3) RULE OF CONSTRUCTION.—This subsection may not be construed—

(A) to require a compensation committee to implement or act consistently with the advice or recommendations of independent legal counsel or other advisers under this subsection; or

(B) to affect the ability or obligation of a compensation committee to exercise its own judgment in fulfillment of the duties of the compensation committee.

(e) COMPENSATION OF COMPENSATION CONSULTANTS, INDEPENDENT LEGAL COUNSEL, AND OTHER ADVISERS.—Each issuer shall provide for appropriate funding, as determined by the compensation committee in its capacity as a committee of the board of directors, for payment of reasonable compensation—

(1) to a compensation consultant; and

(2) to independent legal counsel or any other adviser to the compensation committee.

(f) COMMISSION RULES.—

(1) IN GENERAL.—Not later than 360 days after the date of enactment of this section, the Commission shall, by rule, direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the requirements of this section.

(2) OPPORTUNITY TO CURE DEFECTS.—The rules of the Commission under paragraph (1) shall provide for appropriate procedures for an issuer to have a reasonable opportunity to cure any defects that would be the basis for the prohibition under paragraph (1), before the imposition of such prohibition.

(3) EXEMPTION AUTHORITY.—

(A) IN GENERAL.—The rules of the Commission under paragraph (1) shall permit a national securities exchange or a national securities association to exempt a category of issuers from the requirements under this section, as the national securities exchange or the national securities association determines is appropriate.

(B) CONSIDERATIONS.—In determining appropriate exemptions under subparagraph

(A), the national securities exchange or the national securities association shall take into account the potential impact of the requirements of this section on smaller reporting issuers.

(g) CONTROLLED COMPANY EXEMPTION.—

(1) IN GENERAL.—This section shall not apply to any controlled company.

(2) DEFINITION.—For purposes of this section, the term ‘controlled company’ means an issuer—

(A) that is listed on a national securities exchange or by a national securities association; and

(B) that holds an election for the board of directors of the issuer in which more than 50 percent of the voting power is held by an individual, a group, or another issuer.