Today’s column focuses on new rules of the New York Stock Exchange (NYSE) and the NASDAQ Stock Market (NASDAQ) concerning independence requirements for directors who are members of compensation committees. The new rules must be complied with by listed companies by the earlier of the first annual meeting of shareholders after Jan. 15, 2014, or Oct. 31, 2014.1
NYSE Listed Company Manual Section 303A.02(a)(ii) contains the following requirements regarding compensation committee member independence (references to an NYSE Listed Company Manual Section hereinafter will be referred to as NYSE Section):
[I]n affirmatively determining the independence of any director who will serve on the compensation committee of the listed company’s board of directors, the board of directors must consider all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to:
(A) the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the listed company to such director; and
(B) whether such director is affiliated with the listed company, a subsidiary of the listed company or an affiliate of a subsidiary of the listed company.
Paragraphs (A) and (B) of NYSE Section 303A.02(a)(ii) are verbatim Section 10C(a)(3)(A) and (B) of the Securities Exchange Act of 1934 (the Exchange Act) as added by Dodd-Frank Section 952(a).
These new requirements of NYSE Section 303A.02(a)(ii) as to the independence of compensation committee members are in addition to the general standards for director independence. The section concerning general standards of director independence is Section 303A.02 (within which the new rules relating to independence of compensation committee members are contained).
New NASDAQ Rule
The NASDAQ also has adopted new independence rules for compensation committee members, again reflecting Dodd-Frank. The NASDAQ, however, makes a "bright line" rule as to compensation paid by the listed company to a director. In NASDAQ Rule 5605(d)(2)(A), it provides that a director, to be independent for purposes of serving on the compensation committee
must…not accept directly or indirectly any consulting, advisory or other compensatory fee from the Company or any subsidiary thereof. Compensatory fees shall not include: (i) fees received as a member of the compensation committee, the board of directors or any other board committee; or (ii) the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the Company (provided that such compensation is not contingent in any way on continued service).
Unlike the NYSE rule, the NASDAQ rule leaves no discretion to the board to determine whether the described compensation is sufficiently material to preclude a director from being independent. Preclusion is automatic. The language of new NASDAQ Rule 5605(d)(2)(A) applicable to compensation of a director is virtually the same as the language applied to audit committees by SEC Rule 10A-3(b)(1) under the Exchange Act, incorporated into the NASDAQ rules by NASDAQ Rule 5605(c)(2)(A).
The other new NASDAQ rule regarding independence of compensation committee members—"affiliate" status—also is contained in NASDAQ Rule 5605(d)(2)(A) and virtually repeats Dodd-Frank (like NYSE Section 303A.02(a)(ii)(B), quoted above):
In determining whether a director is eligible to serve on the compensation committee, a Company’s board also must consider whether the director is affiliated with the Company, a subsidiary of the Company or an affiliate of a subsidiary of the Company to determine whether such affiliation would impair the director’s judgment as a member of the compensation committee.
Like the NYSE, the NASDAQ has rules relating to independence of directors generally (in addition to rules as to specific committees). NASDAQ Rule 5605(a)(2) sets forth the general rules as to independence for that exchange.
Both the NYSE and the NASDAQ provide for a cure period in the event a member of the compensation committee fails to qualify as independent.2 In addition, the NASDAQ provides, under certain circumstances, a special rule for the appointment for a period no longer than two years of a committee member who does not meet NASDAQ’s independence standards provided the board determines under "exceptional and limited circumstances" that appointment of such member is "required by the best interests of the Company and its Shareholders."3
Relationships and Affiliations
Commentary to NYSE Section 303A.02 regarding the general standard for director independence states that "when assessing the materiality of a director’s relationship with a listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has affiliations. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others." [Emphasis added.] The quoted language is contained in the commentary to NYSE Section 303A.02 and existed before the new rules were adopted applicable to compensation committee member independence.
The introductory language to new NYSE Section 303A.02(a)(ii) for compensation committee members, as quoted above, also provides that any director’s "relationship" to the listed company that might affect his or her independence in making compensation decisions must be taken into account—not just sources of compensation or whether the director is "affiliated" with the listed company or a subsidiary. While NASDAQ Rule 5605(d)(2) does not contain language like that noted in the preceding sentence that is contained in NYSE Section 303A.02, presumably the NASDAQ will follow a similar policy to the NYSE’s in this regard.4
In adopting Rule 10C-1 under the Exchange Act, the SEC states the following policy to be followed by the exchanges regarding independence of compensation committee members (Rel. 34-67220, at p. 24 (June 20, 2012)): "it is important for the exchanges to consider other ties between a listed issuer and a director, in addition to share ownership, that might impair the director’s judgment as a member of the compensation committee. For example, the exchanges might conclude that personal or business relationships between members of the compensation committee and the listed issuer’s executive officers should be addressed in the definition of independence."5
Open-ended concepts like "relationships" and "affiliations" pose risks to boards trying to make reasonable judgments as to whether certain of their members are qualified to make "independent" decisions on issues involving executive compensation at the listed company. This is emphasized by the disclosure/certification requirements noted in the next section.
Compliance under NYSE Section 303A.02 is subject to the disclosure requirements of Item 407(a) of Regulation S-K. Item 407(a) generally requires that a listed company/registrant disclose, among other things, the following:
When determining whether the members of a committee of the board of directors are independent, the registrant’s definition of independence that it uses for determining if the members of that specific committee are independent in compliance with the independence standards applicable for the members of the specific committee in the listing standards of the national securities exchange….6
In addition to the disclosure just described, the NYSE requires periodic certifications by a listed company that it is in compliance with the governance rules of NYSE Section 303A. Presumably this will include certification of compliance with the new independence standards for compensation committee members.
New NASDAQ Rule 5605(d)(6) requires that each NASDAQ listed company must certify its compliance with Rule 5605(d) ("Compensation Committee Requirements") "no later than 30 days after the final implementation deadline applicable to it." Presumably, for most NASDAQ listed companies the "final implementation deadline" will be the earlier of the first annual shareholders meeting after Jan. 15, 2014, or Oct. 31, 2014. As noted above in connection with the NYSE rules, a registrant that is listed on the NASDAQ will also be subject to the disclosure requirements of Regulation S-K Item 407(a).
Existing disclosure rules and new certification requirements under the rules of both exchanges will be a "spotlight" on determinations by listed companies of the independence of compensation committee members.
Exposure of Directors
Under Delaware law, if directors are found to lack required independence in a matter, they may lose the protection of the Business Judgment Rule. In such event, the burden shifts to the director to establish that the executive pay decision was reasonable. Failure to establish that could mean a court finding that the compensation paid was invalid or excessive and that the directors failing the independence test, as well as those directors who at the time were aware of such failure, are liable for the invalid or excessive payment.
The well-known executive pay litigation involving the Walt Disney Company, which continued for approximately a decade in the Delaware courts, illustrates the significance of relationships between directors and the employer company.7 In the early stages of that litigation, the Delaware Court of Chancery examined the relationships of individual directors to the company.8 Under the new standards for independence of compensation committees of listed companies as discussed above, some of the directors in Disney might have failed the test of independence. For example, the chairman of the compensation committee was the personal attorney of the Disney chief executive officer. To what extent such failure under the current exchange tests for independence would impact on the Business Judgment Rule is unclear but without the protection of that presumption it is quite possible that a different result would have been reached in the Disney case.
Another example in which director independence, in light of the new listing rules, might have been put in question involves the NYSE itself. In 2003, a settlement was reached with Richard Grasso, the then departing chairman of the NYSE, a settlement estimated at the time to be worth approximately $140 million. While the new independence standards are directed at listed companies, not to the exchanges themselves, it seems unlikely that the NYSE itself could have ignored such standards in considering the highly interested composition of its own compensation committee. In that case, the chairman of the NYSE compensation committee was a long-time personal friend of Grasso and several members of the compensation committee were heads of investment firms regulated by the NYSE. Today, a failure of independence on the part of the compensation committee of the NYSE to meet its own current listing standards would at least raise a question as to the validity of such a settlement.
Recent examples of litigation in which independence of compensation committee members have been put in issue are so-called Say-on-Pay cases. These actions are brought under Dodd-Frank Section 951 and have occurred following negative say-on-pay votes. In Gordon v. Goodyear, No. 1:12-cv-00369, 2012 U.S. Dist. LEXIS 97623, 2012 WL 2885 695 (N.D. Ill. July 13, 2012), a federal district court considered whether a shareholder bringing a derivative action in a say-on-pay case should be excused from making demand on the company’s board prior to bringing the action. The shareholder based her position on the two-pronged test in the Aronson case.9
The two-pronged test is (a) whether the directors making the decision were disinterested and independent and (b) whether the directors’ decision was a result of the exercise of valid business judgment. Failure of the board to meet either prong results in excusing the shareholder from the procedural requirement that shareholders in such an action make a demand on the board before instituting the action. In Gordon v. Goodyear, the court rejected the shareholder’s arguments as to both prongs.
Both Aronson prongs, not just the first, involve questions relating to director independence. Protection under the business judgment rule in Delaware, for example, not only requires that the directors have properly informed themselves but also that in reaching the decision they acted in good faith and in the honest belief that what they were doing was in the best interests of the corporation. Directors’ independence (or lack thereof) could impact on a court’s finding as to each of these elements.
Thus, directors of listed companies must not only assure themselves of compliance with new standards as directors of an exchange listed company as to which they must certify compliance, but they also must be aware of the consequences of a failure to meet such standards as evidence that may be introduced in the event of future litigation over the executive compensation that they have approved.
Joseph E. Bachelder III is special counsel to McCarter & English. Howard Berkower, a partner with the firm, and Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this column.
1. New exchange rules affecting compensation committees, in addition to those discussed in today’s column, include rules relating to (a) independence of advisors to compensation committees, (b) the establishment of compensation committees (of particular importance in the case of the NASDAQ which has not, prior to the taking affect of the new rules, required a separate compensation committee) and (c) new requirements as to charters for compensation committees. These rules, as well as the independence rules for compensation committee members discussed in today’s column, have been adopted in accordance with Rule 10C-1 under the Exchange Act; they were approved by the SEC on Jan. 11, 2013 (NYSE: Rel. 34-68639; NASDAQ: Rel. 34-68640).
Certain types of listed companies are exempt from the new compensation committee independence rules under rules of both exchanges. These include "smaller reporting companies," "controlled companies," limited partnerships and companies in bankruptcy.
2. NYSE Section 303A.00 and NASDAQ Rule 5605(d)(4).
3. NASDAQ Rule 5605(d)(2)(B).
4. The use of the term "affiliated" directors in each of the new NYSE and NASDAQ rules is itself a very broad concept. The Exchange Act does not define the term "affiliate." However, the SEC rules promulgated under the Exchange Act define the term "affiliate" as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified," and the term "control" is defined as the "possession, direct or indirect, of the power to direct or cause the direction of management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." [Emphasis added.] Rule 12b-2 under the Exchange Act.
5. An example of the length to which a court may go in considering social relationships for purposes of Delaware’s Aronson rule (discussed further below) is Beam v. Stewart, 845 A.2d 1040 (Del. 2004).
6. Regulation S-K Item 407(a)(1)(i). As part of its disclosure under Item 407 of transactions, relationships, or arrangements taken into account in determining independence, the board is required to include transactions with directors and their immediate family members even if such information may be exempt from disclosure under S-K Item 404, "Transactions with Related Persons, Promoters and Certain Control Persons." Regulation S-K Item 407(a)(3).
7. See In re Walt Disney Derivative Litigation, 906 A.2d 27 (Del. 2006).
8. In re Walt Disney Derivative Litigation, 731 A.2d 342 at 354-361 (Del. Ch. 1998).
9. Aronson v. Lewis, 473 A.2d 805 (Del. 1984).