Corporate Governance, Rule 10C-1, and the SEC: Nasdaq and the Non-Independent Compensation Committee (Part 5)

The Commission approved the listing standard from Nasdaq in Exchange Act Release No. 68640 (Jan. 11, 2013).  The listing standard is here.  Nasdaq filed a reponse to the comments on Dec. 12, 2012.

In adopting the listing standard, however, Nasdaq included some requirements that were questionable given the language of Section 10C.  Most noticeably, the standard provided that in "exceptional and limited circumstances" a board could appoint a non-independent director to the compensation committee.  As the standard provided:

if the compensation committee is comprised of at least three members, one director who is not independent . . . and is not currently an Executive Officer or employee or a Family Member of an Executive Officer, may be appointed to the compensation committee if the board, under exceptional and limited circumstances, determines that such individual’s membership on the committee is required by the best interests of the Company and its Shareholders. A Company that relies on this exception must disclose either on or through the Company’s website or in the proxy statement for the next annual meeting subsequent to such determination . . . the nature of the relationship and the reasons for the determination. In addition, the Company must provide any disclosure required by Instruction 1 to Item 407(a) of Regulation S-K regarding its reliance on this exception. A member appointed under this exception may not serve longer than two years.

As explained more fully here, the provision was arguably inconsistent with Section 10C and congressional intent.  Section 10C states that the listing standards "shall require that each member of the compensation committee of the board of directors of an issuer be . . . independent." In other words, the explicit language mandates that the directors on the committee be independent. 

Moreover, the provision instructs the Commission to provide an opportunity to "cure" any defects.  See Section 10C(f).  Thus, companies should have some opportunity to cure where the director was independent when appointed and later lost that status.  The period for cure potentially contemplates that the non-independent director will serve on the committee for a modest period of time.

But the right to appoint a director ab initio who is not independent does not implicate the cure provision.  It allows for a compensation committee that does not consist of independent directors.  Moreover, the provision contains no real limits on the authority.  The board need only determine that the matter is in the best interests of the company and shareholders, a vague standard applicable to all board decisions. 

Under this approach, the board could, for example, decide that the non-independent director was necessary because of his/her experience or expertise.  Since almost all directors have some type of business experience or expertise, the board can justify the appointment of any non-independent director.  The Delaware courts have recognized this type of justification when a board explains its decision not to accept a letter of resignation when directors fail to receive majority support from shareholders.  

Moreover, while there is a two-year limit on the appointment, the limit applies to the appointed "member."  That, however, is a limit on a particular individual's tenure, not a limit on the length of time a non-independent director can serve.  Thus, at the end of the two-year period, the board can simply appoint another "member" for two years. 

Nasdaq responded by stating that it had included an exceptional and limited circumstances in its listing standards since 2003.  Although used "infrequently," Nasdaq believed "it adds value to the rules on compensation committees."  The flexibility was particularly important "for a smaller Company that may have relationships that require such flexibility." In other words, Nasdaq did not address the argument that Congress prohibited the prohibition, something that would make the existence of the standard since 2003 irrelevant.  Moreover, while claiming that it was beneficial to "smaller" companies, the assertion was not supported by any empirical evidence nor was the provision limited to smaller companies.

As for the assertion that a board could place a non-independent director on the committee indefinitely, Nasdaq simply stated that it was "unaware of any Company that has abused the use of the exception."  To the extent, however, that there was abuse, the "NASDAQ could exercise its discretionary authority to 'apply additional or more stringent criteria for the initial or continued listing of particular securities' and deny use of the exception to any Company that NASDAQ believed was abusing it."  In other words, rather than address the issue explicitly, it was enough to rely on the enforcement authority of Nasdaq.

That Nasdaq would take this position is not surprising.  The exception provides increased flexibility for listed companies.  What is surprising is the Commission's reaction.  In effect, the Commission took the position that the requirement to adopt "relevant factors" for determining independence meant that the exchange could effectively require no factors at all. 

The Commission believes that the discretion granted to each exchange by Rule 10C-1, generally, to determine the independence standards it adopts to comply with the Rule includes the leeway to carve out exceptions to those standards, as long as they are consistent with the Act.

As for the potential for abuse, the Commission was comfortable relying on the exchange to ensure that the provision was not abused. 

The Commission notes that a member appointed under the Exceptional and Limited Circumstances provision may not serve longer than two years. Further, in the Nasdaq Response Letter, the Exchange stated that it tracks the use of the exception by listed companies and would have discretion in its rules to deny the use of the exception if it thought a company was abusing it.

In other words, the Commission did not require any evidence beyond a declaratory sentence.  The Commission did not ask for data on the application of the provision or examine its use.  The Commission did not ask Nasdaq how it would define abuse. 

Indeed, a review of some of the filings invoking the exception indicates that it has been used hundreds of times, suggesting that, at a minimum, the Commission should have probed the characterization of "infrequent."  Moreover, the disclosure made by many of the companies invoking the exception is unilluminating. Some simply note that the appointment occurred and state that the board determined that it was in the best interests of shareholders to designate the non-independent director.  Others note the reason for a vacancy (death of a director) but provide no explanation for the appointment of a particular non-independent director.

In other words, the Commission allowed the exception to remain in place without conducting any kind of rigorous examination of how it worked in practice.  Nor did the Commission explain how the exemption could coexist given the language in the statute that required all directors to be independent.