Corporate Governance, Rule 10C-1, and the SEC: The NYSE, Director Independence, and the Need to Consider Directors Fees (Part 8)
Section 10C required that the exchanges devise a listing standard that set out the "relevant factors" for determining director independence on the compensation committee. The statute listed two of them: Affiliations with the issuer and compensation.
In referencing compensation, boards were required to consider "the source of compensation of such director, including any consulting, advisory or other compensatory fee paid by the listed company to such director." The plain language required consideration of all compensation, including compensation from sources other than the issuer and fees paid for service on the board.
The legislative history also made this broad approach to compensation clear. Congress considered language that would have limited consideration to consulting, advisory or compensatory fees and would not have involved consideration of fees paid for service on the board. This was the approach taken in Section 10A for audit committees. Congress, however, did not adopt this approach with respect to compensation committees. Moreover, in broadening the types of compensation, Congress only required that they be considered. Under the standard, no particular type or amount of compensation would automatically disqualify a director as independent. For a more detailed discussion of this issue, go here.
The NYSE (and Nasdaq) took the position that fees did not have to be considered. As the exchange described:
The Exchange does not believe that it is appropriate to consider board compensation as part of the compensation committee independence determination with respect to individual directors. Non-executive directors devote considerable time to the affairs of the companies on whose boards they sit and eligible candidates would be difficult to find if board and committee service were unpaid in nature. Consequently, independent directors of listed companies are almost invariably paid for their board and committee service. As all independent directors are almost certainly going to receive board compensation from the company and do so on terms determined by the board as a whole, the Exchange does not believe that an analysis of the board compensation of individual directors is a meaningful consideration in determining their independence for purposes of compensation committee service.
The position, however, was challenged. In response to comments on the position, the NYSE refined its analysis somewhat. As the NYSE letter stated:
Brown, the AFL-CIO and IBT all argue that director fees should be an explicit required factor in compensation committee independence determinations. As all non-management directors of a listed company are eligible to receive the same fees for service as a director or board committee member, the NYSE Exchanges do not believe that it is likely that director compensation would be a relevant consideration for compensation committee independence. However, the proposed rules require the board to consider all relevant factors in making compensation committee independence determinations. Therefore, to the extent that excessive board compensation might affect a director’s independence, the proposed rules would require the board to consider that factor in its determination.
Neither explanation addressed the language of Section 10C and the legislative history. To the extent Congress required consideration of fees, the "belief" by the exchange in the unimportance of the analysis was not sufficient to override congressional intent. Moreover, the "belief" was belied by the fact that the materiality of fees has become a much litigated issue in state courts. See Freedman v. Adams, 2012 Del. Ch. LEXIS 74 (Del. Ch. March 30, 2012).
Moreover, the characterization that "all" non-management directors are eligible to receive the same fees is not entirely accurate. On many boards, directors do not receive identical fees. In addition to fees for attending board meetings, boards can provide additional payments for serving on committees, chairing committees, and acting as lead director. Because the definition of director independence varies (one definition applies to the board, another to the audit committee, and another to the compensation committee), not all directors will be eligible to participate in all functions and all committees. In other words, they will not be eligible to receive the same compensation.
Moreover, some boards pay very high fees to the lead directors. As one survey noted: "The extra compensation received by lead directors for their service in this capacity showed considerable variability, with 40% of respondents receiving $15,000 or less, 28% of lead directors receiving between $20,000 and $38,000, and 32% receiving compensation ranging from $50,000 to $150,000." To the extent that the compensation committee determines the amount paid to the lead director, the lead director may not be independent for purposes of compensation decisions.
In the second statement, however, the NYSE backed away from its earlier contention that it was not "appropriate to consider board compensation as part of the compensation committee independence determination with respect to individual directors." While reiterating its belief that fees were not a meaningful consideration, the NYSE noted that boards would have to consider them if they were a relevant factor.
The Commission affirmed the NYSE's position. As the Commission explained:
The Commission recognizes that some commenters did not believe that the proposal went far enough because the Exchange did not adequately consider the compensation that directors receive for board or committee service in formulating its standards of independence for service on the compensation committee, and, in particular, the levels to which such compensation may rise, or otherwise favored additional requirements. The Commission notes, however, that to the extent a conflict of interest exists because directors set their own compensation, companies must disclose director compensation, and investors will become aware of excessive or noncustomary director compensation through this means. In addition, as NYSE states, a company’s board of directors must consider all relevant factors in making compensation committee independence determinations, and if director fees could, in the opinion of the board, impair the director’s independent judgment with respect to compensation-related matters, the board could therefore consider director compensation in that context.
As with the NYSE, the Commission did not address the argument that the language of Section 10C and the legislative history required consideration of fees. Moreover, the Commission was comforted by the fact that fees had to be disclosed and, as a result, the market would know if there were unusual or uncustomary fees. Yet disclosure of amount may not reveal sufficient information about how the compensation was determined.
Moreover, while the market may know that the director received excessive fees, the Commission's approach would still allow that director to sit on the compensation committee. Congress, however, intended for that committee to be made up of only independent directors. Congress did not opt for an approach that would allow any director to sit on the committee as long as possible conflict were disclosed.