Corporate Governance and the Problem of Executive Compensation: The Role of the SEC (Director Independence) (Part 3)
We are discussing Rule 10C-1. The rule requires the exchanges to adopt listing standards that regulate compensation committees. The rule was adopted in Exchange Act Release No. 67220 (June 20, 2012).
Section 952 of Dodd-Frank sought to regulate the definition of director independence. The provision required the board of listed companies to consider certain "factors" in determining the independence of directors serving on the compensation committee. The statute required that the board consider:
- a director’s source of compensation, including any consulting, advisory, or compensatory fee paid by the issuer; and
- whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.
The statute left open the possibility that other factors would be required.
In adopting Rule 10C-1, the Commission did impose a specific set of factors. Instead, the Agency left the matter to the stock exchanges. See 17 CFR 240.10C-1(b) ("In determining independence requirements for members of compensation committees, the national securities exchanges and national securities associations shall consider relevant factors").
Nonetheless, the Commission provided the exchanges with some advice. First, the Agency described the two factors specified in the statute as "the same matters as the prohibitions in Section 10A(m)’s definition of audit committee independence". Exchange Act Release No. 67220 (June 20, 2012). This is not, however, quite true.
Section 10A(m) provides that directors on the audit committee cannot "accept any consulting, advisory, or other compensatory fee from the issuer." The language of the requirement does not extend to fees.
The language in Section 10C, however, is much broader. Independence requires consideration of the "director's source of compensation," something that explicitly includes any "consulting, advisory or compensatory fee." Since directors receive fees as compensation, the amount will need to be considered in determining the independence of directors serving on the compensation committee. This appears to be a significant change in the current analysis used by the board in determining independence.
In addition, the adopting release indicated that the exchanges will need to go beyond the two factors set out in the statute. As the release stated:
in response to concerns noted by some commentators that significant shareholders may have other relationships with listed companies that would result in such shareholders’ interests not being aligned with those of other shareholders, we emphasize that it is important for 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.
The need to consider personal relationships would require the board to consider friendship and other non-financial ties. This is currently not a requirement of the rules of the stock exchange.
The lingering question is why the requirement should be limited to directors on the compensation committee. To the extent a director on the audit or nominating committee also has a disqualifying personal relationship with the CEO, the director should not be treated as independent. The exchange should, therefore, consider application of these factors to all independent directors.
With respect to "business" relationships between directors and officers, the NYSE takes the position that these relationships already must be considered in determining director independence. See The NYSE and the Problems of Director Independence ("representatives of the NYSE advised [the Company] that, in interpreting its rules, the NYSE believes relationships between a director and a member of senior management that are material to either party should be considered by a board of directors in its evaluation of a director’s independence.").
Yet the listing standard is not so explicit. The standard merely requires the board to consider relationships between directors and the company, not directors and executive officers. See NYSE 303A.02 (requiring board to consider any "material relationship with the listed company"). Given this language, at least one company has taken the position that "[p]ersonal business relationships between individuals (as opposed to relationships with the company) generally are not relevant to the independence tests under the New York Stock Exchange rules because they do not create a material relationship between a director and the company." The statement (and the position) was later modified after communications from the exchange.
Nonetheless, the requirement that the board consider "business relationships" between directors and executive officers ought to be made explicit in the listing standards. Moreover, given the NYSE's position, the factor should be made applicable to the consideration of independence for all directors, not just those serving on the compensation committee.