New NASDAQ Listing Rules Applicable to Compensation Committees Now Final

Introduction

On January 11, 2013, the SEC approved new rules for inclusion in NASDAQ Listing Rules (NASDAQ Rules) regarding independence requirements for compensation committees and compensation advisers of companies listed on NASDAQ.¹ NASDAQ initially proposed the new listing rules on September 25, 2012,² based on the final rules that the SEC adopted June 20, 2012 (SEC Rules),³ and NASDAQ amended the initial proposal on December 12, 2012 and January 4, 2013.

Noteworthy Developments Relative to Initial Proposal

The following are matters of note regarding the new NASDAQ Rules that the SEC approved relative to the initial proposal:

By no later than July 1, 2013, a NASDAQ-listed company (NASDAQ Company) must ensure that its compensation committee has expanded authority and responsibilities with respect to the oversight of compensation consultants, outside legal counsel, and other advisers. Such authority and responsibilities do not, however, need to be officially incorporated into a compensation committee’s charter until the earlier of the NASDAQ Company’s first annual meeting after January 15, 2014 or October 31, 2014.

As of July 1, 2013, the compensation committee of a NASDAQ Company may no longer select, or receive advice from, an adviser unless it has conducted the six-factor independence assessment as the new NASDAQ Rules require.

• Although not stated in the new NASDAQ Rules, the SEC order approving the new NASDAQ Rules indicates that the SEC anticipates that a compensation committee will conduct the required independence assessment not less than annually
• Consistent with the disclosure exception set forth in Item 407(e)(3)(iii) of Regulation S-K, a compensation committee need not conduct an independence assessment with respect to any compensation adviser whose role is limited to:
  • Consulting on any broad-based plan that does not discriminate in scope, terms, or operation in favor of executive officers or directors, and that is generally available to all salaried employees
  • Providing information that is not customized for a particular company or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice
• The new NASDAQ Rules expressly state that a compensation committee is not precluded from selecting or receiving advice from a compensation adviser that is not independent

New requirements regarding the independence of NASDAQ Company compensation committee members will not take effect until the earlier of the NASDAQ Company’s first annual meeting of shareholders after January 15, 2014 or October 31, 2014.

Overview

Unlike the newly approved NYSE listing standards,⁴ which largely follow the standards and requirements outlined in the SEC Rules, the changes that NASDAQ adopted go above and beyond the SEC Rules. The new NASDAQ Rules, among other things: require NASDAQ Companies to have compensation committees (as existing NYSE listing standards already require); raise the independence standards for compensation committee members, in some cases applying the heightened independence standards established for audit committees; and require compensation committees to have charters establishing specified rules and standards (as existing NYSE listing standards also already require). In contrast, with regard to factors that may bear on the independence of compensation committee advisers, NASDAQ adopted the factors set forth in the SEC Rules and did not materially change or add to these factors.

A NASDAQ Company must comply with the new NASDAQ Rules regarding selection of compensation committee advisers by July 1, 2013. Furthermore, a compensation committee of a NASDAQ Company must possess the additional responsibilities and authority that the NASDAQ Rules require by July 1, 2013; the requirement to include such responsibilities in the compensation committee’s charter, however, technically does not apply until the earlier of the NASDAQ Company’s first annual meeting after January 15, 2014 or October 31, 2014. Finally, the new NASDAQ Rules requiring a NASDAQ Company to have a compensation committee, mandating contents of its charter, and requiring independence of compensation committee members also take effect upon the earlier of such dates.

Highlights of the New NASDAQ Rules

Compensation Committee Requirement

Although not required to do so under the SEC Rules, the new NASDAQ Rules require NASDAQ Companies, including smaller reporting companies, to have a compensation committee consisting of at least two members of the NASDAQ Company’s board of directors (Board), each of whom must be an “Independent Director” as defined in the NASDAQ Rules. The new NASDAQ Rules effect this requirement by eliminating the ability of a NASDAQ Company to have Independent Directors vote to approve compensation as members of the Board rather than acting as a committee.

Independence of Compensation Committee Members

The SEC Rules directed national securities exchanges to adopt listing standards that require each compensation committee member to be independent and to define the term “independent” in its standards. Consistent with the SEC Rules, the new NASDAQ Rules incorporate the following two factors but do so in two different ways:

• The sources of compensation of compensation committee members, including any consulting, advisory, or other compensatory fee paid by the NASDAQ Company to any member
• Whether a director is affiliated with the NASDAQ Company, a subsidiary of the NASDAQ Company, or an affiliate of a subsidiary of the NASDAQ Company

Under the existing NASDAQ Rules, a Board is already required to make an affirmative determination that an Independent Director does not have any relationship that, in the opinion of the Board, “would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.” Presumably, for a director who will serve as a member of the compensation committee, the Board would need to take into account responsibilities in his or her role on the compensation committee. The NASDAQ Rules currently specify certain categories of directors that cannot qualify as Independent Directors, which categories do not change under the new NASDAQ Rules. Under the new NASDAQ Rules, however, NASDAQ adopted additional independence standards applicable to compensation committee members based on the sources of compensation and affiliated-status factors that the SEC Rules enumerate.

With regard to sources of director compensation, the new NASDAQ Rules apply to compensation committee members the same standard that currently applies to audit committee members under the SEC’s Rule 10A-3 (which rule is incorporated into Rule 5605(c)(2)(A)(ii) of the NASDAQ Rules) and, thus, prohibit compensation committee members from accepting, directly or indirectly, any consulting, advisory, or other compensatory fees (other than solely for Board service and certain retirement amounts) from the NASDAQ Company or any subsidiary of the NASDAQ Company. Also similar to the SEC’s Rule 10A-3, the prohibition on a compensation committee member’s receipt of fees does not include a “look-back” period; rather, the prohibition would apply as of the commencement of the director’s service on the compensation committee. This prohibition is in contrast to the existing NASDAQ Rules, which allow an Independent Director (including a director serving as a compensation committee member) to receive a limited amount of compensation from the NASDAQ Company and its subsidiaries.

Regarding the affiliated-status factor, the new NASDAQ Rules do not prohibit a compensation committee member from having an affiliation with the NASDAQ Company. Rather, in determining whether a director is eligible to be a compensation committee member, a Board must consider whether the director is affiliated with the NASDAQ Company, or its subsidiaries, or other affiliates to determine whether such affiliation would impair the director's judgment as a compensation committee member. NASDAQ did not adopt any “bright-line” tests or prohibitions regarding this factor. In particular, a Board need not make an affirmative finding that a compensation committee member is not independent based solely on the fact that the member (and/or the member’s affiliates) hold in excess of a specific percentage of the NASDAQ Company’s outstanding shares. NASDAQ considered whether to apply the same standards to compensation committee members as it currently applies to audit committee members, which standards prohibit affiliates from being audit committee members and include as “affiliates” persons having beneficial ownership of more than 10 percent of any class of voting shares of the NASDAQ Company. NASDAQ re-affirmed its position that share ownership in a NASDAQ Company aligns the compensation committee member’s interests with those of the NASDAQ Company’s shareholders and, thus, that it may be appropriate for such persons to serve as compensation committee members. No look-back period applies with regard to the affiliated-status factor; hence, a Board will only be required to consider a compensation committee member’s affiliations that exist at and after the start of his or her service as a member.

NASDAQ deems these standards to be sufficient to ensure a compensation committee member’s independence and, therefore, did not adopt any additional factors. The new NASDAQ Rules maintain NASDAQ’s existing exception allowing certain non-independent directors to serve on a compensation committee under exceptional and limited circumstances.⁵ Furthermore, if a NASDAQ Company were to fail to comply in certain circumstances with the compensation committee requirements, it may rely on the existing cure-period provision in the NASDAQ Rules, which provision remains unchanged and is applicable to the new NASDAQ Rules.⁶ These new NASDAQ Rules will not take effect until the earlier of a NASDAQ Company’s first annual meeting of shareholders after January 15, 2014 or October 31, 2014.

Compensation Committee Charter and Authority to Retain Advisers

The new NASDAQ Rules require that (i) a compensation committee have the authority to retain its own compensation advisers, (ii) a compensation committee be directly responsible for the appointment, compensation, and oversight of each adviser that it retains, and (iii) a NASDAQ Company provide appropriate funding to the compensation committee to allow the committee to pay reasonable compensation to its advisers. The new NASDAQ Rules do not require, however, that a compensation committee retain its own advisers.

Although not required by the SEC Rules, the new NASDAQ Rules require each NASDAQ Company to adopt a formal, written compensation committee charter, which charter must be adopted by the earlier of a NASDAQ Company’s first annual meeting of shareholders after January 15, 2014 or October 31, 2014. A compensation committee charter must specify the following:

• The scope of the compensation committee’s responsibilities, and how it carries out those responsibilities, including structure, processes, and membership requirements
• The compensation committee’s responsibility for determining, or recommending to the Board for determination, the compensation of the chief executive officer and all other executive officers of the NASDAQ Company
• That the chief executive officer of the NASDAQ Company may not be present during voting or deliberations by the compensation committee on his or her compensation
• That a compensation committee must have the specific compensation committee responsibilities and authority necessary to comply with SEC Rules relating to: (i) the authority to retain compensation consultants, independent legal counsel, and other compensation advisers; (ii) the authority to fund such advisers; and (iii) the responsibility to consider certain independence factors before selecting such advisers, other than in-house legal counsel

The first three compensation committee charter requirements for NASDAQ Companies are based on existing NASDAQ Rules applicable to compensation committees (or committees currently performing functions typically performed by compensation committees) and therefore should not require any new action on the part of a NASDAQ Company’s Board or compensation committee (unless, of course, the compensation committee is newly formed).⁷ The final compensation committee charter requirement is modeled after NASDAQ Rule 5605(c)(1)(D) related to audit committee charters and thus introduces new authority requirements and responsibilities for compensation committees. Compliance with the final compensation committee charter requirement requires action on the part of a Board prior to the deadline to ensure that the compensation committee charter explicitly provides the compensation committee with such authority and responsibilities.

A NASDAQ Company must submit to NASDAQ a certification, signed by an officer of the company, that the company has complied with the new NASDAQ Rules no later than 30 days after the final implementation deadline applicable to the company.

Compensation Committee Review of Factors Impacting Compensation Adviser Independence

As the SEC Rules stipulate, the new NASDAQ Rules require a compensation committee to take into consideration specified factors that could bear on the independence of any compensation consultant, legal counsel, or other adviser (Compensation Advisers) to the committee, including Compensation Advisers that the compensation committee retains or that management retains. As of July 1, 2013, a compensation committee may no longer select, or receive advice from, a Compensation Adviser unless it has conducted an independence assessment as the new NASDAQ Rules require. The SEC order approving the new NASDAQ Rules indicates that compensation committees should conduct the required independence assessment not less than annually.⁸

NASDAQ adopted exclusively the list of six factors set forth in the SEC Rules and did not impose any specific additional factors. The new NASDAQ Rules do not, in fact, specify the six factors; rather, NASDAQ Rule 5605(d)(3) requires a NASDAQ Company to give its compensation committee the responsibility to consider the six factors enumerated in the SEC Rules before selecting Compensation Advisers. Those six factors are as follows:

• The provision of other services to the NASDAQ Company by the employer of the Compensation Adviser (Advisory Employer)
• The amount of fees received from the NASDAQ Company by the Advisory Employer as a percentage of the total revenue of the Advisory Employer
• The Advisory Employer’s policies and procedures designed to prevent conflicts of interest
• Business or personal relationships of the Compensation Adviser with compensation committee members
• Any stock in the NASDAQ Company owned by the Compensation Adviser
• Business or personal relationships of the Advisory Employer or the Compensation Adviser with executive officers

The new NASDAQ Rules make clear that, consistent with SEC Rule 10C-1(b)(2)(iii), compensation committees are not required to implement or act consistently with the advice or recommendations of retained Compensation Advisers. Moreover, the six factors that the compensation committee must consider do not affect the ability or obligation of the compensation committee to exercise its own judgment in the fulfillment of its duties. Further, the new NASDAQ Rules expressly state that a compensation committee is not precluded from selecting or receiving advice from a Compensation Adviser that is not independent.

It is important to note that the NASDAQ Company need not conduct such independence assessment with respect to in-house legal counsel or any Compensation Adviser whose role is limited to: (a) consulting on any broad-based plan that does not discriminate in scope, terms, or operation in favor of executive officers or directors, and that is generally available to all salaried employees; or (b) providing information that is not customized for a particular company or that is customized based on parameters that are not developed by the adviser, and about which the adviser does not provide advice.⁹

Timing

New NASDAQ Rules Effective as of July 1, 2013

The following new NASDAQ Rules are effective as of July 1, 2013:

• A compensation committee may no longer select, or receive advice from, an adviser unless it has conducted the independence assessment required by the new NASDAQ Rules
• A NASDAQ Company must ensure that its compensation committee has the requisite authority and responsibilities with respect to the oversight of compensation consultants, outside legal counsel, and other advisers (The requirement to include such responsibilities in the compensation committee charter technically does not apply until one of the later effective dates listed below; thus, a NASDAQ Company may rely upon Board approval of resolutions, or comparable action permitted under applicable state law, that occurs on or prior to the effective date applicable to the company)

New NASDAQ Rules Effective the Earlier of a NASDAQ Company’s First Annual Meeting of Shareholders After January 15, 2014 or October 31, 2014

The following new NASDAQ Rules are effective as of the earlier of a NASDAQ Company’s first annual meeting of shareholders after January 15, 2014, or October 31, 2014:

• The NASDAQ Company must have a compensation committee with at least two independent members
• The new independence standards will apply to determinations regarding such compensation committee members’ independence
• The NASDAQ Company must have in place a compensation committee charter
• The NASDAQ Company must certify as to compliance with the new NASDAQ Rules no later than 30 days after the final implementation deadline applicable to the company (i.e., the earlier of the NASDAQ Company’s first annual meeting of shareholders after January 15, 2014, or October 31, 2014)

Phase-In Compliance

Under the new NASDAQ Rules, NASDAQ’s existing phase-in schedules for compensation-related listing rules, applicable to NASDAQ Companies listing in connection with an initial public offering, NASDAQ Companies emerging from bankruptcy, and NASDAQ Companies ceasing to be controlled companies, would remain generally unchanged. The new NASDAQ Rules clarify that such a NASDAQ Company could phase in compliance with the minimum compensation committee size requirement and additional compensation committee member eligibility requirements in reliance on these schedules.

Exemptions

The new NASDAQ Rules provide an exemption for all categories of issuers that are currently exempt from NASDAQ’s existing compensation committee requirements, including asset-backed issuers and other passive issuers, cooperatives, limited partnerships, management investment companies, and controlled companies, as well as foreign private issuers that provide the disclosures already required in the NASDAQ Rules.

Smaller reporting companies would not be required to adhere to the higher independence standards for compensation committee members or to consider the six factors enumerated in the SEC Rules before selecting Compensation Advisers (although a smaller reporting company would be required to have a compensation committee and a compensation committee charter or Board resolution that specifies the committee's responsibilities and authority). A NASDAQ Company ceasing to be a smaller reporting company will be allowed six months (as opposed to the originally proposed 30 days) to certify that it has adopted a formal written compensation committee charter that includes the compensation committee responsibility and authority requirements under the new NASDAQ Rules. In addition, any such company will be allowed to phase in a fully compliant compensation committee, particularly as such compliance relates to the compensation committee member independence requirements pertaining to the receipt of compensatory fees and affiliations.

Actions Companies Should Take Now

NASDAQ Companies should take steps now to ensure timely compliance with the new NASDAQ Rules, including the following:

1. Review current arrangements with Compensation Advisers under the six factors that may bear on independence. A NASDAQ Company should review arrangements with all current Compensation Advisers and carefully consider each of the six factors enumerated in SEC Rule 10C-1(b)(4) and incorporated into the new NASDAQ Rules. NASDAQ Companies should keep in mind that this rule becomes effective July 1, 2013. That is, as of July 1, 2013, a compensation committee may no longer select, or receive advice from, an adviser unless it has conducted the six-factor independence assessment with respect to the adviser.
   
   A NASDAQ Company or its compensation committee should obtain from Compensation Advisers adequate information to enable the compensation committee to consider the six factors. The compensation committee may then determine whether there is information as to any Compensation Adviser that concerns the committee, keeping in mind that there is no requirement that a compensation committee only use Compensation Advisers that are in fact independent. If the NASDAQ Company, rather than its compensation committee, is generally involved in the work to obtain the relevant information, then the NASDAQ Company should nonetheless advise the compensation committee of the new NASDAQ Rules and seek feedback, and ultimately, the committee will need to make the assessment. Of course, if the information raises valid concerns, then the compensation committee will need to consider what actions to take to address the situation.
2. Review engagement arrangements with Compensation Advisers that the compensation committee has retained. Given that a NASDAQ Company’s compensation committee is directly responsible for the appointment, compensation, and oversight of the work of any Compensation Advisers that the compensation committee retains, by July 1, 2013, the NASDAQ Company should review the relevant relationships with any Compensation Advisers that the compensation committee retains to ensure the proper level of committee involvement.
3. Establish a compensation committee. If a NASDAQ Company does not already have a compensation committee, the NASDAQ Company should begin forming this committee. In light of the heighted compensation committee requirements, a Board will require sufficient time to establish a compensation committee that meets the existing and new NASDAQ Rules, especially those regarding the independence of potential compensation committee members. A NASDAQ Company must establish a compensation committee by the earlier of the NASDAQ Company’s first annual meeting of shareholders after January 15, 2014, or October 31, 2014.
4. Review current compensation committee membership in light of the membership standards. A NASDAQ Company should pay special attention to the heightened standard prohibiting compensation committee members from receiving any consulting, advisory, or other compensatory fees (other than solely for Board service and certain retirement amounts) paid by the NASDAQ Company or any of its subsidiaries.
   
   A NASDAQ Company also should focus on whether a director is affiliated with the NASDAQ Company, a subsidiary of the NASDAQ Company, or an affiliate of a subsidiary of the NASDAQ Company. A Board has broad discretion to determine whether any affiliation impairs a director's judgment as a compensation committee member, but it should be able to show that the Board carefully considered this factor and defend why particular affiliations do not disqualify a member.
   
   Such factors must be addressed no later than the earlier of a NASDAQ Company’s first annual meeting of shareholders after January 15, 2014, or October 31, 2014. As a practical matter, a NASDAQ Company will presumably need to address those factors prior to sending its proxy statement for that annual meeting.
5. Prepare or review the company’s compensation committee charter. The new NASDAQ Rules expressly lay out the required elements of a compensation committee charter. If a NASDAQ Company does not currently have a compensation committee charter , or if the charter does not meet all of the requirements of the new NASDAQ Rules, the NASDAQ Company should prepare or amend its charter accordingly, including formal adoption or amendment by the Board. Once the compensation committee charter is in effect, the Board should be able to show that it has complied with the terms of its charter in connection with the evaluation and selection of each compensation committee member. A NASDAQ Company must adopt a compensation committee charter by the earlier of its first annual meeting of shareholders after January 15, 2014, or October 31, 2014. Finally, NASDAQ Companies are required to “review and reassess” the adequacy of the compensation committee charter on at least an annual basis.

¹ The final SEC order approving the new NASDAQ Rules is available on the SEC Web site. The new NASDAQ Rules have been incorporated into the NASDAQ Rules on the NASDAQ Web site.

² The rules that NASDAQ proposed on September 25, 2012 regarding compensation committees are discussed in Foley’s Legal News Alert on this topic, dated October 8, 2012.

³ The SEC Rules regarding compensation committees are discussed in more detail in Foley’s Legal News Alert on this topic, dated June 25, 2012. The SEC Rules were adopted in response to the mandate of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

⁴ We discuss the NYSE listing standards regarding compensation committees that the SEC approved January 11, 2013 in Foley’s Legal News Alert on this topic, dated February 18, 2013.

⁵ NASDAQ Rule 5605(d)(3): “If a Compensation Committee has at least three members, one director who is not independent and not an executive officer, employee or family member of an executive officer, may be appointed as a Member 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.”

⁶ NASDAQ Rule 5605(b)(1)(A) sets forth the applicable cure provision: “If a Company fails to comply with this requirement due to one vacancy, or one director ceases to be independent due to circumstances beyond their reasonable control, the Company shall regain compliance with the requirement by the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with this requirement; provided, however, that if the annual shareholders meeting occurs no later than 180 days following the event that caused the failure to comply with this requirement, the Company shall instead have 180 days from such event to regain compliance. A Company relying on this provision shall provide notice to NASDAQ immediately upon learning of the event or circumstance that caused the noncompliance.”

⁷ These requirements are based on NASDAQ Rules 5605(c)(1)(A), 5605(d)(1) and (2), and 5605(d)(1), respectively.

⁸ The first amendment to the NASDAQ proposal deleted the word “independent” prior to “legal counsel” in NASDAQ Rule 5605(d)(3), thus clarifying that compensation committees of NASDAQ Companies are required to consider the independence factors specified in SEC Rules 10C-1(4)(i) – (vi) when selecting, or receiving advice from, any legal counsel (except in-house legal counsel).

⁹ These two limited exceptions for certain Compensation Advisers essentially track the exception set forth in Item 407(e)(3)(iii) of Regulation S-K to the disclosure requirements regarding a compensation committee’s role in determining or recommending the amount and form of executive and director compensation.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss the topic further, please contact your Foley attorney or:

Patrick G. Quick
Milwaukee, Wisconsin
414.297.5678
pgquick@foley.com

Todd B. Pfister
Chicago, Illinois
312.832.4579
tpfister@foley.com

Mark T. Plichta
Milwaukee, Wisconsin
414.297.5670
mplichta@foley.com

Aubrey V. Refuerzo
Chicago, Illinois
312.832.4368
arefuerzo@foley.com