The NASDAQ Stock Market LLC (“NASDAQ”) has amended its new rules on compensation committee independence to provide additional flexibility for committee members to meet the independence criteria. As a result of the amendment, NASDAQ rules will no longer prohibit a director from serving on a listed company’s compensation committee if the director receives fees from the company. Instead, boards must consider any fees in determining whether a director is eligible to serve on the committee. This change provides additional flexibility for companies and aligns NASDAQ’s compensation committee independence criteria with those of the New York Stock Exchange (“NYSE”).
The rule change, which was filed with the Securities and Exchange Commission (“SEC”) on November 26, is effective immediately. Therefore, it will apply when the new rules on compensation committee independence take effect in 2014. The deadline for complying with the rules is the earlier of a company’s first annual meeting after January 15, 2014 or October 31, 2014.
NASDAQ’s compensation committee independence criteria, which are set forth in NASDAQ Rule 5605(d), are based on SEC Rule 10C-1, which implements the Dodd-Frank Act. The SEC did not mandate that the stock exchanges adopt specific independence standards, but did require the exchanges to consider two factors in developing their standards—sources of a director’s compensation, including whether the director receives any fees from a listed company, and whether the director is affiliated with the company.
According to NASDAQ’s rule filing, it was the only stock exchange to adopt an outright prohibition on the receipt of fees. NASDAQ had adopted the same standard that applies to audit committees, after concluding that there was “no compelling justification” for having different standards for audit and compensation committees. However, following adoption of the rule, NASDAQ has received feedback that a prohibition is burdensome because it may prevent certain directors from serving on the compensation committee, making it difficult for companies to recruit directors because of the different independence standards applicable to directors, audit committees and compensation committees. Additionally, the prohibition may influence companies’ decisions about the stock markets where they choose to list their securities.
NASDAQ’s rule filing provides additional guidance on how companies should approach the independence analysis for compensation committee members.
1. In determining the independence of any director who will serve on the compensation committee, a company’s board of directors must consider the sources of the director’s compensation, including “any consulting, advisory or other compensatory fee” the company pays to the director. In doing so, the board should consider whether the director receives compensation from any person or entity that would impair the director’s ability to make independent judgments about the company’s executive compensation.
2. The board must consider all compensation paid to a director, including fees for board and committee service. In this regard, NASDAQ has removed an exception in the rule stating that compensatory fees do not include fees for board and committee service, or fixed amounts of compensation under a retirement plan for prior service with the company. NASDAQ emphasized in the rule filing that fees for board and committee service “must be considered,” “in aggregate with all other sources of compensation of the director,” in determining whether a director is eligible to serve on the compensation committee. In explaining the reasons for this change, NASDAQ noted that the rules of the other stock exchanges on compensation committee independence do not include a similar exception, and that, during the comment period on the compensation committee independence proposals, NASDAQ received several comments that boards should consider board and committee fees as part of the independence assessment.
NASDAQ also clarified in the rule filing that a similar exception for board and committee fees, and retirement payments, will continue to apply under the bright-line director independence test that precludes directors from receiving compensation of more than $120,000 from the company during any 12-month period within the past three years. However, NASDAQ emphasized that the board must consider all fees, including those below the thresholds in the bright-line director independence tests, in determining whether a director receives any fees that would impact the director’s independence for purposes of serving on the compensation committee.
3. As part of the compensation committee independence analysis, a company’s board of directors also must consider whether a director has any affiliate relationships with the company, its subsidiaries or any affiliate of a subsidiary. This requirement has not changed, but NASDAQ has added guidance stating that the board should assess whether any affiliate relationships place a director under the direct or indirect control of the company or its senior management, or create a direct or indirect relationship between the director and senior management, that would impair the director’s ability to make independent judgments about the company’s executive compensation. The same guidance appears in the NYSE rule.
4. In addition to considering compensatory fees and affiliate relationships, the board must consider all factors that are specifically relevant to determining whether a director has any relationship to the company that is material to the director’s ability to be independent from management in connection with the duties of a compensation committee member. NASDAQ does not view this as a substantive change, because its current rules require all compensation committee members to be independent directors and for any independent director, the board must determine that the director has no material relationships that could interfere with the exercise of independent judgment.
Finally, the amendments clarify that, for purposes of the compensation committee independence criteria, any references to the “Company” include parents and subsidiaries, and cover entities that a company controls and consolidates on its financial statements. This is consistent with the approach reflected in NASDAQ’s existing rules on director independence.
The rule filing, including a redline showing proposed changes to the rule text, is available here.