Compensation committees will soon experience the effects of the latest rule adopted Wednesday by the Securities and Exchange Commission that aims to ensure the independence of directors who set executive compensation.
Under the new rule, securities exchanges must adopt listing standards that require compensation committee members to be independent board members, and the definition of independence must include the source of a director’s compensation and whether the director is affiliated with the company or any of its subsidiaries. Once the listing standards go into effect, companies must meet these standards to continue trading on the exchange.
The rule was established to address potential conflicts of interest for those who set compensation at public companies. “This rule will help to enhance the board’s decision-making process on executive compensation matters, particularly the selection, engagement and oversight of compensation advisers, and will provide more transparency with respect to conflicts of interest of consultants engaged by boards,” said SEC Chairman Mary L. Schapiro in a statement.
The rule also places the burden of responsibility for the appointment, compensation and work of any advisor hired squarely on the shoulders of the committee and lays out six independence factors directors must consider when hiring a comp consultant:
- Whether the compensation consulting company employing the advisor is providing other services to the company.
- The percentage of the advisor’s total revenue that the company has paid in fees to the compensation consulting company employing the advisor.
- The conflicts of interest policies adopted by the compensation consulting company.
- Whether the compensation adviser has a business or personal relationship with a member of the compensation committee.
- Whether the compensation advisor owns stock in the company.
- Whether the compensation advisor or the person employing the advisor has any business or personal relationship with the executive officer of the issuer.
Deborah Lifshey, managing director of Pearl Meyer & Partners, says the new rule is just another step in the developing path of additional disclosure requirements about compensation firms that began in 2009. “Any firm that hasn’t already been thinking about these six points in practice when assessing whether they are independent or conflicted should be doing so,” Lifshey says. “We already have procedures in place that incorporate these themes.”
The biggest change for compensation consultants is that the rule requires a more formalized process. Lifshey cited one internal change for PM&P: The firm will most likely put a formal policy in place to ensure compliance with these six factors.
However, there may be additional issues to consider, particularly for smaller consulting firms. Steven Hall, founding partner and managing director of compensation consultancy Steven Hall & Partners, says that while he agrees independence is a key criterion for consultants, he finds the disclosure of fees the consultant receives as a percentage of overall revenue “troublesome.”
“The smaller the firm, the more challenges there could be in the ways people interpret those figures,” Hall explains. “If you are a single consultant trying to give advice to boards, and you don’t have many clients it doesn’t that mean you’re not as good as larger-firm consultants.”
Another element of the new rule is that companies will have to disclose in proxy statements whether the compensation committee retained a pay consultant or obtained advice from one.
While the additional disclosures didn’t come as a surprise to compensation consultants, Lifshey suggests directors pay close attention to when the exchanges put out their rules on independence. She notes that the new independence rules will apply to any director who sits on a committee that serves in an executive compensation-setting role, even if a formal compensation committee is not established.
The new rule will go into effect 30 days after being published in the Federal Register, and each exchange will have 90 days to propose listing standards. The SEC must then approve these standards within one year.