After listening to SEC Commissioner Luis A. Aguilar speak during Wednesday’s open meeting where the commission in a 5-0 vote approved proposed rules for exchange listing standards related to compensation committees and compensation consultants as well as new disclosures, I was left wondering whether or not such rules will be effective.
I’m not saying the issue of independence and conflicts of interest regarding compensation committees and consultants should not be addressed by various exchanges (i.e. NYSE EuroNext, Nasdaq OMX). In fact, I’m wondering why the SEC didn’t follow the audit committee model in the Sarbanes-Oxley Act. Title III of SOX (Corporate Responsibility) made it mandatory for public companies to have audit committees while the SEC’s proposed Rule 10C-1 under the Dodd-Frank Act doesn’t go that far with compensation committees.
While Aguilar concedes that most public companies already have a compensation committee and thus they would have to abide by the rule, he did say he is worried about the appearance of a loophole. Here’s what he said during Wednesday meeting (Read his full commentary here]:
“The proposal applies the enhanced independence requirements depending on how a company makes compensation decisions. If a company’s decisions are made by a compensation committee, the rules apply, but if decisions are made outside of such a committee, even if made by a sub-set of the Board of Directors, the rules do not apply. The proposal’s focus on form over substance has consequences and I wonder about whether this is the right approach.
“For one thing, by basing the requirements on whether or not a listed company has a compensation committee, the proposal ultimately is reliant on voluntary compliance. This is because companies are not required by law to have a compensation committee, nor do the listing standards at every exchange require compensation committees.”
It was the next thing that Aguilar said that was really startling, especially when you consider he supports the proposed rule.
“In the future if a company wanted to avoid compliance, it could, in theory, dissolve any existing compensation committee or avoid forming one. Even if a company were listed on an exchange whose listing standards require a compensation committee, it is conceivable that a company could move its listing to another exchange whose listing standards are more permissive.”
Considering that SOX was a reaction to the accounting frauds of the early 2000s – and the argument can be made that the number of restatements have curtailed since its enactment – the Dodd-Frank Act was obviously a reaction to the financial crisis of 2007-2009. But one has to wonder why the first substantial regulation related to executive compensation – something that many corporate governance experts agree was a symptom of what was wrong with the financial system – is not as strict as SOX.
Ted Allen, who blogs for RiskMetrics, raised the point in a recent post that the NYSE and Nasdaq could theoretically write different listing standards with different definitions of independent compensation committees and consultants.
Allen writes: “Unlike the Sarbanes-Oxley Act, which mandated stricter independence standards for audit committees, the Dodd-Frank Act and the SEC rules do not require the exchanges to adopt standards that would bar directors with such relationships from serving on pay panels.”
Here is a breakdown of the main requirements of the proposed rules [Here is a link to the PDF of the SEC proposed rules.]:
- The exchanges would be required to adopt listing standards that require each member of a compensation committee to be a member of the board of directors and be independent. (When determining independence, the rule considers the director’s source of compensation and whether or not a director is affiliated with the company or a subsidiary.)
- The exchanges’ listing standards would require a “covered” company to retain or obtain the advice of a compensation adviser and that the committee is appropriately funded by the company.
- The exchanges would have to write listing standards that would set five independence factors when a compensation committee is considering hiring a compensation consultant, legal counsel or another adviser. Those factors are:
- Whether the compensation consulting company employing the compensation adviser is providing other services to the company
- How much the compensation consulting company who employs the adviser has received in fees from the company.
- What policies and procedures have been adopted by the compensation consulting company employing the adviser to prevent conflicts of interest.
- Whether the compensation adviser has any business or personal relationship with a member of the compensation committee.
- Whether the compensation adviser owns stock in the company.
By the way, the public comment period for the proposed rule on compensation committees and consultants ends on April 29. You can make a comment by clicking here.