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Compensation Committee Independence & Hiring

National securities exchanges and associations already have their own requirements to ensure that compensation committee members are independent.  Under NYSE and NASDAQ corporate governance standards, directors can still be considered if they receive up to $60,000 per NASDAQ or up to $100,000 per NYSE  in outside compensation from an issuer during a 12-month period within the last three fiscal years(other than board service compensation).  Another factor for determining independence, as required by both of the aforementioned exchanges, is the member has no material relationship with the company either 1) directly, or 2) as a partner, shareholder or officer of an organization that has any link/affiliation with the company/issuer.  Despite these existing provisions, the drafters of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 20101 apparently did not think these requirements went far enough to protect shareholder interests.  

The Dodd-Frank Act legislation stipulates the following with respect to section 952; which focuses on “Compensation Committee Independence”.  Section 952(a) of the Act adds section 10(c), “Independence of Compensation Committees” to the Securities Exchange Act of 1934 (“the ’34 Act, “the Act”).  This new section requires the Securities and Exchange Commission (“SEC”) to instruct the national securities exchanges and associations to prohibit the listing of any equity security of an issuer (subject to certain exemptions) that does not comply with the requirements that each member of the compensation committee must be independent, per section 10C(a)(2).  Section 10C(a)(3) states that in determining whether a member is independent, the national securities exchanges must consider the following factors: (a) the source of compensation of the member, including any consulting, advisory or other compensatory fee paid by the issuer and; (b) whether the member is affiliated with the issuer, a subsidiary of the issuer or an affiliate.  

We see that the U.S. Department of the Treasury advocated for these independence provisions (the same provisions that were applied to financial firms that received financial assistance under the TARP program) in the Dodd-Frank Act. Further, it is immediately apparent that these independence provisions are highly similar to those provisions created for audit committees under the United States’ previous major financial reform bill; the Sarbanes-Oxley Act (“SarBox”, or “Sox”).   Section 301 of the Sarbanes-Oxley Act prohibited consulting, advisory and other compensatory fees and/or affiliation with the issuer in defining the term “independence”.   Taking a feather from their own cap, the Dodd-Frank Act essentially does for independent compensation committees what the Sarbanes-Oxley Act previously did for independent audit committees.  

In order to find some negative consequences that may be brought on by the executive compensation independence rules, we need look no further than the negative consequences that resulted from Sarbox’s audit committee independence rules.  One of those potentially negative consequences is that a director who represents the largest shareholder will not longer be a member of the executive compensation committee.  There is no logical reason to think that a director who represents a large shareholder would pose any conflict of interest than any other independent compensation committee members.  If anything the large shareholder would face the most financial harm by any unscrupulous decision in respect to compensation.  Representing a large shareholder should be an obvious factor in achieving fairness or a sound decision since a poor performance harms those shareholders who have the greatest vested interest in the firm.  

It will be interesting to see if these new independence provisions will accomplish their intended purpose.  We must remember that the directors of a corporation are charged to act in the best interest of the corporation, not the shareholders.  Accordingly, determining fair and reasonable executive compensation amounts by the executive compensation committee may not reflect or be aligned with the views of the shareholders.  If an independent executive compensation committee follows proper procedure in determining an executive’s individual compensation, then there should be no reason for why the interests of the committee and shareholders would be divergent.