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Compensation Committees and the Stricter Standards of Independence Under SEC Rules and the Internal Revenue Code

01.24.05

There has been renewed focus on the independence of compensation committee members because of listing requirements adopted by the New York Stock Exchange and Nasdaq Stock Market. Companies should not, however, overlook other independence standards in Securities and Exchange Commission Rule 16b-3 and Internal Revenue Code Section 162(m). These provisions apply stricter standards on transactions with the company, with even small amounts preventing independence in some cases. Failure to comply with these standards could result in lost tax deductions and/or liability for "short-swing" profits. Once defective compensation is awarded, it may be too late to cure the defect, so companies should analyze compensation committee independence before awarding stock options or other compensation to executives.

NYSE and Nasdaq Independence Standards
The NYSE and Nasdaq use both a general standard and "bright line" test for determining independence. The board must make an affirmative determination that the director has, for the NYSE, no direct or indirect material relationship with the company, and, for Nasdaq, no relationship that would interfere with the exercise of independent judgment. In addition, a director cannot be considered independent if certain relationships exist between the company and the director or, in many cases, the director's family members. These relationships include serving as an employee or executive officer of the company. In addition, there are specific limits on the amount of payments that may be made to or received from the company. For NYSE listed companies, these limits are:

  • Receiving compensation from the listed company greater than $100,000 during any 12-month period, other than director fees or deferred compensation payments; or
  • Being an employee or executive officer of a company that makes payments to or receives payments from the listed company in an amount that exceeds the greater of $1.0 million or 2% of the other company's consolidated gross revenues.

For Nasdaq listed companies, these limits are:

  • Receipt of more than $60,000 during any 12-month period, other than director fees, retirement benefits and certain other payments; or
  • Being a partner, controlling shareholder or executive officer of a company that makes payments to or receives payments from the listed company in an amount that exceeds the greater of $200,000 or 5% of the recipient's consolidated gross revenues.

Internal Revenue Code Sec. 162(m) - "Outside Director"
Section 162(m) limits tax deductions by publicly held corporations for annual compensation in excess of $1.0 million paid to named executive officers (generally, the CEO and the four most highly paid executive officers other than the CEO). An exception to this limit is for "performance based compensation" that must, among other things, be awarded by a committee with at least two members, each of whom must be an "outside director." Awards of stock options and incentive pay that may otherwise be eligible for this exception will fail if even one committee member is not an "outside director." "Outside director" is defined as a director who:

  • Is not a current employee, is not a former employee who received compensation for prior services in the current year, and has not been an officer of the corporation;
  • Did not directly or indirectly receive any remuneration from the corporation during the current year, other than director fees; or
  • Did not receive more than de minimis remuneration from the corporation during the prior year, other than director fees.

Remuneration is broadly defined to include any payment for goods and services, including payments to entities owned by or employing the director. Payments of more than $60,000 for legal, accounting, consulting and other personal services, and payments representing more than 5% of the director entity's annual revenue, are not considered de minimis.

Rule 16b-3 - Non-Employee Directors
Section 16 of the Securities Exchange Act of 1934 generally requires the disgorgement of "short swing" profits realized by officers, directors and certain shareholders from a purchase and sale of the company's equity securities within a six-month period. SEC Rule 16b-3 provides a key exception for options and other awards approved by a board committee with at least two members, each of whom must be a "non-employee director." An option grant may be treated as a "purchase" for purposes of Section 16 and matched with a sale of shares within six months of the grant if even one compensation committee member approving the grant is not a "non-employee director." Unless another exemption applies, this can cause the insider to be liable for short-swing profits. "Non-employee director" is defined as a board member who:

  • Is not currently an employee or officer of the company or its parent or subsidiaries;
  • Does not directly or indirectly receive compensation greater than $60,000 from the company or its parent or subsidiaries, other than director fees; and
  • Does not have an interest in any transaction or have a business relationship with the company that would require proxy statement disclosure under SEC rules.

What You Should Do About Your Compensation Committee Now
We recommend that public companies consider the following:

  • Require that compensation committee members satisfy the standards for a "non-employee director" under SEC Rule 16b-3 and "outside director" under Section 162(m), in addition to "independent" director standards under NYSE/Nasdaq listing requirements.
  • Review the independence of each compensation committee member, at least annually.
  • Modify D&O questionnaires to address independence of compensation committee members under Rule 16b-3, Section 162(m) and NYSE/Nasdaq listing requirements.
  • If a committee member does not satisfy the Rule 16b-3 or Section 162(m) standards, create a subcommittee of at least two independent directors or find another exemption before making the award. If past awards are defective, there may be solutions to cure.

If you have any questions regarding compensation committee independence, please contact James Bristol at 615.850.8922, Don Moody at 615.850.8852, or any other member of Waller's Tax or Securities practices.

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.