This article is reprinted with permission from the
August 30, 2004
edition of
New York Law Journal.
2003 NLP IP Company.


Compensation Committee Developments

By Joseph E. Bachelder


Current developments of concern to Compensation Committees of public companies include: [i] new requirements of self-regulatory organizations [the New York Stock Exchange [the NYSE], the Nasdaq Stock Market, Inc. [Nasdaq] and the American Stock Exchange [Amex] [SROs]] regarding processes to be followed by Compensation Committees; [ii] new SRO requirements regarding director independence; and [iii] judicial developments regarding independence of directors and the good faith of directors in reaching a decision.


The NYSE has adopted detailed rules on how a compensation committee should function and its specific responsibilities.1 [The Nasdaq and Amex rules are discussed below.] The NYSE rules are effective as of the earlier of [i] the Company's first annual meeting after Jan. 15, 2004 and [ii] Oct. 31, 2004.2 In a filing with the SEC on Aug. 3, 2004, the NYSE has proposed a number of changes to its corporate governance rules, which may affect the current compensation committee rules, discussed below.

The NYSE requires listed companies to have a compensation committee composed entirely of independent directors or, alternatively, the duties and responsibilities of the committee can be allocated by the listed company's board of directors to another board committee as long as that committee satisfies the requirements of the rules.3

The committee must have a written charter addressing, among other things, the committee's purpose and responsibilities, member qualifications, appointment and removal of members, committee structure and operations, reporting to the board and the requirement for an annual performance evaluation of the committee. The charter must be published on the company's website and the company's annual report that is filed with the SEC must state that the charter is available. The committee is also charged with producing the report on executive compensation for the company's annual proxy statement or annual report.

The NYSE rules also list the duties of the compensation committee in connection to CEO and "non-CEO" pay.

For an NYSE listed company, the compensation committee is charged with evaluating and setting CEO pay as follows:

[a] The compensation committee has direct responsibility to review and approve corporate goals and objectives relevant to CEO compensation and to evaluate the CEO's performance in light of these goals and objectives.

[b] The compensation committee [either alone or together with the other independent directors [as directed by the Board]] must also determine and approve the CEO's compensation level based on this evaluation.

In contrast to the Nasdaq and Amex rules, as noted below, the NYSE rules do not prohibit CEO presence during voting or consideration of his or her compensation.

With non-CEO pay, however, the compensation committee is charged only with the responsibility to make recommendations to the board. Non-CEO pay is defined as the pay of those individuals [other than the CEO] who are officers within the meaning of Section 16 of the Securities Exchange Act of 1934.4

The Nasdaq and Amex Rules focus primarily on the procedures for approving the compensation of the CEO and other Section 16 officers.5 There is no explicit requirement to have a compensation committee or, if a company has such a committee, to require it to have a written charter or operate in a certain way [such as requiring it to evaluate the CEO's performance]. These rules are effective as of the earlier of [i] the company's first annual meeting after March 15, 2004 and [ii] Oct. 31, 2004.

Under the respective rules of Nasdaq and Amex, the compensation for both the CEO and other Section16 officers must be determined by [1] the majority of independent directors, [2] a compensation committee comprised solely of independent directors [with one limited exception where the rules permit one non-independent director] or [3] the board upon recommendations provided to it by either [1] or [2]. CEO presence during voting or consideration of his or her compensation is explicitly banned.

Sarbanes-Oxley Act of 2002 does not address the makeup, roles or processes of the compensation committee [in contrast to the audit committee].

Independent Directors

Under the NYSE rules, the compensation committee [or, as noted above, a similarly constituted committee] must be comprised entirely of independent directors. For a director to be deemed independent, the board must make an affirmative determination that such director has "no material relationship with the listed company." The NYSE rules specify that a material relationship includes being a partner, shareholder or officer of an organization that has a relationship with the company.6 In addition to the requirement of the board's affirmative determination, there are specific bars in the NYSE rules to a finding of independence. These include, among others:

[i] Employment of a director or family member. Employment of the director as an employee, or of an immediate family member of a director as an executive officer, by the listed company within the last three years [although the NYSE exempts former service as an interim Chairman or CEO and, if the Proposed Amendments are approved by the SEC, former service as an interim executive officer].7

[ii] Receipt of compensation from a listed company. Receipt by the director or his or her immediate family member of more than $100,000 per year in direct compensation from the listed company during any of the last three years [although certain compensation, such as director and committee fees, a pension and other deferred compensation for prior service, and compensation paid an immediate family member who is a non-executive officer, are exempt]. The Proposed Amendments, if approved by the SEC, would clarify that the test is receipt of more than $100,000 during any 12-month period within the last three years.

[iii] Compensation Committee Interlocks. Employment within the last three years of a director, or his or her immediate family member, as an executive officer of a company on whose compensation committee any of the listed company's present executive officers serve. The Proposed Amendments would clarify this look-back provision.8

The foregoing list does not include two additional bars involving auditor relationships and inter-company payments.9

Nasdaq and Amex Rules

Like the NYSE rules,10 the Nasdaq and Amex rules require an affirmative determination by the board of each director's independence. Nasdaq's test for independence is the absence of a relationship which, in the board's opinion, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. Amex's test is that a director does not have a material relationship with the listed company that would interfere with the exercise of independent judgment.

Nasdaq and Amex provide similar, but not exactly identical, specific bars to a finding of independence, including:

[i] Employment of a director or family member. The rules are the same as the NYSE's current rule, except Nasdaq does not exempt former service as an interim Chairman or CEO.

[ii] Acceptance of payment from a listed company. Acceptance by the director or his or her family member of any payments [not just direct compensation as in the case of NYSE] from the company in excess of $60,000 during any 12-month period within the last three years [for Nasdaq] or during the current or last three fiscal years [for Amex] [with certain exceptions, including fees paid for being a director or committee member and compensation paid a family member who is a non-executive officer].

[iii] Compensation Committee Interlocks. Employment of a director, or his or her family member, as an executive officer of another entity if at any time during the past three years any of the listed company's executive officers served on the compensation committee of such other entity.

As in the discussion of the NYSE rules, the column does not cover all of the specific bars under the Nasdaq and Amex rules.11

Established Rules

Regulations under two Federal statutes require, in certain circumstances, director independence. The degree of independence required differs under the regulations pursuant to these two laws.

Under the 1934 Act, the SEC, in Rule 16b-3[d], states that a "grant, award or other acquisition" of a security approved by a committee of two or more "non-employee directors" is exempt from the short-swing profit rules of Section 16[b] of the 1934 Act.12

Under Section 162[m] of the Internal Revenue Code, in order for compensation awards to be exempted as performance-based awards from the $1 million cap on certain compensation to a "covered employee" [generally, the CEO and the other four most highly compensated officers], the performance goals on which the pay-outs are based must be established by a compensation committee comprised solely of two or more "outside directors." Treas. Reg. [1.162-27[e][3][i].13

Judicial Developments

Director independence was the subject of a 2003 decision by the Delaware Court of Chancery in In re Oracle Corp. Derivative Litigation, 824 A2d 917 [Del. Ch. 2003]. This case requires a standard of independence that is broader than the specific independence tests established by the self-regulatory organizations as noted above. In the Oracle case, in weighing the independence of a special litigation committee appointed in connection with a shareholder's derivative action, the Delaware Court of Chancery found independence lacking, citing, among other things, social and academic ties between the directors making up the special litigation committee and the defendants in the shareholders' derivative action.

Judicial interpretations of director "independence" may be of significance for purposes of self-regulatory organization rules. As discussed above, the board must make an affirmative determination as to the independence of each director. [In addition to this board determination, the CEO must certify the company is in compliance with the NYSE rules.] As part of its general determination of directors' independence, the board should take into account applicable judicial determinations, such as in the Oracle case, regarding requirements for a finding of director independence.

Good Faith

Director "good faith" has been the subject of decisions by the Delaware Supreme Court and the Delaware Court of Chancery in the Disney litigation.14 For example, in the latest opinion, the Court of Chancery made the following statement,

[A]ll of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss. Viewed in this light, plaintiffs' new complaint sufficiently alleges a breach of the directors' obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant directors' conduct fell outside the protection of the business judgment rule.15

As noted above, a context in which director independence is lacking may "set the stage" for a court's examining whether a CEO pay decision was in good faith. For example, in a case in which one or more members of a compensation committee are not independent, in the sense suggested by the Oracle case, it is likely that a court will take a careful look at whether lack of independence led to a decision not being made in good faith.

Independent Consultants

The self-regulatory organizations rules do not prevent the compensation committee from selecting as its own consultant the compensation consultant to company management. This decision should, however, be made only after very careful consideration by the compensation committee. If, for example, a compensation consultant is receiving hundreds of thousands of dollars [in some cases even more] to advise management [including the CEO], can the consultant maintain objectivity in serving as consultant to the compensation committee if conflicts of view exist between management's wants and what an independent third party would consider to be in the best interests of the shareholders?


What is an adequate budget for the expenses of a compensation committee in seeking information, consulting advice and its own counsel on its decisions? Should the compensation committee have its own staff? To what extent should the Committee draw upon the staff of the employer? What if it needs to have confidential communications among its members? In some cases, if a consultant independent of management is retained, that consultant can provide independent, confidential staff assistance. In all events, the compensation committee should estimate annually in advance the amount of time and the budget needed for carrying out its duties, including outside advisors.


[1] NYSE Listed Company Manual, Section 303A.05.

[2] If a listed company with a staggered board needs to replace a non-independent director in order to fully comply with these rules and the director is not up for re-election in 2004, the Company will have until the earlier of [i] the second annual meeting after Jan. 15, 2004 and [ii] Dec. 31, 2005 to comply.

[3] The compensation committee is not required to have a minimum number of members. This contrasts to the audit committee which is required to have at least three members under the NYSE rules. See NYSE Listed Company Manual, Section 303A.07[a].

[4] In the proposed amendments, the NYSE changes the reference from "non-CEO compensation" to "non-CEO executive officer compensation." This codifies the NYSE's prior public announcements [see "Frequently Asked Questions," updated Feb. 13, 2004] that "non-CEO compensation" refers to the compensation of Section 16 officers other than the CEO. In the proposed amendments, the NYSE also clarifies that the board can delegate approval of non-CEO executive officer pay to the Compensation Committee. See SR-NYSE-2004-41. See also Rule 16a-1[f] under the 1934 Act for a definition of "officer" under Section 16 of that Act.

[5] Nasdaq Rule 4350[c]; Amex Company Guide, Section 805.

[6] See NYSE Listed Company Manual, Section 303A.02.

[7] Until Nov. 3, 2004, the look-back period to determine whether there is an automatic bar to a finding of independence is only one year. As of Nov. 4, 2004 and thereafter, the look-back period will be for the full three years. In addition, in the proposed amendments, the NYSE clarifies that an "executive officer" as used in Section 303A refers to Section 16 officers. See also note 4 above.

[8] The proposed amendments would clarify that in applying the look-back period, the board should determine whether there was an overlap between the director's employment [or that of his or her immediate family member] and the executive officer's service on the compensation committee during the last 3 years. See SR-NYSE-2004-41 amending Section 303A.02[b][iv].

[9] These additional bars include [i] ties with the listed company's internal or external auditors and [ii] payments between the listed company and a company which employs the director as an employee, or a member of the director's immediate family as an executive officer, which exceed the greater of $1 million or 2 percent of such company's consolidated gross revenues. See NYSE Listed Company Manual, Section 303A.02[b][iii] and [v]. The proposed amendments would significantly change the test for director independence based on ties with the Company's auditors. See SR-NYSE-2004-41 amending Section 303A.02[b][iii].

[10] For Nasdaq's definition of "independent director," see Rule 4200[a][15]; for Amex's definition of "independent director", see Amex Company Guide, Section 121A.

[11] These additional bars include ties with the company's outside auditors within the last three years and payments between an organization of which a director or the director's family member is a partner, controlling shareholder or executive officer and the listed company if such payments exceed the greater of 5 percent of such organization's consolidated gross revenues for that year or $200,000 in any of the most recent three fiscal years. For more information see Nasdaq Rule 4200[a][15][D] and [F] and Amex Company Guide, Section 121A[d] and [f].

[12] The definition of "non-employee director" under SEC Rule 16b-3[b], in some respects, differs significantly from the self-regulatory organizations rules. For example, a director does not qualify as a "non-employee director" under Section 16[b] if he or she is engaged in a business relationship requiring disclosure under Item 404[b] of Regulation S-K. Thus, a director who is a member of, or of counsel to, a law firm that the issuer has retained during the last fiscal year or is a partner or executive officer of an investment banking firm that has performed certain services during the last fiscal year could be deemed to be "independent" under the self-regulatory organizations rules [if the fees paid by the issuer were below a certain threshold amount] but not a "non-employee director."

[13] Under Treasury Regulation [1.162-27[e][3][i], certain of the requirements to qualify as an "outside director" are more stringent than the SRO rules for determining "independence." For example, the Treasury Regulation would deem a director as not being an "outside director" [i.e., not being independent] if the director is a former officer of the employer at any point in time [not just within the last 3 years] or is a former employee of the employer who receives any compensation for prior services [other than benefits under a tax-qualified retirement plan] during the taxable year [thus, not exempting compensation of $100,000 or less in the case of the NYSE and $60,000 or less in the case of Nasdaq and Amex].

[14] In re The Walt Disney Co. Derivative Litig., 731 A2d 342 [Del. Ch. 1998] [dismissing shareholder derivative action], rev'd in part, Brehm v. Eisner, 746 A2d 244 [Del. 2000]. As a result of Brehm v. Eisner, the plaintiffs filed a new complaint and the defendants' motion to dismiss was denied. See In re The Walt Disney Co. Derivative Litig., 825 A2d 275 [Del. Ch. 2003].

[15] 825 A2d at 289.