Tag: securities exchange act

SEC Revises Tick Size, Access Fees and Round-Lot Definition and Takes Steps to Disseminate Odd-Lot and Other Better Priced Orders

On September 18, the Securities and Exchange Commission (SEC or the Commission) adopted amendments to Rule 612 (Tick Sizes) and Rule 610 (Access Fees) under Regulation NMS under the Securities Exchange Act of 1934, as amended (Regulation NMS).1 The SEC also added and amended definitions and other rules under Regulation NMS to address round-lot and odd-lot sizing and dissemination. We address each category of revisions below and highlight at the outset that the SEC did not adopt the controversial provision that would have prevented market centers from executing orders at prices less than the current or revised tick sizes. That is, the minimum tick size continues to address only the minimum price increment at which a market center can publish a quotation for a security. This is significant, as adopting such a prohibition would have prevented broker-dealers and other market centers from providing price improvement at prices finer than the quotation tick sizes.

The SEC also took a measured approach to other aspects of the rule. As explained more fully below, the Commission adopted only one additional minimum quotation size (rather than the three proposed), narrowed the scope of securities that might be subject to the smaller minimum quotation size, reduced the frequency with which primary listing exchanges must calculate tick sizes and round-lot sizes, and expanded the amount of data to be evaluated for these calculations from one month’s worth to three months’ worth.

Tick Sizes/Minimum Pricing Increments

Rule 612 of Regulation NMS regulates the price increments (that is, the “tick size”) at which a market center can display a quotation and at which a broker-dealer can accept, rank, or display orders or indications of interest in NMS stocks. Currently, for NMS stocks priced at or above $1.00 per share, broker-dealers and market centers can accept orders or quote in one-penny ($0.01) price increments and at a much smaller increment ($0.0001) for NMS stocks priced less than $1.00 per share.

The SEC and other market participants had observed that many stocks were “tick constrained” — that is, bids, offers, and other orders in those stocks might regularly allow for quotation spreads narrower than $0.01, but the penny spread requirement of Rule 612 constrained such narrower quoting. Determining the “right” quote size for a security can be complicated: on the one hand, a narrower spread reduces transaction costs for investors. On the other hand, too narrow a quotation spread allows other market participants to “step ahead” of a quotation — that is, obtain better priority — by entering an order that is priced only slightly better. Obtaining priority by quoting for an economically insignificantly better price disincentivizes those offering liquidity or price improvement to the market. Stated simply, a market participant has little incentive to expose its order to the market if another participant can easily get better priority over that order at an insignificant cost. Accordingly, the Commission sought to balance the two competing concerns of spread size and fear of stepping ahead.

Tick sizes are also relevant in the competition between exchange and non-exchange trading venues. Due to their market structure, exchanges generally execute orders at the prices they quote, but cannot execute at prices within the quoted spread. Narrower spreads provide better opportunities for exchanges to execute at the higher bids or lower offers represented by those narrower spreads. In short, narrower spreads allow exchange venues to be more competitive with off-exchange venues.

In December 2022, the SEC proposed to add three minimum tick sizes for NMS stocks priced $1.00 or more: one-tenth of a cent ($0.001), two-tenths of a cent ($0.002), and five-tenths (or one-half) of a cent ($0.005). Public comment suggested that this proposal was too complicated and the smaller price increment of $0.001 might also have been too small, thereby facilitating stepping ahead.

The adopted rule provides for only one new tick size for certain NMS stocks priced at or above $1.00 per share: $0.005. This half-penny minimum quotation size will apply for those NMS stocks priced at or above $1 that have a “time-weighted average quoted spread” (a metric defined in the rule) of $0.015 during a three-month Evaluation Period (as described in the table below) occurring twice a year.[1] “Time-weighted average quoted spread” seeks to estimate tick constraint and identify those securities that are quoted on average at close to a one-cent spread. Specifically, under the revised rule, primary listing exchanges must calculate the time-weighted average spread over the months of January, February, and March and July, August, and September. The results of the first (Q1) calculation determines which securities are subject to the half-penny tick size for the business days between May 1 and October 31 of that year. The results of the second (Q3) calculation determines which securities are subject to the half-penny tick size for the business days between November 1 of that year and April 30 of the following year.

The following chart shows the applicable tick sizes and calculations:

The SEC’s policy rationale for adopting these amendments is that they relax existing restrictions on tick sizes, which should reduce transaction costs and provide for better price discovery for certain NMS stocks. Additionally, smaller tick sizes for NMS stocks that merit them should improve liquidity, competition, and price efficiency.

Access Fees

Securities exchanges generally charge access fees to those who take liquidity and rebate a portion of that access fee to those who provide liquidity. As the SEC explains, “the predominant exchange fee structure is maker-taker, in which an exchange charges a fee to liquidity takers and pays a rebate to liquidity providers, and the rebate is typically funded through the access fee.”3 Rule 610(c) of Regulation NMS limits the fee that an exchange can charge for accessing protected quotations4 pursuant to Rule 611 of Regulation NMS. Currently, the access fee is capped at 30 cents per 100 shares (or “30 mils” per share) for NMS securities priced at or above $1. The access fee is capped at 0.3% of the quotation price for NMS stocks priced below $1.

With a smaller minimum quotation size, the SEC took the opportunity to revise the access fee cap, which some market participants believed had been set too high. Like the tick size changes, the access fee amendment ultimately adopted was modified from what was originally proposed. Originally, the SEC proposed to reduce access fee caps (a) from 30 mils to 10 mils per share for NMS stocks priced at or over $1 that would have been assigned a tick size larger than $0.001 and (b) to 5 mils per share for NMS stocks priced at or over $1 that would have been assigned a $0.001 tick size. For protected quotations in NMS stocks priced under $1.00 per share, the Commission originally proposed to reduce the 0.3% fee cap to 0.05% of the quotation price.

Ultimately, the Commission adopted a more simplified reduction in access fee caps. Because it added only one tick size to Rule 612, the SEC adopted only one reduction in access fee caps, from 30 mils to 10 mils per share for protected quotations in NMS stocks priced $1.00 or more. For such quotations priced less than $1.00, the Commission reduced the access fee cap from 0.3% to 0.1% of the quotation price per share. In addition, the SEC adopted (as proposed) new Rule 612(d), requiring all exchange fees charged and all rebates paid for order execution to be determinable at the time of execution. Currently, such exchange fees are subject to complex fee schedules that apply tiered and other discounts at month-end. As a result, market participants would not necessarily know intra-month whether their broker might access a higher tier later in the month, which would adjust the fee charged for the subject order. The new rule ends this uncertainty.

Setting the revised access fee cap at 10 mils per share was somewhat controversial, with Commissioners Peirce and Uyeda questioning the manner in which 10 mils was determined, whether another rate should have been used (15 mils? 5 mils? 12 mils?) and whether the Commission should be in the rate-setting business at all. The Commissioners ultimately voted in favor of the proposal based upon a pledge (discussed below) that the SEC staff will, by May 2029, “conduct a review and study the effects of the amendments in the national market system.”5

Required Staff Review and Study

The Adopting Release requires that the Commission staff conduct a “review and study” by May 2029 of the effects of the amendments on the national market system. The details of such study are not clearly defined, but the Adopting Release provides that:

[s]uch a review and study might include, but would not be limited to, an investigation of: (i) general market quality and trading activity in reaction to the implementation of the variable tick size, (ii) the reaction of quoted spreads to the implementation of the amended access fee cap, and (iii) changes to where market participants direct order flow, e.g., to exchange versus off-exchange venues, following the implementation of the amendments.6

Compliance Dates and Timelines

The amendments described above become effective 60 days after the publication of the SEC’s Adopting Release in the Federal Register. The date by which exchanges, broker-dealers, and other market participants must comply with the rule amendments is generally in November 2025 but, in some instances, in May 2026, as described more fully below. Specifically, the Compliance Date:

  • for the tick size amendments (half-penny quoting for “tick-constrained” stocks) of Rule 612 is “the first business day of November 2025,” or November 3, 2025.
  • for the 10 mils per share access fee cap amendment of Rule 610 and the new requirement under Rule 612(d) that exchange fees be known at time of execution in each case, is also November 3, 2025.
  • for the new round-lot definition (100 shares, 40 shares, 10 shares, or 1 share) is November 3, 2025.
  • for the dissemination of “odd-lot information,” including the new BOLO data element, is six months later, to allow broker-dealers and others to program systems accordingly. These changes will take effect on “the first business day of May 2026,” or May 1, 2026.

Closing Thoughts

The tick size and access fee amendments, and the other provisions adopted, appear to reflect negotiated concessions and a reasonable approach to addressing tick-constrained securities while avoiding the complex framework originally proposed. The decision not to prevent executions at prices within the minimum quotation size is appropriate and preserves the ability of market participants to provide price improvement to investors. While there can be some lingering debate about the appropriate level to which to reduce the access fee cap and whether 10 mils is an appropriate level, the net cumulative effect of these amendments appears reasonable. The planned “review and study” of the effect of the amendments may come too late if conducted towards the outer limit of “by May 2029,” but the overall effect of the amendments should serve to narrow spreads and increase quotation transparency through sub-penny quoting, reduced round-lot sizes, and the inclusion of odd-lot information.

1 Release No. 34-101070, Regulation NMS: Minimum Pricing Increments, Access Fees, and Transparency of Better Priced Orders, U.S. Sec. Exch. Comm’n (Sept. 18, 2024), https://www.sec.gov/files/rules/final/2024/34-101070.pdf (the “Adopting Release”).
2 The SEC modified of these requirements in the final rule. For example, the SEC had originally proposed smaller tick sizes for stocks with a time-weighted average quoted spread of $0.04 (rather than $0.015). The proposal also sought to evaluate tick-sizes 4 times per year rather than twice a year and based on monthly data rather than quarterly data.
3 Adopting Release at 15.
4 A protected quotation is defined in Rule 600(b)(82) of Regulation NMS as “a protected bid or protected offer.” 17 C.F.R. § 242.600(b)(82). A protected bid or protected offer is defined as “a quotation in an NMS stock that: (i) is displayed by an automated trading center; (ii) is disseminated pursuant to an effective national market system plan; and (iii) is an automated quotation that is the best bid or best offer of a national securities exchange, or the best bid or best offer of a national securities association.” 17 C.F.R. § 242.600(b)(81)
5 Adopting Release at 288.
6 Id. (emphasis added).
©2024 Katten Muchin Rosenman LLP
For more news on Rule 612 and Rule 610 of Securities Exchange Act of 1934, visit the NLR Securities SEC section.

SEC Enforcement Takes Broad View of Anti-Whistleblower Rule in Latest Action Targeting Investment Advisers and Broker-Dealer

On 4 September 2024, the US Securities and Exchange Commission (SEC) announced that it settled charges against affiliated investment-advisers and a broker-dealer over the use of restrictive language in confidentiality agreements, in violation of Rule 21F-17(a) of the Securities Exchange Act of 1934. The firms agreed to pay a combined $240,000 in civil penalties to settle the charges. The enforcement action is the latest in the SEC’s ongoing focus on confidentiality provisions in release agreements; an emphasis that has increasingly focused on investment advisers and broker-dealers.

Rule 21F-17(a) prohibits companies from impeding an individual’s ability to communicate with the SEC regarding possible violations of the US securities laws. The SEC has read the Rule broadly and objected to what it views as restrictive language in the confidentiality provisions of a variety of agreements. In January 2024, for example, the SEC announced a $18 million civil penalty against a dual registered investment adviser and broker-dealer based on a confidentiality provision in release agreements with retail clients that the SEC interpreted as not permitting affirmative reporting.

The agreements at issue in today’s settlement similarly included language the SEC viewed as limiting an individuals’ ability to report. The SEC viewed these agreements as permitting a response to a Commission inquiry only if the “inquiry [was] not resulting from or attributable to any actions taken by [client].” The SEC also took issue with language that it viewed as requiring clients to certify both they had not made previous reports and that they would refrain from future reporting.

The Order makes clear that the SEC is aggressively enforcing Rule 21F-17(a), interpreting carveouts in confidentiality provisions narrowly and focusing instead on a client’s “reasonable impression” after reviewing the agreement. Firms should take a second look at the confidentiality provisions in their agreements, using the SEC’s strict standard, to ensure that they measure up.

Copyright 2024 K & L Gates
For more news on SEC Enforcement, visit the NLR Securities SEC section.

Federal Agencies Have Placed a Heightened Priority on Whistleblowers and Speedy Cooperation

As new areas of the law emerge, driven in part by technology and the free flow of information, federal agencies are becoming more aggressive with a tried and true carrot-and-stick approach to law and regulatory enforcement.

In a recent PLI panel on government enforcement priorities in May 2024, Brent Wible, Chief Counselor, Office of the Assistant Attorney General, Department of Justice (DOJ or Department); Daniel Gitner, Chief of the Criminal Division, US Attorney’s Office for the Southern District of New York (SDNY or the Office); and Antonia Apps, Director of the New York Regional Office of the Securities and Exchange Commission (SEC or Commission) shared their thoughts, priorities and practices in 2024 enforcement and beyond.

All of the government lawyers stressed that the DOJ and enforcement agencies are open and are actively encouraging whistleblowers with new incentives and programs. To that end, Mr. Gitner from the SDNY stated very directly that corporations need to understand that there is a “need for speed” in corporate self-disclosures. Otherwise, whistleblowers will be closing the door to the benefits of corporate self-disclosures. Put differently, enforcement agencies do not want a corporation to complete lengthy internal investigations before reporting.

A uniform theme and stance taken by all is that whistleblowers are valuable, and bounties will be paid in cash or in deferred prosecution agreements or possibly both. Whistleblowers must be protected. Internal and external whistleblowers should be encouraged.
This article focuses on three whistleblower initiatives—(i) the SEC’s Whistleblower Program, (ii) the SDNY Whistleblower Pilot Program and (iii) DOJ’s Pilot Whistleblower Program for voluntary self-disclosure—and how those programs may impact a corporation’s response to whistleblowers, internal investigations, and disclosures.

SEC 21F WHISTLEBLOWER PROGRAM

Since its inception more than a decade ago, the SEC’s Whistleblower Program is widely viewed as successfully incentivizing whistleblower reports of violations of the securities laws. In its 2023 fiscal year, the SEC received more than 18,000 tips from whistleblowers and issued the most awards to whistleblowers ever in one year, totaling nearly US$600 million. That year, the Commission also issued its largest ever award of US$279 million to a single whistleblower.1

What is the SEC’s Whistleblower Program?

Section 21F of the Securities Exchange Act of 1934, codified as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, requires the SEC to pay awards to whistleblowers who provide information to the SEC about violations of federal securities laws.2 Accordingly, the SEC has issued a series of rulemakings implementing Section 21F to create its whistleblower program. To qualify as a whistleblower, an individual must voluntarily provide the SEC with original information in writing about a possible violation of federal securities law that has occurred, is ongoing, or is about to occur.3 To qualify for an award, this information must lead to a successful enforcement action with monetary sanctions totaling more than US$1 million.4

“Original” information means that it cannot be found in publicly available sources and is not already known by the Commission, but is instead the product of the whistleblower’s independent knowledge or analysis.5 A submission is “voluntary” if the whistleblower provides it to the SEC before receiving a regulatory request or demand for information relating to the same subject matter. Therefore, a submission of information that is made in response to a request, inquiry, or demand by the SEC, the Public Company Accounting Oversight Board, a self-regulatory organization (such as the Financial Industry Regulatory Authority), or a separate federal or state governmental body does not qualify as a voluntary submission.6 Additionally, a submission that is required under a legal or contractual duty to the Commission is not considered voluntary and is thus ineligible for an award.7

The SEC’s whistleblower rules also include anti-retaliation protections intended to ensure that the incentives provided to whistleblowers for reporting are not outweighed by a fear of reprisal from their employer. Under Rule 21F-17, companies are prohibited from interfering with or impeding a whistleblower’s communications to the SEC about a possible violation of the securities laws, including through enforcement or threatened enforcement of a confidentiality agreement that may be read to prevent whistleblower communications with the SEC.8

The SEC is taking violations of Rule 21F-17 seriously and has increased enforcement activity in this area over the last two years. The Commission brought a number of actions, with significant civil penalties, focused on corporate agreements containing confidentiality language that, according to the SEC, does not provide an express exception for whistleblower communications. The enforcement actions extend to different types of companies, including publicly traded companies, privately held companies, broker-dealers and investment advisers, and to a variety of forms of agreements with employees and customers alike.9

For example, a gaming company paid US$35 million to settle claims that it had violated the whistleblower protection rule by requiring former employees to execute separation agreements that obligated them to notify the company of any request for information received from the Commission, in addition to compliance failures regarding workplace complaints.10 In January 2024, the SEC settled the largest ever standalone Rule 21F-17 case, imposing US$18 million in civil penalties against a dually registered investment adviser and broker dealer for allegedly requiring clients to sign a confidential release agreement—without expressly allowing for direct communications to regulators regarding potential securities law violations—in order to receive certain credit or settlement payments.11 In another case involving US$10 million in civil penalties, the Commission charged a registered investment adviser with a standalone violation of Rule 21F-17 based on employment agreements that contained a confidentiality clause prohibiting external disclosure of confidential company information, without a carve-out for voluntary communications with the SEC concerning possible violations of the securities laws.12 As recently stated by the co-chief of the SEC Enforcement Division’s Asset Management Unit, “Investors, whether retail or otherwise, must be free to report complaints to the SEC without any interference. Those drafting or using confidentiality agreements need to ensure that they do not include provisions that impede potential whistleblowers.”13

SDNY WHISTLEBLOWER PILOT PROGRAM

In February 2024, the SDNY launched a whistleblower pilot program. The purpose of the program is to encourage early and voluntary self-disclosure of criminal conduct by individual participants.14 The program is applicable to disclosures of conduct committed by public or private companies, exchanges, financial institutions, investment advisers, or investment funds involving fraud or corporate control failure or affecting market integrity, or criminal conduct involving state or local bribery or fraud relating to federal, state, or local funds.15 In exchange for a qualifying self-disclosure, the Office will enter into a non-prosecution agreement with the whistleblower.16

Given that a non-prosecution agreement is promised, the SDNY has identified factors to determine whether a whistleblower qualifies for a discretionary non prosecution agreement. The most salient include: whether and to what extent the misconduct is unknown to either SDNY or the DOJ; whether the information is disclosed voluntarily to SDNY and not in response to an inquiry or obligation to report misconduct; whether the whistleblower provides substantial assistance in the investigation and prosecution of culpable individuals, and in the investigation and prosecution of the disclosed conduct; whether the whistleblower truthfully and completely discloses all criminal conduct they participated in and are aware of; whether the whistleblower is a chief executive officer or chief financial officer of a public or private company, who is not eligible for the pilot program; and the adequacy of noncriminal sanctions, such as remedies imposed by civil regulators.

Mr. Gitner said the defense bar is coming around to a non-prosecution carrot for individuals involved in wrongdoing within the corporation. Mr. Gitner said that SDNY seeks early discussions, and the pilot program seems to be driving toward that goal.

DOJ PILOT PROGRAM ON VOLUNTARY SELF-DISCLOSURES FOR INDIVIDUALS

In March 2024, the DOJ announced an upcoming program to reward whistleblowers who report corporate crimes. The new program seeks to bolster existing whistleblower programs established by the SEC (discussed above), the Commodities Future Trading Commission (CFTC), the Internal Revenue Service, and the Financial Crimes Enforcement Network.17 Accordingly, the program will offer rewards to whistleblowers who provide information on misconduct that is not under the jurisdiction of those agencies. In particular, the Department is interested in criminal abuses of the US financial system, foreign corruption cases outside of the SEC’s jurisdiction, and domestic corruption cases. In order to qualify, an individual must provide original, nonpublic, and truthful information that assists the Department in uncovering “significant corporate or financial misconduct” and is previously unknown to the agency.18 Like the SEC and CFTC, the Department does not plan to provide awards for information that is submitted under a preexisting duty or in response to an inquiry.19 Access to the program is only available where existing programs or qui tam actions do not exist. Additionally, the whistleblower in this program cannot be involved in the criminal activity itself. After compensation to victims, the whistleblower will receive a portion of the resulting forfeiture as a reward.20

Interestingly, however, it appears the Department may be moving away from offering monetary awards to whistleblowers. In April 2024, the Department introduced a pilot program that tracks with the SDNY and offers mandatory non prosecution agreements to individuals who provide information on corporate misconduct.21 Under the program, an individual must voluntarily self-disclose original information to the Criminal Division about criminal misconduct that is not previously known to the Department. The information must be “truthful and complete,” meaning it must include all known information relating to the misconduct, including the individual’s own culpability. In particular, the Department seeks information on violations by financial institutions; violations related to market integrity committed by financial institutions, investment advisers, investment funds, or public or private companies; foreign corruption and bribery violations by public or private companies; violations relating to health care fraud or illegal health care kickbacks; fraud or deception against the United States in connection with federally funded contracting; and bribery or kickbacks to domestic public officials by public or private companies. The whistleblower also cannot be a chief executive officer, chief financial officer, or those equivalents of a public or private company; or an elected or appointed foreign government or domestic government official; nor can the whistleblower have a previous felony conviction or a conviction of any kind involving fraud or dishonesty. Irrespective of this program, the Department still has the discretion of offering a non-prosecutorial agreement to individuals who may not meet the above criteria in full, subject to Justice Manual and Criminal Division procedures.22

TAKEAWAYS

The takeaways here for corporate in-house legal departments are:

  • Federal agencies are incentivizing whistleblowers with cash and non-prosecution agreements. It is clear that wrongdoers and witnesses now more than ever have several whistleblower programs from which to choose. As a result, corporations must become more vigilant at detecting wrongdoing and effectively utilizing internal reporting systems. Careful consideration of an early self-disclosure to the appropriate agency may also be warranted. Internal investigations will take a heightened priority to aid the c-suite and board on disclosure decisions.
  • Not only is protecting whistleblowers a priority but encouraging whistleblowers through heightened compliance programs, updated hotlines or other internal reporting programs should be considered. You may also wish to consider offering financial incentives for timely reporting to the corporation’s internal reporting program. All of which will benefit the company in any government disclosure.
  • The enforcement risk for companies under the SEC’s whistleblower rules is real and potentially significant, including with respect to day-to-day business activities (such as entering into client or employee confidentiality agreements) that may not otherwise be recognized as creating regulatory exposure. Companies may wish to revisit their standard contracts and compliance materials to ensure that any confidentiality provisions align with Rule 21F-17.

We acknowledge the contributions to this publication from our summer associate Minu Nagashunmugam.

1 https://www.sec.gov/newsroom/enforcement-results-fy23.

2 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 2.

3 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 2.

4 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 3.

5https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 5.

6 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 5.

7 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 5.

8 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 28.

9 The SEC’s Office of the Whistleblower has stated that violations of Rule 21F-17 may be triggered by “internal policies, procedures, and guidance, such as codes of conduct, compliance manuals, training materials, and other such documents.” SEC, Whistleblower Protections (last updated July 1, 2024) https://www.sec.gov/enforcement-litigation/whistleblower-program/whistleblower-protections#anti-retaliation.

10 https://news.bloomberglaw.com/securities-law/sec-biggest-whistleblower-penalty-signals-broad-protection-focus?context=search&index=11

11 In re JP Morgan Sec. LLC, File No. 3-21829 (Jan. 16, 2024), https://www.sec.gov/files/litigation/admin/2024/34-99344.pdf.

12 In re D.E. Shaw & Co., L.P., File No. 3-21775 (Sept. 29, 2023), https://www.sec.gov/files/litigation/admin/2013/34-70396.pdf.

13 SEC Press Release (Jan. 16, 2024), https://www.sec.gov/newsroom/press-releases/2024-7.

14 https://www.justice.gov/d9/2024-05/sdny_wb_policy_effective_2-13-24.pdf

15 https://www.justice.gov/d9/2024-05/sdny_wb_policy_effective_2-13-24.pdf

16 https://www.justice.gov/d9/2024-05/sdny_wb_policy_effective_2-13-24.pdf

17 https://www.justice.gov/opa/speech/acting-assistant-attorney-general-nicole-m-argentieri-delivers-keynote-speech-american

18 https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-monaco-delivers-keynote-remarks-american-bar-associations

19 https://www.justice.gov/criminal/media/1347991/dl?inline

20https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-monaco-delivers-keynote-remarks-american-bar-associations

21https://www.justice.gov/criminal/media/1347991/dl?inline

22 https://www.justice.gov/criminal/media/1347991/dl?inline

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Copyright 2024 K & L Gates
For more on Whistleblowers, visit the NLR Criminal Law Business Crimes section

SEC’s Slimmed Down Climate-Related Disclosures Finally Adopted

On March 6, 2024, the Securities and Exchange Commission (the “SEC”) adopted regulations[1] that will require public companies to file mandatory climate-related disclosures with the SEC beginning in 2026. First proposed in March 2022, the climate-related disclosure rules were finalized after consideration of over 24,000 comment letters and active lobbying of the SEC by business and public interest groups alike. These new rules are aimed at eliciting more consistent, comparable, and reliable information for investors to make informed decisions related to climate-related risks on current and potential investments.

The new rules require a registrant to disclose material climate-related risks and activities to mitigate or adapt to those risks; information about the registrant’s oversight of climate-related risks and management of those risks; and information on any climate-related targets or goals that are material to the registrant’s business, results of operations, or financial condition. In addition, these new rules require disclosure of Scope 1 and/or Scope 2 greenhouse gas (“GHG”) emissions with attestation by certain registrants when emissions are material; and disclosure of the financial effects of extreme weather events.

Unlike the initial proposal, the EU Climate Sustainability Reporting Directive (“CSRD”) and the California Climate Data Accountability Act, the new rules do not require disclosure of Scope 3 GHG emissions. The new rules require reporting based upon financial materiality, not the double-materiality (impact and financial) standard utilized by the EU under the CSRD. Whether registrants will ultimately be required to comply with the new rules depend upon the outcome of anticipated challenges, such as the challenge to the SEC’s authority to promulgate the rule filed in the Eleventh Circuit on March 6th by a coalition of ten states.

Highlights of the New Rule

In the adopting release, the SEC notes that companies are increasingly disclosing climate-related risks, whether in their SEC filings or via company websites, sustainability reports, or elsewhere; however, the content and location of such disclosures have been varied and inconsistent.[2] The new rules not only specify the content of required climate-related disclosures but also the presentation of such disclosures.

The new rules amend the SEC rules under the Securities Act of 1933 (“Securities Act”) and Securities Exchange Act of 1934 (“Exchange Act”), creating a new subpart 1500 of Regulation S-K and Article 14 of Regulation S-X. As a result, registrants, companies that are registered under the Exchange Act, will need to:

  • File climate-related disclosures with the SEC in their registration statements and Exchange Act annual reports;
  • Provide the required climate-related disclosures in either a separately captioned section of the registration statement or annual report, within another appropriate section of the filing, or the disclosures may be included by reference from another SEC filing so long as the disclosure meets the electronic tagging requirements; and
  • Electronically tag climate-related disclosures in Inline XBRL.

The rules require a registrant to disclose:

  • Climate-related risks that have had or are reasonably likely to have a material impact on the registrant’s business strategy, results of operations, or financial condition;
  • The actual and potential material impacts of any identified climate-related risks on the registrant’s strategy, business model, and outlook;
  • Specified disclosures regarding a registrant’s activities, if any, to mitigate or adapt to a material climate-related risk including the use, if any, of transition plans, scenario analysis, or internal carbon prices;
  • Any oversight by the board of directors of climate-related risks and any role by management in assessing and managing the registrant’s material climate-related risks;
  • Any processes the registrant has for identifying, assessing, and managing material climate-related risks and, if the registrant is managing those risks, whether and how any such processes are integrated into the registrant’s overall risk management system or processes;
  • Information about a registrant’s climate-related targets or goals, if any, that have materially affected or are reasonably likely to materially affect the registrant’s business, results of operations, or financial condition. Disclosures would include material expenditures and material impacts on financial estimates and assumptions as a direct result of the target or goal or actions taken to make progress toward meeting such target or goal;
  • For large accelerated filers (“LAFs”) and accelerated filers (“AFs”) that are not otherwise exempted, information about material Scope 1 emissions and/or Scope 2 emissions;
  • For those required to disclose Scope 1 and/or Scope 2 emissions, an assurance report at the limited assurance level, which, for an LAF, following an additional transition period, will be at the reasonable assurance level;
  • The capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, subject to applicable one percent and de minimis disclosure thresholds, disclosed in a note to the financial statements;
  • The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (“RECs”) if used as a material component of a registrant’s plans to achieve its disclosed climate-related targets or goals, disclosed in a note to the financial statements; and
  • If the estimates and assumptions a registrant uses to produce the financial statements were materially impacted by risks and uncertainties associated with severe weather events and other natural conditions or any disclosed climate-related targets or transition plans, a qualitative description of how the development of such estimates and assumptions was impacted, disclosed in a note to the financial statements.

Highlights of what did not get adopted

In its adopting release, the SEC described various modifications it made to its March 2022 proposed rules. The SEC explained that it made many of these changes in response to various comment letters it received. Some of the proposed rules that did not get adopted are:[3]

  • The SEC eliminated the proposed requirement to provide Scope 3 emissions disclosure.
  • The adopted rules in many instances now qualify the requirements to provide certain climate-related disclosures based on materiality.
  • The SEC eliminated the proposed requirement for all registrants to disclose Scope 1 and Scope 2 emissions in favor of requiring such disclosure only by large accelerated filers and accelerated filers on a phased in basis and only when those emissions are material and with the option to provide the disclosure on a delayed basis.
  • The SEC also exempted emerging growth companies and smaller reporting companies from the Scope 1 and Scope 2 disclosure requirement.
  • The SEC modified the proposed assurance requirement covering Scope 1 and Scope 2 emissions for accelerated filers and large accelerated filers by extending the reasonable assurance phase in period for LAFs and requiring only limited assurance for AFs.
  • The SEC eliminated the proposed requirements for registrants to disclose their GHG emissions in terms of intensity.[4]
  • The SEC removed the requirement to disclose the impact of severe weather events and other natural conditions and transition activities on each line item of a registrant’s financial statements. The SEC now requires disclosure of financial statement effects on capitalized costs, expenditures, charges, and losses incurred as a result of severe weather events and other natural conditions in the notes to the financial statements.
  • The adopted rules are less prescriptive than certain of those that were proposed. For example, the former now exclude in Item 1502(a) of Regulation S-K negative climate-related impacts on a registrant’s value chain from the definition of climate-related risks required to be disclosed. Similarly, this definition no longer includes acute or chronic risks to the operations of companies with which a registrant does business. Also, Item 1501(a) as adopted omits the originally proposed requirement for registrants to disclose (a) the identity of board members responsible for climate-risk oversight, (b) any board expertise in climate-related risks, (c) the frequency of board briefings on such risks, and (d) the details on the board’s establishment of climate-related targets or goals. Along the same lines, Item 1503 as adopted requires disclosure of only those processes for the identification, assessment, and management of material climate-related risks as opposed to a broader universe of climate-related risks. The rule as adopted does not require disclosure of how the registrant (a) determines the significance of climate-related risks compared to other risks, (b) considers regulatory policies, such as GHG limits, when identifying climate-related risks, (c) considers changes to customers’ or counterparties’ preferences, technology, or market prices in assessing transition risk, and (d) determines the materiality of climate-related risks. In the same vein, the adopted rules, unlike the proposed rules, do not require disclosure of how the registrant determines how to mitigate any high priority risks. Nor do the new rules retain the proposed requirement for a registrant to disclose how any board or management committee responsible for assessing and managing climate-related risks interacts with the registrant’s board or management committee governing risks more generally.
  • The SEC eliminated the proposal to require a private company that is a party to a business combination transaction, as defined by Securities Act Rule 165(f), registered on Form S-4 or Form F-4, to provide the subpart 1500 and Article 14 disclosures.

Timing of Implementation

The new rules will become effective 60 days after publication in the Federal Register. Compliance with the rules will not be required until much later, however.

Consistent with its earlier proposal, and in response to comments that the SEC received concerning the timing of implementing the proposed rule, the new rules contain delayed and staggered compliance dates that vary according to the registrant’s filing status and the type of disclosure.

The below table from the SEC’s new release summarizes the phased-in implementation dates.[5]

FILING STATUS

Large Accelerated Filers (“LAFs”)—a group whom the SEC believed most likely to be already collecting and disclosing climate-related information—will be the first registrants required to comply with the rule. The earliest that an LAF would be required to comply with the climate-disclosure rules would be upon filing its Form 10-K for the fiscal year ended December 31, 2025, which would be due no later than March 2026.[6]

Accelerated Filers (“AFs”) are not required to comply with the new rules for yet another year after LAFs. Climate-related disclosures for AFs must be included upon filing a Form 10-K for the fiscal year ended December 31, 2026, due no later than March 2027. Smaller Reporting Companies (“SRCs”), Emerging Growth Companies (“EGCs”), and Non-Accelerated Filers (“NAFs”) have yet another year to meet the first compliance deadline for climate-related disclosures. These types of filers need not include their climate-related disclosures until filing their Form 10-Ks for the fiscal year ended December 31, 2027, which, again, would be due no later than March 2028.

TYPES OF DISCLOSURES

The new rules also phase in the requirements to include certain disclosures over time. The requirements to provide quantitative and qualitative disclosures concerning material expenditures and material impacts to financial estimates or assumptions under Items 1502(d)(2), 1502(e)(2), and 1504(c)(2) are not applicable until the fiscal year immediately following the fiscal year in which the registrant’s initial compliance is required. LAFs, for example, are not required to report these qualitative and quantitative disclosures until filing a Form 10-K for the fiscal year ended December 31, 2026, due in March 2027. That should be one year after an LAF files its first Form 10-K with climate-related disclosures. The SEC adopted this phased-in approach to respond to commentators’ concerns regarding the availability (or current lack thereof) of policies, processes, controls, and system solutions necessary to support these types of disclosures.

Likewise, the new rules provide for a further phased-in compliance date for those registrants required to report their Scope 1 and Scope 2 GHG emissions and an even later date for those filers to obtain limited or reasonable assurance for those emissions disclosures. An LAF, for example, is not required to disclose its Scope 1 and Scope 2 emissions until filing its Form 10-K for the fiscal year ended December 31, 2026, due in March 2027. And those disclosures would not be required to be subject to the limited-assurance or reasonable-assurance requirements until filing the Form 10-K for the year ended December 31, 2029 or December 31, 2033, respectively.

In accordance with the table above, AFs, SRCs, EGCs, and NAFs have even more time to meet these additional disclosure requirements, if they are required to meet them at all.

It should be noted that the SEC recognized that registrants may have difficulty in obtaining GHG emission metrics by the date their 10-K report would be due. As a result, the rule contains an accommodation for registrants required to disclose Scope 1 and Scope 2 emissions, allowing domestic registrants, for example, to file those disclosures in the Form 10-Q for the second fiscal quarter in the fiscal year immediately following the year to which the GHG emissions disclosure relates. This disclosure deadline is permanent and not for a transition period.

Liability for Non-Compliance

In the introduction to the adopting release, the SEC explains that requiring registrants to provide certain climate-related disclosures in their filings will, among other things, “subject them to enhanced liability that provides important investor protections by promoting the reliability of the disclosures.”[7] This enhanced liability stems from the treatment of the disclosures as “filed” rather than “furnished” for purposes of Exchange Action Section 18 and, if included or otherwise incorporated by reference into a Securities Act registration statement, Securities Act Section 11.[8] According to the SEC, “climate-related disclosures should be subject to the same liability as other important business or financial information” that registrants include in registration statements and periodic reports and, therefore, should be treated as filed disclosures.[9]

In an attempt to balance concerns about the complexities and evolving nature of climate data methodologies and increased litigation risk, the SEC, in the adopting release, emphasizes certain modifications made in the new rules including:

  • limiting the scope of the GHG emissions disclosure requirement;
  • revising several provisions regarding the impacts of climate-related risks on strategy, targets and goals, and financial statement effects so that registrants will be required to provide the disclosures only in certain circumstances, such as when material to the registrant; and
  • adopting a provision stating that disclosures (other than historic facts) provided pursuant to certain of the new subpart 1500 provisions of Regulation S-K constitute “forward-looking statements” for the purposes of the PSLRA safe harbors.[10]

Registrants are subject to liability under Securities Act Section 17(a), Exchange Act Section 10(b), and/or Rule 10b-5 for false or misleading material statements in the information disclosed pursuant to the new rules.[11]

Observations

Consistent with its recent trajectory, the SEC continues to be a kinder, gentler regulator on climate disclosure requirements. Although the new rules will apply broadly to publicly traded companies, their scope is less demanding than the requirements under recent similar laws enacted in California or the EU. Under the California Climate Corporate Data Accountability Act (the “CCDA”), companies with annual revenues in excess of $1 billion and “doing business in California”[12] will be required to publicly disclose Scope 1 and Scope 2 emissions beginning in 2026, and Scope 3 emissions beginning in 2027. And because the California law applies to all companies, not just those that are publicly traded, it is also more broadly applicable and will trigger assessments and compliance for companies that are not subject to the SEC’s rule. The CCDA is currently the subject of legal challenge that includes questions of whether the required disclosures violate the First Amendment right to free speech, as well as possible federal preemption. As a result, there is a chance that the CCDA may yet be diluted or found unconstitutional. But in light of the imminent timeline for compliance, many companies subject to the CCDA are already developing programs to facilitate and ensure timely compliance with the requirements.

Similarly, the EU has broader reporting obligations under the CSRD than the SEC’s new rules. Compliance with the CSRD is required for both public and private EU companies as well as for non-EU companies with certain net annual turnovers, certain values of assets, and a certain number of employees. Under the CSRD, companies must publish information across a wide spectrum of subjects, including emissions, energy use, diversity, labor rights, and governance. Initial reporting under the CSRD begins to phase-in in 2025.

A key takeaway here is that although the SEC rules may have taken a lighter approach to climate disclosures, many large companies are likely to be subject to more stringent requirements under either the CCDA or the EU CSRD. And as some companies begin to comply to provide this information and data, the market may drive demand and an expectation that other companies, not otherwise subject to these various reporting regimes, follow suit. While the SEC rules may be a slimmed down version of what could have been, it is likely that the trend toward transparency and disclosure will continue to be driven by other regulatory bodies and market forces alike.

[1] Securities and Exchange Commission, Final Rule The Enhancement and Standardization of Climate-Related Disclosures for Investors, 17 CFR 210, 229, 230, 232, 239, and 249, adopting release available at https://www.sec.gov/files/rules/final/2024/33-11275.pdf.

[2] Id. at 48.

[3] Id. at 31-33.

[4] Id. at 225.

[5] Id. at 589.

[6] The new rules’ compliance dates apply to annual reports and registration statements. But, in the case of registration statements, compliance is required beginning with any registration statement that is required to include financial information for the full fiscal year indicated in the table above.

[7] Id. at 13.

[8] Id. at 584. At a high level, Section 18 imposes liability for false and misleading statements with respect to any material fact in documents filed with the SEC under the Exchange Act and Section 11 imposes liability for material misstatements or omissions made in connection with registered offerings conducted under the Securities Act.

[9] Id.

[10] Id. at 803.

[11] Id.

[12] A term which is not defined in the law, but is likely intentionally very broad, and is expected to be interpreted in that way.

© 2024 Foley & Lardner LLP
For more on SEC Climate Disclosures, visit the NLR Environmental, Energy & Resources section.

Regulatory Update and Recent SEC Actions 2024

REGULATORY UPDATES

RECENT SEC LEADERSHIP CHANGES

Stephanie Allen Named as SEC’s Director of Media Relations and Speechwriting

The Securities and Exchange Commission (the “SEC”) announced the appointment of Stephanie Allen as director of media relations and speechwriting, effective Oct. 1, 2023. Allen served as director of speechwriting and senior adviser to the chair since March 2023, and replaces Aisha Johnson, who recently departed the agency.

Allen will serve as the primary spokesperson for the SEC and for Chair Gensler and will lead media relations for the Office of Public Affairs. Allen was previously the executive director of the Ludwig Institute for Shared Economic Prosperity. Before that, she was the director of strategic communications and marketing at Promontory Financial Group, an IBM company. After working for two senators earlier in her career, she served as Chair Gensler’s speechwriter at the Commodity Futures Trading Commission.

SEC Names Kate E. Zoladz as Regional Director of Los Angeles Office

The SEC named, on November 29, 2023, Kate Zoladz as regional director of the SEC’s Los Angeles Office. Zoladz joined the SEC in 2010 as a staff attorney in the Los Angeles office and later joined the Division of Enforcement’s Asset Management Unit in 2017. Zoladz recently served as acting co-director since June 2023 and the associate regional director for enforcement since October 2019.

Daniel Gregus, Director of the Chicago Regional Office, to Depart the SEC

The SEC announced on December 7, 2023, that Daniel R. Gregus, director of the Chicago Regional Office, would leave the agency at the end of December after more than 30 years of service. Vanessa Horton and Kathryn Pyszka are now the acting co-directors. Horton has been an associate regional director of the Investment Adviser/Investment Company (IA/IC) examination program in the Chicago Regional Office since 2020. She joined the SEC’s Chicago office in 2004 as an accountant and was later an exam manager and an assistant regional director in the Chicago IA/IC examination program. Pyszka has served as an associate regional director for enforcement in the Chicago office since 2017. She began her SEC service in 1997 as a staff attorney and later served in the positions of branch chief, senior trial counsel, and as an assistant director in the Chicago office and the Enforcement Division’s Market Abuse Unit.

SEC Risk Alerts

SEC Announces 2024 Exam Priorities

The SEC’s Division of Examinations (the “Division”) issued its report (the “Report”) on October 16, 2023, regarding exam priorities for the upcoming year concerning investment advisers, broker-dealers, self-regulatory organization, and other market participants.

According to the Report, examination priorities continue to focus on whether investment advisers are adhering to their duty of care and duty of loyalty obligations. Areas of continued focus include:

  • Investment advice provided to clients (with an emphasis on advice to older clients and those saving for retirement) with regard to products, investment strategies, and account types:
    • Complex products, such as derivatives and leveraged exchange-traded funds (“ETFs”);
    • High-cost and illiquid products, such as variable annuities and non-traded real estate investment trusts (“REITs”); and
    • Unconventional strategies, including those that purport to address rising interest rates.
  • Processes for determining that investment advice is provided in clients’ best interest, including:
    • Making initial and ongoing suitability determinations;
    • Seeking best execution;
    • Evaluating costs and risks; and
    • Identifying and addressing conflicts of interest.

Per the Report, assessments will look at the factors that advisers consider in light of the clients’ investment profiles, including investment goals and account characteristics. Examinations will review how advisers address conflicts of interest, including: (i) mitigating or eliminating the conflicts of interest, when appropriate, and (ii) allocating investments to accounts where investors have more than one account (e.g., allocating between accounts that are adviser fee-based, brokerage commission-based, and wrap fee, as well as between taxable and non-taxable accounts).

Additionally, examinations will focus on the economic incentives and conflicts of interest associated with advisers that are dually registered as broker-dealers, use affiliated firms to perform client services, and have financial professionals servicing both brokerage customers and advisory clients to identify, among other things: (i) investment advice to purchase or hold onto certain types of investments (e.g., mutual fund share classes) or invest through certain types of accounts when lower cost options are available; and (ii) investment advice regarding proprietary products and affiliated service providers that result in additional or higher fees to investors. Exams will include review of disclosures made to investors and whether they include all material facts relating to conflicts of interest associated with the investment advice sufficient to allow a client to provide informed consent to the conflict.

Specific areas of focus will include:

  • Marketing Rule and whether advisers, including advisers to private funds, have:
    • Adopted and implemented reasonably designed written policies and procedures to prevent violations of the Advisers Act and the rules thereunder including reforms to the Marketing Rule;
    • Appropriately disclosed their marketing-related information on Form ADV;
    • Maintained substantiation of their processes and other required books and records; and
    • Disseminated advertisements that include any untrue statements of a material fact, are materially misleading, or are otherwise deceptive and, as applicable, comply with the requirements for performance (including hypothetical and predecessor performance), third-party ratings, and testimonials and endorsements.
  • Compensation arrangements:
    • Fiduciary obligations of advisers to their clients, including registered investment companies, particularly with respect to the advisers’ receipt of compensation for services or other material payments made by clients and others;
    • Alternative ways that advisers try to maximize revenue, such as revenue earned on clients’ bank deposit sweep programs; and
    • Fee breakpoint calculation processes, particularly when fee billing systems are not automated.
  • Valuation assessments regarding advisers’ recommendations to clients to invest in illiquid or difficult to value assets, such as commercial real-estate or private placements.
  • Disclosure review for the accuracy and completeness of regulatory filings, including Form CRS, with a particular focus on inadequate or misleading disclosures and registration eligibility.
  • Policies and procedures with respect to:
    • Selecting and using third-party and affiliated service providers;
    • Overseeing branch offices when advisers operate from numerous or geographically dispersed offices; and
    • Obtaining informed consent from clients when advisers implement material changes to their advisory agreements.
Investment Advisers to Private Funds

According to the Report, examinations will prioritize specific topics, such as:

  • Portfolio management risks in connection with exposure to recent market volatility and higher interest rates and effects on funds experiencing poor performance, significant withdrawals, and valuation issues for private funds with more leverage and illiquid assets.
  • Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.
  • Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses.
  • Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.
  • Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers.
  • Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor, and the distribution of private fund audited financial statements.
  • Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.
Registered Investment Companies (including Mutual Funds and ETFs)

Per the Report, exam focus may include the following assessments:

  • Compliance programs and fund governance practices—review boards’ processes for assessing and approving advisory and other fund fees, particularly for funds with weaker performance relative to their peers;
  • Disclosures to investors and accuracy of reporting to the SEC;
  • Valuation practices, particularly for those addressing fair valuation practices (e.g., implementing board oversight duties, setting recordkeeping and reporting requirements, and overseeing valuation designees), and, as applicable, the effectiveness of registered investment companies’ derivatives risk management and liquidity risk management programs;
  • Fees and expenses and whether registered investment companies have adopted effective written compliance policies and procedures concerning the oversight of advisory fees and implemented any associated fee waivers and reimbursements. Areas of particular focus include:
    • Charging different advisory fees to different share classes of the same fund;
    • Identical strategies offered by the same sponsor through different distribution channels but that charge differing fee structures;
    • High advisory fees relative to peers; and
    • High registered investment company fees and expenses, particularly those of registered investment companies with weaker performance relative to their peers.
    • Examinations will also review the boards’ approval of the advisory contract and registered investment company fees.
  • Derivatives risk management and whether registered investment companies and business development companies have adopted and implemented written policies and procedures reasonably designed to prevent violations of the SEC’s fund derivatives rule (Investment Company Act of 1940 (the “Investment Company Act”) Rule 18f-4). Review of compliance with the derivatives rule may include:
    • Review of the adoption and implementation of a derivatives risk management program;
    • Board oversight, and whether disclosures concerning the registered investment companies’ or business development companies’ use of derivatives are incomplete, inaccurate, or potentially misleading; and
    • Procedures for, and oversight of, derivative valuations.

Division staff will also focus on the following areas:

  • Cybersecurity
  • Cryptocurrency assets (focus on a range of activities surrounding crypto assets and related products, including offering, selling, recommending, trading, and providing advice on such assets); and
  • Anti-Money Laundering (“AML”) programs.

Cybersecurity: With respect to cybersecurity, the Division noted that “operational disruption risks remain elevated due to the proliferation of cybersecurity attacks, firms’ dispersed operations, intense weather-related events, and geopolitical concerns.” According to the release, the examination staff will focus on firms’ policies and procedures, internal controls, governance practices, oversight of third-party vendors, and responses to “cyber-related incidents” such as ransomware attacks. Reviews will consider how firms train staff on issues including identity theft prevention and customer records and information protection. Staff will also place a particular focus on “the concentration risk associated with the use of third-party providers, including how registrants are managing this risk and the potential impact to the U.S. securities markets.”

Crypto Assets and Emerging Financial Technology: The release highlights concerns based on the continued growth and popularity of crypto assets (and their associated products and services) and the increase in automated investment tools, artificial intelligence, and trading algorithms or platforms. The Division’s goal is twofold: (1) to ensure that registrants meet their fiduciary duties when recommending or advising about crypto assets; and (2) that compliances, risk disclosures, and operational resiliency practices are routinely reviewed and updated to account for the unique challenges crypto assets provide.

For crypto assets that are funds or securities, this includes ensuring that crypto assets are complying with the custody requirements under the Investment Advisers Act of 1940 (the “Advisers Act”) and whether policies and procedures are reasonably designed, and accurate disclosures are made, relating to technological risks associated with blockchain and distributed ledger technology.

Anti-Money Laundering: The Division will continue to focus on whether broker-dealers and certain registered investment companies have proper AML programs as required by the Bank Secrecy Act. Specifically, the Division will examine whether broker-dealers and investment companies are appropriately tailoring AML programs, conducting independent testing, establishing an adequate customer identification program, and meeting their filing obligations.

SEC Rulemaking

SEC Adopts Amendments to Rules Governing Beneficial Ownership Reporting

The SEC adopted rule amendments governing beneficial ownership reporting under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934 (the “Exchange Act”) on October 10, 2023, requiring market participants to provide more timely information on their positions.

Exchange Act Sections 13(d) and 13(g), along with Regulation 13D-G, require an investor who beneficially owns more than five percent of a covered class of equity securities to publicly file either a Schedule 13D or a Schedule 13G, as applicable. An investor with control intent files Schedule 13D, while “Exempt Investors” and investors without a control intent, such as “Qualified Institutional Investors” and “Passive Investors,” file Schedule 13G.

The adopted amendments (among other things): i) shorten the deadline for initial Schedule 13D filings from 10 days to five business days and require that Schedule 13D amendments be filed within two business days; ii) generally accelerate the filing deadlines for Schedule 13G beneficial ownership reports (the filing deadlines differ based on the type of filer); iii) clarify the Schedule 13D disclosure requirements with respect to derivative securities; and iv) require that Schedule 13D and 13G filings be made using a structured, machine-readable data language.

In addition, the adopting release provides guidance regarding the current legal standard governing when two or more persons may be considered a group for the purposes of determining whether the beneficial ownership threshold has been met, as well as how, under the current beneficial ownership reporting rules, an investor’s use of certain cash-settled derivative securities may result in the person being treated as a beneficial owner of the class of the reference equity securities.

The amendments were published in the Federal Register on November 7, 2023, effective on February 5, 2024. Compliance with the revised Schedule 13G filing deadlines will be required beginning on September 30, 2024. Compliance with the structured data requirement for Schedules 13D and 13G will be required on December 18, 2024. Compliance with the other rule amendments will be required upon their effectiveness.

“Today’s adoption updates rules that first went into effect more than 50 years ago. Frankly, these deadlines from half a century ago feel antiquated,” said SEC Chair Gary Gensler. “In our fast-paced markets, it shouldn’t take 10 days for the public to learn about an attempt to change or influence control of a public company. I am pleased to support this adoption because it updates Schedules 13D and 13G reporting requirements for modern markets, ensures investors receive material information in a timely way, and reduces information asymmetries.”

SEC Adopts Rule to Increase Transparency in the Securities Lending Market

The SEC adopted on October 13, 2023, new Rule 10c-1a, which will require certain persons to report information about securities loans to a registered national securities association (“RNSA”) and require RNSAs to make publicly available certain information that they receive regarding those lending transactions. According to the SEC, the rule is intended to increase transparency and efficiency of the securities lending market.

Rule 10c-1a will require certain confidential information to be reported to an RNSA to enhance the RNSA’s oversight and enforcement functions. The new rule requires that an RNSA make certain information it receives, along with daily information pertaining to the aggregate transaction activity and distribution of loan rates for each reportable security, available to the public. The Financial Industry Regulatory Authority (“FINRA”) is currently the only RNSA.

The adopting release was published in the Federal Register on November 3, 2023. The compliance dates for the new rule are as follows: (1) an RNSA is required to propose rules within four months of the effective date; (2) the proposed RNSA rules are required to be effective no later than 12 months after the effective date; (3) covered persons are required to report information required by the rule to an RNSA starting on the first business day 24 months after the effective date; and (4) RNSAs are required to publicly report information within 90 calendar days of the reporting date.

SEC Adopts Rule to Increase Transparency Into Short Selling and Amendment to CAT NMS Plan for Purposes of Short Sale Data Collection

The SEC adopted, on October 13, 2023, new Rule 13f-2 to provide greater transparency to investors and other market participants by increasing the public availability of short sale related data. Specifically, Rule 13f-2 will require institutional investment managers that meet or exceed certain thresholds to report on Form SHO specified short position data and short activity data for equity securities. The Commission will aggregate the resulting data by security, thereby maintaining the confidentiality of the reporting managers, and publicly disseminate the aggregated data via EDGAR on a delayed basis. This new data will supplement the short sale data that is currently publicly available.

Relatedly, the Commission also adopted an amendment to the National Market System Plan (“NMS Plan”) governing the consolidated audit trail (“CAT”). The amendment to the NMS Plan governing the CAT (“CAT NMS Plan”) will require each CAT reporting firm that is reporting short sales to indicate when it is asserting use of the bona fide market making exception in Rule 203(b)(2)(iii) of Regulation SHO.

The adopting release for Rule 13f-2 and related Form SHO, as well as the notice of the amendment to the CAT NMS Plan, was published in the Federal Register on November 1, 2023. The final rule, Form SHO, and the amendment to the CAT NMS Plan will become effective 60 days after publication of the adopting release in the Federal Register. The compliance date for Rule 13f-2 and Form SHO will be 12 months after the effective date of the adopting release, with public aggregated reporting to follow three months later, and the compliance date for the amendment to the CAT NMS Plan will be 18 months after the effective date of the adopting release.

Clearing Agency Governance and Conflicts of Interest

On November 16, 2023, the SEC adopted Rule 17Ad-25 and related rules under the Exchange Act to improve clearing agency governance to mitigate conflicts of interest that may influence the board of directors or equivalent governing body of a registered clearing agency. The rules identify certain responsibilities of the board of a clearing agency, increase transparency into board governance, and, more generally, improve the alignment of incentives among owners and participants of a registered clearing agency. The rules establish new requirements for board and committee composition, independent directors, management of conflicts of interest, and board oversight.

The adopted rules:

  1. Define independence in the context of a director serving on the board of a registered clearing agency and require that a majority of the board—or 34 percent—be independent directors;
  2. Establish independent director requirements for the compensation of certain other board committees and identify circumstances that would preclude a director from being an independent director;
  3. Require a clearing agency to establish a nominating committee and a written evaluation process for evaluating board nominees and the independence of nominees and directors and specify requirements with respect to its composition, director fitness standards, and documentation of the outcome of the written eval practice;
  4. Require a clearing agency to establish a risk management committee, specify requirements with respect to the committees’ purpose and composition, and include an annual re-evaluation of such composition;
  5. Require policies and procedures for the management of risks from relationships with service providers for core services that directly support the delivery of clearance or settlement functionality or any other purpose material to the business of the registered clearing agency, with delineated roles for senior management and the board; and
  6. Require policies and procedures for the board to solicit, consider, and document its consideration of the views of participants and other relevant stakeholders regarding material developments in the registered clearing agency’s risk management and operations.

The final rule was published in the Federal Register on December 5, 2023, with an expected compliance 12 months after such publication for all requirements except for the independence requirement for the board and board committees, for which the compliance date is 24 months after publication.

SEC Defends Voting Disclosure Changes Before Fifth Circuit

In July of 2022, the SEC adopted amendments to its rules governing proxy voting advice. Specifically, the rule requires mutual funds, ETFs and certain other registered funds to disclose more information about how they cast votes on behalf of investors. (See Blank Rome’s Investment Management Regulatory Update dated October 2022, “SEC Adopts Amendments to Proxy Rules Governing Proxy Voting Advice,” for further discussion). The rule is set to become effective July 1, 2024.

Since passing the rule, four states (Texas, Louisiana, Utah, and West Virginia) have challenged the SEC’s authority to require fund managers to disclose additional information about votes they cast. Their argument to the Fifth Circuit is that the real purpose of the voting disclosure change is to empower corporate activities rather than the investing public. The SEC maintains, however, that the amendments fall within its authority under the Investment Company Act and that the SEC reasonably concluded that the changes would facilitate investors’ ability to access information important to investment decisions and mitigate conflicts of interest.

SEC Adopts Rule to Prohibit Conflicts of Interest in Certain Securitizations

On November 27, 2023, the SEC adopted Dodd-Frank rules against trader conflicts. Securities Act Rule 192 implements Section 27B of the Securities Act of 1933 (the “Securities Act”), a provision added by the Dodd-Frank Act. The Rule seeks to prevent the sale of asset-backed securities (“ABS”) that pose a material conflict of interest. Specifically, it prohibits a securitization participant, for a period of time, from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the participant and an investor in the relevant ABS. Rule 192 provides exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities of a securitization participant.

Under new Rule 192, conflicted transactions include a short sale of the relevant ABS, the purchase of a credit default swap or other credit derivative that entitles the securitization participant to receive payments upon the occurrence of specified credit events in respect of the ABS, or a transaction that is substantially the economic equivalent of the aforementioned transactions, other than any transaction that only hedges general interest rate or currency exchange risk.

SEC Adopts Rules to Improve Risk Management in Clearance and Settlement and Facilitate Additional Central Clearing for the U.S. Treasury Market

The SEC adopted rules on December 13, 2023, to enhance risk management practices for central counterparties in the U.S. Treasury market and facilitate additional clearing of U.S. Treasury securities transactions. The rule changes update the membership standards required of covered clearing agencies for the U.S. Treasury market with respect to a member’s clearance and settlement of specified secondary market transactions. Additional rule changes are designed to reduce the risks faced by a clearing agency and incentivize and facilitate additional central clearing in the U.S. Treasury market.

According to the release, the amendments require that covered clearing agencies in the U.S. Treasury market adopt policies and procedures designed to require their members to submit for clearing certain specified secondary market transactions. These transactions include: (i) all repurchase and reverse repurchase agreements collateralized by U.S. Treasury securities entered into by a member of the covered clearing agency, unless the counterparty is a state or local government or another clearing organization or the repurchase agreement is an inter-affiliate transaction; (ii) all purchase and sale transactions entered into by a member of the clearing agency that is an interdealer broker; and (iii) all purchase and sale transactions entered into between a clearing agency member and either a registered broker-dealer, a government securities broker, or a government securities dealer.

Further, the amendments permit broker-dealers to include customer margin required and on deposit at a clearing agency in the U.S. Treasury market as a debit in the customer reserve formula, subject to certain conditions. In addition, the amendments require covered clearing agencies in this market to collect and calculate margin for house and customer transactions separately. Finally, the amendments require policies and procedures designed to ensure that the covered clearing agency has appropriate means to facilitate access to clearing, including for indirect participants. The amendments also include an exemption for transactions in which the counterparty is a central bank, sovereign entity, international financial institution, or natural person.

ENFORCEMENT ACTIONS AND CASES

SEC Charges Investment Adviser with Failing to Properly Disclose Investments by Publicly Traded Fund

The SEC charged an investment adviser, on October 24, 2023, for failing to accurately describe investments in the entertainment industry that comprised a significant portion of a publicly traded fund it advised. The investment adviser settled the charges and agreed to pay a $2.5 million penalty.

According to the SEC’s order, from 2015 to 2019, one of the investment adviser’s trusts made significant investments, through a lending facility, in Aviron Group, LLC, a company that developed print and advertising plans for one to two films per year. According to the SEC’s order, the investment advisor inaccurately described Aviron as a “Diversified Financial Services” company in many of the trust’s annual and semi-annual reports. In addition, according to the order, the investment adviser stated that Aviron paid a higher interest rate than was actually the case, and in 2019, the investment adviser identified these inaccuracies and the trust accurately reported the Aviron investment in reports going forward.

Per the SEC’s order, the investment adviser willfully violated fraud-based disclosure prohibitions under Section 34(b) of the Investment Company Act and Section 206(4) of the Advisers Act and related Rule 206(4)-8. Without admitting or denying the SEC’s findings, the investment adviser agreed to a cease-and-desist order and a censure in addition to a monetary penalty.

Previously, in 2022, the SEC charged and then resolved its action against William Sadleir, the founder of Aviron, for misappropriating the trust’s funds invested in Aviron.

“Retail and institutional investors rely on accurate disclosures of the companies that make up a closed-end or mutual fund’s portfolio to evaluate a current or prospective investment in the fund,” said Andrew Dean, co-chief of the Enforcement Division’s Asset Management Unit. “Investment advisers have a responsibility to provide this vital information, and [the adviser here] failed to do so with the Aviron investment.”

SEC Charges President/CCO of Asset Management Advisory Firm with Fraud

The SEC charged a president and chief compliance officer of registered investment adviser, Prophecy Asset Management LP (“Prophecy”), on November 2, 2023, for his involvement in a multi-year fraud that concealed losses of hundreds of millions of dollars from investors.

Prophecy advised multiple hedge funds and reported more than $500 million in assets under management. The SEC’s complaint alleged that the president and Prophecy misled the funds’ investors, auditors, and administrator about the funds’ trading practices, risk, and performance—all while collecting more than $15 million in fees.

According to the SEC’s complaint, the president led investors to believe that their investments were protected from loss, telling them the funds’ capital was shared among dozens of sub-advisers who traded in liquid securities and posted cash collateral to offset any trading losses they incurred. However, the SEC alleged that in reality, most of the funds’ capital went to one sub-adviser, who incurred massive trading losses that far exceeded the cash collateral he had contributed. In addition, the complaint alleged that the president caused the funds to invest in highly illiquid investments, which also resulted in substantial losses to the funds, concealed these losses by fabricating documents and engaging in a series of sham transactions, and deceived investors about the diversification and trading strategies in two other funds. The complaint pleads by 2020, after losses in funds that Prophecy managed amounted to more than $350 million, the president and Prophecy indefinitely suspended redemptions by investors.

The SEC’s complaint charged the president with violations of Section 17(a) of the Securities Act, Rule 10b-5, Section 206(1) and (2) of the Advisers Act, and Rule 206(4)-8 of the Advisers Act.

SEC Announces Enforcement Results for FY23

The SEC announced on November 14, 2023, its enforcement results for fiscal year 2023. The SEC filed 784 total enforcement actions in fiscal year 2023, a three percent increase over fiscal year 2022. These included 501 original, or “stand-alone,” enforcement actions, an eight percent increase over the prior fiscal year; 162 “follow-on” administrative proceedings seeking to bar or suspend individuals from certain functions in the securities markets based on criminal convictions, civil injunctions, or other orders; and 121 actions against issuers who were allegedly delinquent in making required filings with the SEC.

The stand-alone enforcement actions ranged from billion-dollar frauds to emerging market investments involving crypto asset securities and cybersecurity. The pool of charged individuals or entities included a diverse array of market participants from public companies and investment firms to gatekeepers (such as auditors and lawyers) to social media influencers. Notably, fiscal year 2023 was record-breaking for the SEC’s Whistleblower Program with awards totaling nearly $600 million and more than 18,000 whistleblower tips, which is nearly 50 percent more tips than in the previous fiscal year.

In total, the SEC obtained orders for $4.949 billion in financial remedies, second only to the record-setting $6.439 billion in fiscal year 2022. Of this $4.949 billion, $3.369 billion was obtained in disgorgement and prejudgment interests and $1.580 billion in civil penalties. The SEC also obtained orders barring 133 individuals from serving as officers and directors of public companies, the highest number of bars obtained in a decade.

Crypto Currency Exchange Agrees to pay $4.3 Billion in Fines for Violations of the Bank Secrecy Act

On November 21, 2023, the largest Crypto Currency Exchange (the “Exchange”) in the world agreed to pay a historic $4.3 billion fine for failing to register as a money-transmitting business and allowing users to evade U.S. sanctions against Iran. The Exchange’s founder pled guilty to failing to maintain an effective anti-money laundering program in violation of the Bank Secrecy Act. This agreement marks the end of the Department of Justice’s yearlong investigation over alleged money laundering, bank fraud, and sanctions violations.

The Exchange also agreed to pay several other penalties to resolve enforcement actions by the CFTC and Treasury Department. Under the CFTC’s proposed orders, the Exchange will pay $2.7 billion, the founder will pay $150 million, and former CCO will pay $1.5 million for ignoring potential money launder and terrorists financing on its platform and for failing to register with the CFTC.

Additionally, the FinCEN settlement will require the Exchange to pay $3.4 billion in civil money penalty and will be subject to a five-year monitorship. Office of Foreign Assets Control will require the Exchange to pay a $968 million penalty. The Treasury will also retain access to the company’s books, records, and systems for the five-year monitorship.

SEC Charges Real Estate Fund Adviser with $35 Million Fraud

The SEC filed a complaint in the U.S. District Court for District of Arizona, on November 28, 2023, charging an adviser, his investment company, and related entities controlled by the adviser with violating the antifraud provisions of the federal securities laws.

The SEC alleged that the adviser misappropriated more than $35 million from private real estate funds and other investment vehicles by using a substantial portion of the funds to pay for his family members’ personal expenses and to fund private jets, yachts, and expensive residences. Further, the adviser issued a press release from another wholly owned LLC that stated the company’s intention to purchase 51 percent of all minority shares in an unrelated public company, at $9 a share, more than nine times the company’s then-current trading price. The shares jumped over 150 percent in after-hours trading shortly after the press release was issued. The adviser had purchased more than 72,000 call options in the company at a price far below the stock price in the days leading up to the press release, hoping to exercise the options at a profit after manipulating the stock price.

Global Bank and Affiliated Entities to Pay $10 Million for Providing Prohibited Mutual Fund Services

The SEC announced, on December 13, 2023, that a global bank and two affiliated entities (“Entities”) agreed to pay $10 million to settle the SEC’s charges that they provided prohibited underwriting and advising services to mutual funds.

In October 2022, the Superior Court of New Jersey entered a consent order that resolved a case alleging that the Entities violated the antifraud provisions of the New Jersey securities laws in connection with its role as underwriter to residential mortgage-backed securities. According to the SEC’s order, the global bank and its affiliates were prohibited from serving as a principal underwriter or investment adviser to mutual funds or employees’ securities companies pursuant to the Investment Company Act unless an exemptive order was received. The SEC order found, however, that the Entities continued serving in these prohibited roles until the SEC granted them time-limited exemptions on June 7, 2023. Without admitting or denying the SEC’s findings, the Entities agreed to pay more than $6.7 million in disgorgement and prejudgment interest and civil penalties totaling $3.3 million.

“Today’s action holds the [Entities] accountable for not complying with eligibility requirements,” said Corey Schuster, Asset Management Unit co-chief. “This action reinforces the need for entities to properly monitor for events that may cause disqualification and proactively seek and obtain waivers from the Commission before becoming disqualified, or refrain from performing prohibited services.”

BarnBridge DAO Agrees to Stop Unregistered Offer and Sale of Structured Finance Crypto Product

The SEC announced on December 22, 2023, that BarnBridge DAO (“BarnBridge”), a purportedly decentralized autonomous organization, and its two founders will pay more than $1.7 million to settle charges that they failed to register BarnBridge’s offer and sale of structured crypto asset securities known as SMART Yield bonds. The SEC also charged the respondents with violations stemming from operating BarnBridge’s SMART Yield pools as unregistered investment companies.

According to the SEC’s orders, the respondents compared the SMART Yield bonds to asset-backed securities and marketed them broadly to the public. Investors could purchase “Senior” or “Junior” SMART Yield bonds through BarnBridge’s website application. SMART Yield pooled crypto assets deposited by the investors and used those assets to generate fixed or variable returns to pay investors. A BarnBridge white paper, published by one of the founders, claimed that SMART Yield bonds would “mirror the safety and security of highly rated debt instruments offered by traditional finance…while still providing the outsized return” through its smart contract protocols. According to the orders, SMART Yield attracted more than $509 million in investments from investors, and BarnBridge was paid fees by the investors based on the size of their investment and their choice of yield.

To settle the SEC’s charges, BarnBridge agreed to disgorge nearly $1.5 million of proceeds from the sales, and its two founders each agreed to pay $125,000 in civil penalties.

Without admitting or denying the SEC’s findings, BarnBridge and its two founders agreed to cease-and-desist orders prohibiting them from violating and causing violations of the registration provisions of the Securities Act and the Investment Company Act. The SEC orders referenced remedial actions initiated by the founders.

SEC BuyBack Disclosure Rule Vacated by Appeals Court

The Fifth U.S. Circuit Court of Appeals in New Orleans, on December 19, 2023, granted a motion filed by business groups to vacate the SEC’s new rule that required companies to provide timelier disclosures on stock buybacks. Prior to this ruling, on October 31, 2023, the court found that the SEC “acted arbitrarily and capriciously” and in so doing violated the Administrative Procedure Act by failing to conduct a proper cost-benefit analysis when drafting the rule. The SEC was given 30 days to “correct the defects in the rule” but did not file a new draft. On December 7, 2023, business groups filed a motion for the court to vacate the rule.

The SEC’s finalized rule in May 2023 required companies to disclose daily stock buyback information either quarterly or semiannually to include the number of shares repurchased each day and the average price paid on that day. In addition, the rule required companies to indicate whether certain directors or officers traded the relevant securities within four days before or after public announcement of an issuer’s buyback plan or program.

© 2023 Blank Rome LLP
For more on SEC regulations, visit the NLR Securities & SEC section.

SEC Approves NYSE, NYSE MKT and NASDAQ Compensation Committee Listing Standards

The National Law Review recently published an article by Jeff C. Dodd and Scott L. Olson with Andrews Kurth LLP regarding, SEC regulations:

Andrews Kurth

The Securities and Exchange Commission (SEC) recently approved amendments to the compensation committee listing standards of the New York Stock Exchange (NYSE),1 the NYSE MKT2 and the NASDAQ Stock Market (NASDAQ)3 that were initially proposed in September 2012 to comply with Rule 10C-1 of the Securities Exchange Act of 1934.4 In approving the listing standards, the SEC did not require any changes to the exchanges’ proposals, as amended.

The new listing standards will impact the authority and responsibilities of compensation committees with respect to their advisers and the independence analysis for compensation committee members. Although the SEC has approved the new compensation committee listing standards, issuers with listed equity securities subject to the new standards will have time to comply as follows.

NYSE- and NYSE MKT-listed issuers have until:

  • the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the enhanced compensation committee independence standards; and
  • July 1, 2013 to comply with the remaining standards (e.g., the authority to retain and fund advisers to the committee and the responsibility to consider specified independence factors before selecting or receiving advice from advisers).

NASDAQ-listed issuers have until:

  • July 1, 2013 to establish in the compensation committee charter, board resolutions or other board action the compensation committee’s new responsibilities and authority (i.e., the authority to retain and fund advisers to the committee and the responsibility to consider specified independence factors before selecting or receiving advice from advisers); and
  • the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the remaining standards (e.g., have a formal compensation committee of at least two independent directors, have a compensation committee charter and satisfy the enhanced compensation committee independence standards).

Current compensation committee listing standards will apply pending the transition to the new standards.

Click here to read about key aspects of the NYSE’s new compensation committee listing standards.

Click here to read about key aspects of the NYSE MKT’s new compensation committee listing standards.

Click here to read about key aspects of NASDAQ’s new compensation committee listing standards.

Click here to read about practical considerations for NYSE-, NYSE MKT- and NASDAQ-listed issuers to consider in response to the new compensation committee listing standards.

NYSE Compensation Committee Listing Standards

Committee charter requirements for compensation committee authority and responsibilities regarding its advisers. In addition to current NYSE charter requirements, compensation committee charters must specify the following:

  • the committee’s authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, legal counsel or other adviser (collectively referred to throughout the discussion of the NYSE’s new listing standards as advisers);
  • the committee’s direct responsibility for the appointment, compensation and oversight of the work of any adviser retained by the committee;
  • the issuer’s responsibility to provide for appropriate funding (as determined by the committee) for the payment of reasonable compensation to any adviser retained by the committee; and
  • the committee’s responsibility to conduct an independence assessment before selecting or receiving advice from an adviser to the committee (as discussed in more detail below under “Assessment of adviser independence”).

The new authority and responsibilities regarding advisers do not:

  • require the compensation committee to implement or follow its advisers’ advice or recommendations; or
  • affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.

Assessment of adviser independence. As noted above and subject to limited exceptions discussed below, before selecting or receiving advice from an adviser (for compensation or non-compensation matters and regardless of who retained the adviser), the compensation committee must consider all factors relevant to that adviser’s independence from management, including:

  • the provision of other services to the issuer by the adviser’s employer;
  • the amount of fees received from the issuer by the adviser’s employer, as a percentage of the employer’s total revenue;
  • the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship between the adviser and a compensation committee member;
  • any issuer stock owned by the adviser (as the SEC noted in its adopting release for Rule 10C-1, it interprets this to include stock owned by the adviser’s immediate family members); and
  • any business or personal relationship between either the adviser or the adviser’s employer and an issuer’s executive officer (as the SEC noted in its adopting release for Rule 10C-1, this would include, for example, situations where an issuer’s CEO and the adviser have a familial relationship or where the CEO and the adviser or the adviser’s employer are business partners).

These factors are considerations for the compensation committee rather than bright-line standards. Although compensation committees must consider the specified factors, they are also responsible for identifying and considering all additional factors relevant to an adviser’s independence from management. After conducting the required independence assessment, compensation committees may select or receive advice from any adviser they prefer, even those that are not independent.5 In response to comments that compensation committees should be specifically required to also consider whether an adviser requires a contractual agreement to indemnify the adviser or limit the adviser’s liability, the NYSE noted that it is not apparent that the existence of such indemnification agreements or contractual limitations on liability is relevant to an independence analysis.6

Compensation committees must conduct the independence assessment for any adviser that the committee selects or receives advice from, other than:

  • in-house legal counsel; and
  • any adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the issuer, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular issuer or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice.

In response to comments, the NYSE made it clear that the independence assessment requirement applies to any outside legal counsel consulted by the compensation committee, including any regular outside counsel to the issuer consulted on matters such as SEC filing requirements or federal tax issues associated with equity compensation plans.

In response to a comment expressing concern about the possible need to conduct a new independence assessment before every compensation committee meeting for those advisers that regularly provide advice to the compensation committee, the NYSE indicated that the frequency of the assessment will be a facts and circumstances determination. Specifically, the NYSE noted that “[w]hile an annual assessment may be sufficient in some cases, in other circumstances a more frequent review may be warranted.” In approving the new standards, the SEC noted its expectation that the assessment would be conducted at least annually.

Compensation committee independence. Current listing standards require that a compensation committee be comprised solely of independent directors, and the board must affirmatively determine that a compensation committee member is independent under the general board independence standards set forth in Section 303A.02 of the Manual.

Under the new standards, in making an affirmative independence determination regarding a compensation committee member the board must also consider all factors specifically relevant to determining whether a director has a relationship to the issuer that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including:

  • the source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
  • whether the director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.

These factors do not include any specific numerical or materiality tests, and are considerations for the board rather than bright-line standards. For example, the NYSE did not adopt an absolute prohibition on a board making an affirmative independence finding for a compensation committee member solely because the member or any of his or her affiliates are significant stockholders. Although the board must consider the specified factors, it must also identify and consider all additional factors that would be relevant to a compensation committee member’s independence from management. In response to comments, the NYSE confirmed that a single factor or relationship considered in the independence analysis may be sufficiently material to render a director non-independent.

When considering the source of a director’s compensation, the board should consider whether the director receives compensation from any person or entity that would impair his or her ability to make independent judgments about the issuer’s executive compensation. Likewise, when considering any affiliate relationship, the board should consider whether the relationship places the director under the direct or indirect control of the issuer or its senior management, or creates a direct relationship between the director and senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the issuer’s executive compensation.

In response to comments that director fees should be an explicit factor to be considered in compensation committee independence determinations, the NYSE noted that it does not believe that it is likely that director fees would be a relevant consideration for the independence analysis. However, if “excessive” board compensation might affect a director’s independence, the NYSE noted that the listing standards would require the board to consider that factor in its independence determination, as the standards require the board to consider all relevant factors. The NYSE did not indicate what constitutes “excessive” board compensation.

If a compensation committee member ceases to be independent for reasons outside that member’s reasonable control, the member may, with prompt notice by the issuer to the NYSE, remain a compensation committee member until the earlier of (1) the next annual stockholder meeting or (2) one year from the event that caused the member to cease to be independent. This cure provision is limited to situations where the compensation committee continues to have a majority of independent directors.

Exemptions. The new compensation committee listing standards will not apply to the following issuers that are exempt from the NYSE’s current compensation committee listing standards:

  • controlled companies (i.e., issuers where more than 50% of the voting power for the election of directors is held by an individual, a group or another company);
  • limited partnerships (for example, master limited partnerships (MLPs));
  • companies in bankruptcy;
  • closed-end and open-end funds registered under the Investment Company Act of 1940 (1940 Act);
  • passive business organizations in the form of trusts (for example, royalty trusts);
  • derivatives and special purpose securities; and
  • issuers whose only listed equity security is preferred stock.

Smaller reporting companies (generally issuers with less than $75 million of public equity float) are exempt from the new enhanced compensation committee independence and consideration of adviser independence standards. As a result, their compensation committee charters will not have to reflect these matters. However, these issuers are subject to the other new standards. An issuer that ceases to qualify as a smaller reporting company will have:

  • six months from the date it ceases to be a smaller reporting company to comply with the consideration of adviser independence standard;
  • six months from the date it ceases to be a smaller reporting company to have one member of its compensation committee satisfy the enhanced compensation committee independence standard;
  • nine months from the date it ceases to be a smaller reporting company to have a majority of its compensation committee members satisfy the enhanced compensation committee independence standard; and
  • 12 months from the date it ceases to be a smaller reporting company to have a compensation committee consisting entirely of members that satisfy the enhanced compensation committee independence standard.7

Foreign private issuers that elect to follow home country practice are exempt from the new compensation committee listing standards provided that they comply with the disclosure requirements of Section 303A.11 of the Manual.

Transition periods for newly-listed and other issuers. The current transition periods available to newly-listed issuers and certain other categories of issuers (e.g., issuers listing in connection with a carve-out or spin-off transaction) apply to the new compensation committee listing standards. For example, an issuer listing in connection with its initial public offering (IPO) must have one independent compensation committee member by the earlier of the IPO closing date or five business days from the listing date, a majority of independent members within 90 days of the listing date, and a fully independent committee within one year of the listing date.

Click here to read about practical considerations to consider in response to the new compensation committee listing standards.

NYSE MKT Compensation Committee Listing Standards

Compensation committee authority and responsibilities regarding its advisers. A compensation committee8 must have the following authority and responsibilities:

  • the authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, legal counsel or other adviser (collectively referred to throughout the discussion of the NYSE MKT’s new listing standards as advisers);
  • the direct responsibility for the appointment, compensation and oversight of the work of any adviser retained by the committee;
  • the issuer must provide for appropriate funding (as determined by the committee) for the payment of reasonable compensation to any adviser retained by the committee; and
  • the responsibility to conduct an independence assessment before selecting or receiving advice from an adviser to the committee (as discussed in more detail below under “Assessment of adviser independence”).

The new authority and responsibilities regarding advisers do not:

  • require the compensation committee to implement or follow its advisers’ advice or recommendations; or
  • affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.

Assessment of adviser independence. As noted above and subject to limited exceptions discussed below, before selecting or receiving advice from an adviser (for compensation or non-compensation matters and regardless of who retained the adviser), the compensation committee must consider all factors relevant to that adviser’s independence from management, including:

  • the provision of other services to the issuer by the adviser’s employer;
  • the amount of fees received from the issuer by the adviser’s employer, as a percentage of the employer’s total revenue;
  • the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship between the adviser and a compensation committee member;
  • any issuer stock owned by the adviser (as the SEC noted in its adopting release for Rule 10C-1, it interprets this to include stock owned by the adviser’s immediate family members); and
  • any business or personal relationship between either the adviser or the adviser’s employer and an issuer’s executive officer (as the SEC noted in its adopting release for Rule 10C-1, this would include, for example, situations where an issuer’s CEO and the adviser have a familial relationship or where the CEO and the adviser or the adviser’s employer are business partners).

These factors are considerations for the compensation committee rather than bright-line standards. Although compensation committees must consider the specified factors, they are also responsible for identifying and considering all additional factors relevant to an adviser’s independence from management. After conducting the required independence assessment, compensation committees may select or receive advice from any adviser they prefer, even those that are not independent.9 In response to comments that compensation committees should be specifically required to also consider whether an adviser requires a contractual agreement to indemnify the adviser or limit the adviser’s liability, the NYSE MKT noted that it is not apparent that the existence of such indemnification agreements or contractual limitations on liability is relevant to an independence analysis.10

Compensation committees must conduct the independence assessment for any adviser that the committee selects or receives advice from, other than:

  • in-house legal counsel; and
  • any adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the issuer, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular issuer or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice.

In response to comments, the NYSE MKT made it clear that the independence assessment requirement applies to any outside legal counsel consulted by the compensation committee, including any regular outside counsel to the issuer consulted on matters such as SEC filing requirements or federal tax issues associated with equity compensation plans.

In response to a comment expressing concern about the possible need to conduct a new independence assessment before every compensation committee meeting for those advisers that regularly provide advice to the compensation committee, the NYSE MKT indicated that the frequency of the assessment will be a facts and circumstances determination. Specifically, the NYSE MKT noted that “[w]hile an annual assessment may be sufficient in some cases, in other circumstances a more frequent review may be warranted.” In approving the new standards, the SEC noted its expectation that the assessment would be conducted at least annually.

Compensation committee independence. Current listing standards require that executive officer compensation be determined, or recommended to the board for determination, either by a compensation committee comprised solely of independent directors or by a majority of the independent directors. Moreover, the board must affirmatively determine that a compensation committee member is independent under the general board independence standards set forth in Section 803A(2) of the Guide.

Under the new standards, the board must also affirmatively determine that all of the compensation committee members (or all of the independent directors if an issuer does not have a compensation committee) are independent for compensation committee purposes. To make this determination, the board must consider all factors specifically relevant to determining whether a director has a relationship to the issuer that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including:

  • the source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the issuer to the director; and
  • whether the director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.

These factors do not include any specific numerical or materiality tests, and are considerations for the board rather than bright-line standards. For example, the NYSE MKT did not adopt an absolute prohibition on a board making an affirmative independence finding for a compensation committee member solely because the member or any of his or her affiliates are significant stockholders. Although the board must consider the specified factors, it must also identify and consider all additional factors that would be relevant to a compensation committee member’s independence from management. In response to comments, the NYSE MKT confirmed that a single factor or relationship considered in the independence analysis may be sufficiently material to render a director non-independent.

When considering the source of a director’s compensation, the board should consider whether the director receives compensation from any person or entity that would impair his or her ability to make independent judgments about the issuer’s executive compensation. Likewise, when considering any affiliate relationship, the board should consider whether the relationship places the director under the direct or indirect control of the issuer or its senior management, or creates a direct relationship between the director and senior management, in each case of a nature that would impair the director’s ability to make independent judgments about the issuer’s executive compensation.

In response to comments that director fees should be an explicit factor to be considered in compensation committee independence determinations, the NYSE MKT noted that it does not believe that it is likely that director fees would be a relevant consideration for the independence analysis. However, if “excessive” board compensation might affect a director’s independence, the NYSE MKT noted that the listing standards would require the board to consider that factor in its independence determination, as the standards require the board to consider all relevant factors. The NYSE MKT did not indicate what constitutes “excessive” board compensation.

If a compensation committee member ceases to be independent for reasons outside that member’s reasonable control, the member may, with prompt notice by the issuer to the NYSE MKT, remain a compensation committee member until the earlier of (1) the next annual stockholders meeting or (2) one year from the event that caused the member to cease to be independent. This cure provision is limited to situations where the compensation committee continues to have a majority of independent directors.

The NYSE MKT amended its listing standards so that only smaller reporting companies (generally issuers with less than $75 million of public equity float) may rely on the current exception that allows one non-independent director to serve on the compensation committee under exceptional and limited circumstances, even for a director who fails the enhanced compensation committee independence standards. Under the exception, one non-independent director may be appointed to the compensation committee if:

  • the committee consists of at least three members;
  • the non-independent director is not currently an executive officer, employee, or an immediate family member of an executive officer or employee;
  • the board, under exceptional and limited circumstances, determines that the individual’s membership is required by the best interests of the issuer and its stockholders; and
  • the non-independent director serves for no longer than two years.

A smaller reporting company relying on the exception must provide certain disclosures required by NYSE MKT listing standards in the proxy statement for the next annual meeting following the determination (or annual report on Form 10-K if a proxy statement is not required), and any disclosure required by Instruction 1 to Item 407(a) of Regulation S-K regarding reliance on the exception.

Exemptions. The new compensation committee listing standards will not apply to the following issuers that are exempt from the NYSE MKT’s current compensation committee listing standards:

  • controlled companies (i.e., issuers where more than 50% of the voting power is held by an individual, a group or another issuer);
  • limited partnerships (for example, MLPs);
  • companies in bankruptcy;
  • closed-end and open-end funds registered under the 1940 Act;
  • asset-backed issuers and other passive business organizations (for example, royalty trusts);
  • derivatives and special purpose securities; and
  • issuers whose only listed equity security is preferred stock.

Smaller reporting companies are exempt from the new enhanced compensation committee independence and consideration of adviser independence standards. However, these issuers are subject to the other new standards. An issuer that ceases to qualify as a smaller reporting company will have:

  • six months from the date it ceases to be a smaller reporting company to comply with the consideration of adviser independence standard;
  • six months from the date it ceases to be a smaller reporting company to have one member of its compensation committee satisfy the enhanced compensation committee independence standard;
  • nine months from the date it ceases to be a smaller reporting company to have a majority of its compensation committee members satisfy the enhanced compensation committee independence standard; and
  • 12 months from the date it ceases to be a smaller reporting company to have a compensation committee consisting entirely of members that satisfy the enhanced compensation committee independence standard.11

Foreign private issuers may seek an exemption on the basis that they follow home country practice if they comply with the requirements of Section 110 of the Guide.

Transition periods for newly-listed issuers. The current transition periods available to newly-listed issuers apply to the new compensation committee listing standards. Thus, an issuer listing in connection with its IPO must have one independent compensation committee member at the time of listing, a majority of independent members within 90 days of listing, and a fully independent compensation committee within one year of listing.

Click here to read about practical considerations to consider in response to the new compensation committee listing standards.

NASDAQ Compensation Committee Listing Rules

Compensation committee authority and responsibilities regarding its advisers. A compensation committee must have the following authority and responsibilities:

  • the authority, in its sole discretion, to retain or obtain the advice of a compensation consultant, legal counsel or other adviser (collectively referred to throughout the discussion of NASDAQ’s new listing standards as advisers);
  • the direct responsibility for the appointment, compensation and oversight of the work of any adviser retained by the committee;
  • the issuer must provide for appropriate funding (as determined by the committee) for the payment of reasonable compensation to any adviser retained by the committee; and
  • the responsibility to conduct an independence assessment before selecting or receiving advice from an adviser to the committee (as discussed in more detail below under “Assessment of adviser independence”).

For those issuers without a standing compensation committee, until the requirement to have a standing compensation committee is effective (as discussed in more detail below under “Compensation committee composition and independence”) these requirements will apply to the independent directors who determine, or recommend to the board to determine, the compensation of executive officers.

Issuers will need to consider under the corporate law of the state of their incorporation whether to grant by July 1, 2013 the authority and responsibilities discussed above through a charter, board resolution or other board action.

The new authority and responsibilities regarding advisers do not:

  • require the compensation committee to implement or follow its advisers’ advice or recommendations; or
  • affect the ability or obligation of the compensation committee to exercise its own judgment in fulfilling its duties.

Assessment of adviser independence. As noted above and subject to limited exceptions discussed below, before selecting or receiving advice from an adviser (for compensation or non-compensation matters and regardless of who retained the adviser), the compensation committee must consider the following six independence factors:

  • the provision of other services to the issuer by the adviser’s employer;
  • the amount of fees received from the issuer by the adviser’s employer, as a percentage of the employer’s total revenue;
  • the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship between the adviser and a compensation committee member;
  • any issuer stock owned by the adviser (as the SEC noted in its adopting release for Rule 10C-1, it interprets this to include stock owned by the adviser’s immediate family members); and
  • any business or personal relationship between either the adviser or the adviser’s employer and an issuer’s executive officer (as the SEC noted in its adopting release for Rule 10C-1, this would include, for example, situations where an issuer’s CEO and the adviser have a familial relationship or where the CEO and the adviser or the adviser’s employer are business partners).

These factors are considerations for the compensation committee rather than bright-line standards. After considering the six independence factors, compensation committees may select or receive advice from any adviser they prefer, even those that are not independent.12

Compensation committees must conduct the independence assessment for any adviser (including outside legal counsel) that the committee selects or receives advice from, other than:

  • in-house legal counsel; and
  • any adviser whose role is limited to:
    • consulting on any broad-based plan that does not discriminate in scope, terms, or operation, in favor of executive officers or directors of the issuer, and that is available generally to all salaried employees; or
    • providing information that either is not customized for a particular issuer or that is customized based on parameters that are not developed by the adviser and about which the adviser does not provide advice.

In approving the new listing rules, the SEC noted its expectation that the independence assessment would be conducted at least annually.

Compensation committee composition and independence. NASDAQ’s current listing rules require that an issuer’s executive officer compensation must be determined, or recommended to the board for determination, either by:

  • a compensation committee comprised solely of independent directors; or
  • independent directors constituting a majority of the board’s independent directors in a vote in which only independent directors participate.

NASDAQ eliminated the second alternative and by the relevant 2014 compliance date issuers, including smaller reporting companies (generally issuers with less than $75 million of public equity float), must have a standing compensation committee comprised of at least two members. Each compensation committee member must be an independent director (as defined in current Listing Rule 5605(a)(2)), and boards are required to make an affirmative determination that no independent director has a relationship that, in the board’s opinion, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

In addition to satisfying the requirement that each compensation committee member be an independent director, the new rules provide that:

  • each member is prohibited from accepting directly or indirectly any consulting, advisory or other compensatory fee from the issuer or any of its subsidiaries; and
  • the board must consider whether a compensation committee member is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer to determine whether any affiliation would impair the member’s judgment as a member of the compensation committee.

These independence factors do not include any specific numerical or materiality tests. In approving the listing rules, the SEC confirmed that, despite any explicit statement by NASDAQ on the matter, a single factor could disqualify a director from being independent under the enhanced compensation committee independence rules.

Although director fees are not an explicit factor to be considered in compensation committee independence determinations, NASDAQ noted that as boards must make an affirmative independence determination that each independent director has no relationship that would interfere with the exercise of independent judgment in carrying out the responsibilities of a director the board could, if appropriate, consider director fees in that context.13

The enhanced independence rules adopt the same bright-line prohibition against compensatory fees applicable to audit committees. The prohibition does not include a “look-back” period and, therefore, would apply only during a director’s service on the compensation committee. “Compensatory fees” do not include:

  • fees received for board or board committee service; or
  • the receipt of fixed amounts of compensation under a retirement plan, including deferred compensation, for prior service with the issuer (provided that the compensation is not contingent in any way on continued service).

Unlike the prohibition regarding compensatory fees, the rules do not impose a bright-line prohibition on affiliation, but rather impose a requirement to consider such affiliations when making a compensation committee independence determination. Although a board may conclude differently based on the specific facts and circumstances, NASDAQ does not believe ownership of issuer stock by itself, or possession of a controlling interest through ownership of issuer stock by itself, precludes a board from finding that it is appropriate for a director (for example, as a representative of a significant stockholder) to serve on the compensation committee. The board will not be required to apply a “look-back” period and, therefore, need consider affiliation only with respect to relationships that occur during a director’s service on the compensation committee.

Issuers, including smaller reporting companies, may rely on the current exception that allows one non-independent director to serve on the compensation committee under exceptional and limited circumstances, even for a director who fails the new enhanced compensation committee independence rules. Under this exception, one non-independent director may be appointed to the compensation committee if:

  • the committee consists of at least three members;
  • the non-independent director is not currently an executive officer, employee, or a family member of an executive officer;
  • the board, under exceptional and limited circumstances, determines that the individual’s membership is required by the best interests of the issuer and its stockholders;
  • the non-independent director serves for no longer than two years; and
  • the issuer provides certain disclosures required by the listing rules either on its website or in the proxy statement for the next annual meeting following the determination (or annual report if a proxy statement is not required), and the disclosures required by Instruction 1 to Item 407(a) of Regulation S-K regarding reliance on the exception.

If an issuer, including a smaller reporting company, fails to comply with the compensation committee composition requirements due to one vacancy, or one compensation committee member ceases to be independent for reasons beyond that member’s reasonable control, the issuer must regain compliance by the earlier of (1) its next annual stockholder meeting or (2) one year from the event that caused the non-compliance. If the annual stockholder meeting occurs within 180 days after the event causing the non-compliance, the issuer would instead have 180 days from the event to regain compliance. An issuer relying on the cure period must provide notice to NASDAQ immediately upon learning of the event or circumstances that caused the non-compliance.

Committee charter requirements. Issuers must certify that they have adopted a formal written compensation committee charter and that the compensation committee will review and reassess the adequacy of the charter on an annual basis.14 The charter must specify:

  • the scope of the committee’s responsibilities and how it carries out those responsibilities, including structure, processes and membership requirements;
  • the committee’s responsibility for determining, or recommending to the board for determination, the compensation of the issuer’s executive officers;
  • that the CEO may not be present during voting or deliberations by the committee on his or her compensation; and
  • the specific committee authority and responsibilities discussed above under “Compensation committee authority and responsibilities regarding its advisers.”

Smaller reporting companies must adopt either a formal written compensation committee charter or a board resolution that specifies only the matters in the first three bullets above. These issuers are not required to specify the compensation committee authority and responsibilities set forth in the fourth bullet above or to certify that they will review and reassess the adequacy of the charter or board resolution on an annual basis.

Exemptions. The new listing rules do not apply to the following issuers that are exempt from NASDAQ’s current compensation-related listing rules:

  • asset-backed issuers and other passive issuers;
  • cooperatives;
  • limited partnerships (for example, MLPs);
  • management investment companies registered under the 1940 Act; and
  • controlled companies (i.e., issuers where more than 50% of the voting power for the election of directors is held by an individual, a group or another company).

Smaller reporting companies are exempt from the new compensation committee listing rules, except as follows:

  • they must have (and certify that they have and will continue to have) a formal compensation committee comprised of at least two independent members based on the current independent director definition in Listing Rule 5605(a)(2), but not the enhanced compensation committee independence standards; and
  • they must certify that they have adopted a formal written compensation committee charter or board resolution as discussed above under “Committee charter requirements.”

An issuer that ceases to qualify as a smaller reporting company will have six months from the date it ceases to be a smaller reporting company to:

  • comply with the committee authority and responsibilities standards; and
  • certify to NASDAQ that it (1) has adopted a formal written compensation committee charter, including all of the matters specified above under “Committee charter requirements,” and (2) has, or will within the required phase-in schedule,15 comply with the enhanced compensation committee independence standards.

Foreign private issuers that follow their home country practice are exempt from the new listing rules provided that they comply with the disclosure requirements in current Listing Rule 5615(a)(3). In addition, foreign private issuers that follow their home country practice in lieu of having an independent compensation committee as required by NASDAQ listing rules must disclose in their annual reports filed with the SEC the reasons why they do not have an independent compensation committee.

Certification. Issuers must certify to NASDAQ within 30 days after the final implementation deadline applicable to them, on a form to be provided by NASDAQ, that they have complied with the new compensation committee listing rules. Although smaller reporting companies, foreign private issuers and controlled companies are exempt from some or all of the compensation committee listing standards, based on a sample certification form provided by NASDAQ in one of its rule filings these issuers would need to complete and file the required certification form.16

Transition periods for IPO issuers. Although issuers listing in connection with their IPO are subject to the new rules, they can phase-in compliance with the compensation committee composition requirements in accordance with current phase-in schedules. Thus, these issuers must have one independent compensation committee member at listing, a majority of independent members within 90 days of listing and a fully independent committee within one year of listing.

Practical Considerations

NYSE-, NYSE MKT- and NASDAQ-listed issuers and their boards and compensation committees that are subject to the listing standards should consider the following matters. In addition to the following, issuers should not forget to conduct a review of “conflicts of interest” with compensation consultants who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). A new SEC rule requires any such conflicts of interest to be disclosed in proxy statements for meetings involving the election of directors held on or after January 1, 2013.17 As part of this process, issuers should update their director and officer questionnaire to solicit information about the existence of business or personal relationships with compensation consultants and the consultants’ employers and establish policies and procedures for collecting and analyzing information about compensation consultants to determine whether a conflict of interest exists.

By July 1, 2013:

  • Grant required compensation committee authority and responsibilities regarding advisers.
    • NASDAQ- and NYSE MKT-listed issuers should consider under the corporate law of the state of their incorporation whether to grant the new authority and responsibilities to the compensation committee (or, in lieu of such a committee, the independent directors who determine or recommend executive compensation) through a committee charter amendment, board resolution or other board action. Although the authority and responsibilities must be granted by July 1, 2013, NASDAQ-listed issuers are not required to include these matters in their compensation committee charter until 2014 (as discussed below). NYSE MKT-listed issuers are not required to have a compensation committee charter, but must determine how best to grant the required authority and responsibilities by July 1, 2013. Although not required until 2014, NASDAQ-listed issuers with existing compensation committee charters may determine it is best to amend their charters by July 1, 2013 to grant the required authority and responsibilities instead of relying on a board resolution or other board action.
    • NYSE-listed issuers should review their compensation committee charters and amend as necessary to grant the new authority and responsibilities.
  • Conduct adviser independence assessment.
    • Discuss the new listing standards with each existing and potential adviser to the compensation committee, even those advisers retained by management or the issuer, to determine whether an independence assessment is required.
    • As specifically noted by the SEC in its adopting release for Rule 10C-1, establish policies and procedures for collecting and analyzing information about advisers before the compensation committee can select or receive advice from those advisers. Steps issuers could take include (1) collecting information internally on the services provided by advisers, including identifying the individual advisers that perform services for the issuer and such advisers’ employers, and the fees paid for such services, (2) having the advisers complete a questionnaire or requesting specific representations and covenants in the adviser engagement letter to solicit the information necessary for the compensation committee to consider the enumerated factors set forth in the listing standards and any other factors deemed relevant to the compensation committee, and (3) updating the director and officer questionnaire to determine the existence of any business or personal relationship with any adviser to the compensation committee or such adviser’s employer. Ensure that any policies and procedures developed are consistent with the compensation committee charter and other issuer procedures, and that they provide that the required independence assessment is conducted prior to selecting or receiving advice from new advisers and at least annually for existing advisers.
    • For existing advisers to the compensation committee where an independence assessment is required, assess their independence and then schedule the next assessment for that adviser at least annually thereafter. As part of this exercise, boards of NYSE- and NYSE MKT-listed issuers should identify and consider any factors in addition to the six specified factors that would be relevant to an adviser’s independence from management. The listing standards are clear that advisers are not required to be independent if the independence assessment is conducted before selecting or receiving advice from an adviser. However, compensation committees may want to consider whether to adopt a policy that guides their actions if an adviser is not independent.

By the earlier of the first annual meeting after January 15, 2014, or October 31, 2014:

  • Evaluate compliance with enhanced compensation committee independence standards.
    • Update the director and officer questionnaire to address the enhanced compensation committee independence standards.
    • Evaluate the independence of compensation committee members to ensure they satisfy the enhanced compensation committee independence standards. Except for NASDAQ’s absolute prohibition on compensatory fees from the issuer or its subsidiaries, the enhanced independence standards do not impose a prohibition on committee membership if the enumerated independence factors are not satisfied. However, as stockholders and proxy advisory firms may be concerned if any factor is not satisfied boards should carefully consider how they will respond if a member does not satisfy the enumerated independence factors. Issuers may choose to conduct such an evaluation in 2013, and develop contingency plans in the event one or more of the existing compensation committee members would not be deemed independent under the enhanced independence standards (for example, in the case of a NASDAQ-listed issuer if a member receives any compensatory fees from the issuer or its subsidiaries). In such case, issuers should consider updating their 2013 director and officer questionnaire to include, for compensation committee members, questions that solicit the information that will enable the board to conduct an evaluation under the enhanced independence standards.
  • Establish a compensation committee. For NASDAQ-listed issuers without a formal compensation committee, establish a committee in accordance with the new listing rules.
  • Adopt a compensation committee charter. For NASDAQ-listed issuers, adopt a compensation committee charter that complies with the new charter standards or ensure that the existing compensation committee charter complies with the new charter standards.

Provide compliance certification. NASDAQ-listed issuers must certify to NASDAQ within 30 days after the final implementation deadline applicable to them, on a form to be provided by NASDAQ, that they have complied with the new compensation committee listing rules.

1. New York Stock Exchange LLC, Notice of Filing of Amendment No. 3, and Order Granting Accelerated Approval for Proposed Rule Change, as Modified by Amendment Nos. 1 and 3, to Amend the Listing Rules for Compensation Committees to Comply with Securities Exchange Act Rule 10C-1 and Make Other Related Changes, Release No. 34-68639 (Jan. 11, 2013), 78 Fed. Reg. 4570 (Jan. 22, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-01-22/pdf/2013-01106.pdf. The amendments impact Sections 303A.00, 303A.02(a) and 303A.05 of the NYSE Listed Company Manual (Manual). The text of the amended listing standards is included in Exhibit 5 to this NYSE rule filing.

2. NYSE MKT LLC, Notice of Filing of Amendment No. 3, and Order Granting Accelerated Approval for Proposed Rule Change, as Modified by Amendment Nos. 1 and 3, to Amend the Listing Rules for Compensation Committees to Comply with Securities Exchange Act Rule 10C-1 and Make Other Related Changes, Release No. 34-68637 (Jan. 11, 2013), 78 Fed. Reg. 4537 (Jan. 22, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-01-22/pdf/2013-01104.pdf. The amendments impact Sections 110, 801(h), 803A and 805 of the NYSE MKT Company Guide (Guide). The text of the amended listing standards is included in Exhibit 5 to this NYSE MKT rule filing.

3. The NASDAQ Stock Market LLC, Notice of Filing of Amendment Nos. 1 and 2, and Order Granting Accelerated Approval of Proposed Rule Change as Modified by Amendment Nos. 1 and 2 to Amend the Listing Rules for Compensation Committees to Comply with Rule 10C-1 under the Act and Make Other Related Changes, Release No. 34-68640 (Jan. 11, 2013), 78 Fed. Reg. 4554 (Jan. 22, 2013), available at http://www.gpo.gov/fdsys/pkg/FR-2013-01-22/pdf/2013-01107.pdf. The amendments impact compensation committee- and corporate governance-related Listing Rules 5605(d) and 5615, and add new Listing Rule 5605A. The amendments also include conforming amendments to audit and nominations committee-related Listing Rules 5605(c) and 5605(e)(3) and corrections of typographical errors in other listing rules. The text of the amended listing rules is included in Exhibit 5 to this NASDAQ rule filing.

4. Please see our client alert dated October 22, 2012 for a discussion of the listing standard amendments as originally proposed, NYSE, NYSE MKT and NASDAQ Propose Amendments to Compensation Committee Listing Standards.

5. Issuers should remember that pursuant to new Item 407(e)(3)(iv) of Regulation S-K their proxy statements for meetings involving the election of directors held on or after January 1, 2013 must include disclosure of any “conflict of interest” involving compensation consultants (but not other advisers such as lawyers) who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). “Conflict of interest” is not defined, but to determine whether a conflict of interest exists, issuers should use the factors set out in Exchange Act Rule 10C-1(b)(4) relating to adviser independence, which are the same six factors identified in the new NYSE standards.

6. See Letter from Janet McGinness, Exec. Vice Pres., Corp. Sec’y & Gen. Counsel, NYSE Markets, to Elizabeth M. Murphy, Sec’y, SEC (Jan. 10, 2013), availableat http://www.sec.gov/comments/sr-nyse-2012-49/nyse201249-8.pdf.

7. These issuers would also need to update their compensation committee charters to reflect these matters.

8. For the remainder of the discussion of the NYSE MKT’s new listing standards, references to compensation committee are meant to refer to an issuer’s independent directors as a group where the issuer does not have a compensation committee, but instead relies on its independent directors to determine, or recommend to the board for determination, executive officer compensation.

9. Issuers should remember that pursuant to new Item 407(e)(3)(iv) of Regulation S-K their proxy statements for meetings involving the election of directors held on or after January 1, 2013 must include disclosure of any “conflict of interest” involving compensation consultants (but not other advisers such as lawyers) who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). “Conflict of interest” is not defined, but to determine whether a conflict of interest exists, issuers should use the factors set out in Exchange Act Rule 10C-1(b)(4) relating to adviser independence, which are the same six factors identified in the new NYSE MKT standards.

10. See Letter from Janet McGinness, Exec. Vice Pres., Corp. Sec’y & Gen. Counsel, NYSE Markets, to Elizabeth M. Murphy, Sec’y, SEC (Jan. 10, 2013), availableat http://sec.gov/comments/sr-nyse-2012-49/nyse201249-8.pdf. Although no comments were submitted on the NYSE MKT’s proposed listing standards, comments were submitted on the NYSE’s and NYSE Arca’s proposed listing standards. In response to these comments, NYSE Euronext (the parent company of NYSE, NYSE MKT and NYSE Arca) issued one response letter that addressed the comments on behalf of all NYSE exchanges, including NYSE MKT, as the comments raised are in substance applicable to all three proposals. 

11. Any such issuer that does not have a compensation committee must comply with this transition requirement with respect to all of its independent directors as a group.

12. Issuers should remember that pursuant to new Item 407(e)(3)(iv) of Regulation S-K their proxy statements for meetings involving the election of directors held on or after January 1, 2013 must include disclosure of any “conflict of interest” involving compensation consultants (but not other advisers such as lawyers) who had any role in determining or recommending the amount or form of executive and director compensation (subject to certain exceptions). “Conflict of interest” is not defined, but to determine whether a conflict of interest exists, issuers should use the factors set out in Exchange Act Rule 10C-1(b)(4) relating to adviser independence, which are the same six factors identified in the new NASDAQ rules.

13. See Letter from Erika J. Moore, Assoc. Gen. Counsel., NASDAQ Stock Market LLC, to Elizabeth M. Murphy, Sec’y, SEC (Dec. 12, 2012), available at http://www.sec.gov/comments/sr-NASDAQ-2012-109/NASDAQ2012109-9.pdf.

14. NASDAQ also proposed, and the SEC approved, amendments to NASDAQ’s audit committee listing rules that require listed issuers to proactively certify that the audit committee “will review and reassess” the adequacy of the audit committee charter on an annual basis. Current listing rules require the certification to provide that the audit committee “has reviewed and reassessed” the adequacy of the audit committee’s charter on an annual basis. NASDAQ noted that this change is consistent with its current interpretation of the audit committee charter requirements and will harmonize the audit committee charter requirements with the new compensation committee charter requirements.

15. A smaller reporting company that loses that status must comply with the enhanced compensation committee independence requirements as follows: (1) one member in compliance within six months from the date smaller reporting company status is lost, (2) a majority in compliance within nine months from the date smaller reporting company status is lost and (3) all members in compliance within one year from the date smaller reporting company status is lost.

16. See Exhibit 3 to this NASDAQ rule filing for the form of compensation committee certification NASDAQ intends to use.

17. For more information on this SEC disclosure requirement, please see our client alert dated July 9, 2012, SEC Adopts Rules Implementing Dodd-Frank Requirements for Compensation Committees and Compensation Advisers.

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