HISTORY OF REGULATIONS ON COMPENSATION COMMITTEES

On July 2, 1992, the SEC proposed substantial changes to its executive compensation disclosure rules (Release No. 33-6940). The most important part of this proposal is the new "Board Compensation Committee Report on Executive Compensation" requiring the compensation committee to disclose its specific rationale for executive compensation and the link between compensation and firm’s performance. The SEC proposed that this report should be included in the

“Management's Discussion and Analysis” section of firm’s financial statements and believed this report would "… bring shareholders into the compensation committee or board meeting room and permit them to see and understand the specific decisions made through the eyes of the directors."

Due to commenters’ strong arguments that this proposal would introduce undue intrusion into firms’

internal affairs and interfere with the functioning of the compensation committee, the SEC finally decided to require specific disclosure with respect to CEO rather than all named executives. In addition, the report has to show the names of all compensation committee members (but signatures are not required) and is required to be included in firms’ proxy statements for annual meeting purposes. The final rules were adopted on October 16, 1992 (Release No. 33-9089). One critical problem with the SEC 1992 reforms is that the subsequent amendments on NYSE and NASDAQ

board compensation report can be issued by the governance or nominating committee if compensation committees do not exist. In addition, there was no formal definition of

“independence” for members of compensation committees. This is the legislative event used in Anderson and Bizjak (2003) and Vafeas (2003).

On February 13, 2002, Harvey Pitt, the then chair of SEC, requested that national exchanges should try to improve their governance listing standards (Press Release 2002-23). In response, the NYSE and the NASDAQ sent their proposed changes to the SEC in August 2002 and October 2002, respectively. The SEC approved these proposals with minor changes on November 4, 2003 (Release No. 34-48745). The main provisions of the final listing standards require all firms must have a majority of independent directors (defined as those who have no directly material relationship with the firm or as a partner, shareholder, or officer of an organization that has a relationship with the firm). Also, the compensation committee, nominating committee, and audit committee shall consist of independent directors and should have written charters that define the obligations of these committees. All audit committee members should be financially literate and at least one member has accounting or related financial management expertise. Finally, non-executive directors must meet regularly to oversee the management. There are three major problems with the amended listing standards. First, they allow for exceptions to the independence requirements if the board has determined that the appointment of an inside director to the nominations and/or compensation committee is in the best interests of the company and the firm has disclosed its determination in the proxy statement or annual report filed with the SEC. This exception condition

provides boards with more flexibility to justify their incompliance with the independence requirements. Second, the NASDAQ listing standards still do not require firms establish compensation committees. Finally, even though the NYSE and NASDAQ have the authority to delist firms that do not comply with their governance requirements (see NYSE Governance Rule 202A, Section 13), they use this penalty only in very extreme case. Chhaochharia and Grinstein

(2009) uses the last problem as the reason to explain their puzzling result that not all firms complied with the exchanges’ amended listing standards but does not discuss the other two problems. This is the legislative event used in Chhaochharia and Grinstein (2009).

Because of the financial crisis during 2008~2009, the Dodd–Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203) was signed into federal law by President Barack Obama on July 21, 2010. Section 952 of the Dodd-Frank Act added Section 10C (titled

“Compensation Committees”) to the Securities Exchange Act of 1934 requiring the SEC to direct the national securities exchanges to change their listing standards on the authority of the compensation committee, the independence of the members of the compensation committee, and the consideration by the compensation committee of specific factors relating to the independence of compensation advisers. On June 20, 2012, the SEC adopted Rule 10C-1 to implement the provisions of the Dodd-Frank Act. Rule 10C-1 explicitly requires each exchange to adopt rules providing that each member of the compensation committee of a listed firm must be a member of the board of directors and must otherwise be independent. In addition, the compensation committee should have authority to retain, appoint, compensate, and oversee compensation advisors, as well as to consider the independence of these outside advisors.² Because the NYSE’s existing standards already require each listed firm to have a separate compensation committee consisting solely of directors who satisfy the NYSE’s general independence requirements, the “enhanced independence”

specified in Rule 10C-1 and the new listing standards require that, in affirmatively determining the independence of any director who will serve on the compensation committee, the board must consider all factors specifically relevant to determining whether a director has a relationship to the firm that is material to that director’s ability to be independent from management in connection

2However, the final listing standards emphasize that nothing in the rules requires a compensation adviser to be independent, only that the compensation committee consider the six factors (i.e., the provision of other services to the listed firm by the person that employs the compensation consultant, counsel or other adviser; the amount of fees the advisor receives from the listed firm as a percentage of the advisor’s total revenue; the advisor’s policies and procedures designed to prevent conflicts of interest; any business or personal relationship of the compensation consultant, counsel or other adviser with a member of the compensation committee; any listed firm stock owned by the consultant, counsel or adviser; and any business or personal relationship of the consultant, counsel or adviser with an executive officer of the listed firm) before selecting or receiving advice from such adviser.

the board should consider at least two relevant factors: (a) the sources of compensation of the director or other compensatory fee paid by the company to the director, and (b) whether the director is affiliated with the company or any of its subsidiaries or their affiliates (see Section 10C(a)(3)).

Therefore, to be considered independent, members of the compensation committees must meet both the general independence criteria already included in the exchanges’ listing standards and the new compensation committee-specific criteria required by the new independence standards. The NYSE and NASDAQ submitted their proposed changes to the SEC on September 25, 2012. Both exchanges later submitted amendments to their proposals and the SEC finally approved the exchanges’ proposals, as amended, on January 11, 2013 (Release No. 34-68639). Companies have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new compensation committee independence requirements. These final listing standard changes reflect the latest development in an on-going campaign from all sides (e.g., Congress, the SEC, exchanges, proxy advisers, and shareholders) to hold corporate boards more accountable for their compensation-related procedures and decisions (Poerio et al. 2013). This is the legislative event used in this study.

The main provisions of the 2013 final listing standards are as follows:

(1) The firm’s compensation committee is required to:

(a) be comprised solely of independent directors;

(b) have the authority to retain compensation advisers; and

(c) consider independence factors in selecting not only compensation consultants but also any other advisers, including outside legal counsel.

(2) The firm’s board of directors should affirmatively assess the independence of compensation committee members considering all relevant factors.

(3) The compensation committee must have a formal written charter reflecting the committee’s responsibilities (e.g., structure, processes, and membership requirements, determination of compensation of CEO and all other executive officers).

(4) Special considerations to compensation committee advisors:

(a) the compensation committee may, in its sole discretion, retain or obtain advice of a compensation consultant, independent legal counsel or other adviser;

(b) the compensation committee is directly responsible for the appointment, compensation, and oversight of the work of any such adviser;

(c) the company must provide appropriate funding, as determined by the compensation committee, for payment of reasonable compensation to any such adviser; and

(d) in selecting any adviser, the compensation committee must take into consideration all factors relevant to that person’s independence from management.

(e) Compensation committee is not required to follow the advice of any such adviser.

Obviously, the above discussions indicate that the SEC’s 1992 final rules focused on the mandatory disclosure of CEO compensation and required the compensation committees to issue a report explaining how they determine executive pays and whether such pays are linked to firms’

performance. On the other hand, even though SOX and subsequent amendments in the NYSE and NASDAQ listing standards required that compensation committees be composed of independent directors, firms may use the exception conditions specified in the standards to justify their noncompliance decisions. Also, some firms may simply decide not to comply with the standards because the NYSE seldom penalized them for noncompliance (Chhaochharia and Grinstein 2009).

Due to these reasons, it appears that the association between these legislative events and compensation committee independence is not as straightforward as it might seem. Therefore, Anderson and Bizjak’s (2003) and Chhaochharia and Grinstein’s (2009) finding that there is no association between compensation committee independence and CEO compensation may not be valid. Different from these early legislations, the NYSE and NASDAQ 2013 independence standards aim directly at enforcing the independence of compensation committees. I thus argue that these new independence standards create a much stronger association between a legislative event and compensation committee independence. This provides a good opportunity to examine whether compensation committee independence affects CEO compensation and turnover.