The Treasury Department has proposed draft legislation that would impose more stringent independence standards on compensation committees and their consultants and advisers. The draft legislation would also give shareholders a "say on pay" through a non-binding shareholder vote on executive compensation. The "say on pay" requirement would apply to any public company. The compensation committee independence requirements would apply to any company that is listed on a national securities exchange.

Specifically, the draft legislation would impose the following requirements:

  • Independence standards for compensation committee members of listed companies would be similar to those that apply to audit committee members;
  • Any compensation consultants, legal and other advisers to the compensation committee should also be independent;
  • Compensation committees must have the authority and funding to hire independent compensation consultants and other advisers;
  • If the compensation committee decides not to retain its own independent compensation consultant, it would be required explain that decision to shareholders in the annual proxy;
  • The compensation of executives, and the compensation discussion and analysis (CD&A), of any public company must be submitted to a non-binding shareholder vote each year; and
  • The proxy materials prepared in connection with a merger, consolidation, acquisition or similar transaction must disclose amounts payable to executive officers as a result of or in connection with the transaction and the company must submit such payments to a non-binding vote of the shareholders.

Compensation Committee Independence

Under the draft legislation (which can be found at this link:, each member of the compensation committee for any listed company must be independent. This rule would prohibit compensation committee members from accepting any consulting, advisory or other compensatory fees (other than director fees) from the listed company or from being affiliated with the listed company or any of its subsidiaries.

Comment: An "affiliate" of the company is anyone who controls, is controlled by, or is under common control with the company. Thus, under a technical reading of the draft legislation, a majority shareholder would not be "independent" for this purpose.  

The SEC is authorized to issue rules exempting certain relationships from this prohibition where appropriate.

Comment: The current best practice (and near universal practice, in our experience) is for companies to require that their equity compensation plans be administered by an independent compensation committee. To satisfy independence standards under Section 162(m) of the Internal Revenue Code, a compensation committee member must not be a current employee, must not be a former employee who is still receiving compensation from the company other than under a tax-qualified retirement plan, and must not have been an officer of the company. Moreover, for 162(m) independence purposes, the compensation committee member must not receive any pay, directly or indirectly, from the company. There are de minimus exceptions if the committee member's employer receives no more than 5% of its gross revenues from the company, and if no individual (or his or her firm or company) receives more than $60,000 per year from the company. Independence requirements also apply under SEC Rule 16b-3 and applicable listing standards. Therefore, the committee independence requirement will likely affect only those compensation committees who do not currently meet those independence standards.  

Use of Independent Compensation Consultants and Other Advisers

Under the draft legislation, compensation committees of listed companies would have full authority and discretion to retain independent compensation consultants, legal counsel and other advisers. The compensation committee would be required to retain sole responsibility for the appointment, compensation and oversight of the committee's consultants and advisers. The company is required to fund the compensation committee's advisors at the committee's direction.

The draft legislation would not require a compensation committee to retain independent compensation consultants and advisers but the compensation committee would be required to disclose in the annual proxy whether it has retained and used an independent compensation consultant. If not, the compensation committee must explain why it did not utilize an independent compensation consultant.

In addition, the draft legislation would not require compensation committees to follow or act on the advice and recommendations given by its independent consultants and advisers. The compensation committee would continue to be expected to exercise its own judgment in fulfilling its responsibilities.

The SEC would be required to direct the national exchanges to impose the compensation committee independence standard as a listing requirement within 270 days of enactment of the draft legislation, and to require disclosure as to whether the compensation committee retained independent consultants (and if not, why not) effective for any shareholder meeting occurring one year or more after enactment. The SEC would be authorized to create exemptions to the compensation committee independence standards for certain categories of companies, taking into account the potential impact on smaller listed companies, and to provide a grace period for curing defects.

Comment. Despite the disclaimers that the compensation committee need not actually use independent consultants or follow their advice, the need to explain why in the proxy statement, coupled with the effects of the companion "say on pay" proposals, are likely to make use of independent compensation consultants mandatory as a practical matter.

The legislation appears to impose independence requirements on consultants and advisers "to the compensation committee" if they are engaged for any purpose, not just for advice on executive officer compensation. It is not clear how this would affect other customary compensation committee functions such as oversight of non-executive management incentive programs, management development and succession planning and, at some companies, fiduciary and settlor activities relating to ERISA-regulated benefit plans where the company routinely engages compensation consultants or other advisers. Depending on the specific rules the SEC promulgates as a result of this legislation, it may be advisable to re-think committee structures and charters.

Having two sets of compensation advisors, one for the compensation committee and one for the company, necessarily creates duplicate expenses which may be a significant extra cost for smaller issuers. The extent to which small issuers will be exempted, and the terms of any exemption, remain to be seen.  

Shareholder "Say on Pay"

The draft legislation would also require public companies to provide shareholders with a separate non-binding vote on compensation of executives, including, it appears, on all the compensation tables, the compensation discussion and analysis ("CD&A"), and the compensation committee report recommending that the CD&A be included in the proxy. In addition, if a public company is engaged in a proposed merger, consolidation, sale or other disposition of all or substantially all the company's assets, the proxy materials for such proposed transaction must include a separate non-binding vote of the shareholders to approve any compensation (including deferred or contingent compensation) payable to any executive officer that is based on or relates to the transaction, including golden parachutes ("transaction-based pay").

A shareholder vote on transaction-based pay would be required whether or not the transaction is a "change in control" as traditionally understood. The transaction-based pay is to be disclosed in a "clear and simple" tabular format to be prescribed by the SEC, and accompanied by a discussion and analysis.

Comment: Currently, compensation contingent on a change in control or termination of employment or retirement is not required to be disclosed in tabular format (though many companies have devised a tabular disclosure that is appropriate for their particular programs) because such programs were thought to be too diverse to conform to a prescribed table. The SEC, with two proxy seasons' experience under the current rules, has had an opportunity to observe similarity in transaction-based compensation design, and hopefully will be able to prescribe an appropriate table.  

The draft legislation specifies that any "say-on-pay" vote will be non-binding on the company or its board, is not to be construed as overruling any decision made by the board, and does not create or imply any additional fiduciary duties on the board. It also does not limit shareholders' rights to make proposals regarding executive compensation.

Comment: The stated objective in the draft "say on pay" legislation is to increase dialogue between corporations and shareholders on executive compensation. As a practical matter for many companies, this will likely result in increased dialogue between the corporation and RiskMetrics, or similar proxy voting advisors. The draft legislation is likely to significantly increase the influence of RiskMetrics (and similar organizations) over executive compensation generally.

The NYSE proposed in February 2009 to prohibit brokers from voting shares for directors unless they receive explicit instructions from the owner. Currently brokers vote such shares in their discretion, usually with the management recommendation. If the proposal becomes effective, it could potentially enhance the risk to incumbent directors for say-on-pay.

There is a significant time lag between when a compensation committee adopts a compensation program and when the effect of a negative shareholder vote would be reflected in the annual proxy. Companies with substantial amounts of stock held by activist institutional shareholders may choose to preview major changes in the compensation program with shareholder representatives prior to adopting them.

The role of the compensation committee is also likely to become much more difficult as it will need to balance its desire to meet shareholder concerns with the need to attract and retain capable management.  

Although the draft legislation provides say-on-pay votes will be required with respect to shareholder meetings and transaction votes occurring on or after December 15, 2009, the SEC has twelve months from enactment to promulgate rules and regulations implementing the legislation.