SEC Expected to Approve Final Nasdaq Corporate Governance Standards


Summary

On October 9, 2003, The Nasdaq Stock Market, Inc. filed an amendment to its proposed listing standards concerning director independence and other corporate governance matters with the SEC. As a general rule, listed companies will need to be in compliance with the new rules prior to their 2004 annual shareholders meeting.

Although widely expected to be in final form at this time, the proposals must be approved by the SEC before becoming final, and the SEC could require further revisions. This Advisory is based on the text submitted for SEC approval by Nasdaq, which is available at http://www.nasdaq.com/about/ProposedRuleChanges.stm. The key requirements are as follows:

  • Nasdaq-listed companies must have a majority of their board of directors comprised of independent directors.
  • Independent directors must meet separately on a regular basis outside of the presence of management.
  • Boards of directors must make affirmative determinations as to which directors are "independent," and the rules set out some detailed categories of relationships that would preclude a finding of independence.
  • Executive compensation and director nominations must be determined either by a majority of the independent directors or by committees comprised solely of independent directors.
  • Companies must have audit committees comprised of directors who meet the Nasdaq standards for independence as well as meet two additional requirements imposed by SEC rules: (i) not having received any payments from the company and (ii) not being an "affiliate" of the company.
  • Audit committees must be delegated certain additional authority and responsibilities, including giving the audit committee direct responsibility for overseeing the outside auditors, making the audit committee responsible for adopting "whistleblower" procedures to identify potential problems with accounting or auditing matters and granting the audit committee explicit authority to engage outside advisors. Majority Independent Board and Executive Sessions

Majority Independent Board and Executive Sessions

Majority Independent Board

A central premise of the reforms implemented by these new rules is that "independent" directors play a critical role in guarding against conflicts of interest and ensuring that a board of directors discharges its responsibilities in a manner consistent with its duties to shareholders. In furtherance of that objective, the rules require that independent directors comprise a majority of the board of directors of every Nasdaq-listed company other than "controlled companies" as described below.

Executive Sessions

To encourage and enhance communication among the independent directors, the new rules require that these independent directors have regularly scheduled "executive session" meetings at which only independent directors are present. While Nasdaq did not address the responsibilities and structure of these executive sessions (e.g., how the agenda is determined or who presides at the meetings), Nasdaq did recommend that these executive sessions occur at least twice per year, and perhaps more frequently, in conjunction with regularly scheduled meetings of the full board of directors.

Grace Period for Noncompliance

A company which fails to have a majority independent board due to one vacancy, or one director ceasing to be independent due to circumstances beyond its reasonable control, must regain compliance by the earlier of the company's next annual shareholder meeting, or one year from the event causing the non-compliance. Companies must provide Nasdaq with notice immediately upon learning of the event or circumstance that caused non-compliance.

Director Independence

General

Under Nasdaq's new rules, a director may be considered independent if he or she is not an officer or employee of the listed company or its subsidiaries and he or she does not have a relationship, which, in the opinion of the company's board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. As a result, the board of directors must evaluate each of its members and make an affirmative determination whether the member qualifies as independent under this standard. Companies must disclose which directors its board has determined to be independent in their annual proxy statements (or, if no proxy statement is filed, in its Form 10-K or 20-F).

To promote greater transparency and consistency in the application of the independence standard, the rules specify categories of individuals that are precluded from qualifying as independent. These categories are intended to be clear and objective standards; boards may not waive their application to any director. On the other hand, even if a director does not fit into a precluded category, he or she must still be affirmatively determined to be independent by the board. In evaluating a director's independence, Nasdaq has stated that ownership of company stock, by itself, is not sufficient to preclude a finding of independence. Thus, absent other relationships bearing on his or her independent judgment, a significant investor or venture capitalist could qualify as independent. These individuals may not, however, be eligible for membership on an audit committee, because, in addition to this general Nasdaq independence standard, audit committee members must satisfy some additional requirements to qualify as independent, which are discussed below under the heading "Rules Relating to Audit Committees."

Precluded Categories

Individuals that fit within one of the following categories are precluded from being considered independent:

  • Employees, Former Employees and Family Members. Directors who, at any time during the past three years, were employed by the company or any parent or subsidiary or who had a "Family Member" employed as an executive officer by the company or its parent or subsidiaries. For these purposes, "Family Member" includes a person's spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person's home; "executive officer" is intended to be consistent with the definition already in use under Section 16; and "parent or subsidiary" is intended to pick up entities the company controls and consolidates with its financial statements.

  • Payments in Excess of $60,000. Directors who have accepted, or who have a "Family Member" who accepted, any payments from the company or any parent or subsidiary in excess of $60,000 during the current or any of the past three fiscal years, other than:

    • compensation for board or board committee service;
    • payments arising solely from investments in the company's securities;
    • compensation paid to a "Family Member" who is a non-executive employee of the company or a parent or subsidiary;
    • benefits under a tax-qualified retirement plan or non-discretionary compensation; or
    • loans permitted under Section 13(k) of the Exchange Act, which is the statutory provision implementing the Sarbanes-Oxley ban on loans to corporate insiders.

    The category is intended to cover situations in which a payment is made directly to, or for the benefit of, a director or his or her Family Member. For example, this category covers consulting or personal service contracts or political campaign contributions.

  • Business or Charitable Relationships. Directors who are, or who have a "Family Member" who is, a partner (other than a limited partner) in, or a controlling shareholder or an executive officer of, any organization (including a charitable organization) to which the company made, or from which the company received, payments for properties or services (or charitable contributions) in the current or any of the past three fiscal years that exceed 5% of the recipient's consolidated gross revenue for that year, or $200,000, whichever is more, other than:

    • payments arising solely from investments in the company's securities; and
    • payments under non-discretionary charitable contribution matching programs.

    Even if the director does not fit into this precluded category, Nasdaq indicated that independence issues could be raised in situations in which a director or their Family Member and the company each have a relationship with the same charity.

    Nasdaq acknowledged that, in exceptional circumstances, such as when a director has direct significant business holdings, it may be appropriate to assess the director's independence under this test rather than the test for direct payments described immediately above. Companies which believe they have exceptional circumstances of this sort should contact Nasdaq to discuss the appropriate analytical framework for their particular facts.

  • Interlocking Compensation Committees. Directors who are, or who have a "Family Member" who is, employed as an executive officer of another entity if, at any time during the past three years, an executive officer of the listed company served on the compensation committee of such other entity.

  • Auditors. Directors who are, or who have a "Family Member" who is, a current partner of the company's outside auditor, or was a partner or employee of the company's outside auditor who worked on the company's audit at any time during the past three years.

  • Investment Companies. In lieu of the foregoing list of precluded categories, a director of an investment company will be precluded from being considered independent if the director qualifies as an "interested person" as defined in Section 2(a)(19) of the Investment Company Act of 1940, other than in a director's capacity as a member of the board or any board committee.

Oversight of Executive Compensation

General

In recognition of the need for independent oversight of executive compensation, the new Nasdaq rules formalize the role of independent directors in the process for determining the compensation of listed companies' executives.

The rules require that the compensation of the chief executive officer and all other executive officers be determined, or recommended to the full board of directors for determination, by either

  • a majority of independent directors, or
  • a compensation committee comprised solely of independent directors.

The CEO may not be present during voting or deliberations with respect to the determination of his or her compensation, though he or she could be present during the deliberations relating to the compensation of other executives.

Limited Exception for Non-Independent Directors

Under the Nasdaq rules, one director who does not qualify as independent may serve on the compensation committee under exceptional and limited circumstances if the following conditions are satisfied:

  • the compensation committee has at least three members;
  • the non-independent director is not a current officer or employee or a Family Member of an officer or employee of the company;
  • the board determines that such individual's membership on the committee is required by the best interests of the company and its shareholders;
  • the board discloses, in the proxy statement for the next annual meeting after such determination, the nature of the relationship and the reasons for the determination (or, if no proxy statement is filed, in its Form 10-K or 20-F); and
  • the non-independent director does not serve on the compensation committee for more than two years.

Oversight of Director Nomination Process

General

The Nasdaq rules require that directors be nominated, or recommended to the full board of directors for nomination, by either

  • a majority of independent directors, or
  • a nominations committee comprised solely of independent directors.

Written Charter/Board Resolutions

Each company must also certify that it has adopted a formal written charter or board resolutions, as applicable, addressing the nominations process and such related matters as may be required under the federal securities laws.

Limited Exception for Non-Independent Directors

Under the Nasdaq rules, one director who does not qualify as independent may serve on the nominations committee under exceptional and limited circumstances if the following conditions are satisfied:

  • the nominations committee has at least three members;
  • the non-independent director is not a current officer or employee or a Family Member of an officer or employee of the company;
  • the board determines that such individual's membership on the committee is required by the best interests of the company and its shareholders;
  • the board discloses, in the proxy statement for the next annual meeting after such determination, the nature of the relationship and the reasons for the determination (or, if no proxy statement is filed, in its Form 10-K or 20-F); and
  • the non-independent director does not serve on the nominations committee for more than two years.

Right to Appoint a Director Held by Third Party

The new rules do not require independent director participation in the selection and nominations process if the right to nominate a director legally belongs to a third party, for example, if investors have negotiated a right to appoint one or more directors; if preferred stockholders have a right to nominate or appoint directors following defaults; or if a shareholders' agreement to which the company is a party allocates the right to nominate some directors. Even in these situations, however, companies are not exempted from the requirement to have a majority independent board, or to have an audit committee and, if applicable, a compensation and nominations committee, that satisfy the new rules.

Pre-Existing Noncompliant Nomination Structure

Similarly, companies are exempt from complying with the rules governing the nominations process if the company is subject to a binding obligation that requires a director nomination structure inconsistent with the rule and such obligation was in effect prior to these new rules.

Rules Relating to Audit Committees

Nasdaq's new listing standards also enhance the rules applicable to audit committees. Some of these new rules have been adopted to implement the requirements of Section 301 of the Sarbanes-Oxley Act of 2002.

Audit Committee Composition

Each listed company must have an audit committee of at least three members, each of whom must:

  • meet the general Nasdaq standards for independence described under "Director Independence" above;
  • satisfy two additional requirements for independence of audit committee members set forth in the Sarbanes-Oxley Act and implemented in SEC Rule 10A-3(b)(1), which generally requires that a director (i) have received no payments from a company other than in connection with board service, and (ii) not be an affiliate of the company;
  • not have participated in the preparation of the financial statements of the company or any subsidiary at any time during the past three years; and
  • be able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement at the time such member joins the board.

Companies are also required to certify that they have, and will continue to have, at least one member of the audit committee who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual's financial sophistication, including being or having been a CEO, CFO or other senior officer with financial oversight responsibilities. Individuals who qualify as "audit committee financial experts" under SEC rules are presumed to meet this standard for financial sophistication.

Relationship of Nasdaq and SEC Audit Committee Independence Requirements

SEC rules supplement Nasdaq's independence requirements by adding two additional requirements to be satisfied for audit committee members to be considered independent. As a result, directors who meet the general Nasdaq independence requirements may nevertheless be ineligible to serve on the audit committee. The SEC rules impose two basic audit committee member independence requirements:

  • No Compensatory Fees. Audit committee members may not accept, directly or indirectly, any consulting, advisory or other compensatory fees from the company or any subsidiary of the company, other than (i) for service as a member of the board of directors and any board committee, (ii) fixed retirement payments or deferred compensation for prior service with the company that is not contingent in any way on continued service or (iii) dividends or other payments on account of securities owned by a committee member, if they are made to all shareholders as a class. This prohibition precludes payments to a committee member as an officer or employee. There is no de minimus exception to this requirement.

    "Indirect" compensatory payments include payments to spouses, minor children or stepchildren, or children or stepchildren sharing a home with the member. In addition, indirect payments include those made to an entity in which the audit committee member is a partner, member, an officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (but not limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity) and which provides accounting, consulting, legal, investment banking or financial advisory services to the company or any of its subsidiaries.

  • No Affiliated Persons. A member of the audit committee of a company other than an investment company may not be an "affiliate" of the company or any subsidiary due to any relationship (including stock ownership) other than his or her capacity as a member of the board and any board committee of the company. The SEC's rules specifically provide that an executive officer, a director who is also an employee, a general partner or a managing member of an entity that is an affiliate of the listed company will be deemed to be an affiliate of the company for purposes of the audit committee independence rules. In lieu of this requirement, a director of investment company must not be an "interested person" as defined in Section 2(a)(19) of the Investment Company Act of 1940.

    One effect of this requirement under the SEC's standard "control" test for affiliate status is to disqualify from membership on the audit committee representatives of significant shareholders. To assist in the application of the "control" test, the SEC adopted a safe harbor, which provides that a person who is not an executive officer or the direct or indirect beneficial owner of 10% or more of any class of voting equity securities of the listed company or of an entity that controls, is controlled by or is under common control with the listed company will be deemed not to be an affiliate for the purposes of this rule. Whether or not a director who is not an executive officer but beneficially owns (directly or indirectly) more than 10% of the listed company's voting equity securities is an affiliate must still be analyzed based on a review of all relevant facts and circumstances.

    Unlike the new Nasdaq standards, there are no "look-back" periods under the SEC's additional independence requirements; these prohibitions apply only to current relationships between the audit committee member and the listed company. The requirements of the SEC rules are intended to be clear and objective; there is no exception from the application of these requirements, and the SEC rules specifically prohibit the Nasdaq from granting ad hoc exemptions and waiver.

Exceptional and Limited Circumstances Exception

One director, who is not independent under the general Nasdaq independence rules but who meets the two specific requirements applicable to audit committee members in the SEC Rules and who is not a current officer or employee or a Family Member of an officer or employee, may be appointed to the audit committee if the board, under exceptional and limited circumstances, determines that such individual's membership on the committee is required by the best interests of the company and its shareholders, and the board discloses, in the proxy statement for the next annual meeting after such determination, the nature of the relationship and the reasons for the determination (or, if no proxy statement is filed, in its Form 10-K or 20-F). A member appointed under this exception may not serve more than two years and may not chair the audit committee.

Audit Committee Responsibilities and Authority

To enhance the effectiveness of audit committees in carrying out their responsibilities, the new rules supplement the existing requirements for audit committees to expressly require that audit committees have the specific responsibilities and authority necessary to comply with SEC rules relating to audit committees adopted in April 2003 pursuant to the Sarbanes-Oxley Act. The SEC rules require that:

  • the audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of the company's auditors and the company's auditors must report directly to the audit committee;

  • the audit committee must establish procedures for:
    • the receipt, retention and treatment of complaints received by the company regarding accounting, internal accounting controls or auditing matters; and
    • the confidential, anonymous submission by employees of the company of concerns regarding questionable accounting or auditing matters;
    • the audit committee must have authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties; and

  • the company must provide for appropriate funding, as determined by the audit committee, for payment of:
    • compensation to the company's auditors;
    • compensation to any advisers engaged by the audit committee; and
    • ordinary administrative expenses of the audit committee that are necessary or appropriate in carrying out its duties.

Additional Responsibilities for Investment Companies

In addition to the foregoing requirements, Nasdaq requires the audit committee for an investment company to establish procedures for the confidential, anonymous submission of concerns regarding questionable accounting or auditing matters by employees of the investment adviser, administrator, principal underwriter, or any other provider of accounting-related services for the investment company, as well as employees of the investment company.

Audit Committee Charter

The new rules amend the existing rules concerning the content of audit committee charters to require a statement that the committee's purpose is to oversee the company's accounting and financial reporting process and the audits of the company's financial statements and add to the existing rules on the responsibilities and authorities of audit committees a requirement to include the responsibilities and authorities required by the SEC rules that are described above.

Cure Periods for Non-Compliance

If a company's audit committee fails to comply with the SEC and Nasdaq rules governing audit committee composition because one member ceases to be independent for reasons outside that member's reasonable control, that member may remain on the audit committee until the earlier of the company's next shareholders meeting or one year from the event causing the non-compliance.

If a company's audit committee fails to comply with the Nasdaq rules governing audit committee composition because of one vacancy on the committee, but the committee continues to comply with the SEC rules and the company is not using the "exceptional and limited circumstances" exemption for a non-independent director or the grace period described in the preceding paragraph, the company has until the earlier of its next shareholders meeting or one year from the event causing the non-compliance to regain compliance.

If a company wishes to avail itself of either of the foregoing grace periods, then it must notify Nasdaq immediately upon learning of the events causing non-compliance.

Prompt Notice of Non-Compliance with Corporate Governance Rules

The new rules require that listed companies must provide Nasdaq with prompt notification after an executive officer becomes aware of any material noncompliance with the requirements of the qualitative Nasdaq listing standards.

Effective Dates

Generally, listed companies must be in compliance with these new rules by the earlier of: (i) the company's first annual shareholders meeting after January 15, 2004, or (ii) October 31, 2004. Thus, listed companies will need to be in compliance with the new rules prior to their 2004 annual shareholders meeting. Companies with a staggered board may have an additional year to comply with the new rules other than those related to audit committees. If the new rules would require a company with a staggered board to change a director who would not normally stand for election prior to 2006, the company has until its second annual meeting after January 15, 2004, but not later than December 31, 2005, to be in compliance. Prior to the effective date, listed companies will need to continue to comply with Nasdaq's existing audit committee rules.

Foreign private issuers and small business issuers have until July 31, 2005 to be in compliance with the new rules.

Application to Certain Companies

Controlled Companies

"Controlled Companies" are exempt from the these new rules. A "controlled company" is a company of which more than 50% of the voting power is held by an individual, a group or another company. For a group to hold control, the members of the group must have filed public notice, for example a Schedule 13D, that they are acting as a group. If a company determines that it qualifies as a controlled company, then it must disclose that determination and its basis for reaching that conclusion in its annual meeting proxy statement (or, if no proxy statement is filed, in its Form 10-K or 20-F). Despite the foregoing, controlled companies are still required to comply with the requirement that independent directors meet regularly in executive session and the rules relating to audit committees.

Initial Public Offerings

Companies listing on Nasdaq in connection with their IPO will have a grace period to come into compliance with the corporate governance rules. For each committee that it adopts, the company must have one independent member at the time of listing, a majority of independent members within 90 days of listing and the committee must be fully independent within one year. Companies that do not adopt compensation or nomination committees will have 24 months from initial listing to comply with the majority independent board requirement. Investment companies are not eligible for this grace period in connection with an initial listing.

Transferees from Other Markets

Nasdaq will allow any company transferring from another market with a substantially similar requirements to have the balance of any grace period under the other market's rules. Companies transferring from markets without a substantially similar requirement will have one year from its date of listing on Nasdaq to be in compliance.

Foreign Private Issuers

In general, foreign private issuers must comply with all of Nasdaq's new corporate governance rules. However, Nasdaq has the ability to grant exemptions from provisions of the new rules for specific companies when the provisions are contrary to a law, rule or regulation of any public authority exercising jurisdiction over the company or contrary to generally accepted business practices in the company's home country, except to the extent that exemptions would be contrary to federal securities laws, including the SEC rules relating to audit committees. Foreign private issuers that receive such an exemption must disclose the exemption in their annual report and describe the home country practice on the particular subject.

Management Investment Companies

Management investment companies (open-end and closed-end funds) are exempt from most of the new corporate governance rules, though these entities must comply with the rules relating to audit committees. Other investment companies, including business development companies, however, must generally comply with all of the new corporate governance rules.

Asset-backed Issuers and Other Passive Issuers

These new corporate governance rules do not apply to asset-backed issuers and issuers that are organized as trusts or other unincorporated associations that do not have a board of directors or persons acting in similar capacity and whose activities are limited to passively owning or holding securities, rights, collateral or other assets on behalf of or for the benefit of the holders of the listed securities.

Cooperatives

Cooperative entities, such as agricultural cooperatives, that are structured to comply with relevant state law and federal tax law and that do not have a publicly traded class of common stock are exempt from the bulk of the new rules, though these entities must comply with the rules relating to audit committees.


The Corporate Governance, Securities Litigation and M&A attorneys at Goodwin Procter keep current on these matters. We are available to help advise public companies and their officers and directors on specific issues as well as to provide educational presentations to help them understand and meet their responsibilities under both current and proposed rules and regulations. Please contact us either directly or through your regular Goodwin Procter contact if we may be of assistance.

Joseph L. Johnson IIIjmatarese@goodwinprocter.com617.570.1633
John R. LeClairejleclaire@goodwinprocter.com617.570.1144
L. Kevin Sheridan Jr.lsheridan@goodwinprocter.com212.813.8874

John T. Haggerty contributed to the preparation of this Advisory.

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