On November 4, 2003, the Securities and Exchange Commission (SEC) approved listing standards proposed by the New York Stock Exchange (NYSE) and the Nasdaq Stock Market, Inc. (Nasdaq) relating to board composition and director independence. The new listing standards affect the composition of the boards of directors and board committees of listed companies and impact the individual members of the board. The new NYSE rules generally do not apply to closed-end and open-end management investment companies that are registered under the Investment Company Act of 1940, as amended.
Majority of independent board members. The NYSE requires that a majority of the board of directors of a listed company be "independent," unless the company is a "controlled company," a limited partnership, is in bankruptcy proceedings or lists only preferred or debt securities. A controlled company is a company in which more than 50 percent of the voting power is held by an individual, group or another company. Although controlled companies, limited partnerships, companies in bankruptcy proceedings and companies listing only preferred or debt securities are not required to have a majority of independent directors, such companies remain subject to the independent audit committee requirements discussed below. Under the NYSE listing standards, foreign private issuers are not required to have a majority of independent directors on their boards of directors. Foreign private issuers are required, however, to disclose any significant ways in which their home-country practices differ from those followed by a domestic company.
Independent committees. Companies listed on the NYSE are required to establish audit, nominating/corporate governance and compensation committees composed entirely of independent directors. Each of these committees is required to have a formal written charter that includes minimum content requirements as set forth in the new NYSE rules. Foreign private issuers, controlled companies, limited partnerships, companies in bankruptcy proceedings and NYSE companies listing only preferred or debt securities are exempt from the requirement of having nominating/corporate governance and compensation committees, although these companies may be required to comply with the SEC's rules pertaining to audit committees discussed below. While the NYSE listing standards call for each director to be selected through the nominating committee process, if there is a contractual right to nominate a director, the selection and nomination of the director need not be subject to the nominating committee process.
Timetable for compliance. NYSE-listed companies must implement the new requirements by their first annual meeting occurring after January 15, 2004, but no later than October 31, 2004. However, if a company with a classified board is required to change a director who would not normally stand for election in such annual meeting, the company would be permitted to continue such director in office until the second annual meeting after such date, but no later than December 31, 2005. Foreign private issuers have until July 31, 2005, to comply with the new audit committee requirements. Companies listing in conjunction with their initial public offering, or companies listing upon transfer from another market generally would have 12 months after listing to comply with the new requirements, provided that companies transferring from another market with substantially similar requirements would be afforded the balance of any grace period afforded by the other market.
Majority of independent board members. Nasdaq requires that a majority of the board of directors of a listed company be "independent," unless the company is a controlled company (as defined above), a management investment company registered under the Investment Company Act of 1940, or a limited partnership. Although controlled companies and limited partnerships are not required to have a majority of independent directors, such companies remain subject to the independent audit committee requirements discussed below. Nasdaq companies that are foreign private issuers are also required to have a majority of independent directors and comply with the other corporate governance rules generally applicable to other Nasdaq companies. However, Nasdaq has the ability to provide foreign private issuers with exemptions from the corporate governance rules when the provisions of the rules are contrary to a law, rule or regulation of any public authority exercising jurisdiction over such issuer or contrary to generally accepted business practices in the issuer's country of domicile, except to the extent that such exemptions would be contrary to the federal securities laws.
Independent committees. Companies with securities quoted on Nasdaq are required to have audit committees composed entirely of independent directors. The requirements for audit committee composition are discussed below. Nasdaq companies are not required to have nominating or compensation committees. For Nasdaq companies other than controlled companies, limited partnerships and management investment companies, the compensation payable to the company's chief executive officer and other executive officers must be approved either by a majority of the independent directors on the board or a compensation committee comprised solely of independent directors, subject to certain exceptions. Similarly, for these companies, director nominations must be approved either by a majority of the independent directors on the board or a nominating committee composed solely of independent directors, subject to certain exceptions. Where the right to nominate a director legally belongs to a third party (i.e., pursuant to a shareholders agreement), the selection and nomination of directors by independent directors or a nominating committee would not be required.
If a Nasdaq company elects to establish compensation and nominating committees, and those committees have at least three members, then one director, who is not independent under the rules and who is not currently an officer or employee of the company or a family member of such director, may serve on each of those committees, provided that the board determines that such director's membership on the committee is in the best interests of the company, and the company discloses the nature of the relationship and its determination in its next annual proxy statement.
Timetable for compliance. Nasdaq companies must comply with the new rules regarding board composition by the earlier of the company's first annual meeting occurring after January 15, 2004, but no later than October 15, 2004, or, in the case of foreign private issuers and small business issuers, July 31, 2005. A company with a classified board has until its second annual meeting after January 15, 2004, to implement the new requirements relating to board composition, other than the audit committee requirements, if the company would be required to change a director who would not normally stand for election at an earlier annual meeting. Companies listing in conjunction with their initial public offering or transferring from another market, generally have one year to comply, provided that companies transferring from another market with substantially similar requirements would be afforded the balance of any grace period afforded by the other market.
Effect of Independence Requirement
In some cases, existing directors will no longer meet new independence standards for board representation and audit committee membership. This will result in changes to the composition of the boards and committees of certain listed companies. We also may witness some public companies significantly increasing the size of their boards. In addition, directors who meet the new independence standards will likely have to be more involved with the companies on whose boards they sit. This increased involvement may come in the form of more board meetings, additional committee meetings and continuing education.
WHO IS AN "INDEPENDENT" DIRECTOR?
"No material relationship." Under the NYSE listing standards, no director qualifies as "independent" unless the board of directors affirmatively determines that the director has "no material relationship" with the listed company, either directly or as a partner, shareholder or officer of an organization that has a relationship with the company.
Companies must disclose these determinations, and the basis for a determination that a relationship is not material, in their annual proxy statements. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships. The NYSE has noted that ownership of even a significant amount of stock, by itself, should not be a bar to a finding of independence.
Persons who are not independent. A director will not be considered independent under the NYSE listing standards if, within the preceding three years –
- the director is an employee, or whose immediate family member is an executive officer, of the listed company Pursuant to the NYSE listing standards, an "immediate family member" of a person includes the person's spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than domestic employees) who shares such person's home;
- the director receives, or whose immediate family member receives, more than $100,000 per year in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service)
- the director is affiliated with or employed by, or whose immediate family member is affiliated with or employed in a professional capacity by, a present or former internal or external auditor of the listed company
- the director is employed, or whose immediate family member is employed, as an executive officer of another company where any of the listed company's present executives serve on that company's compensation committee
- the director is an executive officer or an employee, or whose immediate family member is an executive officer, of another company that makes payments to, or receives payments from, the listed company for property or services in an amount which, in any single fiscal year, exceeds the greater of $1 million or 2 percent of such other company's consolidated gross revenues.
Transition rule for director independence test. The three-year "look back" provided for in the categories above will begin to apply only from and after November 4, 2004. Until November 3, 2004, only a one-year "look back" will apply. For example, until November 3, 2004, a company need look back only one year when testing whether a director received more than $100,000 in compensation from the company. Beginning November 4, 2004, however, the company would need to look back the full three years. This transition rule, which has been modified from earlier NYSE proposals, will allow certain directors to be deemed independent who otherwise would be presumed to be non-independent if the three-year look back period was applied retroactively from the date of the SEC's adoption of the new listing standards.
No interference with independent judgment. Nasdaq's rules provide that an independent director is a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship that, 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. The company is required to disclose in its annual proxy statement those directors that the board has determined to be independent under the rules. Similar to the NYSE, Nasdaq has stated in its proposed rules that ownership of company stock by itself should not preclude the board from concluding that such shareholder/director is independent.
Persons who are not independent. Under the Nasdaq rules, the following persons are not considered independent:
- a director who is, or at any time during the past three years was, employed by the listed company or by any parent or subsidiary of the listed company
- a director who accepted or has a family member who accepted any payments from the listed company or any parent or subsidiary of the listed company in excess of $60,000 during the current or any of the past three fiscal years, other than the following:
- compensation for board or board committee service,
- payments arising solely from investments in the listed company's securities,
- compensation paid to a family member who is a non-executive employee of the listed company or a parent or subsidiary of the listed company,
- benefits under a tax-qualified retirement plan, or non-discretionary compensation or
- loans permitted under Section 13(k) of the Securities Exchange Act of 1934
- a director who is a family member of an individual who is, or at any time during the past three years was, employed by the listed company or by any parent or subsidiary of the listed company as an executive officer
- a director who is, or has a family member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the listed company made, or from which the listed company received, payments for property or services in the current or any of the past three fiscal years that exceed 5 percent of the recipient's consolidated gross revenues for that year, or $200,000, whichever is more, other than the following:
- payments arising solely from investments in the listed company's securities or
- payments under non-discretionary charitable contribution matching programs
- a director who is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the listed company have served on the compensation committee of such other entity
- a director who is, or has a family member who is, a current partner of the listed company's outside auditor, or was a partner or employee of the listed company's outside auditor who worked on the listed company's audit at any time during any of the past three years.
Unlike under the NYSE listing standards, the Nasdaq rules do not provide any exceptions to the three-year "look back" provided for in the categories above. For example, from and after the effectiveness of the Nasdaq rules, a company would need to look back the full three fiscal years to determine whether a director received more than $60,000 in non-exempt payments from the company.
AUDIT COMMITTEE STANDARDS AND RESPONSIBILITIES
The NYSE and Nasdaq rules require companies to maintain audit committees of at least three members, each of whom must be independent. The standards and responsibilities for audit committees are governed by the Sarbanes-Oxley Act and the SEC rules promulgated thereunder as well as the NYSE and Nasdaq listing standards. At a minimum, audit committees of listed companies are required to comply with the Sarbanes-Oxley Act and the SEC rules and the additional constraints imposed by the exchange or quotation system on which their securities are listed.
Additional Independence Criteria - Sarbanes-Oxley Act and SEC Rules
Fee prohibition. Section 301 of the Sarbanes-Oxley Act and the SEC rule implementing that section prohibit audit committee members of listed companies from accepting, directly or indirectly, any consulting, advisory or other compensatory fees from the company (other than fees for being a director or audit committee member). An indirect payment includes any fees paid to a family member of the director or to an entity in which such director is a partner, member or principal and which provides accounting, consulting, legal, investment banking, financial or other advisory services or any similar services to the company.
Not an "affiliate." An audit committee member of a listed company cannot be an "affiliate" of the company or a subsidiary of the company. The SEC rules define an "affiliate" of a specified person as a person who directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the specified person. The SEC defines "control" - consistent with its other uses of this term in the Exchange Act - as the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract or otherwise.
The SEC deems the following persons to be affiliates of the company: an executive officer, general partner or managing member of an affiliate or a director who is also an employee of an affiliate. Under a safe harbor, the SEC has said that an audit committee member who is not an executive officer, director or shareholder of more than 10 percent of any class of the company's equity securities will not be deemed to control the company and, thus, will not be an "affiliate" of the company.
Additional Independence Criteria - NYSE
Under the NYSE listing standards, subject to certain narrow exceptions, director and committee fees are the only compensation an audit committee member may receive from the company. If an audit committee member simultaneously serves on the audit committee of more than three public companies, and the NYSE-listed company does not limit the number of audit committees on which its audit committee members may serve, then in each case the board must determine that such simultaneous service would not impair the ability of such committee member to serve on the listed company's audit committee and must disclose such determination in the company's annual proxy statement.
Additional Independence Criteria - Nasdaq
Audit committee members of Nasdaq companies must be independent in accordance with the Nasdaq rules and must meet the independence requirements of Section 301 of the Sarbanes-Oxley Act and the SEC rules implementing such provision. In addition, audit committee members must not have participated in the preparation of the financial statements of the company or any current subsidiary of the company at any time during the past three years. A director who meets the independence requirements of Section 301 of the Sarbanes-Oxley Act and the implementing rules thereunder, but who otherwise fails to meet the independence requirements of the Nasdaq rules and is not a current officer or employee of the company, may serve on the audit committee under "exceptional and limited circumstances" for up to two years, but may not serve as the chair of the audit committee.
Financial Literacy Requirement
The NYSE requires that each member of the audit committee be financially literate, as such qualification is interpreted by the company's board in its business judgment, or become financially literate within a reasonable period of time after his or her appointment to the audit committee. Under the Nasdaq rules, all audit committee members must be able to read and understand fundamental financial statements, including a company's balance sheet, income statement and cash flow statement, at the time they are appointed to the committee.
Audit Committee Financial Expert Requirement
SEC rules require each issuer (including non-listed reporting companies) to disclose in its periodic reports whether or not (and if not, the reason) the issuer's audit committee is comprised of at least one member who is an "audit committee financial expert." The SEC defines an "audit committee financial expert" as a person who has an understanding of generally accepted accounting principles in connection with the accounting for estimates, accruals and reserves; experience preparing, auditing, analyzing or evaluating financial statements that present accounting issues generally comparable to those that may arise in the issuer's financial statements; experience with internal controls; and an understanding of audit committee functions.
The NYSE requires that at least one member of the audit committee have accounting or related financial management expertise, as such qualifications are interpreted by the company's board in its business judgment. The NYSE notes that a person who satisfies the SEC test for an "audit committee financial expert" will be presumed to be a person who has accounting or related financial management expertise.
Under the Nasdaq rules, at least one member of the audit committee must have past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background that results in the individual's financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities. Nasdaq has said in commentary that this requirement will be presumed to be met if this individual meets the requirements of an "audit committee financial expert" under the SEC rules.
Responsibilities of the Audit Committee
Under Sections 202 and 301 of the Sarbanes-Oxley Act and the SEC rules implementing those sections, audit committees of listed companies shall -
- be directly responsible for the appointment, compensation and oversight of the company's accounting firm, and the accounting firm must report directly to the audit committee
- pre-approve all auditing services and non-audit services provided to the company by the outside auditor, subject to a de minimis exception for non-audit services of not more than 5 percent of the total amount of revenues paid by the company to the auditor during the fiscal year in which the non-audit services are provided, provided that such services were not recognized by the company at the time of the engagement to be non-audit services and such services are approved by the audit committee prior to the completion of the audit
- 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
- have the authority to engage independent counsel and other advisers as it determines necessary to carry out its duties.
Audit committees have further responsibilities as set forth in the audit committee charter requirements contained in the NYSE and Nasdaq rules. In addition, under the Nasdaq rules, a company's audit committee or a comparable body of the board of directors is required to review and approve all related party transactions.
OTHER RECENTLY ADOPTED NYSE AND NASDAQ RULES ON CORPORATE GOVERNANCE
Executive sessions of non-management or independent directors (NYSE/Nasdaq). The new NYSE listing standards require that non-management directors meet at regularly scheduled executive sessions without management. The NYSE believes these meetings will serve as a check on management and will promote more open discussion among the non-management directors. "Non-management" directors are directors who are not company officers, and includes such directors who are not independent by virtue of a material relationship, former status or family membership, or for any other reason. However, if the group of non-management directors includes a director who is not independent under the rules above, the NYSE has noted that listed companies should at least once a year schedule an executive session including only independent directors. The new Nasdaq rules require the independent directors on the board to conduct regularly scheduled meetings at which only independent directors are present.
Internal audit function (NYSE). NYSE-listed companies must maintain an internal audit function to provide management and the audit committee with ongoing assessments of the company's risk management processes and system of internal control. A company may choose to outsource this function to a third-party service provider other than its independent auditor.
Corporate governance guidelines (NYSE). NYSE-listed companies must adopt corporate governance guidelines and disclose these guidelines on the company's Web site. The guidelines must address the following topics: director qualification standards, director responsibilities, director access to management and independent advisors, director compensation, director orientation and continuing education, management succession and annual performance evaluation of the board.
Code of business conduct (NYSE/Nasdaq). NYSE-listed companies must adopt a code of business conduct and ethics for directors, officers and employees and disclose its code of business conduct on the company's Web site. In addition, companies are required to promptly disclose to shareholders any waivers of the code granted to directors or executive officers. The code must address the following topics: conflicts of interest, corporate opportunities, confidentiality, fair dealing, protection and proper use of company assets, compliance with laws, rules and regulations (including insider trading laws) and encouraging the reporting of any illegal or unethical behavior. Similarly, Nasdaq companies are required to adopt a code of conduct applicable to all directors, officers and employees, and make the code publicly available. The code must comply with the definition of "code of ethics" in Section 406(c) of the Sarbanes-Oxley Act and the rules promulgated by the SEC under that section, and must provide for an enforcement mechanism. Any waivers of the code for directors or executive officers must be approved by the board of directors and, consistent with SEC rules, must be disclosed in a Form 8-K within five days. Nasdaq companies must be in compliance with this new rule by May 4, 2004.
Annual compliance certification (NYSE). The chief executive officer of a NYSE-listed company must certify to the NYSE each year that he or she is not aware of any violation by the company of NYSE corporate governance listing standards. This annual certification must be disclosed in the company's annual report to shareholders or, if the company does not prepare an annual report, in the company's Form 10-K filed with the SEC. In addition, each chief executive officer must promptly notify the NYSE in writing after any executive officer of the company becomes aware of any material non-compliance with any applicable corporate governance listing standards.
Exemptions for foreign private issuers (Nasdaq). Nasdaq companies that are foreign private issuers are required to disclose any exemptions they may receive from Nasdaq's corporate governance listing standards. This rule became effective as of November 4, 2004.
Audit opinions with going concern qualifications (Nasdaq). Nasdaq companies are required to issue a press release disclosing any audit opinions with going concern qualifications within seven days following the filing of the audit opinion in a public filing with the SEC. This rule became effective as of November 4, 2004.