SEC Expected to Approve Final NYSE Corporate Governance Listing Standards

Summary

Completing a process that began in June 2002, the SEC is expected to approve the New York Stock Exchange's new corporate governance listing standards. This Advisory discusses the proposed standards as published by the NYSE on October 9, 2003. In most cases, listed companies must comply with the new standards in time for their 2004 annual meeting. The key requirements are as follows:

• a majority of the board of directors must be independent
• non-management directors must meet regularly without management present
• the audit committee must meet requirements in addition to those established by the SEC
• listed companies must maintain an internal audit function
• listed companies must maintain compensation and nominating/corporate governance committees composed entirely of independent directors
• corporate governance guidelines must be adopted and disclosed
• a code of business conduct and ethics must be adopted and disclosed

The determination of which directors are "independent" reflects significant changes from earlier versions of the proposed NYSE standards. In particular, the NYSE has modified the "look-back" and transition periods so that conditions or relationships pre-dating the effective date of the new standards must be taken into account, with the look-back period being one year for the first year of effectiveness and three years thereafter. The NYSE has also clarified the objective conditions that would disqualify a director from being independent.

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On October 9, 2003 the NYSE published a second revision of its proposed amendments to its corporate governance listing standards. The NYSE published its original amendments in August 2002 and then revised that proposal in April 2003. The October 2003 NYSE proposals are expected to be the last revision to be published before the SEC approves amended NYSE and Nasdaq corporate governance requirements. This Advisory is based on the NYSE's October filing, but the SEC has not yet approved the final text, so further changes are possible. The NYSE filing is available at http://www.nyse.com/pdfs/amend2-10-08-03.pdf.

The new listing standards will generally apply to all companies with listed common equity securities. There are exceptions for controlled companies, companies with only listed preferred stock or debt securities, and foreign private issuers. There are also exceptions and some differences in effective dates for limited partnerships, closed-end and open-end funds, business development companies and companies in bankruptcy that are not summarized in this Advisory.

Significant Change in Look-Back Periods

For many listed companies, the most significant change from earlier NYSE proposals will be the phase-in of the independence tests to include transactions and relationships in years prior to the effectiveness of the new NYSE standards. The revised NYSE proposal published in April 2003 would have phased in a five-year look-back for independence over five years, and therefore would never have applied to transactions and relationships in years before the NYSE standards became effective. The NYSE has shortened the look-back period to three years, but has also revised this provision so that the independence tests have a one year look-back during the first year after the standards are approved by the SEC, with the full three-year look-back period becoming effective after the end of that first year. The look-back and transition periods are described in greater detail below. The NYSE transition provisions do not extend the compliance date for the NYSE and SEC requirements that apply to audit committees and members, which are summarized later in this Advisory.

Effective Dates

With the exception of a transition period described below for the look-back period for testing director independence, listed companies must comply with the amended NYSE listing standards by the earlier of (i) their first annual meeting that occurs after January 15, 2004 or (ii) October 31, 2004. Currently applicable NYSE listing standards remain in force until the effective date of the amended standards.

Companies with a staggered board of directors have an additional year to deal with directors who are not scheduled to stand for election in 2004 when complying with the requirement that independent directors comprise at least a majority of the company's directors. As a result, these companies can manage the recruitment of additional independent directors over a two-election cycle, rather than immediately. This additional transition period, however, does not apply to the special requirements for audit committee members. This one-year transition period, combined with the phase-in of the three-year look-back and the special requirements for audit committee members, may require careful evaluation and planning by listed companies whose directors serve staggered three year terms.

Board Independence Requirements

A Majority of the Board of Directors Must Be Independent

A listed company's board of directors must affirmatively determine that directors comprising at least a majority of the company's board have no direct or indirect material relationship with the company or any of its consolidated subsidiaries. In determining whether a director is independent, a board must consider all relevant facts and circumstances. The commentary to the listing standards indicates that the analysis must include not only the director personally, but any persons or organizations with which the director is affiliated. This would include family and charitable relationships as well as commercial, financial, consulting, legal and accounting relationships, among others. Ownership of the company's stock, however, is not itself a disqualifying relationship, even if the director owns a significant amount. Listed companies must also consider the new NYSE standards and SEC rules (discussed in the "Audit Committees" section below) that apply additional independence criteria to members of the audit committee.

Companies must disclose the basis for these determinations in their proxy statements each year. If the company does not file a proxy statement, it must include this disclosure (and the other disclosures required elsewhere in the new listing standards) in its annual report on Form 10-K.

Instead of making these determinations subjectively on a case-by-case basis, boards may adopt and disclose objective categorical standards for independence. If a board does so, the company must disclose the standards and make a general disclosure that the independent directors meet the standards, but the amount of required disclosure relative to determinations for individual directors would be reduced. If the board determines that a director who does not meet the listed company's categorical standards is nevertheless independent, the company must disclose the specific basis for that determination. It is too early to say whether use of categorical standards will become prevalent.

Disqualifying Conditions

In addition to the general requirement that the Board determine that each independent director has no material relationship with the company, the new listing standards include five "bright line" conditions that disqualify a director from being independent. Boards are not allowed to waive these disqualifying conditions.

In each case, these disqualifying conditions apply not only to the director, but also to any immediate family member of the director. "Immediate family member" means a 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. When applying the look-back provisions in the bright-line tests, listed companies need not consider individuals who are no longer immediate family members as a result of legal separation or divorce, or those who have died or become incapacitated. In addition, references to the "company" would include any parent or subsidiary in a consolidated group with the company.

Under the final listing standards, a director is disqualified from being independent for a period of three years after the condition ceases to exist, rather than the five-year period originally proposed by the NYSE. The disqualifying conditions include:

• Employment. A director who is an employee, or whose immediate family member is an executive officer, of the company is disqualified until three years after the end of the employment relationship. This disqualification does not apply to directors who serve as an interim chairman or CEO.
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• Compensation Other Than Board Fees or Pensions. A director who receives, or whose immediate family member receives, more than $100,000 per year in direct compensation from the company is not independent until three years after the person ceases receiving more than $100,000 compensation per year. This disqualification does not apply to (i) fees for Board and committee service or (ii) pension and other forms of deferred compensation for prior service that are not contingent on continued service.
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• Auditor Affiliation. A director who is employed by or affiliated with, or whose immediate family member is in a professional capacity employed by or affiliated with, a present or former internal or external auditor is disqualified until three years after the end of the employment, affiliation, or auditing relationship.
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• Compensation Committee Interlocks. A director who is employed, or whose immediate family member is employed, as an executive officer of another company where any of the listed company's current executives serve on the other company's compensation committee is disqualified until three years after the end of that service or the employment relationship.
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• Business Relationships. A director who is an executive officer or employee, or whose immediate family member is an executive officer, of a company that makes payments to or receives payments from the listed company for property or services in a single fiscal year that exceed the greater of (i) $1 million or (ii) 2% of the other company's (i.e. the director's or family member's employer's) consolidated gross revenues is disqualified until three years after any payments fall below these thresholds. This test applies only to the financial relationship between the listed company and the director's (or family member's) employer. Charitable organizations are not "companies" for purposes of this test, but a listed company must disclose in its proxy statement any charitable contributions made by the company to any charity in which a director serves as an executive officer if contributions during any one of the three preceding fiscal years exceeded the greater of $1 million or 2% of the charity's consolidated gross revenues.
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Non-Management Meetings of Directors

Non-management directors must hold regularly scheduled executive sessions without participation of the company's management. For this purpose, a non-management director includes a director who does not satisfy the independence requirements, as long as he or she is not a current executive officer of the company under SEC rules (for example, a director who served as the company's CEO within the preceding three years, though not independent, would be a "non-management" director). Boards may choose a presiding director for these sessions, or they may use another method to designate a director to serve in this capacity. The NYSE commentary indicates that if non-management directors who are not independent attend these meetings, the independent directors should meet at least annually without any non-management directors who are not independent present.

Companies must disclose in their proxy statements either the name of the director who presides at these sessions or they must disclose the procedures by which the presiding director is selected. Companies must also disclose a method for "interested parties" to communicate directly with the presiding director or with the non-management directors as a group. The NYSE commentary points out that companies may use their existing audit committee complaint procedure for this purpose.

Audit Committees

The new NYSE standards will expand current NYSE and SEC requirements for audit committees and their members. Earlier NYSE proposals included both specific NYSE requirements and a reiteration of the generally applicable SEC requirements adopted in April 2003. In a change from its earlier proposal, the final NYSE standards deal with the SEC requirements by referring to the SEC rules and interpretations that apply to audit committee membership for all public companies and making compliance with the SEC pronouncements a further listing requirement. As a result of these requirements, directors who meet the NYSE requirements for board independence may be ineligible for membership on the audit committee. The SEC requirements, as well as the final revised NYSE requirements, are summarized below.

Relationship of NYSE and SEC Audit Committee Independence Requirements

The enhanced independence requirements for audit committee members are contained in part in SEC rules and in part in the new NYSE standards that supplement SEC rules. 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 all 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 (i) in which the audit committee member is a partner, a member, an officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (but not that of limited partner, non-managing member and those occupying similar positions who, in each case, have no active role in providing services to the entity) and (ii) which provides accounting, consulting, legal, investment banking, or financial advisory services to the company or any of its subsidiaries.
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• No Affiliated Persons. A member of the audit committee may not be an "affiliate" of the company or any subsidiary of the company 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.
  
  One effect of this requirement under the SEC's standard "control" test for affiliate status may be to disqualify representatives of significant shareholders from membership on the audit committee. To provide some clarity on this issue, the SEC adopted a safe harbor to the effect 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 affiliated person. This is only a safe harbor, however, meaning that 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 can still be determined not to be an affiliate under a facts-and-circumstances analysis of actual control.
  
  Unlike the NYSE independence 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. It should be noted that the SEC eliminated the "exceptional and limited circumstances" exemption that under old NYSE standards allowed one member of the audit committee not to meet the independence criteria. Moreover, the SEC rules specifically prohibit the NYSE from granting ad hoc exemptions and waivers.

New NYSE Audit Committee Requirements

In addition to the requirements generally applicable to audit committees under SEC rules, the NYSE standards will require the following:

• Three Members. The audit committee must consist of at least three independent directors (under the "enhanced" independence standards described above). If a committee member serves on the audit committees of more than three public companies and the company does not impose a limit on the number of audit committees on which audit committee members serve, the board must determine in each case that simultaneous service will not impair that member's effectiveness. In these cases, the company must disclose this determination in its proxy statement.
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• Financial Literacy; Financial/Accounting Expertise. Each member of the committee must be (or become) financially literate, and at least one committee member must have accounting or related financial management expertise, in both cases as interpreted by the board. This latter requirement does not mean that the NYSE will require that one committee member qualify as an "audit committee financial expert" under SEC rules, though the NYSE commentary indicates that the board may presume that a director who is designated an "audit committee financial expert" under SEC rules satisfies the NYSE's "expertise" requirement.
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• Written Charter; Public Availability. The audit committee must have a written charter, which must be posted on the company's website. The company must state in its Form 10-K that the charter is available on its website and will be sent to stockholders who request a paper copy upon request.
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• Annual Evaluation. The audit committee charter must provide for an annual performance evaluation of the committee.
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• Purposes and Responsibilities. The audit committee charter must address the committee's purpose, responsibilities and related matters, which must at a minimum include:
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  • assisting board oversight of (i) the integrity of the company's financial statements, (ii) the company's compliance with legal and regulatory requirements, (iii) the independent auditor's qualifications and independence, and (iv) the performance of the company's internal audit function and independent auditors;
  • preparing the audit committee report required by SEC rules;
  • discharging the responsibilities of the audit committee required by SEC rules relating to the company's independent auditor, handling complaints, engaging advisors and funding;
  • obtaining and reviewing at least annually a report by the independent auditor that describes: (i) the accounting firm's internal quality-control procedures; (ii) any material issues raised by the most recent internal quality-control review, or peer review, of the accounting firm, or by any inquiry or investigation by governmental or professional authorities, within the preceding five years, with respect to one or more independent audits carried out by the firm, and any steps taken to deal with any such issues; and (iii) all relationships between the accounting firm and the listed company, so the committee can assess the auditor's independence and present the committee's assessment to the full board;
  • discussing the company's annual audited financial statements and quarterly financial statements with management and the independent auditor, including the company's disclosures under "Management's Discussion and Analysis of Financial Condition and Results of Operations;"
  • discussing the company's earnings press releases, as well as financial information and earnings guidance provided to analysts and rating agencies, although this discussion may be done in general terms, and need not occur before each earnings release or issuance of earnings guidance;
  • discussing the company's risk assessment and risk management policies;
  • meeting separately on a periodic basis with management, with internal auditors (or other personnel responsible for the internal audit function), and with the independent auditor;
  • reviewing any audit problems or difficulties and management's response with the independent auditor;
  • establishing clear hiring policies for employees or former employees of the independent auditor; and
  • reporting regularly to the full board of directors.

Internal Audit Function

Each listed company must maintain an internal audit function that provides the audit committee and management with ongoing assessments of the company's risk management processes and internal controls. The company may outsource this function to a third party, but the independent auditor may not perform internal audit services.

Compensation, Nominating and Corporate Governance Committees

Each listed company's board of directors will be required to establish and maintain a compensation committee and a nominating/corporate governance committee. Boards may assign the responsibilities of these committees to other committees having other names or additional responsibilities, but these other committees must satisfy the requirements of the NYSE listing standards. The requirements for the compensation and nominating/corporate governance committees are generally similar to each other and include the following:

• Solely Independent Directors. The committees must be composed entirely of directors who satisfy the independence standards for board membership summarized above.
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• Written Charter; Public Availability. The committees must have written charters, which must be posted on the company's website. The company must state in its Form 10-K that the charters are available on its website and will be sent to stockholders who request a paper copy upon request.
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• Annual Evaluation. The committee charters must provide for an annual performance evaluation of the committee.
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• Purposes and Operation. The committee charters must address the committee's purpose, responsibilities and related matters. These must include, at a minimum:
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  • qualifications of committee members and their appointment and removal;
  • committee structure and operations, including authority to delegate to subcommittees;
  • committee reporting to the full board; and
  • sole authority to retain and terminate professional advisors and to fix their engagement terms and fees.
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• Compensation Committee Responsibilities. The committee's charter must provide, at a minimum, that the committee has direct responsibility to:
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  • review and approve corporate goals and objectives that are relevant to the CEO's compensation, to evaluate (alone or with other independent directors) the CEO's performance, and fix the CEO's compensation;
  • make recommendations to the board concerning non-CEO compensation, incentive compensation plans and equity-based plans; and
  • produce the report on executive compensation required by SEC rules.
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• Nominating/Corporate Governance Committee Responsibilities. The committee's charter must provide, at a minimum, that the committee has direct responsibility to:
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  • identify persons qualified to serve as directors, consistent with criteria approved by the full board;
  • select (or recommend selection of) nominees for director at the company's next annual meeting;
  • recommend a set of corporate governance principles for board approval; and
  • oversee evaluations of the board and management.

The selection and nomination of directors by third parties under a legally binding agreement with the company, such as preferred stock rights to elect directors upon a dividend default, shareholder agreements, and management agreements, are not subject to these nominating committee requirements.

Corporate Governance Guidelines and Code of Business Conduct and Ethics

Listed companies must adopt and disclose corporate governance guidelines. In addition, a listed company must adopt and disclose a code of business conduct and ethics, and must promptly disclose any waivers of the code for its directors or executive officers.

The disclosure requirements for listed companies' corporate governance guidelines and codes of business conduct and ethics are the same as those that apply to the principal committee charters: the company must post the documents on its website, and must disclose in its Form 10-K that the documents are available on its website and in paper form if a stockholder requests a copy. Although the NYSE has not indicated how companies may satisfy this requirement, similar NYSE requirements that companies disclose material information generally require the company to issue a press release. The code must provide that only the board or an authorized committee can grant waivers of the code.

Corporate Governance Guidelines

The corporate governance guidelines must address the following subjects:

• qualification standards for directors, including at least independence under NYSE listing standards and potentially including other substantive requirements, such as limiting the number of boards on which a director may serve, as well as director tenure, retirement and succession;
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• director responsibilities, including attendance and advance review of meeting materials; director access to management and independent advisors;
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• director compensation;
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• director orientation and continuing education;
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• management succession policies and principles; and
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• annual performance evaluation of the board and its committees.
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Code of Business Conduct and Ethics

The code must apply to directors, officers and employees. It must, at a minimum, address certain specified topics, including conflicts of interest, preservation of corporate opportunities, confidentiality of company information, fair dealing with the company's customers, suppliers, competitors and employees, protection and proper use of company assets, compliance with legal requirements (including insider trading laws), and encouraging reporting of any illegal or unethical behavior.

CEO Certification and Notice Requirements

The CEO of each listed company must certify to the NYSE annually that the CEO is not aware of any violation of NYSE corporate governance listing standards by the company. In addition, the CEO must promptly notify the NYSE in writing after any executive officer of the listed company becomes aware of any material non-compliance with any applicable requirement of the new listing standards described above. Because this notice requirement is triggered by any executive officer becoming aware of material non-compliance, listed companies should provide a mechanism that will promptly inform the CEO.

Application to Certain Companies

The NYSE proposal includes special provisions and transition rules for a variety of listed companies, several of which are summarized below. Other provisions and transition rules, not summarized in this Advisory, apply to limited partnerships, closed-end and open-end funds, business development companies and companies in bankruptcy.

Controlled Company Exception

Companies whose voting securities are more than 50% held by an individual, group or another company do not need to comply with the requirement that a majority of the board be independent and the requirements applicable to compensation and nominating/corporate governance committees.

Preferred and Debt Securities

Companies that have only preferred stock or debt securities listed on the NYSE are required to comply only with (i) the SEC's rules governing minimum standards for audit committee members described above and (ii) the requirement that the CEO notify the NYSE of any material non-compliance with the new listing standards applicable to the company.

Foreign Listed Companies

Foreign private issuers may generally follow the practices of their home countries, but must comply with the audit committee requirements and the CEO certification and notice requirements summarized above. Foreign private issuers must disclose any significant differences between their corporate governance practices and those required by NYSE listing standards. This disclosure may be provided either on the company's website or in the company's annual report to its U.S. stockholders.

Look-Back Period and Transition Period

Potential Loss of Independence Due to Passage of Time

When the new NYSE director independence standards become applicable on the compliance date described above, the look-back period will include the company's prior fiscal year. However, the full three-year look-back period provided in the NYSE standards will become applicable on the first anniversary of the date of SEC approval. As a result, a transaction or relationship that would not affect a director's independence in 2004 because it occurred or existed during 2002 (in the case of calendar year companies) could affect that director's independence in 2005. This timing issue is significant, as a director's independence may be compromised as a result of a past transaction or relationship merely by the passage of time.

Classified or Staggered Boards

In the case of classified or "staggered" boards, the new listing standards provide only one additional year for companies to comply with the independence standards at the full board level. Directors who would not normally stand for election at the company's first annual meeting after January 15, 2004 will not be included when measuring compliance with the new majority independence requirement until the company's second annual meeting after that date but not later than December 31, 2005. This one-year transition period, combined with the phase-in of the three-year look-back, may require careful evaluation and planning by listed companies whose directors serve staggered three year terms.

Audit Committee Independence Requirements

The extended compliance date does not extend the deadline for audit committee members to satisfy NYSE and SEC independence requirements.

Initial Public Offerings and Newly Listed Companies

Companies listing in conjunction with their initial public offerings will be required to phase in their independent nomination and compensation committees on the same schedule as Rule 10A-3 mandates for audit committees, namely, one independent director at the time of listing, a majority within 90 days and fully independent committees within one year. Companies listing in conjunction with an initial public offering will also be required to have a majority independent board within 12 months of listing. The 12-month transition period will also apply to companies that transfer to the NYSE from other markets that do not impose the same requirements for listing. Foreign private issuers have until July 31, 2005 to comply with the new audit committee standards.

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.

John O. Newell contributed to the preparation of this Advisory.

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