In light of recent events involving corporate malfeasance, the New York Stock Exchange (NYSE) and the Nasdaq Stock Market (Nasdaq) have each submitted proposals that overhaul their respective corporate governance listing standards to the U.S. Securities and Exchange Commission (SEC) for its review and required approval.
The Sarbanes-Oxley Act of 2002, the corporate reform law enacted on July 30, 2002, requires some of the proposed changes to be made by April 2003. But the SEC is expected to act before this date and comprehensively revised standards should become effective sometime in fall 2002. The precise timetable for the enactment of the new rules depends on when the SEC first publishes the proposals for comment and how long a public comment and final approval period it deems appropriate. The SEC Staff has indicated that the NYSE and the Nasdaq proposals will be published for comment in tandem.
The SEC Staff has also indicated that it will require, to a greater extent than it has previously, that the NYSE and Nasdaq corporate governance standards be harmonized to some degree. Currently, the respective listing standards and the proposals of the NYSE and Nasdaq have many dissimilarities, although generally the same objectives. Accordingly, the SEC will likely require further changes to the proposals submitted to it by the NYSE and Nasdaq before it publishes them for public comment.
The following are summaries of the proposed NYSE and Nasdaq corporate governance standards based on the text of the proposed rule changes and commentary released by the NYSE and on a Nasdaq summary of its new rule proposals.
Summary of NYSE Proposals
Majority of Independent Directors
The NYSE will require boards of directors of listed companies to be composed of a majority of independent directors. At the same time, as summarized below, the NYSE proposes to tighten the definition of "independent director." Listed companies will have 24 months from the date the rule is enacted to comply with the requirement.
The NYSE proposals provide an exemption from the majority independent requirement for "controlled" companies where more than 50 percent of the voting power is held by an individual, a group or another company. Also, any such company will not be required for listing purposes to comply with the proposed requirements summarized below that it have nominating/corporate governance and compensation committees composed of independent directors. However, all controlled companies will be required to have at least a minimum three-person audit committee composed entirely of independent directors.
Tighter Definition of Independent Director
To qualify as an independent director, the board of directors will be required to affirmatively determine that the director has no material relationship with the listed company and disclose this determination. Noting that it is not possible to anticipate, or explicitly to provide for, all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of a director’s relationship to a listed company, the NYSE proposal recommends that boards making "independence" determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of
a director’s relationship with the company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation.
The commentary to the rule proposals notes that material relationships can include "commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships (among others)." Stating its view that the concern is independence from management, the NYSE noted that it does not view ownership of a significant amount of stock, by itself, as a bar to an independence finding.
Under the proposals, "independence" determinations made by the board will be required to be publicly disclosed together with the basis therefor, in a listed company’s annual proxy statement. The proposal provides, however, that companies will be able to adopt and disclose categorical standards to assist it in determining director independence and make a general disclosure for directors who meet these standards. Any independence determination for a director who does not meet the standards will need to be specifically explained.
The grant of discretion to the board in the NYSE independence proposal could be considered in conflict as to audit committee members with a requirement of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act requires that, by April 2003 the SEC, must ensure the listing standards of the stock exchanges mandate that audit committees be composed solely of "independent" members, with board members being independent only if they receive no compensation other than directors’ fees and are not "affiliated persons" (a term not defined in the Sarbanes-Oxley Act) of the company or its subsidiaries.
The SEC was granted authority to issue regulations interpreting portions of the Sarbanes-Oxley Act. It remains to be seen whether it will accept the flexibility and discretion provided for in the NYSE rule proposals or require a stricter standard in interpreting the meaning of "affiliated persons" for purposes of Section 301 of the Act. If, for instance, the SEC interprets this provision of the Sarbanes-Oxley Act with reference to its standard definition of affiliate ("any person controlling, controlled by or under common control with the other person") that would conflict with the NYSE view that ownership of even a significant amount of stock, by itself, is not a bar to an independence finding.
In addition, in any event, under the NYSE proposed definition, no director is deemed to be independent if he or she, or any of his or her immediate family members, is or within the prior five years has been:
- employed by the company;
- affiliated with or employed by a present or former auditor of the company (or of any of the company’s affiliates); or
- employed by a company whose compensation committee includes an executive officer of the listed company.
Regular Executive Sessions of Non-Management Directors
To promote open discussion among non-management directors, the proposals require companies to schedule regular executive sessions in which non-management directors meet without management participation. The NYSE has suggested that regular scheduling of such meetings is important not only to foster better communication among non-management directors, but also to prevent any negative inference from the calling of executive sessions. Further, in order for interested parties to be able to make their concerns known to non-management directors, a listed company will be required to disclose a method for such parties to communicate directly with the director presiding at such executive sessions or with non-management directors as a group. NYSE-listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
Nominating/Corporate Governance Committee Composed Entirely of Independent Directors
The proposals require listed companies (other than controlled companies) to place the responsibility of new director and committee member nominations in the hands of an independent nominating/corporate governance committee. This committee will be required to have a written charter and will also be responsible for taking a leadership role in shaping the corporate governance of a corporation. The written charter must address:
- the committee’s purpose, which, at minimum, must be to: identify individuals qualified to become board members, and to select, or to recommend that the board select, the director nominees for the next annual meeting of shareholders; and develop and recommend to the board a set of corporate governance principles applicable to the corporation;
- the committee’s goals and responsibilities, which must reflect, at minimum, the board’s criteria for selecting new directors, and oversight of the evaluation of the board and management; and
- an annual performance evaluation of the committee.
The nominating/corporate governance committee charter should also address the following items: committee member qualifications; committee member appointment and removal; committee structure and operations (including authority to delegate to subcommittees); and committee reporting to the board. In addition, although not required, the charter should give the nominating/corporate governance committee sole authority to retain and terminate any search firm to be used to identify director candidates, including sole authority to approve the search firm’s fees and other retention terms.
Boards may allocate the responsibilities of the nominating/corporate governance committee or the compensation committee, discussed below, to another committee of their own denomination, provided that such a committee is composed entirely of independent directors. Any such committee must have a published committee charter that complies with all of the requirements for the nominating/corporate governance committee charter or the compensation committee charter, as applicable. NYSE-listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
If a company is legally required by contract or otherwise to provide third parties with the ability to nominate directors, the selection and nomination of such directors need not be subject to the nominating committee process.
Within two years of enactment of the final rules, the required nominating/corporate governance committee (however denominated) must be composed entirely of independent directors and, within six months, must include at least one independent director.
Compensation Committee Composed Entirely of Independent Directors
The proposed standards require listed companies (other than controlled companies) to have compensation committees comprised solely of independent directors. The compensation committee will be required to have a written charter that addresses:
- the committee’s purpose, which, at minimum, must be to discharge the board’s responsibilities relating to compensation of the company’s executives, and to produce an annual report on executive compensation for inclusion in the company’s proxy statement, in accordance with applicable rules and regulations,
- the committee’s duties and responsibilities, which, at minimum, must be to:
- review and approve corporate goals and objectives relevant to CEO compensation, evaluate the CEO’s performance in light of those goals and objectives, and set the CEO’s compensation level based on this evaluation; and
- make recommendations to the board with respect to incentive-compensation plans and equity-based plans, and
- an annual performance evaluation of the compensation committee.
Commentary by the NYSE indicates that the compensation committee charter should also address the following items: committee member qualifications; committee member appointment and removal; committee structure and operations (including authority to delegate to subcommittees); and committee reporting to the board.
Commentary also suggests that the compensation committee charter should provide the committee with sole discretion to retain or terminate compensation consultants to the extent they assist in evaluating executive officer compensation. NYSE-listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
Within two years of enactment of the final rules, the required compensation committee must be composed entirely of independent directors and, within six months, must include at least one independent director.
Additional "Independence" Requirements for Audit Committee Members
Current NYSE standards require each company to have at a minimum a three-person audit committee composed entirely of independent directors. In addition to the current requirements regarding audit committee members’ independence, the proposed standards would require that directors’ fees be the only compensation that audit committee members receive from the company. However, the NYSE does support additional directors’ fees to compensate audit committee members for the significant time and effort they expend to fulfill their duties as audit committee members.
Disallowed compensation for an audit committee member includes fees paid directly or indirectly for services as a consultant or a legal or financial advisor, regardless of the amount. It also includes compensation paid to such a director’s firm for consulting or advisory services even if the director is not the actual service provider.
Increased Authority and Responsibilities of Audit Committee
The NYSE proposals will increase the authority and responsibility of the audit committee, including (among others):
- requirements that the audit committee have the sole authority to hire and fire the outside auditor, approve all audit engagement fees and terms, and approve any significant non-audit work by the auditors,
- requirements that the audit committee must also annually review a report by the company’s independent auditors as to:
- the company’s internal quality-control procedures;
- material issues presented by the most recent quality-control review, peer review, or investigation by governmental or professional authorities, within the preceding five years; and
- all relationships between the company and the auditors,
- discuss the company’s annual audited financial statements and quarterly financial statements (including MD&A) with management and the company’s independent auditors,
- meet separately periodically with each of management, internal auditors, and outside auditors, and
- discuss earnings press releases as well as financial information and earnings guidance provided to analysts and ratings agencies.
Internal Audit Function
The rule proposed will require that within six months of the adoption of final rules, a listed company must have an internal audit function. In the commentary, the NYSE noted that this "does not necessarily mean that a company must establish a separate internal audit department or dedicate employees to the task on a full-time basis; it is enough for a company to have in place an appropriate control process for reviewing and approving its internal transactions and accounting." A listed company can outsource this function, although the company’s independent auditors are strictly prohibited by the Sarbanes-Oxley Act from providing internal audit services.
Approval of All Equity-Compensation Plans
Effective immediately upon adoption of the new rules, equity-based compensation plans will require shareholder approval, including material revisions to the terms of such plans. For example, repricing options under a plan would trigger the proposed NYSE stockholder approval requirement. The proposal provides exemptions for inducement grants, option plans assumed in mergers and acquisitions, and tax-qualified plans (e.g., 401(k) plans and ESOPs). The proposed rules and the commentary do not include a grandfathering provision for existing plans, although the commentary acknowledges that the NYSE has received requests to include one. Existing NYSE standards require shareholder approval of equity-compensation plans in which officers or directors may participate but provide certain exceptions to the shareholder approval requirement, including so-called "broadly based plans" and, in effect, those using only treasury shares. Neither exception would apply under the new rules.
Additionally, the proposed rules would prohibit brokers from voting their customers’ shares with respect to any equity-compensation plan without voting instructions from such customers.
Corporate Governance Guidelines
The proposed rules will require listed companies to adopt and disclose corporate governance guidelines. These guidelines will be required to be disclosed on a company’s website along with the charters of the company’s most important committees (including at least the audit, compensation and nominating committees) and the company’s code of business conduct and ethics (described below). Further, each company’s annual report will be required to state that the foregoing information is available on its website, and the information is available in print to any shareholder who requests it.
The following subjects must be addressed in the corporate governance guidelines:
- director qualification standards;
- director responsibilities;
- director access to management and, as necessary and appropriate, independent advisors;
- director compensation;
- director orientation and continuing education;
- management succession; and
- annual performance evaluation of the board.
NYSE listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
Code of Business Conduct and Ethics
Recognizing that a code of business conduct and ethics can focus the board and management on areas of ethical risk, the NYSE has proposed that listed companies adopt a code that provides guidance to personnel to help them recognize and deal with ethical issues. As discussed above, the code must be disclosed on a company’s website and should address the following subjects:
- conflicts of interest;
- corporate opportunities;
- 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.
Each code of business conduct and ethics must also contain compliance standards and procedures that will facilitate the effective operation of the code and must require that any waiver of the code for executive officers or directors may be made only by the board or a board committee and must be promptly disclosed to shareholders. NYSE listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
Listed foreign companies will be required to make their U.S. investors aware of the significant ways in which their home-country practices differ from those followed by U.S. companies under NYSE listing standards. Although listed foreign private issuers will not be required to present a detailed, item-by-item analysis of these differences, the NYSE has suggested that U.S. shareholders should be aware of the significant ways that the governance of a listed foreign private issuer differs from that of a U.S. listed company. What will be required is a brief, general summary of the significant differences, not a cumbersome analysis. NYSE-listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
The proposed rules will require each chief executive officers of listed companies to certify that they are unaware of any violation by the company of NYSE corporate governance listing standards. In addition, both this certification to the NYSE, and any CEO/CFO certifications required to be filed with the SEC regarding the quality of the company’s public disclosure, will be required to be disclosed in the listed company’s annual report to shareholders. NYSE-listed companies will be granted a six-month period following SEC approval of this proposal to achieve compliance.
Public Reprimand Letters
The proposals would grant the SEC authority to issue a public reprimand letter to a company that it determines has violated a NYSE listing standard. The NYSE has proposed this sanction to be less harmful to the shareholders than suspending trading in or delisting a company’s securities. For companies that repeatedly or flagrantly violate NYSE listing standards, however, suspension and delisting remain the ultimate penalties.
Summary of Nasdaq Proposals
Nasdaq has not provided transition dates by which quoted companies must comply with its new standards once they become effective except with respect to its proposal to require a company to modify the composition of its board of directors, which will become effective immediately following a company’s first annual meeting that is at least 120 days after SEC approval of the proposed changes.
Increase Board Independence
Nasdaq has proposed a series of rule changes that are intended to increase the independence of boards of directors of Nasdaq quoted companies. The proposed rule changes would:
- require a majority of independent directors on the board;
- require regularly convened executive sessions of the independent directors;
require that a company’s audit committee or a comparable body of the board of directors review and approve all related-party transactions;
- prohibit an independent director from receiving any payments (including political contributions) in excess of $60,000 other than for board service and extend such prohibition to the receipt of payments by a non-employee family member of the director;
- the current rule prohibiting a director from being considered independent if the company makes payments to an entity where the director is an executive officer and such payments exceed the greater of $200,000 or 5 percent of either the company’s or the entity’s gross revenues will be expanded to cover not-for-profit entities;
- prohibit former partners or employees of the outside auditors who worked on a company’s audit engagement from being deemed independent; and apply a three-year "cooling off" period to directors who are not independent due to:
- interlocking compensation committees;
- the receipt by the director or a family member of the director of any payments in excess of $60,000 other than for board service; or
- having worked on the company’s audit engagement.
"Controlled" companies will be exempt from the requirements for a majority independent board, executive sessions of the independent directors, and independent compensation and nominating committees. A controlled company is a company of which more than 50 percent of the voting power is held by an individual, group or another company. A controlled company relying upon this exemption will be required to disclose in its annual meeting proxy statement that it is a controlled company and the basis for that determination. Such companies, however, will remain subject to each of the audit committee requirements.
Additional "Independence" Requirements for Audit Committee Members
In addition to the independence requirements summarized above, audit committee members will be prohibited from receiving any payment other than payment for board or committee service. Directors will also be prohibited from serving on the audit committee in the event they are deemed an affiliated person of the issuer or any subsidiary. In this regard, audit committee members will be prohibited from owning or controlling 20 percent or more of the issuer’s voting securities (or such lower number as may be established by the SEC in rulemaking under Section 301 of the Sarbanes-Oxley Act).
Increased Role of Independent Directors in Director Nominations
The proposed rules will require independent director approval of director nominations, either by an independent nominating committee or by a majority of the independent directors. A single non-independent director would be permitted to serve on an independent nominating committee if the individual is an officer who owns or controls more than 20 percent of the issuer’s voting securities or pursuant to an "exceptional and limited circumstances" exception.
Increased Role of Independent Directors in Compensation Decisions
The proposed rules will require independent director approval of CEO compensation, either by an independent compensation committee or by a majority of the independent directors meeting in executive session. The proposed rules will require independent director approval of other executive officer compensation, either by an independent compensation committee or by a majority of the independent directors in a meeting at which the CEO may be present. A single non-independent director, who is not an officer, would be permitted to serve, for two years, on the independent compensation committee pursuant to an "exceptional and limited circumstances" exception.
Increased Responsibilities of Audit Committee Members
Nasdaq has proposed several rule changes that are intended to grant audit committees increased power and authority and to harmonize its listing standards with the audit committee requirements set forth in the Sarbanes-Oxley Act. The proposed rule changes will:
- require that audit committees have the sole authority to appoint, determine funding for, and oversee the outside auditors;
- require that audit committees approve, in advance, the provision by the auditor of all permissible non-audit services;
- require that audit committees have the authority to engage and determine funding for independent counsel and other advisors;
- require that the audit committee establish procedures for the receipt, retention and treatment of complaints received by the issuer and ensure that such complaints are treated confidentially and anonymously;
- require that in selecting the financial expert necessary for compliance with the Nasdaq audit committee composition requirements, issuers will also need to consider whether a person has, through education and experience as a public accountant or auditor or a principal financial officer, comptroller or principal accounting officer of an issuer or from a position involving the performance of similar functions, sufficient financial expertise in the accounting and auditing areas;
- require that all audit committee members be able to read and understand financial statements at the time of their appointment rather than "within a reasonable period of time" thereafter;
- limit the time that a non-independent director may serve on the audit committee pursuant to the "exceptional and limited circumstances" exception to two years and prohibit that person from serving as the chair of the audit committee. Those directors not satisfying the audit committee independence requirements of the Act are not eligible for this exception; and
- eliminate exceptions from the audit committee requirements for Small Business issuers.
Continuing Education for Directors
Although Nasdaq has not published its proposed rules on the matter, it has indicated that it will require continuing education for all directors of Nasdaq-listed companies.
Codes of Conduct
Nasdaq has indicated that it will require all companies to have a code of conduct addressing, at a minimum, conflicts of interests and compliance with applicable laws, rules and regulations, with an appropriate compliance mechanism and disclosure of any waivers to executive and directors. Waivers can only be granted by the independent directors. In addition, the code of conduct will be required to be publicly available.
Shareholder Approval of All Equity-Compensation Plans
The proposed rules will require shareholder approval for the adoption of all stock option plans and for any material modification of such plans. An exemption would permit inducement grants to new employees if the grants are approved by an independent compensation committee or a majority of the company’s independent directors. Exemptions will also be available for certain tax-qualified plans (e.g., employee stock ownership plans) and for the assumption of pre-existing grants in connection with an acquisition or merger. Existing option plans will be unaffected under this proposal, unless there is a material modification made to the plan.
Loans to Officers and Directors
Apparently attempting to mirror a provision of the Sarbanes-Oxley Act, Nasdaq quoted companies would be prohibited from extending or maintaining credit in the form of a personal loan to its directors and officers. Existing extensions of credit will likely be exempt from this requirement, provided that there is no material modification to any such arrangement or any renewal of an extension of credit following approval of the rule. It remains to be seen whether this proposal, if enacted, covers more than the prohibition on personal loans set forth in the Sarbanes-Oxley Act.
The proposed rules will require that non-U.S. companies disclose any exemptions to Nasdaq’s corporate governance requirements at the time the exemption is received and on an annual basis thereafter, as well as any alternative measures taken in lieu of the waived requirements. In addition, the proposed rules will require that non-U.S. issuers file with the SEC and Nasdaq all interim reports filed in their home country, and, at a minimum, file with the SEC and Nasdaq a semi-annual report, including a statement of operations and an interim balance sheet prepared in accordance with the requirements of the home country marketplace. An English translation of any such reports will also be required.
The proposed rules will also require that non-U.S. issuers satisfy the Nasdaq SmallCap initial and continued listing requirements for bid price and market value of publicly held shares that are currently applicable to domestic issuers, subject to an 18-month phase-in period. In addition, the proposed rules will require that the underlying shares of SmallCap issuers represented by American Depositary Receipts (ADRs) quoted on Nasdaq satisfy the same publicly held shares and shareholder requirements that are applicable to domestic issuers.
In addition to the above items that address corporate governance concerns, Nasdaq has proposed the following rule changes:
- Harmonize the Nasdaq rule on the disclosure of material information with Regulation FD so that issuers may use Regulation FD compliant methods such as conference calls, press conferences and webcasts, so long as the public is provided adequate notice (generally by press release) and granted access.
- Require that a going concern qualification in an audit opinion be disclosed through the issuance of a press release.
- Clarify that Nasdaq will presume that a change of control will occur, for purposes of the shareholder approval rules, once an investor acquires 20 percent of an issuer’s outstanding voting power, unless a larger ownership and/or voting position is held on a post-transaction basis by:
- a shareholder, or an identified group of shareholders, unaffiliated with the investor, or
- the issuer’s directors and officers that are unaffiliated with the investor.
- Clarify the authority of Nasdaq to deny re-listing to an issuer based upon a corporate governance violation that occurred while that issuer’s appeal of the delisting was pending.