Last week the SEC released final rules – effective January 1, 2004 – that require public companies to disclose nominating committee procedures and procedures for shareholder communications with directors. These new rules harmonize with the recently finalized NYSE and Nasdaq nominating committee requirements and represent the SEC's latest step in its ongoing effort to make board operations more transparent to shareholders. Many companies already provide disclosure that meets or exceeds these new SEC requirements.

What follows is a summary of the new requirements and some practical advice on complying with them for the upcoming proxy season.

Final Rules: Two Core Components

The final rules primarily amend Schedule 14A and Item 401 of Regulation S-K to add two additional areas of required disclosure: the nominating committee and its processes, and shareholder communications with directors.

        1.    Companies Must Disclose Additional Information in the Proxy Statement About the Nominating Committee and Nomination Process

Companies must make specific disclosures in the proxy statement about the existence, composition, charter and procedures of the nominating committee that fall into two broad categories: (a) disclosures about the nominating committee itself and its charter, and (b) disclosures about the director nomination process. Many issuers have already focused on the nominating committee and its charter in connection with the now final NYSE and Nasdaq listing standards. Under the new rules, issuers will need to give careful thought to the second category of disclosures concerning the nomination process, and start planning now to comply with these requirements for the upcoming proxy season.

Companies Must Make Disclosures About Nominating Committee and Charter. Companies must make the following three disclosures about the nominating committee and its charter:

• Does the Company Have a Nominating Committee? Each company must state whether it has a nominating committee (or committee performing similar functions) and, if not, why not.
• Are the Members of the Nominating Committee Independent? Each company must disclose whether its nominating committee members are independent within the meaning of the applicable self-regulatory organization's listing standards.
• Does the Nominating Committee Have a Charter (and Where Can It Be Found)? Each company must disclose in its proxy statement whether its nominating committee has a charter, and, if so, either provide a website address or include a copy of the charter as an appendix to the proxy statement at least once every three years.

Companies Must Disclose Director Nomination Process. Companies will need to explain in the proxy statement the process used to identify and evaluate nominees for the board of directors, and include the following four new specific disclosures:

• "Minimum Qualifications" of Nominees.

Companies must describe in the proxy statement the "minimum qualifications" that must be met for a nominee to be recommended by the nominating committee, including "any specific qualities or skills" necessary for a nominee. Note: While the SEC did not adopt its proposed "specific standards for the overall structure and composition of the company's board of directors," we expect to see exactly these sorts of standards emerge in proxy statements in 2004. 

• Shareholder-Recommended Board Candidates. Companies must state in the proxy statement whether the company has a policy regarding consideration of shareholder-recommended board candidates and, if not, why not. Companies must also describe in the proxy statement the material terms of this policy, including whether the committee will consider shareholder-recommended candidates and, if so, what the procedures are for recommending them.
• Source and Evaluation of Candidates. Companies must describe in the proxy statement the nominating committee's process for identifying and evaluating potential nominees for the board, including shareholder-recommended candidates. If shareholder-recommended candidates are evaluated on a different basis from other candidates, companies must disclose and explain these differences.
• For all nominees proposed by the committee for election (other than executive officers or directors standing for reelection), companies must disclose which of the following recommended each nominee: shareholder; non-management director; CEO; other executive officer; third-party search firm; or other specified source. The proxy statement also must disclose the identity and role of any third party engaged to identify or evaluate potential board candidates.

5% Shareholder Candidates. 

If a 5% or greater shareholder (or group) that has held its position for at least a year recommends a director candidate at least 120 calendar days prior to the anniversary of the mailing date of the prior year's proxy statement, the company must disclose the name of the candidate and of the recommending shareholder – and whether the company nominated the candidate.
• The SEC settled on this 5% threshold to harmonize this rule with the beneficial ownership reporting requirements under Sections 13(d) and 13(g) of the Securities Exchange Act of 1934.  
• This new disclosure under Item 7(d)(2)(ii)(L) of Schedule 14A may foreshadow possible SEC action on its highly controversial October 14, 2003 proposal to require companies to include in proxy statements shareholder nominees for director.

Companies Will Report Material Changes to Procedures for Shareholder Nomination of Directors.

The final rules also require companies to disclose any material change to the procedures for shareholder nomination of directors. The disclosure goes in the Form 10-Q filed for the period in which the material change occurred (or Form 10-K, for the fourth quarter).

• Note: Adopting procedures for the first time will be considered a material change.

        2.    Companies Must Include Additional Disclosure in the Proxy Statement Regarding Shareholder Communications With the Board

The second component of the final rules requires companies to disclose:

• Whether the company has a process for shareholders to communicate with the board of directors. 
• If not, why does the board of directors think that it is appropriate not to have a process?  
• If so, how do shareholders send communications to the board or to specific individual directors?

Effective Date of Final Rules

The new rules are effective January 1, 2004. Companies must comply with the new disclosure requirements in proxy statements first distributed to shareholders on or after that date. Companies must disclose any material change to the procedures for shareholder nomination of directors in reports filed for quarters ending on or after that date.

Practical Tips: Prepare Now to Comply With These New Rules for the Upcoming Proxy Season For the upcoming proxy season, we propose that companies implement four new procedures: Use the New Disclosure Requirements as a Checklist. Companies should review the new disclosure requirements with their nominating committees as soon as possible, use the requirements as a checklist for review and possible modification of nominating committee processes, and make any needed changes now. Start the Nominating Committee Report Early. Treat the nominating committee disclosure as if it were a "Nominating Committee Report," and follow the same procedures that you use for your compensation and audit committee reports. For example, if you are a calendar year company, you should prepare a draft report early in January and distribute the report to the nominating committee in advance of its next meeting. The nominating committee should discuss the draft report fully before presenting it to the board. Retain Independent Advisors. Consider retaining independent advisors for the nominating committee, including a search firm or a consultant who can assist in identifying candidates. The company's proxy statement will have to disclose who that consultant is, and the function that it performs. As a "Best Practice," Consider Adopting Standards That Require Directors to Look Out for the Best Interests of the Company as a Whole. Although the SEC has not yet adopted rules mandating standards that apply to overall board composition, you should consider implementing and publishing "best practice" standards for your nominating committee. These standards should be sufficiently general to guarantee nominating committee discretion, but specify that the nominating committee will select nominees with a view toward the best interests of the company as a whole, as opposed to candidates who may pursue the best interests of particular shareholders or groups.

Full Text of Final Rules This Update is intended only as a summary of the final rules. For the full text of the final rules, please see http://www.sec.gov/rules/final/33-8340.htm. You can find further discussion of other recent laws, regulations and rule proposals of interest to public companies on our website.

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