Last week the Nasdaq Stock Market delivered to the SEC several new and revised Nasdaq rule proposals, for publication in the Federal Register for public comment. These proposals reflect Nasdaq's continued response to the SEC's request made in February 2002 for corporate governance reform of Nasdaq listed companies. This Update summarizes these recent proposals, as well as previously published rules and proposals. This Update also identifies additional proposals described by Nasdaq but for which specific text has not yet been published. Please be advised that the SEC may revise these proposals prior to adoption.

Nasdaq contemplates that rule changes affecting Board of Director or Board committee composition will become effective with a listed company's first annual meeting after January 1, 2004.

Increased Board Independence and Role of Independent Directors

Majority of Independent Directors

A majority of the directors of a listed company would be required to qualify as "independent" directors.

Qualification as an Independent Director

The new rules would tighten the definition of "independent" director. A director could not be deemed "independent" by a company's Board of Directors if he or she

• or a "family member" (i.e., a relative by blood, marriage or adoption, or any person who has the same residence) accepted from the company or its affiliates any payments in excess of $60,000 during the current or any of the past three fiscal years, including any political contributions, but excluding Board fees, benefits under tax-qualified retirement plans, and non-discretionary compensation,

• is or within the past three years has been employed by (or has a family member who is or within the past three years has been employed as an executive officer of) the company or its parent or subsidiary,
• is a partner, executive officer or controlling shareholder of any organization (including a not-for-profit organization) that in the current or any of the past three fiscal years received from or made payments to the company exceeding the greater of $200,000 or 5% of the recipient's consolidated gross revenues for the year, other than payments arising solely from investments in the listed company's securities,
• is a former partner or employee of the company's outside auditor and worked on the company's audit within the past three years, or
• is part of an "interlocking directorate" -- where a listed company's executive officer serves on another company's compensation committee that employs the director as an executive -- or if such relationship existed within the past three years.

Executive Sessions for Independent Directors

Independent directors would be required to meet "regularly" in executive sessions, without management or other directors present. Nasdaq contemplates at least two executive sessions each year, and proposes that this rule become effective six months after SEC approval.

Increased Role in Compensation and Nomination Decisions

An independent compensation committee or a majority of the independent directors meeting in executive session would determine compensation for the CEO and other executive officers. The CEO could be present for compensation discussions for other executive officers, but could not vote. One non-independent director could serve for two years on the independent compensation committee if "exceptional and limited circumstances" exist.

The "exceptional and limited circumstances" exception for committee service would be available for a director who is not an officer or employee of the company or a family member of such a person, but only if the Board determines that the director's service on the committee is in the best interests of the company and its shareholders and the company discloses in the next annual proxy statement the director's relationship to the company and the basis for the Board's determination. A director relying on the special and limited circumstances exception could not serve on the committee for more than two years.

An independent nominating committee or a majority of the independent directors would be required to approve all director nominations, except where a third party by contract or otherwise legally has the right to nominate a director. The "exceptional and limited circumstances" exception would also be available for service on the nominating committee under the same conditions as for service on the compensation committee. Alternatively, one non-independent director who

• is not an officer or employee of the company or a family member of such a person,

• does not own or control more than 20% of the company's voting securities,
• receives no compensation from the company other than as a Board or committee member, and
• is not an "affiliated person" of the company or any subsidiary,

could serve on the nominating committee if the Board determines his or her service on the committee is in the best interests of the company and its shareholders, and the company discloses in the next annual proxy statement the director's relationship to the company and the basis for the Board's determination.

Controlled Company Exception

There is no "controlled company" exemption from the Sarbanes-Oxley Act. Nasdaq proposes an exception, however, from many of its requirements for independent directors. If a listed company is a "controlled company" (i.e., one where more than 50% of the voting power of the company's securities is held by an individual, group or another company), the company need not:

• have a majority of independent directors on its Board,

• hold regular executive sessions of independent directors, or
• maintain independent compensation and nominating committees.

The company must disclose in its annual proxy statement that it is a controlled company and the basis for that determination. A controlled company must continue to comply with Nasdaq's requirement for an independent audit committee and other audit committee rules.

Increased Independence and Role of Audit Committee

Further Independence Requirements for Audit Committee Membership

Existing Nasdaq rules generally require that listed companies have an audit committee comprised solely of at least three independent directors. The proposed rules would impose additional requirements for audit committee members beyond the tightened definition of "independent" director discussed above. Consistent with Section 301 of the Sarbanes-Oxley Act, audit committee members could not:

• receive any compensation from the company other than payment for Board or committee service, or

• be an "affiliated person" of the company or any subsidiary.

Nasdaq would impose the additional requirement that no audit committee member own or control 20% or more of the company's voting securities, or such lower percentage as the SEC may designate.

Nasdaq's "exceptional and limited circumstances" exception would apply in a modified form for the audit committee. A director who does not satisfy the general "independence" standard for directors, but does satisfy the additional audit committee independence requirements of the Sarbanes-Oxley Act listed above and who is not a current officer or employee or a family member of a company employee, could serve on the audit committee for up to two years, but not as the committee chair.

Financial Statement Literacy of Audit Committee Members; Financial Expert

All audit committee members would need to be able to read and understand fundamental financial statements at the time of their appointment. Also, the audit committee must have at least one "financial expert," consistent with Section 407 of the Sarbanes-Oxley Act. The SEC recently indicated that its proposed definition of "financial expert" will include all the attributes listed in Section 407 (essentially that the individual has expertise or be experienced in preparing or auditing financial statements of public companies as a result of education or service as a CPA, CFO, comptroller or other role with similar functions) and that the SEC will provide a list of factors companies should consider in determining whether a member of the audit committee is a financial expert.

Approval of Related Party Transactions

A listed company's audit committee or a comparable body of independent directors would be required to review and approve all related-party transactions. Only review of these transactions is required under existing Nasdaq rules. Related-party transactions are described in Item 404(a) of SEC Regulation S-K and include transactions to which the company or a subsidiary will be a party that involve over $60,000 and in which any director or nominee, executive officer, 5% or more shareholder or any family member of the foregoing has or will have a direct or indirect "material" interest.

Authority and Power of Audit Committee Over the Audit Process

Consistent with Sections 202 and 301 of the Sarbanes-Oxley Act, the proposed rules would require that the audit committee:

• have exclusive authority to appoint, determine funding for, and oversee the outside auditors,

• pre-approve all audit and permissible non-audit services provided by the company's accountants,
• be authorized to engage and determine funding for independent legal counsel and other advisors, and
• establish procedures for the receipt, retention and treatment of complaints to the company regarding accounting, internal accounting controls or auditing matters, and for the confidential, anonymous submission by employees of accounting or auditing concerns.

These responsibilities and other matters would be required to be included in audit committee charters within six months after SEC approval of the proposed rule.

Elimination of Exception for Small Business Issuers

Small Business issuers would no longer be exempt from audit committee requirements generally applicable to U.S. listed companies.

Shareholder Approval of Equity Compensation Plans

To expedite review and processing, the SEC asked Nasdaq to separate its proposal regarding shareholder approval of equity compensation plans from its other corporate governance proposals. The SEC published this separately filed proposal in the Federal Register on October 17, 2002 for public comment, and the rules are expected to become effective on November 21, 2002.

Shareholder approval generally would be required for the adoption of all new stock option plans or arrangements, and for any material amendment to existing plans or arrangements. Permitted exceptions would include:

• grants to newly hired officers or directors if the grants are a material inducement to the individual's entering into employment or service with the company and are approved by an independent compensation committee or by a majority of the company's independent directors,

• tax-qualified, non-discretionary plans or "parallel nonqualified plans" (i.e. certain pension plans within the meaning of ERISA designed to work in parallel with Section 401(a) plans), if they are approved by an independent compensation committee or by a majority of the company's independent directors,
• option grants made to convert, replace or adjust outstanding awards to reflect acquisitions or mergers, and certain post-transaction grants of available shares under plans assumed in acquisitions or mergers, and
• warrants and rights offerings made to all company shareholders.

This proposal would eliminate existing exceptions from shareholder approval for de minimis grants of the lesser of 25,000 shares or 1% of outstanding shares and for "broad based" plans, in which less than 50% of participants are directors or executive officers and less than 50% of option grants are made to directors and executive officers.

Prohibition on Loans to Officers and Directors

Nasdaq anticipates proposing a rule to mirror Section 402 of the Sarbanes-Oxley Act that would prohibit listed companies from making personal loans or extending credit to executive officers or directors. Due to existing debate as to what constitutes a "loan" or an "extension of credit" for purposes of Section 402, it is currently unclear what will be the ultimate scope and application of Nasdaq's proposal.

Code of Conduct

Listed companies would need to adopt and publicly disclose a Code of Conduct for directors, officers and employees. The Code would be required to address, at a minimum, conflicts of interest and compliance with laws, rules and regulations, and include an enforcement mechanism. A company's Board of Directors could grant specific waivers to the Code of Conduct for executive officers or directors if the company promptly discloses the waivers.

Other Rules and Proposals

Delisting for Misrepresentations to Nasdaq and Denial of Re-Listing for Violations

Nasdaq recently clarified existing rules to specify that it can delist a company that:

• fails to provide requested information or documentation to Nasdaq, or

• makes a material misrepresentation, or omits material information in a communication to Nasdaq.

Nasdaq also clarified that it can deny re-listing to a company that violates corporate governance provisions during a pending appeal of delisting action.

These clarifications became effective in July 2002.

Harmonization of Nasdaq Disclosure Rules with SEC Regulation FD

Existing Nasdaq rules generally require disclosure of certain material information by a widely disseminated press release. Proposed revisions would:

• expand the permitted manner of disclosure to include SEC Regulation FD compliant methods such as conference calls, press conferences and web casts, provided the company provides adequate notice to the public of the disclosure (generally by press release) and grants access to the disclosure, and

• revise the list of material events that would require public disclosure.

Change of Control Definition

Nasdaq proposes clarifying its definition of "change of control" to assist issuers in determining when a change of control transaction exists, which triggers shareholder approval requirements. A change of control would be presumed to occur when an investor acquires 20% or more of an issuer's outstanding voting power, unless a larger ownership or voting position is held on a post-transaction basis by:

• a shareholder, or an identified shareholder group, unaffiliated with the investor, or

• the issuer's directors and officers who are not affiliated with the investor.

Accelerated Disclosure of Insider Transactions

Nasdaq is considering rules that would require accelerated disclosure (generally within two business days) of insider transactions in company stock, consistent with recent rule changes resulting from the Sarbanes-Oxley Act and related SEC rule modifications.

Transparency With Respect to Non-U.S. Companies

Nasdaq traditionally has exempted non-U.S. listed companies from certain corporate governance rules, recognizing that foreign home country law might differ. Commencing January 1, 2004, Nasdaq's proposed rules would require any non-U.S. company whose corporate governance practices differ from rules generally applicable to domestic listed companies to publicly disclose the differences in its SEC annual report and, if its first U.S. listing is on Nasdaq, in the applicable registration statement.

Director Continuing Education

Nasdaq expects to propose rules that would require continuing education for all directors.

Public Announcement of Going Concern Qualifications

Listed companies would be required to disclose by press release any going concern qualification included in an auditor's report within seven days after the filing of the SEC report that contains the auditor's report. Nasdaq determined that inclusion of the auditor's report in the SEC filing alone provides inadequate notification to the public of this material information.

Text of Proposed Rules

You can find the proposed text of most of the rules discussed above and Nasdaq announcements regarding the rules at http://www.Nasdaqnews.com, Corporate Governance button. You can find further discussion of the Sarbanes-Oxley Act and of other recent laws and regulations of interest to public companies on our website.

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