The Securities and Exchange Commission recently approved the Nasdaq Stock Market's corporate governance rules, which finalize Nasdaq corporate governance proposals made over the last 18 months.
The most significant changes from Nasdaq's most recent corporate governance rule proposals include:
Amending the "bright line" tests for director independence, including:
- A narrower definition of "family member," and
- Expanded application of the relationships that preclude a finding of independence to apply not only to directors, but also to family members.
- Providing "cure periods" for audit committee and Board noncompliance with independence requirements that result from Board vacancies or circumstances where a director ceases to be independent for reasons outside the director's control.
- Permitting the compensation and nominating committees to make decisions directly or recommend those decisions to the Board for determination.
- Amending rules regarding nomination decisions, including:
- Exempting a company from the nominating rules if a third party has a right to nominate a director or if the company is already subject to a legally binding obligation that prescribes a nomination structure, and
- Requiring either a written charter or, if a majority of independent directors make nomination decisions, a written Board resolution addressing the nominations process.
- Dropping the proposed requirement to prohibit directors who own or control 20% or more of the listed company's voting securities from serving on audit committees.
This Update summarizes the final Nasdaq corporate governance rules and two related proposals that are still pending.
Effective Dates and Transition Periods
General Effective Dates
Generally, companies must comply with the new rules by the earlier of their first annual shareholders meeting after January 15, 2004 or October 31, 2004. This deadline is the same as the date by which companies must comply with the SEC's Rule 10A-3 under the Securities Exchange Act of 1934 (relating to audit committee independence and related requirements).
Some requirements will become effective at different dates, including:
- Starting January 15, 2004, audit committees must approve related party transactions;
- Starting May 4, 2004, listed companies must adopt and disclose a code of conduct; and
- Starting November 4, 2004, listed companies must disclose any going concern qualification included in any audit opinion.
A company with a classified board can delay replacing a nonindependent director beyond its first annual meeting after January 15, 2004, until the earlier of the second annual shareholders meeting after January 15, 2004 or December 31, 2005, if the director would not otherwise be up for election at that meeting (unless replacement of that director would be necessary to comply with the SEC's Rule 10A-3).
Foreign Private Issuers and Small Business Issuers
Foreign private issuers and small business issuers have until July 31, 2005 to implement the corporate governance rules regarding director independence and independent committees.
A company listing in connection with its initial public offering will be allowed to phase in the Board composition requirements. For each committee the company adopts, the company must have one independent member at listing, a majority of independent members within 90 days of listing and fully independent committees within one year. Companies that choose not to adopt a compensation or nomination committee, and instead choose to rely on a majority of independent directors to discharge responsibilities under the rules, will be required to meet the majority of independent members requirement within one year of listing.
A company transferring from another market has one year from the date of transfer in which to comply with Nasdaq's Board composition requirements to the extent the market on which it was previously listed did not have the same standards. To the extent a company's previous market had substantially similar requirements but also had a transition period from the effective date of that market's rules, the company would have the same transition period as would have been available to the company on the previous market.
Nasdaq Requires Increased Board Independence and Enhanced Role for Independent Directors
A Majority of Directors Must Be Independent
A majority of the members of the Board of a listed company must qualify as "independent directors." The Board must make an affirmative determination that independent directors do not have a relationship with the listed company that would interfere with the exercise of independent business judgment. A company must name its "independent directors" in its annual proxy statement.
Director Independence Is Subject to Three-Year Bright Line Disqualifiers
A director cannot be independent if the director has any one or more of the following relationships:
Compensation in Excess of $60,000. A director who has, or whose "family member" has, accepted from the company (which includes any parent or subsidiary of the company) payments in excess of $60,000 within the current fiscal year or any of the past three fiscal years, other than:
- Compensation for Board or committee service;
- Payments arising solely from investments in the company's securities;
- Compensation paid to a family member who is a non-executive employee of the company or its parent or subsidiary;
- Benefits under tax-qualified retirement plans or nondiscretionary compensation; or
- Loans excluded from the Sarbanes-Oxley prohibition on loans to directors and officers implemented under Section 13(k) of the Exchange Act.
"Family member" includes a director's spouse, parents, children, siblings, whether by blood, marriage or adoption, and anyone residing in the director's home.
- Employment Relationship. A director who is or was employed by, or who has a family member who is or was employed as an executive officer of, the company at any time during the past three years.
- Significant Business Relationship. A director who is, or who has a family member who is, a partner, executive officer or controlling shareholder of any organization (including a not-for-profit organization) that received from or made payments to the company exceeding the greater of $200,000 or 5% of the recipient's consolidated gross revenues for property or services in the current fiscal year or any of the past three fiscal years, other than payments arising solely from investments in the listed company's securities or payments under nondiscretionary charitable contribution matching programs.
- Relationships With the Auditor. A director who is, or who has a family member who is, a current partner of the company's outside auditor, or was a partner or employee of the company's outside auditor who worked on the company's audit at any time during the past three years.
- Interlocking Directorate. A director who is, or who has a family member who is, employed as an executive officer of another company where any of the listed company's executive officers serve or served on such other company's compensation committee at any time during the past three years.
Note that audit committee members are subject to stricter independence requirements under the Nasdaq's final rules, which are discussed below.
Companies Can "Cure" Inadvertent Noncompliance With Independent Majority Requirement
Nasdaq provides a cure period for failure to comply with the independent majority requirement if one director ceases to be independent "for reasons outside the director's reasonable control" or in the case of a single vacancy on the Board. The cure period would end on the earlier of the company's next annual shareholders meeting or the first anniversary of the event that caused the noncompliance. The company must notify Nasdaq immediately upon learning of the noncompliance.
Independent Directors Must Meet Regularly in Executive Sessions
Independent directors must meet "regularly" in executive sessions, without management or other directors present. Nasdaq contemplates at least two executive sessions each year.
Independent Directors Must Play Increased Role in Compensation and Nomination Decisions
Independent Directors Must Make or Recommend Compensation Decisions
An independent compensation committee or a majority of the independent directors must determine, or recommend to the Board for determination, compensation for the CEO and other executive officers.
The CEO may not be present during voting or deliberations concerning the CEO's compensation. One nonindependent director can serve for two years on the independent compensation committee if the committee has at least three members and "exceptional and limited circumstances" exist.
Exception for "exceptional and limited circumstances"
The "exceptional and limited circumstances" exception is available if:
- The non-independent director is not an officer or employee of the company or a family member of an officer or employee;
- The Board determines that the non-independent director's service on the committee is in the best interests of the company and its shareholders; and
- The company discloses in its next annual proxy statement the non-independent director's relationship to the company and the basis for the Board's determination.
Independent Directors Must Make or Recommend Nomination Decisions
An independent nominating committee or a majority of the independent directors must select, or recommend to the Board for selection, all director nominations, except where a third party has the legal right, by contract or otherwise, to nominate a director. The "exceptional and limited circumstances" exception described above is also available for service by one nonindependent director on the nominating committee.
A listed company must certify that its Board has adopted either a formal written charter, if it has a nominating committee, or a board resolution, if a majority of independent directors make nomination decisions, that addresses the nomination process and such related matters as may be required under federal securities laws.
Companies subject to a binding agreement entered into prior to November 4, 2003 that contains nomination requirements inconsistent with Nasdaq rules are not required to comply with these requirements until the agreement expires.
A Controlled Company Is Exempt From the Independence Requirements
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; or
- Independent directors, or independent compensation and nominating committees, make compensation and nomination decisions.
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, and its independent directors must hold regular executive sessions.
Final Rules Require Stricter Independence Requirements and Enhanced Role for Audit Committee
Audit Committee Members Must Meet Stricter Independence Requirements
A listed company must have an audit committee consisting of at least three independent directors, each of whom meets the definition of independence discussed above.
The final rules clarify that directors who have participated in the preparation of the financial statements of the company or any current subsidiary of the company during the past three years cannot serve on the audit committee. In addition, consistent with the Sarbanes-Oxley-mandated audit committee independence requirements implemented by the SEC, audit committee members may not:
- Receive any payment from the company other than for Board or committee service; or
- Be an "affiliated person" of the company or any subsidiary.
Final Rules Eliminate Proposed Bright Line Disqualification Test for Beneficial Ownership of Company Voting Securities
The final Nasdaq rules eliminate the proposed requirement that no audit committee member own or control 20% or more of the listed company's voting securities. Instead, the final rules determine audit committee independence based on share ownership consistent with the "safe harbor" approach of the SEC's Rule 10A-3. Under this Rule, an audit committee member is deemed not to be an affiliate if he or she is not an executive officer of the issuer (or a subsidiary of the issuer) and does not beneficially own 10% or more of any class of voting equity securities of the company or any of its subsidiaries. Nasdaq recommends that a company disclose in its annual proxy statement whether any director is deemed independent but falls outside the SEC's "non-affiliate" safe harbor.
Modified "Exceptional and Limited Circumstances" Exception Applies to Audit Committee Independence Requirements
Nasdaq's "exceptional and limited circumstances" exception applies in a modified form for the audit committee. A director who does not satisfy the general independence standards for directors, but who does satisfy the additional Sarbanes-Oxley-mandated audit committee independence requirements, and who is not a current officer or employee, or a family member of a company employee, can serve on the audit committee for up to two years. However, this director may not serve as the committee chair. The company must disclose the nature of the director's relationship, and the reasons for the Board's determination that the director's service on the committee is in the best interests of the company and its shareholders, in the company's next annual proxy statement.
Companies Can "Cure" Inadvertent Noncompliance With Audit Committee Composition Requirements
The cure period requirements described above for the majority-of-independent-directors rule is also available if a company fails to comply with the audit committee composition requirements. The company must notify Nasdaq immediately upon learning of the noncompliance, and the cure period would only apply to one committee member. The noncomplying committee member is excused from meeting the Nasdaq independence requirements, but must still meet the independence requirements under the SEC's Rule 10A-3.
Audit Committee Members Must Be Financially Literate and One Member Must Be Financially Sophisticated
All audit committee members must be able to read and understand fundamental financial statements at the time of their appointment. In addition, the audit committee must have at least one member with "financial sophistication." Financial sophistication may result from past employment experience in finance or accounting, requisite professional certification in accounting or any other comparable experience or background, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities. Although Nasdaq's final rule does not formally adopt the SEC's definition of "audit committee financial expert," the rules clarify that a Board may presume that a person who meets the SEC's "audit committee financial expert" standards set forth in Item 401(h) of SEC Regulation S-K has sufficient accounting or related financial expertise to meet Nasdaq's "financial sophistication" standard.
Audit Committee Charter Must Establish Audit Committee Authority and Power Over the Audit Process
A listed company's audit committee charter must set forth the responsibilities and authority of the committee to comply with the SEC's audit committee requirements in the SEC's Rule 10A-3. Among other things, Rule 10A-3 requires that a listed company's audit committee:
- Be directly responsible for the appointment, compensation and oversight of the outside auditors;
- Preapprove all permissible non-audit services provided by the company's accountants;
- 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; and
- Be authorized to engage, and determine funding for, independent legal counsel and other advisors.
Audit Committee Must Approve Related Party Transactions
A listed company's audit committee, or a comparable body of independent directors, must review and approve all related party transactions. Prior Nasdaq rules required only review of these transactions. Related party transactions are described in Item 404 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;
- certain business relationships of a director or nominee that have existed within the past fiscal year; and
- indebtedness to the company or a subsidiary exceeding $60,000 by a director, nominee or any family member, certain related entities, or certain estates of those persons.
This rule will take effect on January 15, 2004.
Small Business Issuers Are No Longer Exempt From Audit Committee Requirements
Small business issuers are no longer exempt from audit committee requirements generally applicable to U.S. listed companies.
All Companies Must Adopt and Disclose a Code of Conduct
A listed company must adopt and publicly disclose a code of conduct applicable to all its directors, officers and employees. The final Nasdaq rules require that the code of conduct be in compliance with the "code of ethics" requirements of Section 406 of Sarbanes-Oxley. Item 406 of SEC Regulation S-K defines a code of ethics as written standards reasonably designed to deter wrongdoing and to promote honest and ethical conduct. Additionally, a company's code of conduct must provide for an enforcement mechanism, and any waivers from the code for directors or executive officers must be approved by the company's Board and disclosed in a Form 8-K filed within five days. The code of conduct rule will take effect on May 4, 2004. You can find more information concerning the SEC's code of ethics requirements in our February 5, 2003 update.
Companies Must Publicly Announce Going Concern Qualifications
Nasdaq requires a listed company to publicly disclose through a press release any going concern qualification included in an auditor's opinion. The disclosure must be made within seven days of the filing of the SEC report that contained the auditor's opinion. This requirement is effective as of November 4, 2003.
Companies Must Notify Nasdaq of Material Noncompliance With Corporate Governance Rules
A listed company must promptly notify Nasdaq if an executive officer of the company becomes aware of any material noncompliance by the company with Nasdaq's corporate governance rules.
Rules Apply to Foreign Private Issuers, but With Different Effective Dates and Transition Periods
Under Nasdaq's final rules, only foreign private issuers (as opposed to all foreign issuers) may apply for exemptions from Nasdaq's corporate governance rules. Exemptions are available for foreign private issuers upon a showing that Nasdaq's corporate governance rules are contrary to a law, rule or regulation of any public authority exercising jurisdiction over the issuer or are contrary to generally accepted business practices in the issuer's country of domicile, provided that the exemptions are not contrary to federal securities law (including the audit committee requirements of the SEC's Rule 10A-3). Compliance with these limitations on corporate governance exemptions is required by July 31, 2005.
Nasdaq requires that foreign issuers publicly disclose any exemptions they receive from Nasdaq's corporate governance rules in the issuer's annual report filed with the SEC. The foreign issuer must also describe in its annual report any alternative practice to the Nasdaq rule for which it received an exemption. Foreign issuers making their initial public offerings or first U.S. listings on Nasdaq must disclose any exemptions in their registration statements. These disclosure requirements take effect for new filings and listings after January 1, 2004.
Some Nasdaq Governance Rules Are Still Pending
Proposed Amendment to Change of Control Definition
Nasdaq's proposal to clarify its definition of "change of control" is still pending. The clarification is intended to assist companies in determining when a change of control transaction exists that triggers shareholder approval requirements. Under the proposal, a change of control is presumed to occur when an investor or a group of investors acquires 20% or more of a company's common stock or 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 company's directors and officers, as a group, who are not affiliated with the investor.
Proposal to Require Shareholder Approval of Private Placement
Nasdaq also has still pending a proposal to clarify when shareholder approval is required in connection with a stock issuance to an officer or director of the company in a private placement. The proposed revisions specify that shareholder approval is not required for a private placement to officers and directors for less than the market value of the stock if the total number of shares to be issued to all such officers and directors of the company is less than 5% of the total shares issued in the private placement and less than 1% of the total shares outstanding before the private placement. In this context, "market value" is defined as:
- the closing bid price immediately preceding the execution of a fully binding definitive agreement that is not subject to any contingency other than a regulatory contingency, or
- an average of the closing bid prices for a period of up to five days ending immediately preceding the execution of a fully binding definitive agreement that is not subject to any contingency other than a regulatory contingency.