The Securities and Exchange Commission recently approved the New York Stock Exchange's corporate governance listing standards, which finalize NYSE corporate governance proposals made over the last 18 months.
The most significant changes from NYSE's most recent proposal (in April 2003) include:
- Accelerating of the effectiveness dates relating to board and committee independence requirements.
- Amending to the "bright line" tests that disqualify a director from being considered independent, including
- a new bright line disqualification for any director who was employed, or whose immediate family member was employed as an executive officer, by a listed company in the last three years, and
- expanding of the bright line disqualification for receipt of compensation in excess of $100,000 to include immediate family members of directors.
- Shortening the "look-back" periods relating to bright line independence disqualifications from five to three years, coupled with a phase-in approach on look-back periods that is less generous than was proposed in April 2003.
What follows is a summary of the final NYSE corporate governance listing standards.
Effective Dates and Transition Periods
Generally, companies must comply with the new NYSE listing standards by the earlier of their first annual shareholders meeting after January 15, 2004 or October 31, 2004. Companies must comply with the SEC's rules under Section 10A-3 of the Securities Exchange Act of 1934 (relating to audit committee independence and financial expertise requirements) by the same deadline. Transition provisions are available to companies with classified boards, IPO companies and companies transferring from other markets.
A company with a classified board can delay replacing a non-independent director beyond its first annual shareholders 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).
A company listing with NYSE in connection with its initial public offering will be allowed to phase in its independent nomination and compensation committees on the same timeline that IPO companies have to comply with the Exchange Act's Section 10A-3 audit committee rules. Together with the SEC's Rule 10A-3, NYSE's phase-in rules for IPO companies mean that one member of each core committee (audit, compensation and nomination) must be independent at the time of listing, a majority of the members of each core committee must be independent within 90 days of listing and all the members of each core committee must be independent within one year of listing. Moreover, IPO companies will have 12 months from the date of listing to satisfy the requirement that a majority of the board be independent.
A company transferring from another market has one year from the date of transfer to comply with the applicable NYSE standards to the extent the market on which it was previously listed did not have the same standards. To the extent the other market had substantially similar requirements but also provided a transition period from the effective date of that market's rules, the transferring company can rely on the other market's transition period (other than for audit committee requirements, unless a transition period is available under the SEC's Rule 10A-3).
NYSE Requires Increased Board Independence and Enhances Role of Independent Directors
A Majority of Directors Must Be Independent
As expected, the final NYSE standards reflect the importance of director independence as a core corporate governance principle. The new standards require a majority of the directors of a NYSE-listed company to be independent. In addition, all members of the three core board committees must be independent. Controlled companies and foreign companies are exempt from some independence requirements. Under the new NYSE standards, for a director to qualify as "independent," a company's board will need to affirmatively determine that the director has "no material relationship with the listed company" (including any parent or subsidiary in a consolidated group). The board must consider the materiality of a director's direct relationships and his or her indirect relationships as a partner, shareholder or officer of an organization with links to the company. In addition, a company will need to disclose in its proxy statement the basis for a board's determination that a relationship between a director and the company is not material. Alternatively, the board may adopt categorical standards to assist it in making independence determinations (as long as such standards do not conflict with NYSE's bright line disqualifications discussed below). In that case, the categorical standards adopted by a board would need to be described in the proxy statement and the proxy statement may simply disclose that a director meets the categorical standards, rather than detailing the basis for the board's determination of independence. On the other hand, if a board determines that a director who fails to meet the board's categorical independence standards is nevertheless independent, the proxy statement must specifically explain the rationale.
Companies Must Determine Director Independence Using Three-Year Bright Line Disqualifications
Under the new NYSE standards, any director who has one or more of the following relationships will not be considered independent until three years after the relationship has terminated (or one year during the phase-in period described below):
- Employment Relationship. A director who is an employee, or whose immediate family member is an executive officer, of a listed company. However, service as an interim Chairman or CEO would not disqualify the director from being considered independent once the interim employment relationship ended.
- Compensation in Excess of $100,000. A director who receives, or whose immediate family member receives, more than $100,000 per year in direct compensation from a listed company, other than director and committee fees and pension or other deferred compensation for prior service that is not contingent on continued service. Compensation received by a director for former service as an interim Chairman or CEO, and compensation received by an immediate family member for non-executive employment, need not be considered for purposes of this disqualification.
- Relationships With Internal or External Auditor. A director who is affiliated with or employed by, or whose immediate family member is affiliated with or employed in a professional capacity by, a present or former internal or external auditor of a listed company.
- Interlocking Directorate. A director who is employed, or whose immediate family member is employed, as an executive officer of another company whose compensation committee includes a current executive of the listed company.
- Significant Business Relationship. A director who is an executive officer or employee, or whose immediate family member is an executive officer, of another company that made payments to or received payments from a listed company in an amount which exceeds the greater of $1 million or 2% of that other company's consolidated gross revenues. The payments and gross revenues to be measured are those reported for the last completed fiscal year. The look-back period applies only to the financial relationship between the listed company and the other company. Former employment of the director or immediate family member by a company with whom the listed company has (or had) a significant business relationship would not disqualify the director.
Note that while charitable organizations are not considered "companies" for purposes of the "significant business relationship" disqualification, a listed company must disclose in its annual proxy statement any contributions made by the company to any charitable organization in which a director serves as an executive officer if, within the previous three years, contributions in any single fiscal year exceeded the greater of $1 million or 2% of such charitable organization's consolidated gross revenues.
Transition Period for Three-Year Look-Back Period.
In order to facilitate a smooth transition to NYSE's new independence requirements, NYSE will phase in the three-year "look-back" provisions of the bright line independence disqualifications. Until November 4, 2004, the look-back period for the disqualifications described above will be one year; after that date, the full three-year look-back period will apply.
Non-Management Directors Must Meet Regularly
The listing standards require companies to schedule "regular" executive sessions in which "non management directors" meet without management participation. The term "non-management directors" excludes company officers, but includes other directors who are not independent because of a material relationship, former status or family membership. If the group of "non-management directors" includes any non-independent directors, then the new standards state that at least once a year an executive session attended solely by independent directors should be held.
The non-management directors may either appoint a single presiding director for all executive sessions or rotate the presiding position pursuant to a set procedure. The name of the presiding director or the procedure by which the presiding director is selected for each or all executive sessions must be disclosed in the listed company's proxy statement.
A listed company must also disclose a method for interested parties to communicate directly with the presiding director or with the non-management directors as a group.
NYSE Specifies Stricter Independence Standards for Audit Committee and Enhanced Role
Companies Must Have Independent Audit Committee
Companies must have an audit committee of at least three independent members that satisfies the requirements of the SEC's Rule 10A-3, which are described in more detail in our May 5, 2003 Update SEC Issues Final Rule to Implement Audit Committee Requirements of Section 301 of Sarbanes-Oxley.
Audit Committee Members Must Possess Financial Literacy
Each member of the audit committee must be, or within a reasonable period of time following appointment to the audit committee must become, "financially literate." At least one member must have accounting or related financial management expertise. The standards for financial literacy and financial expertise are to be determined by each company's board in its business judgment. A board may presume that a person who meets the standards set forth in Item 401(e) of Regulation S-K promulgated pursuant to the Sarbanes-Oxley Act has sufficient accounting or related financial expertise to meet NYSE's standard.
Audit Committee Must Adopt Written Charter
The listing standards require a company's audit committee to have a written charter that addresses:
The committee's purpose, which in addition to preparing the annual audit committee report for the proxy statement must be, at a minimum, to assist the board in its oversight of:
- the integrity of the company's financial statements;
- the company's legal and regulatory compliance;
- the independent auditor's qualifications and independence; and
- the performance of both the internal audit function and independent internal auditors.
- Annual evaluations of the committee's performance.
- Duties and responsibilities, which must include, at a minimum:
- those required by the SEC's Rule 10A-3(b)(2)-(5);
- annual review of the auditor's independence and internal quality control procedures;
- discussion of quarterly and annual financial statements with management and the independent auditors, including management's discussion and analysis;
- discussion of earnings releases or guidance to analysts and rating agencies (although pre-release review is not mandatory);
- retention of outside advisors (legal, accounting, etc.), as appropriate;
- discussion of the company's process for setting policies to govern risk assessment and management, including guidelines, policies and major financial risk exposure;
- separate and periodic meetings with management, internal auditors and independent auditors;
- review of audit problems or difficulties (and management's responses) with the independent auditors;
- establishment of clear hiring policies for employees or former employees of the independent auditors; and
- regular reporting to the board on:
- financial statements,
- compliance with law and other applicable regulations,
- external and internal auditors' performance, and
- internal audit procedures.
Board Must Evaluate Effect of Director's Service on Multiple Audit Committees
If a director serves on the audit committees of more than three public companies, then the board of the listed company must determine whether the director's simultaneous service on each additional audit committee will impair the director's ability to effectively serve on its own audit committee. The board's determination must be disclosed in the listed company's annual proxy statement.
NYSE Requires Independent Nominating/Corporate Governance Committee
Each listed company is required to have a nominating/corporate governance committee composed solely of independent members.
Nominating/Corporate Governance Committee Must Adopt Written Charter
The nominating/corporate governance committee must have a written charter that addresses:
The committee's purpose and responsibilities, which must be to, at a minimum:
- identify qualified director nominee candidates consistent with criteria approved by the board;
- select or recommend that the board select director nominees for the next annual meeting of shareholders;
- develop and recommend to the board a set of corporate governance guidelines; and
- oversee the evaluation of the board and management.
- Annual evaluation of the committee's performance.
This charter should also address:
- member qualifications;
- member appointment and removal;
- committee structure and operations (including authority to delegate to subcommittees);
- committee reporting to the board; and
- delegating sole authority to the committee to retain and terminate any search firm used to identify director candidates, including sole authority to approve the search firm's fees and other retention terms.
Companies Must Have Independent Compensation Committee
Each company must have a compensation committee composed solely of independent directors.
Compensation Committee Must Adopt A Written Charter
The compensation committee must have a written charter that addresses:
The compensation committee's purpose and responsibilities, which in addition to preparing the annual compensation committee report for the proxy statement must be, at a minimum to:
- directly review and approve corporate goals and objectives relevant to the CEO's compensation;
- evaluate the CEO's performance in light of those goals and objectives;
- determine and approve the CEO's compensation level based on this evaluation (either as a committee or with other independent directors as directed by the board); and
- make recommendations to the board with respect to non-CEO compensation, incentive-compensation plans and equity-based plans.
- Annual evaluation of the committee's performance.
NYSE Requires Internal Audit Function
Each listed company is required to have an internal audit function. A company may outsource this function to a third party other than its independent auditor.
Companies Must Adopt Corporate Governance Guidelines
Each listed company is required to adopt and disclose Corporate Governance Guidelines. The guidelines, as well as the company's Code of Business Conduct and Ethics and the charters of its most important committees (including at least the audit, compensation and nominating committees), must be posted on the company's website. The company's annual report filed with the SEC on Form 10-K must state that this information is available on its website and also available in print to any shareholder who requests it.
The Corporate Governance Guidelines must address:
- director qualification and independence standards;
- director responsibilities;
- director access to management and independent advisors;
- director compensation;
- director orientation and continuing education;
- management succession; and
- annual performance evaluation of the board.
Companies Must Adopt a Code of Business Conduct and Ethics
Each company is required to adopt and disclose a Code of Business Conduct and Ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers.
The Code of Business Conduct and Ethics should address, at a minimum:
- 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
- reporting of illegal or unethical behavior.
The code must require that any waiver of the code for executive officers or directors be made only by the board, or a board committee, and be promptly disclosed to shareholders. In addition, the code must contain compliance standards that will lead to the effective operation of the code. A company must include its code on its website and the company's annual report filed with the SEC on Form 10-K must state that the code is available on its website and is available in print to any shareholder who requests it.
CEO Must Certify to NYSE Company's Compliance With Corporate Governance Standards
Each listed company's CEO must annually certify to NYSE that he or she is not aware of any violation by the company of NYSE's corporate governance listing standards. A CEO is required to promptly notify NYSE in writing if any executive officer of the company becomes aware of any material non-compliance with the corporate governance listing standards. A listed company must disclose the certifications in its annual report to shareholders.
NYSE May Issue Public Reprimand Letters
NYSE may issue a public reprimand letter to a listed company that it determines has violated any NYSE listing standard. This sanction is not intended to be used in the event a company falls below NYSE's financial and other continued listing standards provided in Chapter 8 of NYSE's Listed Company Manual or certain of the audit committee listing standards. For companies that repeatedly or flagrantly violate NYSE listing standards, suspension and delisting remain the ultimate penalties.
NYSE Standards Do Not Apply to Controlled Companies, Foreign Issuers and Some Other Companies
Controlled Company Exception
A "controlled company" - a company of which more than 50% of the voting power is held by an individual, a group or another company - need not have a majority of independent directors on its board or a nominating/corporate governance or compensation committee composed solely of independent directors, but must comply with the other corporate governance standards. A controlled company that chooses to take advantage of the "controlled company" exemptions must disclose in its annual meeting proxy statement that it is a controlled company and the basis for that determination.
Foreign Company Exception
Companies that are foreign private issuers are allowed to follow home country practices in lieu of NYSE's corporate governance listing standards, except that they must:
- have an audit committee that satisfies the requirements of the SEC's Rule 10A-3;
- disclose significant ways in which their corporate governance standards differ from those of NYSE (either in the annual report to shareholders or on their website); and
- have their CEO promptly notify NYSE in writing if any executive officer of the company becomes aware of any material non-compliance with the applicable corporate governance listing standards.
Foreign companies have until July 31, 2005 to comply with the audit committee standards. Foreign companies have until the earlier of their first annual shareholders meeting after January 15, 2004 or October 31, 2004 to comply with the other two requirements.
The final NYSE rules also contain special provisions relating to closed-end management companies, business development companies, certain passive business organizations and issuers of derivatives and special purpose securities.
Text of the NYSE Final Corporate Governance Listing Standards
This Update is intended only as a summary of the standards. You can find further discussion of other recent laws, regulations and rule proposals of interest to public companies on our website.