- SEC Approves the NASDAQ Corporate Governance Rules
- December 9, 2003
- Law Firm: Blank Rome LLP - Philadelphia Office
On November 4, 2003, the Securities and Exchange Commission ("SEC") approved amendments to the corporate governance rules (the "New NASDAQ Rules") proposed by The Nasdaq Stock Market, Inc. ("Nasdaq"). These rules were adopted in response to the requirements of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") and the New NASDAQ Rules promulgated by the SEC thereunder.
The New NASDAQ Rules apply to all companies with the common equity securities quoted on the Nasdaq National and Small Cap Markets or applying for quotation of its common equity securities on the National or Small Cap Markets, other than limited partnerships. There are several special rules applicable to foreign private issuers which are not addressed in this Alert.
The New NASDAQ Rules require, among other things, that:
- listed companies have a majority of independent directors;
- directors of listed companies be subject to more stringent standards for qualifying as an "independent" director;
- independent directors of listed companies hold require regularly scheduled meetings;
- the compensation of executive officers (including the CEO) of listed companies be determined, or recommended to the board for determination, either by a majority of independent directors or a compensation committee comprised solely of independent directors;
- director nominees of listed companies to be selected, or recommended to the board for selection, either by a majority of independent directors or a nominations committee comprised solely of independent directors;
- the adoption by listed companies of a charter or board resolution addressing the nominations process;
- the audit committee or another independent body of the board of directors of the listed companies to review and approve all related party transactions;
- more stringent standards of independence apply to audit committee members;
- the audit committee be given significant increased authority;
- the audit committee and its members have substantially increased responsibilities;
- the adoption and public disclosure by listed companies of a code of business ethics and conduct;
- public disclosure by listed companies of the receipt of a "going concern" qualification from their auditors; and
- written notification to Nasdaq by listed companies upon any material non-compliance with the New NASDAQ Rules.
II. Director Independence
The New NASDAQ Rules require that a majority of the directors of a company1 be independent. Under the prior rules, a director qualified as "independent" if he or she is not an employee of the company and does not have a relationship which in the opinion of the company's board of directors would interfere with the exercise of independent judgment in the discharge of the duties and responsibilities of a director of the company. A director's ownership of the company's stock, even at significant levels, does not of itself preclude the board from determining that the director is independent.
Under the New NASDAQ Rules, if a director has a relationship with the company that the board determines is not material for independence purposes, the company's annual proxy statement (or Form 10-K, if no proxy statement is filed) must disclose the basis for that determination. The board may adopt objective standards for determining independence. If the board adopts such standards, the standards must be disclosed in the company's proxy statement and the proxy statement may state that the independent directors meet the standards set by the board without detailing particular aspects of immaterial relationships between individual directors and the company. Any determination of independence for a director who does not meet these standards, or who has a relationship not covered by the standards, must be specifically explained.
The New NASDAQ Rules provide the following relationships will disqualify a director from being independent:
- A director who is, or at any time during the past three years was, employed by the company;
- A director who accepted, or who has a family member2 who accepted, any payments from the company in excess of $60,000 during the current or any of the past three fiscal years, other than compensation for board or board 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, benefits under a tax-qualified retirement plan, or non-discretionary compensation, or loans permitted under Section 13(k) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"); this provision (sometimes referred to as the "payments provision") is intended to apply in situations where a payment is made directly to, or for the benefit of (emphasis added) the director or a family member of the director;
- A director who is a family member of an individual who is, or at any time during the past three years was, employed by the company as an "executive officer" (as defined in Rule 16a-1(f) under the Exchange Act);
- A director who is, or has a family member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services3 in the current or any of the past three fiscal years that exceed 5% of the recipient's consolidated gross revenues for that year, or $200,000, whichever is more, other than payments arising solely from investments in the company's securities or payments under non-discretionary (emphasis added) charitable contribution matching programs. The New NASDAQ Rule (sometimes referred to as the "business relationship provision") is generally intended to capture payments to an entity with which the director or family member is affiliated by serving as a partner (other than a limited partner), controlling shareholder or executive officer of such entity; under exceptional circumstances, such as where a director has direct, significant business holdings, it may be appropriate to apply the corporate measurements in the business relationship provision, rather than the individual measurements of the payments provisions described above. The independence requirements of the business relationship provision are broader than the rules for audit committee member independence set forth in Rule 10A-3(e)(8) under the Exchange Act. In addition, under the business relationship provision, a director who is, or who has a family member who is, an executive officer of a charitable organization may not be considered independent if the company makes payments to the charity in excess of the greater of the greater of 5% of the charity's revenues or $200,000. Payments from the company to a law firm of a director who is a partner of that firm will be tested under the business relationship provision to determine if that director is independent; however, any partner in a law firm that receives any payments from the company is ineligible to serve on the company's audit committee;
- A director of the listed company who is, or has a family member who is, employed as an executive officer of another entity at any time during the past three years where any of the executive officers of the listed company serve on the compensation committee of such other entity; and
- A director who is, or 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, and worked on the company's audit, at any time, during any of the past three years.
For those Rules utilizing the three year look-back test, the test would apply to relationships that existed at any time during the three year period and the three year "look-back" periods commence on the date the relationship ceases. The three year "look-back" provisions are phased in so that until November 4, 2004 the look-back period may be limited to one year. If a company chooses to apply only a one year period, it may be required to make changes to the composition of their board on November 4, 2004.
As described below, members of the audit committee will also be required to satisfy several additional and important independence criteria.
III. Annual Proxy Statement Disclosure
A listed company must disclose in its annual proxy statement those directors determined by the board to be independent. If a listed company does not file proxy statements, any disclosure required by the New NASDAQ Rules to be made in a proxy statement must be made in the company's Annual Report on Form 10-K.
If a company fails to comply with the requirement to have a majority of independent directors due to one vacancy, or if one director ceases to be independent as a result of circumstances beyond the director's reasonable control, the company must regain compliance by the earlier of its next annual shareholders' meeting or one year from the occurrence of the event that caused the non-compliance. A company relying on this "cure period" must provide notice to Nasdaq immediately upon learning of the circumstance that caused the non-compliance.
IV. Meetings of Independent Directors
The independent directors of a listed company must have regularly scheduled meetings without the non-independent directors. Although there is no minimum number of these meetings required, at least two such meetings per year is strongly encouraged.
V. Compensation and Compensation Committee Requirements
Compensation of the CEO and all other officers must be determined, or recommended to the board of directors for determination, either by a majority of the independent directors or by a compensation committee comprised solely of independent directors. The CEO may not be present during voting or deliberations relating to his or her compensation.
If a company's compensation committee is comprised of at least three members, the board may appoint to the Compensation Committee one director who is not independent and is not a current officer or employee of the company or a family member of an officer or employee of the company, provided the board, under "exceptional and limited circumstances," determines that such membership is required by the best interests of the company and its shareholders. The board must disclose in the company's next annual proxy statement such determination, the nature of the relationship and the reasons for such determination. A member appointed pursuant to this exception may not serve longer than two years. Nasdaq recommends that the company disclose in its annual proxy if any director is deemed independent but falls outside the safe harbor provisions of Exchange Act Rule 10A-3(e)(1)(ii).
VI. Nomination of Directors and Nominating Committee Requirements
Director nominees must either be selected, or recommended for the board of directors' selection either by a majority of independent directors, or by a nominating committee comprised solely of independent directors.4 Each company must adopt and certify that it has adopted a formal written charter or board resolution, as applicable, addressing the nominations process and all related matters as may be required under federal securities laws; the SEC's recently proposed rules for additional disclosure regarding the nominating process will be applicable to this charter and board resolutions.
If a company's nominating committee is comprised of at least three members, the board may appoint to the nominations committee one director who is not independent and is not a current officer or employee or a family member of an officer or employee, provided the board, under "exceptional and limited circumstances," determines that such membership is required by the best interests of the company and its shareholders. The board must disclose such determination, the nature of the relationship and the reasons for such determination in the company's next annual proxy statement (or next Form 10-K if the company does not file a proxy statement). A member appointed pursuant to this exception may not serve longer than two years.
VII. Audit Committee Requirements
A company must have, and must certify that it has and will continue to have, an audit committee comprised of at least three members. Each member of the audit committee must meet the requirements of an independent director outlined above, meet the independence criteria set forth in SEC Rule 10A-3 (subject to the applicable exceptions), which provide that an audit committee member cannot accept, directly or indirectly, any consulting, advisory or other compensatory fee from the company other than fees for board and committee service, or be an "affiliated person" (as defined in Rule 10A-3) of the company (except as a director of an affiliate of the company if the director is otherwise independent), nor may an audit committee member have participated in the preparation of the financial statements of the company or any current subsidiary of the company at any time during the past three years. Each audit committee member must also be able to read and understand fundamental financial statements, including a company's balance sheet, income statement and cash flow statement.
Notwithstanding the requirement that each member must meet the independent director criteria applicable to directors generally, the board may appoint to the audit committee one director who is not independent under those criteria, but is independent under Rule 10A-3(b)(1), and is not a current officer or employee or a family member of a current officer or employee, provided the board, under "exceptional and limited circumstances," determines that such membership is required by the best interests of the company and its shareholders. The board must disclose such determination, the nature of the relationship and the reasons for such determination in the proxy statement for the next annual meeting (or next Form 10-K if the company does not file a proxy statement). A member appointed pursuant to this exception may not serve longer than two years and may not chair the audit committee.
Each NASDAQ company is required to certify that it has, and will continue to have, at least one member of the audit committee who has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual's financial sophistication, including being or having been a CEO, CFO or other senior officer with financial oversight responsibilities.5
If a company fails to comply with the audit committee composition requirements under Exchange Act Rule 10A-3 and new NASD Rule 4350(d)(2), because an audit committee member ceases to be independent for reasons outside the member's reasonable control, or due to one vacancy on the audit committee (provided this is the only such vacancy), the rules provide for a cure period until the earlier of the company's next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply with the requirements. During the cure period the audit committee member that has ceased to be independent may continue to serve on the committee. A company relying on such cure period is required to provide notice to Nasdaq immediately upon learning of the circumstance that caused the non-compliance.
VIII. Audit Committee Charter Requirements
The New NASDAQ Rules continue the existing requirements that the company must adopt and certify that it has adopted a formal written audit committee charter and that the audit committee must review and assess the adequacy of the charter and the performance of the audit committee on an annual basis. The audit committee charter must specify the significantly expanded scope of the audit committee's responsibilities (which must include all responsibilities specified under Rule 10A-3 as set forth below) and how the committee carries out those responsibilities, including structure, process and membership requirements. The audit committee has responsibility for ensuring its receipt from the outside auditors of a formal written statement delineating all relationships between the auditor and the company, and for actively engaging in a dialogue with the auditor with respect to any disclosed relationships or services that may impact the objectivity and independence of the auditor and for taking appropriate action to oversee the independence of the outside auditor.
The audit committee's charter must also specify the committee's purpose of overseeing the accounting and financial reporting processes of the company and the audits of the financial statements of the company, and must also include the specific audit committee responsibilities and authority mandated by Rule 10A-3, which implements the audit committee minimum standards set forth in Section 301 of Sarbanes-Oxley. Rule 10A-3 prohibits Nasdaq from listing any security of a company that does not have an audit committee comprised of independent directors and that is not in compliance with the following standards:
- The audit committee must be directly responsible for the appointment, compensation, retention and oversight of the work of any independent auditor (including resolution of disagreements between management and the auditor regarding financial reporting) engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the company, and the independent auditor must report directly to the audit committee;
- The audit committee must establish procedures for the receipt, retention and treatment of complaints received by the company regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters;
- The audit committee must have the authority to engage outside advisors, including independent counsel, as it determines necessary to carry out its duties; and
- The company must provide appropriate funding, as determined by the audit committee, for payment of:
- compensation to any independent auditor engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the company,
- compensation to any independent advisors employed by the audit committee, and
- ordinary administrative expenses of the audit committee.
IX. Code of Business Ethics and Conduct
The company must adopt a code of conduct applicable to all directors, officers and employees, which must be publicly available and must comply with the "code of ethics" definition set forth in Item 406(c) of Sarbanes-Oxley, which include such standards as are reasonably necessary to promote the ethical handling of conflicts of interest, full and fair disclosure, and compliance with laws, rules and regulations. The code of conduct must also include an enforcement mechanism that ensures prompt and consistent enforcement of the code, protection for persons reporting questionable behavior, clear and objective standards for compliance, and a fair process by which to determine violations.
Any waivers of the code of conduct for directors or executive officers must be approved by the board of directors and disclosed, together with the reasons for such waiver, in a Current Report on Form 8-K within five days.
X. Related Party Transactions
The company is required to conduct an appropriate review of all related party transactions for potential conflict of interest situations on an ongoing basis. All related party transactions would have to be approved by the company's audit committee or by another independent body of the board of directors. "Related party transactions" include those transactions required to be disclosed by the company pursuant to Item 404 of Regulation S-K.
XI. Notification of Non-Compliance
The company must promptly notify Nasdaq after any executive officer becomes aware of any material non-compliance with any applicable provisions of the New NASDAQ Rules.
XII. Going Concern Qualifications
The New NASDAQ Rules now require that all listed companies announce publicly through the news media the receipt of an audit opinion with a going concern qualification. Prior to the release of the public announcement, the company would be required to provide the text of the public announcement to the StockWatch section of Nasdaq's MarketWatch Department. The public announcement must be provided to Nasdaq StockWatch and released to the media not later than seven (7) calendar days after the filing of the audit opinion in a public filing with the SEC.
XIII. Effective Dates/Transition Periods
Nasdaq-listed companies (other than small business issuers (as defined in Exchange Act Rule 12b-2)) will have until the earlier of October 31, 2004, or their first annual meeting after January 15, 2004, to comply with the New NASDAQ Rules regarding director independence, independent committees and notification of non-compliance. Small business issuers will have until July 31, 2005 to comply with these particular NASDAQ Rules.
The New NASDAQ Rules relating to codes of conduct will be effective on May 4, 2004. The New NASDAQ Rules relating to audit committee review and approval of related party transactions become effective on January 15, 2004. The remainder of the New NASDAQ Rules are as of November 4, 2003. To the extent that timely compliance with the New NASDAQ Rules (other than the audit committee requirements) would require a company with a staggered board to change a director not scheduled to stand for election at an earlier annual meeting, the New NASDAQ Rules provide that the director may continue in office until the second annual meeting after January 15, 2004, but no later than December 31, 2005. Each company would be required to comply with the audit committee requirements pursuant to the implementation schedule set forth above.
Companies listing only preferred or debt securities are generally not covered by the New NASDAQ Rules, except that they are required to have an audit committee that satisfies the audit committee minimum standards mandated by Sarbanes-Oxley, and must comply with the requirement that the Chief Executive Officer ("CEO") notify NASDAQ regarding material non-compliance with the applicable corporate New NASDAQ Rules.
Exceptions to these requirements exist for "controlled companies," asset backed issuers, passive business organizations in the form of trusts, or other unincorporated associations and cooperatives without a publicly traded class of common stock, and closed-end and open-end management investment companies registered under the Investment Company Act of 1940. A "controlled company" is a company of which more than 50% of the voting power is held by an individual, group or another company. In order for a group to exist for purposes of this rule, the shareholders must have publicly filed a notice that they are acting as a group (e.g., a Schedule 13D). Controlled companies are exempt from the requirement to have a majority of independent directors, and are exempt from the requirements relating to the compensation of officers and the nominations of directors; however, the independent directors would still be required to have regularly scheduled meetings at which only independent directors are present. A controlled company electing to utilize any exemption must disclose in its annual proxy statement its election and how it qualifies as a controlled company.
1It should be noted that references to the "company" include any parent or subsidiary in a consolidated group with the company (but not to an entity reflected as an investment in the consolidated financial statements).
2For purposes of determining board independence, a "family member" includes a person's spouse, parents, children and siblings, whether by blood, marriage or adoption, and anyone who resides in such person's home.
3Notwithstanding the reference to making or receiving payments for "property or services," the commentary states that this paragraph applies to a director who is, or who has a family member who is, an executive officer of a charitable organization. In addition to the express standard set forth above, Nasdaq states that it encourages companies to consider other situations where a director or his family member and the company each have a relationship with the same charity when assessing director independence.
4The new requirements relating to nominating committees will not apply in cases where the right to nominate a director legally belong to a third party, or the company is already subject to a legally binding obligation that requires a director nomination structure inconsistent with the rule.
5Although Nasdaq does not require an audit committee to have a member who qualifies as an "audit committee financial expert," a person qualifying as such (as defined in Section 401(h) of Regulation S-K), is presumed to have the requisite financial sophistication.