SEC Approves Nasdaq Final Corporate Governance Listing Standards. December 2003

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1 650 Page Mill Road Palo Alto, CA PHONE FAX SEC Approves Nasdaq Final Corporate Governance Listing Standards December 2003 Introduction On November 4, 2003, the SEC approved Nasdaq s new corporate governance listing standards (see SEC Release No ). Time Frame for Compliance Nasdaq s revised listing standards related to stockholder approval of equity compensation (contained in amended NASD Rule 4350(i) and IM ) became effective June 30, 2003 and are discussed in a separate WSGR memorandum. The requirement to announce receipt of a going concern qualification is also already effective; the related party transaction approval requirements will become operative on January 15, 2004; and the compliance date by which companies must have adopted the required code of conduct will be May 4, Each of these requirements is described in this memorandum. The compliance date for the remainder of the new corporate governance listing standards, which are described in this memorandum, for each current Nasdaq listed company will generally be the earlier to occur of their first annual meeting after January 15, 2004, or October 31, A company with a staggered board will have until their second annual meeting after January 15, 2004, but not later than December 31, 2005, to implement all new requirements (other than the audit committee requirements, which must be complied with as described in the preceding sentence), if the company would be required to change a director who would not normally stand for election at an earlier annual meeting. Small business issuers will have until July 31, 2005 to comply. An accommodation is also set forth for companies transferring from other markets. afforded exemptions from all board composition requirements consistent with the exemptions afforded in SEC Rule 10A-3(b)(1)(iv)(A). That is, for each committee that the company adopts it must have one independent member at the time of listing, a majority of independent members within 90 days of listing, and the committee must be fully independent within one year. Companies which choose not to adopt a compensation or nomination committee will be required to meet the majority independent board requirement within one year of listing. Key Changes The following briefly summarizes the key differences between the final Nasdaq corporate governance listing standards and Nasdaq s prior proposals of March and July: Director Independence Standards The definition of family member has been narrowed; Nasdaq has expanded the relationships that preclude a finding of independence to apply not only to directors but also to family members of such directors; Nondiscretionary charity match programs have been excluded from the payments that would preclude a finding of independence; Loans permitted under Section 13(k) of the Exchange Act have likewise been excluded from such payments; Nasdaq has expanded the scope of relationships with the company s outside auditor that preclude a finding of independence; Companies that have listed or will be listed in conjunction with their initial public offering will be

2 Nasdaq has clarified applicability of the rule, particularly with respect to directors associated with law firms; The term executive officer has been clarified as meaning Section 16 officers, i.e., those covered in SEC Rule 16a-1(f); and A requirement has been added that companies identify in their proxy statement those directors that the board has determined to be independent. Independent Board Committees Changes to the audit committee requirements have been adopted to conform to SEC Rule 10A-3; Nasdaq clarified that directors who have participated in the preparation of the financial statements of the company or any current subsidiary during the past three years cannot serve on the audit committee; Nasdaq has clarified that the nominations and compensation committees may either take action or recommend that the board take action; Nasdaq has clarified that the nominations rule does not apply in cases where the right to nominate a director legally belongs to a third party, or the company is already subject to a legally binding obligation that requires a director nomination structure inconsistent with the Nasdaq rule; Nasdaq removed the provision that would have allowed one director holding 20% or more of the company s stock to serve on the nominations committee although the director would not be independent because that director is also a company officer; A requirement for a nominations committee charter has been added; Controlled companies will remain subject to the independent director executive session requirement; and Nasdaq added cure periods for the audit committee and majority independent board requirements with respect to board vacancies as well as circumstances where a director ceases to be independent for reasons outside the director s control. The following is a summary of the final listing standards: Board Structure and Composition Independent Board Members Under the Nasdaq listing standards, a majority of the board must be comprised of independent directors. Prior Nasdaq listing standards required only that a listed company have enough independent members to form an audit committee comprised solely of at least three independent directors. Executive Sessions The listing standards provide that the independent directors must meet at regularly scheduled executive sessions at which only they are present. It is contemplated that executive sessions will occur at least twice a year, and perhaps more frequently, in conjunction with regularly scheduled board meetings. Independent Committees. Nasdaq-listed companies will be required to have an audit committee each of whose members is both independent as defined by Nasdaq and independent as defined in SEC Rule 10A-3. Nasdaq also now requires that director nominees be selected, or recommended for the board s selection, either by a majority of the independent directors or a nominations committee comprised solely of independent directors. Independent director oversight of nominations shall not apply in cases where the right to nominate a director legally belongs to a third party, though this does not relieve a company s obligation to comply with the committee composition requirements under the governance listing standards. The nominations rule will not apply if the company is subject to a binding obligation that requires a director nomination structure inconsistent with Nasdaq s 2

3 nominations rule and such obligation pre-dates November 4, Similarly, Nasdaq now requires that the compensation of all executive officers be determined, or recommended to the board for determination, either by a majority of the independent directors or a compensation committee comprised solely of independent directors. The CEO may not be present during voting or deliberations on his or her own compensation. Limited Independence Exceptions Provided they are comprised of at least three members, each of the audit, nominations and compensation committees may include one director who is not independent as defined by Nasdaq, and who is not a current officer or employee or family member of an officer or employee, if the board, under exceptional and limited circumstances, determines that such membership is required by the best interests of the company and its shareholders and certain disclosures are made in the company s proxy statement. Members appointed under such an exception may not serve longer than two years. In the case of the audit committee, such member must still satisfy the SEC s separate independence criteria in SEC Rule 10A-3, and may not chair the committee. Additional Audit Committee Requirements The listing standards require that the audit committee have at least three members, none of whom participated in the preparation of the financial statements of the company or any current subsidiary during the past three years. In addition, the listing standards require the audit committee to satisfy the additional Sarbanes-Oxley requirements now contained in SEC Rule 10A-3 (subject to the exemptions contained in SEC Rule 10A-3(c)). This rule, which is discussed in a separate WSGR memorandum, addresses audit committee independence, oversight of independent auditors, whistleblower requirements, authority to engage advisors and funding for the committee. The additional independence requirements of the rule are that audit committee members may not, other than in their capacity as a member of the board or a 3 committee: (i) accept directly or indirectly any consulting, advisory or other compensatory fee from the company or any subsidiary (excluding fixed amounts under a retirement plan for prior service not contingent on future service); or (ii) be an affiliated person of the company or any subsidiary. All members of the audit committee must be able to read and understand fundamental financial statements, and one member must have 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. An audit committee financial expert, as defined by the SEC in Item 401(h) of Regulation S-K, is presumed to qualify as financially sophisticated. Cure Periods If a company fails to comply with the majority independent board requirement due to one vacancy, or one director ceases to be independent due to circumstances beyond their reasonable control, the company must regain compliance with the requirement by the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply. Similarly, if a company fails to comply with the audit committee composition requirement under SEC Rule 10A-3(b)(1) (the SEC s audit committee independence rule) and NASD Rule 4350(d)(2) (Nasdaq s audit committee composition requirement) because an audit committee member ceases to be independent for reasons outside the member s reasonable control, such person may remain on the audit committee until the earlier of its next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply. If a company fails to comply with the audit committee composition requirement under NASD Rule 4350(d)(2)(A) due to one vacancy on the committee, and the cure period in the preceding sentence is not otherwise being relied upon for another member, the company will have until the earlier of the next annual shareholders meeting or one year from the occurrence of the event that caused the failure to comply.

4 A company relying on any of the foregoing provisions must provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance. Controlled Company Exemption A controlled company is exempt from the majority independent board, nominations and compensation requirements of the listing standards (though not from the audit committee requirements or the requirement for executive sessions of the independent directors). A controlled company is one of which more than 50% of the voting power is held by an individual, group or other 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). A controlled company relying on this exemption must disclose in its annual meeting proxy statement (or, if the company does not file a proxy statement, in its Form 10-K or 20-F) that it is a controlled company and the basis for that determination. Definition of Independence Independence Generally For a director to be considered independent under the listing standards (other than the additional requirements applicable to audit committee members under SEC Rule 10A-3 discussed above), the board has a responsibility to make an affirmative determination that no relationships exist between the director and the company which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. However, ownership of company stock by itself would not preclude a board finding of independence (although it could be problematic under SEC Rule 10A-3 for audit committee members). Per Se Bars to Independence Regardless of the board s determination, under the listing standards, a director could not qualify as independent if such director: Is, or at any time during the past three years was, employed by the company or by any parent or subsidiary of the company; 4 Accepted or has a family member who accepted any payments from the company or any parent or subsidiary of the company in excess of $60,000 during the current or any of the past three fiscal years, other than: o Compensation for board or board committee service; o Payments arising solely from investments in the company s securities; o Compensation paid to a family member who is a nonexecutive employee of the company or a parent or subsidiary of the company; o Benefits under a tax-qualified retirement plan, or nondiscretionary compensation; or o Loans permitted under Section 13(k) of the Exchange Act; Is a family member of an individual who is, or at any time during the past three years was, employed by the company or by any parent or subsidiary of the company as an executive officer; Is, or has a family member who is, a partner (and not simply a limited 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 services 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: o Payments arising solely from investments in the company s securities; or o Payments under nondiscretionary charitable contribution matching programs; Is, or has a family member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company serve on the compensation committee of such other entity; or Is, or has a family member who is, a current partner of the company s outside auditor, or was a

5 partner or employee of the company s outside auditor who worked on the company s audit at any time during any of the past three years. Three-Year Look-Backs The three-year look-back periods in the first, third, fifth and sixth bullet points in Per Se Bars to Independence above commence on the date the relationship ceases. For example, a director employed by the company is not independent until three years after such employment terminates. Executive Officer The reference in the independence listing standards to executive officers means Section 16 officers, i.e., those covered in SEC Rule 16a-1(f). Family Member The listing standards define family member to mean a person s spouse, parents, children and siblings, whether by blood, marriage or adoption, and anyone residing in such person s home. The reference to marriage is intended to capture relationships specified in the rule (parents, children and siblings) that arise as a result of marriage, such as in-law relationships. Parent or Subsidiary The listing standards reference to a parent or subsidiary is intended to cover entities the company controls and consolidates with the company s financial statements (but not if the company reflects such entity solely as an investment in its financial statements). 1 Individual Versus Corporate Measurements Under exceptional circumstances, such as where a director has direct, significant business holdings, it may be appropriate to apply the corporate measurements in the fourth bullet point in Per Se Bars to Independence above, rather than the 1 Nasdaq has informally indicated that the rule is intended to cover in this respect not just entities the issuer controls but also, in the case of a parent, an entity which controls the issuer, and that the definition covers not only direct but also indirect parents and subsidiaries. 5 individual measurements of the second bullet point above. Companies should contact Nasdaq if they wish to apply the rule in this manner. Payments to a law firm would generally be considered under the corporate measurements of the fourth bullet point, though if the firm is a sole proprietorship, the individual measurements of the second bullet point would apply. Charitable Organizations Under the corporate measurements of the fourth bullet point in Per Se Bars to Independence above, 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 5% of the charity s revenues or $200,000. Disclosure Requirement The company must disclose in its annual proxy statement (or, if the company does not file a proxy statement, in its Form 10-K or 20-F) those directors that the board has determined to be independent. Board Responsibilities Expanded Audit Committee Charter The listing standards require a company to certify that it has adopted a formal written audit committee charter and that the audit committee has reviewed and reassessed the adequacy of the charter on an annual basis. The charter must specify: The scope of the audit committee s responsibilities, and how it carries out those responsibilities, including structure, processes, and membership requirements; The audit committee s responsibility for ensuring its receipt from the outside auditors of a formal written statement delineating all relationships between the auditor and the company, consistent with Independence Standards Board Standard 1, and the audit committee s responsibility for actively engaging in a dialogue with the auditor with respect to any disclosed relationships or services that may impact the objectivity and

6 independence of the auditor and for taking, or recommending that the full board take, appropriate action to oversee the independence of the outside auditor; The committee s purpose of overseeing the accounting and financial reporting processes of the company and the audits of the company s financial statements; and The specific audit committee responsibilities and authority necessary to comply with SEC Rule 10A-3(b)(2), (3), (4) and (5) (subject to the exemptions provided in SEC Rule 10A-3(c)), concerning responsibilities relating to: o Registered public accounting firms; o Complaints relating to accounting, internal accounting controls or auditing matters; o Authority to engage advisors; and o Funding as determined by the audit committee. Approval of Related Party Transactions Effective January 15, 2004, each Nasdaq-listed company must conduct a review of all related party transactions for potential conflict of interest situations on an ongoing basis and all such transactions must be approved by the audit committee or another independent body of the board. All directors that review and approve the transaction must not only be independent as specified under Nasdaq rules but also disinterested in the transaction. The term related party transaction refers to transactions required to be disclosed under Item 404 of Regulation S-K. Nominations Committee Charter The listing standards require that companies adopt a formal written charter or board resolution, as applicable, addressing the nominations process and such related matters as may be required under the federal securities laws. 6 Code of Conduct By May 4, 2004, Nasdaq-listed companies will be required under the listing standards to adopt a code of conduct applicable to all directors, officers and employees, which shall be publicly available. A code of conduct satisfying this rule must comply with the definition of a code of ethics set out in Section 406(c) of the Sarbanes-Oxley Act and SEC regulations thereunder. The SEC has defined such a code of ethics to mean written standards that are reasonably designed to deter wrongdoing and to promote: Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; Full, fair, accurate, timely and understandable disclosure in reports and documents that the company files with, or submits to, the SEC and in other public communications made by the company; Compliance with applicable governmental laws, rules and regulations; The prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and Accountability for adherence to the code. The code must contain 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 for directors or executive officers must be approved by the board and must, along with the reasons for the waiver, be disclosed on Form 8-K within five days. 2 The company can satisfy this obligation by adopting one or more codes of conduct, such that all directors, 2 Although the rule as currently published states that the Form 8-K must be submitted within five days, Nasdaq has informally indicated that the intended deadline is five business days, consistent with the SEC s Form 8-K disclosure requirement in connection with code of ethics waivers, and that Nasdaq plans to amend the published rule in this respect.

7 officers and employees are subject to a code that satisfies the definition of a code of ethics. Announcement of Going Concern Qualification Already effective as of November 4, 2003, a company that receives an audit opinion that contains a going concern qualification must, not later than seven calendar days following the filing of such audit opinion in a public filing with the SEC, make a public announcement through the news media disclosing the receipt of such qualification. Prior to the public announcement, the company must provide the text of the announcement to Nasdaq s MarketWatch Department. Notification to Nasdaq of Material Noncompliance A company must provide Nasdaq with prompt notification after an executive officer becomes aware of any material noncompliance by the company with the requirements of the Nasdaq s qualitative listing requirements in NASD Rule 4350, including the new corporate governance listing standards. Application to Foreign Private Issuers Foreign private issuers will have until July 31, 2005 to implement the new listing standards. Such companies may, however, apply to Nasdaq for an exemption from Nasdaq s corporate governance listing standards if such rules would require the company to do anything contrary to the laws, rules, regulations or generally accepted business practices of its home country, except to the extent that such an exemption would be contrary to the federal securities laws, including without limitation the audit committee requirements of SEC Rule 10A-3. A foreign company which receives such an exemption must disclose in its annual reports filed with the SEC each requirement from which it is exempted and describe the home country practice, if any, followed by the company in lieu of such requirements. In addition, a foreign company making its initial public offering or first U.S. listing on Nasdaq must disclose any such exemptions in its registration statement. Although, as mentioned above, foreign private issuers will have until July 31, 2005 to implement the new governance listing standards, the requirement that such a company disclose the receipt of a corporate governance exemption from Nasdaq shall be effective for new listings and filings made after January 1, This memorandum is intended only as general information about the matters discussed, and should not be construed as legal advice. For more information about these matters, please contact your Wilson Sonsini Goodrich & Rosati partner 7