Legal Alert: Overview of NYSE and Nasdaq Corporate Governance Listing Rules December 10, 2003

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1 Legal Alert: Overview of NYSE and Nasdaq Corporate Governance Listing Rules December 10, 2003 Introduction On November 4, 2003, the SEC approved changes to the listing rules of the NYSE and the Nasdaq. 1 The new listing rules will require listed companies that have their common equity securities listed on the NYSE or the Nasdaq to institute significant corporate governance changes. Listed companies must generally comply with the new corporate governance listing rules by the earlier of their first annual meeting after January 15, 2004, or no Background On February 13, 2002, former SEC Chairman Harvey Pitt sent a letter to the NYSE and the Nasdaq asking them to review their corporate governance and listing standards, including the important issues of officer and director qualifications and the codes of conduct of public companies. In response to the SEC s request, the NYSE and the Nasdaq appointed special working groups to review their corporate governance listing requirements. On June 6, 2002, the Nasdaq submitted its proposed corporate governance rule changes to the SEC. On August 16, 2002, the NYSE submitted its proposed corporate governance rule changes to the SEC. Since such time, the SEC has worked with the NYSE and the Nasdaq to harmonize their proposed corporate governance listing rules. Some of the more significant requirements contained in both the NYSE s and the Nasdaq s new listing rules include the following:! the board of directors of a listed company must be comprised of a majority of independent directors;! the director nominees of a listed company must be identified by the listed company s independent directors;! the compensation of a listed company s executive officers must be subject to the oversight of the listed company s independent directors;! the non-management or independent directors of a listed company must hold regularly scheduled executive sessions; and! a listed company must adopt a code of business conduct and ethics. 1 See SEC Release No (November 4, 2003). This article is for informational purposes and is not intended to constitute legal advise.

2 1. Board Independence Discussion The following table summarizes the significant provisions contained in the NYSE s and the Nasdaq s new listing rules. Issue NYSE NASDAQ Independent directors must comprise a majority of the board. Independent directors must comprise a majority of the board. Exemptions: Controlled companies are exempt from the requirement to have a majority of independent directors on their boards. A controlled company is a company of which more than 50% of the voting power is held by an individual, group or another company. A controlled company relying upon this exemption must disclose in its annual proxy statement or, if the company does not file an annual proxy statement, in its annual report on Form 10-K that it is a controlled company and the basis for that determination. Closed-end and open-end funds, limited partnerships, companies in bankruptcy and passive business organizations in the form of trusts are exempt from the requirement to have a majority of independent directors on their boards. Disclosure: If the board determines that a director s relationship with the listed company is not material, the company must disclose the basis for such determination in its annual proxy statement or, if the company does not file an annual proxy statement, in its annual report on Form 10-K. A board may adopt and disclose categorical standards to assist it in making determinations of independence and may make general disclosure if a director meets these standards. first annual meeting after January 15, 2004, or no Exemptions: Controlled companies are exempt from the requirement to have a majority of independent directors on their boards. A controlled company is a company of which more than 50% of the voting power is held by an individual, group or another company. A controlled company relying upon this exemption must disclose in its annual proxy statement or, if the company does not file an annual proxy statement, in its annual report on Form 10-K that it is a controlled company and the basis for that determination. Investment companies registered under the Investment Company Act of 1940 are exempt from this requirement. Disclosure: A listed company must disclose in its annual proxy statements or, if the company does not file an annual proxy statement, in its annual report on Form 10-K those directors that the board has determined to be independent. first annual meeting after January 15, 2004, or no later than October 31, This article is for informational purposes and is not intended to constitute legal advise. 2

3 2. Definition of Independent Director In order for a director to be independent, the board must affirmatively determine that the director has no material relationship with the listed company (either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company). The following persons shall not be considered independent directors: In order for a director to be independent, the board must determine that the director has no relationship which would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The following persons shall not be considered independent directors: (i) A director who is an employee, or whose Immediate Family Member is an executive officer, of the company is not independent until three years after the end of such employment relationship. (ii) A director who receives, or whose Immediate Family Member receives, more than $100,000 per year in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service), is not independent until three years after he or she ceases to receive more than $100,000 per year in such compensation. (iii) 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 the company is not independent until three years after the end of the affiliation or the auditing relationship. (iv) A director who is employed, or whose Immediate Family Member is employed, as an executive officer of another company where any of the listed company s present executive officers serve on that company s compensation committee is not independent until three years after the end of such service or the employment relationship. (v) A director who is an executive officer or an employee, or whose Immediate Family Member is an executive officer, of a company that makes payments to, or receives payments from, the listed company for property or services in an amount which, in any single fiscal year, exceeds the greater of $1 million, or 2% of such other company s consolidated gross revenues is (i) A director who is, or any time during the past three years was, employed by the company or by any parent or subsidiary of the company. (ii) A director who accepted or who 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 the following: 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 or a parent or subsidiary of the company; benefits under a tax-qualified retirement plan, or non-discretionary compensation; or loans permitted under Section 402 of the Sarbanes-Oxley Act of (iii) 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 or by any parent or subsidiary of the company as an executive officer. (iv) 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 services in the current or any of the past three fiscal years that exceeded 5% of the recipient s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following: payments arising solely from investments in the company s securities; or payments under non-discretionary charitable contribution matching programs. This article is for informational purposes and is not intended to constitute legal advise. 3

4 not independent until three years after falling below such threshold. (v) A director of the listed company who 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 listed company serve on the compensation committee of such other entity. (vi) 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 who worked on the company s audit at any time during any of the past three years. An Immediate Family Member includes a person s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughtersin-law, and anyone who shares such person s home. Business development companies do not determine director independence based on the above standards. Instead, a director of a business development company shall be considered independent if the director is not an interested person of the business development company, as defined in Section 2(a)(19) of the Investment Company Act of Phase-In Period: Each of the above standards contains a three-year look-back provision. The three-year look-back period does not start to take effect until November 4, Until then, a one-year look-back period applies. Family Member means a person s spouse, parents, children and siblings, whether by blood, marriage or adoption, or anyone residing in such person s home. Business development companies do not determine director independence based on the above standards. Instead, a director of a business development company shall be considered independent if the director is not an interested person of the business development company, as defined in Section 2(a)(19) of the Investment Company Act of Phase-In Period: Each of the above standards contains a three-year look-back provision. The three-year look-back period commences on the date the relationship in question ceases. The three-year look-back period commences when the new listing standards become effective. Unlike the NYSE rules, there is no phase-in period. This article is for informational purposes and is not intended to constitute legal advise. 4

5 3. Executive Sessions of Non-Management Directors Non-management directors must meet without management in regularly scheduled executive sessions. The company must disclose the name of the individual who will preside over the sessions or the procedure for selecting the presiding member. A company must provide a method for shareholders and employees to communicate with the non-management directors. If the non-management directors are not independent, then the company should schedule an annual executive session to include only the independent directors. first annual meeting after January 15, 2004, or no Independent directors must have regularly scheduled executive sessions at which only independent directors are present. Investment companies registered under the Investment Company Act of 1940 are exempt from this requirement. first annual meeting after January 15, 2004, or no later than October 31, Audit Committee The new listing rules will continue to require that (i) a listed company have an audit committee composed solely of three or more independent directors and (ii) the members of the audit committee possess certain financial literacy standards. Additional Independence Requirement: In order for an audit committee member to be deemed to be independent, the audit committee member (i) must satisfy the board independence requirements noted above under the caption Board Independence and (ii) must not: accept, directly or indirectly, any consulting, advisory, or other compensatory fee from the listed company or any subsidiary thereof, other than the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the company (provided that such compensation is not contingent in any way on continued service); The new listing rules will continue to require that (i) a listed company have an audit committee composed solely of three or more independent directors and (ii) the members of the audit committee possess certain financial literacy standards. Additional Independence Requirement: In order for an audit committee member to be deemed to be independent, the audit committee member (i) must satisfy the board independence requirements noted above under the caption Board Independence and (ii) must not: accept, directly or indirectly, any consulting, advisory, or other compensatory fee from the listed company or any subsidiary thereof, other than the receipt of fixed amounts of compensation under a retirement plan (including deferred compensation) for prior service with the company (provided that such compensation is not contingent in any way on continued service); in the case of non-investment company issuers, be an affiliated person (as defined in Section 10A-3 of the Securities Exchange Act of 1934) of the listed company or any subsidiary thereof; or in the case of investment company issuers, be an interested person of the listed company as defined in Section 2(a)(19) of the in the case of non-investment company issuers, be an affiliated person (as defined in Section 10A-3 of the Securities Exchange Act of 1934) of the listed company or any subsidiary thereof; in the case of investment company issuers, be an interested person of the listed company as defined in Section 2(a)(19) of the Investment Company Act of 1940; or This article is for informational purposes and is not intended to constitute legal advise. 5

6 Investment Company Act of Simultaneous Service on More Than Three Public Company Audit Committees: If an audit committee member serves simultaneously on the audit committee of more than three public companies and the listed company does not limit the number of audit committees on which its audit committee members may serve, then the listed company s board of directors must determine that such simultaneous service would not impair the ability of the audit committee member to effectively serve on the listed company s audit committee. The listed company must disclose such determination in its annual proxy statement or, if the company does not file an annual proxy statement, in its annual report on Form 10-K. Charter: have participated in the preparation of the financial statements of the listed company or any current subsidiary of the listed company at any time during the past three years. Simultaneous Service on More Than Three Public Company Audit Committees: The Nasdaq rules do not address this issue. Charter: The audit committee s charter must address the audit committee s purpose and duties which, at a minimum, must be to: assist the board in overseeing the integrity of the company s financial statements, the company s compliance with legal and regulatory requirements, the independent auditors qualifications and independence, and the performance of the company s internal audit function and independent auditors; prepare an audit committee report as required by the SEC to be included in the company s annual proxy statement; annually evaluate the performance of the audit committee; obtain and review, at least annually, a report of the independent auditors describing: the firms internal quality-control procedures; any material issues raised by the most recent internal quality-control review, or peer review, of the firm, or by any inquiry or investigation by governmental or professional authorities, within the preceding five years, respecting one or more independent audit carried out by the firm, and any steps taken to The audit committee s charter must specify the following: the audit committee has the ultimate authority and responsibility to select, evaluate, and, where appropriate, replace the outside auditor; the audit committee must establish procedures for the receipt, retention and treatment of complaints regarding the accounting, internal accounting controls, or auditing matters; the audit committee must have the authority to engage and determine funding for independent counsel and other advisors; the audit committee must be able to retain and compensate independent counsel and other advisers as the audit committee determines necessary to carry out its duties; and the audit committee must determine the appropriate level of funding to be provided by the company for payment of the independent auditors and outside advisers incurred by the audit committee in carrying out its duties. This article is for informational purposes and is not intended to constitute legal advise. 6

7 carried out by the firm, and any steps taken to deal with any such issues; and (to assess the auditors independence) all relationships between the independent auditors and the company; discuss annual and quarterly financial statements with management and the independent auditors, including MD&A; discuss earnings press releases as well as information and guidance provided to analysts and rating agencies; discuss policies with respect to risk assessment and risk management; meet separately with management, the internal auditors and with the independent auditors on a periodic basis; review with the independent auditors any audit problems and management s response; be responsible for the appointment, compensation and oversight of the work of the independent auditors; retain and compensate independent counsel and other advisers as the audit committee determines necessary to carry out its duties; determine the appropriate level of funding to be provided by the company for payment of the independent auditors and outside advisers incurred by the audit committee in carrying out its duties; establish procedures for the receipt, retention and treatment of complaints regarding the accounting, internal accounting controls, or auditing matters; set clear policies for hiring former employees of the independent auditors; and report regularly to the board of directors. first annual meeting after January 15, 2004, or no first annual meeting after January 15, 2004, or no later than October 31, This article is for informational purposes and is not intended to constitute legal advise. 7

8 5. Nominating/ Corporate Governance Committee Listed companies must have a nominating/ corporate governance committee composed entirely of independent directors. Charter: The nominating/corporate governance committee must have a written charter that addresses the committee s purpose and responsibilities which, at a minimum, must be to: identify individuals qualified to become board members and to select, or to recommend that the board select, specified nominees for the next annual meeting of shareholders; annually evaluate the performance of the committee; develop and recommend to the board a set of corporate governance principles applicable to the listed company; and oversee the evaluation of the board and management. Controlled companies are exempt from this requirement. The selection and nomination of directors need not be subject to the nominating committee process where a third party has a legal or contractual right to nominate a director. Director nominees must either be selected, or recommended for the board s selection by: a majority of the independent directors, or a nominating committee comprised solely of independent directors. Unlike the NYSE rules, the Nasdaq rules do not require a listed company to create a nominating committee. However, if the listed company chooses to create a nominating committee, then it must be comprised solely of independent directors. Charter: Listed companies must adopt a formal written charter or board resolution, as applicable, addressing the nominating process and such related matters as may be required under the federal securities laws. Controlled companies and investment companies registered under the Investment Company Act of 1940 are exempt from this requirement. The selection and nomination of directors need not be subject to the nominating process where a third party has a legal or contractual right to nominate a director. first annual meeting after January 15, 2004, or no later than October 31, This article is for informational purposes and is not intended to constitute legal advise. 8

9 6. Compensation Committee Listed companies must have a compensation committee composed entirely of independent directors. Charter: The compensation committee must have a written charter that includes the committee s purpose and duties and that provides for an annual performance evaluation of the committee. At a minimum, the committee s charter must provide that it is responsible for: reviewing and approving the corporate goals and objectives relevant to CEO compensation, evaluating CEO performance in light of those goals and objectives, and, either as a committee or together with the other independent directors, determining and approving the CEO s compensation level based on this evaluation; making recommendations to the board with respect to non-ceo compensation, incentivecompensation plans and equity-based plans; and producing a compensation committee report on executive compensation as required by the SEC to be included in the listed company s annual proxy statement or annual report on Form 10-K filed with the SEC. Controlled companies are exempt from this requirement. Compensation of the listed company s executive officers must either be determined, or recommended to the board for determination, by: a majority of the independent directors, or a compensation committee comprised solely of independent directors. Unlike the NYSE rules, the Nasdaq rules do not require a listed company to create a compensation committee. However, if the listed company chooses to create a compensation committee, then it must be comprised solely of independent directors. Charter: The Nasdaq rules do not contain a specific requirement that the compensation committee adopt a compensation committee charter. Controlled companies are exempt from this requirement. Investment companies registered under the Investment Company Act of 1940 are exempt from this requirement. first annual meeting after January 15, 2004, or no later than October 31, This article is for informational purposes and is not intended to constitute legal advise. 9

10 7. Corporate Governance Guidelines 8. Code of Business Conduct and Ethics Listed companies must adopt and publish corporate governance guidelines. Listed companies must publish these guidelines and the charters of the important board committees on their websites, disclose the website location in their annual reports on Form 10-K and provide copies of these materials to shareholders upon request. The guidelines must address: director qualification standards; director responsibilities; director access to management and, as necessary and appropriate, independent advisors; director compensation; director orientation and continuing education; management succession; and annual performance evaluation of the board. Listed companies must adopt 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. In addition, each listed company must publish its code on its website, disclose the website location in its annual report on Form 10-K and provide copies of the code to shareholders upon request. Waivers of the code for executive officers or directors may be made only by the board or a board committee and must be promptly disclosed to shareholders. Topics covered by the code must include: conflicts of interest; The Nasdaq rules do not address this issue. Listed companies are required to adopt a code of business conduct and ethics applicable to all directors, officers and employees. The code must be made publicly available. The code must provide for an enforcement mechanism. Any waivers of the code for directors or executive officers must be approved by the board and disclosed in a Form 8-K within five business days. Investment companies registered under the Investment Company Act of 1940 are exempt from this This article is for informational purposes and is not intended to constitute legal advise. 10

11 corporate opportunities; requirement. confidentiality; fair dealing; protection and proper use of company assets; compliance with laws, rules and regulations (including insider trading); and provisions that encourage the reporting of any illegal or unethical behavior. 9. Internal Audit Function 10. Foreign Private Issuers Unlike the rule recently adopted by the SEC which will require companies to disclose in their annual reports on Form 10-K whether they have adopted a code of ethics that covers their principal executive officers and senior financial officers, the NYSE rules will require that listed companies adopt a code of business conduct and ethics. Each listed company must have an internal audit function. A listed company may choose to outsource this function to a third-party service provider (other than its independent auditors). Listed foreign private issuers are permitted to follow home country practice in lieu of the NYSE corporate governance listing standards with the following exceptions: Listed foreign private issuers must have an audit committee that satisfies the additional independence requirements noted above under the caption Audit Committee. Listed foreign private issuers must disclose any significant ways in which their corporate governance practices differ from the NYSE rules. The disclosure of significant differences between a foreign private issuer s corporate governance and the NYSE Unlike the rule recently adopted by the SEC which will require companies to disclose in their annual reports on Form 10-K whether they have adopted a code of ethics that covers their principal executive officers and senior financial officers, the Nasdaq rules will require that listed companies adopt a code of business conduct and ethics. Compliance Date: May 4, The Nasdaq rules do not address this issue. Nasdaq has the ability to provide exemptions from its corporate governance listing standards to a foreign private issuer when provisions of its corporate governance listing standards are contrary to a law, rule or regulation of any public authority exercising jurisdiction over such issuer or contrary to accepted business practices in the issuer s country of domicile. A foreign private issuer that receives an exemption shall disclose in its annual reports filed with the SEC each requirement from which it is exempted and describe the home country practice. This article is for informational purposes and is not intended to constitute legal advise. 11

12 requirements for domestic companies is not intended to be a laundry list and may be made by a brief, general summary of material differences. 11. CEO Annual Certifications 12. Disciplinary Actions 13. Going Concern Opinion 14. Approval of Related-Party Transactions CEOs must certify annually that they are not aware of any company violations of the NYSE corporate governance listing standards. Each listed company CEO must promptly notify the NYSE after any executive officer of the company becomes aware of any material non-compliance with any applicable provisions of the NYSE corporate governance listing standards. The NYSE certifications, together with any CEO/CFO certifications that must be filed with or furnished to the SEC, must be disclosed in each company s annual report to shareholders, or if the company does not prepare such a report, in the company s annual report on Form 10-K. If the NYSE discovers a violation of its corporate governance listing standards, it may issue a public reprimand letter. The NYSE rules do not address this issue. The NYSE rules do not address this issue. Compliance Date: New listings or filings made on or after January 1, The Nasdaq rules do not address this issue. Nasdaq may deny the listing of a security if it determines that there have been violations or evasions of its corporate governance standards by the issuer of the security. A listed company that receives a going concern qualification in an audit opinion must make a public announcement of such fact through the news media. The public announcement must be provided to Nasdaq and released to the media within seven days following disclosure of the audit opinion in a public filing with the SEC. Compliance Date: November 4, 2003 Related-party transactions must be approved by a listed company s audit committee or another independent body of the board. A related party transaction is any transaction which is required to be disclosed pursuant to Item 404 of Regulation S-K. Compliance Date: January 15, 2004 This article is for informational purposes and is not intended to constitute legal advise. 12

13 Further Information This publication has been prepared solely for informational purposes and is not intended as legal advice. For more information about the matters discussed in this Legal Alert, please contact the Sutherland Asbill & Brennan LLP attorney with whom you work, or any of the attorneys listed below. ATLANTA WASHINGTON, D.C. Robert J. Pile Steven B. Boehm Jeffrey M. Taylor Cynthia M. Krus Geoffrey W. Edwards Harry S. Pangas This article is for informational purposes and is not intended to constitute legal advise. 13