February 2004 Bulletin 04-06 Using Categorical Standards to Determine Director Independence Under New NYSE and NASDAQ Rules If you have questions or would like additional information on the material covered in this Bulletin, please contact the author: Robert K. Morris (Pittsburgh) 412.288.3126 rmorris@reedsmith.com or the Reed Smith attorney with whom you regularly work. This bulletin is presented for informational purposes and is not intended to constitute legal advice. Reed Smith LLP 2004. All Rights Reserved. Reed Smith refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware. On November 4, 2003, the Securities and Exchange Commission approved rule changes filed by the New York Stock Exchange and NASDAQ to amend director independence requirements for NYSE and NASDAQ companies (www.sec.gov/rules/sro/34-48745.htm). In both cases, the new rules are, with certain exceptions, effective on the date of a company s first annual meeting of shareholders after January 15, 2004, but no later than October 31, 2004. Among other things, both the NYSE and NASDAQ rules require companies to have a majority of independent directors. However, the rules differ in their approach to defining independence for these purposes. The NYSE Approach to Defining Director Independence Under NYSE Rule 303A.02(a), in order for a director to be independent, the board of directors 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). 1 The Rule also requires that such determinations must be publicly disclosed. The NYSE commentary to this rule states that boards making independence determinations should broadly consider all relevant facts and circumstances. In particular, the issue should be viewed both from the standpoint of the director and that of persons or organizations with which the director has an affiliation. The commentary further states that a board may adopt and disclose categorical standards to assist it in making determinations of independence. If such standards are adopted and disclosed, the company may make a general statement that the independent directors meet the standards set by the board without detailing the aspects of relationships the directors may have with the company which do not violate the standards. If a director does not meet these adopted and disclosed standards but is nevertheless is determined to be independent, a board must disclose the basis for that determination. The permitted use of categorical standards is of great potential benefit to a board. It permits the board to avoid the necessity of a case-by-case analysis of all facts which could be considered to bear upon a particular director s relationship with the company and an explanation of the basis upon which, after consideration of such particulars, the director was affirmatively determined to be independent. Instead, a board can make its affirmative determination of independence after concluding that the director meets across-the-board standards applicable to all directors. Although the NYSE states that a board must affirmatively determine the independence of a director, the decision to be made by the board LONDON NEW YORK LOS ANGELES SAN FRANCISCO WASHINGTON, D.C. PHILADELPHIA PITTSBURGH OAKLAND PRINCETON NORTHERN VA WILMINGTON NEWARK MIDLANDS, U.K. CENTURY CITY RICHMOND HARRISBURG WESTLAKE VILLAGE r e e d s m i t h. c o m
is essentially a negative one that the individual does not have a material relationship with the company. Accordingly, the categorical standards adopted and disclosed by the company can be expected to describe those types of relationships which would be considered material; and a conclusion of independence would follow from a determination that in the case of a particular director none of the enumerated material relationships was present. In developing categorical standards, the board does not have unfettered discretion. The NYSE has enumerated five relationships which will preclude a finding of independence (303A.02(b)(i)-(v)) 2. The board thus is not free to develop categorical independence standards which are less stringent than these enumerated standards, i.e., a director who meets board-developed independence standards but who has a relationship identified in 303A.02(b)(i)-(v) could not be considered independent. In Frequently Asked Questions issued by the NYSE on January 29, 2004, the NYSE indicated that a company may not take the position that any director who does not have one of the five relationships enumerated in Section 303A.02(b) is per se independent (www.nyse.com/pdfs/section303afaqs.pdf). In its discussion, the NYSE emphasized that 303A.02(a) requires a board to make an affirmative determination that the director has no material relationship with the company, based on all relevant facts and circumstances, and that the criteria in 303A.02(b) were not intended to be exhaustive for all companies on this question. Accordingly, it would not seem to be appropriate, in the NYSE s view, for a company to simply state that in assessing director independence, it has applied the NYSE standards, or that a majority of its directors are independent as defined in NYSE standards. Instead, the board must establish and express its own standards (if it opts to use standards instead of specific case-by-case judgment for each director). On the other hand, there would appear to be nothing to preclude a board, after consideration of the particular circumstances of a company and its directors, from adopting and disclosing, as its guidelines for determining director independence, categorical standards which are substantially identical to the enumerated standards in 303A.02(b). In formulating guidelines for determining the absence of material relationships, it would be open to the board to conclude that the only types of relationships which would be material in the company s situation are relationships relating to employment, direct compensation, relations with the auditor, interlocking directorates and affiliated business transactions. It would also be open to the board to determine that the numerical levels of materiality, time periods and applicability to family members to be incorporated in the standards are the same as those enumerated in 303A.02(b). And, there is nothing to prevent a board of an NYSE-listed company from developing categorical standards which are more stringent than the enumerated standards. The standards could be more stringent in broadening the five enumerated standards to prohibit independence based on the relationships identified in these standards using lower thresholds of materiality, greater subject time periods, or expanded related party coverage. Or, the categorical standards could identify other types of relationships which would preclude a finding of independence, not identified in 303A.02(b)(i)-(v). Use of more stringent categorical standards could be beneficial from an investor relations standpoint, and could be especially attractive if, given the particular directors in question, the more stringent standards do not actually result in disqualifying any additional directors from being considered independent. The interest of some investors in seeing the application of more stringent independence standards is illustrated, for example, by independence guidelines put forth by Institutional Shareholder Services ( ISS ), an organization which holds itself out as being the world s largest provider of proxy voting and corporate governance services. ISS will typically advise its clients to withhold votes from non-independent directors of a company whose board is not majority-independent, as independence is defined in ISS guidelines. Such guidelines, as most recently amended in 2004, impose more stringent definitions of independence than either the NYSE or NASDAQ rules. 3-2 -
The NASDAQ Approach to Defining Director Independence The new NASDAQ rules include the following definition of Independent Director (Rule 4200(a)(15)): Independent director means a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship, which, in the opinion of the company s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. This definition is followed by an enumeration of seven categories of individuals who shall not be considered independent. 4 Although the structure of the NYSE and NASDAQ approaches is similar in specifying lists of persons who may not be considered to be independent, the nature of the required board judgment on independence by NASDAQ seems on its surface to differ radically from that required by the NYSE. While the NYSE requires an affirmative determination of independence, NASDAQ Rule 4200(a)(15) seems to only require the absence of a Board determination of non-independence. The NASDAQ rule leaves it open to the board to determine that an individual has a relationship which would interfere with the exercise of independent judgment. But in the absence of such a determination for any individual, such individual, under the text of the rule, would be considered independent, without need of an affirmative determination of independence. However, when certain other provisions of the NASDAQ rules, together with the NASDAQ commentary to the rules, are taken into account, this apparent difference between the NYSE and NASDAQ approaches proves illusory. The NASDAQ commentary to the independent director definition stresses that it is important that investors have confidence that individuals serving as independent directors do not have a relationship with the company that would impair their independence. The commentary states that the board has a responsibility to make an affirmative determination that no such relationships exist. This expression of the board s duty essentially transforms the NASDAQ approach to determining independence into the NYSE approach--requiring an affirmative determination of independence and providing that certain enumerated relationships preclude such a determination. In addition, NASDAQ Rule 4350(c)(1) provides that a company must disclose in its annual report those directors that the board of directors has determined to be independent under Rule 4200. Theoretically, this disclosure could simply state that the identified directors have been determined by the board to be independent under Rule 4200, because the board has not made any determination that such individuals have a relationship which, in the board s opinion, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. In other words, the board would affirmatively determine independence by stating that it had not made a determination of non-independence. Obviously, this is not nearly as satisfactory a disclosure as would be a statement that the board had affirmatively determined that identified directors are independent. However, it would likely be cumbersome to identify the specific factors for each individual director which formed the basis for such a determination. For this reason, it could be useful for a NASDAQ board to adopt and disclose categorical standards to assist in such determinations (in the same way which the NYSE has suggested for NYSE companies), and simply disclose that each independent director met those standards. Although the NASDAQ rules do not specifically authorize such use of categorical standards, establishment and disclosure of the standards, together with a statement that the directors identified as independent meet the standards, would seem to meet the requirement of Rule 4350(c) that a company must disclose those directors that the board of directors has determined to be independent under Rule 4200. As with the NYSE approach, the standards adopted by the board could either track the NASDAQ-enumerated standards in 4200(a)(15) or be more stringent than those standards. - 3 -
Deadlines for Compliance For both NYSE and NASDAQ companies, generally, the deadline for meeting the requirements as to board composition is the date of the company s first annual meeting after January 15, 2004, but no later than October 31, 2004. For calendar year companies that typically hold an annual meeting in the spring, the board composition requirements will be effective on the date of the upcoming annual meeting. The deadline for meeting the requirements to disclose which board members are independent and what standards were used for making that determination differs for NYSE and NASDAQ companies. The NYSE has indicated in its Frequently Asked Questions that such disclosure requirements will apply only for disclosures after the first annual meeting after January 15. Thus, for calendar year companies, such disclosures, as a technical matter, would not be required to be included in the proxy statement for the upcoming annual meeting. However, there may be good reasons for an NYSE company to opt to include the disclosures in this year s proxy statement. This may be a good investor-relations strategy, particularly for companies with institutional shareholders who have a high level of interest in corporate governance matters. It is possible that excluding such disclosure could provoke an adverse reaction and vote recommendation from ISS or similar firms. And, inclusion of the disclosure may avoid any question about whether the proxy materials, in the absence of the disclosure, may have omitted material information. NASDAQ has indicated that a NASDAQ company must generally disclose its board determinations relating to director independence in the proxy statement for the first annual meeting occurring after January 15, 2004 (www.nasdaq.com/about/faqscorpgov.stm#cg3_1). So, for calendar-year companies, such disclosure must be included in the upcoming proxy statement. This means, for NASDAQ companies who wish to utilize categorical standards in making such determinations, the board must act to adopt such standards and make the independence determinations prior to the mailing of the proxy statement, so that appropriate disclosure can be made. * * * * * * * Reed Smith, a leading global law firm with nearly 1,000 lawyers located in 16 U.S. and two U.K. cities, represents Fortune 100 as well as mid-market and emerging companies. Clients include technology companies and entrepreneurs, financial services firms, life sciences companies and health care providers and insurers, communications companies, manufacturers, universities, non-profit organizations, real estate developers, and municipalities throughout the United States and in 40 countries. For more information, please visit reedsmith.com. 1 2 The independence concept established by this Rule focuses solely upon the director s relationship with the company, meaning a business, employment or other transactional relationship. There is no broader requirement that the board ascertain that a director's judgment, viewpoint or outlook is in a more general sense independent from management, presumably because such a requirement would be too vague to admit of practical application. 1. 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. 2. 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. - 4 -
3 4 3. 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 current or former internal or external auditor of the company is not independent until three years after the end of the affiliation or the employment or auditing relationship. 4. 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 current executives serve on that company s compensation committee is not independent until three years after the end of such service or the employment relationship. 5. 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 percent of such other company s consolidated gross revenues, is not independent until three years after falling below such threshold. Among other things, ISS guidelines deem non-independent : a former executive of the company or its affiliates, or of an acquired firm, or of a former parent or predecessor firm, even if the person has not been employed by the company for three years or more; a relative of a current employee (not just an executive officer) of the company or its affiliates; a person who provides professional services (regardless of amount) to the company; and a founder of the company, even if the person has not been employed by the company for three years or more. Rule 4200(a)(15). The following persons may not be considered independent: 1. A director 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; 2. A director who accepted or who has a Family Member (as defined) 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 certain specified payments; 3. 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; 4. 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 exceed 5 percent of the recipient s consolidated gross revenues for that year, or $200,000, whichever is more, other than certain specified payments; 5. A director of the subject 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 subject company serve on the compensation committee of such other entity; 6. 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; and 7. In the case of an investment company, a director who is an interested person of the company as defined in the Investment Company Act of 1940. - 5 -