NYSE and Nasdaq Propose Changes to Corporate Governance Rules

The NYSE and Nasdaq have begun to recommend changes to their corporate governance rules in response to SEC Chairman Pitt’s calls for reform following Enron’s collapse. The proposed changes are summarized below.

The New York Stock Exchange
An NYSE committee report on recommended rule changes was published last week and is available on the NYSE’s website, nyse.com. The committee is seeking public comment on the report before submitting it to the full NYSE board for approval on August 1, 2002. Once approved, the NYSE will draft proposed rule changes and submit them to the SEC where the proposed changes will undergo notice and comment. SEC approval could be obtained before the end of 2002. The principal NYSE rule changes proposed by the committee are as follows:

Independent Directors

• Independent directors must comprise a majority of the board of every listed company.
• Current NYSE rules require that only 3 members of a company’s board qualify as independent directors, regardless of the size of the board.
• Director “independence” standards are expressly stated:
• The board must affirmatively determine that an independent director has no material relationship with the company and disclose the basis for this determination.
• Several relationships preclude a finding of independence, including:
• Employment with the company
• Employment or affiliation with the company’s current or former auditor; and
• Employment as an executive officer of a different company whose compensation committee includes an officer of the listed company.
  Directors who have had a prohibited relationship (or whose immediate family members have had such a relationship) would be subject to a 5-year “cooling-off’ period before becoming eligible to be independent directors.
• By contrast, under current listing standards, the independent director requirement has been an unwritten rule outside of the audit committee context, and independence determinations have been left entirely within the board’s discretion.
• Non-management directors must hold regularly scheduled meetings, outside the presence of management. The company must designate a lead director to preside at these meetings and publicly identify such lead director.
• Listed companies must have a nominating committee and a compensation committee that are composed entirely of independent directors.

Independence and Authority of Audit Committee

• Members of the audit committee would be subject to additional standards beyond the independence determination described above.
• Audit committee members must receive no compensation from the company other than directors’ fees. Directors’ fees paid in the form of equity awards, additional amounts payable to chairs or members of committees with time-consuming responsibilities, and deferred compensation related to prior employment of directors are all permitted compensation, however.
• A director that represents a 20% or greater stockholder, even if such director has been deemed independent by the board, could serve on the audit committee but may not chair the committee or vote on matters before the committee.
• The chairperson of the audit committee must have accounting or related financial management experience.
• Under the current rules, audit committee members are qualified to serve if all members are independent and “financially literate.” One of the members, not necessarily the chair, must have accounting or related financial management expertise.
• The audit committee must have sole responsibility for hiring and firing the independent auditors and for approving significant non-audit work by the auditors.
• The current rules, by contrast, provide that the audit committee and the board retain ultimate responsibility for selection, evaluation and replacement of the auditors.
• Other responsibilities with which the audit committee would be expressly charged include:
• Reviewing internal controls, evaluating the performance of the auditors and reviewing at least annually all relationships between the auditor and the company;
• Meeting at least quarterly with management and the independent auditors and discussing all annual and quarterly reports, including MD&A, with these groups.
• Discussing earnings press releases, as well as financial data and guidance provided to analysts and rating agencies; and
• Setting hiring policies for former employees of the auditors.

Corporate Governance Guidelines and Officer Certifications

• Listed companies must adopt and disclose their corporate governance guidelines, written charters for the audit, nominating and compensation committees, and a code of business ethics for directors, officers and employees. Any waivers of the code for directors and executive officers would have to be promptly disclosed.
• Each listed company CEO would have to certify to the NYSE that the company has established procedures for verifying the accuracy and completeness of information provided to investors, that the procedures have been followed, and that he or she has no reasonable cause to believe that the information provided to investors is not accurate.
• Each listed company CEO must certify to the NYSE that he or she is not aware of any violation by the company of the listing standards.

Stockholder Approval of Equity-Based Compensation Plans

• Stockholders must approve all equity compensation plans.
• Under the current rules, this stockholder approval requirement applies only to plans in which officers and directors participate. Moreover, the current rules contain some widely-used exceptions for broadly based plans, inducement awards and plans funded with treasury shares.

Broker Discretion to Vote Customer Shares for Equity Plans

• Brokers would not have the discretion to vote shares for customer accounts on equity compensation plans in the absence of instructions from the customer.
• Under current rules, brokers have discretion to vote a customer’s shares to approve an equity compensation plan in the absence of instructions from the customer, provided that the plan does not authorize the issuance of shares in an amount exceeding 5% of the shares outstanding.
• Because this rule applies to brokers that are NYSE member firms, rather than listed companies, it would affect all publicly-traded companies regardless of the market or exchange on which they are listed or traded.

The Nasdaq Stock Market
A Nasdaq advisory council has also recommended changes to its corporate governance rules, and Nasdaq’s approval of the first set of these changes was announced in a press release recently distributed to all Nasdaq-listed companies. Nasdaq is in the process of submitting proposed rule changes for these measures to the SEC. As described above, the SEC will subject the proposed changes to notice and comment before approving the new rules, a process which could be complete by year end. Nasdaq has proposed, among other changes, the following changes to its corporate governance rules:

Stockholder Approval of Option and Stock Purchase Plans

• Stockholders must approve all option and stock purchase plans in which officers and directors participate.
• No exception for broadly-based plans.
• Exceptions are retained, however, for tax qualified, non-discriminatory benefit plans, plans assumed in a merger or acquisition, and inducement grants for new officers.

Independent Directors

• Additional restrictions that would preclude a director from being considered independent, including:
• Payments (other than for board service) to a director or the director’s family members, including political contributions, in excess of $60,000;
• Payments to a charity of which the director is an executive officer which exceed the greater of $200,000 or 5% of either the company’s or the charity’s gross revenues
• By way of context, the current Nasdaq rules already prohibit some relationships, many of which are featured in strengthened form in the NYSE committee proposals. The relationships currently prohibited by Nasdaq rules include: employment (of a director or his immediate family member) within the past 3 years; compensation in excess of $60,000 annually (other than for board service); affiliation with companies doing business with the company in excess of certain dollar thresholds within the past 3 years; and employment with a company whose compensation committee includes an executive of the listed company.

Related Party Transactions

• All related party transactions must be reviewed (as required by current Nasdaq rules) and affirmatively approved by the audit committee or comparable body.

Disclosure of Going-Concern Opinions

• Going-concern qualifications in the opinion of a company’s independent auditors must be disclosed in a press release.

Nasdaq has also announced a second round of reform initiatives to be examined by the council and submitted to the Nasdaq board in July. These reforms display substantial overlap with those featured in the NYSE report and include:

• A majority of independent directors;
• Compensation committees composed solely of independent directors;
• A cooling-off period during which employees of former auditors would be precluded from serving on corporate audit committees; and
• Expanding the scope of audit committee authority.

The changes proposed by the NYSE and Nasdaq, organizations which have traditionally tried to compete for listing companies’ favor by offering the least restrictive listing requirements, cover much of the same ground. The reforms proposed by the NYSE committee, however, are significantly more restrictive and far-reaching, particularly in the area of required stockholder approval of option plans. While the NYSE and Nasdaq circulate and garner feedback on their proposed rule changes, we may see the two sets migrate to frameworks that more closely resemble each other.