Issues of board independence are not new. However, as this year's proxy season nears, public company directors for the first
time must apply the new New York Stock Exchange and Nasdaq independence rules. As a consequence, public companies must follow
at least three general standards for director independence:
- the overarching standard for all board members set forth in the listing rules,
- the higher standard for audit committee members imposed by Congress and the SEC under Sarbanes-Oxley, and
- the criteria established by courts under state law for purposes of special board committees or board approvals.
Other criteria arise from various statutes that, while not required of all boards, may be necessary to obtain the benefits
of the statutes. Paradoxically, the independence standards set by Nasdaq, the NYSE and the SEC, which apply at all times,
may have little to do with the standards set by the courts, which typically apply to specific transactions or other situations.
This article will help guide board members by setting forth each of the general standards and their application to the boardroom.
NYSE and Nasdaq Rules
Both the NYSE and Nasdaq now require (subject to transition rules) all listed companies to have a majority of independent
directors on their boards. They also require all listed companies to have only independent directors on their audit, nominating/corporate
governance and compensation committees (or, in some cases, a process for decision by majority of the independent members of
the board). Both the NYSE and Nasdaq provide limited exceptions for "controlled companies" (meaning those companies in which
more than 50% of the voting power is held by one person or entity) and foreign private issuers, subject to disclosure requirements.
The new rules establish a two-part test, including both a set of objective, disqualifying criteria and a broad, subjective
standard. The disqualifying criteria include specified relationships between the company, on the one hand, and the director
or members of the director's family, on the other hand. Due in part to pressure from professional investors, both the NYSE
and Nasdaq provide that ownership of even a significant amount of stock in a company, in and of itself, does not disqualify
a director from being independent. This article focuses on the subjective standard, given the greater potential difficulties
in application.
NYSE
The NYSE requires a board to determine affirmatively that an independent director has no "material relationship" with the
company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company).
Material relationships can include commercial, banking, consulting, legal, accounting, charitable and family relationships,
among others. The NYSE recognized, however, that it would not be possible to anticipate all potential conflicts, and thus
instructed boards to "broadly consider all relevant facts and circumstances." The NYSE also instructed boards to consider
the issue of independence from the standpoint of persons or organizations with which the director has an affiliation.
Nasdaq
Nasdaq requires a board to determine that an independent director does not have a relationship that would "interfere with
the exercise of independent judgment" in carrying out the responsibilities of a director. Nasdaq emphasized that a board must
determine that members serving as independent directors do not have "relationships with the company that would impair their
independence."
ISS View
Institutional Shareholder Services (ISS) has established three categories for directors: inside, affiliated and independent.
To be deemed independent, a director must have "no connection to the company other than a board seat." The affiliated director
category includes persons who might qualify as independent under the NYSE and Nasdaq standards. ISS recommends that shareholders
withhold votes from inside and affiliated directors on boards that are not at least majority independent. While not a legal
requirement, the ISS policy may become increasingly relevant if the SEC adopts its proposed rules that open the door for certain
shareholders to participate in proxy solicitations for new directors there are 35% withheld votes for any director candidate.
Recommended Practice for Applying the Standards
The board will be protected by the business judgment rule in making their determination, provided they exercise due care in
the process. The application of the subjective standards should be made by the entirety of the board in open discussion. The
recommended practice thus is to:
- First, apply the objective criteria articulated by the NYSE or Nasdaq.
- Second, consider the subjective criteria to determine whether any director who satisfies the objective criteria nonetheless
has relationships or other attributes that would preclude him or her from being found independent.
Particularly in the second step, we recommend that each board consider whether there are reasons unique to the company for
adopting objective criteria beyond those articulated by the NYSE or Nasdaq. One example of a company going beyond the NYSE's
specific criteria is General Electric, whose policy does not consider a director independent if he or she is employed by a
company that receives more than 1% of its gross revenue in payments from GE. The relevant NYSE standard is 2%.
SEC Audit Committee Requirements
The general definition of independence as established by the NYSE and Nasdaq rules described above suffice for compensation
and nominating committee members. However, the Sarbanes-Oxley Act of 2002 establishes a more exacting standard for audit committee
members. To be independent for this purpose, a director generally may not, other than in his or her capacity as a member of
the board or any committee thereof, accept, directly or indirectly, any consulting, advisory or other compensatory fee from
the company or any subsidiary thereof (except certain compensation under a retirement plan) or be an affiliated person of
the company or any subsidiary thereof.[fn1]
The rules define indirect acceptance to include acceptance of fees by a director's family members or by an entity in which
the director is a partner, member, managing director or executive officer or occupies a similar position (except limited partners,
non-managing members and those occupying similar positions with no active role in providing services to the entity) and which
provides accounting, consulting, legal, investment banking or financial advisory services to the company or any subsidiary
of the company. The rules use the same definition of affiliated person as is used in other areas of the federal securities
laws, with an additional safe harbor. Under the safe harbor, if an audit committee member is not an executive officer or beneficial
owner of greater than 10% of the company's outstanding equity securities, the member is not deemed to be an affiliated person.
Failure to fit within the safe harbor does not necessarily mean that the person is an affiliate. Only executive officers,
directors who are also employees of the company or its affiliates, general partners and managing members of an affiliate are
automatically deemed to be affiliates. Passive, non-control positions, such as limited partners, and those that do not have
policymaking functions are not considered affiliates.
State Law and Special Committees
Boards from time to time form special committees or require some members to recuse themselves in order to consider matters
where individual directors may have conflicts. For example, a board may need to consider a take-over proposal from an entity
with which a director is affiliated or a possible shareholder derivative suit in which a director would be a defendant. Board
members who are sufficiently disinterested in a transaction also can prevent a transaction from being deemed void because
of the participation or vote of an interested director.[fn2] The standards for determining whether a director can serve on a special committee or on the board without recusal are different
from those established by the NYSE, Nasdaq and the SEC for audit, compensation and nominating committees.
The test for this purpose is focused on the individual or transaction involved, rather than on the company as a whole. These
standards are driven by a state court's interpretation of state corporate law. While directors serving in these capacities
often are referred to as "independent," they also frequently are called "disinterested" to distinguish them from other members
who may be independent of the company but somehow involved in the transaction or matter at hand.
Expansion of Factors
Recent court cases seem to have expanded the factors that must be considered in determining whether a director is sufficiently
disinterested to serve on a special committee. In one case,[fn3] the Delaware Chancery court applied a "contextual approach" that took into account, among other things, various social connections
of two directors (one of whom was a former SEC commissioner) appointed to a special litigation committee to investigate claims
of insider trading. The court stated that the test for independence focuses on whether a director "for any substantial reason,
cannot act with only the best interests of the corporation in mind." The court emphasized that the board must consider factors
beyond the economic impact on individual directors, such as personal and other relationships.
Here, the court noted the multiple connections between the defendants, the committee members and Stanford University. Both
members of the committee were tenured professors at Stanford University, while the defendants were major contributors to Stanford.
In addition, one of the defendants was a professor at Stanford and had taught one of the committee members, and was on the
steering committee of a Stanford research institute at which the committee member was a senior fellow and steering committee
member. Overall, the court found the situation "painted in too much vivid Stanford Cardinal red for the [committee] members
to have reasonably ignored it." The court recognized that the requirement to take into account all circumstances would result
in some uncertainty. However, the uncertainty would be compensated by having independence determinations "tailored to the
precise situation at issue."
Other Statutory Requirements
Other statutory provisions may affect a company's choice of "independent" directors. While space constraints preclude a discussion
of all these provisions, two stand out.
Internal Revenue Code
Under the Internal Revenue Code,[fn4] to avoid disallowance of the deduction for annual compensation of a company's top officers in excess of $1 million, the compensation
must be performance-based and the compensation plan must be administered by "outside directors." The regulations under the
Code define outside director by setting out disqualifying criteria, including that the director must not ever have been an
officer of the company.
Short-Swing Profit Rules
The short-swing profit rules under Section 16(b) of the Securities Exchange Act provide exemptions for compensatory awards
that, subject to prescribed procedures, have been approved by the board of directors or a committee of "non-employee directors."
To qualify, among other things, a director must not be engaged in the type of transaction or maintain the type of relationships
that would trigger proxy statement disclosure under applicable SEC rules.
Although these standards are not mandated for all companies, in order to get the benefit of the statutory provisions companies
typically seek to fill their compensation committees with members who satisfy these criteria.
Footnotes
1: Rule 10A-3(b).
2: For example, both Delaware (General Corporation Law Sec. 144) and California (General Corporation Law Sec. 310) have statutes
that allow a majority of disinterested directors, following appropriate disclosure, to approve a transaction involving a board
member. The California statute, however, also requires that the transaction be "just and reasonable" to the company.
3: In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch., June 13, 2003)
4: Sec. 162(m).
