National Venture Capital Association
February 14, 2003
Jonathan G. Katz
Re: File No S7-02-03, Standards Relating to Listed Company Audit Committees - Audit Committee Member Independence
Dear Mr. Katz:
The comment letter of the National Venture Capital Association ("NVCA" or "the Association")1 is intended to assist the Commission in establishing the most appropriate criteria for determining an audit committee director's independence from management under the proposed rule: "Standards Relating to Audit Committees" ("Proposed Rule").
NVCA members serve on audit committees of many companies in which venture capital funds invest. These venture capital fund (VCF) directors represent significant shareholdings of initial public offering (IPO) companies and newly public companies. Some venture capital funds retain significant interests in publicly traded companies long after the end of the standard six-month lock-up period. Moreover, in some cases, the public company board nominates the same person who represented a venture capital fund to continue to serve as a director after the venture capital fund has divested itself of it's interest in the issuer.
NVCA's comments on the Proposed Rule stems from our members' long-standing interest in audit committee service. Venture capital professionals, representing venture capital funds, view the audit committee as the best position from which to protect the large investments that funds have in issuers during their pre-public and newly public phases. NVCA has worked extensively with the Nasdaq Stock Market (NASDAQ) and the New York Stock Exchange (NYSE) over the past three years as those organizations have developed qualitative listing standards on audit committee composition. The NYSE, NASDAQ, NASD and the American Stock Exchange LLC (AMEX) (a group of markets and self regulatory organizations (SROs) I will refer to as "the exchanges") have focused on the critical issues of independence, financial sophistication and the demonstrated value that directors who represent significant shareholdings bring to corporate boards. Recognition of the independence of directors who represent large venture capital shareholdings is critical to the effectiveness of this Proposed Rule in populating audit committees with financially savvy, independent directors.
NVCA appreciates the care and thought that is apparent in the SEC's Proposed Rule and the Release. We believe that the Commission need only take one additional step in its analysis to arrive at an interpretation of new Exchange Act Section 10A(m)(2) that allows issuers and shareholders to continue to benefit from the audit committee service of seasoned VCF directors.
I. Summary of Comments
Our recommendation, in sum, is that the Commission should base "independence" not just on a level of share ownership that indicates "control" under conventional "affiliate" analysis. Rather, it should either strike the right balance between the proven benefit of large shareholders as directors and the risk that a large shareholder will abuse its voting power, or allow the exchanges to determine this balance.
NVCA believes that, under the typical structure of a venture capital fund, a representative of that fund on the audit committee presents no material risk of abuse of control and, indeed, brings significant benefit to the company and its shareholders. We believe that a full review of the issues will lead the SEC to conclude that a representative of a venture capital fund is generally the type of financially savvy, independent board member that the Act and the Commission seek. Accordingly, NVCA urges the SEC to adopt an interpretation of the terms "affiliate " and "control" that reflects the structure under which venture capital funds own large share positions following an IPO, and that takes into account the independent nature of directors who represent large fund shareholdings (e.g., a VCF director's fiduciary obligations to the venture capital fund it represents). As discussed in more detail below, NVCA believes that this can be achieved through the Proposed Rule's "facts and circumstances" approach in a way that weighs the risk of abuse of control against the benefits that large shareholders provide the investor interests in corporate performance.
Should the Commission determine that such analysis is not appropriate in its rules, it should permit the exchanges to exercise their sound judgment and experience in applying these concepts through their listing standards.
The Proposed Rule defines the terms "`affiliate' of, or a person `affiliated' with a specified person" to mean "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified." 68 Fed. Reg. 2638, 2641 (emphasis added). The term "control" is defined, under the Proposed Rule, as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." Id.
While this definition identifies the directors who, by way of stock ownership, contract, or otherwise, would seem to have "power," it does not take into account other relevant facts and circumstances, which may actually be the decisive factors in determining whether a particular director presents an actual risk of abusing that power. In other words, directors may have relationships and hold positions with the company, or hold percentages of stock that, in theory, would indicate a level of power to control certain actions within a company. However, in certain circumstances, there are mitigating facts that would prevent in practice the exercise of such power, especially in a way that would cause harm to the company and its shareholders. Accordingly, such directors realistically present minimal, if any, risk of abuse. Moreover, many such directors, by virtue of their positions with, and relationship to, the company, and the percent of stock they represent, deliver significant benefit to the company by serving on its board and audit committee. This is precisely the case with directors who represent venture capital shareholdings.
The Proposed Rule's definition of "control" is predicated upon SEC Rule 12b-2, and related rules promulgated by the exchanges. Interpreting the concept of "control" based on bright-line tests, e.g., a rebuttable presumption of control at one ownership level and near-certain presumption of control at some higher level, may result in disqualification of venture capital fund representatives from audit committee service. Under traditional control analysis, ownership greater than 10% has raised "affiliate" issues, at least preliminarily.
However, such analysis runs the risk of results contrary to the overall purpose of the Proposed Rule and Section 301 of the Act for four reasons, which are discussed in greater detail below. First, empirical evidence demonstrates that large shareholder directors enhance corporate performance and increase shareholder value, (see Section A below). Second, there is minimal, if any, risk that VCF directors would abuse "control" (see Section B below). Third, due to the nature of their relationship to the company and their share ownership, VCF directors actually have very little power by which to exercise abusive control (see Section C below). Finally, VCF directors have no motive to abuse control (see Section D below).
For these reasons, NVCA urges the SEC to formulate final rules that define the terms "`affiliate' of, or a person `affiliated' with a specified person" and "control" in a way that ensures that venture capital directors are not disqualified from serving on audit committees solely on the basis of the size of the shareholding they represent. Specifically, NVCA recommends that the final rule include a definition of "affiliate" that focuses on the risk of abuse of control actually presented by a potential audit committee member (i.e., the nature of that person's position with, and relationship to, the company), rather than the "power" a person technically may have through ownership of voting securities or otherwise.
NVCA proposes that this be accomplished by employing a facts and circumstances approach in determining whether a director has "control" - an approach that reflects the inherent safeguards that exist in a company's relationship with directors who represent large venture capital shareholdings. In the alternative, or in addition, NVCA proposes that the safe harbor included in the final rule incorporate a safe harbor for directors like VCF directors in order to reflect the minimal risk of abuse of control presented by such directors. Likewise, NVCA believes that the non-investment company safe harbor threshold should be increased to twenty percent (20%), which would ensure that many (though not all) VCF directors could rely upon it.
A. Through either definition or exemption, the Commission should ensure that large shareholders who are independent of management are not disqualified from audit committee service.
In order to continue the development of their venture-backed IPO companies, the board frequently requests VCF directors to remain on the board following the IPO and to continue to serve on the audit committee. Representatives of venture capital funds with large ownership stakes are often the best directors for audit committee service because they are not only financially sophisticated, but also independent from management, and well informed about the company and its financial condition. In representing (and protecting) the large stake they represent in the company, the VCF director in turn promotes (and protects) the interests of all shareholders.
As a general proposition, NVCA believes that large shareholders often make the best directors. The capital markets bear this out. In marketing an IPO to potential investors, it is a selling point that the VCF director will be on the audit committee since it shows continuity of governance and a continued commitment by the venture investors. There is also increasing empirical verification of the general view that persons with significant shareholdings often make the best directors. An important academic study shows that directors with a meaningful stake are a pivotal governance factor in improved corporate performance.2 For some time, experts have argued that significant director shareholdings are the most effective way to get outside directors to vigorously represent the firm's shareholders.3 In "Outside Directors With a Stake: The Linchpin In Improving Governance," supra note 2, Donald C. Hambrick and Eric M. Jackson, empirically examine the impact of outside director share ownership in both well performing and poorly performing companies. Their results showed a strong correlation between the significance of outside directors' share ownership and company performance.4
Similarly, a study by Sanjai Bhagat, Dennis C. Carey and Charles M. Elson, "Director Ownership, Corporate Performance, and Management Turnover," 54 Bus. Law. 885 (1999), confirms both the effective agency created by directors that are substantial shareholders and the correlation between large shareholder directors and effective board oversight. The study emphasizes the importance of "ownership and control through meaningful director stock ownership and hence better management monitoring." 5
Therefore, the value of large shareholders as directors has been repeatedly demonstrated.6 Certainly, the latest evidence shows that the presence of directors with large shareholdings correlates strongly with corporate performance and shareholder value - key issues for any public company board. VCF directors clearly offer this advantage to publicly traded companies both as directors and as audit committee members. They combine the familiarity with the issuer and its business that the typical outside director lacks, with the independence from management that the Sarbanes-Oxley Act is intended to promote.7
Additionally, VCF directors are highly cognizant of the litigation risks that newly public companies face. They are acutely aware that the IPO's share price will be watched closely by plaintiff law firms and that any precipitous drop in the stock price will result in a securities class action. Many VCF directors view the audit committee as the best vantage point from which to guard against the kinds of financial reporting irregularities that can cause a sudden drop in a company's stock. In protecting himself or herself, the VCF director helps shield all shareholders from the ravages of securities class actions. Therefore, the typical VCF director provides a special benefit to the company and its shareholders. It should also be noted that the threat of liability can be enough to persuade a VCF director that remaining on the company's board presents too great a risk if he or she cannot oversee financial reporting as an audit committee member.
Finally, as a practical matter, the VCF director's financial sophistication serves a venture-backed company as it prepares its board and audit committee for the IPO. The board of a pre-public venture-backed company typically needs to add directors as part of the pre-IPO governance restructuring. The board relies on the then-serving venture fund representative to be among the most financially sophisticated directors on the audit committee. To disqualify the VC representative, based merely on the level of fund's share ownership, would unnecessarily disadvantage venture-backed IPOs by forcing them to recruit specifically for a financially sophisticated outside director, diverting significant resources without necessarily adding strength or breadth to the board.
B. Under the Proposed Rule, the risk that a large shareholder could abuse control is low.
We understand that there may be situations where a large shareholder has such overwhelming control that he or she can abuse other shareholders for their singular benefit. However, we are not aware of any such case involving a venture-backed company or a member of the Association. Moreover, close analysis of the situation shows a number of practical barriers to the effectuation of such a scheme through a position on the audit committee.
First, the scheming director would need to either control management or collude with management so that financial results were misstated. In either case, the mere involvement of a director in management's financial reporting creates suspicion - and evidence - of the director's scheme.
The director would then need to avoid or overcome the scrutiny of the other members of the audit committee and the company's auditors. In trading under such circumstances, the director would violate the insider trading laws as well as the anti-fraud and anti-manipulation provisions of the securities laws. Finally, the circumstances necessary to make an abusive profit would likely require or cause the type of share price volatility that routinely attracts a private shareholder class action. In such circumstances, the director's stock transactions would be discovered, increasing the director's personal liability and creating a roadmap for criminal prosecution.
Therefore, even assuming that a VCF director had both the opportunity through control and a motive to defraud other shareholders, he or she would face a number of barriers, and significant risks in carrying out the scheme. As a practical matter, NVCA believes that both this opportunity and the necessary motivation are missing in the typical VCF director's situation.
C. The nature of the typical VC fund's relationship with, and share ownership,
NVCA believes that the nature of the director's relationship with a company, rather than the mere fact that the director has a position on the board, or a contract or other relationship, should determine whether an audit committee member is independent. Likewise, NVCA believes the nature of a director's share ownership, rather than the mere level of share ownership, should determine whether an audit committee member is independent. The nature of a VCF director's relationship and share ownership, in most cases, denies the VCF director the opportunity to abuse other shareholders because it often denies the VCF director the ability to time the sale of the shares he or she represents.
While there is no standard venture capital fund, the typical fund is composed of investments by limited partners or, in the case of a limited liability company (LLC) structure, shareholders. A general partner or LLC manager (the "VC general"), formed by the venture capital firm (VC firm), manages the fund. The limited partners are invariably institutional investors - pension funds, college endowments, insurance companies, foundations, etc. - or wealthy individuals. The VC general invests the fund's assets in companies (the VC fund's "portfolio companies") and manages those investments.
If a portfolio company goes public, the transaction by which the VC fund exits the investment is normally the distribution or distributions of the portfolio company's shares to the investors. In this case, no sale is executed by the VC general on behalf of the fund. Each investor chooses to sell or hold the shares beyond this point. Therefore, sale of the vast bulk of shares takes place at a time determined individually by the various limited partner investors, not the VC general.
Although in most VC funds the VC general determines the date of distribution, the limited partner investors determine the timing of distribution in some cases. Notwithstanding who determines the distribution date, every venture fund's position in an IPO is subject to "lock-up" agreements which preclude the sale of the fund's shares for a period of months - usually 180 days - following the IPO. These agreements vary with each IPO and are negotiated with the investment banker who handles the offering. Lock-up agreements and Rule 144 limitations often cause the distribution to be staggered so that the distribution of VC fund shares does not take place in a single month or quarter. In addition, Rule 144 alone requires a holding period for all stock held by the fund and places limits on the volume of sale in any three-month period. These restrictions apply to limited partner investors after distribution, as well as to the fund.8 Therefore, many factors beyond the control of the VC general affect the timing of distribution and sale of the VC fund's shareholdings.
Because the venture fund usually lacks control over the time of sale and often cannot predict the time of distribution of shares to its investors, the opportunity to manipulate a company's share price through its financial reporting is significantly reduced. The diversity of ownership, the individuality of sale decisions, and the variety of factors affecting distribution timing work together to diminish the VC general's opportunity to control the timing of sales of shares.
D. The typical VCF director does not have a motive to abuse other shareholders.
The concern that a larger shareholder may attempt to abuse his or her position on the audit committee is not applicable to the typical VCF audit committee member. It is not applicable because the VCF audit member lacks the motive, as well as the opportunity, to serve himself or herself to the detriment of other shareholders. Certainly, if any member of the audit committee has the motivation and finds the opportunity to exert control over the company in a way that serves to benefit him at the expense of the other shareholders, the risk of personal legal consequences are significant. As noted above, in such unique and rare instances, individuals who violate established securities laws face serious risk of detection and prosecution.
In addition, and more importantly, VCF directors have every incentive to protect their reputations for integrity. The VC firm, as general partner of the fund, has fiduciary duties to the limited partner investors. Furthermore, the investors that the firm approaches for its next fund may well be the same parties who were fellow shareholders in another portfolio company. Even the hint of abuse will undermine the VC firm's credibility in the venture capital community, undermining its ability to raise capital and remain in the venture capital business.
III. Responses to Specific Questions in Request for Comment
Q: Should the safe harbor threshold be higher?
A: Yes. A director who is associated with a holder of no more than 20% of a company's voting stock should not be determined to lack independence based solely on that association. While the Proposed Rule is clear that the safe harbor's 10% criterion is not a ceiling for shareholdings, pre-public companies need a significant degree of certainty as they configure their board committees to meet listing standards. Therefore, the safe harbor, with a higher limit, will assist significantly in the assurance of good governance and continuity on the boards of venture-backed newly public companies.
Q: Should additional relationships be exempted from the independence requirement at this time?
A: Yes. The Commission has the discretion under Section 10A(m)(3)(C) to create an exception for "a particular relationship with respect to audit committee members as the Commission determines appropriate in light of the circumstances." The Proposed Rules are probably correct in declining to have the Commission address exemptions on a case-by-case basis; however, the Rules should explicitly provide that a director who is independent in all other respects should not be disqualified from audit committee service based solely on the fact that he or she is associated with a 20% shareholder. The exchanges should be able to review the totality of facts and circumstances based on a presumption that a 20% shareholder is independent of management. If circumstances indicate that the director is under the influence of management or is likely to abuse a seat on the audit committee, the exchanges should have the authority to deem the director not independent for audit committee purposes. Examples of the types of relationships the safe harbor could include would be directors who represent private equity funds, mutual funds, pension funds, foundations or endowments. Should the Commission wish to fashion an exemption specifically for venture capital directors, it could be based upon the fact that the majority of VC funds are owned by sophisticated, institutional investors - representing foundations, endowments, insurance companies, pension funds, etc.
Q: Should the exemption for newly public companies be longer than the proposed 90 days?
A: Yes. A one-year transitional period is needed to allow the board to reconfigure itself on the usual annual schedule of the shareholder meeting. As noted, the VCF director often serves on the audit committee through the IPO transaction. The ability to count on the VCF director to serve on the audit committee, at least until the transition to a fully-reporting public company is complete (e.g., filing of 10K, annual meeting of public shareholders, etc.), will greatly assist the board of the newly public company. A shorter transition period would make the independence of the VCF director uncertain depending upon the actual date of sale or distribution of the issuer's shares held by the VC fund. Typically, lock-up periods, do not expire before the 180th day after the offering date. A one-year transition will permit the fund to distribute or liquidate its shares in an orderly manner without creating a situation where the VCF director's membership on the audit committee would be subject to an arbitrary witching hour. In addition, even the lapse of lock-up periods does not always result in the fund's divestiture. Secondary market sales of issuer shares soon after expiration of lock-ups is often inadvisable, because of market reaction. Therefore, a full year transition will provide for an orderly transition, and allow for a VCF director with long experience to remain on the audit committee. Such a transition period should apply, at least, to those directors who would be deemed non-independent because of share ownership alone, regardless of the percentage of ownership.
Q: Should there be an exceptional and limited provision for the board to allow a single audit committee member?
A: Yes. Should a one-year transition be deemed too long, boards should be permitted to rely upon and explain to shareholders the exceptional circumstances that make it proper to allow a VCF director to serve on the audit committee during a time limited to one year.
We believe that the rules that the SEC and the exchanges have developed thus far on audit committee composition reflect their appreciation of the value that financially savvy directors who are independent of management bring to board service. These requirements for, and definitions of, "independent" audit committee members contained in these rules reflect the Commission and exchanges' study of the value that venture capitalists bring to such service. VCF directors, representing large shareholdings, are independent of management and knowledgeable about the company and its industry. They also provide financial expertise to audit committees.
Under the Proposed, there is a risk that some VCF directors might not qualify as "independent" based on the Rule's overly restrictive definitions of the terms "`affiliate' of, or a person `affiliated' with a specified person" and "control." It would be an extremely unfortunate result of the Sarbanes-Oxley Act if newly public companies felt compelled to replace seasoned and financially savvy venture capitalists on their audit committees because these directors failed to satisfy the technical independence requirement, particularly, when in reality, VCF directors are actually quite independent for all the reasons articulated above.
Faced with the prospect of serving on a board, but not the audit committee, some VCF directors may resign from the board. This result would neither promote good corporate governance nor would it enhance the ability of the board to help the company deliver long-term shareholder value. Finally, such a result would deny both investors and the broader economy the benefit that VCF directors provide to the companies they help to bring to the public markets.
NVCA would be pleased to provide further input. Please do not hesitate to contact me, or NVCA's outside counsel, Brian Borders at 202-263-3374.