Brian T. Borders
Attorney at Law
1747 Pennsylvania Avenue, NW
Washington, DC 20006
( 202 ) 296 - 8420
Fax (202) 296-8494
November 12, 1999
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington D.C. 20549-0609
Re: File no. SR-NASD-99-48; and also SR-NYSE-99-39 and SR-Amex-99-38.
Dear Mr. Katz:
I am writing on behalf of the National Venture Capital Association ("NVCA" or "the Association") to comment specifically on the proposed new listing standards for Nasdaq companies. While the vast majority of venture-backed companies access the public equity markets through Nasdaq, some go public on the NYSE and the Amex. Therefore, while our specific comments focus on the proposed new listing standards for Nasdaq, NVCA's general comments apply equally to all three new listing standard proposals.
NVCA member firms provide the start-up and development funding for many companies that ultimately go public on the Nasdaq Stock Market. The engine of economic growth has received tremendous benefits from the willingness of venture capital investors to place long-range investments in early-stage enterprises. At the same time they invest, venture capital firms usually commit the time and talent of their professional staff to assist in the governance of the enterprise. From their positions on the boards of pre-public and newly public firms, venture capitalists have gained significant insights into the proper role and functioning of audit committees. They also understand the qualifications needed for good audit committee members. It is from this perspective that the NVCA comments upon the proposed new Nasdaq listing standards.
Basic NVCA Positions
Generally, the new listing requirements will require pre-public companies to expand their audit committees' membership, exclude certain audit committee members for lack of "independence" and actively recruit audit committee members who meet the two new requirements of financial acumen. In addition, most companies will need to adopt an audit committee charter.
NVCA believes that the new requirements will narrow the pool of permissible audit committee candidates. They will also increase the risk, or at least the perceived risk, of legal liability for audit committee service. These two effects together may substantially increase the difficulty of recruiting good audit committee members. Moreover, the new restrictions will certainly disqualify some good audit committee candidates and audit committee members.
The collective impact of these new requirements will be substantial on companies in the pre-public and early IPO stages. NVCA does not believe that these new requirements will improve the quality of financial reporting in ways that will justify the expense and difficulties they create. Therefore, NVCA would prefer that the SEC and Nasdaq test these new requirements prior to mandating them.
However, NVCA is aware of the background of these new listing standards. It expects that the SEC will approve these new standards. Therefore, the Association asks consideration of some alternative suggestions. First, the Association requests a clarification that will insure that investors like venture capital firms are not excluded from audit committee service based on the new definition of independence. Second, it recommends that the disqualification period of former employees be reduced.
NVCA also recommends that a transition provision be included that allows newly public companies time in which to come into compliance with the new audit committee requirements after they go public. The reasons why such a period is appropriate are set out below. Finally, the Association recommends expansion of the size of company that would qualify for the "small business" exception.
I. Disqualification from Audit Committee for Lack of "Independence"
The new definition of "independent director" is of special concern to venture capital firms. Representatives of venture capital firms often sit on the boards and audit committees of newly public companies. As investors, who as board members oversee management, these representatives are truly independent. The rule's description of the pertinent disqualifying relationship seems to contemplate an exemption from disqualification for such investors.
The new rule would exclude "a partner, controlling shareholder, or an executive officer of any for-profit business to which the corporation made, or from which it received, payments (other than those arising solely from investments in the corporation's securities) that exceed 5 percent of the organization's consolidated gross revenues for that year, or $200,000, whichever is more, in any of the past three years." [emphasis supplied]. Venture capital firms can receive substantial stock from companies in the form of stock once the company. These payments usually result "from investment" through the conversion of the company's preferred stock to common stock.
It is important that the parenthetical exemption "arising solely from investments in the corporation's securities" covers these audit committee members whose firms receive these "payments". It is also important that the qualifying term "solely" does not swallow this exemption. The Association requests clarification to that effect in any enacting release or other statement issued by the Commission, the staff or the Nasdaq.
NVCA has a second, more general concern with the independence definition. The fact that specific relationships would automatically disqualify an outside director for three years may well deprive a company of a high quality audit committee member. Outside directors who have been "employed by the corporation or its affiliates in the current or past three years" have an appreciation for the operational aspects of the business. Operational experience enables an audit committee member to spot problems with financial reporting based on an understanding of the substance behind the financial data. To automatically exclude them for three years presents the risk that audit committees will be made up entirely of people who know nothing about the operations of the company.
Three years is an extremely long time for the types of leading edge technology companies in which many venture capital firms invest. Therefore, if a disqualification for some time is necessary, it should be substantially shorter than three years.
II. Audit Committee Composition and Member Qualifications
NVCA agrees with the need for independent audit committees, but finds the new definition of independence overly restrictive and expect that it will increase the difficulty of recruiting audit committee members.
Similarly the requirement that audit committees be composed entirely of directors who are "able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement, or will become able to do so within a reasonable period of time" will make it more difficult to recruit audit committee members. The financial "sophistication" requirements will cause similar problems. There are at least two reasons why.
First, there will be a smaller pool of qualified candidates. These requirements (along with new independence requirements) will shrink the pool of audit committee candidates. Those who assuredly meet the new standards, particularly the "financially sophisticated" standard, will be very much in demand for audit committee service. We anticipate that individuals who clearly and assuredly meet these standards will command a premium since they may be required to prove their qualifications in court and must be prepared to do so.
Second, NVCA believes, based on years of experience with securities class action litigation that these new requirements will attract allegations that they have been breached. Moreover, even the perception of increased liability will cause potential audit committee members to think twice about servicing. In the securities fraud class action litigation business -- which flourishes -- legal standards like financial literacy or sophistication inevitably invites scrutiny of those who must meet the standard.
While the "business judgment rule" defenses may be available to the company, the full liability potential of this new requirement has not been fully appreciated. Moreover, the practical problem remains: companies seeking audit committee candidates must deal with the perception of increased liability. These new standard will not escape the notice of the class action lawyers, and good audit committee candidates know it.
III. Audit Committee Charters
The requirement that the audit committee adopt a formal written charter will likely result in a pro forma adoption. The required terms of the charter are the ordinary requirements of an audit committee. The audit committee could be formally made aware of these requirements without new mandates. Since the charters would seem to state the obvious, the Association asks if this exercise is really necessary?
IV. Partial Exemption for Small Businesses
The Nasdaq should adopt the $50 million revenue test proposed in the "aircraft carrier" as the proper threshold for this "SB" exception. The fact that independence will be defined by the new rules will nonetheless create a substantial new burden for smaller and newer companies. For this reason, the Association urges the SEC to seriously consider NVCA's proposal for a transition period to apply to all IPOs as set out below.
V. Transition Period for New Public Companies
The new Nasdaq listing standards would be effective 18 months after the SEC approves them in order to give Nasdaq issuers time to recruit new members. Serving audit committee members would be allowed to complete their current terms. This period is an appropriate accommodation of companies that are currently listed, and will help those that go public on Nasdaq during the eighteen-month period. However, additional transitional relief should be provided for all newly public companies going forward after the expiration of the eighteen month transition.
Going public is one of an array of strategic goals that pre-public companies are encouraged to consider. Other goals include growth by acquisition or merger, private re-capitalization or even selling the company. Companies often pursue various "exit strategies" on parallel tracks. A decision to sell or to re-capitalize privately may come only after the company has made substantial preparation for, and is close to becoming public. In those cases, the substantial cost and effort required to meet the new audit committee listing standards will be wasted. These new requirements are justifiable only if they improve the financial reporting for public investors. Neither Nasdaq, nor the SEC has any need, or authority, to impose this new requirement on private firms. Therefore, a reasonable transition period should be developed for newly listed companies after they have moved from private to public status.
NVCA recommends maintaining the current Nasdaq audit committee requirement for IPOs during a post-offering transition period. This accommodation would ensure that the new audit committee requirements do not become an impediment to going public and do not cause private companies to waste precious resources complying with requirements that will apply only if they follow through with plans to go public.
If an eighteen month transition is appropriate for companies the are now public, eighteen months should be the right amount of time for newly public companies to come into compliance. This transition period would be appropriate for companies going public on the Amex and NYSE as well.
The NVCA doubts that these new requirements will bring about the desired results. However, in recognition of the likelihood that they will be adopted, the Association strongly recommends the changes or clarifications discussed above: (1) that the SEC further clarify officially that the normal relationship between a venture capital investor and the company is excluded from the disqualifications based on independence; (2) that the disqualification period of former employees be reduced: (3), that the small business exemption be expanded to apply to companies with less than $50 million in revenue and; (4) that IPOs be given a transition period of eighteen months for coming into compliance.
Finally, the Association strongly recommends that the Commission systematically review the effects of these new requirements at an appropriate time in the future to determine if they have had the desired effect, or the unintended and detrimental effects that the NVCA and other critics predict.
I thank you for your consideration of NVCA's comments and request. Please feel free to contact me if I can be of assistance in this matter.
Very Truly Yours,
Brian T. Borders /s/
Brian T. Borders, Esq.
For The National Venture Capital Association