June 2, 2003
Via e-mail: firstname.lastname@example.org
Securities and Exchange Commission
Re: Proposed NYSE/Nasdaq Corporate Governance Listing Standards
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Section of Business Law (the "Committee")* in response to the Commission's request for comments on the above-identified Releases issued March 17, 2003 and April 11, 2003 regarding the proposals submitted to the Commission by the Nasdaq Stock Market ("Nasdaq") and the New York Stock Exchange ("NYSE" and, collectively, with Nasdaq, the "SROs") to establish new corporate governance listing standards (the "Releases").
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committee.
We commend the very significant effort by the NYSE and Nasdaq to develop corporate governance listing standards that are appropriate in the current market and business environment, culminating in the proposals currently before the Commission for approval in accordance with Section 19(b) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Inasmuch as development of these corporate governance listing standards has been underway for an extended period of time and there already has been significant discussion and comment on the various proposals, including consideration by NYSE and Nasdaq of comments on earlier proposals, we are not, at this juncture, commenting on the proposals in the Releases as a whole or addressing many of the issues which have been raised previously. We do, however, have a limited number of comments and observations which we hope will be of assistance to the SROs and the Commission in finalizing and implementing new corporate governance listing standards.
In summary, our comments are as follows:
(1) The role of the full board of directors in relation to the role of the board committees contemplated by the proposed listing standards should be clarified so as to provide that:
(A) the board determines how much final decisionmaking authority shall be delegated to a particular committee,
(B) the board establishes the charter of each committee, and
(C) the board determines the degree of oversight it will exercise over the activities of a particular committee and its ultimate authority to act on matters which the committee has addressed.
The role of the board as so clarified would be consonant with the requirements and goal of independent director oversight of corporate affairs that underlies the proposed listing standards, including, where pertinent, the requirements of the Sarbanes-Oxley Act of 2002 pertaining to the role and responsibilities of independent directors.
(2) The independence standards for audit committee members should be clarified in relation to Rule 10A-3 under the Exchange Act so that:
(A) only compensatory fee payments to those family members of a director specified in Rule 10A-3(e)(8) will, regardless of amount, automatically disqualify the director from audit committee service, and
(B) for purposes of determining a director's eligibility for audit committee service, the "look-back" period, if any, to be applied with respect to non-contemporaneous compensatory fee payments to directors, and to their family members and associated entities (as provided by Rule 10A-3(e)(8)), is specified.
(3) In order to protect investors from the consequences of delisting and to facilitate compliance by the maximum number of companies, the SROs should provide procedures whereby listed companies can obtain, in appropriate extraordinary circumstances beyond their control, a transitional period of permitted noncompliance with the listing standards while the company undertakes steps to achieve compliance.
I. Board Committee Requirements
State corporate law and longstanding corporate practice establish as a bedrock principle of corporate governance that the board of directors as a whole is responsible for directing the management and supervising the affairs of a publicly-owned company. While in accordance with this principle boards of directors act as collective bodies, they nevertheless may, and in common practice do, delegate to committees of their members some of their responsibilities, subject to the overall supervision of committee activities by the full board. The proposed listing standards build on this practice by providing that board committees having important characteristics of independence should carry out specified functions relating to audit, executive compensation, nomination of director candidates and governance policies.
There are certain differences in the requirements proposed by the NYSE and Nasdaq. The NYSE proposes to require its listed companies to establish independent board committees which have certain functions, but would permit all the independent directors to constitute such committees. The Nasdaq proposal also looks to the establishment of independent board committees to carry out certain board functions, but explicitly permits these function to be carried out by the independent directors, meeting in executive session, without the establishment of a separate committee. Both proposals also establish independence standards which differ in certain respects. We see merit in the specifics of both the NYSE and the Nasdaq approach and do not believe that the Commission should mandate one or the other approach. We do suggest, however, that insofar as the establishment of a board committee is to be required by listing standards or, even if not required, is instituted by listed companies for the purpose of carrying out specified board functions, the following considerations should be addressed.
The delegation of powers and authority to a committee of a board of directors should be subject to the board's own ability to act to carry out its responsibilities. Specifically, committee activities should be subject to such oversight and control by the board as may be required to enable the board to carry out its responsibility to manage and supervise the corporation's affairs and to comply with state law and the charter and bylaws requirements of the particular company.1 Conflict between these corporate law and listing standards and uncertainty about how the two relate should be avoided. Even in those instances where listing standards will require independent audit committees to possess specific powers and authority in order to carry out the responsibilities specified by Section 301 of Sarbanes-Oxley Act of 2002 in accordance with the Commission's recently adopted Rule 10A-3 under the Exchange Act, the role of the entire board of directors should be considered.
Although they may mandate certain powers and authority for board committees, listing standards do not preempt state corporate law as such and therefore do not alter the responsibilities of a board of directors. Listing standards do not relieve the board of directors from its overall supervisory responsibility over corporate affairs, including over the activities of board committees, as established by state law (although they may influence the attitude of the state courts in applying standards of director conduct and liability). On the other hand, delisting for failure to comply with a listing standard will be of significant consequence to any listed company and its shareholders, particularly since there will be few, if any, listing alternatives for most companies. The risk of delisting will naturally weigh heavily on a board of directors. Accordingly, it is important to avoid, wherever possible, situations where compliance with the listing standards may prevent or inhibit directors from carrying out in an effective manner their role as fiduciaries for the corporation and its shareholders.
Accordingly, we recommend that the proposed listing standards in addressing the role of board committees should explicitly recognize the oversight role and the responsibilities of the board of directors as a whole. A board of directors should not be obligated to transfer to a committee authority to act unilaterally on behalf of the company on matters which can affect broadly the business and welfare of the company, its shareholders, employees and other constituents. In particular, we recommend that provisions in the proposed listing standards stating that a committee's functions should include "discharging the board's responsibilities" concerning a matter or giving committees "sole authority to determine" a matter should be reconsidered. Although it has established a board committee to deal with a subject, the board of directors should not be precluded from requiring, in appropriate circumstances, that action on a specified matter within such subject area nevertheless be taken by it as a whole, after appropriate inquiry and consideration by the committee and after receiving the committee's recommendation on the matter. Directors interested in the matter would be recused from the vote in accordance with customary practice.
For example, few board actions are more important than the selection, evaluation and retention of the company's chief executive and other executive officers. The compensation package which the company provides the chief executive and other officers is obviously relevant to board decisionmaking in this area, but is but one of many elements that may factor into the board's decision. In this sense executive compensation is not a "standalone" item for consideration only by the compensation committee. While it is appropriate for the compensation committee to address the compensation of the chief executive and other executive officers, it is not necessarily appropriate for it to make a final corporate decision on the hiring or firing of the company's executives; other considerations are involved in management hiring, retention and termination decisions.
In instances where a matter is to be acted upon by the full board of directors, even though within the subject matter for which a committee is to be established as provided in the listing standards, the committee would receive reports and make inquiries on such matters, vote on a course of action to recommend to the board and report on its recommendation to the full board. Thus, there would be a process and a record of committee deliberation and action on the matter consistent with the goal of independent director involvement in board decisions underlying the proposed listing standards. The full board, which under the proposed listing standards will be required in all relevant circumstances to be composed of a majority of independent directors, will then vote on the independent committee's recommendation. Board committees have commonly operated in this way and we do not see why a change to bar this customary practice is necessary. This permits the possibility that, in appropriate circumstances the board, if it were concerned with the advisability of the committee's recommendation, could return the matter to the committee for further consideration or, where it considered the matter to be sufficiently clear for decision, act on the matter itself. Board action on the matter could require under the listing standards approval of a majority of the independent directors. The applicable circumstances of committee and board action would be disclosed by the listed company to shareholders as appropriate.
Similarly, the charter of each committee should be established by the full board of directors, and not by a committee itself. This is entirely consistent with the basic principle of corporate law that a board committee is established by and responsible to the board of directors. We do not understand the SROs to intend a change in the customary manner in which board committees are authorized and their functions and powers are specified, provided that an audit committee's functions comply with the requirement of the Commission's new Rule 10A-3(c)(2) and (3). This customary practice would not prevent a committee from recommending to the board the specific role the committee should play and its functions and, as contemplated by the proposed listing standards, regularly reviewing the adequacy of its charter in permitting it to carry out effectively its purposes and reporting thereon to the full board of directors with recommended changes.
With these clarifications, listed companies would have flexibility to provide for delegation to the committee of final authority over some or all of the functions of the audit, compensation and nominating/governance committees as the board deemed appropriate in light of the particular circumstances of the company from time to time. The approach taken by the listed company would be disclosed in the committee charters, as contemplated by the proposed listing standards.
II. Independence Standards for Audit Committee Members
Rule 10A-3 under the Exchange Act establishes certain minimum standards regarding the audit committees which the SROs must require their listed companies to satisfy, including minimum standards for eligibility on the audit committee based on certain independence criteria. The rule, however, permits the SROs to establish standards for such audit committees that go beyond its minimum requirements. Both the NYSE and Nasdaq have proposed listing standards which include independence criteria for audit committee membership that differ from those required by Rule 10A-3. Both proposals provide, consistent with the requirements of Rule 10A-3, that the minimum standards of the Rule also are to be applied by their listed companies in determining eligibility for audit committee membership. With regard to such additional independence standards, two interpretive issues arise. Both concern whether a provision contained in the proposed listing standard for determining director independence in general is also to be used in determining eligibility for audit committee service when applying the criteria mandated by Rule 10A-3. The first issue concerns the categories of family members who should be considered in determining if a director meets the audit committee eligibility requirements pertaining to compensatory fees. The second concerns the "look-back" period (if any) which is to be applied in determining if a director meets the eligibility requirements pertaining to compensatory fees.
A. Compensatory Fee Payments to Family Members
i. Proposed NYSE Listing Standards
As proposed, Section 303A(2)(b)(i) provides that a director who receives, or whose immediate family member receives, more that $100,000 per year in direct compensation from a listed company (other than director and committee fees and non-contingent pension or other deferred compensation payments for prior service) is presumed not to be independent. This presumption applies with respect to compensation received before the individual became a director until five years have gone by since the director or any of his or her immediate family members received compensation in excess of the $100,000 threshold. The commentary to Section 303A(2)(b) provides a definition of "immediate family member" to be used in applying this and the other specific independence criteria proposed by the NYSE. In addition, Section 303A(6), as proposed, provides that the requirements of Rule 10A-3(b)(1) shall also apply to the determination of a director's independence for purposes of serving on a listed company's audit committee (subject to the exceptions provided by Rule 10A-3(c)).
Rule 10A-3(e)(8) defines compensatory fee payments made to a family member having any of certain specified relationships to a director as "indirect" payments to the director which impair the director's independence (unless an exception for such payments is available). As the NYSE has pointed out, the definition of immediate family member that will apply for purposes of applying Section 303A(2)(b)(i), as proposed, includes a broader set of family relationships than those which are to be considered under Rule 10A-3(e)(8) as prohibited indirect payments. However, the impact of this difference on application of the proposed NYSE standard for audit committee eligibility is unclear.
We believe it would be helpful to listed companies for the NYSE to confirm (in the listing standards or related commentary) that the NYSE's definition of "immediate family member" should not be used in applying Section 303A(6) to determine eligibility for audit committee membership. Accordingly, only compensatory fee payments to a family member of a director having one of the family relationships specified in Rule 10A-3(e)(8) will disqualify the director from audit committee service under Section 302A(6). Compensatory fee payments to the broader category of persons who are considered "immediate family members" under the NYSE definition will not be an automatic bar from audit committee membership but are to be considered in determining a director's independence under the general independence standards of Section 302A(2)2
ii. Proposed Nasdaq Listing Standards
As proposed, Rule 4200(a)(15)(B) provides that a director or a family member who accepts any payments from the company in excess of $60,000 during the current fiscal year or any of the past three fiscal years (except for certain limited payments) shall not be considered independent. Rule 4350(d)(2)(A)(i), as proposed, provides that the requirements of Section 10A(m)(3) of the Exchange Act shall apply as well as the Rule 4200 standards to the determination of a director's independence for purposes of serving on a listed company's audit committee.
The definition of family member proposed by Nasdaq to apply for purposes of applying Rule 4350(d) includes a broader set of family relationships than those treated as causing prohibited indirect payments under Rule 10A-3(e)(8). As in the case of the NYSE proposal, to provide guidance to companies in determining the eligibility of directors for audit committee service, it would be helpful for Nasdaq to confirm (in the listing standards or related commentary) that the Nasdaq's definition of family member should not be used in applying Rule 4350(d)(2)(A), so that, while compensatory payments of any amount to a family member of a director having one of the family relationships specified in Rule 10A-3(e)(8) will automatically disqualify the director from audit committee service, compensatory payments to other persons within the category of family members defined by Nasdaq will be considered under the $60,000 test of Rule 4200(a)(15)(B).
B. "Look-Back" With Respect to Compensatory Fee Payments
Similarly, to provide guidance to listed companies in determining the eligibility of directors for audit committee service, it would be helpful for the NYSE to confirm (in its listing standard or related commentary) whether the NYSE intends the five year look-back provision of Proposed Section 303A(2)(b), or payments made in any period prior to board service, to be considered in applying Proposed Section 303A(6), whether the payments are made to a family member or to a firm providing advisory or professional services to the listed company with which a director is or was associated in the capacities referred to in Rule 10A-3(e)(8). Likewise, it would be helpful for Nasdaq to confirm (in its listing standard or related commentary) whether the three year look-back provision of Proposed Rule 4200(a) should be applied in determining audit committee eligibility under Proposed Rule 4350(d)(2)(A)(i).
III. Permitted Transitional Periods of Noncompliance
There may be a variety of extraordinary circumstances in which companies will be unable to comply with elements of the proposed listing standards and for reasons beyond their control also will be unable to come back into compliance for a transitional period. During such periods, companies (and their shareholders) should be able to obtain some assurance from their SRO that they will not be subject to delisting, as long as they are undertaking the steps necessary to achieve compliance. In some circumstances, the SROs' customary delisting procedures involving hearings and appeals may not be adequate for this purpose and a procedure for establishing a transitional period of permitted noncompliance would be helpful in permitting a listed company to achieve compliance. This may be preferable subjecting shareholders to the consequences of delisting. We urge the SROs to address this situation by appropriate provisions in the proposed listing standards or supplemental commentary.
For example, as the NYSE has noted, the significant changes in a company's affairs that can follow the commencement of bankruptcy proceedings by a listed company may make continued compliance with the listing standards impossible or impracticable. Significant changes in board composition and bankruptcy court approval requirements (which generally extend to any matter outside the ordinary course of business) may result in board or committee composition that does not comply with the listing standards and a period in which the company is unable to take the actions necessary to come back into compliance. Delisting may not be an appropriate consequence in such circumstances and the prospect of delisting may in fact work against the company in its effort to comply with the good corporate governance standards the listing standards are intended to promote.
We recognize that the NYSE has provided an exemption from some of its corporate governance listing standards in cases of bankruptcy. Nasdaq has no such exemption in its proposals, and we urge it to address this circumstance. However, even with this exemption, it may be impossible or impracticable for a company that has just commenced a bankruptcy case to comply with other of the proposed requirements, such as those relating to the audit committee, and -- particularly given the uncertainty in corporate affairs that often surrounds a bankruptcy filing -- a period of time, which could extend for several months, may be necessary while various aspects of the bankruptcy process are addressed before it can be determined if the company will be able to achieve compliance. Where the company to the satisfaction of the SRO undertakes to come in compliance in a reasonable period under the circumstances and explains how it intends to do so - and the SRO otherwise is not prepared to commence delisting proceedings - companies and their shareholders ought to be able to obtain some assurance from the SRO that the company will not be subject to delisting for an appropriate period. Having this period without a risk of imminent delisting may even be important to the company in being able to maintain sufficient investor interest to develop a favorable reorganization alternative.
We hope that these comments will be helpful to the Commission and its Staff. We would be pleased to discuss with the Commission or its Staff any
aspect of this letter. Questions may be directed to Stanley Keller (617) 239-0217 or Robert Todd Lang (212) 310-8200.
cc: Hon. William H. Donaldson
Hon. Paul Atkins
Hon. Roel Campos
Hon. Cynthia A. Glassman
Hon. Harvey Goldschmid
Alan L. Beller, Director
Annette L. Nazareth, Director
Paul Roye, Director
Martin Dunn, Deputy Director
Richard P. Bernard, Executive Vice President and General Counsel
Edward S. Knight, Executive Vice President and General Counsel
T. Grant Callery, Senior Vice President and General Counsel