National Venture Capital Association
May 8, 2003
Jonathan G. Katz
Re: Release No. 34-47672; File No. SR-NYSE-2002-33; Proposed Amendments to NYSE Rules Relating to Corporate Governance
Dear Mr. Katz:
The National Venture Capital Association ("NVCA" or "the Association")1 is pleased to comment on Release No. 34-47672 ("Release") and the proposed rule changes to NYSE Listed Company Manual on corporate governance listing standards ("Proposed Rules"). NVCA has participated fully in both SEC and SRO rulemaking on corporate governance listing standards over the past few years.
NVCA members serve on boards of directors, audit, compensation and nominating committees of many companies in which venture capital funds invest. These venture capital fund (VCF) directors represent significant shareholdings of pre-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 its interest in the issuer.
NVCA's comments on the Proposed Rules stems from our members' long-standing interest in the governance of pre-IPO and newly public companies. NVCA has worked extensively with the New York Stock Exchange and the Nasdaq Stock Market since 1999, as they have developed more extensive corporate governance listing standards. NVCA's focus has been on the critical issues of independence, board experience and financial sophistication that VCF directors bring to corporate boards. As with other rules in this area, a recognition of the independence of directors who represent large venture capital shareholdings is critical to the effectiveness of these Proposed Rules in populating boards and committees with experienced, financially savvy, independent directors.
I. General Comments
NVCA supports NYSE's efforts to strengthen the corporate governance standards that apply to listed companies. We share the SEC's and NYSE's interest in maintaining investor confidence and enhancing the quality of corporate governance in NYSE-listed companies. NVCA has long -- and publicly -- supported a primary role for the SROs in "address[ing] these governance and disclosure issues with a nuance appropriate to these complex and multifaceted issues."2
NVCA is particularly sensitive to the risk that new definitions of director independence in the Proposed Rules could have the unfortunate effect of limiting the ability of venture capitalists to serve on audit and compensation committees. NVCA has long been a proponent of the view that "venture capitalists, acting as fiduciaries to funds with significant shareholdings, typically have all the qualities that the independent director definition is intended to ensure," Release, p. 23.3 Certainly, venture capitalists are among the directors who most clearly are independent of management. They also have significant experience as directors of growing companies. Therefore, we appreciate the sensitivity that the NSYE has shown on issues affecting the relationship between large shareholding and independence from management.
However, there are provisions of the Proposed Rules to which NVCA recommends modification in order to avoid the exclusion of some highly-qualified VCF directors from board or committee service.
II. Specific Comments
A. Audit Committee Requirements
1. Definition of Independence
NVCA supports the NYSE's decision to allow SEC Rule 10A-3 to define audit committee member independence requirements. This is one of the most important aspects of the Proposed Rules for venture capitalist because of the Sarbanes-Oxley Act's disqualification of any "affiliated person of the issuer" from audit committee service. NVCA strongly supports an interpretation of SEC Rule 10A-3 that recognizes the independence of a director whose only connection to the issuer is significant ownership of the stock of the issuer. This interpretation is consistent with the fact that the presence of directors with significant shareholdings has been shown to be a strong indicator of good corporate governance. Rather than restate the substantial support for this view, I am including as part of this filing, NVCA's comment on the recent SEC proposal on Standards Relating to Listed Company Audit Committees and Audit Committee Member Independence under Sarbanes-Oxley Act, Section 301, File No S7-02-03 ("Enclosure"), which cites significant authority at pages 4-6.
As we read Rule 10A-3, the SEC determined that there need be no upper limit on the share ownership of an independent audit committee member. Indeed, when the Commission set a Safe Harbor shareholding level of 10%, it emphasized that the facts and circumstance of each situation must be analyzed to determine affiliate status. See, Release Nos. 33-8220 and 34-47654, p. 11, and SEC Rule 10A-3(e),
NVCA believes that the situation of the typical VCF director on an audit committee argues for a presumption in favor of independence. The NYSE can apply the Rule 10A-3 requirement to evaluate the facts and circumstances of each audit committee director's situation to create this presumption. We believe it is appropriate to conclude that the fact that a director represents a large shareholder fund, as a fiduciary, coupled with the absence of any circumstances that would indicate an affiliation with management, supports a conclusion that a director is independent for audit committee purposes. We recommend that the Commentary to Rule 303A(6) address this issue so that issuers -- particularly pre-public issuers - can confidently include VCF directors on their audit committees.
This interpretation is consistent with the practical need for venture-backed companies going public on the NYSE to configure their boards of directors with a certainty that they will pass muster under the Rule 10A-3 flexible standard. It is also consistent with the SEC's admonition that "[a] director who is not an executive officer of the company but beneficially owns more than 10% of the issuer's voting equity could be determined to be not an affiliate under a facts and circumstances analysis of control." Id., p.11. Moreover, this approach to share ownership will allow for a VCF director, whose fund's strategy does not call for divestiture of the stock of newly public companies to continue to serve on the audit committee of the issuer beyond the one-year IPO transition period, provided under SEC Rule10A-3.
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 leads to the conclusion that a representative of a venture capital fund is generally the type of financially savvy, independent board member who promotes good corporate governance on an audit committee. See Enclosure, pp. 3-8.
2. Composition of Audit Committees
The Commentary to Proposed Rules 303A(6) requires that one member of the audit committee "must have accounting or related financial management expertise, as the board determines in its business judgment." Release, p. 9. Regarding current requirements for one financially sophisticated audit committee member, NVCA has assumed that the typical venture capitalist fit this definition. However, the Commentary's use of the term "financial management expertise" and its reference to the SEC's definition of audit committee financial expert," id., p. 10, could lead to the conclusion that something more than financial sophistication is required. Therefore, we reiterate the view that a venture capitalist, by virtue of his or her role and experience should, in most cases, provide the requisite financial expertise at the member level on an audit committee. Particularly, with the new requirement that audit committees have broad authority to retain outside experts, a venture capitalist's experience in reading financial statements and overseeing management's presentation of financial results is far more valuable than more narrow technical expertise.
We recommend the Commentary to Rule 303A(6) be modified to eliminate any reference to the highly restrictive SEC definition of audit committee financial expert and make clear the "accounting or related financial management expertise" does not require any particular background, certification or education.
B. Definition of Independence for Board Members
NVCA generally supports the new requirement that boards be composed of a majority of independent directors, and that nominating and key compensation decisions be made by independent directors only. VCF directors can add particular value on compensation committees because of their extensive experience with executive management and motivation. Furthermore, since VCF directors represent shareholders, and are often key decision makers in hiring and firing management, compensation committee membership is particularly appropriate. Our support for these provisions is conditional, however, because of concerns with new restrictions related to "look-backs" in the definition of board member independence in the Proposal.
The proposed five-year look-back provisions are excessive. A five-year disqualification from independence, based on prior relationships, ignores the speed with which businesses and the overall business environment changes. Particularly in the fast-moving, innovative sectors in which most venture capital is invested, five years represents an extremely long time.
Two additional reasons exist for significantly shortening the look-back period under the proposed amendments on director independence. First, the SEC requested comment on the question of look-backs in its recent rulemaking process under Sec.10A(m) and found no need to impose any in Rule 10A-3. Second, to impose such a lengthy look-back presumptively ignores the fact that directors who may have once had an allegiance or affiliation to the issuer or its auditor now have a legal duty to act independently.
Because of his or her fiduciary duties to the investors in the venture capital fund, a VCF director is legally bound to act independently as soon as he or she begins managing the assets of the fund. Nevertheless, such a director could fall into one of the five-year look-backs applicable to the broad categories described in proposed Rule 303A(2)(b). It is nearly scandalous to suggest that a VCF director's current legal obligations to fund investors could be compromised by a prior business relationship. It is especially troubling to suggest that this would be the case for a relationship that ended five years hence.
While NVCA must oppose any such restriction being applied to VCF directors on principle, we note that shortening the look-back period to one year would significantly mitigate the harm of such a rule. We prefer a more sophisticated rule that recognized the de minimus impact of past affiliations when a director is subject to new duties that clearly overwhelm any lingering effects of past business affiliations.
Finally, NVCA strongly supports the Commentary to proposed Rule 303A(2)(a) where it states that: "[A]s the concern [with a director's relationships with the listed company] is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding." Release, p. 4 [emphasis supplied]. NVCA most certainly agrees. The academic research cited in the Enclosure, shows why significant director stock ownership is, indeed, an indicator of good governance.
3. Exceptions to Board and Committee Composition Requirements
As noted above, NVCA supports the Proposed Amendments regarding board and committee composition, provided "independent" is properly defined.
NVCA supports the controlled company exception to Proposed Rule 303A(1), (4) and (5), pertaining to board, executive and compensation committee composition. While few venture capital firms will own more than 50% of the voting stock of a listed company, the exception from the new requirements is appropriate.
NVCA also supports the exception noted in the Commentary to 303A(4) which provides that nominating committee approval is not required where the right to nominate a director legally belongs to a third party. While NVCA members do not frequently hold such rights in listed companies, their enforceability can be a critical component of the capital structure of some public companies.
We believe that the Proposed Rules generally advance the goals of improving accountability and good governance. We urge the NYSE to modify them in ways recommended in this letter. In particular, we hope that the final rules will avoid the disqualification of VCF directors, who are independent, knowledgeable and able to provide financial sophistication as well as significant experience in compensation committee functions, based on an excessive look-back requirement.
It would be an extremely unfortunate result of the recent reforms if newly public companies felt compelled to replace seasoned, independent and financially savvy venture capitalists on their boards or committees because these directors failed to satisfy an overly inclusive requirement having little to do with genuine independence from management.
NVCA shares the NYSE's goal of promoting good corporate governance and enhancing the ability of companies to deliver long-term shareholder value. NVCA would be pleased to consult on any issues raised in this letter. Please do not hesitate to contact me, or NVCA's outside counsel, Brian Borders at 202-263-3374.
Mark G. Heesen
Enclosures [as part of this electronic document, below]
NVCA comment on the recent SEC proposal on Standards Relating to Listed Company Audit Committees and Audit Committee Member Independence under Sarbanes-Oxley Act, Section 301, File No S7-02-03.