National Venture Capital Association
April 16, 2003
Jonathan G. Katz
Re: File No. SR-NASD-2002-141; Proposed Amendments to NASD Rules 4200 and 4350 Regarding Board Independence and Independent Committees
Dear Mr. Katz:
The National Venture Capital Association ("NVCA" or "the Association")1 is pleased to comment on the proposed amendments to Nasdaq rules on corporate governance listing standards ("Proposed Amendments"). 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 it's interest in the issuer.
NVCA's comments on the Proposed Amendments stems from our members' long-standing interest in the governance of pre-IPO and newly-public companies. NVCA has worked extensively with the Nasdaq Stock Market and the New York Stock Exchange since 1999 as they have developed corporate governance listing standards. NVCA's focus has been on the critical issues of independence, 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 Amendments in populating boards and committees with experienced, financially savvy, independent directors.
I. General Comments
NVCA supports Nasdaq's efforts to strengthen the corporate governance standards that apply to listed companies. Nasdaq has historically been the primary IPO venue for venture-backed companies. We share the SEC's and Nasdaq's interest in maintaining investor confidence and demonstrating the integrity of the Nasdaq Market. 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 possibility that new definitions of director independence in the Proposed Amendments could have the unfortunate effect of limiting the ability of venture capitalists to serve on audit and compensation committees. Certainly, venture capitalists are exactly the types of financially savvy, independent-minded board members that are sought for service on board and committees of publicly traded companies.
While we appreciate the degree to which the Proposed Amendments properly accommodate VCF directors, we believe that certain modifications are necessary 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
The Proposed Amendments increase audit committee member independence requirements in two ways. In addition to satisfying the independent director requirements, audit committee members must meet the independence standards in the Sarbanes-Oxley Act ("SOXA") Sec. 10A(m)(3), and SEC rules implementing them. NVCA recognizes that restrictions on consulting, advisory, or other compensatory fees are statutory. In this context, we note that neither SOXA nor SEC rules treat gains from sale of stock as a disqualifying "fee," nor should they. We also note that the Proposed Amendments retain the current Nasdaq rule on board member independence that exempts "payments ...arising solely from investments in the company's securities." Proposed Rule 4200(a)(15)(D). Therefore, we read the Proposed Amendments to continue to say that a representative of an investment fund, like a VCF director, faces no risk of disqualification from audit committee service based on receipt by the fund of proceeds from sale of company stock. NVCA notes the importance of this exception and the important policy supporting it, i.e., shareholders are inherently independent of management and shareholder service on boards should be encouraged.
One of the most important Proposed Amendments modifies the rule defining a disqualified "affiliated person" of the issuer. The Proposed Amendments create a bright-line rule regarding the key issue of stock ownership, a significant concern for NVCA. NVCA strongly supports the Nasdaq rule that a director who represents up to 20% of the stock of the issuer should be deemed to be unaffiliated with the issuer provided the director has no other relevant affiliation. Rather than restate the substantial support for this view, I am including as part of this filing, 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 ("Enclosure"), which cites significant authority.
We are mindful that the Proposed Amendments would also affect the independence of a director based on shareholdings at a lower threshold as might have been established by the SEC in its recent rulemaking under Section 10A(m). As we read the Final SEC Rule under Section 10A(m), the SEC declined to set such a lower share ownership threshold. Indeed, while the Commission chose a safe harbor shareholding level of 10%, it emphasized in its Enacting Release Nos. 33-8220 and 34-47654, p. 11, and in its new Rule 10A-3(e), that the facts and circumstance of each situation of each audit committee director must be analyzed to determine affiliate status. NVCA believes that the Proposed Amendments should be read to reflect Nasdaq's judgment that the fact that a director represents shareholdings up to 20%, coupled with the absence of any other circumstance that would indicate an affiliation with management, will not affect the independence of the director.
This interpretation is consistent with the need for venture-backed companies going public on Nasdaq to configure their boards of directors with a degree of certainty. 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 level of ownership will allow for VCF directors, whose funds' strategy does not call for divestiture of the stock of newly public companies to continue to serve an important function on the audit committee of the issuer beyond the one-year IPO transition period provided under new SEC rules under Section 10A(m).
Furthermore, NVCA urges Nasdaq to reconsider the presumption inherent in its Proposed Amendment that representing shareholding in excess of 20% would per se disqualify a director as an affiliate. This rule is certainly more restrictive than new SEC rules. Furthermore, such a rule will automatically deny issuers the services of large shareholder directors who might otherwise be the types of directors whose independence from management makes them exceptional audit committee members. Therefore, we urge that the Nasdaq rule be modified to provide for a facts and circumstances analysis of audit committee members who represent shareholdings of 20% or more to determine whether the subjective test of affiliate person is met.
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 a board committee. See Enclosure, pp. 3-8.
2. Composition of Audit Committees
NVCA notes that the Proposed Amendments do not change the requirement that a single audit committee member be financially sophisticated. Since the SEC rulemaking on disclosures regarding an audit committee financial expert have heightened scrutiny of such definitions, we will reiterate our view that the vast majority of VCF directors will qualify as financially sophisticated. The Nasdaq rule requires that each listed company's board must certify that at least one audit committee member has "past employment experience in finance ...or other comparable experience or background which results in the individual's financial sophistication...." (emphasis supplied). In our view, past (and current) employment as a venture capitalist fits this definition on a per se basis.
The two new requirements that small business issuers now must have an audit committee of three members who are all independent will add a new burden for companies that are struggling with a slow economy and a sluggish stock market. While we realize that SOXA requires fully independent audit committees and that the SEC declined to create any exceptions for small business issuers, the new requirement for a third audit committee member is discretionary and unnecessary. At the least, small business issuers should be granted additional time to come into compliance. The SEC's transition until July 31, 2005 for Rule 10A-3 audit committee requirements would be an appropriate transition period for all new board and committee composition requirements for small business issuers.
B. Definition of Independence for Board Members (Rule 4200)
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. Our support for these provisions is conditional, however, because of concerns with one of the new restrictions related to "look-backs" in the definition of board member independence in proposed amendments to Rule 4200.
Look-back provisions were proposed in the Nasdaq rule proposals on audit committees in 1999. NVCA's comments to that proposal, below, are equally applicable to proposed new restrictions on board member independence.
Two additional reasons exist for significantly shortening the look-back period under the proposed amendments to Rule 4200 on director independence. First, the SEC requested comment on the question in its recent rulemaking process under Sec.10A(m) and found no need to impose look-backs 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.
A VCF director who falls into one of the three-year look-backs applicable to the broad categories described in Proposed Rule 4200(a)(15)(A)(D)(E) or (F), would be legally bound by his or her fiduciary duties to the investors in the fund to act independently as soon as he or she began managing the assets of the venture capital fund. It is nearly scandalous to suggest that a VCF director's current legal obligations to fund investors could be compromised, for a period of up to three years, by a prior business relationship even if that relationship applied directly to the director. However, the Proposed Amendments go still further by applying a three-year look-back to such highly attenuated relationships as those described in the subparagraphs identified above.4
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. 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 would be better still.
Finally, NVCA strongly supports the proposed Interpretive Material to Rule 4200, IM-4200 Definition of Independence - Rule 4200(a)(15), which states that "Nasdaq does not believe that ownership of company stock by itself would preclude a board finding of independence...." 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 (Rule 4350)
As noted above, NVCA supports the Proposed Amendments regarding board and committee composition, provided "independent" is properly defined. 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.
We also support the retention of board discretion to appoint a director who does not meet all the requirements of Rule 4200 to the nominating or compensation committee under "exceptional and limited circumstances." Unfortunately, we are aware of few companies that have used the "exceptional and limited" status during the years in which it was available for audit committee purposes. One reason for its limited use has been the necessity for extensive disclosure in proxy statements. NVCA recommends that Nasdaq rules retain the "exceptional and limited" status but apply a more focused safeguard against its abuse, e.g., a report to Nasdaq rather than proxy disclosure. Such an approach would truly respect, and encourage, the use of board discretion to judge individual cases "in the best interests of the company and its shareholders," Proposed Rule 4350(c)(3)(C).
NVCA also supports the controlled company exception in Proposed Rule 4350(c)(5). While few venture capital firms would own more that 50% of the voting stock of a listed company, the exception from the new requirements regarding board and committee independence are appropriate.
Similarly, NVCA supports Proposed IM-4350-4 on Board Independence and Independent Committees, which provides that independent director approval of all nominations 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, their enforceability can be a critical component to a transaction whereby a public company obtains a capital infusion from a private equity fund.
We believe that the Proposed Amendments are essentially sound. We urge Nasdaq 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.
It would be an extremely unfortunate result of the recent reforms if newly public companies felt compelled to replace seasoned and financially savvy venture capitalists on their boards or committees because these directors failed to satisfy any overly inclusive independence requirement.
Nasdaq and NVCA share the 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.
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.