Does Freddie Mac Comply With Current NYSE Listing Rules?
United States: SEC Approves Strengthening of Corporate Governance Standards for NYSE, Nasdaq Listed Companies - Most Companies Must Meet Heightened Standards by Next Annual Shareholders’ Meeting
by Brian G. Cartwright, Scott Hodgkins, Tricia Emmerman, Raymond Y. Lin, Howard A. Sobel, Erica H. Steinberger, John J. Huber, William P. O’Neill, Marc D. Bassewitz
Introduction
On November 4, 2003, the Securities and Exchange Commission approved long-anticipated modifications to the corporate governance listing standards of both the New York Stock Exchange and the Nasdaq National Market.1 Hailed by SEC Chairman William Donaldson as being "at the core of a broad movement by our markets to enhance the corporate governance practices of the companies traded on them," the new rules represent a sea change in the governance of listed companies, mandating stricter measures of board independence and independent director oversight of processes relating to corporate governance, auditing, director nominations and compensation.
The rules to modify NYSE and Nasdaq listing standards were first proposed in 2002 when, in response to a series of high-profile corporate accounting scandals and a resulting loss of investor confidence in the U.S. securities regulation system, then-Chairman of the SEC Harvey Pitt requested that the NYSE and Nasdaq, as well as the other exchanges, review their corporate governance listing standards. The NYSE and Nasdaq revised their respective rule proposals numerous times in response to comments from the public and revisions suggested by the SEC and to conform the proposed listing standards to Rule 10A-3 under the Securities Exchange Act of 1934, as amended, adopted by the SEC in April 2003 pursuant to the Sarbanes-Oxley Act of 2002 to prohibit the listing on any national securities exchange or association of any security of an issuer that is not in compliance with certain audit committee requirements. Now in final form, the new NYSE and Nasdaq rules will trigger a surge of reform by listed companies, many of which have anxiously delayed corporate governance changes pending final rules.
“These rule changes are at the core of a broad movement by our markets to enhance the corporate governance practices of the companies traded on them . . . ."
SEC Chairman William Donaldson
The following summarizes the final NYSE and Nasdaq corporate governance rules and highlights new requirements that require immediate attention. Due in great part to the SEC’s efforts to harmonize the listing standards of the major markets, the NYSE and Nasdaq rules have converged in many respects, including the timeframe for compliance. Listed companies will have until the earlier of their first annual meeting after January 15, 2004 or October 31, 2004 to comply with the new standards, subject to limited exceptions. Longer transition periods apply in certain circumstances for companies with classified boards, foreign private issuers and newly listed companies. Nasdaq’s requirement that the audit committee approve related-party transactions takes effect January 15, 2004, and its requirement that companies adopt codes of conduct for their directors, officers and employees is effective beginning May 2004.
Final NYSE Corporate Governance Rules
The new NYSE corporate governance rules2 amend the current listing standards to require the following:
Listed companies must have a majority of independent directors.
No director qualifies as "independent" unless the board affirmatively determines that the director has no material relationship with the company, either directly or as a partner, shareholder or officer of an organization that has a relationship with the company. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships and must be assessed not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. However, ownership of even a significant amount of stock, by itself, is not a bar to an independence finding. Companies must disclose these determinations in their annual proxy statement or, if the company does not file an annual proxy statement, in the Form 10-K filed with the SEC. A board may adopt and disclose categorical standards to assist it in making determinations of independence and may make only general disclosure if a director meets these standards.
By definition, a director cannot be independent
unless at least three years* have passed since:
the director (or any immediate family member**) was an executive officer of the company
the director (or any immediate family member) received more than $100,000 per year in direct compensation from the company, other than director and committee fees and pension or other forms of deferred compensation for prior service not contingent on continued service
the director was affiliated with or employed by (or whose immediate family member was affiliated with or employed in a professional capacity by) a present or former external auditor
the director (or any immediate family member) was employed as an executive officer of another company whose compensation committee includes an executive of the company
* Transition Rule: For the year ending November 4, 2004, only a one-year “look-back" will apply (rather than a three-year look-back).
** "Immediate family member" is defined to include a person’s spouse, parents, children, siblings, mothers and fathers-in-law, sons and daughters-in-law, brothers and sisters-in-law, and anyone (other than a domestic employee) who shares such person’s home. References to the "company" would include any parent or subsidiary in a consolidated group with the company
if the director is an executive officer or an employee (or whose immediate family member is an executive officer) of a company that makes payments to, or receives payments from, the company for property or services in an amount which, in any single fiscal year, exceeds the greater of $1 million or 2 percent of such other company’s consolidated gross revenues. Charitable organizations are not "companies" for purposes of this test, but companies are required to disclose charitable contributions made by the company to any charitable organization in which a director serves as an executive officer in excess of this threshold.
Non-management directors must meet at regularly scheduled executive sessions without management. "Non-management" directors are all those who are not company officers3 but includes those who are not independent by virtue of some other material relationship. If the company’s group of "non-management" directors includes directors who are not "independent" under the standards described above, an executive session of solely independent directors must be scheduled at least once a year. Companies must disclose either the name of the director who would preside at these executive sessions or the procedure for selecting a presiding director for each session.
Companies must have a nominating/corporate governance committee composed entirely of independent directors, with a written charter that addresses the committee’s purpose and certain specified responsibilities, including new director and board committee nominations and oversight of the evaluation of the board and management. If a company is legally required by contract or otherwise to provide third parties with the ability to nominate directors, the selection and nomination of such directors need not be subject to the nominating committee process.
Companies must have a compensation committee composed entirely of independent directors, with a written charter that addresses the committee’s purpose and certain specified responsibilities, including review and approval of the compensation of the CEO and, to a lesser degree, non-CEO officers and incentive-compensation plans and equity-based plans.
Companies must have an audit committee that satisfies the Sarbanes-Oxley-enhanced independence standards.4 The audit committee must have a minimum of three members, each of whom is independent and financially literate and at least one of whom has accounting or financial management experience. "Independence" is more tightly defined for audit committee members, who must not only satisfy the independence standards described above, but also may not, directly or indirectly, receive any other compensation from the company (other than their compensation for board and committee service) or be an affiliated person of the company or any subsidiary. Under certain circumstances, if a company fails to comply with the audit committee composition requirements, a cure period will apply. If an audit committee member simultaneously serves on the audit committees of more than three public companies, and the company does not limit the number of audit committees on which its audit committee members serve, then in each case the board must determine that such simultaneous service would not impair the ability of such member to serve effectively on its audit committee and must disclose such determination in the company’s annual proxy statement (or, if the company does not file an annual proxy statement, in its Form 10-K).
The audit committee must have a written charter that addresses the committee’s purpose and certain specified responsibilities. These include selecting and overseeing the company’s independent accountant, establishing procedures for handling complaints regarding the company’s accounting practices, annually obtaining and reviewing a report by the independent auditor, discussing the company’s annual audited financial statement and quarterly financial statements with management and the independent auditor, the company’s earnings press releases, financial information and earnings guidance provided to analysts and rating agencies and policies with respect to risk assessment and risk management, and setting clear hiring policies for employees or former employees of the independent auditors.
Companies must have an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management processes and system of internal control. This function may be outsourced to a third-party service provider other than the company’s independent auditor.
Companies must adopt and disclose corporate governance guidelines. While the guidelines will necessarily be company-specific, key areas that must be addressed are director qualification standards5 and director responsibilities, director access to management and independent advisors, director compensation, director orientation and continuing education, management succession and annual performance evaluation of the board.
Companies must adopt and disclose a code of business conduct and ethics for directors, officers and employees and promptly disclose any waivers of the code for directors or executive officers. This code must address, among other things, conflicts of interest, corporate opportunities, confidentiality, fair dealing, protection and use of company assets, compliance with laws, rules and regulations (including insider trading laws) and encouraging the reporting of illegal or unethical behavior. The code must contain compliance standards and procedures to facilitate its effective operation and must require that any waiver of the code for executive officers or directors be made only by the board or a board committee.
Each year the CEO must certify to the NYSE that he/she is not aware of any violation by the company of NYSE corporate governance listing standards. Among other things, the chief executive officer must certify that he/she has no reasonable cause to believe that the information provided to investors is not accurate and complete in all material respects and that he/she is not aware of any company violations of NYSE listing standards. In addition, the company CEO must promptly notify the NYSE in writing after any executive officer of the company becomes aware of any material non-compliance with any NYSE corporate governance listing standard. The new standards provide that the NYSE may issue a public reprimand letter to any listed company that violates a NYSE listing standard, enabling the Exchange to apply a lesser sanction (as compared to suspending trading or delisting a company) to deter companies from violating its corporate governance or other listing standards.
Companies must post their corporate governance guidelines, code of business conduct and ethics, and the charters of the most important board committees (including at least the audit, and if applicable, compensation and nominating committees) on their Web sites and indicate in their Form 10-K that the information is available on the Web site and in print to requesting shareholders.
The final NYSE corporate governance rules can be viewed on the NYSE’s Web site at http://www.nyse.com/pdfs/finalcorpgovrules.pdf.
Final Nasdaq Corporate Governance Rules
The new Nasdaq corporate governance rules,6 amend the current listing standards to require the following:
Listed companies must have a majority of independent directors.
No director qualifies as "independent" unless the board affirmatively determines that the director has no relationship with the company that would impair his/her independence. An independent director continues to be defined as "a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship, which, in the opinion of the company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director."
A director cannot be independent
unless at least three years have passed since:
the director was employed by the company or by any parent or subsidiary of the company (or any Family Member* of the director was employed by the company or by any parent or subsidiary of the company as an executive officer)
the director (or any Family Member of the director) was a partner or employee of the company’s outside auditor who worked on the company’s audit, or is a current partner of the company’s outside auditor
the director (or any Family Member) was employed as an executive officer of another company whose compensation committee includes an officer of the company
if the director (or any Family Member of the director) accepted payments from the company or any parent or subsidiary of the company in excess of $60,000 during the current or any of the past three fiscal years, other than (i) compensation for director or board committee service, (ii) payments arising solely from investments in the company’s securities, (iii) compensation paid to a Family Member who is a non-executive employee of the company or a parent or subsidiary of the company, (iv) benefits under a tax-qualified retirement plan, or non-discretionary compensation, or (v) loans permitted under Section 13(k) of the Exchange Act, but including political contributions
if the director (or a Family Member) is a partner in, controlling shareholder or executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5 percent of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than (i) payments arising solely from investments in the company’s securities; or (ii) payments under non-discretionary charitable contribution matching programs.
*"Family Member” is defined to include a person’s spouse, parents, children, siblings, whether by blood, marriage or adoption, or anyone residing in such person’s home. A "parent or subsidiary" covers entities the company controls and consolidates with its financial statements as filed with the SEC. "Executive officer" means those officers covered in Rule 16a-1(f) under the Exchange Act.3
Ownership of company stock, by itself, is not a bar to an independence finding.
Companies must disclose these independence determinations in their annual proxy statement or, if the company does not file an annual proxy statement, in the Form 10-K filed with the SEC.
Independent directors must meet at regularly scheduled executive sessions (at least twice a year) without management.
Companies must have an audit committee that satisfies the Sarbanes-Oxley-enhanced independence standards.4 The audit committee must have a minimum of three members, each of whom is independent (except as permitted under "exceptional and limited circumstances" for a single member), has not participated in the preparation of the financial statements of the company or any current subsidiary of the company at any time during the past three years and is able to read and understand fundamental financial statements, including a company’s balance sheet, income statement and cash flow statement, at the time of appointment. In addition, at least one audit committee member must have past employment experience in finance or accounting or other comparable experience or background which results in financial sophistication, including being or having been a chief executive offer, chief financial officer or other senior officer with financial oversight responsibilities. "Independence" is more tightly defined for audit committee members, who must satisfy the independence standards described above, but also may not receive any other compensation from the company (other than their compensation for board and committee service) or be an affiliated person of the company or any subsidiary. The time that a non-independent director may serve on the audit committee pursuant to the "exceptional and limited circumstances" exception (only available to directors who satisfy the audit committee independence requirements set forth in the preceding sentence) is limited to two years, and any such person is prohibited from serving as the chair of the audit committee. Under certain circumstances, if a company fails to comply with the audit committee composition requirements, a cure period will apply. A company must promptly notify Nasdaq of any failure to comply with these audit committee requirements.
The audit committee must have a written charter that addresses the committee’s purpose and certain specified responsibilities. These include selecting and overseeing the company’s independent accountant and establishing procedures for handling complaints regarding the company’s accounting practices.
In addition, the company’s audit committee must review and approve all related-party transactions. A company’s audit committee or comparable body will be required to approve all related-party transactions, effective January 15, 2004.
Director nominees must be selected, or recommended for the Board’s selection, by either a majority of the independent directors, or a nominations committee comprised solely of independent directors. Each company must certify that it has adopted a written charter or board resolutions addressing the nomination process and related matters under the federal securities laws. A single non-independent director, who is not an officer or employee (or Family Member of an officer or employee), may serve for up to two years on an independent nominations committee comprised of at least three members, pursuant to an "exceptional and limited circumstances" exception. Issuers whose nominations process is legally controlled by a third party, or subject to a pre-existing (i.e., prior to November 4, 2003) binding obligation that requires a different director nomination structure, would not be required to comply with this rule until the arrangement expires, though the obligation to comply with the board and audit committee composition requirements still applies.
Compensation of the CEO and all other executive officers must be determined, or recommended to the Board for its determination, either by a majority of the independent directors, or a compensation committee comprised solely of independent directors. The CEO may not be present during voting or deliberations concerning his/her compensation. A single non-independent director, who is not an officer or employee (or Family Member of an officer or employee), may serve for up to two years, on an independent compensation committee comprised of at least three members, pursuant to an "exceptional and limited circumstances" exception.
Companies must adopt and disclose a code of conduct for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers. This code must include written standards that are reasonably designed to deter wrongdoing and to promote: (i) honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships; (ii) full, fair, accurate, timely and understandable disclosure in reports and documents that a registrant files with, or submits to, the Commission and in other public communications made by the registrant; (iii) compliance with applicable governmental laws, rules and regulations; (iv) the prompt internal reporting of violations of the code to an appropriate person or persons identified in the code; and (v) accountability for adherence to the code. Companies must comply with this requirement by May 4, 2004.
Companies must disclose a going concern qualification in an audit opinion through the issuance of a press release. This requirement became effective upon SEC approval.
Nasdaq has also submitted separate rule proposals to harmonize Nasdaq’s disclosure rule with Regulation FD and to clarify other existing listing standards. These proposals remain subject to SEC approval.
The complete rule text of the final Nasdaq corporate governance rules can be viewed on Nasdaq’s Web site at http://www.nasdaq.com/about/RecentRuleChanges.stm.
Controlled Companies Exemption
Both the NYSE and Nasdaq rules provide an exemption from the requirements for a majority independent board and independent nominating and compensation committees (but not for an independent audit committee) for "controlled companies"—those in which 50 percent or more of the voting power is controlled by an individual, group or another company. Reliance on this exemption and the basis for the determination that the company is a controlled company must be disclosed in the company’s annual proxy statement.
Transition Rules for New Issuers
Companies listing in conjunction with their initial public offering are provided a longer period for compliance.
NYSE: New issuers will have until 12 months from listing to meet the majority independent board requirement. They will also be able to phase in their independent committees: they must have one independent director at the time of listing, a majority of independent directors within 90 days thereafter, and fully independent committees as required within one year.
Nasdaq: Nasdaq provides for the same transition periods for both the majority independent board requirement and independent committees as the NYSE, but new issuers can choose not to adopt a nomination or compensation committee and instead rely upon a majority of the independent directors on the board to discharge the responsibilities of such committees.
Foreign Private Issuers
Both the NYSE and Nasdaq recognize that foreign private issuers may be subject to conflicting home country corporate governance rules.
NYSE: Listed foreign private issuers are permitted to follow home country practice instead of these new listing standards (except with respect to Sarbanes-Oxley-enhanced independence standards for audit committee members, with which they must comply by July 31, 2005). However, they must disclose any significant ways in which their corporate governance practices differ from those followed by domestic companies under NYSE standards. This disclosure should be made on the company’s Web site (if in English) or in the annual report.
Nasdaq: Nasdaq may provide exemptions from the corporate governance listing standards when provisions of the standards are contrary to a law, rule or regulation of any public authority exercising jurisdiction over such issuer or contrary to generally accepted business practices in the issuer’s country of domicile, subject to compliance with the federal securities laws. Foreign private issuers must disclose any exemptions from Nasdaq’s corporate governance requirements, as well as any alternative measures taken instead of the waived requirements.
Foreign private issuers must be in compliance with these rules by July 31, 2005, except that the requirement that a foreign private issuer disclose the receipt of a corporate governance exemption from Nasdaq applies to new listings and filings made after January 1, 2004.
Shareholder Approval of Equity Compensation Plans
Effective June 30, 2003 the SEC approved new rules proposed and adopted by the NYSE and Nasdaq requiring shareholder approval of equity compensation plans, including stock option plans.7
The NYSE requires that shareholders be given the opportunity to vote on all equity-compensation plans and material revisions to such plans, subject to limited exemptions. The exemptions include: (1) employment inducement awards, (2) mergers and acquisitions when conversions, replacements or adjustments of outstanding options or other equity compensation awards are necessary to reflect the transaction and when shares available under certain plans acquired may be used for certain post-transaction grants and (3) certain tax-qualified, non-discriminatory employee benefit plans (e.g., plans intended to meet the requirements of Sections 401(a) or 423 of the Internal Revenue Code) and parallel excess plans. Plans and amendments that are exempt from this shareholder approval requirement must be approved by the company’s compensation committee or a majority of independent directors. Material revisions include an increase in shares available under the plan (other than to effect a reorganization, stock split or similar transaction), including evergreen provisions for plans with a term of 10 or more years, and repricings. Pre-existing plans are unaffected by this rule, unless a material modification is made to the plan.
Brokers may not vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions (i.e., discretionary voting by brokers is now prohibited). As a result of this change, shareholder approval will be more difficult to obtain.
Nasdaq requires shareholder approval for the adoption of all stock option plans and for any material modification of such plans, subject to limited exemptions. The exemptions include: (1) employment inducement awards, (2) mergers and acquisitions when conversions, replacements or adjustments of outstanding options or other equity compensation awards are necessary to reflect the transaction and when shares available under certain plans acquired may be used for certain post-transaction grants and (3) certain tax-qualified, non-discriminatory employee benefit plans (e.g., plans intended to meet the requirements of Sections 401(a) or 423 of the Internal Revenue Code) and parallel excess plans. Plans and amendments that are exempt from this shareholder approval requirement must be approved by the company’s compensation committee or a majority of independent directors. Pre-existing plans are unaffected by this rule, unless a material modification is made to the plan.
Conclusion
Since, subject to narrow exceptions, most listed companies must comply with the above requirements by the earlier of the first annual shareholders’ meeting after January 15, 2004 or October 31, 2004, companies must act swiftly to improve or supplement their corporate governance practices in accordance with the new listing standards. Among other things, listed companies should:
Examine all director relationships, including those that do not require disclosure but could cause regulators or others to question directors’ independence, and consider their board and committee composition and make any changes in board composition or committee memberships necessary to comply with the new requirements in advance of the next annual shareholders’ meeting.
Review board committee charters, code of conduct and corporate governance guidelines for compliance with the final standards and, if necessary, prepare revisions for board review and approval in advance of the next annual shareholders’ meeting. Companies that have waited to see the final rules before finalizing any of these documents may now have a more limited time to do so.
Review all board and committee meeting schedules—in particular, the audit committee’s—to ensure that they enable directors to thoroughly address their board and committee responsibilities under the new rules.
Assess director orientation and continuing education program and consider bolstering or formalizing director orientation and continuing education as a means of ensuring that the company has an effective and informed board. Both the NYSE and Nasdaq are encouraging greater attention to this component of corporate governance.
Endnotes
1 See SEC Order Approving Rule Changes, NASD and NYSE Rulemaking: Relating to Corporate Governance (November 4, 2003), available on the SEC’s Web site at http://www.sec.gov/rules/sro/34-48745.htm.
2 The new NYSE corporate governance rules are codified in Section 303A of the NYSE’s Listed Company Manual and are available on the NYSE’s Web site at http://www.nyse.com/pdfs/finalcorpgovrules.pdf.
3 For purposes of this requirement, company "officers" are defined, by reference to Rule 16a-1(f), to mean an issuer’s president, principal financial officer, principal accounting officer (or, if there is no such accounting officer, the controller), any vice-president of the issuer in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the issuer. Officers of the issuer’s parent(s) or subsidiaries shall be deemed officers of the issuer if they perform such policy-making functions for the issuer. In addition, when the issuer is a limited partnership, officers or employees of the general partner(s) who perform policy-making functions for the limited partnership are deemed officers of the limited partnership. When the issuer is a trust, officers or employees of the trustee(s) who perform policy-making functions for the trust are deemed officers of the trust.
4 As directed by the Sarbanes-Oxley Act of 2002, the SEC adopted a new rule to direct the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements mandated by Sarbanes-Oxley. These requirements relate to: the independence of audit committee members; the audit committee’s responsibility to select and oversee the issuer’s independent accountant; procedures for handling complaints regarding the issuer’s accounting practices; the authority of the audit committee to engage advisors; and funding for the independent auditor and any outside advisors engaged by the audit committee.
5 Note that the SEC’s proposed shareholder access rules would not require shareholder nominees to meet any subjective qualifications established by the company or its board. See Latham & Watkins LLP Client Alert No. 343, SEC Proposes Rules to Increase Shareholder Proxy Access, available at http://www.lw.com/resource/Publications/ClientAlerts/clientAlert.asp?pid=841" target="_new">http://www.lw.com/resource/Publications/http://www.lw.com/resource/Publications/ClientAlerts/clientA....
6 The new Nasdaq corporate governance rules are codified in NASD Rules 4200 and 4350 and are available on Nasdaq’s Web site at http://www.nasdaq.com/about/RecentRuleChanges.stm" target="_new">http://www.nasdaq.com/about/http://www.nasdaq.com/about/RecentRuleChanges.stm.
7 See Latham & Watkins LLP Client Alert No. 306, SEC Approves Equity Compensation Shareholder Approval Rules, available at http://www.lw.com/resource/Publications/ClientAlerts/clientAlert.asp?pid=757" target="_new">http://www.lw.com/resource/Publications/http://www.lw.com/resource/Publications/ClientAlerts/clientA...
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Will Freddie Mac and Fannie Mae meet these requirements in time?
Ref: FBI Baltimore Field Office Operation Overage Outage (OOO)
http://baltimore.fbi.gov/
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