PART 2-Sarbanes-Oxley Corporate Governance-Rule 10A-3  PREVIOUS                                                               NEXT

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Part 2 SOX--Corporate governance --Rule 10A-3

Although we do not discuss listing at this point (see Part 4), we make the assumption that the company will list its securities on the Nasdaq Stock Market. The Nasdaq corporate governance provisions are applicable to Nasdaq Global Market (NGM) (formerly Nasdaq National Market)   issuers and to the Nasdaq Capital Market (NCM) securities (formerly Nasdaq SmallCap).[1] The corporate governance provisions were significantly modified and enhanced as a result of initiatives taken by the SROs post-Enron/WorldCom and specific requirements imposed by SEC rules mandated by the Sarbanes-Oxley Act. We assumed that the company will list its securities on Nasdaq, presumably as NCM securities, but the SOX impact will be the same if it is listed as a NGM or the highest Nasdaq Global Select tier. The corporate governance provisions  of SOX in large part go through the stock exchanges; hence, can be avoided by not listing, but that has some offsetting costs that makes listing the choice for companies going public. We discuss why listing is the only realistic source for most companies at Part 3.. Sarbanes-Oxley required the Commission by April 26, 2003 to adopt Rules directing all registered stock exchanges and Nasdaq, which has since become a registered stock exchange (hereinafter collectively SROs) to require all listed companies as a condition to listing to establish an audit committee and impose specified requirements with respect to such committees.[2] Each member of the audit committee is to be an independent member of the board of directors. To be an independent director, the director must not be an affiliated person of the issuer or any subsidiary and must not receive any “consulting, advisory, or other compensatory fee” from the issuer other than in their capacity as a director or a member of any committee of the board.[3] The SRO must empower the audit committee with a number of specific powers that are discussed below. The Commission on January 8, 2003, proposed Rule 10A-3 to implement the Sarbanes-Oxley mandate and with some modification adopted Rule 10A-3 on April 9, 2003,[4] requiring all SROs to deny listing to companies if they do not have audit committees meeting the independence standards established by the rules and that are appropriately empowered.

Rule 10A-3 requires that all SROs prohibit the listing or continued listing of company that does not have an audit committee composed exclusively of independent members of the board of directors as defined by the rule and otherwise complies with the requirements of the rule.[5] Rule 10A-3 follows closely the language of the Act as to what constitutes independence. To be independent, the members of the audit committee must not be an affiliated person of the issuer or a subsidiary of the issuer (other than as a director of the issuer or member of the audit committee or other board committee).[6] In addition, to be independent an audit committee member most not receive “directly or indirectly any consulting, advisory, or other compensatory fee from the issuer or subsidiary thereof” other than compensation received as a director, as a member of the audit committee, or as a member of another board committee. The audit committee members, however, if not precluded by the rules of the exchange, can also receive fixed amount of compensation under a retirement plan for prior services to the issuer provided the compensation is not contingent in any way on continued services.[7] Through the device of defining indirect compensation,[8] a member of the audit committee is deemed to receive the prohibited compensation as the result of (1) compensation received by certain family members and (2) as the result of compensation received by certain types of entities with which the director is associated in certain designated capacities. The latter relates to entities that receive compensation for providing “accounting, consulting, legal, investment banking, or financial advisory services to the issuer or any subsidiary of the issuer.”[9] An entity in which the director has a limited role (limited partner, non-managing member, and similar roles with no active role in providing services to the entity) can receive such compensation without impacting the director’s independence.[10] The family relationships that give rise to indirect compensation are “a spouse, a minor child or stepchild or child or stepchild sharing a home” with the director.[11]

Nasdaq Independence Standard

On February 13, 2002, several months before the adoption of Sarbanes-Oxley, then SEC Chairman Pitt requested the New York Stock Exchange and Nasdaq Stock Exchange to review corporate governance and listing standards, including the issues of officer and director qualifications.[12] In response to Chairman Pitt’s call for reform, the NYSE Corporate Accountability and Listing Standards Committee and Nasdaq proposed substantial changes to their corporate governance and listing standards.[13] Nasdaq on July 24[14] responded to then SEC Chairman Pitt’s request to the SROs with a number of proposed revisions to its corporate governance rules. With the adoption of Sarbanes-Oxley, the NYSE and Nasdaq changed course somewhat to combine their proposed corporate governance provisions that went beyond SOX with what was necessary to meet the requirements of Rule 10A-3. On November 4, 2003, the Commission announced that it had approved the proposed rules of the NYSE and Nasdaq as amended.[15] The rules have much in common but they also differ in a number of respects. The NYSE revised corporate governance provisions constitute a new Section 303A of the Listed Company’s Manual. The Nasdaq rules take the form of an amendment to the definition of independent director as Rule 4200(a)(15) and a new Rule 4350 setting forth additional corporate governance provisions.

There is a transition exemption for an issuer that theretofore was not a reporting company under the Exchange Act and is registering a class of securities under the Exchange Act or has filed a registration statement under the Securities Act covering an initial public offering of securities to be listed. All of the members of the audit company of such issuer except one are exempt from the independence requirement for a period of 90 days after the effective date of the registration statement. A minority of the members of the committee are exempt from the independence requirement for a period of one year.[16] Such listed issuers must disclose reliance on the exemption and the company’s assessment whether and how such reliance could materially adversely affect the independence of the audit committee and the ability of the committee to otherwise meet the requirements of the Rule 10A-3. Such disclosure must be made in the proxy or information statement in connection with the meeting at which the directors are elected and included in or incorporated by reference in the annual report filed with the Commission pursuant to the Exchange Act.[17]

The Nasdaq Stock Market combined its corporate governance proposals relating to audit committees with those of more general application. The changes to the Nasdaq rules preserve much of what was established pursuant to the recommendations of the blue ribbon panel and at the same time adapted them to the requirements of Sarbanes-Oxley.

A person cannot be deemed an independent director if such person falls in any of the following categories:[18]

(A) S/he was employed by the company, a parent or subsidiary of the company at any time during the past three years.

(B) S/he, or any Family Member who is an executive employee of the company, accepted payments from the company, a parent or subsidiary of the company in excess of $60,000 during the current or any of the past three fiscal years excluding for this purpose (i) compensation for board or board committee service; (ii) payments arising solely from investments in the company’s securities; (iii) benefits under a tax-qualified retirement plan, or non-discretionary compensation; or (iv) loans permitted under Section 13(k) of Sarbanes-Oxley.[19]

(C) S/he is a Family Member of an individual who is or at any time during the past three years was employed as an executive officer by the company, a parent or subsidiary of the company.

(D) S/he, or any Family Member, is a partner in, or controlling shareholder or executive officer of a company to which the list company made or from which it received payments for property or services in the current of any of the past three fiscal years that exceed five percent of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is greater, excluding (i) payments arising solely from investments in the company’s securities; or (ii) payments under non-discretionary charitable contribution matching programs.

(E) S/he or any Family Member, is employed as an executive officer of another entity if any time during the past three years any executive officers of the listed company served on the compensation committee of the other entity during the past three years.

(F) S/he or any Family Member, is a current partner of the company’s outside auditor, or was a partner or employee of the company’s outside auditor during the past three years:

Family member where referenced is defined as “a person’s spouse, parents, children and siblings, whether by blood, marriage or adoption or anyone residing in such person’s home.”[20]

Audit Committee

A number of the foregoing provisions go beyond Rule 10A-3 in keeping a director from being deemed independent; particularly, to the extent they look back to the prior three years. On the other hand, the provision allowing payments up to $60,000 a year for compensation other than services rendered as a member of the board is inconsistent with Rule 10A-3 and specifically provides “that audit committee members are subject to additional, more stringent requirements under Rule 4350(d)).” Rule 4350(d) in turn provides that a listed company must have an audit committee consisting of not less than three members “each of whom must: be independent as defined under Rule 4200(a)(15), [and] meet the criteria for independence set forth in Rule 10A-3(b)(1) under the Act.”[21]

Audit committee members must be able to read and understand the basic (balance sheet, income statements, statement of cash flows) financial statements. At least one member of the audit committee as a result of past employment or comparable experience or background have “financial sophistication,” including non-exclusively experience as a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.”[22]

The exception for small business issuers is eliminated and such issuers are required to meet the same audit committee requirements.

Other Nasdaq Corporate Governance Provisions

In addition, to meeting the requirement of Rule 10A-3, the Nasdaq revised rules require the following:

The rules provide that a majority of the board of directors must be independent.[23] This provision and those discussed BELOW relating to nominating and compensation committees, however, are not applicable to controlled companies. A controlled company is defined as a company in which “more than 50% of the voting power is held by an individual, a group or another company,” A company relying on this exemption must disclose such reliance and the basis for being a controlled company in its proxy statement relating to the annual meeting.[24]

The revisions to the Nasdaq corporate governance rules require the nomination of company directors to be selected or recommended for selection either by a majority of the independent directors or a nomination committee consisting solely of independent directors.[25] Compensation of the chief executive officer is to be determined either by a majority of the independent directors or by a compensation committee comprised solely of independent directors.[26] Compensation of other officers is to be determined in the same manner.[27] The chief executive officer may not be present during voting or deliberations.[28] If the nomination is by a nomination committee and/or compensation is determined by a compensation committee, in either event the requirement that the committee consist only of independent directors is subject to an identical qualification. The in common qualification permits one member of the committee to be not independent provided (a) the committee consists of at least three members; (b) such director is not a current officer or employee or family member of a current officer or employee; (c) there are exceptional and limited circumstances; (d) the board determines it in the best interest of the company and shareholders; (e) such member does not serve on the committee for longer than two years, and (f) the proxy statement for the next annual meeting following the determination discloses the nature of the relationship and the reasons for the determination.[29] The provisions relating to a nominations committee are not applicable to the extent (1) the right to nominate a director legally belongs to a third party,[30] or (2) the company is subject to a binding obligation that requires a director nomination structure inconsistent with the rule and the obligation predates the adoption of the rule.[31]

A company going public must take the foregoing into account and be prepared, among things, to have a board the majority of which are independent and an audit committee all of the members of which are independent.  There is little time to have this in place. The transition provisions relating to the audit committee as set forth in Rule 10A-3 are set forth ABOVE. A newly listed company has one year to bring itself in compliance with the requirement that it have a majority of its board members who are independent.

RULE 10A-3
NYSE CORPORATE GOVERNANCE RULE 303A
Nasdaq CORPORATE GOVERNANCE RULE (RULE 4200(a)(15); RULE 4350)
NYSE CORPORATE GOVERNANCE FAQ
AMEX CORPORATE GOVERNANCE
OTHER SROs

Backdrop to Adoption of Sarbanes-Oxley (optional) Securities Law Handbook