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Are Your Directors Independent?

In July 2002, the United States Congress enacted the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”). One of the areas addressed by Sarbanes-Oxley and by subsequently adopted rules of the Securities and Exchange Commission (“SEC”) was the independence of a publicly traded company’s directors and, specifically, the independence of the members of the company’s audit committee. Prior to the enactment of Sarbanes-Oxley, other provisions of federal law and regulations and the listing requirements of the New York Stock Exchange (“NYSE”) and The Nasdaq Stock Market (“Nasdaq”) had imposed requirements for independence of directors under various circumstances. Additional requirements were adopted after enactment. The following summarizes the current requirements for and criteria to be used to determine director independence under various statutes, rules, and listing standards.

Independent Boards of Directors
Both the NYSE and Nasdaq impose a requirement that a majority of the members of a listed company’s board of directors be independent, in accordance with their respective definitions.

NYSE
NYSE Rule 303A.01 requires that listed companies have a majority of independent directors. Rule 303A.02 sets forth the standards for determining whether a particular director is independent. The general rule is that no director qualifies as “independent” unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company). Under this standard, the board is to make determinations based on all relevant facts and circumstances with regard to a particular director’s relationship with the company or his or her relationship with other businesses or entities that have a relationship with the listed company.
In addition, however, certain individuals are deemed not to be independent. These include:

• a director who is an employee, or whose immediate family member is an executive officer, of the company is not independent until three years after the end of such employment relationship;
• a director who receives, or whose immediate family member receives, more than $100,000 per year in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service), is not independent until three years after he or she ceases to receive more than $100,000 per year in such compensation;
• a director who is affiliated with or employed by, or whose immediate family member is affiliated with or employed in a professional capacity by, a present or  former internal or external auditor of the company is not independent until three years after the end of the affiliation or the employment or auditing relationship;
• a director who is employed, or whose immediate family member is employed, as an executive officer of another company where any of the listed company’s present executives serve on the other company’s compensation committee is not independent until three years after the end of such service or the employment relationship; and
• a director who 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 listed company for property or services in an amount which, in any single fiscal year, exceeds the greater of $1 million, or 2% of such other company’s consolidated gross revenues, is not independent until three years after falling below such threshold.

“Immediate family member” includes 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. Individuals who are no longer immediate family members as a result of legal separation or divorce, or those who have died or become incapacitated, need not be considered when applying the three-year look-back provisions.

Nasdaq
Nasdaq Rule 4350(c) requires that a majority of a listed company’s board of directors be independent. Under Rule 4200(a)(15), an “independent director” is 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. The following persons are not considered independent:

• a director who is, or at any time during the past three years was, employed by the company or by any parent or subsidiary of the company;
• a director who accepted or who has a Family Member who accepted any 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 the following:

(i)         compensation for board or board committee service;

• payments arising solely from investments in the company’s securities;
• compensation paid to a Family Member who is a non-executive employee of the company or a parent or subsidiary of the company;
• benefits under a tax-qualified retirement plan or non-discretionary compensation; or
• loans permitted under Section 13(k) of the Securities Exchange Act (“Exchange Act”);
• a director who is Family Member of an individual who is, or at any time during the past three years was, employed by the company or by any parent or subsidiary of the company as an executive officer;
• a director who is, or has a Family Member who is, a partner in, or a controlling shareholder or an 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% of the recipient’s consolidated gross revenues for that year, or $200,000, whichever is more, other than the following:

(i)         payments arising solely from investments in the company’s securities; or

• payments under non-discretionary charitable contribution matching programs;
• a director who is, or has a Family Member who is, employed as an executive officer of another entity where at any time during the past three years any of the executive officers of the company have served on the compensation committee of such other entity; or
• a director who is, or has a Family Member who is, a current partner of the companies’ outside auditor, or was a partner or employee of the company’s outside auditor who worked on the company’s audit at any time during any of the past three years.

“Family Member” means a person’s spouse, parents, children, and siblings, whether by blood, marriage, or adoption, or anyone residing in such person’s home.

Independent Audit Committee
Under NYSE and Nasdaq rules and Sarbanes-Oxley and related SEC rules, all members of the audit committee must be independent. 

Sarbanes-Oxley
Under Section 301 of Sarbanes-Oxley and related Rule 10A-3(b)(1) under the Exchange Act, in order to be considered independent, the member may not:

• accept directly or indirectly any consulting, advisory, or other compensatory fee other than compensation as a board member or member of a board committee; or
• be an affiliated person of the issuer or any subsidiary thereof except as related to his or her service on the board of directors.

Unlike similar rules, this rule does not provide that a specified minimum amount of fees may be paid without disqualifying the recipient from being independent.  With regard to status as an “affiliate,” the SEC has provided a safe harbor, stating that an individual who is not a 10% holder of the issuer’s securities or an executive officer of the issuer will not be deemed to be an affiliate.
In addition, Item 401(h) of Regulation S-K requires that a company disclose whether there is at least one “audit committee financial expert” on its audit committee. An “audit committee financial expert” is a person with the following attributes:

• An understanding of generally accepted accounting principles and financial statements;
• The ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves;
• Experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the company’s financial statements, or experience actively supervising one or more persons engaged in such activities;
• An understanding of internal control over financial reporting; and
• An understanding of audit committee functions.

These attributes must have been acquired through (i) education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor, or experience in one or more positions that involve the performance of similar functions; (ii) experience actively supervising an individual described in (i); (iii) experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing, or evaluation of financial statements; or (iv) other relevant experience.

NYSE
Under Rule 303A.07, a company listed on the NYSE must have an audit committee with a minimum of three members, each of whom must satisfy the requirements for independence set out in Rule 303A.02 (discussed above) and SEC Rule 10A-3. In addition, each member must be financially literate or become financially literate within a reasonable period of time after appointment to the audit committee. In addition, at least one member must have accounting or related financial management expertise. The NYSE does not require that a listed company’s audit committee include a person who satisfies the definition of “audit committee financial expert” as set forth in Item 401(h) of Regulation S-K.

Nasdaq
Under Rule 4350(d)(2)(A), each issuer must have an audit committee of at least three members, each of whom must:

• be independent as defined under Rule 4200(a)(15) (see definition above);
• meet the criteria for independence set forth in Rule 10A-3(b)(1) under the Exchange Act (described above);
• not have 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
• be able to read and understand fundamental financial statements, including a company’s balance sheet, income statement, and cash flow statement.

Additionally, at least one member of the audit committee must have past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer, or other senior officer with financial oversight responsibilities.

Compensation Committee Composition
Under certain federal statutes and rules and under the NYSE rules, members of a company’s compensation committee must meet certain standards. 

NYSE
Under Rule 303A.05 of the NYSE, a listed company must have a compensation committee composed entirely of independent directors (as defined in Rule 303A.02 (as discussed above)). 

Section 162(m) of the Internal Revenue Code
Under Section 162(m) of the Internal Revenue Code, companies are denied a tax deduction for compensation in excess of $1 million per year paid to defined executive officers unless the compensation satisfies certain criteria. One of the criteria is that the compensation committee must consist of two or more “outside directors.”
For purposes of Section 162(m), the compensation committee must consist of two or more “outside directors.”  An “outside director” is an individual who:

• is not a current employee of the corporation;
• is not a former employee of the corporation who receives compensation for prior services (other than benefits under a tax qualified retirement plan);
• has not been an officer of the corporation; and
• does not receive remuneration from the corporation, either directly or indirectly, in any capacity other than as a director.

“Remuneration” includes any payment for goods or services.  It is considered to be paid to the director if it is paid:

• to the director personally;
• to an entity in which the director has a beneficial ownership interest of greater than 50%;
• if such payments exceed $60,000, to an entity in which the director has a beneficial ownership of at least 5% but not more than 50%; or
• unless such payments satisfy the de minimis test (defined below), to an entity by which the director is employed or self-employed other than as a director.

Remuneration is considered paid when actually paid or, if earlier, when the corporation became liable to pay it (thus preventing avoidance of the rule by deferring payments to a later year). 
A payment is considered “de minimis” if payments to the entity during the tax year of the entity ending with or within the tax year of the corporation did not exceed 5% of the entity’s gross revenues. Further, remuneration in excess of $60,000 (even if less than 5% of gross revenues) is not considered de minimis (i) if the payment is remuneration for “personal services” provided by an entity by which the director is employed or self-employed or (ii) if the director is a 5% (but not more than 50% owner) of the entity. 
Remuneration is for “personal services” if two requirements are satisfied. First, the remuneration must be paid for personal or professional services, consisting of legal, accounting, investment banking, and management consulting services (and similar services that may be specified by the commissioner of the Internal Revenue Service), performed for the corporation.  Second, the director must perform significant services (whether or not as an employee) for the corporation, division, or similar organization (within the entity) that actually provides the personal services or more than 50% of the entity’s gross revenues must be derived from the personal-service-providing corporation, division, or organization.

Under Section 16(b) of the Exchange Act, purchases and sales of a company’s securities by certain insiders are subject to the short swing profit rule. To avoid application of this rule, Rule 16b-3 exempts certain transactions between a company and such insiders (in particular, transactions related to compensation paid in the form of or related to the company’s stock) if the transactions meet certain criteria. One such criterion is that if such grants are made by a committee of the board, that committee must consist of “non-employee directors” as defined in the rule.
            A “nonemployee director” for purposes of Rule 16b-3 is an individual who:

• is not currently an employee of the company or a parent or a subsidiary of the company;
• does not receive compensation, directly or indirectly, from the company or a parent or a subsidiary of the company in any capacity other than as a director, except for an amount that does not exceed the $60,000 threshold requiring disclosure under Item 404(a) of Regulation S-K;
• does not have an interest in any other transaction for which disclosure would be required pursuant to Item 404(a) of Regulation S-K; and
• is not engaged in a business relationship with the company or any of its subsidiaries required to be disclosed under Item 404(b) of Regulation S-K.

Item 404(b) of Regulation S-K requires the description of business relationships where the director is or during the most recent fiscal year has been an executive officer or owns of record or beneficially in excess of a 10% equity interest in any business or professional entity that either has made payments to the company or has received payments from the company for property or services where such payment exceeds 5% of either the company’s consolidated gross revenues for its last full fiscal year or the other entity’s consolidated gross revenues for its last full fiscal year (typically the fiscal year ending concurrently or within the company’s last fiscal year). 

Companies listed on the NYSE are required to have nominating and governance committees comprised entirely of independent directors as defined in the NYSE rules.
Under SEC and Nasdaq rules, companies are not required to have a nominating committee, but if one is appointed, it is to consist of directors who are independent as defined in the relevant NYSE or Nasdaq rules.

In order to allow companies to change the composition of their boards, if necessary, to comply with these new rules, both the NYSE and Nasdaq have implemented transitional periods. Affected companies should consult the appropriate rules to determine when they will need to comply.

©Moss & Barnett, A Professional Association, 2005