Exchange Rules Impact Compensation Committee Composition

Thursday, April 1, 2004 - 01:00



The SEC recently approved corporate governance rules submitted by the New York Stock Exchange ("NYSE") and Nasdaq Stock Market, Inc. ("Nasdaq").Both provide that "independent directors" must comprise a majority of the board of every listed company (with some limited exceptions).


The NYSE rules require listed companies to maintain a compensation committee consisting of "independent directors."The Nasdaq rules require listed companies to either determine (or recommend to the board for determination) CEO and other executive officer compensation: (i) through a committee comprised of "independent directors"1 or (ii) by a majority vote of"independent directors."


These rules take effect with a company's first annual meeting occurring after January 15, 2004, but no later than October 31, 2004, with the following exceptions:


 •a company with a classified board that would be required to change a director who would not normally stand for election prior to such annual meeting is allowed to keep such director in office until the second annual meeting after such date, but no later than December 31, 2005;2


 •a company having its initial public offering on NYSE or Nasdaq must have one independent member at the time of listing, a majority of independent members within ninety days of listing, and fully independent committees within one year;


 •a company listing on NYSE or Nasdaq upon the transfer from another market would have 12 months from the date of transfer in which to comply with this requirement, to the extent the market on which they were listed did not have the same requirement; and


 •a company transferring from another market that has substantially similar independent director requirements will be afforded the balance of any grace period afforded by that market.

Other Director Requirements


Most compensation committees of public companies include at least two directors that are "outside directors" under Section 162(m) of the Internal Revenue Code (the "Code") and "non-employee directors" under Rule 16b-3 of the Securities Exchange Act (the "Act").Although the exchange "independence" definitions are similar to these definitions, there are differences.Accordingly, NYSE or Nasdaq listed companies should review compensation committee composition prior to the effective dates.

Exchange Director Independence Rules


NYSE


Independence


NYSE requires that a listed company's board affirmatively determine, based on all facts and circumstances, that each independent 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 (including any parent or subsidiary).The company must publicly disclose this determination (in a proxy or Form 10-K if a proxy is not filed).


Conflicts


A director lacks independence if, currently, or during a look-back period, he:


 •is an employee (except for interim Chairman or CEO), or his immediate family member3 is an executive officer, of the company;


 •receives, or his immediate family member receives, more than $100,000 per year in direct compensation from the company, other than (i) director and committee fees; (ii) pension or other deferred compensation for prior service (provided such compensation is not contingent on continued service); (iii) compensation received by a director for former service as interim Chairman or CEO; or (iv) compensation received by an immediate family member for service as a non-executive employee of the company;


 •is affiliated with or employed by, or his 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 employed, or his immediate family member is employed as an executive officer of another company where any of the listed company's present executives serve on that company's compensation committee; or


 •is an executive officer or an employee, or his 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 gross revenues.


Look-Back


Prior to November 4, 2004 a one-year look-back period applies after the termination of the offending relationship, and a three-year look-back applies thereafter.4


Nasdaq


Independence


Nasdaq defines "independent director" 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 would interfere with the exercise of independent judgment in carrying out a director's responsibilities.


Conflicts


A director lacks independence if, currently or during a look-back period, he:5


 • is employed by the company or by any parent or subsidiary of the company;6


 •has accepted or has a family member7 who accepted any payments from the company or any parent or subsidiary of the company in excess of $60,000 other than (i) compensation for board (or 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 Act;


 •is a family member of an individual who is employed by the company or by any parent or subsidiary of the company as an executive officer;


 •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 listed company made, or from which the company received, payments for property or services that exceed the greater of 5% of the recipient's consolidated gross revenues for that year, or $200,000, other than (i) payments arising solely from investments in the company's securities or (ii) payments under non-discretionary charitable contribution matching programs;


 •is, or has a family member who is, employed as an executive officer of another entity where any of the executive officers of the listed company serve on the compensation committee of such other entity; or


 •is, or has a family member who is, a current partner of the company's outside auditor, or was a partner or employee of the company's outside auditor who worked on the company's audit.


Look-Back


The disqualifying circumstances described above are subject to a three-year look-back period commencing on the date the relationship ceases.

Other Factors Affecting Committee Structure


162(m)


Under 162(m), a publicly-held corporation8 is not allowed to deduct compensation in excess of $1 million paid to its CEO or its other four most highly paid officers listed in its proxy in a taxable year unless it is qualified "performance-based compensation."For compensation to be performance-based the performance goals under which compensation is payable must be established by a committee comprised solely of two or more "outside directors," and any grants and awards of stock options and other stock-based compensation must be made by the committee.The committee must certify in writing the attainment of the performance goals prior to payment except where the compensation is solely attributable to a stock price increase (e.g., stock options).


In order to qualify as an "outside director" for this purpose, a director:


 •cannot be a current employee of the publicly-held corporation;


 •cannot be a former employee of the publicly-held corporation who receives compensation for prior services during the taxable year (other than benefits under a tax-qualified retirement plan);


 •cannot be a current or former officer of the publicly-held corporation; and


 •cannot receive remuneration from the publicly-held corporation, either directly or indirectly, in any capacity other than as a director.9


16b-3


16b-3 of the Act exempts grants of stock based awards to executive officers and directors from short-swing trading liability under Section 16 of the Act if a committee of the board composed solely of two or more "non-employee" directors approves the grant or award.In order to qualify as a "non-employee" director, a director generally cannot be a current officer or employee of the company or a parent or subsidiary of the company and since the beginning of the company's last fiscal year the director:


 •cannot receive compensation in excess of $60,000, either directly or indirectly, from the company or a parent or subsidiary of the company, for services rendered as a consultant or in any capacity other than as a director;


 •cannot possess an interest in any related party transactions where the amount involved exceeds $60,000; and


 •cannot engage in a business relationship for which disclosure would be required pursuant to Item 404(b) of Regulation S-K.

Conclusion


Listed companies should review existing compensation committee composition to ensure compliance with exchange, tax and securities law rules.Although the various director "independence" rules are similar, it is possible that a director could be "independent" under one rule but not the other.

1If the committee has at least three members, the Nasdaq rules permit one non-independent director, who is not a current officer or employee, or family member of a current officer or employee, to serve on the compensation committee for no more than two years, provided that (i) the board, under exceptional and limited circumstances, determines that the inclusion of such director on the compensation committee is required by the best interests of the company and its shareholders and (ii) the board publicly discloses in the next annual meeting proxy statement the use of such exception, the nature of the individual's relationship to the company and the reasons for the board's determination.


2The NYSE has recently indicated in an answer to a Frequently Asked Question, published on January 29, 2004, that if such a company is able to comply with these requirements by the earlier date of its annual meeting and October 31, 2004, by replacing any non-independent directors who would normally stand for election at its 2004 annual meeting, it must comply by such earlier date.


3NYSE defines an "immediate family member" as an individual's spouse, parents, children, siblings, mother-in-law and father-in-law and sons and daughters-in-law and anyone (other than domestic employees) who shares such person's home.A listed company need not consider individuals who are no longer immediate family members as a result of legal separation or divorce or those who have died or become incapacitated.


4The look-back period for the last test described above applies solely to the financial relationship between the listed company and the director or the immediate family member's current employer; a listed company need not consider former employment of the director or immediate family member.


5In lieu of the rules described below, in the case of an investment company, a director who is an "interested person" as defined in Section 2(a)(19) of the Investment Company Act of 1940, other than in his or her capacity as a member of the board of directors or any board committee, will be unable to qualify as an independent director.


6Nasdaq has indicated that it will only look to the parent and those subsidiaries that are controlled by and consolidated with the company's financial statements when determining director independence.


7Nasdaq defines "family member" as a person's spouse, parents, children, and siblings, whether by blood, marriage (including in-laws) or adoption, or anyone residing in such person's home.


8A publicly-held corporation means a corporation issuing any class of common equity securities required to be registered under Section 12 of the Exchange Act.Whether a corporation is publicly-held is determined based solely on whether, as of the last day of its taxable year, the corporation is subject to the reporting obligations of Section 12 of the Exchange Act.A publicly-held corporation also includes an affiliated group of corporations, as defined in Section 1504 of the Code.However, an affiliated group of corporations does not include any subsidiary that is itself a publicly-held corporation.


9Remuneration includes any payments in exchange for goods or services and is deemed to be received, directly or indirectly, by a director if: (i) paid, directly or indirectly, to the director or to an entity (any organization that is a sole proprietorship, trust, estate, partnership (including limited liability company) or corporation) in which the director has a beneficial ownership interest of greater than 50%; (ii) remuneration, other than de minimis remuneration, was paid by the publicly-held corporation in its preceding taxable year to an entity in which the director has a beneficial ownership interest of at least 5% but not more than 50%; and (iii) remuneration, other than de minimis remuneration, was paid by the publicly-held corporation in its preceding taxable year to an entity by which the director is employed or self-employed other than as a director.De minimis remuneration is measured based on the amount paid by the publicly-held corporation in its preceding taxable year and may not exceed 5% of the gross revenue of the entity for the entity's taxable year ending with or within the publicly-held corporation's preceding taxable year.Remuneration in excess of $60,000, even if less than 5% of gross revenue, is not de minimis if the remuneration is paid to an entity in which the director has a beneficial ownership interest of at least 5% but not more than 50%, or is paid for personal services (as defined in the applicable Treasury regulations) to an entity by which the director is employed or self-employed other than as a director.

Ira G. Bogner is a Partner and Michael Krasnovsky is an Associate in the Tax Department of Proskauer Rose LLP, and both are members of the Employee Benefits and Executive Compensation Group at Proskauer.

Please email the authors at ibogner@proskauer.com or mkrasnovsky@proskauer.com with questions about this article.