SEC, NYSE and NASDAQ Propose Next Wave of Post-Enron Reforms

The Securities and Exchange Commission, the New York Stock Exchange and the Nasdaq Stock Market have announced the next wave of proposed disclosure and corporate governance reforms for public companies in response to the Enron disaster. On June 12, 2002, the SEC announced new proposals to (1) require CEOs and CFOs to certify the accuracy and completeness of disclosures in Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q and (2) substantially expand Form 8-K filing triggers and accelerate the filing deadline to two business days for all required Form 8-K filings. See SEC Release No. 34-46079 (June 14, 2002); SEC Release No. 33-8106 (June 17, 2002).

On June 6, 2002, the NYSE announced significant proposed changes to its corporate governance listing standards. Among other things, NYSE-listed companies would be required to have:

• independent directors (under a stricter definition) make up a majority of the board;
• audit, nominating and compensation committees consisting entirely of independent directors;
• shareholders approve all equity-based compensation plans; and
• their CEOs certify annually the accuracy and completeness of information provided to investors.

Nasdaq proposed an initial round of changes to its corporate governance listing standards at the end of May and has indicated its intent to consider additional changes later this month that would bring Nasdaq requirements more closely in line with the NYSE proposals.

The latest SEC proposals come in the wake of important proposals in April (to accelerate Form 10-K and 10-Q filing deadlines and expand Form 8-K trigger events to cover director and officer trading and loans) and in May (to require new MD&A disclosure regarding critical accounting policies). The April and May proposals are discussed in our Client Advice Memorandums of April 18, 2002, and May 14, 2002, respectively, available on our web site at www.dorseylaw.com.

The latest proposed changes would apply to all U.S. domestic reporting companies. The comment periods for the latest proposals will expire in mid-August.

Certification of Quarterly and Annual Reports

Under the proposal, CEOs and CFOs would be required to certify in Form 10-K and 10-Q reports that:

• they have read the report;
• to their knowledge, the information in the report is true in all “important” respects as of the last day of the period covered by the report; and
• the report contains all information about the company of which they are aware that they believe is “important” to a reasonable investor as of the last day of the period covered by the report. (Because of the narrower scope of the quarterly report, this last certification would be limited in Form 10-Q by inserting “in light of the subjects required to be addressed in the report” after the word “investor.”)

The certification would include a statement that information should be considered “important” to a reasonable investor if “there is a substantial likelihood that a reasonable investor would view the information as significantly altering the total mix of information in the report” and “the report would be misleading to a reasonable investor if the information was omitted from the report.” The SEC’s proposing release states that this “importance” standard is intended to reflect the current disclosure standards for “material” information.

The proposal would also require companies to maintain procedures to provide reasonable assurances of ability to collect, process and disclose in a timely manner the information required in periodic and current reports under the Securities Exchange Act of 1934 and to perform a periodic review and evaluation of such procedures. Annual evaluations would be presented to the CEO, CFO and board each year. The CEO and CFO would be required to certify in the Annual Report on Form 10-K that they had reviewed the results of these evaluations.

New Form 8-K Disclosure Requirements and Deadlines

The SEC had indicated in February its intent to propose substantial expansion of the trigger events requiring filing of a Current Report on Form 8-K and to require that such reports be filed sooner. The SEC is now proposing that all required Form 8-K filings be made within two business days of the reported event (instead of the current five- or 15-day periods). The proposal would substantially expand the list of trigger events to include (in addition to existing triggers and the new director and officer trading and loan triggers proposed in April):

• entry into, or termination of, a material agreement not made in the ordinary course of business;
• termination or reduction of a business relationship with a customer that would result in a 10% reduction in consolidated revenues;
• creation of a direct or contingent financial obligation that is material to the company as well as events triggering such a direct or contingent financial obligation (including any default or acceleration of an obligation);
• exit activities, including any material write-off or restructuring charge;
• any material impairment;
• change in a rating agency decision, issuance of a credit watch or change in company outlook;
• movement of the company’s securities from one national exchange or quotation system to another, delisting or notice of noncompliance with listing standards;
• conclusion or notice that investors should no longer rely on the company’s previously issued financial statements or a related audit report; and
• any material limitation, restriction or prohibition (including beginning and end of lock-out periods) regarding the company’s employee benefit, retirement and stock ownership plans.

In addition to these new trigger events, the proposal would shift two disclosure items that are currently required in Form 10-K or 10-Q to Form 8-K: (1) unregistered sales of equity securities by the company; and (2) material modification to rights of holders of the company’s securities. The proposal would also amend several existing Form 8-K items to include: (1) departure of a director for reasons other than disagreement or removal for cause; (2) appointment or departure of a principal officer and election of new directors; and (3) material amendment to a company’s articles or certificate of incorporation or bylaws. The proposal would also create a liability safe-harbor for late filings meeting certain conditions and a two-business-day extension of deadline to companies filing a proper notice form and meeting certain requirements.

Earlier this year, SEC Chairman Harvey Pitt asked the NYSE and Nasdaq to review their corporate governance listing standards in light of Enron. In response, the NYSE appointed a Corporate Accountability and Listing Standards Committee consisting of prominent representatives of U.S. public companies, Wall Street and the institutional investor community.

The Standards Committee submitted a lengthy report to the NYSE Board of Directors on June 6, 2002, recommending significant changes to the NYSE corporate governance listing standards. Following a comment period of approximately two months, the NYSE Board expects to take final action on the report on August 1. The new standards would go into effect shortly after approval by the NYSE Board and the SEC.

Greater Role and Authority of Independent Directors

Independent majority. Under the changes proposed by the Standards Committee report, NYSE-listed companies would be required to have a majority of their boards comprised of independent directors (as defined under a new, stricter definition). Current NYSE listing standards require only three independent directors regardless of board size. Listed companies would have two years from adoption of the new standards to meet the independent majority requirement and would be required to make public disclosure when they become compliant.

Stricter definition of independence. Under the proposed, new standard, an independent director is one who the board determines has “no material relationship” to the company. Current independence standards (which apply only to members of the audit committee) provide that a director is independent if he or she has “no relationship to the company that may interfere with the exercise of . . . independence from management and the company.” Under the proposal, a company would have to disclose in its proxy statements any existing relationships between an “independent” director and the company and explain why the board determined that the relationships were not material.

No director who is a former employee of the listed company or who is associated with the company’s auditor can be “independent” until five years after such employment or association has ended. The current cooling-off period is three years. In addition, no director who is part of an interlocking directorate (in which an executive officer of the listed company serves on the compensation committee of another company that employs the director) may be “independent” until five years after such interlocking directorate ends. Directors with immediate family members in these categories would also be subject to the five-year cooling-off period.

Regular meetings of non-management directors; assignment of lead director. To promote open discussion among non-management directors, the proposed standards would require regular executive sessions in which non-management directors meet without management participation. The name of the director who would preside at such executive sessions would be required to be disclosed in the proxy statement. There is no existing NYSE listing standard requiring such meetings or lead director.

Compensation and nominating/corporate governance committees with published charters. The proposed new standards would require NYSE-listed companies to have a compensation committee and a nominating/corporate governance committee both of which would be made up entirely of independent directors. Current NYSE standards require only that listed companies have an audit committee.

Both the compensation and nominating/corporate governance committees would be required to have written charters addressing the committee’s purpose, goals and responsibilities and annual performance evaluation. Charters would also lay out member qualifications, appointment and removal procedures, committee structure and operations, committee reporting to the board and certain minimum duties outlined in the proposal.

Enhanced Audit Committee Qualifications and Responsibilities

Enhanced qualifications. To serve on the audit committee of NYSE-listed companies, directors would have to be “independent” under the new definition and could receive no compensation from the company other than director’s fees. (The report indicates that director’s fees may include, for this purpose, equity-based awards, additional amounts paid for chairing the committee or for long-term service as well as pensions or other deferred compensation.) In addition, any director associated with an owner of 20% or more of the company’s stock may not be a voting member or chair of the audit committee.

The proposal would require that the chair of an audit committee have “accounting or related financial management expertise.” Current standards require that all audit committee members be financially literate and that at least one member have accounting or financial management expertise.

If any audit committee member serves on the audit committee of more than three public companies, the full board of the NYSE-listed company would be required to determine that such simultaneous service would not impair the ability of such member to serve on its audit committee and to disclose such determination in its proxy statement.

Enhanced responsibilities. The proposal would require that audit committee charters provide that the audit committee (1) has sole authority to hire and fire independent auditors and to approve significant non-audit relationships with them; (2) must obtain and review a report from the company’s independent auditors evaluating internal audit controls; (3) must discuss with management and auditors not only the annual and quarterly financial statements but also the company’s MD&A disclosures, earnings press releases and earnings guidance given to analysts and rating agencies; (4) must meet separately, at least once per quarter, with management, with internal auditors and with independent auditors; and (5) must set clear hiring policies for employees or former employees of the independent auditors. The proposal encourages the audit committee to seek independent legal advice in connection with its work.

Equity-Compensation Plans

Shareholder approval of all plans. Under the proposed new standards, shareholder approval would be required for all equity-compensation plans, including stock option and stock purchase plans. Currently, shareholder approval of stock-based compensation plans is necessary when officers and directors may acquire more than one percent, individually, or five percent, collectively, of the company’s common stock under such plans, but is not required for “broadly based” and certain other plans. The proposal would require shareholder approval for all plans and all material revisions to the terms of such plans (including for repricing of options).

Prohibition on broker discretionary votes. Under current rules, NYSE members may, under certain circumstances, vote customer’s proxies in favor of approval of an equity-compensation plan if they have not received voting instructions from the customer. The proposals would prohibit NYSE members from voting customer’s proxies in favor of equity-compensation plans without having received voting instructions from the customer.

CEO Certification to the NYSE

The proposals would require that the CEO of any NYSE-listed company certify to the NYSE each year that:

• the company has established procedures for verifying the accuracy and completeness of the information provided to investors, and those procedures have been carried out;
• the CEO has reviewed with the board such procedures and the company’s compliance with them;
• the CEO has no reasonable cause to believe that the information provided to investors is not accurate and complete in all material respects; and
• the CEO is not aware of any violation by the company of NYSE listing standards.

Governance Guidelines and Codes of Business Conduct and Ethics

The proposals would require NYSE-listed companies to adopt and disclose corporate governance policies and codes of business conduct and ethics. Listed companies would be required to make these guidelines and codes available, along with board committee charters, on their company websites. Their annual reports would be required to state that such documents would also be provided in print to any shareholder requesting them.

The report indicates that an appropriate code of business conduct or ethics would include flat prohibitions on director or executive officer conflict-of-interest transactions or taking of corporate opportunities, use of corporate property or position for personal gain or competing with the company. The proposal would require prompt public disclosure of any waivers of the code for directors or executive officers.

Other NYSE Proposals

Public reprimand letters. Recognizing that suspension of trading or delisting, when used by the NYSE as sanctions, can be harmful to the very shareholders the NYSE is seeking to protect, the proposals recommend authorization of public reprimand letters as a lesser sanction to deter companies from violating corporate governance listing standards. Suspension and delisting would remain available in cases of repeated or flagrant violations.

Director education and orientation. The Standards Committee report recommends that NYSE-listed companies establish an orientation program for new directors and that the NYSE develop a Directors Institute that would offer continuing education forums around the United States for new and experienced directors.

Foreign private issuers. Listed foreign private issuers would continue to be permitted to follow home-country practices with respect to corporate governance matters. But foreign private issuers would be required to make their U.S. investors aware of any significant ways in which home-country practices differ from those required under NYSE listing standards.

Further recommendations. The Standards Committee report also makes several recommendations for further reform by others, including recommendations that the SEC: create a private-sector organization to regulate the accounting industry; require companies to report complete GAAP-based financial information before any reference to “pro forma” or “adjusted” financial information and to reconcile pro forma information to GAAP in press releases and other public communications; prohibit relationships between independent auditors and audit clients that may impair the effectiveness of audits; adopt proposals for improved MD&A disclosure and prompt disclosure of insider transactions; and evaluate the impact of Regulation F-D on corporate behavior and capital markets.

May Proposals

On April 12, 2002, the Nasdaq Listing and Hearing Review Council announced a series of initial recommendations to amend Nasdaq corporate governance listing requirements. Key areas for action included corporate codes of conduct, related party transactions, shareholder approval of stock option plans, enhancement to news dissemination methods, director independence definition and audit committee qualifications and authority. In late May, Nasdaq announced that its board of directors had approved an initial round of proposed corporate governance reforms for submission to the SEC for approval.

Shareholder approval of equity-compensation plans. The proposal would require shareholder approval of essentially all plans in which officers and directors participate, eliminating the current exceptions for broadly based plans and for de minimis plans or arrangements. The existing exemptions for inducement grants to new executive officers and tax-qualified, non-discriminatory plans (such as Employee Stock Ownership Plans) would be retained. The exemption for so-called “treasury shares” (shares repurchased to fund plans) would be eliminated.

Independent directors. The proposal would make the Nasdaq definition of independent director more strict. The definition currently prohibits independent directors from receiving more than $60,000 from the company in “compensation” other than compensation for board services. The proposal would extend this $60,000 cap to cover any type of payment to the director (including political contributions) other than compensation for board services. The cap would also extend to any payment to a director’s immediate family. Certain large payments to charities of which the director is an executive officer would also prevent independent status.

Related party transactions. The proposal would expand the current requirement that the audit committee (or comparable body) review related party transactions to require both review and approval of such transactions.

Explicit prohibition on misrepresenting information to Nasdaq. The proposal clarifies that Nasdaq may delist any issuer making an intentional misrepresentation or omission of material fact in a communication to Nasdaq.
Audit opinion with going concern qualifications. The proposal would require a Nasdaq-listed issuer to disclose a going concern qualification in an audit report through a prompt press release.

Disclosure of material information. Current Nasdaq rules require companies to disclose material developments to investors through the news media via broadly disseminated press release, with prior notice to Nasdaq required in some cases. The proposal would expand the means permitted for public disclosure to be co-extensive with SEC Regulation FD. Nasdaq companies would be able to comply with the Nasdaq disclosure obligation through conference calls, press conferences and webcasts (so long as the public is provided adequate notice of such communication, typically via press release, and given access).

Additional Proposals To Come

In early June (contemporaneously with the release of the NYSE Standards Committee report), Nasdaq announced that its Nasdaq Listing and Hearing Review Council would meet on June 26 through 28 to consider its next round of corporate governance reform proposals. The announcement indicated that reform areas to be considered would include: independent majority on corporate boards; compensation committees composed solely of independent directors; cooling-off period during which former auditors would be precluded from serving on corporate audit committees; enhancing audit committee qualifications and authority; strengthening continuing education for directors; and increasing use of corporate codes of conduct and compliance methods to support them. As the revision process continues, it appears that Nasdaq corporate governance reforms will become more aligned with NYSE proposals.

CONCLUSION

Corporate America has been deluged in recent months with reform proposals and has yet to see what may emerge from Congress. The latest wave of proposals from the SEC, NYSE and Nasdaq are certain to be shaped by comments to be submitted over the next months. But the general direction of post-Enron reforms seems clear. Independent directors will be playing a central role in corporate governance. Governance rules will increasingly be embodied in listing standards and published guidelines and codes. Corporate executives will be required to certify personally to investors regarding corporate disclosures on a periodic basis. And public companies will move from a regimen of periodic reporting to one of essentially continuous disclosure.

June 18, 2002