MEMORANDUM
TO: |
Nasdaq-Listed Companies |
FROM: |
Gray Cary Ware & Freidenrich LLP |
DATE: |
January 21, 2004 |
RE: |
Many Nasdaq-listed companies have adopted a wait-and-see approach with respect to compliance with Sarbanes-Oxley and Nasdaq requirements due to the evolving nature of the rules and the desire to learn from early adopters.The time for companies in this category to act is now rapidly approaching, particularly for those with calendar year fiscal periods.Most of the new requirements will apply to each company as of the date of its first annual meeting after January 15, 2004, but in no case later than October 31, 2004, and many of the them will affect the disclosures made in the next Form 10‑K or proxy statement.
The following are a list of action items that most listed companies will need to have completed in early 2004, and the new disclosure requirements that will apply:
Board Actions
Independence Review.The independence of each member of the board and its audit, compensation and nominating committees must be re-evaluated in light of the new and heightened standards, which will apply as of the earlier of the 2004 annual meeting or October 31, 2004. A company may be able to include a non-independent director on its audit, compensation or nominating committee under “exceptional and limited circumstances,” subject to certain conditions. Companies that are majority-owned subsidiaries or controlled by a single stockholder or stockholder group are not subject to the independence requirements other than those pertaining to the audit committee. Each company should review its particular circumstances and determine whether any changes to the board or its committees are advisable before the filing of the 2004 proxy statement.
Audit Committee Financial Expert.The board must determine whether any member of the audit committee qualifies as an “audit committee financial expert,” and if so, that member must be identified in the proxy statement. If there are more than one such members, the company may choose to name only one. The definition of “audit committee financial expert” requires some experience with preparation or audit of financial statements, or supervision of such activities, and the board should carefully review this definition in determining whether a director is a financial expert. If no member of the audit committee satisfies the definition, the company will need to disclose that fact in its next proxy statement and explain why that is the case.Remember also that Nasdaq has a separate requirement that all audit committee members be financially literate and that at least one member be financially sophisticated based on his or her professional experience. An audit committee financial expert is deemed to meet the financial sophistication requirement.
Audit Committee Charter Revisions.The new requirements regarding audit committees and their charters will require amendments to most companies’ audit committee charters.Companies that amended their charters based on preliminary rule proposals should review their charters against the final rules and make adjustments if necessary. The amended charter will need to be included as an appendix to the proxy statement.
Whistleblowing Policy.The audit committee must adopt procedures for the receipt and retention of confidential, anonymous complaints concerning accounting, auditing, financial reporting and internal controls, generally referred to as a “whistleblowing policy,” before the earlier of the 2004 annual meeting or October 31, 2004.Companies have the choice of outsourcing this process or handling it internally, so long as the audit committee is reasonably satisfied that the procedure ensures confidentiality and anonymity.Key issues to consider include who in the organization has responsibility for routing, investigating and retaining complaints and how the audit committee is to be kept informed.
Pre-Approval Policy for Audit and Non-Audit Services.Under SEC rules that took effect this past year, an audit committee may adopt policies and procedures for pre-approval of services provided by the outside auditor, so long as the policies and procedures do not have the effect of delegating the pre-approval function to management. While such policies and procedures are not mandatory, they may afford the company a measure of flexibility in its dealings with the auditor.If adopted, these policies and procedures must be described in the proxy statement.
Code of Conduct and Code of Ethics.Under a Nasdaq rule that takes effect in May 2004, the board, or a committee designated by the board (such as the nominating and governance committee), must adopt a code of conduct applicable to all employees, officers and directors.This code of conduct must satisfy the requirements of a code of ethics for senior financial officers, as defined in the SEC’s rules. Although the Nasdaq requirement will not be in effect until mid-2004, the corresponding SEC rule requires all companies to include disclosure in their Form 10‑K (which can be incorporated from the proxy statement) whether they have such a code for senior financial officers, and if not, why not.Accordingly, companies should consider implementing a code of conduct prior to the filing of the next proxy statement.
Compensation Committee.Under the Nasdaq rules, beginning with the earlier of the 2004 annual meeting or October 31, 2004, executive compensation must be approved by a compensation committee composed of independent directors or by a majority of the independent directors. Companies should review their committee charters or, in the absence of a compensation committee, their procedures for approving compensation matters, to ensure that executive compensation matters will be approved in accordance with the new Nasdaq requirement.
Director Nominations.Beginning in 2004, Nasdaq companies will be required to have a nominating committee composed of independent directors or have all director nominations approved by a majority of the independent directors. Each such committee is required to have a written charter, while a company that does not have a nominating committee must adopt a formal board resolution addressing the director nomination process.Many Nasdaq companies are following the NYSE’s lead and constituting their committees as nominating and corporate governance committees, which review both board nominations and specific corporate governance matters.
The SEC has adopted rules, effective January 1, 2004, requiring disclosure in the proxy statement of specific matters relating to the process by which the nominating committee (or the board, in the absence of such a committee) considers director nominations recommended by management or by stockholders. Companies should consider what kinds of policies and procedures may be advisable in light of these new disclosure requirements, including minimum qualifications for directors, procedures for consideration of stockholder nominations and the process for identifying and evaluating director candidates, whether recommended by management or by stockholders.
The SEC has also proposed a new rule that would provide for shareholder access to the proxy statement for the purpose of proposing board nominees.Under this rule, a company would be required to include one or more stockholder-proposed nominees in its proxy statement if any of its directors received “withheld” votes from at least 35% of the votes cast at either of the prior two annual meetings or if a 1% stockholder submits a proposal that the company become subject to the shareholder access rule and the proposal is approved by a majority of the votes cast at the meeting. Although it has not yet been adopted by the SEC, the rule is expected to be in effect in some form during the 2005 proxy season. Under the rule as currently proposed, events occurring at an annual meeting held before the rule takes effect could trigger access rights with respect to subsequent meetings. Accordingly, in planning for their 2004 annual meetings, companies should be aware of the possibility that institutional investors may initiate campaigns to withhold enough votes from a single director to trigger the nomination rights under the shareholder access rule, or there may be a stockholder proposal to make the company subject to the rule.
Policies on Stockholder Communications and Attendance at Annual Meetings.Also taking effect on January 1, 2004 are new disclosure requirements regarding stockholder communications with directors and attendance by directors at annual meetings. In light of these disclosure requirements, companies should consider procedures by which stockholders may communicate with the board, as well as whether it is advisable to adopt a policy that requires or encourages directors to attend annual meetings in person.
Corporate Governance Principles.NYSE-listed companies are required to adopt corporate governance principles, which must be posted on their websites. Many Nasdaq-listed companies are voluntarily adopting corporate governance principles as well, which Institutional Shareholder Services considers a positive factor in its corporate governance ratings.Under the NYSE rules, such principles should address matters relating to director qualifications, responsibilities and compensation and annual director evaluations, among other things.The exercise of developing a set of corporate governance principals is likely to have some carry-over benefits when the company reviews its director nomination process.
Executive Sessions.Nasdaq listed companies are required to have regular executive sessions involving only independent directors. Nasdaq does not provide a specific requirement regarding the number of executive sessions that are held, but has suggested in its interpretive material that such sessions should occur at least twice annually.
Required Disclosures and Filings.
Independent Directors.The Nasdaq independence rules require that a company identify in its proxy statement which directors are considered to be independent.Since the new rules do not take effect until the 2004 annual meeting, the proxy disclosure relating to board independence technically would not apply to proxy statements for the upcoming meeting.However, a senior SEC official has stated that such disclosure is advisable in all proxy statements to provide stockholders with all material facts.
Audit Committee Independence.The proxy statement must identify the names of each audit committee member and disclose whether each of them is independent for purposes of the applicable listing standards. If a non-independent member is included on the audit committee in reliance upon the “exceptional and limited circumstances” exception, the company must disclose the nature of the relationship that makes the member non-independent and the reasons for the board’s determination that the member should be included on the committee.In addition, Nasdaq suggests that if the audit committee includes a member whom the board considers to be independent but who is a greater-than-10% stockholder, that fact should be disclosed in the proxy statement.
As noted above, Nasdaq companies technically will not yet be subject to the new independence requirements or associated disclosure requirements at the time they mail their 2004 proxy statement (with the exception of proxy statements that are mailed on or after October 31, 2004).However, a senior SEC official has suggested that disclosure of board independence under the new Nasdaq requirements may involve facts that are material to stockholders and that it is advisable to include this disclosure in all proxy materials filed before then.
Audit Committee Financial Expert.The proxy statement must identify each audit committee member whom the Board has determined to be an audit committee financial expert.If there is no such member, the company must disclose that fact in its proxy statement and explain why its audit committee does not include a member who satisfies the financial expert criteria.
Audit Committee Pre-Approval Policies.The disclosure regarding fees paid to the company’s outside auditor must now be accompanied by disclosure of any policies and procedures adopted by the audit committee for pre-approval of services provided by the outside auditor.
Disclosure Regarding Fees Paid to Auditor.The SEC has revised the required proxy disclosure regarding fees paid to the company’s independent auditor, with companies now being required to categorize those fees as audit fees, audit-related fees, tax fees and all other fees billed by the auditor and describe the nature of the audit-related, tax and other non-audit services to which such fees relate. Under a policy now followed by Institutional Shareholder Services (ISS), if the sum representing “all other fees” exceeds the sum of audit, audit-related and tax fees, ISS will recommend a vote against ratification of auditors and a “withheld” vote with respect to each director who serves on the audit committee. There is a trap for the unwary:Under ISS’s guidelines, “tax fees” only includes fees relating to tax compliance and preparation, assistance with tax refund claims and the like, whereas fees relating to tax advice, tax planning and the like are treated by ISS as part of “all other fees.” Moreover, unless the issuer breaks out its tax fees into the relevant categories, all tax fees will be treated as part of “all other fees.” Therefore, issuers whose non-audit fees may exceed their audit and audit-related fees are strongly encouraged to break out their tax fees in greater detail than required by the proxy disclosure rules.
Audit Committee Charter.The audit committee charter must be filed as an appendix to the proxy statement if any changes have been made since it was last filed in this manner.Many companies are also posting this charter on their website, as is required of NYSE companies.
Director Nomination Process.Any proxy statement filed on or after January 1, 2004 must include a new set of disclosures regarding the nominating committee (if there is one), the company’s policies and procedures regarding stockholder nominations, minimum qualifications for directors and the process for identifying and evaluating director candidates. If the committee has established a process for director evaluations and has considered the results of such evaluation during the nomination process, that fact should be disclosed. If there are any non-incumbent nominees, the company must identify the category of person who recommended each nominee. If the company pays a search fee it must disclose the fee and the function performed. Additional disclosures are required if any board nominee has been recommended by a stockholder or stockholder group whose holdings meet certain criteria.As was the case previously, companies also need to disclose any advance notice bylaws regarding director nominations, although this disclosure is now relevant to the discussion of the company’s policies on stockholder nominations.
Any interim changes to the company’s policies and procedures must be reported in the company’s next Form 10‑K or 10‑Q (including the initial adoption of such policies and procedures if they were adopted after the date of the last proxy statement).
If there is a nominating committee charter, it must be made publicly available, either on the company’s website (with the website address being provided in the proxy statement) or as an appendix to the proxy statement at least once every three years. As with the audit committee charter, companies are increasingly posting their nominating committee charter on their website.
Stockholder Communications with Directors.Beginning on January 1, 2004, companies are required to disclose in their proxy statements the manner in which stockholders may communicate directly with the board and, if applicable, to specified individual directors, and, if such communications are not sent directly to board members, a description of the company’s process for determining which communications will be relayed to board members.If there is no process for such communications, the company must disclose the basis for the board’s view that it is appropriate not to have one. The company may provide these disclosures in its proxy statement or on its website, provided that if it does the latter it must provide the relevant website address in its proxy statement.
Director Attendance at Annual Meetings.Any proxy statement filed on or after January 1, 2004 must include a description of the company’s policy, if any, with regard to director attendance at annual meetings, and disclosure of the number of directors who attended the prior year’s annual meeting. As an alternative, the company may post this information on its website and provide the website address in its proxy statement.
Code of Conduct/Ethics.Reports on Form 10-K must now include disclosure regarding whether the issuer has a code of ethics, and if not, why not. As the disclosure requirement appears in Part III of Form 10‑K (which covers matters such as executive compensation, related party transactions and beneficial ownership of securities), most issuers will probably opt to incorporate this disclosure by reference from the proxy statement, as the SEC has acknowledged in its release on the topic. Unfortunately, the proxy rules do not themselves include a reference to the code of ethics or the related disclosure item in Regulation S‑K, and issuers who choose to make the disclosure in the proxy statement must remember to include this disclosure without the typical regulatory “prompt” of finding the requirement in the applicable rules.
The code must also be made publicly available, either (a) as an exhibit to the Form 10‑K, (b) through the company’s website, provided the website address is provided in the company’s Form 10‑K, or (c) by means of an undertaking in the Form 10‑K to provide a copy upon request free of charge.
Any amendments or waivers to the code that affect directors or executive officers must be disclosed within five business days.Although the SEC rules provide for other alternatives for making such disclosures, the Nasdaq rules require that such disclosures be made on Form 8‑K.
Company Websites.Whether or not they are required to do so by new SEC rules or Nasdaq listing standards, companies are increasingly following the practice of providing corporate governance documents on their websites, including their committee charters, codes of conduct, director nomination procedures, director communication procedures and any corporate governance principles.The company may want to consider ways to make it easier for investors to navigate the site and find documents demonstrating the company’s compliance with the new requirements.
Recent SEC Guidance Regarding MD&A.The SEC staff is continuing its efforts to improve the overall quality of disclosure in MD&A. The staff has suggested that MD&A lead with an executive overview that highlights the trends and uncertainties discussed in the section. The staff is discouraging cross-references to other sections or the notes to financial statements. Where a trend has multiple causes, the staff prefers that the issuer quantify each cause to the extent possible. Finally, the staff has reiterated that MD&A should focus on material information and not merely track the line items of the financial statements. According to a senior SEC official, issuers should only include information that is responsive to a line item or that, if not disclosed, would represent a material omission; everything else should be excluded. Issuers should also take care to exclude old information that is no longer relevant. Companies should strive to improve the disclosure regarding the impact of management’s judgment relating to critical accounting policies, as this is a key focus of the SEC.
More recently, the staff has addressed many of these points in an interpretive release issued on December 19, 2003. The release provides specific guidance regarding (a) the overall presentation and focus of MD&A (including through executive-level overviews, a focus on the most important information and a reduction of duplicative information), (b) emphasis on analysis of financial information, (c) known material trends and uncertainties, (d) key performance indicators, including non-financial indicators, (e) liquidity and capital resources and (f) critical accounting estimates.
The staff has indicated that it will be actively reviewing 10‑K’s and 10‑Q’s again this year.
Off-Balance-Sheet Arrangements and Contractual Obligations.MD&A disclosure in filings covering fiscal years ending on or after June 15, 2003 must comply with the new requirements regarding disclosure of off-balance sheet arrangements, which include some requirements that apply even to companies without off-balance sheet arrangements per se.MD&A disclosure in filings covering fiscal years ending on or after December 15, 2003 must include tabular disclosure, as of the end of the fiscal year, of the future payments that are expected to become due under contracts in certain specified categories.This new requirement may require some effort for the company to inventory all of such arrangements.
Share Repurchases.Companies that repurchase their own shares, whether under a Rule 10b‑18 program or otherwise, will be required to make specified disclosures regarding their repurchases in each Form 10‑K or 10‑Q covering the quarter in which such purchases were made, beginning with the first quarter ending on or after March 15, 2004.
Filing Deadlines for Accelerated Filers.Beginning with the 2004 reporting season, companies that are accelerated filers will become subject to the first set of earlier filing deadlines being phased in by the SEC. Any report on Form 10‑K for a fiscal year ending on or after December 15, 2003 will be due 75 days after fiscal year-end, and the next three reports on Form 10‑Q will be due 40 days after the end of the quarter.The accelerated filing rules do not affect the definitive proxy statement, which, as before, must be filed within 120 days after fiscal year-end if any portions are incorporated by reference in Part III of the company’s Form 10‑K. If a company is unable to file the definitive proxy statement by this deadline, it must amend its Form 10-K to add the information required by Part III.
Provided By DLA Piper