SEC Disclosure Rules on Nominating Committee and Security Holder Communications with Board of Directors

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1 FEBRUARY 2004 SEC Disclosure Rules on Nominating Committee and Security Holder Communications with Board of Directors By Richard F. Langan, Jr. 1 February 27, 2004 In November 2003, the Securities and Exchange Commission adopted new disclosure requirements and amendments to existing proxy and information statement disclosure requirements. These requirements are the first of a two-part process undertaken by the SEC to enhance the transparency of the operations of public company boards of directors and to disclose the board nomination and communication processes of public companies. In addition, the SEC has solicited public comment on another, more controversial rule proposal that would require the inclusion of security holder nominees in public company proxy materials under specified circumstances. The new disclosure requirements expand: disclosure to investors regarding the nominating committees and the nominating processes of public companies; and disclosure of means by which security holders may communicate with the boards of the directors of public companies in which they invest. The new rules implement some of the recommendations made by the Division of Corporation Finance of the SEC in its July 15, 2003 Staff Report and have been adopted in essentially the form as proposed on August 8, 2003, despite significant public comment. The rules adopt disclosure requirements, but do not impose substantive corporate governance obligations on public companies. As with many other rules, the SEC disclosure rules must also be considered in light of the new corporate governance listing requirements of the national securities exchanges and Nasdaq. 1 Richard F. Langan, Jr., leads Nixon Peabody s National Business Group and Corporate Governance Team. He is resident in the New York City office. 1 of 7

2 The SEC has stated that, during the next two years, it will carefully monitor the newly required disclosures. In the view of the directive given to the SEC, pursuant to Section 408 of the Sarbanes-Oxley Act of 2002, to conduct regular, and in any case no less than triennial, reviews of public company periodic reports, public companies can expect that these disclosures may be the source of frequent SEC comments during its review of filings made during 2004 and The new disclosure requirements do not apply to foreign private issuers or to domestic companies that are not required to file proxy statements. This article does not discuss the disclosure requirements applicable to registered investment companies. Effective Date Companies must comply with the new disclosure requirements in proxy or information statements that are sent to security holders on or after January 1, 2004, and in periodic reports on Forms 10-K, 10-KSB, 10-Q and 10-QSB for reporting periods ending after January 1, 2004 (either directly or by incorporation by reference, except as noted below). Proxy and Information Statement Disclosure Regarding the Nomination Process Under the SEC disclosure requirements in effect prior to the adoption of the new rules, a public company was required to disclose in its proxy or information statements whether or not it had a nominating committee or a committee performing similar functions. If the company had a nominating or similar committee, the disclosure also needed to detail the committee s functions, its members, the frequency of committee meetings and whether the committee would consider shareholder recommendations for board nominees. These requirements can be found in Item 7(d) of SEC Schedule 14A. The recently adopted disclosure requirements expand this line of disclosure to mandate that, if a public company does not have a standing nominating committee or committee performing similar functions, the company must disclose the basis for the company s board of directors is of the view that it is appropriate for the company not to have such a committee, and the name of each director who participates in the consideration of director nominees. The newly adopted disclosure rules also require public company disclosure regarding a number of matters relating to a public company s nomination process, including: A statement as to whether or not the nominating committee has a written charter and, if so, whether a copy is available for review on the company s website and disclosure of the company s website address. If the nominating committee has a charter and a current copy of the charter is not available to security holders on the company s website, the company must include a copy of the charter as an appendix to the company s proxy statement at least once every three fiscal years. Moreover, if a current copy of the charter is not available to security holders on the company s website, and is not included as an appendix to the company s proxy statement for a given year, the company 2 of 7

3 must identify in its proxy statement the prior fiscal year in which the charter was so included in satisfaction of the requirement. Under the recently adopted listing standards of the New York Stock Exchange, listed companies are required to having a nominating committee comprised solely of independent directors and to have a written charter addressing the committee s purpose, goals, and responsibilities. The nominating committee of a NYSE-listed company must conduct an annual performance evaluation. The Nasdaq rules require director nominees to be selected or recommended for the board s selection by a majority of the independent directors or by a nominating committee comprised solely or independent directors. Each Nasdaq-listed company must certify that it has adopted a formal written charter or a board resolution addressing the nominations process. Each public company whose securities are listed on national securities exchange or Nasdaq is required to disclose in its proxy or information statement whether each member of its nominating committee is independent. In determining whether a member of the nominating committee is independent, the public company must use the definition of independence contained in the listing standards applicable to the company. If the company s securities are not listed on national securities exchange or Nasdaq, the company is required to state whether each member of its nominating committee would be independent under either the definition of independence adopted by a national securities exchange or Nasdaq. The company must identify whose definition it applied. The independence standard selected by such a public company must be applied consistently from year to year and must be used also in complying with the separate disclosure requirement pertaining to the independence of audit committee members. A statement as to whether the nominating committee has a policy with regard to the consideration of any director candidates recommended by security holders, including a statement as to whether the committee will consider such nominees. A description and material terms of the procedures security holders should follow to submit candidates for such consideration must be included, as determined by the nominating committee (or the company s by-laws). If a nominating committee does not have a policy of considering nominees recommended by security holders, the company must include a statement explaining the basis for the view of the board of directors that it is appropriate for the company not have such a policy. A description of any specific, minimum qualifications that the nominating committee believes must be met by a person to be recommended by the nominating committee for a position on the company s board of directors, and a description of any specific qualities or skills that the nominating committee believes are necessary for one or more of the company s directors to possess. Through the SEC process of reviewing proxy and information statements, comments may be issued seeking more detailed descriptions of these qualifications. If the SEC issues these types of comments, it may influence the level of detail provided in nominating committee charters with respect to these matters. 3 of 7

4 A description of the process used by the nominating committee for identifying and evaluating director nominees, including nominees recommended by security holders, and any differences in the manner in which the nominating committee evaluates director nominees based on whether the nominee is recommended by security holder or another source. Comments issued by the SEC may also impact the level of detail provided in response to this disclosure requirement and in related nominating committee charter provisions. With regard to each nominee approved by the nominating committee for inclusion on the company s proxy card, other than nominees who are executive officers or are directors standing for re-election, a statement as to whether the nominee was recommended by a security holder, a non-management director, the chief executive officer, another executive officer, a third-party search firm or another source. The disclosure need not include the name of the recommending person or entity. If, however, the recommending person or entity is not one of the specified categories, the nature of the source must be described. Moreover, if multiple sources recommended the nominee, each category of source is to be disclosed. Disclosure of the function performed by any third-party to which the company pays a fee to identify or evaluate or assist in identifying or evaluating potential nominees. A statement as to whether the nominating committee received, by a date not later than the 120th calendar day before the date of the company s proxy statement was released to security holders in connection with the previous year s annual meeting, a recommendation from a security holder or group that, individually or in the aggregate, beneficially owned greater than 5% of the company s voting common stock for at least one year and the identification of that candidate and the security holder or group that nominated the candidate, and whether the committee chose to nominee the candidate. No identification or disclosure is required unless both the security holder or group and the identified candidate consent. In its release proposing the adoption of a rule contained in this disclosure requirement, the SEC had proposed that the ownership threshold be set at 3%, rather than 5%. The SEC ultimately adopted the 5% threshold to be in line with the beneficial ownership reporting requirements under Regulation13D so as to facilitate determinations as to whether the recommending security holder satisfies the ownership threshold to trigger the additional disclosure requirements. Additional Disclosure Regarding the Nomination Process In Periodic Reports If a company changes or implements procedures for security holders to recommend nominees for the board of directors since the last proxy statements description, the company must describe the changes in its next quarterly report on Form 10-Q (or Form 10-QSB) or, if the change occurs in the last fiscal quarter of the year, its annual report on Form 10-K (or Form 10-KSB). This requirement applies only to those periodic reports and is contained in Regulation S-K Item 401(j) (or Regulation S-B Item 401(g) for small business issuers). 4 of 7

5 Security Holder Communications with the Board of Directors The SEC's recently adopted rules also impose disclosure requirements with regard to security holder communications with board members. The disclosure standards of new paragraph (h) to Item 7 of Schedule 14A are intended to improve the transparency of board operations and to increase security holder understanding of the companies in which they invest. In particular, the recently adopted rules require a public company to make the following disclosures in its proxy or information statement regarding the election of directors: A statement concerning whether the company has a process by which security holders can send communications to the board of directors and, if not, a statement of the board s view as to why it is appropriate for the company not to have such a process. A description of the manner in which security holders can send communications to the board of directors and, if applicable, specified individual directors. If all security holder communications are not sent directly to board members, a description of the process by which the company determines which communications will be relayed to board members. The instructions to the rules provide, however, that a company s process for collecting and organizing shareholder communications and similar or related activities need not be disclosed if the process is approved by majority of the independent directors. Communications among directors and by officers to directors, even though such individuals are security holders, are expressly not subject to the disclosure requirement. However, communications to board members by employees or other agents of the company are subject to the disclosure requirement if made solely in their capacity as a security holder. A description of the company s policy, if any, with regard to attendance by board members at annual meetings and the number of board members who attended the prior year s annual meeting. In lieu of disclosure of the procedures for communications from security holders to the board of directors and the company s on board member attendance at the company s annual meeting and related statistics in the proxy or information statement, disclosure may be made on the company s website provided that the company discloses in its proxy or information statement the website address where the information may be found. 5 of 7

6 If you have any questions or require further information regarding these or any other matters, please call your regular Nixon Peabody contact or feel free to contact any of the partners and counsel in our Corporate Governance Law practice group listed on the final page of this Corporate Responsibility Alert. The foregoing summary of recent developments in the law and practice of corporate governance is provided by Nixon Peabody for education and informational purposes only. It is not a full analysis of the matters summarized and is not intended and should not be construed as legal advice. This publication may be considered advertising under applicable laws. If you are not currently on our mailing list and would like to receive future publications of our Corporate Responsibility Alert, please send your contact information, including your address, to nppublications@nixonpeabody.com. 6 of 7

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