New England Biz Law Update
When the director of the Securities and Exchange Commission’s Division of Corporation Finance addressed an audience of securities law professionals soon after the new executive compensation rules were finalized, he underscored two words in describing a central theme of the reforms: “Principles matter.”
A principles-based approach to disclosure of related-person transactions and director independence follows a regulatory trend of rejecting reliance on bright-line rules and demanding a more rigorous inquiry into, and greater public disclosure regarding, director independence.
When events and circumstances cannot be dismissed by bright-line rules, public company advisors need to step up to a higher level of interaction and engagement with the underlying facts, and materiality judgments take on even greater importance.
The process by which relationships are collected, documented, considered and disclosed is even more critical to the integrity of independence determinations, and may itself be the best defense in the event more remote relationships are not identified.
Directors must be engaged in this process. But inevitably they will depend heavily on their advisors to ensure an effective process is instituted to safeguard director independence from being questioned in hindsight, and to also allow them to discharge their duties effectively in monitoring the business of the corporation.
Related-person transaction disclosure
Revised Item 404(a) of the executive compensation rules requires a description of (i) any transaction since the beginning of the company’s last fiscal year (or any currently proposed transaction), (ii) in which the company was or is a participant, (iii) the amount involved exceeds $120,000, and (iv) in which any related person had or will have a direct or indirect material interest.
Key changes from the current disclosure requirements include:
Many of the more specific standards that previously guided the Item 404 analysis of certain transactions, including the bright line tests currently set out under Item 404(b) and some of the instructions to current Item 404(a), are eliminated.
The new rule applies the same standard, rooted in the landmark cases of Basic v. Levinson and TSC Industries v. Northway, by which the materiality of a direct or indirect interest is determined on the basis of the significance of the information to investors in light of all the circumstances.
The definition is intended to capture the business relationships among companies with which a director is associated that previously were separately covered by Regulation S-K, Item 404(b).
Director independence disclosure
Item 407 of Regulation S-K will require new disclosure regarding director independence. The new information includes identification of each director and nominee for director who is independent, as well as identification of each member of the compensation, nominating or audit committee that is not independent.
If a company uses its own definitions for determining whether its directors are independent, the company must disclose those definitions on its website or in an appendix to its proxy statement.
The new rules also require a description, by specific category or type, of any transactions, relationships or arrangements not disclosed as a related-person transaction that were considered by the board of directors in determining a director’s independence.
Tips for meeting new disclosure requirements
Securities counsel have already begun reconsidering their processes for reviewing related-person transactions and director independence. The following discusses some of the implications of the new rules and practical suggestions for promoting effective compliance.
1. Some relationships will need to be reconsidered, and previous disclosure may need to be revised in light of the changes. The elimination of the specific standards for disclosure in current Item 404(b) of Regulation S-K may change the analysis regarding disclosure of certain types of transactions.
Companies will no longer be able to rely on the telephone interpretation in which the SEC staff took the view that disclosure would not be required under Item 404(a) “if a transaction or relationship is permitted to be excluded pursuant to Item 404(b).” (Item 25, Section J, Item 402 of Regulation S-K, Manual of Publicly Available Telephone Interpretations (July 1997)).
Under this interpretation, transactions with a value in excess of the current $60,000 disclosure threshold may not have required disclosure if they did not have a value in excess of the 5 percent revenue threshold of Item 404(b), and did not afford a director any additional “special benefits.”
Item 404(b)’s current instruction excluding payments made or received by subsidiaries other than significant subsidiaries will also be eliminated.
2. Because a director cannot qualify as a “non-employee director” under Rule 16b-3 if disclosure concerning the director is required under Item 404, prior determinations of “non-employee director” status and the composition of the compensation committee may need to be reconsidered.
Any changes in a company’s Item 404 disclosure resulting from the new rules and emphasis on principles-based disclosure may affect a director’s status as a “non-employee director.” Companies will need to plan ahead for any changes to the composition of the compensation committee that could be required as a result.
The final rules provide some relief in this regard by allowing companies to rely on the most recent fiscal year’s Item 404(a) disclosure in determining “non-employee director” status. Companies must still believe in good faith that no current or contemplated transaction in which the director participates would require Item 404(a) disclosure.
3. Companies should anticipate the need to disclose by type or category relationships considered in director independence determinations but not disclosed under Item 404. Guidelines regarding independence determinations previously adopted by the board should be reviewed to ensure they provide sufficient guidance as to the types or categories of relationships that the board has determined would not impugn a director’s independence.
4. Directors should be sensitized to the importance of the information collected. In order to ensure all of the relevant facts are available to those responsible for determining whether relationships are material, directors will need to understand the importance of thorough responses that err on the side of reporting information that may seem insignificant.
They should be aware of their role in the process of ensuring the disclosure resulting from the questionnaires is accurate and complete, and they should be prepared in advance for the possibility of follow-up questions that may be necessary to determine the overall significance of all the facts surrounding relationships in which they or their family members are involved.
5. D&O questionnaires will need to be revised to reflect changes in the letter and spirit of the new rules. This year’s questionnaires should be revised both to reflect the new rules, and to ensure they are sufficiently broad to capture any facts or circumstances that may need to be considered to meet the new rules’ emphasis on principles-based disclosure.
6. Timelines for the collection, review and analysis of information may need to be revised. Sufficient time should be provided in the schedule for distributing and reviewing D&O questionnaires for the additional analysis and interactive follow-up with board members that may be necessary to compile all of facts relevant to an analysis of the materiality of a transaction or relationship.
7. Analysis of related-person transactions and director independence should be a continuous process. In order to ensure compliance with the disclosure requirements, the process of collecting and reviewing director relationships should not be confined to an annual review.
Companies should encourage continuous communication regarding independence issues by asking directors to report any new relationships that could affect independence determinations.
Companies may also wish to institute processes, such as updating a review of the company’s business relationships with, and the SEC filings of, other entities with whom directors are known to have relationships, to periodically check for changes relevant to independence determinations.
Tobias L. Knapp is a partner in Jenner & Block’s New York City office and is a member of the firm’s corporate, securities, private equity/investment management and mergers & acquisitions practices. He may be reached at [email protected]. Jenner & Block LLP (www.jenner.com) is a national law firm with offices in Chicago, Dallas, New York City and Washington, D.C. Founded in 1914, the firm has over 400 lawyers offering experience in virtually every area of the law.
