Implications of New Rules and Regulations

Public companies will need to have independent directors in several roles, particularly on audit and nominating committees. To date, the most complex rules relate to the role of independent directors on audit committees.

Audit Committees

Under the Sarbanes-Oxley Act, every public company must have an audit committee, each member of which must be independent. Under the Sarbanes-Oxley Act, an audit committee member may not receive any consulting, advisory or other fees from the issuer, other than for service on the board or its committees. In addition, to be independent a director must not be an 'affiliated person'.

The term 'affiliated person' is not defined in the Sarbanes-Oxley Act, but hopefully will be explained further in forthcoming SEC regulations. NASDAQ's proposed rules would exclude from the audit committee any person who owns or controls 20% or more of the company's voting securities, or such lower percentage as the SEC may determine under the Sarbanes-Oxley Act.

One possible indication of where the SEC might set its rules for an 'affiliated person' comes from mutual fund regulation where the SEC defines affiliation through a 5% ownership test. The Investment Company Act of 1940 in part reads: "Affiliated person of another person means (A) any person directly or indirectly owning, controlling, or holding with power to vote, 5 per centum or more of the outstanding voting securities of such other person; (B) any person 5 per centum or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person; (C) any person directly or indirectly controlling, controlled by, or under common control with, such other person." 

It is not clear whether these SEC regulations will impose a higher or lower standard than the proposed NASDAQ 20% limitation on stock ownership. What is clear is that lawyers representing public companies will have to agonize over the issue of what affiliation means until the SEC issues regulations covering this matter.

Nominations and Other Decisions

As a result of the new regulations, it is clear that directors in public companies will have more significantly increased responsibilities and time commitments than they have had in the past. Under NASDAQ's proposed rules, director nominations must be approved either by an independent nominating committee, or by a majority of the independent directors. Other proposed NASDAQ rules would require independent director approval of executive compensation and related-party transactions. Independent directors would also be required to meet regularly in executive session without management and other non-independent directors. Other exchanges may also adopt similar rules.

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