Proposed Nasdaq Rule Change re Independence Exception

By Cydney Posner

The SEC has posted a Nasdaq proposal to modify slightly one of its corporate governance rules.  The proposal relates to the exception that allows a non-independent director to serve on a listed company's audit, compensation or nominating committee under exceptional and limited circumstances. Generally, Nasdaq rules require that these committees be composed of "independent directors," as defined under Nasdaq rules. Among that factors that preclude independence are whether the director is currently, or was during the prior three years, employed by the company or has a family member who is, or at any time during the past three years was, an executive officer of the company.

Nasdaq's rules also include an exception that permits a listed company, under exceptional and limited circumstances and with proper disclosure, to allow one non-independent director to serve on the audit, compensation or nominating committee for up to two years. (The exception has been used only infrequently: Nasdaq reports that, on December 31, 2011, only nine companies were relying on it.) Under current rules, the exception is not available if the director has a family member who is an employee of the listed company, even if that family member is not an executive officer of the company (assuming here that the director is not independent for an unrelated reason). Ironically, however, that same family relationship would not preclude the director from being considered independent. For example, if a director was, within the past three years, an employee of a listed company and had a son who was also an employee, but not an executive, of the company, that director could not be considered independent until three years after the end of his or her employment. Because the son is not an executive, the son's employment would not be a factor that would preclude independence of the director. However, if the listed company sought to appoint this same director to a committee under the exception, the son's employment would preclude the appointment.

Nasdaq characterizes this distinction in its rules as "incongruous." Accordingly, Nasdaq proposes to amend Listing Rules 5605(c)(2)(B), 5605(d)(3) and 5605(e)(3) to allow a director who is a family member of a non-executive employee of a listed company to serve on the listed company's audit, compensation or nominating committee under exceptional and limited circumstances. If the family member were an executive officer, the exception would still be unavailable. Under both the current and proposed versions of the exception, the board must affirmatively determine that the non-independent director's membership on a committee is required by the best interests of the company and its stockholders. Nasdaq expects that the board would consider any family relationship in making that determination. The proposed rule change also would substitute "Executive Officer," which is a defined term, for "officer," an undefined term now used in the exception. Nasdaq confirms that it has always interpreted these two terms in the same way.

In addition, under both the current and proposed versions of the exception, for audit committees, the exception would not be available for a director who did not meet the criteria set forth in Section 10A(m)(3) of the Exchange Act and related rules. In addition, if a listed company, other than a foreign private issuer, relied on the exception for an audit committee member, the company would have to comply with the disclosure requirements set forth in Item 407(d)(2) of Reg S-K. if the company relied on the exception for a compensation or nominating committee member, the company would need to disclose either on or through the company's website or in the proxy statement for the next annual meeting, the nature of the relationship that makes the committee member not independent and the reasons for the determination to rely on the exception. Instruction 1 to Item 407(a) of Reg S-K may also require additional disclosure regarding reliance on the exception.

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