SEC Staff Report On Off-Balance Sheet Arrangements, Special Purpose Entities and Related Issues

On June 15, 2005 the Securities and Exchange Commission announced the release of a staff report prepared by the Office of the Chief Accountant, the Office of Economic Analysis and the Division of Corporation Finance on off-balance sheet arrangements, special purpose entities and related issues. The report was prepared pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002. As required by that Act, the report has been submitted to the President, the Committee on Banking, Housing and Urban Affairs of the Senate, and the Committee on Financial Services of the House of Representatives. The staff report includes an analysis of the filings of issuers as well as an analysis of pertinent U.S. generally accepted accounting principles and Commission disclosure rules. The report describes the staff's study, details its findings, and provides recommendations.

Chairman Donaldson said, "The staff report we are releasing today sets forth important principles for long-term improvements to financial reporting. Improving financial reporting to better reflect these principles and goals will require the commitment and support of standard-setters, as well as reporting companies, auditors and investors. I also should note that more than 100 of our staff participated in the completion of the study and report and I sincerely appreciate their efforts."

The staff took a broad approach to the scope of the report by including a review of a range of topics with potential off-balance sheet implications, including consolidation issues, transfers of financial assets with continuing involvement, retirement arrangements, contractual obligations, leases, contingent liabilities and derivatives, as well as a discussion of special purpose entities (SPEs).

The report identifies several goals for those involved in the financial reporting community, including efforts to

• discourage transactions and transaction structures motivated primarily and largely by accounting and reporting considerations, rather than economics;
   
• expand the use of objectives-oriented standards;
   
• improve the consistency and relevance of disclosures; and
   
• focus financial reporting on communication with investors, rather than just compliance with rules.
   

Donald T. Nicolaisen, SEC Chief Accountant, said "The report identifies improvements that have occurred in financial reporting since passage of the Sarbanes-Oxley Act and, importantly, it offers recommendations for further improvements designed to increase both the transparency and usefulness of the balance sheet. Greater transparency can be achieved in some areas simply by reducing accounting choices and complexity. Since the events leading to passage of the Sarbanes-Oxley Act, we have made progress in improving financial reporting to investors, but more can still be done. I'm hopeful that this report will help focus efforts on further ways to improve transparency."

Alan Beller, Director of the Division of Corporation Finance, said, "This report points up the challenges faced by issuers in communicating financial information important to investment decisions of investors. I believe that even without rule changes issuers can do a better job of communicating in a transparent manner information and analysis regarding their off-balance sheet activities and the impact on their income, cash flow and balance sheets."

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SEC Adopts Expanded Rules for Disclosure on Form 8-K

On March 16, 2004, the Securities and Exchange Commission promulgated its final rules release expanding the types of information and occurrences required to be reported on Form 8-K and shortening the time frame for making such filings. The action was taken pursuant to the provisions of Section 409 of the Sarbanes-Oxley Act, which directed the Commission to develop rules for the "rapid and current" reporting of "information concerning material changes in the financial condition or operations of the issuer."

The amendments require reports on Form 8-K to be filed within four business days of a triggering event. The filing deadline for disclosures under Regulation FD, voluntary disclosures and certain exhibits are not affected by the new deadline. Previously, reports were required to be filed anywhere between five business days and fifteen calendar days, depending on the event reported.

As amended, Form 8-K requires information regarding the following events to be reported (some of these items are carryovers from the previous 8-K requirements):

• Creation or termination by the issuer of a material definitive agreement not made in the ordinary course of business. An issuer must also disclose any material amendment to a material definitive agreement. The SEC dropped a proposal to require that non-binding agreements such as letters of intent also be disclosed.
• Entry into bankruptcy or receivership.
• Acquisition or disposition of a significant amount of assets, otherwise than in the ordinary course of business.
• Results of operations and financial condition, if a public announcement (such as an earnings release) has been made.
• Creation of material direct obligations or obligations or contingent liabilities for off-balance sheet items, and the occurrence of triggering events that increase or accelerate any such obligations.
• If the issuer becomes committed to an exit or disposal plan or termination of employees that will require a material charge under GAAP.
• Determination that a material charge for impairment of assets is required under GAAP.
• Receipt of notices that the issuer's securities will be delisted by an exchange or Nasdaq, or that the issuer's securities do not satisfy a rule or standard for continued listing or inclusion.
• Unregistered sales of equity securities.
• Material modifications to the rights of holders of any class of registered securities.
• Changes in the issuer's principal accountants.
• Determination of the need to restate financial statements.
• Changes in control of the issuer.
• Resignations, removals or termination of directors or principal executive officers.
• Amendments to the issuer's Articles of Incorporation or Bylaws if not disclosed in a previous proxy statement.
• Temporary suspension of trading under an employee benefit plan.
• Amendments to the issuer's code of ethics, or waiver of a provision in the code of ethics.
• Items required to be filed pursuant to Regulation FD.
• Other information that the issuer voluntarily elects to disclose because of its importance to security holders.

See Release Nos. 33-8400; 34-49424; File No. S7-22-02, March 16, 2004 http://www.sec.gov/rules/final/33-8400.htm

SEC Extends Deadline for Reporting on Internal Control

On February 24, 2004, the Securities and Exchange Commission extended the compliance deadlines under Section 404 of the Sarbanes-Oxley Act for issuers to begin including in their annual reports a report by management on the company's internal control over financial reporting and an accompanying auditor's report. The extension amends the deadlines originally implemented by the Commission's rules that were adopted on June 5, 2003. Under the new deadlines, "accelerated filers" (generally, these are U.S. companies with market capitalization over $75 million that have filed at least one annual report) must begin internal control reporting with respect to their first fiscal year ending on or after Nov. 15, 2004, rather than the June 15, 2004 as originally required. Non-accelerated filer must begin with respect to their first fiscal year ending on or after July 15, 2005, rather than April 15, 2005.

The extensions will give many filers an extra year to comply with the Section 404 requirements, which are costly and time consuming to implement. Notable in the group receiving relief will be the numerous companies with June 30 fiscal year ends. Accelerated filers with September 30 year ends will also get an extension although non-accelerated September 30 issuers will not.

See Release Nos. 33-8392; 34-49313; IC-26357; File Nos. S7-40-02; S7-06-03, February 24, 2004

http://www.sec.gov/rules/final/33-8392.htm

SEC Adopts Rules on Disclosure of Nominating Committee Functions and Communications between Security Holders and  Board of Directors

On November 19, 2003, the Securities and Exchange Commission adopted new rules requiring enhanced proxy statement disclosures regarding nominating committee processes. The rules implement rules first proposed by the SEC on August 8, 2003 based on a report of the SEC's Division of Corporation Finance on July 15. Though not technically issued pursuant to the Sarbanes-Oxley Act, the rules pursue the Act's goal of improved corporate governance.

The new disclosure requirements are intended to enhance the transparency of public companies' nominations and communications processes and to improve communications with shareholders on these important aspects of corporate governance.

The new disclosure standards require companies to disclose important additional information regarding a company's process of nominating directors, including:

• whether a company has a separate nominating committee and, if not, the reasons why it does not and who determines nominees for director;
• whether members of the nominating committee satisfy independence requirements;
• a company's process for identifying and evaluating candidates to be nominated as directors;
• whether a company pays any third party a fee to assist in the process or identifying and evaluating candidates;
• minimum qualifications and standards that a company seeks for director nominees;
• whether a company considers candidates for director nominees put forward by shareholders and, if so, its process for considering such candidates; and
• whether a company has rejected candidates put forward by large, long-term security holders or groups of security holders.

The new disclosure standards also require companies to disclose significant, new information regarding shareholder communications with directors, including:

• whether a company has a process for communications by shareholders to directors and, if not, the reasons why it does not;
• the procedures for communications by shareholders with directors;
• whether such communications are screened and, if so, by what process; and
• the company's policy regarding director attendance at annual meetings and the number of directors that attended the prior year's annual meeting.

The new rules apply to proxy or information statements that are first sent or given to shareholders on or after January 1, 2004, and in Forms 10-Q, 10-QSB, 10-K, 10-KSB, and N-CSR for the first reporting period ending after January 1, 2004.

See Release Nos. 33-8340; 34-48825; IC-26262; File No. S7-14-03, November 24, 2003
http://www.sec.gov/rules/final/33-8340.htm#compliancedate

SEC Approves New NYSE and Nasdaq Corporate Goverance Rules

On November 4, 2003, the SEC approved proposed rule changes to the listing standards of the New York Stock Exchange and the Nasdaq Stock Market to implement corporate governance reforms for listed companies. The new rules address the following issues, among others:

• They require that the boards of all listed companies consist of at least a majority of independent directors.
• They tighten definitions of director "independence" by, for example, excluding certain past professional relationships and certain relationships with charitable organizations that are beneficiaries of corporate donations.
• They require independent directors to meet periodically in executive session without the participation of management.
• They require all listed companies to handle nominating and compensation committees composed entirely of independent directors and having written charters addressing certain specified matters (Nasdaq permits these functions to be approved by a majority of independent directors in lieu of a committee).
• They expand the required duties of audit committees (previous regulations already required all listed companies to have audit committees composed entirely of independent directors).
• They require listed companies to have an internal audit function.
• They require listed companies to adopt corporate governance guidelines addressing specified matters and to adopt a Code of Ethics

The rules strengthen the corporate governance requirements of the NYSE and Nasdaq and add additional requirements to those already required under Sarbanes-Oxley and related rules.

See Release No. 34-48745; File Nos. SR-NYSE-2002-33, SR-NASD-2002-77, SR-NASD-2002-80, SR-NASD-2002-138, SR-NASD-2002-139, and SR-NASD-2002-141, November 4, 2003

http://www.sec.gov/rules/sro/34-48745.htm

SEC Adopts Rules to Implement Management's Report on Internal Controls

The Securities and Exchange Commission voted to adopt rules concerning management's report on internal control over financial reporting and certification of disclosures in Exchange Act periodic reports.

The new rules implement requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Proposed rules had been published in October, 2002. Section 404 requires that each annual report of a company, other than a registered investment company, contain (1) a statement of management's responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) management's assessment, as of the end of the company's most recent fiscal year, of the effectiveness of the company's internal control structure and procedures for financial reporting.

The new rules require management's internal control report to state management's responsibility for establishing and maintaining adequate internal controls over financial reporting; to identify the framework used by management to evaluate the effectiveness of internal controls; to provide management's assessment of the effectiveness of the internal controls as of the end of the company's most recent fiscal year; and to include a statement that its auditor has issued an attestation report on management's assessment.

Under the new rules, management must disclose any material weakness and may not conclude that the company's internal controls are effective if there are one or more material weaknesses in the controls. The framework on which management's evaluation is based must be a suitable, recognized control framework that is established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment.

The rules also require companies to perform quarterly evaluations of changes that have materially affected or are reasonably likely to materially affect the company's internal control over financial reporting.

Compliance with the rules has been extended somewhat and will be required for larger companies, other than foreign private issuers (generally, U.S. companies that have equity market capitalization over $75 million and have filed an annual report with the Commission) for fiscal years ending on or after June 15, 2004, while all other issuers must comply for fiscal years ending on or after April 15, 2005.

The requirement for the report on internal controls and auditor's attestation have led many reporting companies to expend large sums to create programs that will enable them to comply.

See Release Nos. 33-8238; 34-47986; IC-26068; File Nos. S7-40-02; S7-06-03, June 5, 2003 http://www.sec.gov/rules/final/33-8238.htm

SEC Adopts Rule on Improper Influence on Conduct of Audits

As required by Section 303(a) of the Sarbanes-Oxley Act, the SEC has adopted rules to prevent improper influence on the conduct and results of audits of reporting company financial statements. In addition to prohibiting directors and officers from making materially false or misleading statements and omitting material facts, the rule would prohibit them from taking any action to coerce, manipulate or mislead accountants so as to result in rendering financial statements materially misleading. This would include causing an accountant (i) to issue a report on financial statements not warranted under the circumstances, (ii) not to perform a procedure required by generally accepting auditing standards or other professional standards, (iii) not to withdraw an issued report or (iv) not to communicate matters to an issuer's audit committee. Additional standards are set forth for investment adviser's of registered investment companies.

See Release Nos. 34-47890, IC-26050; FR-71; File No. S7-39-02, May 20, 2003
http://www.sec.gov/rules/final/34-47890.htm

Nasdaq and the New York Stock Exchange Revise Shareholder Approval Requirements for Equity Compensation Plans

On June 30, 2003, the Securities and Exchange Commission (the “SEC”) approved changes to the listing requirements of Nasdaq and the New York Stock Exchange (the “SROs”) requiring shareholder approval of most equity compensation plans. [fn1] The SEC’s approval was the culmination of a protracted year-long effort by the SROs and the SEC to reconcile differences between the SROs’ proposals so that both final versions are substantially consistent with one another. As a result, as of June 30, 2003, all equity compensation plans of SRO listed companies (“Companies”) (with certain grandfathering exceptions described below) and any material revisions or amendments to plans in existence before or after that date must be approved by the Companies’ shareholders. Additionally, the SEC has approved the NYSE’s rules to preclude broker-dealers from voting proxies on equity compensation plans unless the beneficial owner of the shares has given voting instructions.

The range of equity compensation plans subject to shareholder approval was dramatically expanded by the changes to the SROs’ rules. No longer will all “broadly-based plans” (plans where the participation of directors and officers was limited) be exempt from the shareholder approval requirement. In addition, Nasdaq has eliminated the de minimis exception which allowed for grants of the lesser of 1% or 25,000 shares of a Company’s common stock without seeking shareholder approval. However, Nasdaq has retained the exception for warrants or rights offered generally to all shareholders.

• equity compensation plans pursuant to which stock may be acquired by directors, officers, employees or consultants;
• use of repurchased shares to fund existing plans;
• one-time stock option grants to directors, officers, employees or consultants;
• de minimis grants or awards of equity compensation; and
• warrants with below market exercise prices issued to directors, officers, employees or consultants in connection with a private financing.

The following arrangements are exempted from the shareholder approval requirements under the SROs’ rules:

• Tax qualified, non-discriminatory employee benefit plans (e.g., ESOPs);
• Parallel nonqualified or excess plans that fall within the meaning of “pension plan” as defined in the Employee Retirement Income Security Act; [ fn2]
• Employee stock purchase plans under Section 423 of the Internal Revenue Code (the “IRC”) (these types of plans already are generally required to receive shareholder approval under Section 423 of the IRC, but now when shareholder approval is not required under the IRC, no shareholder approval will be required by the SROs);
• Dividend reinvestment plans;
• Inducement grants or awards to new employees or to previous employees being rehired after a bona fide period of interruption of employment, and to new employees in connection with a merger or acquisition;
• The conversion, replacement or adjustment of outstanding options or other equity compensation awards to reflect a merger or acquisition;
• Certain awards or grants (other than to individuals employed immediately prior to the transaction by the acquiring company) made after a transaction under pre-existing plans previously approved by the target company’s shareholders acquired in acquisitions or mergers; [fn3]
• Non-material amendments or revisions to equity compensation plans; and
• Non-U.S. Companies may continue to apply to their respective SRO for specific exemptions from the shareholder approval requirements if they are inconsistent with the requirements of their home jurisdiction.

All “material” revisions (used by the NYSE) or amendments (used by Nasdaq) to existing equity-compensation plans must be approved by the Company’s shareholders. The SROs have provided, in response to comments, similar definitions through a non-exhaustive list of what constitutes a material revision or amendment. They include:

• A material increase in the number of shares available under the plan (other than to reflect a reorganization, stock split, merger, spin-off or similar transaction) (also see discussion below regarding evergreen and formula provisions);
• An expansion of the types of awards available under the plan;
• A material expansion of the class of participants eligible to participate in the plan;
• A material extension of the term of the plan;
• A material change to the method of determining the strike price of options under the plan (under the NYSE rule); and
• Repricing of options and the deletion or limitation of any provision prohibiting repricing of options, permitting repricing or decreasing the exercise price of the options.

The final SRO rules do not provide any factors to consider when weighing the materiality of other revisions or amendments to existing plans. Nasdaq has informally indicated that it will continue to consider past SEC Section 16 no action letters in evaluating whether a revision or amendment to a plan is material. [fn4]

Under the final SRO rules, if a plan contains a provision for automatic increases in the shares available pursuant to a specified formula (often called an “evergreen plan”) or for automatic grants pursuant to a specified formula (“formula plan”), each such increase or grant will be considered a “material revision” to the plan requiring shareholder approval unless the plan has a term of ten years or less. Examples of automatic grants pursuant to a formula include:

• annual grants to directors of restricted stock having a certain dollar value, and
• “matching contributions,” whereby stock is credited to a participant’s account based upon the amount of compensation the participant elects to defer.

Under the final SRO rules, if a plan contains no limit on the number of shares available and is not a formula plan (a “discretionary plan”), then each grant under the plan will require separate shareholder approval regardless of whether the plan was previously approved by shareholders or has a term of ten years or less. A requirement that grants be made out of treasury shares or repurchased shares will not, in itself, be considered a limit or pre-established formula so as to prevent a plan from being considered a discretionary plan requiring shareholder approval for additional grants. Therefore, the SROs have effectively ended the practice of awarding equity compensation under discretionary plans. The NYSE rule provides for a transition period (see “Grandfather Provisions” section below).

Generally, pre-existing plans that were adopted prior to June 30, 2003 are “grandfathered” and will not require shareholder approval unless the plans are materially revised or amended.

Though grants of equity compensation under discretionary plans, regardless of whether they were previously approved by shareholders, require shareholder approval, the NYSE rule permits a transition period where approval is not necessary for grants occurring before the earlier of (1) the company’s next annual meeting at which directors are elected that occurs on or after December 27, 2003, (2) June 30, 2004, or (3) the expiration of the plan. The Nasdaq rule does not contain such a transition period.

The NYSE rule also provides the same transition period for evergreen/formula plans that either (1) have not been previously approved by shareholders or (2) have a term of greater than ten years. A shareholder approved formula plan that has a term of greater than ten years may continue to be used after the end of the transition period if it is amended so that it has a term of ten years or less (measured from either the date of the plan’s initial adoption or shareholder approval). In addition, an evergreen/formula plan not previously approved by shareholders may continue to be used without shareholder approval after the transition period if grants are limited to shares available from formulaic increases that occurred before June 30, 2003. Under the Nasdaq rule, existing evergreen/formula plans may continue to be used without shareholder approval until the end of ten years from the date of adoption or shareholder approval (unless the plan has an earlier expiration date), unless there is a material amendment.

Generally, the revised shareholder approval requirements of the SROs were harmonized during the rulemaking process. However, there are some differences.

NYSE Broker Non-Vote Rule for Equity Compensation Plans

The final NYSE rule eliminates the ability of broker-dealers to vote proxies on the equity compensation plans of NYSE Companies without the explicit consent and instruction of the beneficial owners. Broker-dealers were already prohibited from voting proxies without explicit instructions from beneficial holders under the Nasdaq’s rules. This change will be effective for any meeting of shareholders that occurs on or after September 28, 2003.

The new rules will have a significant effect on how quickly new equity compensation plans can be adopted. Approval of equity compensation plans will likely become more common place on annual and special meeting proxy statements of Companies.

In addition, any material revision or amendment to a plan will require shareholder approval. Although the SROs’ adopting releases provide examples of what will constitute a “material” revision or amendment to a plan, there will be grey areas when making many materiality determinations. Informal telephonic guidance from the staff at the SROs will continue to be important in resolving uncertainty.

Footnotes

1. The American Stock Exchange has proposed similar rules, which are still pending before the SEC and should be approved by the SEC sometime this summer.

2. The NYSE and Nasdaq are considering limiting this exemption to exclude any plan if the employee-participant in such plan receives employer contributions under the plan in excess of 25% of the participant’s cash contributions.

3. Any shares reserved for listing in connection with a merger or acquisition will be counted by the SROs in determining whether the transaction triggers shareholder approval under the SROs’ “20% rule.”

4. Prior to 1996 before significant changes were made to Section 16, the SEC issued numerous no action letters that focused on whether specific revisions or amendments to employee compensation plans were deemed “material” changes to the plan. Although these letter are no longer relevant for Section 16 purposes, the Nasdaq has continued to consider them when evaluating whether a revision or amendment to an existing equity compensation plan is material and, therefore, would require shareholder approval.

5. SRO disclosure is in addition to the two-business day public disclosure requirements of Section 16(a) of the Securities Exchange Act of 1934.

SEC Adopts Final Rules Relating to Director Nomination Process and Shareholder Communications with Directors

The Securities and Exchange Commission (Commission) recently adopted final rules requiring expanded disclosure of companies' director nomination processes and specific disclosure of procedures by which shareholders may communicate with directors.^[1] At the open meeting at which the new rules were approved, Commission Chairman William Donaldson noted that the rules regarding disclosure of director nomination processes are "a significant step in making the director nomination process more accessible to [shareholders] by enhancing the transparency of that process." He stated that the rules regarding disclosure of shareholder communication processes "allow investors to more effectively use existing procedures" and "access those procedures in connection with their evaluation of the management and oversight" of the companies in which they invest. The new rules require very specific disclosures in proxy statements for meetings at which directors will be elected. The Commission stated that these specific, detailed disclosure requirements are "necessary and appropriate to assure that investors are provided with disclosure that presents the desired degree of clarity and transparency" and that it believes that, in the absence of these specific disclosure requirements, "disclosure could be at a level of generality that would not be sufficiently useful to [shareholders]." These new rules were proposed^[2] soon after the July 15, 2003 release of a Division of Corporation Finance (Division) report recommending a number of rule changes, including recommendations about these rules and another set of proposed rules that would provide, under certain circumstances, direct shareholder access to the company's proxy materials in connection with the nomination of directors.^[3] The proposed shareholder access rules are still pending.^[4] Significant Revisions from Proposed Rules The Commission adopted the rules substantially as originally proposed, but the following significant differences were highlighted at the open meeting and in the adopting release:

• The Commission increased from three percent to five percent the threshold percentage of voting securities that must be owned by a nominating shareholder (or group) for purposes of determining when a company must disclose that it has received a director nomination recommended by that shareholder or group.^[5]
  Where a company has received a nomination recommended by a more than five percent shareholder or group, the company would be required to disclose the name of the nominee (in addition to the name of the nominating shareholder or group, as originally proposed), but only if both the nominee and the nominating shareholder provide their consent at the time of recommendation, but would not, as had been proposed, be required to disclose the specific reasons for not nominating the candidate if the candidate was not approved by the committee.
  A company will not be required to disclose the name of the source of a candidate that it includes as a nominee, but rather the category or categories of persons or entities making the recommendation (e.g., shareholder, non-management director, chief executive officer, other executive officer, third-party search firm or other specified source).
  Companies will not be required, as had been proposed, to disclose any specific standards for the overall structure and composition of the board.
  Companies will be required to affirmatively state whether nominating committee members are "independent" under applicable NYSE and Nasdaq listing standards, but will not be required to disclose, as had been originally proposed, whether there was any instance during the prior fiscal year in which any member of the nominating committee did not satisfy such standards of independence.
  If a company's nominating committee has a written charter, that charter must be made publicly available either through publication on the company's Website or through filings with the Commission (rather than describing the charter in the proxy statement, as had been proposed).
  Companies will be required to disclose in their next Form 10-Q or 10-QSB or Form 10-K or 10-KSB any changes in the procedures by which its shareholders may recommend nominees from those described in the proxy statement.
  Companies will be required to describe their policy, if any, with regard to board members' attendance at annual meetings and disclose the number of board members who attended the prior year's annual meeting.
  
• Companies will not be required, as had been originally proposed, to disclose material actions taken by the board as a result of shareholder communications during the preceding fiscal year.

Required Disclosures Regarding Nominating Process Item 7(d) of Schedule 14A currently requires proxy statements for meetings at which directors will be elected to state whether the company has a nominating or similar committee and, if it does, state "whether the committee will consider nominees recommended by [shareholders] and, if so, describe the procedures to be followed by [shareholders] in submitting such recommendations."^[6] The Commission has significantly expanded these disclosure requirements in order "to make more transparent to [shareholders] the operation of the boards of directors of the companies in which they invest." The new disclosure requirements include specific disclosures about the nominating process, the nominating committee's charter, and the independence of nominating committee members. What new disclosures are required about a company's nominating process? The final rules require the following additional disclosures about a company's nominating process (the first of which arguably just rephrases the existing requirements of Item 7(d)(2) of Schedule 14A):

• If the nominating committee has a policy with regard to the consideration of any director candidates recommended by shareholders, a description of the material elements of that policy, which must include, but need not be limited to, a statement as to whether the committee will consider candidates recommended by shareholders;
  If the nominating committee does not have a policy with regard to the consideration of any director candidates recommended by shareholders, disclosure of that fact and the basis for the view of the board of directors that it is appropriate for the company not to have such a policy;
  If the nominating committee will consider candidates recommended by shareholders, a description of the procedures to be followed by shareholders in submitting such recommendations and, if material changes are made to such procedures, a description of such changes in the company's next Form 10-Q or 10-QSB or Form 10-K or 10-KSB;^[7]
  A description of any specific, minimum qualifications that the nominating committee believes must be met by a nominating committee-recommended nominee and any specific qualities or skills that the nominating committee believes are necessary for one or more of the directors to possess;^[8]
  A description of the committee's process for identifying and evaluating nominees for director, including nominees recommended by shareholders, and any differences in the manner in which the nominating committee evaluates nominees based on whether the nominee is recommended by a shareholder;
  Disclosure of the category or categories of persons or entities (shareholder, non-management director, chief executive officer, other executive officer, third-party search firm or other specific source^[9]) who recommended each nominee approved by the nominating committee for inclusion on the company's proxy card, except when the nominee is an executive officer or a director standing for reelection;^[10]
  If the company pays a fee to any third party to identify or evaluate or assist the company in identifying or evaluating potential nominees, disclosure of the function performed by the third party;
  
• If the nominating committee receives, not later than the 120th calendar day before the date of the company's proxy statement released to shareholders in connection with the previous year's annual meeting,^[11] a nominee recommendation from a shareholder or group of shareholders that has beneficially owned more than five percent of the company's voting common stock for at least one year as of the date of the recommendation, the company is required to disclose (a) the name or names of the shareholder(s) who recommended the candidate and the name of the candidate, and (b) whether the nominating committee chose to nominate the candidate; provided the company receives the written consent of both the shareholder nominating group and the candidate prior to making such disclosure.^[12]

Do the final rules require a nominating committee to consider candidates recommended by a company's shareholders?
No. As stated by the Commission, the rules require disclosure "but do not mandate any particular action by a company or its board of directors." Under the rules, a company is only required to disclose whether it has a policy with respect to the consideration of candidates recommended by shareholders and whether the nominating committee will consider such candidates. If the nominating committee does not have a policy with regard to the consideration of any director candidates recommended by shareholders, the company must disclose that fact and state the basis for the view of its board of directors that it is appropriate for the company not to have such a policy. The Commission did not include in the final rules the portion of the proposed rule that would have required disclosure of the specific reasons for not including a candidate proposed by a large shareholder or group of shareholders, which if adopted may have implied that the nominating committee would have been required to undertake some level of consideration of the candidate.

Is the nominating committee required to have a written charter?
Not under the Commission's rules, but there are other possible sources of a charter requirement that companies should consider. For example, the NYSE listing requirements require that NYSE-listed companies have a written nominating committee charter, while the Nasdaq listing requirements require that Nasdaq-listed companies have either a written nominating committee charter or a board resolution addressing the nominating process.

Must the nominating committee charter be publicly disclosed?
Yes, but companies have some flexibility in how that disclosure is accomplished. The Commission's rules require companies to disclose whether a copy of the written charter is available to shareholders on the company's Website and, if it is, to provide the company's Website address. If the nominating committee has a charter and a current copy of it is not available on the company's Website, then the company is required to include the charter as an appendix to the company's proxy statement at least once every three fiscal years, and, if not included in the current proxy statement, to identify the prior fiscal year in which it was so included.

What disclosures are required about the directors serving on the nominating committee?
The company is required to disclose whether the members of the nominating committee are independent as defined in the listing standards applicable to the company. As with existing disclosures regarding the independence of audit committee members, a non-listed company must assess the independence of nominating committee members under any listing standard chosen by the company (but the company is required to use the same listing standard that it uses to assess the independence of its audit committee members).

What about companies that do not have separate nominating committees?
A company without a nominating committee or a committee performing similar functions does not escape any of the new requirements. If a company does not have a nominating committee (or committee serving similar functions), the company is required to disclose that fact in its proxy statement and state the basis for the view of the board of directors that it is appropriate for the company not to have such a committee. The new rules also require a company to disclose the names of those directors who participate in the consideration of director nominees in lieu of a nominating committee. In addition, an instruction to the new rules states that the disclosures described in response to the preceding questions must be provided with respect to any committee performing a function similar to a nominating committee, or for groups of directors fulfilling the role of a nominating committee, including the entire board, where applicable.

How do the new disclosure requirements relate to the previously existing and recently adopted NYSE and Nasdaq listing standards?
The NYSE and Nasdaq have adopted revised listing standards that, among other requirements, require listed companies to have independent nominating committees.^[13] These listing standard changes do not require nominating committees to consider shareholder nominees or companies to make the disclosures required by the new rules. The Commission's new rules, on the other hand, require disclosure of information to shareholders regarding the nomination process, the manner of evaluating nominees, and the extent to which the boards of directors of the companies in which they invest have a process for considering, and do in fact consider, shareholder recommendations. Accordingly, the Commission stated that it believes that its new disclosure requirements will operate in conjunction with and as a complement to the revised listing standards regarding nominating committees.

How do the new rules interrelate with companies' bylaw provisions relating to shareholder nominations?
The new rules only require disclosure regarding how a company's nominating committee deals with shareholder recommendations of candidates to the committee. The rules are not structured to directly correlate with state law and bylaw provisions that govern shareholder nominations of persons for election to the board of directors, such as bylaw provisions requiring advance notice of a director nomination. As a result of these new rules, companies will need to reexamine their bylaw provisions and other policies relating not only to nominating committee review of recommendations by shareholders, but also to the method by which the company handles director nominations and the election of directors generally. Disclosures Regarding Shareholder Communications with Board Members The Commission stated that it has become increasingly aware of investors' desire for a means to communicate with boards of directors and that it believes that providing shareholders with disclosure about the process for communicating with board members will improve the transparency of board operations, as well as shareholder understanding of the companies in which they invest. To address those concerns, the Commission has created a number of new disclosure requirements relating to the manner in which shareholders may communicate directly with directors. What new disclosures are required? The Commission's new rules require the following new disclosures about the manner in which shareholders may communicate directly with directors:^[14]

• Whether a company's board of directors provides a process for shareholders to send communications to the board of directors and, if the company does not have such a process for shareholders to send communications to the board of directors, the basis for the view of the board of directors that it is appropriate for the company not to have such a process;
  
• If a company has a process for shareholders to send communications to the board of directors:
  

• a description of the manner in which shareholders can send communications to the board and, if applicable, to specified individual directors; and
  
• if all shareholder 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;^[15] and
  
• A description of a company's policy, if any, with regard to board members' attendance at annual meetings and the number of board members who attended the prior year's annual meeting.^[16]
  

Do the rules require companies to institute any procedures to facilitate shareholder communications with directors?
No. The rules only require disclosure of whether the company provides a process by which shareholders may communicate directly with directors and, if not, why the board believes it is appropriate not to have such a process. However, as with many Commission disclosure requirements, the disclosure requirement will most likely have the effect of encouraging companies to adopt procedures in order to avoid potentially embarrassing disclosures.

Do the rules apply to communications governed by Exchange Act Rule 14a-8?
No. The Commission stated that the current disclosure requirements with regard to shareholder proposals contemplated by Exchange Act Rule 14a-8 are adequate to inform shareholders of how they may communicate with boards via that mechanism, and accordingly, it expressly excluded shareholder proposals submitted pursuant to Exchange Act Rule 14a-8, and communications made in connection with such proposals, from the new disclosure rules.

What about communications from employees and others who also happen to be shareholders?
The Commission acknowledged that not all communications from officers, directors, employees and agents of the company are the types of communications that the new disclosure standards are intended to capture. The Commission added an instruction to Item 7 clarifying that:

• Communications from an officer or director of the company will not be viewed as shareholder communications for purposes of the disclosure requirement; and
  
• Communications from an employee or agent of the company will be viewed as shareholder communications for purposes of the disclosure requirement only if those communications are made solely in the employee's or agent's capacity as a shareholder.

Are there any comparable disclosure requirements under previously existing or recently adopted NYSE and Nasdaq listing standards?
Yes, for NYSE-listed companies, but not for Nasdaq-listed companies. The NYSE recently adopted a new listing standard that will require a company to disclose a method for interested parties to communicate directly with the "presiding director" of the non-management directors or with the non-management directors as a group.^[17] Nasdaq has not adopted any similar requirement.

Scope of Disclosure Requirements

Do the new disclosures apply to companies that are not subject to the proxy rules?
No. The rules requiring disclosure of both the nomination process and shareholder communication with the board amend only Schedule 14A.^[18] Therefore, the disclosure requirements do not apply to any company that is not subject to the requirements of Section 14(a) of the Exchange Act, including, for example, foreign private issuers and companies that file Exchange Act reports pursuant to either Section 15(d) of the Exchange Act or an indenture covenant.

Do the new disclosures apply to investment companies?
Yes. Under the rules, both the director nominating process and the director communication proposals are applicable to investment companies with slight modifications. Effectiveness and Implementation When are the new disclosure requirements applicable? The rules are effective on January 1, 2004 and companies must comply with the rules with respect to proxy or information statements that are first sent or given to shareholders on or after January 1, 2004 and in Forms 10-Q, 10-QSB, 10-K, 10-KSB and N-CSR for the first reporting period ending after January 1, 2004. Companies are permitted to comply with the new rules before their effective date.

What should companies do now?
Since the new rules will be effective for the next annual meeting season, companies that are subject to these new disclosure requirements should consider taking the following actions as quickly as possible. With respect to the director nomination process:

• If the company does not have an independent nominating committee, it should consider forming one.
  If the company has a nominating committee, it should confirm the independence of committee members in light of the recently adopted NYSE and Nasdaq listing standards.
  If the nominating committee does not have a charter, or if the charter does not address many aspects of the new rules, the company should consider amending its existing charter or adopting a new charter. In addition, the company should consider posting the charter on its Website to avoid having to attach the charter to its proxy statement.
  If the company has not previously disclosed a method by which shareholders can submit recommendations for nominees, it should consider identifying a method (perhaps nothing more than directing shareholders to submit recommendations in writing to the Corporate Secretary at a specified address, but perhaps also specifying any related personal information about the nominee and/or recommending shareholder(s) that the company believes should be required).
  Boards should consider whether they have (or want to adopt) any specific, minimum qualifications (including independence) or skill requirements for director nominees and whether they have (or want to adopt) any policies with respect to the consideration of nominees, whether submitted by shareholders or others.
  
• Companies should also reassess existing bylaw advance notification requirements for direct nominations by shareholders (as contrasted with the types of shareholder recommendations contemplated by the new rules).

With respect to shareholder communications with directors:

• If companies do not yet have a process by which shareholders can communicate directly with directors, they should consider adopting one. Such a process will be mandatory for NYSE-listed companies, in any event.
  Companies should consider whether they want such a process to involve only paper mail, or will include e-mail and/or Website methods of communication.
  Companies should consider whether to adopt any filtering or screening process for such communications. If they do adopt a filtering or screening process, companies are encouraged to consider having that process approved by a majority of independent directors, in order to avoid having to describe that process on their Website or in their proxy statement.
  
• Companies should consider whether they have (or want to adopt) a policy regarding director attendance at annual meetings.

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FOOTNOTES [1] Final Rule: Disclosure Regarding Nominating Committee Functions and Communications between Security Holders and Boards of Directors, Securities Act Rel. No. 33-8340, Exchange Act Rel. No. 34-48825, Investment Co. Act Rel. No. IC-26262, http://www.sec.gov/rules/final/33-8340.htm (Nov. 24, 2003). This advisory supersedes our earlier Special Alert regarding the adoption of these rules. See Alston & Bird LLP Securities Law Advisory-Special Alert, "SEC Adopts New Disclosure Rules Relating to Director Nomination Process and Shareholder Communications with Directors," http://www.alston.com/articles/Special%20Alert%2011-19-03.pdf (Nov. 19, 2003).

[2] Proposed Rule: Disclosure Regarding Nominating Committee Functions and Communications between Security Holders and Boards of Directors, Exchange Act Rel. No. 34-48301, Investment Co. Act Rel. No. IC-26145, http://www.sec.gov/rules/proposed/34-48301.htm (Aug. 8, 2003). See also Alston & Bird LLP Securities Law Advisory, "SEC Proposes New Rules Relating to Director Nomination Process and Shareholder Communications with Directors," http://www.alston.com/articles/Director%20Nomination%20Process.pdf (Aug. 13, 2003).

[3] The Commission's news release announcing the publication of the Division's report can be found at http://www.sec.gov/news/press/2003-83.htm (Jul. 15, 2003). The Division's report and related summary of comments can be found at http://www.sec.gov/news/studies/proxyrpt.htm (Jul. 15, 2003). See also Alston & Bird LLP Securities Law Advisory-Special Alert, "SEC Releases Staff Report on Proxy Review Process," http://www.alston.com/articles/Special%20Alert%207-15-03.pdf (Jul. 15, 2003).

[4] Proposed Rule: Security Holder Director Nominations, Exchange Act Rel. No. 34-48626, Investment Co. Act Rel. No. IC-26206, http://www.sec.gov/rules/proposed/34-48626.htm (Oct. 14, 2003). See also Alston & Bird LLP Securities Law Advisory, "SEC Issues Proposed Rules Mandating Shareholder Access to Proxies," http://www.alston.com/articles/Shareholder%20Access%20to%20Proxies.pdf (Oct. 24, 2003). The comment period for these proposed rules ends on December 22, 2003.

[5] The Commission stated that because a recommending shareholder with a more than five percent ownership interest would be subject to the beneficial ownership reporting requirements of Regulation 13D under the Securities Exchange Act of 1934 (Exchange Act), the process by which a determination is made that the recommending shareholder satisfies the ownership threshold to trigger the additional disclosure requirement will be simplified and, where a shareholder or group has reported its beneficial ownership prior to making a recommendation, such disclosure will help to ensure that the company and its shareholders have basic information about the recommending shareholder.

[6] Item 22(b)(14) of Schedule 14A requires substantially similar disclosures in investment company proxy statements.

[7] A new instruction to Item 401 states that adoption of procedures by which shareholders may recommend nominees to a company's board of directors, where the company previously disclosed that it did not have in place such procedures, constitutes a material change and is required to be disclosed in the company's next Form 10-Q or 10-QSB or Form 10-K or 10-KSB.

[8] The final rules do not require, as had been proposed, that the company disclose any specific standards for the overall structure and composition of the board. Beyond the requirements of the rules of the Commission and the NYSE and Nasdaq regarding director and committee member qualification, it is difficult to determine what the Commission would expect to be described in response to this disclosure requirement, particularly since nomination decisions are usually made on a case-by-case basis by companies without regard to any easily-defined "minimum qualifications."

[9] In the case of investment companies, the required categories are security holder, director, chief executive officer, other executive officer, or employee of the investment company's investment adviser, principal underwriter, or any affiliated person of the investment adviser or principal underwriter.

[10] The proposed rules would have required the source, rather than the category of the source, of nominees other than executive officers and directors standing for reelection. The Commission stated that, in providing the required disclosure, companies should consider what category of person initially recommended, or otherwise brought to the attention of the nominating committee, each candidate and that in disclosing the category of persons or entities that initially recommended a candidate to the nominating committee, companies should ensure that they identify also any person or entity that caused a particular candidate to be recommended. For example, if the chief executive officer asks a third party to evaluate a potential candidate, and that third party ultimately recommends the candidate to the nominating committee, both the chief executive officer and the third party should be identified as recommending parties in the company's disclosure.

[11] The Commission added an instruction clarifying that, where a company has changed its meeting date by more than 30 days from the date of the previous year's meeting, a shareholder must make its recommendation by a date that is a reasonable time before the company begins to print and mail its proxy statement in order to trigger the additional disclosure requirements.

[12] An instruction to Item 7 states that a company will be required to provide these disclosures only if, at the time of the recommendation, the shareholder or group provides the written consent of each party to be identified and, where the shareholder or group members are not registered holders, proof of ownership of sufficient shares to trigger this disclosure requirement. As a result, a company is not required to affirmatively seek such consent or proof of ownership in order to meet its disclosure obligations.

[13] In the case of Nasdaq, companies alternatively may provide that the nomination of directors be determined by a majority of the independent directors. NASD and NYSE Rulemaking: Relating to Corporate Governance, Exchange Act Rel. No. 34-48745, http://www.sec.gov/rules/sro/34-48745.htm (Nov. 4, 2003).

[14] These disclosures (other than the disclosures in the first bullet point) may be provided on the company's Website in lieu of including them in the proxy statement, in which case disclosure to that effect, including the company's Website address, must be provided in the proxy statement.

[15] The final rules do not require, as had been originally proposed, the disclosure of the department or group within the company that makes decisions about which communications are relayed to board members. In addition, the Commission added an instruction to clarify that a company's process for collecting and organizing shareholder communications, as well as similar or related activities, need not be disclosed, provided that the company's process is approved by a majority of the independent directors.

[16] The Commission stated that this requirement, which was not included in the proposed rules, was adopted to give shareholders a more complete picture of a company's policies related to opportunities for communicating with directors.

[17] NASD and NYSE Rulemaking: Relating to Corporate Governance, Exchange Act Rel. No. 34-48745, http://www.sec.gov/rules/sro/34-48745.htm (Nov. 4, 2003).

[18] The rules also amend Item 401 of Regulation S-K to require disclosure of changes in methods shareholders may use to submit nomination recommendations, but only where such disclosure was first required to be included in an annual meeting proxy statement under Schedule 14A.