Public Companies Must Respond to New SEC Disclosure Requirements Regarding Nominating Committee Functions and Communications with Directors

The Securities and Exchange Commission ("SEC") has adopted new disclosure requirements regarding the operations of board nominating committees and the means by which security holders may communicate with directors. Release 33-8340; 34-48825; IC-26262 (November 24, 2003), www.sec.gov/rules/final/33-8340.htm (the "Adopting Release").

The Adopting Release became effective on January 1, 2004. The new disclosure requirements apply to proxy or information statements that are first sent or given to security holders on or after January 1, 2004 and for Forms 10-Q and 10-K filed for periods ending after January 1, 2004.¹

On April 14, 2003, the SEC directed the Division of Corporation Finance to review the proxy rules relating to the election of corporate directors. The Division published its findings in a report provided to the SEC on July 15, 2003, which identified two particular areas of concern related to the election of corporate directors:

• the nomination of candidates for election as director; and

• the ability of security holders to communicate effectively with members of the boards of directors.²

Largely in response to the Division’s findings, the SEC proposed new disclosure standards on August 8, 2003. Release 34-48301; IC-26145 issued on August 8, 2003 available at www.sec.gov/rules/proposed/34-48301.htm (the "Proposing Release"). The Adopting Release adopts, in most respects, the proposed disclosure standards after revising some elements in response to public comments and suggestions.

The new standards do not mandate any particular action by a company or its board of directors. Rather, the new disclosure requirements are intended to make the operation of companies’ boards more transparent to investors by requiring full and complete disclosure regarding policies and procedures relating to the nomination of directors and security holder communications with a company’s board of directors. Nevertheless, public companies are well-advised to review their existing policies and procedures with respect to director nominations and communications with the board, to assess whether these policies or procedures should be updated and enhanced in light of the new disclosure requirements. A list of matters that should be reviewed is outlined below.

The first area of concern in the Division’s report related to director nomination policies and procedures. Accordingly, the Adopting Release amended Item 7(d)(e)(2) of Schedule 14A of the Exchange Act to expand a company’s required disclosure regarding its process for the nomination of candidates for election as directors.

New Item 7(d) Requirements. Under the old Item 7(d), a company was only required to state whether or not it had a nominating committee and the names of the directors serving on the nominating committee. Revised Item 7(d) requires enhanced disclosure regarding nominating policies and procedures to provide a complete overview regarding that process. Under the revised Item 7(d), a company is now required to:

• disclose whether it has a nominating committee,

• make the nominating committee’s charter publicly available,

• describe the nominating committee’s processes for identifying and evaluating candidates for the board of directors,

• describe the minimum qualifications for nominees recommended by the nominating committee,

• describe the qualities and skills that the nominating committee believes are necessary or desirable for board members, and

• assess whether each member of the nominating committee is independent.

The SEC’s rationale underlying the new rules is that a complete understanding of the nomination process will better assist investors in evaluating the boards of directors and nominating committees of companies in which they invest and, therefore, provide security holders with important information regarding the management and oversight of those companies.

Required Disclosures Regarding Nomination Process. Under the new disclosure standards, a company is required to include, at a minimum, the following information in its proxy or information statements:

• A statement whether the company has a standing nominating (or similar) committee. If not, an explanation why the company’s board believes it is appropriate not to have a nominating committee, and identification of each director who participates in the consideration of director nominees.
• If the nominating committee has a charter, the company is required to either post a current copy of the charter on its website and disclose its website address, or include a copy of the current charter as an appendix to the company’s proxy statement at least once every three fiscal years. If the nominating committee does not have a charter, the company is required to disclose that fact.
• If the company’s securities are listed on a national securities exchange or in an automated inter-dealer quotation system that has independence requirements for nominating committee members, the company must disclose whether the members of the nominating committee are "independent," as defined in the listing standards applicable to the company. If the company’s securities are not listed, the company must determine whether the members of its nominating committee are independent by using a definition of independence of any national securities exchange registered pursuant to Section 6(a) of the Exchange Act or a national securities association registered pursuant to Section 15A(a) of the Exchange Act. In disclosing the results of its assessment, the company must state which definition of "independent" it used.
• If the nominating committee has a policy regarding the consideration of any director candidates recommended by security holders, the company must describe the material elements of that policy. At a minimum, the company must disclose whether the nominating committee will consider director candidates recommended by security holders. If the nominating committee does not have a policy regarding the consideration of any director candidates recommended by security holders, thecompany must disclose that fact and the basis for its view that it is appropriate for the company not to have such a policy.

• If the nominating committee will consider candidates recommended by security holders, the company must describe the procedures security holders must follow to submit their recommendations.

• The company must describe any specific, minimum qualifications that the nominating committee believes must be met by a nominating-committee-recommended director nominee. In addition, the company must describe any specific qualities or skills that the nominating committee believes are necessary for one or more of the company’s directors to possess.

• The company must disclose the nominating committee’s process for identifying and evaluating nominees for director, including nominees recommended by security holders, and any differences in the manner the nominating committee evaluates nominees recommended by a security holder.

• For each nominee approved by the nominating committee for inclusion on the company’s proxy card (other than nominees who are executive officers or who are directors standing for re-election), the company must identify how each candidate was recommended (for example, by a security holder; a non-management director, the chief executive officer, another executive officer, a third-party search firm, or other, specified source).
• The company must disclose if it pays any fees to third parties to identify or evaluate potential nominees, and describe the function performed by such third party.Finally, if the company’s nominating committee received, by a date not later than the 120th calendar day before the date of the company’s proxy statement released to security holders in connection with the previous year’s annual meeting, a recommended nominee from a security holder (or group of security holders) that beneficially owned more than 5 percent of the company’s voting common stock for at least one year as of the date the recommendation was made, the company must identify the recommended candidate and the security holder (or group of security holders) that recommended the candidate and whether the nominating committee chose to nominate the candidate.³

Matters That Should Be Reviewed in Light of New Director Nomination Disclosure Requirements. In light of the new disclosure requirements, public companies should review their director nomination policies and procedures.

• If the company does not have an independent nominating committee or other independent committee performing these functions, consider whether to create a fully independent nominating committee or to delegate to another fully independent committee responsibility for the nomination process.

• If the company does not have a nominating (or similar) committee, prepare a written explanation of the reasons why the company does not have one and identify each director who participates in the consideration of director nominees.

• If the nominating (or similar) committee has a charter, review the charter and make any necessary revisions, being mindful of both the new SEC disclosure requirements and those of the applicable exchange or quotation system. If the nominating committee does not have a charter, consider adopting one.

• Assess whether the members of the nominating (or similar) committee are "independent" under the listing standards of the applicable exchange or quotation system (for example, NYSE, NASDAQ, AMEX).

Prepare written descriptions of the policies required by the new rules, and have them reviewed and adopted by the nominating (or similar) committee or full board and determine how the company will meet the SEC’s publication requirements.

• Review any "advance notice" provisions on shareholder proposals or nominations in the company’s existing articles and bylaws, to ensure that they are consistent with the new disclosure rules, and adopt any necessary revisions.

• If a company uses third parties to assist in identifying director candidates, identify the financial arrangements and services performed.

Disclosure of Material Changes to Procedures for Director Nominations. The Adopting Release requires a company to report any material changes to its procedures for a security holder to submit nominees for election as directors in its quarterly or annual report filed for the period in which the change occurs. The Adopting Release clarifies that a "material change" will include the adoption of procedures by which security holders may recommend nominees where the company previously disclosed that it did not have such procedures.

The Adopting Release adds a new Item 7(h) to Schedule 14A, which requires disclosure of the manner in which security holders can engage in communications with its board. Similar to revised Item 7(d), new Item 7(h) does not require a company to take any affirmative actions. Rather, these new disclosure requirements are intended to improve the transparency of board operations and to improve security holders’ understanding of the company in which they invest. However, public companies should review their existing policies and procedures in light of the new disclosure requirements.

New Item 7(h). Under new Item 7(h), companies must disclose the following information regarding security holder communications with board members:

• The company must disclose whether or not it has adopted a process for security holders to send communications to its board. If the company does not have such a process, the company must disclose its basis for the view of why it is appropriate not to have a process.

• If the company has a process for security holders to send communications to the board, the company must include a description of the manner in which security holders can send communications to the board and, if applicable, to specified individual directors. In addition, if all security holder communications are not sent directly to board members, the company must describe its process for determining which communications will be relayed to board members.

• Finally, a company is required to describe its policy, if any, with regard to board members’ attendance at annual meetings and a statement of the number of board members who attended the prior year’s annual meeting.

Matters That Should Be Reviewed in Light of New Director Communication Disclosure Requirements. In response to these new rules, public companies should review the processes, if any, for communications with directors. If the company does not have such a process and decides not to adopt one, a written explanation of the reasons for this determination should be prepared and the company should determine how it will meet the SEC’s publication requirements. Similarly, companies should review or consider adopting a policy with respect to attendance by board members of the company’s annual meeting. If a company is preparing new policies in relation to these disclosure requirements, it should be mindful of any pre-existing policies relating to communications by security holders with the company’s audit committee and make sure that they are not inconsistent.

This article is presented for informational purposes only and is not intended to constitute legal advice.