Recent Post-Enron Corporate Governance Developments

By John F. Olson, Ronald O. Mueller, Brian J. Lane and Amy L. Goodman

Originally published on June 25, 2002

The months following the collapse of Enron have brought heightened scrutiny to corporate governance issues. The President, Congress, the Securities and Exchange Commission (SEC), the major securities markets, institutional investors and others have called for changes in corporate governance practices. The changes proposed to date reflect a number of common themes, including:

• a continued and expanded emphasis on the independence of the board as a whole, including heightened independence standards, requirements for independence determinations, and consideration of "soft" factors such as close relationships with management, political contributions and ties to non-profit organizations that receive corporate contributions;
• the establishment of three key committees of the board – audit, nominating/corporate governance and compensation – each composed entirely of independent directors;
• the development and publication of corporate governance principles and codes of conduct for officers and directors;
• CEO certification requirements; and
• broadened shareholder approval requirements for equity-based compensation plans.

In the wake of the proposals, companies should undertake a corporate governance audit. Although the corporate governance requirements that have been proposed – and particularly the recommended changes to the listing standards of the New York Stock Exchange (NYSE) and the Nasdaq Stock Market, Inc. (Nasdaq) – are not yet in final form, it is not too early to begin assessing their impact. A proactive approach will position companies to comply with the requirements, when implemented, effectively and with minimal disruptions. Moreover, in a time when the investing public has been increasingly vocal in demanding change, prompt attention to corporate governance issues could yield investor relations benefits.

On June 6, 2002, the NYSE issued the report of its Corporate Accountability and Listing Standards Committee (Listing Standards Committee), which contains recommendations for comprehensive changes to the NYSE's corporate governance listing standards. Two weeks prior to that, on May 24, Nasdaq announced an initial set of changes to its corporate governance listing standards and indicated that it will be considering additional proposals throughout the summer. On May 14, The Business Roundtable, an association of chief executives of the largest companies in the United States, issued its Principles of Corporate Governance (2002), designed to assist corporate management and boards of directors in their individual efforts to implement corporate governance best practices.

In addition, more than 30 bills have been introduced in the House and Senate to date. The Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002 (sponsored by Michael Oxley (R-OH)) passed the House of Representatives on April 24. Various bills are currently pending in the Senate, including the Public Company Accounting Reform and Investor Protection Act of 2002 (sponsored by Paul Sarbanes (D-MD)), which was reported out of the Senate Banking, Housing, and Urban Affairs Committee by a 17-4 vote on June 18.

The specific elements of the NYSE and Nasdaq proposed changes are outlined below, followed by a summary of the best practices recommended by The Business Roundtable. Companies should keep in mind that the NYSE and Nasdaq proposals must be submitted to the SEC for approval and put out for public comment, so there may be revisions in the final listing standards.

A. The Major Securities Markets

In February 2002, SEC Chairman Pitt asked both the NYSE and Nasdaq to review their corporate governance listing standards. Among the issues he asked them to address were the need for mandatory codes of conduct, continuing education and ethical training for officers and directors, and whether audit committee requirements should be strengthened by, for example, vesting audit committees with exclusive authority to hire and fire the outside auditor. In addition, Chairman Pitt reiterated his emphasis on the need for full, continuous disclosure by public companies.

On June 6, 2002, the NYSE's Listing Standards Committee issued a report to the NYSE board of directors setting forth recommended changes to the NYSE's corporate governance listing standards, as well as recommendations to the SEC and Congress on regulatory and legislative changes. The recommendations and the full text of the report are available at http://www.nyse.com/pdfs/corp_recommendations_nyse.pdf and http://www.nyse.com/pdfs/corp_govreport.pdf, respectively. After a two-month public comment period, the NYSE board of directors expects to take action on the report at its August 1 meeting. The report recommends changes in the following areas:

1. Board independence.

• The board must have a majority of independent directors. Companies would have 24 months to comply with the new independence rule and would be required to publicly disclose when they have achieved majority independence.
• For a director to be deemed "independent," the board must affirmatively determine that the director has no material relationship with the listed company other than service as a director.
• The basis for board determinations that a relationship is not material must be disclosed in the company's proxy statement.
• A five-year "cooling off" period applies, during which the following are not considered independent:
• a former employee of the listed company;
• a former employee of the listed company's present or former (within the past five years) outside auditor;
• a former employee of any company whose compensation committee includes an executive officer of the listed company; and
• any immediate family member of the above.

2. Executive sessions of the board/Presiding director.

• Non-management directors must meet at regularly scheduled executive sessions without management.
• The independent directors must designate a director to preside at executive sessions and the company must disclose the name of this director in its proxy statement. According to the report of the Listing Standards Committee, this disclosure is intended to facilitate communications by employees and shareholders directly with non-management directors.

3. New requirements for audit committee members and audit committees.

• Additional qualifications. Audit committee members must meet additional qualifications (beyond the independence requirement):
• director fees must be the only compensation an audit committee member receives from the company;
• a committee member who holds 20% or more of the company's stock or who is a general partner, controlling shareholder or officer of any such holder, cannot chair the committee or vote; and
• the audit committee chair must have accounting or related financial management expertise, as defined under existing listing standards.^[1]
• Additional responsibilities. The audit committee must perform additional substantive responsibilities, which must be set forth in its charter. The audit committee must:
• discuss earnings releases, and financial information and earnings guidance provided to analysts and rating agencies; and
• discuss the company's policies on risk assessment and management.
• Meetings. The audit committee must meet separately, at least quarterly, with management, the internal auditors, and the outside auditor.
• Outside advisors. The audit committee must have the authority (which should be set forth in its charter) to retain legal, accounting and other advisors without seeking board approval.
• Outside auditor. The audit committee must have exclusive authority, without deliberation or approval by the full board, to hire and fire the outside auditor, including authority to approve all engagement fees and terms and to approve any significant non-audit relationship with the independent auditor.
• Best practice recommendations on auditor rotation and hiring former auditor personnel. The Listing Standards Committee does not recommend mandatory periodic rotation in its report because it believes that this may undercut the effectiveness of the auditor and disrupt the quality of the audit. As a matter of best practices, however, the report recommends that the audit committee consider whether, in order to assure continuing independence, there should be regular rotation of the lead audit partner or of the audit firm itself. The audit committee should make its own decision about whether the company is obtaining high-quality audits and whether rotating the auditor would be helpful for the company. The Listing Standards Committee also recommends, as a best practice, that the audit committee set clear policies for hiring employees or former employees of the outside auditor.

4. Nominating/corporate governance and compensation committees.

• Companies must have a nominating/governance committee and a compensation committee. Each committee must be composed entirely of independent directors and must have a written charter. Companies must post these charters (along with the charters of the audit committee and other important committees) on their websites.
• The nominating/corporate governance committee and the compensation committee should have sole authority, without requiring full board action to retain and terminate outside advisors, such as search firms used to identify director candidates and compensation consultants.
• The Listing Standards Committee report spells out specific responsibilities for the audit, nominating/corporate governance and compensation committees that must be included in their respective charters, including annual performance evaluations for each committee.

5. CEO certification.

• The CEO of each listed company must certify to the NYSE each year that:
• the company has established procedures for verifying the accuracy and completeness of information provided to investors, that those procedures have been carried out and that, based upon the CEO's assessment of the adequacy of the procedures and the diligence of those carrying them out, the CEO has no reasonable cause to believe that the information provided to investors is not accurate and complete in all material respects;
• the CEO has reviewed these procedures, and the company's compliance with them, with the board; and
• the CEO is not aware of any violations by the company of NYSE listing standards.
• The Listing Standards Committee proposed an additional certification requirement in its recommendations to the SEC. This proposal recommends that the SEC require CEOs to certify to shareholders that, to their best knowledge and belief, their companies' financial statements and disclosures fairly present the information that reasonable investors should have to make informed investment decisions.^[2]

6. Shareholder approval of option plans.

• Shareholders must vote to approve or disapprove all equity compensation plans.
• Brokers may not vote customer shares on any equity compensation plans unless the broker has the customer's instructions to do so.^[3]

7. Corporate governance principles.

• Companies must adopt a set of corporate governance principles and post these principles on their websites.
• The principles should address: director qualification standards and responsibilities; director access to management and independent advisors; director compensation; director orientation and continuing education; management succession; and annual board evaluations.

8. Codes of business conduct and ethics.

• Companies must adopt and disclose (including by posting on their websites) a code of business conduct and ethics for directors, officers, and employees. The code must:
• require that any waivers of the code for directors or executive officers can be made only by the board or a board committee and that such waivers be promptly disclosed to shareholders; and
• contain compliance standards and procedures that ensure prompt and consistent action against violations of the code.
• A code of business conduct and ethics should address: conflicts of interest; corporate opportunities; confidentiality; fair dealing with the company's customers, suppliers, competitors and employees; protection and proper use of company assets; compliance with laws, rules and regulations, including laws on insider trading; and reporting illegal or unethical behavior.

9. Penalties for violating listing standards.

• Suspending trading or delisting a company is harmful to a company's shareholders. Accordingly, the NYSE should be able to impose the lesser sanction of issuing a public reprimand letter to companies that violate its listing standards.

10. Foreign issuers.

• Listed foreign private issuers must disclose significant ways in which their corporate governance practices differ from those of domestic companies listed on the NYSE.

On May 24, 2002, Nasdaq announced that its board of directors had approved modifications to its corporate governance standards. Nasdaq has indicated that these modifications, which grew out of recommendations from Nasdaq's Listing and Hearing Review Council, are only a first step and that it will continue to review corporate governance issues. The text of the rule proposals (as submitted to the SEC) is available on Nasdaq's website at http://www.nasdaqnews.com/. The Listing and Hearing Review Council is scheduled to meet to consider additional reform proposals on June 26-28. The rule changes approved on May 24 address:

1. Board independence.

• The definition of "independent director," which prohibits directors from receiving more than $60,000 in compensation (other than for board service, benefits under a tax-qualified retirement plan, or non-discretionary compensation), will be tightened to address additional relationships that may impair a director's independence. The definition will be extended to:
• prohibit any payments, including political contributions, in excess of $60,000 (the existing exceptions will remain intact);
• cover the receipt of any such payments by a director's family;
• cover any director who is a partner in, or a controlling shareholder or executive officer of, an organization, including a non-profit entity, if the company makes payments to the organization that exceed the greater of $200,000 or five percent of either the company's or the organization's gross revenues.

2. Shareholder approval of option plans.

• Shareholders must vote to approve stock option plans that include executive officers or directors.
• Nasdaq would retain the existing exception that allows companies to provide inducement grants to new executive officers, but any such grants would have to be approved by an independent compensation committee or a majority of the independent directors.

3. Related-party transactions.

• The audit committee or a comparable body of the board must review and approve all related-party transactions.

4. Penalties for misrepresenting information to Nasdaq.

• Companies can be delisted for making an intentional misrepresentation to Nasdaq, intentionally omitting necessary material information in a communication with Nasdaq, or otherwise failing to provide requested information to Nasdaq.

5. Require disclosure of audit opinions with going concern qualifications.

• Companies must disclose the receipt of an audit opinion with a going concern qualification.

6. Regulation FD.

• Companies will be permitted to disseminate material information via Regulation FD-compliant methods of disclosure, such as conference calls, press conferences and webcasts, instead of solely by press release. The public must be given adequate notice (generally by press release) and granted access.

B. The Business Roundtable's Principles of Corporate Governance (2002)

In May 2002, The Business Roundtable (Roundtable) released its Principles of Corporate Governance (Principles), a set of guiding principles intended to assist corporate management and boards of directors in their individual efforts to implement corporate governance best practices. The Principles are available on the Roundtable's website at http://www.brtable.org/pdf/704.pdf. While many of the Roundtable's Principles were followed a month later in the NYSE proposals, the Roundtable recognizes that no structure is right for all corporations, and that not all of the best practices outlined in the Principles will be appropriate for every corporation in every circumstance. The Roundtable recommendations to boards address, among other things:

1. The roles of the board and management.

• Effective directors are monitors, not managers, of business operations. The board's most important function is the selection, compensation and evaluation of a well-qualified and ethical CEO.
• The CEO, with senior management, operates the corporation on a daily basis. In addition to having the requisite skills and experience, the CEO should be a person of integrity who takes responsibility for the corporation adhering to the highest ethical standards.

2. Board leadership.

• While most American corporations are well served by a structure in which the CEO also serves as chair of the board, each corporation should make its own determination of what leadership structure works best, given its present and anticipated circumstances.
• Some corporations have found it useful to separate the roles of CEO and chair of the board to provide continuity of leadership in times of transition.
• The board should have contingency plans to provide for transitional board leadership if questions arise concerning management's conduct, competence, or integrity or if the CEO dies or is incapacitated.

3. Board independence.

• A substantial majority of directors of the board of a publicly owned corporation should be independent of management. This best practice is stronger than the NYSE Listing Standards Committee recommendation, which would require that a simple majority of the board be independent.
• Determinations as to independence should be made by the board, which should consider:
• the appearance (as well as the fact) of independence; and
• personal and other types of relationships – including those with non-profit organizations that receive corporate contributions – in assessing independence.

4. Committees of the board.

• As with the proposals of the NYSE Listing Standards Committee, the Roundtable recommends that every corporation not only have an audit committee made up of independent directors (as already required by the major securities markets), but also fully independent committees responsible for addressing nominating/corporate governance and compensation issues.
• The Roundtable spells out specific proposed responsibilities for each of the three key committees and recommends that these responsibilities be clearly defined in a charter or board resolution:
• Audit. The audit committee should (1) supervise the company's relationship with its outside auditor, including making an annual recommendation to the board about the selection of the auditor, evaluating the auditor's performance, and considering whether it would be appropriate for the outside auditor periodically to rotate senior audit personnel or for the corporation periodically to change its outside auditor; (2) develop policies on the provision of non-audit services; (3) review and discuss the corporation's financial statements and critical accounting policies with management and the outside auditor; (4) oversee the corporation's internal controls and internal audit function and review the appointment and replacement of the senior internal auditing executive; and (5) develop policies on the hiring of former auditor personnel. Like the NYSE Listing Standards Committee, the Roundtable recommends that the audit committee meet four times per year and meet with the outside auditor, without management present, at every meeting.
• Corporate governance. The corporate governance committee should (1) recommend nominees to the board and its committees, including establishing criteria for board membership, reviewing candidates' qualifications and potential conflicts with the corporation's interests, and assessing the contributions of current directors in connection with their renomination; (2) monitor and safeguard the board's independence; (3) oversee and review the corporation's processes for providing information to the board; (4) develop and recommend to the board a set of corporate governance principles; and (5) oversee board and management evaluation.
• Compensation. The compensation committee should set CEO and senior management compensation and oversee the corporation's overall compensation structure to assess whether it establishes appropriate incentives for management and employees at all levels.

5. Board and management evaluation.

• The board should have an effective mechanism for assessing on a continuing basis the effectiveness of the full board, the board's committees, individual directors, and management:
• the non-management members of the board, under the oversight of a committee made up of independent directors, should annually review the performance of the CEO and participate with the CEO in evaluation of senior management;
• the performance of the full board and its committees should be evaluated annually; and
• the board should have a process for evaluating whether individuals sitting on the board have the skills and expertise appropriate for the corporation and how these individuals work as a group, and a director's ability to continue contributing to the board should be evaluated each time the director is considered for renomination. (This last recommendation goes beyond the proposals of the NYSE Listing Standards Committee).

6. Director and management compensation.

• A meaningful portion of directors' compensation should be in the form of long-term equity. Corporations may wish to consider establishing a requirement that, for as long as directors remain on the board, they acquire and hold stock in an amount that is meaningful and appropriate to each director.
• The structure of management compensation should directly link the interests of management to the interests of shareholders. Companies should establish a management compensation structure that balances short- and long-term incentives and includes different forms of compensation.
• The compensation committee should examine the overall compensation structure of the corporation to determine whether it establishes appropriate incentives not only for directors and senior managers, but for employees at all levels.

7. Shareholder approval of option plans.

• Corporations should obtain shareholder approval of new stock option and restricted stock plans in which directors or executive officers participate. This conforms to the Nasdaq proposal, and to the stated position of SEC Chairman Harvey Pitt, but does not go as far as the recommendation of the NYSE Listing Standards Committee summarized above.

8. Corporate governance principles.

• All corporations should adopt and publicize statements of corporate governance principles.

9. Codes of conduct.

• Companies should have and publicize a code of conduct with effective reporting and enforcement mechanisms. Employees should have a means of alerting management and the board to potential misconduct without fear of retribution, and violations of the code should be addressed promptly and effectively.

10. Relationship with outside auditor.

• Selection.The audit committee should make an annual recommendation to the full board about the selection of the outside auditor, based on a due diligence process that includes a review of the auditor's qualifications, work product, independence and reputation.
• Non-audit services. The audit committee should develop policies concerning the provision of non-audit services by the corporation's outside auditor and should consider the nature and dollar amount of all services provided by the outside auditor when assessing the auditor's independence.
• Auditor rotation. The audit committee should consider whether it would be appropriate for the outside auditor periodically to rotate senior audit personnel or for the corporation periodically to change its outside auditor. The audit committee should base its decisions about selecting and possibly changing the outside auditor on its assessment of what is likely to lead to more effective audits.
• Hiring former auditor personnel. The audit committee should consider adopting a "cooling-off" period or other policy restricting the hiring of former auditor personnel. Each corporation should consider what policy is appropriate for it.

In the wake of the proposals and recommendations outlined above, companies should review their corporate governance practices to assess how their practices compare with those endorsed by the NYSE Listing Standards Committee, Nasdaq and The Business Roundtable. Companies should also understand that any proposed changes to the listing standards of the NYSE and Nasdaq must be submitted to the SEC, put out for public comment and approved by the SEC before they become final. Accordingly, the listing standards that are ultimately adopted may differ from the proposals that have been issued to date. Nevertheless, companies should begin the process of considering their corporate governance practices now, with an eye toward improving and supplementing their existing practices and implementing the new listing standards promptly after they are approved. Among other things:

• Companies should conduct a corporate governance audit. In assessing and developing corporate governance practices, consideration should be given to the company's size, industry, employees and culture. The nominating/corporate governance committee can play a role in this process by preparing recommendations about practices to the full board.
• Companies that do not yet have them should establish board nominating/corporate governance and compensation committees, made up entirely of independent directors.
• Referring to the standards under consideration by the market where the company's stock is listed, and the considerations noted in the Roundtable's Principles, each board should review the qualifications and independence of the members of the three key committees. Boards should examine all director relationships, including those that do not currently require disclosure but that could cause investors or regulators to question directors' independence.
• Companies should review existing charters or, if needed, prepare new charters for all key committees for board review and approval as soon as relevant listing standards are adopted. Companies should consider each subject specified in the NYSE Listing Standards Committee recommendations and the Roundtable's Principles, but should also maintain flexibility in their charters to focus on policies and procedures that are important to their specific business operations and company and board culture.
• Audit committees should review their schedules and, if they do not do so now, consider meeting at least four times a year and having a private session with the outside and internal auditors at each meeting. Both of these practices may well be required in the future if approved by the NYSE board and the SEC. Quarterly meetings should take place with sufficient time to review earnings releases and 10-Qs, as well as any report from the outside auditor on its quarterly review of the interim financial statements. The burdens of more frequent meetings can be lessened by altering board schedules to precede earnings release dates and by using audio and video conference capabilities for some committee meetings. Audit committee members should make sure that committee schedules and agendas permit – and encourage – active engagement and give-and-take discussions with management and with the auditors, both in general sessions and in private sessions.
• Companies should review all board and committee meeting schedules to be sure that committees, as well as the full board, thoroughly and thoughtfully cover their respective agenda items, based on listing standards and their charters. This will often mean that committees will need to meet on the day prior to board meetings, so that they are not rushed through their agendas and have the ability to extend the length of their meetings as needed.
• Companies should consider moving immediately to publicize information about their corporate governance practices by posting this information on their websites.
• If companies disagree with any of the recommendations issued by the NYSE Listing Standards Committee or Nasdaq, they should submit comments as soon as possible.

NYSE. Comments can be submitted to the NYSE at: corporategovernancefeedback@nyse.com

Copyright © 2002 Gibson, Dunn& Crutcher LLP

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