More corporate boards appear to be adopting “categorical standards” to help them make the required disclosures related to their director independence determinations, according to a recent corporate governance survey.
Out of the 100 largest U.S. public companies, 72 have adopted categorical standards, according to their most recent proxy statements—up from 57 companies in 2004. So says the law firm Shearman & Sterling, which conducts an annual survey of governance practices at Fortune 100 companies.
Experts say the adoption of categorical standards has been driven primarily by New York Stock Exchange listing standards, which permit boards to adopt such standards to assist them as they make independence determinations. The standards must be disclosed in the company’s annual proxy statement, and can be broad statements such as “neither the director nor his immediate family members are an employee of the corporation” or “neither director nor his immediate family members work for the corporation’s external auditor.”
Under NYSE corporate-governance rules, boards must determine affirmatively that a director has no direct or indirect material relationship with the listed company. Companies must identify directors deemed independent and disclose the basis for that determination in their proxy statements or annual reports. If a director who is deemed independent has a relationship with the company that is found to be immaterial, the company must disclose that relationship, too.
By making a general statement that independent directors meet the categorical standards adopted by the board, companies don’t have to detail all of the particulars of the immaterial relationships with individual directors, if those relationships are covered by such standards. “Categorical standards offer the general potential for making disclosure easier,” says Robert Morris, a partner at the law firm Reed Smith.
Matheson
David Matheson, a partner at the law firm Perkins Coie, says many NYSE companies have adopted categorical standards to lighten the burden of proxy disclosures, since the standards avoid a discussion of immaterial relationships. And while Nasdaq requirements don’t discuss categorical standards, he says some Nasdaq-listed companies may have adopted categorical standards “as a best practice, in demonstrating that they are raising the bar beyond the minimum Nasdaq bright line tests.”
SAMPLE STANDARD
Below is an excerpt of the categorical standards adopted by Bank of America:
In order to assist the board in making determinations of independence, any relationship described below shall be presumed material if it existed within the preceding year (and, beginning November 4, 2004, if it existed within the preceding three years):
the director was an employee of the Corporation or an immediate family member of the director was an executive officer of the Corporation;
the director or an executive officer of the Corporation who is an immediate family member of the director received more than $100,000 per year in direct compensation from the Corporation, other than director and committee fees and pension or other deferred compensation for prior service (provided that such compensation was not contingent in any way on continued service);
the director was affiliated with or employed by the Corporation's present or former internal or external auditor (or had an immediate family member who was affiliated with or employed in a professional capacity by such internal or external auditor);
the director was an executive officer of a company in which an executive officer of the Corporation served on the compensation committee of the board of directors (or had an immediate family member who was an executive officer of such company);
the director was an employee or executive officer, or an immediate family member of the director was an executive officer, of another company that made payments to or received payments from the Corporation for property or services in an amount which, in any single fiscal year, exceeded the greater of $1 million or 2% of such other company's consolidated gross revenues for the most recently ended fiscal year for which total revenue information is available; or
the director, or an immediate family member of the director who resides in the same home as the director, was employed as an executive officer of a nonprofit organization, foundation or university to which the Corporation made discretionary contributions (excluding for this purpose matching funds paid by the Corporation or the Bank of America Foundation as a result of contributions by the Corporation’s directors or employees) that, in any fiscal year exceeded the greater of $1 million or 5% of the entity’s consolidated gross revenues for the most recently ended fiscal year for which total revenue information is available.
For purposes of the above-described categorical standards, the term “immediate family member” includes a person’s spouse, parents, children, siblings, mothers- and fathers-in-law, sons- and daughters-in-law, brothers- and sisters-in-law and anyone (other than domestic employees) who shares such person’s home; provided, that any such persons who no longer have any such relationship as a result of legal separation or divorce, or death or incapacitation, shall not be considered immediate family members.
Source
Bank Of America Corporation Director Independence Categorical Standards
Morris agrees that NYSE rules have been the main driver for companies to adopt such standards. Still, he adds, even for businesses not listed on the NYSE, “a lot of companies have found that in practice, they make disclosure a lot easier.” The only companies that would not need to consider categorical standards are those where no director has any business relationship with the company at all—and “that’s relatively unusual,” he says.
Setting Your Standards
Morris
Morris says the process of adopting categorical standards is “pretty simple.” Companies usually already have an idea of the sorts of relationships that exist between company and director, since that information has been required disclosure for years. “After taking into account what they know, the board develops and adopts the categorical standards,” he says.
Matheson says most of the categorical standards that have been adopted are “very similar to NYSE’s bright-line independence criteria,” although he notes that the NYSE has expressed concern with a company’s categorical standards for a subjective test “being the same as the bright-line standards.” One tweak he says some companies have added to the categorical standards is to extend the “cooling-off” or “look-back” period under the bright-line tests.
Many of the differences between the two sets of criteria are based on specific standards for determining related-party transactions under Item 404 of Regulation S-K, says Matheson, which seems a logical extension because it focuses on material relationships between the directors and the company and independently requires disclosure of any material relationships. “Companies generally haven’t ventured beyond these sorts of extensions, if any,” he says.
One type of relationship for which many companies have adopted categorical standards relates to charitable contributions. Indeed, 68 of the companies in the Shearman & Sterling survey have adopted a categorical standard relating to a director’s affiliation with a nonprofit organization that receives contributions from the listed company, with variations in the look-back period for such contributions, the amount of such contributions, and the nature of the director’s affiliation.
Another common relationship addressed by categorical standards is indebtedness. Twenty-seven of the Fortune 100 companies have adopted a categorical standard relating to a director’s affiliation with a company that owes money to the listed company or relating to the listed company owing money, with variations in the look-back period for such indebtedness, the amount of the debt, and the nature of the director’s affiliation with the other company.
Matheson says one new disclosure added as part of the SEC’s 2006 overhaul of the executive-pay disclosure comes under Item 407(a)(2) of Regulation S-K: If a company has its own definition for determining independent directors (that is, categorical standards), it must disclose the definition on its Web site or in its proxy statement. That, Matheson says, may spur some companies to adopt categorical standards.
Morris at Reed Smith says categorical standards may help companies comply with part of Item 407. While SEC rules already required the disclosure of a variety of related-party transactions at various thresholds, part of Item 407 also requires companies to disclose for directors who are determined to be independent “by specific category or type,” any transactions, relationships, or arrangements not disclosed under Item 404(a) that were considered by the board under the applicable independence definition in determining the directors’ independence.
“Since those transactions can be described by category or type, categorical standards can help satisfy that disclosure requirement if they’re crafted carefully,” says Morris.
Matheson notes that the language of Item 407(a)(3) ”may reinforce adoption of categorical standards as a way to generally categorize specific immaterial relationships.” For example, a company might describe the relationship and indicate that it didn’t represent a material relationship under a particular categorical standard.
However, since reporting companies may have to disclose under Item 407(a)(3) immaterial relationships that they don’t otherwise have to disclose under NYSE rules, he says, “Some of the benefit to NYSE listed companies in adopting categorical standards may now be diminished.”
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