Corporate Governance

The SEC's Access Proposal: Some Observations (Preempting the NYSE)

By J. Robert Brown

We have been talking about the SEC's access proposal and its efforts to preempt state law.  The proposal also, however, overrides the requirements of the NYSE, effectively "preempting" them.   The effort highlights the weaknesses in the standards used to determine director independence. 

Proposed Rule 14a-18 requires nominating shareholders to file a Schedule 14N.  The schedule must represent that the nominee meets all relevant legal requirements (including the listing standards of the exchange) except it does not have to meet the requirements for director independence under the exchanges.  Proposed Rule 14a-18(a).  Instead, the shareholder must represent that the nominee meets the "objective criteria" for independence contained in the relevant stock exchange.  The comment notes that there need not be representation with respect to compliance with any "subjective criteria" imposed by the exchange.

As for an example, the release notes that the NYSE listing standards:

• include both subjective and objective components in defining "independent director."  As an example of a subjective determination, Section 303A.02(a) of the NYSE Listed Company Manual provides that no director will qualify as "independent" unless the board of directors "affirmatively determines that the director has no material relationship with the listed company . . . "  On the other hand, Section 303A.02(b) provides that a director is not independent if he or she has any of several specified relationships with the company that can be determined by a "bright-line" objective test.

The release doen't reference the Nasdaq standard but presumably applies to it with equal vigor.  See Nasdaq rule 5605(a)(2)(disqualifying any director "having a relationship which, in the opinion of the Company's board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director."). 

But is it really subjective?  The NYSE Manual doesn't say so. According to Rule 303A.02 of the NYSE Manual:

• No director qualifies as "independent" unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company). Companies must identify which directors are independent and disclose the basis for that determination.

Nor does the commentary to the provision provide much insight other than to rule out stock holdings as a basis for non-independence.  As the comment notes:

• It is not possible to anticipate, or explicitly to provide for, all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of a director's relationship to a listed company. Accordingly, it is best that boards making "independence" determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director's relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.

Characterizing the materiality standard as "subjective" runs contrary to the usual approach taken with the term.  Thus, under the securities laws, "materiality" is interpreted in an objective fashion.  See Tsc Indus. v. Northway, 426 U.S. 438, 445 (1976)("The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor."). On the other hand, Delaware does it differently.  The courts have developed a materiality standard that is subjective.  The standard has been used to deny shareholders the right to show a lack of independence since a subjective standard is often difficult to show at the motion to dismiss stage.  For more discussion on this issue, see Disloyalty Without Limits: 'Independent' Directors and the Elimination of the Duty of Loyalty).

The term may, therefore, cover objective relationships not otherwise picked up by the standard. Calling the test subjective, however, pinpoints a critical weakness in the standard.  As a subjective, undefined test, the board can apparently do whatever it wants, even ignoring relationships that are objectively material.  We have noted often on this Blog that directors can receive exorbitant total compensation (say $700,000) and still be treated as independent under the NYSE standard.   and not be treated as having a material relationship, something that on an objective basis would be hard to justify.

But by labeling the "materiality" standard in the NYSE listing standards as subjective, the SEC has rendered it entirely inapplicable to nominees submitted by shareholders. It is an attempt to reduce board discretion in rejecting nominees.  In truth, the SEC ought not to have to do this.  The check on the arbitrary disqualification of a director ought to come from rigorous stock exchange oversight and enforcement (or, alternatively, rigorous fiduciary duties).  The SEC apparently concluded that neither could be counted on and instead simply preempted the requirement.

Full post as published by The Race to the Bottom on July 01, 2009 (boomark / email).