Listing Standards, Director Independence, and the Obligation to Consider Personal and Business Relationships
As we have discussed extensively on this Blog, the stock exchanges recently adopted listing standards that govern compensation committees. As part of the listing standards, the exchanges were required to set out the relevant factors that the board had to consider in determining director independence.
The Commission in the adopting release for Rule 10C-1 instructed the exchanges to consider whether the factors should include "personal and business" relationships between directors and executive officers. Commentators on the proposed listing standards recommended that the factor be included. The NYSE acknowledged that the board was required to consider personal and business relationships when determining independence.
Nonetheless, the exchanges opted not to include personal and business relationships as an explicit factor. They took the position that that listing standards already required board consideration of these relationships and, as a result, they did not need to be explicitly included in the standard. See NYSE Comment Letter ("Commentary to Section 303A.02(a) explicitly notes with respect to the board’s affirmative determination of a director’s independence that the concern is independence from management, and NYSE MKT and NYSE Arca have always interpreted their respective director independence requirements in the same way. Consequently, the NYSE Exchanges do not believe that any further clarification of this requirement is necessary.").
The Commission, in adopting these standards, stated specifically that these factors had to be considered. As the Commission explained:
Although personal and business relationships, related party transactions, and other matters suggested by commenters are not specified either as bright-line disqualifications or explicit factors that must be considered in evaluating a director’s independence, the Commission believes that compliance with NYSE’s rules and the provision noted above would demand consideration of such factors with respect to compensation committee members, as well as to all Independent Directors on the board.
The comment by the SEC clarified the need to consider these factors. Yet the factor did not actually appear in the listing standard. The "geography" of the requirement, however, matters and the failure of the Commission to require explicit inclusion in the listing standard may impair compliance.
In complying with annual legal requirements, directors are typically given a questionnaire and asked for the relevant information. See In re WR Grace & Co., 53 SEC 235, 240 (1997) ("The Company provided Grace, Jr. with directors' and officers' questionnaires ("D&O Questionnaires') in the course of preparing its 1992 Form 10-K and 1993 proxy statement and its 1993 Form 10-K and 1994 proxy statement."). Often, these forms track the language in the relevant statutes or listing requirements.
Because the listing requirements do not explicitly refer to “personal and business” relationships, some questionnaires may not specifically ask for the information. They may simply request that directors disclose "material relationships with the issuer." Directors may not realize that they have to set out personal and business relationships with executive officers. The result is that the factors will not be disclosed to, or considered by, the board when determining director independence.
Lawyers who know about the requirement will presumably insure that the factor is covered by the D&O Questionnaire. Less aware lawyers may not.