Director Independence

Director independence continues to be a focus of investors and regulators, as evidenced by the new director independence and related person transactions disclosure rules of the Securities and Exchange Commission (SEC), which accompanied the more renowned changes to the SEC's executive compensation disclosure requirements. This article discusses these new SEC disclosure rules as well as the independence criteria and disclosure rules of the New York Stock Exchange (NYSE) and Nasdaq. We review guidelines of proxy advisers, focusing on use of categorical standards to strengthen applied independence criteria, as appropriate, and to filter out certain immaterial relationships that would otherwise need to be specifically considered by a listed company's board in assessing independence. This article summarizes several of the more common types of categorical standards and variations within such standards. Finally, this article provides compliance practice tips.

SEC Disclosure Rules

Public companies must comply with the SEC's new disclosure rules regarding director independence and related person transactions for the 2007 proxy season or earlier if a company files a registration statement on or after Dec. 15, 2006.

Director Independence. Under new Item 407 of SEC Regulation S-K, a listed company must disclose in plain English:

• whether each director who served at any time during the past year and each director nominee is independent (and whether any committee member is not independent) under applicable stock exchange listing standards, and whether the company is relying on any exemptions from applicable independence requirements,
• for companies that have adopted their own definitions of independence for directors and committee members (ie, categorical standards), whether those definitions are posted on the company's Web site and, if not, those definitions must be included as an appendix to the company's proxy statement at least once every 3 years or sooner if the definitions have been materially amended since the company's last fiscal year, and
• on a director-by-director basis, a description, by specific category or type, of any transaction, relationship or arrangement that was: 1) not disclosed as a related person transaction, but 2) considered by the board in determining the independence of the director or director nominee. The new rules do not require disclosure of the specific details of each such relationship, but the description of the category or type must be sufficiently detailed so that its nature is readily apparent.

Using categorical standards of director independence eliminates the need for a board to specifically consider relationships deemed to be categorically immaterial.

Related Person Transactions Consideration of related person transactions overlaps with consideration of director independence. The SEC's amended rules retain the existing principles for disclosure of related person transactions, but eliminate certain bright-line tests in favor of a principles-based materiality analysis. The SEC's amended rules require disclosure in plain English regarding:

• any transaction or series of related transactions, including indebtedness, since the beginning of the company's last fiscal year, or any currently proposed transaction, in which the company was or is to be a participant,
• in which the amount exceeds 120,000 (up from $60,000), and
• in which any related person (in-cluding directors, director nominees, executive officers, 5% shareholders and their respective immediate family members) had or will have a direct or indirect material interest.

The SEC's new rules also require companies to disclose their policies and procedures for reviewing, approving or ratifying any reportable transactions with a related person, which many companies will now need to revise. In addition, a company must identify any disclosed related party transaction that was not subject to the company's policies and procedures or where those policies and procedures were not followed. Related person transaction disclosure requirements should be considered in preparing or revising categorical standards.

NYSE and Nasdaq Director Independence Standards

The NYSE and Nasdaq require listed company boards to make independence determinations based on both objective and subjective standards. The bright-line objective independence standards of the NYSE and Nasdaq apply to relationships of the director and the director's immediate family members (ie, spouse, parents, children, siblings, corresponding in-laws and anyone not a domestic employee sharing such director's home). The objective independence standards, which have a 3-year look-back, address such relationships as employment by the company, compensation by the company for service other than as a director, employment by the internal or external auditor, interlocking directorships, and employment by a company that does significant business with the listed company.

NYSE Subjective Independence Standards

In addition to meeting the NYSE's bright-line objective independence tests, for a director to be independent, his or her board must affirmatively determine that the director has no material relationship directly or indirectly with the listed company, other than as a director. The NYSE requires that listed companies identify which directors are independent and disclose the basis for any determination that a relationship is not material in the company's annual proxy statement or Form 10-K. In this regard, the NYSE permits a board to adopt categorical standards, which must be disclosed, describing relationships that the board has determined are per se immaterial and make a general disclosure if a director meets such standards without detailing particular aspects of immaterial relationships between the director and the company. A board is permitted to determine that a director who fails to meet a categorical standard that it sets for itself is independent, but such determination must be explained.

The NYSE has clarified in frequently asked questions that it is not appropriate for a company to take the position as a categorical matter that any director who passes the NYSE's bright-line objective tests is per se independent, or that all relationships other than those which would disqualify a director from being independent under the NYSE's objective independence tests are per se immaterial.

NASDAQ Subjective Independence Standards

In addition to meeting Nasdaq's objective independence requirements, for a director to be independent the listed company's board must affirmatively determine that the director has no relationship that would interfere with the director's exercise of independent judgment in carrying out the responsibilities of a director. A listed company must disclose in its annual proxy statement or Form 10-K those directors that the board has determined to be independent.

While Nasdaq rules do not explicitly instruct the use of categorical standards, to simplify the process of affirmatively determining which directors are independent and to clearly communicate the basis of such determinations to shareholders in a manner that reduces mistaken assumptions, it would be beneficial for a Nasdaq-listed company to adopt, use and disclose categorical independence standards.

Proxy Adviser and Institutional Shareholder Standards

In developing or revising categorical standards companies should determine who the institutional holders of the company's securities are and obtain copies of their director independence guidelines, if the company has not done this recently. Also, review the director independence guidelines of proxy advisors and other influential shareowner-rights associations, such as the Council of Institutional Investors. These guidelines often suggest stricter independence criteria that boards may want to consider adopting to avoid conflict with such shareholders.

Institutional Shareholder Services (ISS), a leading proxy advisory firm, classifies directors as 'inside directors,' 'affiliated outside directors' or
'independent outside directors' and applies these classifications for various purposes in its voting recommendations. For instance, ISS will recommend 'withhold' votes for director nominees it classifies as 'affiliated outside directors' if such directors serve on a company's audit, compensation or nominating committee. ISS uses its own more stringent objective independence criteria and makes its own subjective determination as to whether a director has 'no material connection to the company other than a board seat.'

The importance of proxy adviser recommendations will increase with the NYSE's proposed amendment to its Rule 452, the so-called 'broker vote rule,' filed by the NYSE filed with the SEC on Oct. 24, 2006. Under the proposed amendment, which is subject to SEC approval, a broker would no longer be permitted to vote shares held in street name in an uncontested director election if the broker does not receive voting instructions from the beneficial owner of the stock within a specified period before the shareholder meeting. Brokers typically vote in favor of the board's director nominees. Elimination of the broker vote rule could have significant impact on the proportions of for and withhold votes, which is particularly relevant if a company has adopted a policy on majority voting in director elections.

Categorical Standards

Provided below is a discussion of the more common types of categorical standards that companies have adopted. Broadly speaking, the categorical standards that companies adopt fall into three classes: 1) standards that specify more restrictive criteria for relationships addressed by objective independence standards; 2) standards that carve out relationships of a type addressed but not disqualified under the objective independence standards; and 3) standards that address relationships not addressed by the objective independence criteria.

Increasing the Look-Back Period

Under this standard, companies increase the NYSE- and Nasdaq-mandated look-back period of 3 years to a more restrictive 4 or 5 years.

Lowering the Threshold for Disqualifying Commercial Transactions

Another example of tightening objective standards, in the case of a NYSE-listed company, is lowering the threshold on disqualifying commercial transactions between a company at which the director is an employee and the listed company to transactions that exceed the greater of $1 million or 1% (rather than 2%) of such other company's gross revenues.

Relationships Arising in the Ordinary Course of Business

Listed companies that sell consumer products or services should not overlook consumer relationships with a director. These relationships can be addressed in a categorical standard that provides that services or goods provided to a director in the ordinary course of the company's business and on substantially the same terms as those prevailing at the time for comparable goods or services provided to unrelated third parties or the company's employees on a broad basis shall not disqualify a director from being independent.

Certain Familial Relationships

The NYSE and Nasdaq both list several disqualifying relationships be-tween a listed company and a director's immediate family members, although Nasdaq uses a different term. Some companies adopt a standard that states a relationship involving a director's relative will not be considered a disqualifying relationship solely by virtue of the family relationship if the relative is not an immediate family member of the director.

Carving Out Payments That Are Not Disqualifying Under Objective Independence Criteria

The NYSE and Nasdaq provide that payments in excess of $100,000 for a NYSE-listed company, or $60,000 for a Nasdaq-listed company, to a director during any 12-month period within the three years preceding the determination of independence for services other than as director disqualify the director from being independent. Certain companies adopt a categorical standard providing that payments that fall under such limit, or that are up to a maximum amount below such limit, do not disqualify a director from being independent.

Contributions to Charitable Organizations

Unlike Nasdaq, the NYSE does not specify an objective limit on the contributions by a listed company to a charitable organization with which a director is affiliated that would disqualify a director from being independent. However, the NYSE requires that a listed company disclose in its proxy statement or annual report contributions in any single fiscal year, within the preceding 3 years, to a tax-exempt organization in which a director serves as an executive officer that exceeded the greater of $1 million, or 2% of such organization's consolidated gross revenues. Certain NYSE listed companies adopt this test as a categorical independence standard. Other companies adopt a modified version of the NYSE disclosure test as a categorical standard, varying: 1) the look-back period for such contributions; 2) the disqualifying threshold amount of such contributions; and 3) the nature of the director's relationship with the charitable organization. A number of companies that adopt a charitable contribution standard do not count contributions made to any charitable organization pursuant to a matching gift program maintained by the listed company and specify as disqualifying any contribution to a family foundation created by a director.

Ownership of Stock of the Listed Company

Both the NYSE and Nasdaq provide that ownership of stock, even a significant amount of stock in the case of the NYSE, of a listed company by itself does not preclude a finding that a director is independent. Share ownership by directors is typically encouraged, and in come cases mandated in company policy, as a means of aligning the personal financial interests of directors with shareholder interests. However, being a significant shareholder may be viewed as compromising independence. The principal consideration is typically whether such significant shareholdings amount to 'control.' A stock ownership categorical standard would generally provide that beneficial ownership of up to a specific percentage of the listed company's stock (typically ranging from 5% to 20%) will not by itself disqualify a director from being independent.

Ownership of a Company That Has a Relationship with the Listed Company

While the NYSE objective independence rules address a director's em-ployment with a company that does business with the listed company, the rules do not address a director's ownership of such a company. Nasdaq objective independence rules address, in addition to employment with such a company, serving as a partner in or controlling shareholder of such a company, but do not address ownership of less than a controlling interest. To fill in this gap, certain companies have adopted a categorical standard providing that a relationship arising solely from a director's ownership interest in a party engaged in a transaction with the listed company shall not disqualify a director from being independent so long as such director's ownership interest does not exceed a certain percentage (typically ranging from 2% to 10%).

Affiliation with a Company Indebted to the Listed Company or to Which the Listed Company Is Indebted

A typical example of this categorical standard provides that a director shall not be deemed to lose his independence if the director is or was an executive officer of another company which is indebted to the listed company, or to which the listed company is indebted, and the total amount of either entity's indebtedness to the other (except amounts due for purchases subject to the usual trade terms or publicly issued debt) in any of the last three years did not exceed 5% of the total consolidated assets of the indebted entity. The principal variations in this standard are: 1) the look-back period; 2) the amount of debt, generally expressed as a percentage of the debtor company's consolidated assets; and 3) the nature of the director's affiliation to the company with a debt relationship with the listed company.

Conclusion

To reduce the possibility of noncompliance with applicable independence rules, companies and their directors must assess director independence more frequently than annually in connection with preparation of the proxy statement and annual report. Continual vigilance is necessary. Adopting appropriate categorical standards eases the burden of continuous assessment by eliminating the need for boards to specifically consider relationships deemed to be categorically immaterial.

Sidebar: SEC Disclosure Rules May be Inconsistent with Proposed Amendments to NYSE Rules

Under proposed amendments to NYSE rules filed with the SEC in late 2005, listed companies would have to disclose that each director either has no relationship with the listed company (other than as a director and/or shareholder) or has only immaterial relationships. If an immaterial relationship exists, a listed company must disclose the relationship along with the basis of the board's determination that the relationship doesn't preclude independence. Alternatively, a board can deem certain relationships are categorically immaterial and disclose such categorical standards. A company would not be able to treat as categorically immaterial any transaction required to be disclosed as a related person transaction under SEC rules.

Unlike the NYSE rules, the SEC's new rules may not permit companies to omit disclosure of an individual relationship deemed categorically immaterial even though it is unnecessary for a board to specifically consider such relationship in assessing independence. Look for clarification from the SEC and/or the coalescing of opinion on this matter.

Sidebar: Practice Tips

• Adopt, or if already adopted, review and, as necessary, update categorical standards of director independence, including standards related to the SEC's new related person transaction rules. Consider whether such independence standards will appear reasonable when disclosed in the proxy with respect to the categories of transactions and relationships that will and will not be considered in making independence determinations.
• Update director and officer questionnaires to address the categorical standards the company adopts and transactions that may need to be disclosed under the SEC's amended related person transaction rules and otherwise to cover a broad array of business and personal relationships and family members.
• Procure the assistance of the finance department to monitor related party transactions that may affect independence. With a list of directors, relatives and organizations with which the directors or their relatives are affiliated, this department can keep an eye out for transactions for disclosure or independence consideration.
• Develop a plan to keep director independence determinations current. Consider requiring directors to provide quarterly updates on their direct and indirect relationships with the company. NYSE-listed companies that have a director whose independence status changes must file an Interim Written Affirmation promptly with the NYSE.

Scott D. McKinney is a counsel at Akin Gump Strauss Hauer & Feld LLP in the corporate finance and mergers and acquisitions practice group in Washington, DC. He can be reached by phone at 202-887-4192 and by e-mail at [email protected].

Director independence continues to be a focus of investors and regulators, as evidenced by the new director independence and related person transactions disclosure rules of the Securities and Exchange Commission (SEC), which accompanied the more renowned changes to the SEC's executive compensation disclosure requirements. This article discusses these new SEC disclosure rules as well as the independence criteria and disclosure rules of the New York Stock Exchange (NYSE) and Nasdaq. We review guidelines of proxy advisers, focusing on use of categorical standards to strengthen applied independence criteria, as appropriate, and to filter out certain immaterial relationships that would otherwise need to be specifically considered by a listed company's board in assessing independence. This article summarizes several of the more common types of categorical standards and variations within such standards. Finally, this article provides compliance practice tips.

SEC Disclosure Rules

Public companies must comply with the SEC's new disclosure rules regarding director independence and related person transactions for the 2007 proxy season or earlier if a company files a registration statement on or after Dec. 15, 2006.

Director Independence. Under new Item 407 of SEC Regulation S-K, a listed company must disclose in plain English:

• whether each director who served at any time during the past year and each director nominee is independent (and whether any committee member is not independent) under applicable stock exchange listing standards, and whether the company is relying on any exemptions from applicable independence requirements,
• for companies that have adopted their own definitions of independence for directors and committee members (ie, categorical standards), whether those definitions are posted on the company's Web site and, if not, those definitions must be included as an appendix to the company's proxy statement at least once every 3 years or sooner if the definitions have been materially amended since the company's last fiscal year, and
• on a director-by-director basis, a description, by specific category or type, of any transaction, relationship or arrangement that was: 1) not disclosed as a related person transaction, but 2) considered by the board in determining the independence of the director or director nominee. The new rules do not require disclosure of the specific details of each such relationship, but the description of the category or type must be sufficiently detailed so that its nature is readily apparent.

Using categorical standards of director independence eliminates the need for a board to specifically consider relationships deemed to be categorically immaterial.

Related Person Transactions Consideration of related person transactions overlaps with consideration of director independence. The SEC's amended rules retain the existing principles for disclosure of related person transactions, but eliminate certain bright-line tests in favor of a principles-based materiality analysis. The SEC's amended rules require disclosure in plain English regarding:

• any transaction or series of related transactions, including indebtedness, since the beginning of the company's last fiscal year, or any currently proposed transaction, in which the company was or is to be a participant,
• in which the amount exceeds 120,000 (up from $60,000), and
• in which any related person (in-cluding directors, director nominees, executive officers, 5% shareholders and their respective immediate family members) had or will have a direct or indirect material interest.

The SEC's new rules also require companies to disclose their policies and procedures for reviewing, approving or ratifying any reportable transactions with a related person, which many companies will now need to revise. In addition, a company must identify any disclosed related party transaction that was not subject to the company's policies and procedures or where those policies and procedures were not followed. Related person transaction disclosure requirements should be considered in preparing or revising categorical standards.

NYSE and Nasdaq Director Independence Standards

The NYSE and Nasdaq require listed company boards to make independence determinations based on both objective and subjective standards. The bright-line objective independence standards of the NYSE and Nasdaq apply to relationships of the director and the director's immediate family members (ie, spouse, parents, children, siblings, corresponding in-laws and anyone not a domestic employee sharing such director's home). The objective independence standards, which have a 3-year look-back, address such relationships as employment by the company, compensation by the company for service other than as a director, employment by the internal or external auditor, interlocking directorships, and employment by a company that does significant business with the listed company.

NYSE Subjective Independence Standards

In addition to meeting the NYSE's bright-line objective independence tests, for a director to be independent, his or her board must affirmatively determine that the director has no material relationship directly or indirectly with the listed company, other than as a director. The NYSE requires that listed companies identify which directors are independent and disclose the basis for any determination that a relationship is not material in the company's annual proxy statement or Form 10-K. In this regard, the NYSE permits a board to adopt categorical standards, which must be disclosed, describing relationships that the board has determined are per se immaterial and make a general disclosure if a director meets such standards without detailing particular aspects of immaterial relationships between the director and the company. A board is permitted to determine that a director who fails to meet a categorical standard that it sets for itself is independent, but such determination must be explained.

The NYSE has clarified in frequently asked questions that it is not appropriate for a company to take the position as a categorical matter that any director who passes the NYSE's bright-line objective tests is per se independent, or that all relationships other than those which would disqualify a director from being independent under the NYSE's objective independence tests are per se immaterial.

NASDAQ Subjective Independence Standards

In addition to meeting Nasdaq's objective independence requirements, for a director to be independent the listed company's board must affirmatively determine that the director has no relationship that would interfere with the director's exercise of independent judgment in carrying out the responsibilities of a director. A listed company must disclose in its annual proxy statement or Form 10-K those directors that the board has determined to be independent.

While Nasdaq rules do not explicitly instruct the use of categorical standards, to simplify the process of affirmatively determining which directors are independent and to clearly communicate the basis of such determinations to shareholders in a manner that reduces mistaken assumptions, it would be beneficial for a Nasdaq-listed company to adopt, use and disclose categorical independence standards.

Proxy Adviser and Institutional Shareholder Standards

In developing or revising categorical standards companies should determine who the institutional holders of the company's securities are and obtain copies of their director independence guidelines, if the company has not done this recently. Also, review the director independence guidelines of proxy advisors and other influential shareowner-rights associations, such as the Council of Institutional Investors. These guidelines often suggest stricter independence criteria that boards may want to consider adopting to avoid conflict with such shareholders.

Institutional Shareholder Services (ISS), a leading proxy advisory firm, classifies directors as 'inside directors,' 'affiliated outside directors' or
'independent outside directors' and applies these classifications for various purposes in its voting recommendations. For instance, ISS will recommend 'withhold' votes for director nominees it classifies as 'affiliated outside directors' if such directors serve on a company's audit, compensation or nominating committee. ISS uses its own more stringent objective independence criteria and makes its own subjective determination as to whether a director has 'no material connection to the company other than a board seat.'

The importance of proxy adviser recommendations will increase with the NYSE's proposed amendment to its Rule 452, the so-called 'broker vote rule,' filed by the NYSE filed with the SEC on Oct. 24, 2006. Under the proposed amendment, which is subject to SEC approval, a broker would no longer be permitted to vote shares held in street name in an uncontested director election if the broker does not receive voting instructions from the beneficial owner of the stock within a specified period before the shareholder meeting. Brokers typically vote in favor of the board's director nominees. Elimination of the broker vote rule could have significant impact on the proportions of for and withhold votes, which is particularly relevant if a company has adopted a policy on majority voting in director elections.

Categorical Standards

Provided below is a discussion of the more common types of categorical standards that companies have adopted. Broadly speaking, the categorical standards that companies adopt fall into three classes: 1) standards that specify more restrictive criteria for relationships addressed by objective independence standards; 2) standards that carve out relationships of a type addressed but not disqualified under the objective independence standards; and 3) standards that address relationships not addressed by the objective independence criteria.

Increasing the Look-Back Period

Under this standard, companies increase the NYSE- and Nasdaq-mandated look-back period of 3 years to a more restrictive 4 or 5 years.

Lowering the Threshold for Disqualifying Commercial Transactions

Another example of tightening objective standards, in the case of a NYSE-listed company, is lowering the threshold on disqualifying commercial transactions between a company at which the director is an employee and the listed company to transactions that exceed the greater of $1 million or 1% (rather than 2%) of such other company's gross revenues.

Relationships Arising in the Ordinary Course of Business

Listed companies that sell consumer products or services should not overlook consumer relationships with a director. These relationships can be addressed in a categorical standard that provides that services or goods provided to a director in the ordinary course of the company's business and on substantially the same terms as those prevailing at the time for comparable goods or services provided to unrelated third parties or the company's employees on a broad basis shall not disqualify a director from being independent.

Certain Familial Relationships

The NYSE and Nasdaq both list several disqualifying relationships be-tween a listed company and a director's immediate family members, although Nasdaq uses a different term. Some companies adopt a standard that states a relationship involving a director's relative will not be considered a disqualifying relationship solely by virtue of the family relationship if the relative is not an immediate family member of the director.

Carving Out Payments That Are Not Disqualifying Under Objective Independence Criteria

The NYSE and Nasdaq provide that payments in excess of $100,000 for a NYSE-listed company, or $60,000 for a Nasdaq-listed company, to a director during any 12-month period within the three years preceding the determination of independence for services other than as director disqualify the director from being independent. Certain companies adopt a categorical standard providing that payments that fall under such limit, or that are up to a maximum amount below such limit, do not disqualify a director from being independent.

Contributions to Charitable Organizations

Unlike Nasdaq, the NYSE does not specify an objective limit on the contributions by a listed company to a charitable organization with which a director is affiliated that would disqualify a director from being independent. However, the NYSE requires that a listed company disclose in its proxy statement or annual report contributions in any single fiscal year, within the preceding 3 years, to a tax-exempt organization in which a director serves as an executive officer that exceeded the greater of $1 million, or 2% of such organization's consolidated gross revenues. Certain NYSE listed companies adopt this test as a categorical independence standard. Other companies adopt a modified version of the NYSE disclosure test as a categorical standard, varying: 1) the look-back period for such contributions; 2) the disqualifying threshold amount of such contributions; and 3) the nature of the director's relationship with the charitable organization. A number of companies that adopt a charitable contribution standard do not count contributions made to any charitable organization pursuant to a matching gift program maintained by the listed company and specify as disqualifying any contribution to a family foundation created by a director.

Ownership of Stock of the Listed Company

Both the NYSE and Nasdaq provide that ownership of stock, even a significant amount of stock in the case of the NYSE, of a listed company by itself does not preclude a finding that a director is independent. Share ownership by directors is typically encouraged, and in come cases mandated in company policy, as a means of aligning the personal financial interests of directors with shareholder interests. However, being a significant shareholder may be viewed as compromising independence. The principal consideration is typically whether such significant shareholdings amount to 'control.' A stock ownership categorical standard would generally provide that beneficial ownership of up to a specific percentage of the listed company's stock (typically ranging from 5% to 20%) will not by itself disqualify a director from being independent.

Ownership of a Company That Has a Relationship with the Listed Company

While the NYSE objective independence rules address a director's em-ployment with a company that does business with the listed company, the rules do not address a director's ownership of such a company. Nasdaq objective independence rules address, in addition to employment with such a company, serving as a partner in or controlling shareholder of such a company, but do not address ownership of less than a controlling interest. To fill in this gap, certain companies have adopted a categorical standard providing that a relationship arising solely from a director's ownership interest in a party engaged in a transaction with the listed company shall not disqualify a director from being independent so long as such director's ownership interest does not exceed a certain percentage (typically ranging from 2% to 10%).

Affiliation with a Company Indebted to the Listed Company or to Which the Listed Company Is Indebted

A typical example of this categorical standard provides that a director shall not be deemed to lose his independence if the director is or was an executive officer of another company which is indebted to the listed company, or to which the listed company is indebted, and the total amount of either entity's indebtedness to the other (except amounts due for purchases subject to the usual trade terms or publicly issued debt) in any of the last three years did not exceed 5% of the total consolidated assets of the indebted entity. The principal variations in this standard are: 1) the look-back period; 2) the amount of debt, generally expressed as a percentage of the debtor company's consolidated assets; and 3) the nature of the director's affiliation to the company with a debt relationship with the listed company.

Conclusion

To reduce the possibility of noncompliance with applicable independence rules, companies and their directors must assess director independence more frequently than annually in connection with preparation of the proxy statement and annual report. Continual vigilance is necessary. Adopting appropriate categorical standards eases the burden of continuous assessment by eliminating the need for boards to specifically consider relationships deemed to be categorically immaterial.

Sidebar: SEC Disclosure Rules May be Inconsistent with Proposed Amendments to NYSE Rules

Under proposed amendments to NYSE rules filed with the SEC in late 2005, listed companies would have to disclose that each director either has no relationship with the listed company (other than as a director and/or shareholder) or has only immaterial relationships. If an immaterial relationship exists, a listed company must disclose the relationship along with the basis of the board's determination that the relationship doesn't preclude independence. Alternatively, a board can deem certain relationships are categorically immaterial and disclose such categorical standards. A company would not be able to treat as categorically immaterial any transaction required to be disclosed as a related person transaction under SEC rules.

Unlike the NYSE rules, the SEC's new rules may not permit companies to omit disclosure of an individual relationship deemed categorically immaterial even though it is unnecessary for a board to specifically consider such relationship in assessing independence. Look for clarification from the SEC and/or the coalescing of opinion on this matter.

Sidebar: Practice Tips

• Adopt, or if already adopted, review and, as necessary, update categorical standards of director independence, including standards related to the SEC's new related person transaction rules. Consider whether such independence standards will appear reasonable when disclosed in the proxy with respect to the categories of transactions and relationships that will and will not be considered in making independence determinations.
• Update director and officer questionnaires to address the categorical standards the company adopts and transactions that may need to be disclosed under the SEC's amended related person transaction rules and otherwise to cover a broad array of business and personal relationships and family members.
• Procure the assistance of the finance department to monitor related party transactions that may affect independence. With a list of directors, relatives and organizations with which the directors or their relatives are affiliated, this department can keep an eye out for transactions for disclosure or independence consideration.
• Develop a plan to keep director independence determinations current. Consider requiring directors to provide quarterly updates on their direct and indirect relationships with the company. NYSE-listed companies that have a director whose independence status changes must file an Interim Written Affirmation promptly with the NYSE.

Scott D. McKinney is a counsel at Akin Gump Strauss Hauer & Feld LLP in the corporate finance and mergers and acquisitions practice group in Washington, DC. He can be reached by phone at 202-887-4192 and by e-mail at [email protected].