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Director Independence Developments Warrent Review of Policies and Procedures

    Client Alerts
  • October 20, 2008

Public company boards of directors should carefully review their policies and procedures for evaluating director independence in response to two recent developments:

  • The New York Stock Exchange (NYSE), the Nasdaq Stock Market (NASDAQ) and the American Stock Exchange (Amex) have modified certain “bright-line tests” for determining director independence; and
  • The Securities and Exchange Commission (SEC) recently determined that a director of three public companies caused each company to violate federal securities laws and levied substantial personal fines on the director.

Revised Bright-Line Independence Tests

Increased Director Compensation Threshold. The NYSE, NASDAQ and Amex amended the bright-line test for direct compensation of a director or his or her immediate family members by increasing the dollar threshold from $100,000 to $120,000. Accordingly, a director cannot be deemed independent if he or she has received, or has an immediate family member who has received, during any twelve-month period within the three years preceding the independence determination, more than $120,000 in direct compensation from the company. (Note that, as before, amounts received as compensation for board or committee service, compensation paid to an immediate family member who is an employee of the company (other than an executive officer) and benefits under a tax-qualified retirement plan do not count toward the $120,000 limit.)

The amendments were adopted to be consistent with the SEC’s 2006 amendment to Item 404 of Regulation S-K, which increased the threshold for disclosure of related person transactions from $60,000 to $120,000.

(See Section 303A.02(b)(ii) of the NYSE Listed Company Manual, NASDAQ Rule 4200(a)(15)(B) and Section 803(A)(2)(b) of the Amex Company Guide.)

Narrowed Auditor Affiliation Test.
The NYSE further revised its director independence requirements applicable to auditor affiliation. Prior to the amendment, a director could not be deemed independent when an immediate family member was a current employee of the company’s audit firm and participated in the firm’s audit, assurance or tax compliance practice. Consequently, under the previous test, a director would not be independent if, for example, the director’s child took an entry-level staff position and had no involvement with the company’s audit. 

Under the amended test, an independent director may have an immediate family member serving as an employee (but not a partner) of the company’s independent auditor, provided the family member is not personally involved (and has not been personally involved for the past three years) with the company’s audit.

(See Section 303A.02(b)(iii) of the NYSE Listed Company Manual.)

SEC Enforcement Action

Mark C. Thompson was found by the SEC to be the cause of several reporting violations of three public companies on whose boards he served by failing to disclose to the companies his business relationship with Ernst & Young LLP (E&Y), the companies’ independent auditor.

While serving as a director for each of the companies, and as a member of the audit committee for one of the three, Mr. Thompson created a series of business development audio CDs for E&Y to provide to prospective clients. The SEC noted that Mr. Thompson failed to properly disclose this relationship on director and officer questionnaires that he submitted to two companies and that he failed to submit a questionnaire to one of the companies until after tendering his resignation.

As a result:

  • E&Y’s independence as the auditor of the companies was impaired. This caused non-independent audit reports to be filed with the annual reports and proxy statements of two of the companies, in violation of federal securities laws. 
  • The proxy statements filed by all three companies requesting stockholder ratification of the retention of E&Y as independent auditor did not include a description of Mr. Thompson’s relationship with the firm. Because Mr. Thompson favored the recommendation of E&Y as independent auditor, failure to disclose the relationship constituted a violation of federal securities laws.
  • Mr. Thompson was ordered to disgorge to the companies $100,662 of board fees he received during his E&Y business relationship and pay $23,255 in interest. 

(See the full text of the SEC Administrative Proceeding at

Practical Tips

Public companies should take the following actions in light of these recent developments:

  • Review and revise the company’s categorical director independence standards to align with NYSE, NASDAQ or Amex amendments, as applicable.
  • Review and revise the company’s director and officer questionnaire to ensure it fully reflects the director independence test rule changes and captures business relationships with the company’s independent auditor.
  • Include with each questionnaire an “executive summary” reminding directors of:
    • The purposes of the questionnaire;
    • The importance of carefully considering and accurately answering the questions posed, rather than mindlessly checking “no”; and
    • The director’s duty to report promptly to the company any changes in the information provided, including those that may affect independence.