Companies are going
public again (or talking about it), and the initial public offering can again
be discussed, without embarrassment, in polite company.
contemplating an IPO needs to address the composition of its board of directors
well in advance of that undertaking.
One recent regulatory thrust of the Securities and Exchange
Commission, acting together with the SROs (self-regulatory organizations such
as the Stock Exchanges and the NASDAQ), has been to make public boards of
directors more powerful.
That thrust has two prongs: First, to place upon directors
more mandatory functions (particularly but not exclusively in the audit and
financial control area), and second, to turn boards into independent watchdogs
by requiring that a majority of the public board (and all members of certain
key committees) be independent of management.
This article will explore how these dual prongs impact on
building a board in anticipation of an IPO.
Although there is no requirement that a newly public company
must list its shares for trading on any particular exchange or through the
auspices of any SRO, we will focus on the steps to be taken by an IPO
registrant intending to have its shares listed for trading on the NASDAQ
National List, a typical approach particularly for technology enterprises.
Other SROs may have different requirements, but those
differences are only in the details, and (given the push by the SEC) not
surprisingly there is a common denominator running through the various SRO
Timing Is Everything
The federal statutory scheme, primarily driven by the
Sarbanes-Oxley Act of 2002, together with the NASDAQ rules, would allow an IPO
company to first comply with certain board composition requirements 90 days
after its IPO.
Although some directors prefer to join boards only after the
completion of the IPO, so as to reduce the risk they may run for any material
misstatements or omissions contained in the IPO prospectus, there may be some
advantage in putting in place a quality board of directors prior to the IPO
Additionally, if board composition requirements are
applicable a mere three months after the IPO, prospective board members must be
identified in advance even if they formally begin to serve only after the
closing of the IPO. Given requirements of director independence, and the other
factors discussed below in building a board, adding more directors is no longer
the quick and casual exercise it might have been prior to Sarbanes-Oxley.
Building The New Public
The most important requirement is that a majority of
directors be “independent.” The concept of an “independent director” is highly
complex and fact-dependent. An independent director cannot have a relationship,
which, in the opinion of the company’s board, would interfere with the exercise
of independent judgment.
Each current and proposed member of the board of directors
must be evaluated with care and sensitivity. “Independence” is primarily driven
by SRO regulation, so our IPO company must keep its NASDAQ rulebook close at
There are certain express ground rules that direct us on the
path of “independence.” You cannot be independent if, among other matters:
by the company or any of its affiliates during the current year or the prior
three years (affiliation generally means that one company controls another or
that the two are under common control);
compensation from the company or its affiliates in excess of $60,000 during the
prior year (except as compensation for service on the board or under certain
other limited circumstances);
“family” is, or in the past three years has been, employed by the company or
its affiliates as an executive officer (“family” actually is described as
“immediate family” and includes spouse, parents, children, siblings, in-laws
and anyone who resides in your home; “executive officer” has the technical
definition contained in an SEC rule under the Securities and Exchange Act of
family member is, a partner, controlling stockholder or executive officer of
another enterprise that has conducted $200,000 of business with the company in
any of the past three years (or if the volume of such business has exceeded 5
percent of the recipient company’s gross);
family member is, or in the prior three years was, a partner or employee of the
company’s audit firm; or
family member is, employed as an executive of another enterprise, and a
company’s executive serves on the compensation committee of that other enterprise
within the prior three years.
These specifics are only examples. The board must determine
whether a proposed member is in fact independent. Recently decided cases have
suggested that independence also can be compromised by a variety of social or
charitable interlocks, which in the past might have been viewed benignly as a
combination of friendship and support for the same good causes.
It is important for a board to make inquiry of its own
members and of executive employees, to ferret out all linkages, who knows whom,
how did the candidate get recommended, by whom and based upon what
relationship, and how close is that relationship to the business of the
company, its other directors and its executives?
Factors Other Than
There are other factors, aside from determining
independence, that may bear upon selection of board members. Expertise in the
company’s business, or expertise in an area which is important to the company’s
growth (such as corporate finance, government contracting, or the guidance of
rapidly expanding enterprises) might be desirable.
Diversity in gender, race or geography may be important,
from a strictly business standpoint or to present the company in a particular
Serving as a director, and particularly serving on certain
committees of public companies, has become very time consuming. Care should be
taken not to add individuals who, because of a combination of other work and/or
directorship responsibilities, will not be able to discharge the directorship
and committee responsibilities you anticipate.
Persons who serve as CEOs, or on audit committees of other
public companies, particularly should consider limiting their involvement in
other public companies to not more than two. Total directorships likely should
not exceed four, although certain professional directors only hold a greater
number of appointments.
In the IPO, or soon thereafter depending on the sequence of
facts, a public company must make substantial disclosures concerning its
directors. These disclosures include business transactions between the company
and a director (or companies affiliated with the director) involving more than
$60,000 annually, and specific information concerning the director’s
employment, past financial problems (personal and with affiliated companies),
criminal or securities law violations and the like. Building a board involves
asking the embarrassing questions so as to pre-qualify potential directors.
“Independent” directors are needed to staff the audit
committee, and any compensation committee or nominating committee that may be
established. How hard are your potential directors willing to work? Naming
three independent directors who might staff all of these committees may not be
very smart. Many companies have at least four independent directors so as to
provide a large enough “working group” (and since independent directors must be
a majority, that means a board of seven).
NASDAQ exempts a company owned 50 percent or more by one
person or entity from most of the foregoing requirements. Thus, a public
holding company with a partially publicly held subsidiary need not fill that
subsidiary’s board with a majority of independent directors. However, certain
requirements remain in place, such as the independence requirement for the audit
committee, and all disclosure requirements that are mandated by SEC (as opposed
to NASDAQ) rules.
The board must elect an audit committee, and Sarbanes-Oxley
places a great deal of responsibility on that committee. The committee must be
entirely made up of independent directors who have certain minimal qualitative
capacity to read and understand financial statements.
Audit committee members also are subject to even stricter
technical independence criteria, as described in SEC Rule 10A-3(b). (A
three-member audit committee can in fact include one non-independent director
who is not a current officer or employee, or family member of a current officer
or employee, under certain limited circumstances for a period of up to two
years, provided the company’s next annual meeting proxy statement discloses the
reasons that the board believes such membership is in the best interest of the
company and its shareholders.)
The audit committee also should have at least one member who
is a “financial expert,” a person with past employment experience in finance or
accounting, a professional certification in accounting, or any other comparable
experience or background that creates financial sophistication.
If an audit committee does not contain such an expert, under
Sarbanes-Oxley Section 407 the company must make an undesirable and perhaps
embarrassing disclosure in its SEC filings as to the reason that it has not
complied with this requirement.
Although not mandated by NASDAQ, many companies have both a compensation
committee and a nominating committee. The compensation committee sets
compensation for executive officers and administers stock option plans. The
nominating committee selects nominees for board positions. If a NASDAQ company
does choose to have either of these committees (which are indeed mandatory for
NYSE listing), the entire membership of these committees similarly must be
The existence of a compensation committee implicates two
The Internal Revenue Code denies a compensation deduction to
public companies paying more than $1,000,000 per year to their CEO and next
four highly compensated executives unless approved by shareholders and payable
solely upon obtaining one or more performance goals determined by a compensation
committee that consists only of two or more “independent” directors.
And the SEC requires public disclosure if any members of a
compensation committee have at any time been an officer or employee of the
company. Similarly, if a company’s executive officer serves on the board or
compensation committee of an enterprise whose executive officers themselves
serve on the company’s board or compensation committee, a disclosure is
required of such “such compensation committee interlock.”
None of these considerations address the important issue of
Not only must directors actually become active participants
in the management of a company; since the regulatory scheme establishes the
independent directors in somewhat of an arms-length relationship to management,
it is also important for management to cause its present board to select
“independent” directors who are committed to civility and to communication.
After going public, when that complaint of irregularity is
lodged with the audit committee against practices of management, company
management will be well-served if it has selected independent directors who
will work with management in a constructive way, so as to resolve tense matters
without impairing shareholder value or destabilizing the company, or its
Stephen M. Honig is a member of Duane Morris’
corporate department, and is a resident in its Boston office. His practice
includes counseling public companies in matters of SEC compliance and corporate