Feature

In August 2002, the New York Stock Exchange (NYSE) and NASDAQ asked the Securities and Exchange Commission (SEC) to examine and rule on specific (and stricter) director independence guidelines for their listed companies. These requests focused on the issue of whether a potential conflict of interest arises when corporations make charitable contributions to nonprofits with which a corporate director is affiliated.

After careful consideration, on November 4, 2003, the SEC approved new rules for those corporations that are listed for trading on the NYSE and NASDAQ exchanges. Specifically, the new rules provide guidance on corporate director independence in relation to charitable contributions. Companies have two years to comply with these changes:

NYSE. Generally, for companies listed on the NYSE, a majority of the board of directors must be "independent." A director will only qualify as "independent" if the board affirmatively determines that such person has "no material relationship" with the listed company, either directly or indirectly through another. Thus, under the new rule, a director's independence can be jeopardized if he or she is closely affiliated with a charitable organization that has received a substantial contribution from the listed company. Accordingly, listed companies must disclose contributions to a charity of which a director serves as an executive officer, where such contributions exceed the greater of $1 million or 2 percent of the charitable organization's annual gross revenues. The listed company's boards must also consider the materiality of such relationships in assessing director independence generally.

NASDAQ. As with the NYSE, the NASDAQ rules require that a majority of the board of a listed company be "independent." Under the NASDAQ's new rules, a director will be disqualified from being considered independent if he or she (or a family member) is an executive officer of a charitable organization that receives the greater of $200,000 or 5 percent of its revenue from the listed company. This is also true for a director (or a family member of a director) who is an executive officer of a charitable organization that pays an equivalent amount to the listed company. Payments made under a matching gift program do not count in figuring out whether the $200,000 or 5 percent threshold has been met.

Commentary to the NASDAQ proposal states that the exchange "encourages" companies to go beyond automatic disqualification to "consider other situations where a director or their family member and the company each have a relationship with the same charity when assessing director independence." This suggests that boards should assess whether smaller, but still substantial, gifts impair a director's independence.

Because of the SEC rulings on the NYSE and NASDAQ, public companies are examining the independence of their outside directors, including the relationship between corporate director independence and corporate charitable donations. Of special note is the willingness of companies such as Aetna and GE that established director independence standards before the SEC ruled, and the revisions they made to comply with the rulings.

This updated article (originally published in the October 2003 Corporate Currents newsletter of the Council on Foundations' Corporate Services Department) highlights significant milestones in the debate on corporate governance and director independence, discusses corporate grantmaker responses and provides questions for further exploration.

Examining Corporate Relationships

According to reports in the business press, problems arising from corporate–board relationships emerged in the late 1990s. As New York Attorney General Eliot Spitzer was investigating conflicts of interest from the investment banking and research departments at several Wall Street firms, he uncovered questionable corporate–board relationships, which included allegations of inappropriate corporate–nonprofit affiliations. Although Spitzer's investigation did not result in any criminal charges, these events hinted at the potential problems resulting from CEOs serving on one another's boards, as well as the charitable affiliations between corporations, their directors and the nonprofits with which their directors are associated.

Concurrent with Spitzer's investigation, the Enron scandal unfolded. Although the media focused on the more egregious examples of inappropriate and illegal behavior, allegations were made that company insiders made charitable donations to nonprofits headed by Enron directors to ensure a director's loyalty (Bank and Lublin, The Wall Street Journal, 2003). Corporate governance experts contend that the board relationships had little to do with Enron's demise, but the relationships brought additional attention to issues that sometimes arise from the often interconnected relationships of corporate boards.

Introduction of the Sarbanes-Oxley Act

Concurrent with Spitzer's investigations and the Enron situation, Congress responded by passing the Sarbanes-Oxley Act of 2002. Led by Senator Paul Sarbanes (D-MD) and Representative Michael Oxley (R-OH), the act changed governance of public companies. An early version of that bill in the House of Representatives would have mandated the disclosure of relationships between registered companies and nonprofit organizations if company directors and their family members were also members of the nonprofit's board or were employed by the nonprofit in an executive capacity. Disclosure would have included not only company contributions, but also contributions and volunteer activities of the company's executive officers and members of their families. Although the final language of the act demanded sweeping changes to corporate boards, the nonprofit disclosure provision was dropped, and Sarbanes-Oxley did not require companies to consider charitable gifts when determining director independence.

Stock Exchange Recommendations

Although Sarbanes-Oxley did not ultimately require companies to address links between charitable contributions and directors, the stock exchanges voluntarily addressed this issue as part of changes to the standards companies must meet to have their shares listed for trading. In separate proposals to the SEC (68 Federal Registers 14451 and 19051, respectively), the NYSE and the NASDAQ recommended stricter director independence rules for their listed companies. In March 2003, the SEC requested public comment on those proposals.

The New York Stock Exchange

According to Business 2.0, the NYSE proposed significant changes to its listing standards, including wanting the board of every listed company to have a majority of independent members—directors without any financial interest in the corporation or ties to the company's management.

The NYSE proposal included the following: "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 disclose these determinations…'material' relationships can include commercial, legal, accounting, charitable and familial relationships, among others…the basis for a board determination that a relationship is not material must be disclosed in the company's annual proxy statement…a board may adopt and disclose categorical standards to assist it in making determinations of independence and may make a general disclosure if a director meets these standards. Any determination of independence for a director who does not meet these standards must be specifically explained. A company must disclose any standard it adopts." (68 Federal Register 19051).

Unlike certain other areas where the NYSE specifies a numeric test for assessing independence, the proposal did not explicitly define "material," so it was left to the company's corporate board to decide whether its charitable relationships were material (Bank and Lublin). To simplify the process, the NYSE's proposal allowed individual corporations to set and disclose "categorical standards" to make material determinations. For example, a company could define material contributions as, "charitable contributions that exceed the greater of X dollar amount or Y percent of the recipient's gross revenue."

NASDAQ

The NASDAQ proposal for its listed companies included adoption of a bright-line test for measuring a director/nonprofit relationship: "The NASDAQ would disqualify as independent any director who is an executive officer of a nonprofit organization to which the corporation gives $200,000, or five percent of the nonprofit's annual revenue, whichever is greater."

Reactions

Some corporate governance experts contend that the impact of Sarbanes-Oxley and the stock exchange proposals on director independence will not be felt for many years. Furthermore, some critics believe that such legislation will not alter behavior. According to Linda Selbach, proxy manager for Barclays Global Investors (Task, "In Search of Director Independence," TheStreet.com, 2002), "Mandating honesty is kind of a losing battle; you either are or you aren't. It all comes down to enforcement, penalties for violations and resources for detecting lack of [compliance]. That's going to be a hard one for the stock exchanges to really take on because of the competition between them [for listings]. It's going to be hard for them to speak out against member companies."

Similarly, during the July 2003 Chamber of Commerce/Council on Foundations Tri-Sector Conference on Public-Private-Community Partnerships, in a panel discussion on director independence, a former SEC director noted that the "SEC cannot legislate honesty." With pressing issues facing corporations and corporate boards, how much attention and oversight will be given to the relatively minor issue of corporate philanthropy?

In addition to Enron, there have been documented cases that, on the surface, suggest questionable contributions practices. According to the Washington Post (Hilzenrath, "Directors' Charities Got NYSE Money," 2003), during the tenure of NYSE Director Richard Grasso, "the exchange and its charitable foundation made extensive contributions to organizations affiliated with NYSE directors." NYSE spokesman Robert T. Zito disagreed with Sarah Teslik, Council of Institutional Investors, who said, "Accountability suffers if you buy off your overseers." Said Zito, "We…encourage our people to give back and to serve on charitable organizations…if we can't be a significant voice in our community in terms of helping worthy causes, where can we?"

Several other companies have recently come under media scrutiny for directing money to nonprofits affiliated with former directors. Directors contend that donations would flow into these organizations regardless of whether they were on the corporate board. In fact, some corporate–nonprofit relationships long precede the corporate–director relationship. However, even before the SEC ruled, some companies, including Automatic Data Processing, Dell, NCR, Aetna and GE, instituted limits on contributions to avoid any appearance of conflicts. Their proposals went beyond those of the stock exchanges in imposing limits on company gifts, not just to nonprofits that employ company directors, but also to nonprofits that have a company director on their boards.

Company Responses and Practices

Automatic Data Processing. ADP capped its annual donations to a nonprofit of which a board member is an employee, officer or director at the lesser of $100,000 or one percent of the total contributions the nonprofit receives annually.

Dell. In January 2003, Dell began including its executives' individual charitable contributions in its determination of whether a nonprofit official should be considered an independent director. If Dell and its executives contribute more than one percent of the nonprofits' annual receipts, a review determines the independence of the associated board member (Bank & Lublin).

NCR. Also in January 2003, NCR established director independence standards for its board, stating "a director or director candidate cannot be an executive officer or director of a foundation, university or other nonprofit entity receiving significant contributions from NCR,"
(www.ncr.com/de/corpgovernance/corpgov_director_independence.htm).

Company Responses and Practices

AETNA. In February 2003 Aetna's board of directors adopted standards to help its members avoid conflicts of interest and shed more light on relationships among directors, other companies or nonprofit organizations and Aetna.

Under Aetna's rules, a director could lose independent status if he or she is an officer or director of a nonprofit organization that receives an Aetna charitable contribution representing 5 percent or more of the nonprofit's total annual charity collection. The matching contributions that Aetna makes to its employees' individual donations are not included in the calculation.

According to Bill Casazza, corporate secretary of Aetna, Aetna has always strived to be a "best practice company" in corporate governance. After the passage of Sarbanes-Oxley, Aetna's board decided to adopt guidelines for director independence consistent with the proposed NYSE rules. (Casazza also noted that the company had already decided to undergo a thorough corporate governance review and "the combination of Sarbanes-Oxley, the stock exchange proposals and internal company processes, propelled us to go ahead.")

Before the 5 percent ceiling on charitable contributions, funding of directors' charities was examined on a case-bycase basis. Casazza and Marilda Gándara, executive director of the Aetna Foundation, used a pre-determined figure as a benchmark when directors submitted proposals. Aetna's 5 percent threshold set overall limits on those charitable donations. To ensure all relevant information is gathered and measured, board members are required to identify which charities they are affiliated with in an annual board survey.

Casazza believed that if companies act in a "reasonable and rational manner, maintain their own standards and disclose director information," a uniform, set amount—as recommended by the NASDAQ—should not be required. Companies should be allowed the flexibility to set their own standards.

Update: In compliance with the November 2003 SEC ruling, Aetna amended its guidelines to state a director is not independent if he or she serves as an executive officer of a charitable organization, and Aetna's discretionary charitable contributions to the organization are less than two percent of that organization's annual revenue. The board will annually review commercial and charitable relationships of directors.

GE. According to Marc Saperstein, former president of the GE Foundation and GE vice president for corporate citizenship, GE's chairman and CEO and board of directors drove its corporate governance overhaul. Given GE's commitment to playing a leadership role on governance issues, the board decided not to wait for the SEC's final ruling. Under GE's Governance Principles, "A director will not be independent if, at the time of the independence determination, the director serves as an officer, director or trustee of a charitable organization, and GE's discretionary charitable contributions to the organization are more than one percent of that organization's total annual charitable receipts during its last completed fiscal year. (GE's automatic matching of employee charitable contributions will not be included in the amount of GE's contributions for this purpose)."

Saperstein noted that with strong compliance review processes and a network of approximately 450 auditors and 300 ombudspersons, compliance is embedded in the GE culture.

GE maintains an integrity and compliance policy for its employees known as the Spirit & the Letter, which requires employees to seek approval from their managers before "accepting a board position from a nonprofit entity, where there may be a GE business relationship with the entity or an expectation of financial or other support from GE." Note that "other support" may include charitable donations, but it is not explicitly stated. However, GE's explicit director independence clause has proactively assessed and managed any potential conflicts of interest.

Questions to Explore

The Council suggests exploring the following questions: 

• It is common practice for corporations to make donations to nonprofits with which its directors are affiliated. In fact, nonprofit board members are usually expected to provide financial support through personal giving or fundraising. How have SEC rulings affected your company's board selection and charitable giving?   
• Did your company need to make any changes in its grantmaking program based on the SEC rulings? Will its reporting change?   
• Given the media attention this issue has generated, was your company willing to change its practices, even if the SEC had not mandated any specific limits?

Online Resources

Council on Foundations, www.cof.org

Federal Register, www.gpoaccess.gov/fr/index.html

NASDAQ, www.nasdaq.com

New York Stock Exchange, www.nyse.com

Securities Exchange Commission, www.sec.gov

NCR, www.ncr.com/de/corpgovernance/corpgov_director_independence.htm

Aetna, www.aetna.com/governance/independence_standards.html

GE, www.ge.com/en/citizenship/governance/govprinc.htm

Additional Resources

Bank, David and Joann S. Lublin, "Officials From Nonprofits Spark Concern When Directors' Position Helps Raise Funds," The Wall Street Journal, June 20, 2003.

The NASDAQ proposal appeared in 68 Federal Register 14451, March 25, 2003.

The NYSE proposal appeared in 68 Federal Register 19051, April 17, 2003.

Hellweg, Eric, "Can Wall Street Reform Itself?" Business 2.0, June 12, 2002.

Task, L. Aaron, "In Search of Director Independence," TheStreet.com, October 15, 2002.

Norton, Leslie P., "Sweet Charity: Should the Head of a NonProfit be on the Compensation Committee of One of its Corporate Donors?," Barron's, March 31, 2003.

Hilzenrath, David S., "Directors' Charities Got NYSE Money," The Washington Post, September 19, 2003.