This article is reprinted with permission from the
January 31, 1997
edition of

New York Law Journal.
1997 NLP IP Company.


'Non-Employee' and 'Outside' Directors Under SEC, Tax Rules

By Joseph E. Bachelder.


OVER THE NEXT several months public corporations will be addressing issues relating to executive compensation plans and awards. This year, in particular, they will be reviewing whether the relevant committee of the board of directors (usually the compensation committee) qualifies as administrator of the incentive compensation plans subject to new Rule 16b-3 under the Securities and Exchange Act of 1934 (1934 Act).

A large number of public corporations also will be taking steps necessary to assure that incentive plans that were previously grandfathered under the transition rules of Treasury Regulation 1.162-27(h)(3) will now meet the requirements for "performance-based" plans that qualify for exception from the $1 million deduction limitation of 162(m) of the Internal Revenue Code. These requirements, which now must be met by such previously grandfathered plans, include that the plan be administered by a committee of "outside directors."

This column will focus on the different definitional tests that the Securities and Exchange Commission and the Internal Revenue Service have adopted in seeking to assure independence of directors for purposes of these respective rules. (The text of the column does not discuss the shareholder approval requirement, which, under Treasury Regulation 1.162-27(e)(4), accompanies the "outside director" requirement for a performance-based plan, but a brief summary is provided in footnote 8 below.)

'Non-Employee Director'

Effective Aug. 15, 1996, the SEC issued new Rule 16b-3. 1 In that revision, the SEC adopted a new definition of "non-employee directors" (previously, disinterested directors), meaning those directors qualifying under Rule 16b-3 to administer plans. 2

To be eligible as a "non-employee director" under new Rule 16b-3, a director must not

(A) currently be employed by, or be an officer (whether or not an employee) of, the issuer, or the parent or a subsidiary of the issuer;

(B) receive compensation, directly or indirectly, from the issuer, or the parent or a subsidiary of the issuer, for service as a consultant, or in any capacity other than as a director, except for an amount not required to be reported under Item 404(a) of Regulation S-K (an amount not greater than $60,000 in a given year);

(C) have an interest in any other transaction requiring disclosure under Item 404(a) of Regulation S-K; or

(D) be engaged in a business relationship requiring disclosure under Item 404(b) of Regulation S-K (except in the case of law firms and investment banks, generally a relationship in which the amount involved must exceed 5 percent of the consolidated gross revenue of either the issuer or the other entity). 3

Staff Response

Two of the foregoing standards, those described in clauses (C) and (D), raise questions that were addressed in a letter to the staff of the SEC from the American Society of Corporate Secretaries. 4 On Dec. 11, the staff of the SEC gave its response. The staff's general conclusion in respect of the standard described in clause (C) is as follows:

This standard will be satisfied generally if the director does not personally have a material direct or indirect interest for which disclosure is required.

The staff also stated that in applying the standards described in clauses (C) and (D) issuers may rely on the instructions to Item 404(a) and (b). It gave the following illustration:

For example, Instruction 8.A to Item 404(a) provides that a person's interest in a transaction will not be deemed material where it arises only from the person's position as a director of another corporation or organization that is a party to the transaction.

The staff also noted that:

[If] a business relationship does not require disclosure pursuant to Item 404(b) because the 5 percent of consolidated gross revenues standards of that paragraph are not satisfied, transactions pursuant to the relationship need not be disclosed under Item 404(a) unless the public company director derives special benefits from the relationship.

Following are some general observations drawn from the foregoing staff comments. Generally, a director will not be disqualified as a non-employee director merely because he or she is a director of a company with which the issuer engaged in a transaction, or a series of transactions, involving revenues in excess of $60,000 forin the insurer's fiscal year in question.

On the other hand, if such a director derived a special benefit from a transaction, or a series of transactions, involving the issuer and a third party, such director would be disqualified as a non-employee director unless the transaction, or series of transactions, did not involve an amount in excess of $60,000 in the fiscal year in question.

This would be so even if the business relationship did not exceed the 5 percent of consolidated gross revenue standard. (Business relationships involving lawyers and investment bankers are not excluded from disclosure under Item 404(b) even if the revenue the lawyers' and investment bankers' firms receive are less than 5 percent of the revenue of such firms for the year in question. Therefore, practicing lawyers and investment bankers whose firms are retained by the issuer generally will not qualify as non-employee directors.)

In another interpretative letter, responding to questions raised by the American Bar Association Section of Business Law, the staff of the SEC addressed the question of when the status of a director as a non-employee director is determined. 5 As stated in the letter to the staff from the ABA, "[The] test under Item 404 is whether any of the described transactions or relationships have occurred since the beginning of the last fiscal year or are currently proposed. By contrast, the language of Rule 16b-3(h)(3) speaks only in the present tense."

The staff stated, as a general rule:

For purposes of determining whether a director satisfies the tests for Non-Employee Director status set forth in Rules 16b-3(b)(i)(B), (C) and (D), the issuer generally may rely on the Regulation S-K Item 404 disclosure with respect to the issuer's most recently completed fiscal year set forth in the disclosure document most recently filed with the Commission in which Item 404 disclosure is presented (filing).

The staff then qualified this general rule:


Where a transaction or relationship disclosed in the filing . . . was terminated before the director's proposed service as a Non-Employee Director, such transaction or relationship will not bar the director from acting as a Non-Employee Director.


[Because] the Rule 16b-3(b)(3)(i) tests envision compliance at the time the director votes to approve a transaction, the issuer may rely on the positions stated above only where the issuer in good faith believes that any current or contemplated transaction or relationship with such director will not require disclosure under Items 404(a) and (b), respectively, based on information readily available to the issuer and the director at the time such director proposes to act as a Non-Employee Director.

At such time as the issuer in good faith believes, based on information readily available, that a current (or currently contemplated) transaction or relationship with a director will require Item 404(a) or (b) disclosure in a future filing, such director no longer will be eligible to serve as a Non-Employee Director.

Finally, the staff stated that:

[A] determination that a director no longer is eligible to serve as a Non-Employee Director will not result in the retroactive loss of a Rule 16b-3(d)(1) or Rule 16b-3(e) exemption with respect to a transaction previously approved by such director while serving as a Non-Employee Director in reliance on the interpretation set forth above.

In the American Society of Corporate Secretaries letter, the staff clarified how, even if a member of the compensation committee does not qualify as a non-employee director, the compensation committee may function without disqualifying itself for purposes of being authorized to approve a plan. There are two ways this may be accomplished:

1. A subcommittee of the compensation committee, composed solely of two or more non-employee directors may do the approving; or

2. The members of the compensation committee itself who do not qualify as non-employee directors either may abstain or recuse themselves from approving the transaction in question, provided there are two or more non-employee directors remaining on the committee that do the approving.

To qualify under new Rule 16b-3, approval can be given, instead, by the board of directors (including directors who fail to qualify as non-employee directors) or by the shareholders. Of course, action on a particular award or grant by shareholders, or even by the board, may be undesirable or inappropriate. Accordingly, for many public corporations, the qualification of the directors on the committee administering the plan in question as non-employee directors will be an important matter. 6

End of Transition Rule

Under Code 162(m), public companies that had compensation plans approved by shareholders before Dec. 20, 1993, have been "grandfathered" from two requirements for performance-based plans under Code 162(m): (a) shareholder approval of certain required provisions in the plans and (b) administration of the plan by a committee of "outside directors." 7 A performance-based plan is excepted from the $1 million deduction limitation under 162(m).

Under Treasury Regulation 1.162-27(h)(3)(ii) the grandfathering just described comes to an end on the earliest to occur of the following:

(i) expiration or material modification of the plan

(ii) issuance of all the stock and other compensation authorized under the plan

(iii) the first meeting of shareholders at which directors are to be elected that occurs after Dec. 31, 1996.

Many of the companies that have relied on being grandfathered from the shareholder approval and outside director requirements of 162(m) will now need to submit the plan for shareholder approval at the next annual shareholders meeting. At that time the directors administering the previously grandfathered plan must also be "outside directors" within the meaning of the regulations. (This column will not discuss further the shareholder approval requirement except as briefly summarized in the accompanying footnote.) 8

Outside Directors

Following are the requirements under Treasury Regulation 1.162-27(e)(3) that must be met by all members of a compensation committee administering a compensation plan in order for them to be "outside directors" and for the plan to meet the requirements for a performance-based plan:

An "outside director" must not be:

(i) a former employee of the publicly held corporation receiving compensation for prior services (other than under a tax-qualified retirement plan);

(ii) a current employee of the publicly held corporation;

(iii) a former officer of the publicly-held corporation; or

(iv) receiving remuneration, directly or indirectly, from the publicly held corporation in any capacity other than as a director, including remuneration for goods as well as services.

At least some public corporations with previously grandfathered incentive plans will need to comply for the first time with the foregoing two requirements as to shareholder approval and a committee of "outside directors" to administer future awards. As noted, this must be done no later than the forthcoming annual meeting of shareholders.

The "outside director" test for purposes of 162(m) is substantially different from the "non-employee director" test of new Rule 16b-3 described earlier in this column. Qualification of a director under one of the tests quite obviously does not mean the director will qualify under the other.


1 Release No. 34-37260, 61 Fed. Reg. 30,376, June 14, 1996. See this column, July 31, 1996.

2 Id. New Rule 16b-3 substantially liberalized the prior rule, eliminating many of its requirements and replacing the term "disinterested director" with "non-employee director."

3 Rule 16b-3(b)(3)(i). Rule 16b-3(b)(3)(ii) provides that ". . . a Non-Employee Director" of a closed investment company shall mean a director who is not an 'interested person' of the issuer, as that term is defined in 2(a)(19) of the investment Company Act of 1940."

4 American Society of Corporate Secretaries (Dec. 11. 1996). The letter to the SEC and the staff's response address a number of other questions of interpretation under new Rule 16b-3.

5 American Bar Association (Dec. 20, 1996). As in the American Society of Corporate Secretaries letter the staff answers a number of questions in addition to the question discussed in this column.

6 A third interpretative letter has been issued by the SEC staff. Gibson, Dunn & Crutcher LLP (Nov. 2, 1996). That letter is limited to a discussion of the consequences to a director's status in a case in which a family member has an interest in a transaction or a business relationship with an issuer.

7 The transition rules for plans approved by shareholders before Dec. 20, 1993, are set forth in Treas. Reg. 1.162-27(h)(3). Special transition rules for certain non-publicly held corporations that became publicly held are provided in Treas. Reg. 1.162-27(f) and (j)(2)(ii)(iii).

8 To meet the shareholder approval requirement of Treas. Reg. 1.162-27(e)(4), the "material terms" of the performance goal, or goals, must be disclosed to and approved by shareholders before the compensation is paid. Treas. Reg. 1.162-27(e)(4)(i) describes generally what is meant by "material terms" and 1.162-27(e)(4)(ii)-(v), with examples, provides greater detail on what must be disclosed to shareholders. Treas. Reg. 1.162-27(e)(4)(vii) provides that approval by shareholders is sufficient if, in a separate vote, a majority of the votes cast on the issue (including abstentions to the extent abstentions are counted as voting under applicable state law) are cast in favor of approval.