In March, Nasdaq advised Applied Materials (NMS-AMAT) that a member of its audit committee, Y.S. Liu, failed to meet Nasdaq’s independence requirements. Mr. Liu promptly resigned as a member of the committee. The basis upon which Mr. Liu was disqualified suggests that Nasdaq interprets independence strictly. Nasdaq’s action also suggests that it intends to monitor SEC filings aggressively to police compliance with its listing requirements. Nasdaq can be expected to make use of its newly obtained right to issue public letters of reprimand in its enforcement efforts.

Mr. Liu had provided services to the board as a consultant for three months prior to his appointment as a director. He had received as compensation an option to purchase 45,000 shares of the company’s stock. Under the company’s board compensation arrangements, all members of the board receive similar options upon their appointment as directors. Mr. Liu agreed, when he received his options, that if he were later appointed to the board, he would waive the options he would otherwise have received upon appointment. Therefore, from a compensation perspective, the net consequence of Mr. Liu’s service as a consultant was only that he received his options earlier than if he had received them upon his appointment as a director and received three additional months of credit for the purposes of vesting. Regardless of this, and the fact that the options remained unvested at the time of the action by Nasdaq, Nasdaq ruled that the since options had been granted to Mr. Liu as a consultant and were valued in excess of $60,000, based on the Black- Scholes option pricing model, Mr. Liu did not satisfy the independence requirements.

Nasdaq’s rules generally require that each issuer have an audit committee comprised entirely of directors who are independent. Among the requirements for independence are that, with certain exceptions, the person not have accepted payments from the company in excess of $60,000 during any period of twelve consecutive months within the preceding three years. Even though no cash had changed hands, the option granted had not vested, and the net compensation gain that Mr. Liu ultimately enjoyed as a result of his consulting services was three months of credit on the vesting of options he would otherwise have received on his appointment as a director, Nasdaq ruled that Mr. Liu failed to satisfy the prohibition on the receipt of payments in excess of $60,000.

Particularly given Nasdaq’s actions with respect to Applied Materials, issuers should give a broad reading to Nasdaq’s independence requirements when making appointments to their audit committees. Issuers are now on notice that Nasdaq will be giving the requirements such a reading and will not be reluctant to challenge issuers who cross the line.

Nasdaq has now demonstrated its intentions to step up enforcement of its rules by monitoring SEC filings and taking action when it finds violations. In December 2005, Nasdaq was granted the right to issue public letters of reprimand to listed companies for violations of its rules for which delisting would be too harsh a remedy. Nasdaq may well be expected to use this new enforcement tool to increase compliance with its rules. An issuer receiving a letter of reprimand must report the event under Item 3.01 of Form 8-K, disseminate the full text of the letter publicly and consider whether the circumstances warrant an amendment to its Nasdaq corporate governance certification form. While the receipt of a letter of reprimand is a far less serious event than a proposed delisting, it can be damaging to an issuer’s reputation and embarrassing to its management.

For information on Nasdaq’s recent use of letters of reprimand to enforce compliance with its listing standards, click here.

A copy of Applied Materials’ Form 8-K reporting Mr. Liu’s disqualification and resignation is available by clicking here.

Nasdaq’s Marketplace Rules are available by clicking here. 

For further information, please contact William T. Manierre at (415) 774-3283.