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EMPLOYEE BENEFITS MEMORANDUM

DATE: June 11, 1999
RE: Requirements for Outside Director Status

QUESTIONS PRESENTED

  1. What are the requirements for outside director status under Internal Revenue Code ("IRC") § 162(m)?
  2. What are the requirements for non-employee director status under Securities and Exchange Commission ("SEC") rule 16b-3?
  3. In light of the above requirements, can an individual debtor who holds a loan from Bank A be an outside director of Bank A?

DISCUSSION

  1. Requirements under IRC § 162(m).

    Treas. Reg. 1.162-27(e) (as amended in 1996) outlines the requirements needed for an individual to qualify as an outside director under IRC § 162(m).

    1. The individual cannot be a current employee of the corporation. Treas. Reg. § 1.162-27(e)(3)(i)(A) (as amended in 1996). The Internal Revenue Service has said that fees collected by members of boards of directors constitute self-employment income. Thus, corporate directors (in their capacity as such) are not employees of the corporation. 1

    2. The individual cannot be a former employee of the corporation who receives compensation for prior services (other than benefits under a tax-qualified retirement plan) during the taxable year. Treas. Reg. § 1.162-27(e)(3)(i)(B) (as amended in 1996).

    3. The individual cannot have been an officer of the corporation. Treas. Reg. § 1.162-27(e)(3)(i)(C) (as amended in 1996). An officer can be an administrative executive who is or was in regular and continued service. Someone who only has or had the title of 'officer' but lacked the authority of an officer is not an officer. Whether or not the individual is or was an officer depends on the facts and circumstances (including the source of the individual's authority, the term for which the individual is elected or appointed, and the nature and extent of the individual's duties). Treas. Reg. § 1.162-27(e)(3)(vii) (as amended in 1996); Priv. Ltr. Rul. 9732011.

    4. The individual cannot receive remuneration from the corporation, directly or indirectly, in a capacity other than as a director. Remuneration includes any payment for goods or services. Treas. Reg. § 1.162-27(e)(3)(i)(D) (as amended in 1996). Remuneration also includes certain payments to organizations with which the individual is affiliated, as outlined in the following table:

      Type of organization (A) organization -- the director has a beneficial ownership interest of 50% or more (B) organization -- the director has a beneficial ownership interest of 5% to 50% (C) organization -- the director is employed by the organization or is self-employed in a position than as a director
      Definition of remuneration Treas. Reg. § 1.162-27(e)(3)(ii) (as amended in 1996) Payments made in the current year to a director personally or to the organization Payments made in the preceding taxable year (other than de minimis remuneration) to the organization Payments made in the preceding taxable year (other than de minimis remuneration) to the organization
      Definition of de minimis remuneration Treas. Reg. § 1.162-27(e)(3)(iii) (as amended in 1996) Not applicable Payments to the entity of less than 5% of the gross revenue of the entity for the taxable year ending with or within the preceding taxable year, but remuneration in excess of $60,000 is not de minimis. The de minimis level is therefore the lesser of $60,000 or 5% of an entity's gross revenue. Payments to the entity of less than 5% of the gross revenue of the entity for the taxable year ending with or within the preceding taxable year, but remuneration in excess of $60,000 is not de minimis if paid for personal services. For personal services, the de minimis level is the lesser of $60,000 or 5% of an entity's gross revenue.

      In each case, remuneration is considered paid when actually paid or, if earlier, when the corporation becomes liable to pay it.

      Remuneration for personal services is defined under Treas. Reg. § 1.162-27(e)(3)(iv) (as amended in 1996) as: (1) remuneration for personal or professional services performed for the corporation and (2) significant services performed by the director for an entity that provides the personal or professional service or more than 50% of the entity's gross revenues for the preceding taxable year are derived from the corporation. Remuneration for incidental purchases of goods or services is not considered personal services. Treas. Reg. § 1.162-27(e)(3)(iv)(A) (as amended in 1996).

      Given the complexity of the foregoing 162(m) requirements, the general consensus is that an individual will not qualify as an "outside director" if (i) the individual's firm receives more than $60,000 annually or (ii) 5% or more of the firm's annual revenue comes from the corporation with respect to which the individual serves as a director. 2 If, though, the individual has a 50% or greater beneficial ownership interest in the firm, any remuneration received by the firm will disqualify the individual from having outside director status.

  1. Requirements under SEC Rule 16b-3

    Rule 16b-3 requires that an individual meet the following four requirements for non-employee director status:

    1. The individual cannot be a current officer (as defined in 17 C.F.R. § 240.16a-1(f) (1998)) of the issuer or a parent or subsidiary of the issuer, or be a current employee of the issuer, a parent, or a subsidiary. 17 C.F.R. § 240.16b-3(b)(3)(i)(A) (1998). 17 C.F.R. § 240.16a-1(f) (1998) defines officer as a president, vice president, treasurer, secretary, comptroller, and any person who performs policy-making functions for an issuer. An interpretive release, 17 C.F.R. § 241.18114 (1989), notes that persons may be officers if they regularly perform a substantial part of the duties of officers whom they assist. However, an individual is not an officer if his duties are primarily routine administrative duties. Finally, an officer whose title is in name only is not an officer under 17 C.F.R. § 240.16a (1998). 3 17 C.F.R. § 241.18114 (1989).

    2. The individual cannot receive direct or indirect compensation from the issuer, or a parent or subsidiary, for services rendered as a consultant or in any capacity other than as a director, unless the amount would not require disclosure under 17 C.F.R. § 229.404(a) (1998). 17 C.F.R. § 229.404(a) (or Item 404a of Regulation S-K) sets the threshold for disclosure at $60,000. Persons having limited consulting relationships with the issuer may still be non-employee directors. 61 Fed. Reg. 30376 (1996).

    3. The individual cannot possess an interest in any other "transaction" for which disclosure would be required pursuant to 17 C.F.R. § 229.404(a) (1998). 17 CFR § 229.404(a) requires a disclosure of transactions exceeding $60,000 between the registrant and any of its directors or executive officers or members of their immediate family. 4 No disclosure, however, is required if the company judges the transaction to be immaterial to investors. 5 17 C.F.R. § 229.404(a) does not draw a bright line as to what transactions must be disclosed. Rather, 17 C.F.R. § 229.404(a) leaves it to the discretion of the issuer as to whether or not the transaction is material and requires disclosure. The $60,000 materiality threshold in 17 C.F.R. § 229.404(a) is to be applied on a transaction-by-transaction basis, rather than to the total of all transactions unless the transactions are "similar." 6 Moreover, when a corporation makes a loan to an individual before his election as a director, the loan should generally be disclosed in the proxy statement relating to the meeting in which he is nominated. 7 Moreover, disclosure is also not required where the director's indirect interest is immaterial (e.g. if a director is only a director or a limited partner and/or if the director owns less than 10% equity interest in the entity other than a partnership, or if the director holds only an equity or creditor interest in an entity and that entity engages in transactions with the registrant if the transactions are not material to the person). 8 Instruction 8 to Paragraph (a) of Item 404, 17 CFR § 229.404(a).

    4. The individual cannot possess an interest in any other transaction for which disclosure would be required under 17 C.F.R. § 229.404(b) (1998). 17 C.F.R. § 229.404(b) (Item 404(b) of Regulation S-K) lists business "relationships" that must be disclosed. An entity must disclose relationships for the most recent fiscal year with customers, suppliers, law firms, investment banks, creditors, and any other similar relationships between the nominee director and the entity. Generally, if a nominee or director owns or has owned more than 10% equity interest in any entity which makes payments to (customers) or receives payments from (suppliers) the registrant in excess of 5% of either party's consolidated gross revenues for the last fiscal year, then disclosure is required. For creditors, disclosure is required where a director is an executive officer or a 10% shareholder of any business to which the corporation is indebted in an amount greater than 5% of the registrant's assets. 9 With regard to law firms, disclosure is required only when the fees paid exceeds 5% of the law firm's gross revenue for the preceding fiscal year. Commentators have written that 17 C.F.R. § 229.404(b) generally requires disclosure of transactions where the amount involved exceeds 5% of the consolidated gross revenue of either the company or the other entity. 4 Fed. Sec. L. Rep. (CCH) 26,101.064.

CONCLUSION

Regarding the specific question whether loans can prevent an individual from having outside director status, it would be a stretch in my judgment to construe the term "remuneration," as used in Section 162(m), as encompassing loans from the bank to a director. It is less clear whether disclosure of loans is required under 17 C.F.R. § 229.404(a) or 17 C.F.R. § 229.404(b). However, given the precedent of general disclosure set by Regions proxy statements and the existence of 17 C.F.R. § 229.404(c), loans would probably not fall under 17 C.F.R. §§ 229.404(a) or 229.404(b) to disqualify an individual from being a non-employee director under the Section 16(b)-3 regulations.

  1. See generally Tax Mgmt. (BNA) Employment Status - Employee v. Independent Contractor, § 104 Directors, A-50.
  2. For a general discussion of Treas. Reg. § 1.162-27(e)(3) (as amended in 1996), see Tax Mgmt. (BNA) Reasonable Compensation, Detailed Analysis VIII.D, A-34(2). See also Priv. Ltr. Rul. 9731006.
  3. See also Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Livingston, 556 F.2d 1119 (9th Cir. 1978).
  4. See Order Instituting Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Relief, Release No. 34-40446, 1998 WL 635065 (S.E.C.) at *3 (Sept. 17, 1998).
  5. See Valerie F. Jacobs, Registration and Reporting Requirements under the Securities Exchange Act of 1934, in UNDERSTANDING THE SECURITIES LAW, at 503, 557 (PLI Corp. Law & Practice Course Handbook Series Order No. B4-7208, 1997).
  6. HAROLD S. BLOOMENTHAL, GOING PUBLIC AND THE PUBLIC CORPORATION 6.07 (1998).
  7. Id. at 6.07.
  8. Id. at 557-8.
  9. Id. at 558.


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