Director independence is a core corporate governance requirement for a Nasdaq listing. It affects whether the board can satisfy the majority independent board standard, whether key committees are properly constituted, and whether the company can make accurate proxy and annual report disclosures about independence determinations. Nasdaq’s approach combines a board judgment standard with bright-line disqualifiers, then layers on committee-specific requirements, especially for the audit committee.
The Nasdaq definition of an independent director, Rule 5605(a)(2)
Nasdaq Listing Rule 5605(a)(2) defines an independent director using a principles-based concept that ultimately requires a board-level judgment. The key phrase is that an independent director is someone without a relationship that, in the board’s opinion, would interfere with independent judgment. Nasdaq’s rule text frames it as a director for whom no relationship would “interfere with the exercise of independent judgment.”
In practice, that means independence is not just a checkbox exercise. Even when a director does not trip any of the bright-line disqualifiers, the board still needs a record that it considered relevant relationships, assessed materiality, and made an affirmative determination.
Nasdaq Bright-line disqualifiers, the tests that preclude independence
Rule 5605(a)(2) includes objective factors that preclude a finding of independence. These are the bright-line disqualifiers most frequently addressed in questionnaires, director and officer due diligence, and proxy disclosure drafting.
- Employment: Current or within the past 3 years employed by the company.
- Family of EO: Family member of current/past-3-year company executive officer. Nasdaq defines ‘Family Member’ broadly to include spouse, parents/children/siblings, in-laws, and anyone sharing the home (other than domestic employees).
- Compensation: Director/family member accepted >$120,000 in any 12-month period in the past 3 years (exceptions: board fees, non-executive officer family employee pay, tax-qualified benefits).
- Organizational Payments: Director/family member is partner/controlling shareholder/executive officer of entity with payments to/from company > greater of 5% revenues or $200,000 in current/past 3 fiscal years (exceptions: securities investments, charitable matching).
- Compensation Interlocks: Director/family member of executive officer at entity where company executive officer served on comp committee in the past 3 years.
- Auditor Ties: Current partner of the company’s auditor, or partner/employee who worked on an audit in the past 3 years.
Note that these are the per se disqualifiers—boards must still affirmatively determine no other relationships impair independence (per IM-5605).
Does stock ownership eliminate independence under Nasdaq rules?
A common misconception is that a meaningful stock position automatically destroys independence. Nasdaq’s interpretive material to Rule 5605(a)(2) says otherwise. Nasdaq explains that “ownership of Company stock by itself” does not preclude a board finding of independence, so ownership is not included among the objective disqualifiers.
This does not mean ownership is irrelevant. The board still evaluates whether a given ownership stake, together with other relationships, could interfere with independent judgment. But the Nasdaq framework is clear that ownership alone is not a per se bar to independence under Rule 5605(a)(2).
Committee overlays, why independence can change by committee
Nasdaq independence is not one size fits all. Nasdaq’s interpretive material notes that there are “additional, more stringent requirements” for audit committee service.
4.1 Audit committee independence, Rule 5605(c) and SEC Rule 10A 3
Rule 5605(c) requires audit committee members to satisfy Rule 5605(a)(2) independence and also meet the SEC audit committee independence criteria under Rule 10A 3, including restrictions on compensatory fees and affiliation.
Practically, that means a director who is independent for general board purposes could still face audit committee limitations if the director’s facts suggest affiliation concerns or prohibited compensatory arrangements.
4.2 Compensation committee and nominating oversight
Nasdaq imposes independent director oversight of compensation and nominations through Rule 5605(d) and Rule 5605(e), including committee structure and charter expectations, with exemptions and phase-ins addressed in Rule 5615.
Board process, disclosure, and how to document independence determinations
A well-run independence process typically includes an annual director and officer questionnaire, a relationship inventory, a committee overlay review, and a board resolution reflecting the affirmative determinations. Securitieslawyer101.com emphasizes that boards must affirmatively determine independence and that meeting the rule criteria does not automatically make a director independent.
For Nasdaq-listed companies other than foreign private issuers, Nasdaq’s interpretive material ties independence determinations to Regulation S K Item 407(a) disclosure.
A useful drafting approach is to align the proxy disclosure with the rule structure. First, state that the board applied Nasdaq Rule 5605(a)(2). Second, state that the board considered all relevant relationships. Third, for each director identified as independent, describe any relationships considered and explain why they do not impair independent judgment, particularly where there are transactions, consulting arrangements, family relationships, or meaningful ownership interests.
Nasdaq Listing Center Q&A guidance, audit committee examples
Nasdaq publishes practical FAQs in its Listing Center Reference Library. These Q &A items are useful because they often answer the procedural questions companies face immediately after a change in committee composition.
Q: Must a company obtain Nasdaq approval to use the exceptional and limited circumstances provision for its audit committee under Rule 5605(c)(2)(B)?
A: Nasdaq’s answer is concise. “No. A company may choose to rely on the exception without obtaining Nasdaq’s approval.”
Q: May a company use the exceptional and limited circumstances provision even if it already has three or more independent directors on the audit committee?
A: Yes, if the individual meets the Section 10A(m)(3) criteria, is not currently an executive officer or employee, is not a family member of an executive officer, and the board determines the appointment is required by the best interests of the company and shareholders.
Q: What happens if an audit committee member resigns and the company falls out of compliance?
A: Nasdaq explains that the company generally has until the earlier of the next annual shareholders meeting or one year from the resignation to replace the member, with a 180-day rule if the annual meeting occurs within 180 days, and that the company must notify Nasdaq immediately upon learning of the resignation.
Q: What if an audit committee member later becomes non-independent for reasons outside the member’s reasonable control?
A: Nasdaq explains the member may remain until the earlier of the next annual meeting or one year from the event, and the company must notify Nasdaq immediately upon learning of the event.
Common scenarios and how Rule 5605 is applied
Scenario 1: an investor director owns 5 percent of the company’s shares
Under Nasdaq’s Rule 5605(a)(2) framework, ownership alone is not an objective disqualifier, and Nasdaq’s interpretive material expressly says ownership by itself does not preclude an independence finding. The board still documents why the director’s ownership does not impair judgment, and separately checks audit committee overlays if the director will serve on the audit committee.
Scenario 2: The director’s law firm provides services to the company
The analysis often turns on whether the director is a partner, controlling shareholder, or executive officer of the firm, and whether payments exceed the greater of 5 percent of the recipient’s revenues or 200,000 dollars. Nasdaq’s interpretive material also notes that a sole proprietorship can pull the analysis into the 120,000 dollars compensation test.
Scenario 3: A former employee is nominated for the board
Rule 5605(a)(2) uses a three-year look back for employment, but boards should also evaluate whether the prior role and any continuing ties could still impair judgment even after the look back period.
Scenario 4: An audit committee member resigns mid-year
Nasdaq’s Q&A points directly to the cure period rule and emphasizes immediate notification to Nasdaq. Compliance teams should have a standing process for tracking committee composition and triggering notifications promptly.
If you are considering listing your company on the Nasdaq or would like to speak with a Securities Attorney, Hamilton & Associates Law Group, P.A. is ready to help. Our Founder, Brenda Hamilton, has over two decades of experience assisting issuers worldwide with going public on the Nasdaq, NYSE, and OTC Markets. You may speak with Brenda Hamilton at (561) 416-8956, or by email at [email protected].