Self-Regulatory Organizations; Order Approving Proposed Rule Change by the New York Stock Exchange, Inc. Amending the Exchange's Audit Committee Requirements and Notice of Filing and Order Granting Accelerated Approval of Amendments No. 1 and No. 2 Thereto

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42233; File No. SR-NYSE-99-39]

Self-Regulatory Organizations; Order Approving Proposed Rule

Change by the New York Stock Exchange, Inc. Amending the Exchange's

Audit Committee Requirements and Notice of Filing and Order Granting

Accelerated Approval of Amendments No. 1 and No. 2 Thereto

December 14, 1999.

I. Introduction

On September 20, 1999, the New York Stock Exchange, Inc. (``NYSE''

or ``Exchange'') submitted to the Securities and Exchange Commission

(``SEC'' or ``Commission''), pursuant to section 19(b)(1) of the

Securities Exchange Act of 1934 (``Act'') \1\ and Rule 19b-4

thereunder,\2\ a proposed rule change amending the Exchange's audit

committee requirements.

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\1\ 15 U.S.C. 78s(b)(1).

\2\ 17 CFR 240.19b-4.

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The Federal Register published the proposed rule change for comment

on October 13, 1999.\3\ In response, the Commission received 25 comment

letters.\4\ On October 15, 1999 and December 8, 1999, the Exchange

submitted Amendments No. 1 \5\ and No. 2,\6\ respectively, to the

proposed rule change. This order approves the proposed rule change and

grants accelerated approval to Amendments No. 1 and No. 2. The

Commission is also soliciting comment on Amendments No. 1. and No. 2 to

the proposed rule change.

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\3\ Securities Exchange Act Release No. 41980 (Oct. 6, 1999), 64

FR 55514 (Oct. 13, 1999). The Nasdaq Stock Market, Inc. and The

American Stock Exchange LLC have proposed rule changes relating to

audit committees. See Securities Exchange Act Release No. 41982

(Oct. 6, 1999), 64 FR 55510 (Oct. 13, 1999) (``Nasdaq Proposal''),

and Securities Exchange Act Release No. 41981 (Oct. 6, 1999), 64 FR

55505 (Oct. 13, 1999) (``Amex Proposal'').

\4\ The comment letters are discussed in Section III of this

order.

\5\ Letter from James E. Buck, Senior Vice President and

Secretary, NYSE, to Richard Strasser, Assistant Director, Division

of Market Regulation (``Division''), Commission, dated October 14,

1999 (``Amendment No. 1''). The Exchange submitted Amendment No. 1

to require issuers to adopt a formal written audit committee charter

within six months of the effective date of the proposed rule change.

As originally filed, the proposed rule change required issuers to

adopt the charter within eighteen months of the effective date of

the proposed rule change. Amendment No. 1 also extends the

definition of ``officer'' in Rule 16a-1(f) under the Act to

Paragraph 303 of the Exchange's Listed Company Manual. Previously,

the Exchange permitted each company's by-laws and charter to define

this term.

\6\ Letter from James E. Buck, Senior Vice President and

Secretary, NYSE, to Richard Strasser, Assistant Director, Division,

Commission, dated December 6, 1999 (``Amendment No. 2''). Amendment

No. 2 revises proposed rule 303.01(B)(1) to require the board to

adopt the audit committee charter. Under the original proposal, the

audit committee adopted the charter, subject to board approval.

Amendment No. 2 also revises proposed Rule 303.01(B)(1)(c) to

replace the provision that required the board to take appropriate

steps to ensure the independence of the outside auditors. The

revised provision requires the board ``to take appropriate action in

response to the outside auditors report to satisfy itself of the

outside auditor's independence.'' Finally, Amendment No. 2 revises

proposed Rule 303.02 to require companies listing on the Exchange in

conjunction with an initial public offering to have two qualified

audit committee members in place within three months of listing, and

a third qualified member within twelve months of listing.

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II. Description of the Proposed Rule Change

A. Background

In February 1999, the Blue Ribbon Committee on Improving the

Effectiveness of Corporate Audit Committees (``Blue Ribbon Committee'')

issued a report containing recommendations aimed at strengthening the

independence of the audit committee, making the audit committee more

effective, and addressing mechanisms for accountability among the audit

committee, the outside auditors, and management.\7\

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\7\ Report and Recommendations of the Blue Ribbon Committee on

Improving the Effectiveness of Corporate Audit Committees (1999). A

copy of this Report can be found on-line at www.nasdaqnews.com.

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The Exchange distributed to its listed companies the Exchange

staff's suggestions for rule changes in response to the Blue Ribbon

Committee's report. The comments from the Exchange's listed companies

were generally supportive of the suggestions put forth by the Exchange,

with some commenters expressing concerns about ``financial literacy''

requirement.

In response to the Blue Ribbon Committee's recommendations, the

Exchange proposes to revise its listing standards regarding audit

committees. The proposed rule change specifies four requirements for a

qualified audit committee and defines the terms ``Immediate Family''

and ``Affiliate'' for purposes of the proposed audit committee

requirements.

The text of the proposed rule change, as amended by Amendments No.

1 and No. 2, is as follows. Language deleted by Amendments No. 1 and

No. 2 is in brackets. Language added by Amendments No. 1 and No. 2 is

in italics.

NYSE Listed Company Manual

* * * * *

Section 3

Corporate Responsibility

303.00 Corporate Governance Standards

In addition to the numerical listing standards, the Exchange has

adopted certain corporate governance listing standards. These standards

apply to all companies listing common stock on the Exchange. However,

the Exchange does not apply a particular standard to a non-U.S. company

if the company provides the Exchange with a written certification from

independent counsel of the company's country of domicile stating that

the company's corporate governance practices comply with home country

law and the rules of the principal securities market for the company's

stock outside the United States.

303.01 Audit Committee

(A) Audit Committee Policy. Each company must have a qualified

audit committee.

(B) Requirements for a Qualified Audit Committee.

(1) Formal Charter. [Each audit committee must adopt a formal

written charter that is approved by the Board of Directors.] The Board

of Directors must adopt and approve a formal written charter for the

audit committee. The audit committee must review and reassess the

adequacy of the audit committee charter on an annual basis. The charter

must specify the following:

(a) The scope of the audit committee's responsibilities and how it

carries out those responsibilities, including structure, processes and

membership requirements;

(b) That the outside auditor for the company is ultimately

accountable to the Board of Directors and audit committee of the

company, that the

[[Page 71530]]

audit committee and Board of Directors have the ultimate authority and

responsibility to select, evaluate and, where appropriate, replace the

outside auditor (or to nominate the outside auditor to be proposed for

shareholder approval in any proxy statement); and

(c) That the audit committee is responsible for ensuring that the

outside auditor submits on a periodic basis to the audit committee a

formal written statement delineating all relationships between the

auditor and the company and that the audit committee is responsible for

actively engaging in a dialogue with the outside auditor with respect

to any disclosed relationships or services that may impact the

objectivity and independence of the outside auditor and for

recommending that the Board of Directors take appropriate action [to

ensure the independence of the outside auditor] in response to the

outside auditors' report to satisfy itself of the outside auditors'

independence.

(2) Composition/Expertise Requirement of Audit Committee Members.

(a) Each audit committee shall consist of at least three directors,

all of whom have no relationship to the company that may interfere with

the exercise of their independence from management and the company

(``Independent'');

(b) Each member of the audit committee shall be financially

literate, as such qualification is interpreted by the company's Board

of Directors in its business judgment, or must become financially

literate within a reasonable period of time after his or her

appointment to the audit committee; and

(c) At least one member of the audit committee must have accounting

or related financial management expertise, as the Board of Directors

interprets such qualification in its business judgment.

(3) Independence Requirement of Audit Committee Members. In

addition to the definition of Independent provided above in (2)(a), the

following restrictions shall apply to every audit committee member.

(a) Employees. A director who is an employee (including non-

employee executive officers) of the company or any of its affiliates

may not serve on the audit committee until three years following the

termination of his or her employment. In the event the employment

relationship is with a former parent or predecessor of the company, the

director could serve on the audit committee after three years following

the termination of the relationship between the company and the former

parent or predecessor.

(b) Business Relationship. A director (i) Who is a partner,

controlling shareholder, or executive officer of an organization that

has a business relationship with the company, or (ii) Who has a direct

business relationship with the company (e.g., a consultant) may serve

on the audit committee only if the company's Board of Directors

determines in its business judgment that the relationship does not

interfere with the director's exercise of independent judgment. In

making a determination regarding the independence of a director

pursuant to this paragraph, the Board of Directors should consider,

among other things, the materiality of the relationship to the company,

to the director, and, if applicable, to the organization with which the

director is affiliated.

``Business relationships'' can include commercial, industrial,

banking, consulting, legal, accounting and other relationships. A

director can have this relationship directly with the company, or the

director can be a partner, officer or employee of an organization that

has such a relationship. The director may serve on the audit committee

without the above-referenced Board of Directors' determination after

three years following the termination of, as applicable, either (1) The

relationship between the organization with which the director is

affiliated and the company, (2) The relationship between the director

and his or her partnership status, shareholder interest or executive

officer position, or (3) The direct business relationship between the

director and the company.

(c) Cross Compensation Committee Link. A director who is employed

as an executive of another corporation where any of the company's

executives serves on that corporation's compensation committee may not

serve on the audit committee.

(d) Immediate Family. A director who is an Immediate Family member

of an individual who is an executive officer of the company or any of

its affiliates cannot serve on the audit committee until three years

following the termination of such employment relationship. See para.

303.02 for definition of ``Immediate Family.''

303.02 Application Standards

(A) ``Immediate Family'' includes a person's spouse, parents,

children, siblings, mothers-in-law and fathers-in-law, sons and

daughters-in-law, brothers and sisters-in-law, and anyone (other than

employees) who shares such person's home.

(B) ``Affiliate'' includes a subsidiary, sibling company,

predecessor, parent company, or former parent company.

(C) Written Affirmation. As part of the initial listing process,

and with respect to any subsequent changes to the composition of the

audit committee, and otherwise approximately once each year, each

company should provide the Exchange written confirmation regarding:

(1) Any determination that the company's Board of Directors has

made regarding the independence of directors pursuant to any of the

subparagraphs above;

(2) The financial literacy of the audit committee members;

(3) The determination that at least one of the audit committee

members has accounting or related financial management expertise; and

(4) The annual review and reassessment of the adequacy of the audit

committee charter.

(D) Independence Requirement of Audit Committee Members.

Notwithstanding the requirements of subparagraphs (3)(1) and (3)(d) of

para. 303.01, one director who is no longer an employee or who is an

Immediate Family member of a former executive officer of the company or

its affiliates, but is not considered independent pursuant to these

provisions due to the three-year restriction period, may be appointed,

under exceptional and limited circumstances, to the audit committee if

the company's board of directors determines in its business judgment

that membership on the committee by the individual is required by the

best interests of the corporation and its shareholders, and the company

discloses, in the next annual proxy statement subsequent to such

determination, the nature of the relationship and the reasons for that

determination.

(E) ``Officer'' shall have the meaning specified in Rule 16a-1(f)

under the Securities Exchange Act of 1934, or any successor rule.

(F) Initial Public Offering. Companies listing in conjunction with

their initial public offering (including spin-offs and carve outs) will

be required to have two qualified audit committee members in place

within three months of listing and a third qualified member in place

within twelve months of listing.

B. Charter

The Exchange proposes to require audit committees to adopt a formal

written charter that is approved by the company's board and to review

and reassess annually the adequacy of the charter. The charter must

specify: (i)

[[Page 71531]]

The scope of the audit committee's responsibilities and how they are

being carried out; (ii) the ultimate accountability of the outside

auditor to the board and audit committee; (iii) the responsibility of

the audit committee and board for selection, evaluation and replacement

of the outside auditor; and (iv) The responsibility of the audit

committee for ensuring the independence of the outside auditor by

reviewing, and discussing with the board if necessary, any

relationships between the auditor and the company or any other

relationships that may adversely affect the independence of the

auditor.

C. Structure and Membership of the Audit Committee

The Exchange also proposes to change the structure and membership

qualifications of the audit committee. Under the proposed rule change,

each audit committee must have at least three independent directors,

subject to a board override for one director. The board may override

the three-year bar for one audit committee member after finding that an

override is required in the best interests of the company and its

shareholders. If it exercises the override, the company must disclose

in its next annual proxy statement the nature of the relationship and

the reasons for that determination. Potential candidates that are not

considered independent because of a business relationship with the

company or a cross compensation committee link may not be the subject

of a board override.

As a result of the audit committee's responsibility for a company's

accounting and financial reporting, the Exchange believes that audit

committee members should have a basic understanding of financial

statements. Therefore, the proposed rule change requires each audit

committee member to be financially literate, or to become financially

literate within a reasonable period of time after his or her

appointment to the audit committee, as such qualification is

interpreted by the company's board in its business judgment.

Furthermore, in order to further enhance the effectiveness of the audit

committee, the proposal requires at least one member of each audit

committee to have accounting or related financial management expertise,

as the company's board interprets such qualification in its business

judgment.

D. Independence

The proposed rule change places four restrictions on audit

committee members for purposes of determining each member's

independence. First, Employees (including non-employee executive

officers) of the company or its affiliates may not serve on the audit

committee until three years following the termination of employment.

However, if the relationship is with a former parent or predecessor of

the company (see definition of ``Affiliate'' described in Subsection F

below), the three-year bar applies to the time period following the

severance of the relationship between the company and the former parent

or predecessor.

Second, a director: (i) who is a partner, controlling shareholder,

or executive officer of an organization that has a business

relationship with the company, or (ii) who has a direct business

relationship with the company (e.g., a consultant), may serve on the

audit committee only if the company's board determines in its business

judgment that the relationship does not interfere with the director's

exercise of independent judgment. Business relationships can include

commercial, industrial, banking, consulting, legal, accounting and

other relationships. A director can have this relationship directly

with the company, or the director can be a partner, officer or employee

of an organization that has the business relationship.

Third, a director who is employed as an executive of another

corporation where any of the company's executives serves on that

corporation's compensation committee may not serve on the audit

committee.

Fourth, a director who is ``Immediate Family'' (as that term is

defined by proposed Exchange Rule 303.01(B)(3)(d)) of an individual who

is an executive officer of the company or any of its affiliates cannot

serve on the audit committee until three years following the

termination of such employment relationship.

E. Written Affirmation

To monitor compliance with the proposed rule change, the Exchange

proposes to incorporate an ongoing written affirmation requirement. In

this regard, as part of the initial listing process, and with respect

to any subsequent changes to the composition of the audit committee,

and otherwise approximately once each year, each company must provide

the Exchange written confirmation regarding:

(i) Any determination that the company's board has made regarding

the independence of directors;

(ii) The financial literacy of the audit committee members;

(iii) The determination that at least one of the audit committee

members has accounting or related financial management expertise; and

(iv) The annual review and reassessment of the adequacy of the

audit committee charter.

F. Definitions

The Exchange proposes to codify two long-standing interpretations

under the current audit committee requirements as follows:

(i) ``Immediate Family'' includes a person's spouse, parents,

children, siblings, mother-in-law and fathers-in-law, sons and

daughters-in-law, brothers and sisters-in-law, and anyone (other than

employees) who shares such person's home; and

(ii) ``Affiliate'' includes a subsidiary, sibling company,

predecessor, parent company, or former parent company.

G. Implementation

The Exchange proposes to implement a transition period to provide

its issuers with sufficient time to comply with the proposed rule

change. Specifically, the Exchange proposes to: (i) ``grandfather'' all

public company audit committee members qualified under current NYSE

rules until they are re-elected or replaced; and (ii) give companies

that have less than three members on their audit committees eighteen

months from the date of Commission approval of this rule filing to

recruit the requisite members. Issuers listed on the Exchange as of the

effective date of the proposed rule change will have six months to

adopt a formal written audit committee charter.\8\

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\8\ See Amendment No. 1, supra n. 5.

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III. Comments

As of December 9, 1999, the Commission received 25 comment letters

on the proposed rule change.\9\ In

[[Page 71532]]

general, most commenters favored the proposed rule change but

recommended certain modifications. Three commenters opposed the

proposed rule change.\10\

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\9\ See letters from: Ernst & Young LLP (``E&Y'') dated November

1, 1999; Deloitte & Touche LLP (``Deloitte'') dated November 3,

1999; Council of Institutional Investors (``CII'') dated November 8,

1999; Brian T. Borders (on behalf of the National Venture Capital

Association (``NVCA'')) dated November 12, 1999; Investment Company

Institute (``ICI'') dated November 3, 1999; PriceWaterhouseCoopers

LLP (``PWC') dated November 1, 1999; Gary P. Kreider (``Kreider'')

dated November 5, 1999; Emerson Electric Co. (``Emerson'') dated

November 1, 1999; Exxon Corporation (``Exxon'') dated November 3,

1999; McDonald's Corporation (McDonald's) dated November 1, 1999;

Connectiv (``Connectiv'') dated November 2, 1999; Texas Instruments

(``TI'') dated November 2, 1999; Dime Bancorp, Inc. (``Dime'') dated

November 3, 1999; Airlease Management Services, Inc. (``Airlease'')

dated November 3, 1999; The Dun & Bradstreet Corporation (``D&B'')

dated November 3, 1999; EMC Corporation (``EMC'') dated November 1,

1999; Dorsey & Whitney LLP (``Dorsey'') (on behalf of nine closed-

end investment management companies whose stock is listed on the

Exchange) dated October 28, 1999; Massachusetts Financial Services

Company (``MFSC'') (on behalf of six closed-end funds advised by

MFSC) dated November 22, 1999; Meritor Automotive, Inc.

(``Meritor'') dated November 24, 1999; American Federation of Labor

and Congress of Industrial Organizations (``AFL-CIO'') dated

November 29, 1999; Mayer, Brown & Platt on behalf of Morgan Stanley

Dean Witter (``MSDW'') dated November 29, 1999; Arthur Andersen LLP

(``Arthur Andersen'') dated December 3, 1999; Association of

Publicly Traded Companies (``APTC'') dated December 6, 1999; Robert

A. Profusek (``Profusek'') dated December 3, 1999; Stanley Keller

and Richard Rowe (``Keller and Rowe'') dated December 7, 1999; and

The Committee on Securities Regulation of the Business Law Section

of the New York State Bar Association (``NYSBA'') dated December 1,

1999.

\10\ See Kreider Letter at 2; EMC Letter at 2; APTC Letter at 2.

Kreider stated his belief that the proposed rule change circumvents

state corporate law. EMC stated that the proposed rule change

substitutes over-generalized restrictions for the more flexible,

traditional standards of good faith, candor, care and loyalty that

underlie the business judgment rule under state law. EMC also stated

that the independence standards may deprive audit committees of

valuable financially-expert directors.

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In particular, the CII supports the new requirements, but stated

that the proposed board override provision, which allows a company's

board to include a non-independent director on an audit committee, is

not appropriate because companies should not have a problem finding

financially literate, truly independent directors.\11\ In addition, the

AFL-CIO stated that the restriction period for former employees, or

relatives of former employees, should be three years instead of five

years.\12\ MFSC stated that audit committees should not be required to

describe in their charters how they carry out their

responsibilities.\13\

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\11\ CII Letter at 2; see also AFL-CIO Letter at 2.

\12\ AFL-CIO Letter at 2.

\13\ MFSC Letter at 1.

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Many of the commenters pointed to differences between the proposed

rule change, on the one hand, and the Amex Proposal and Nasdaq

Proposal, on the other. Specifically, several commenters stated that

the Exchange should adopt the Amex's and Nasdaq's definitions of

financial literacy and expertise.\14\ These commenters noted that

allowing individual companies to define these terms will lead to

inconsistencies. In addition, several commenters stated that the

proposed rule change will discourage qualified candidates from serving

on audit committees.\15\ Moreover, one commenter stated that the

restriction that prohibits an individual who is an immediate family

member of an executive officer of the company or any of its affiliates

from serving on the audit committee should not be limited to executive

officers.\16\ Finally, three commenters stated that the Exchange should

adopt a bright line test for identifying when a director has a

significant business relationship with the company, as in the Amex

Proposal and Nasdaq Proposal.\17\ On the other hand, another commenter

opposed a bright line test and stated that the Exchange should not

revise its current test to determine if a significant business

relationship exists.\18\

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\14\ Dorsey Letter at 7, 9; E&Y Letter at 3; Connectiv Letter at

2; D&B Letter at 2; Emerson Letter at 2; NYSBA Letter at 5. In

addition, two commenters stated that the terms financial literacy

and expertise are too subjective and should be further defined, but

did not state the Amex/Nasdaq versions should be adopted. See

McDonald's Letter at 1; MFSC Letter at 2. MFSC Letter at 2. MFSC

also stated that it is not reasonable to expect a company's board to

request agreement from a potential audit committee candidate that he

will become financially literate because there are no accreditation

criteria or specific timeframes for completing this undertaking.

MFSC Letter at 2.

\15\ Dime Letter at 2; NVCA Letter at 2; D&B Letter at 2; MFSC

at 2.

\16\ Keller and Rowe Letter at 2.

\17\ E&Y Letter at 2; Emerson at 2; Arthur Andersen Letter at 1.

In addition, the AFL-CIO stated that the NYSE should adopt a bright

line test, but does not think the $60,000 threshold adopted by the

Amex and Nasdaq is stringent enough. AFL-CIO Letter at 3.

\18\ Profusek Letter at 2.

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In addition, one commenter stated that past non-executive

employment should be treated as a significant business

relationship.\19\ This commenter also stated that consultants who

receive from the company more than a de minimis amount of compensation

should be treated as employees, while consultants who do not should be

treated as having a business relationship with the company.\20\

According to the commenter, the company's board should be permitted to

determine that the compensation does not impair the director's

objectivity.\21\ Moreover, the commenter objected to the financial

expertise requirement and stated that no director will want to be

designated the financial expert because of the added exposure to

liability.\22\

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\19\ Keller and Rowe Letter at 2.

\20\ Id at 3.

\21\ Id.

\22\ Id.; see also NYSBA Letter at 6.

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APTC stated that the proposed rule change will be counter

productive to the goal of better audit committees.\23\ In addition,

APTC stated that the proposed rule change will disadvantage smaller

companies more than larger companies, but concluded that it is

appropriate to apply the proposed rule change to all companies,

regardless of size.\24\ Moreover, APTC is opposed to the proposal's

financial literacy requirement.\25\ APTC believes that the financial

literacy requirement may deprive audit committees of the service of

individuals with ``exceptional character and/or operational

experience.'' \26\ The commenter suggested that the Exchange replace

this requirement with a requirement that the committee as a whole

posses a certain level of financial acumen.\27\

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\23\ APTC Letter at 2.

\24\ Id. at 3.

\25\ Id. at 4-5.

\26\ Id.

\27\ Id. at 5.

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TI stated that to reduce unrealistic expectations, the proposed

rule change should require or permit a disclaimer in the audit

committee charter stating that the committee does not provide any

special assurances with regard to the company's financial statements,

nor does the audit committee give a professional evaluation of the

quality of the audits performed by the independent public

accountants.\28\ Exxon and NYSBA stated that the company's board, not

the audit committee, should be required to adopt the audit committee

charter because audit committees are created by the board in its

discretion and under authority granted by state law.\29\

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\28\ TI Letter at 1.

\29\ Exxon Letter at 1; NYSBA Letter at 2.

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Exxon also stated that proposed Rule 303.01(B)(2)(a), which

requires audit committees to have at least three directors, all of whom

must be independent, should provide a business judgment standard for

independence, as subparts (b) and (c) of this Rule do with respect to

financial literary and expertise.\30\ Exxon also stated that proposed

Rule 303.01(B)(1) should not give both the board and the audit

committee ultimate responsibility to select, evaluate, and replace the

outside auditor.\31\ Exxon stated that only one body can have ultimate

authority.\32\ McDonald's stated that a yearly written confirmation

regarding financial literacy, financial expertise, independence of

directors, and adequacy of the audit committee's charter is

unnecessary.\33\

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\30\ Exxon Letter at 2. The Commission notes that proposed Rule

303.01(B)(2)(b) and (c) require each company's board to interpret

the terms ``financial literary'' and ``financial expertise.'' The

business judgment standard therefore applies to the board's

interpretation of these terms. Subpart (a) of the rule does not

require the board to interpret the term ``independence'' and, thus,

there is no need for a business judgment standard.

\31\ Exxon Letter at 1.

\32\ Id.

\33\ McDonald's Letter at 2.

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Deloitte and PWC each stated that requiring a company's board or

audit committee to ``ensure'' the

[[Page 71533]]

independence of the outside auditor goes beyond what can reasonably be

expected of the board and the audit committee in their oversight

role.\34\ Deloitte suggested that the Exchange replace the word

``ensure'' with ``monitor'' or ``actively oversee.'' \35\ E&Y supports

the proposed rule change overall, but stated that Small Business Filers

should not be exempt from the financial literacy and expertise

requirements and that the Exchange should expand its definition of

immediate family member to include sons-in-law and daughters-in-

law.\36\ Airlease stated that smaller companies should not be required

to have three independent auditors on their audit committees.\37\

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\34\ Deloitte Letter at 1; PWC Letter at 1; Meritor Letter at 2.

\35\ Id. at 2.

\36\ E&Y Letter at 4. In addition, the NVCA stated that the

exemption for Small Business Filers should be expanded to apply to

companies with less than $50 million in revenue. NVCA Letter at 4.

The Commission notes, unlike the Nasdaq Proposal and the Amex

Proposal, there is no exemption for Small Business Filers under the

NYSE's proposed rule change.

\37\ Airlease Letter at 1.

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In addition, the NVCA stated that the proposed rule change should

exclude venture capital investors from the independence

qualifications.\38\ The NVCA also stated that the proposed rule change

should give companies that have just completed an initial public

offering (``IPO'') eighteen months to comply with the new

requirements.\39\

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\38\ NVCA Letter at 5.

\39\ Id at 4.

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Three commenters stated that the proposed rule change should not

apply to closed-end investment companies.\40\ ICI and MSDW noted that

closed-end investment companies are adequately regulated under the 1940

Act.\41\ These two commenters also stated that the potential abuses

that the proposed rule change is designed to address do not exist with

respect to closed-end investment funds because the assets of closed-end

funds, consist exclusively of investment securities and thus there is

no opportunity to ``manage'' earnings or results through the selective

application of accounting policies.\42\

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\40\ ICI Letter at 2; MSDW Letter at 1; Keller and Rowe Letter

at 3. In addition, Keller and Rowe stated that the proposed rule

change should exempt all investment companies because their audit

committee members are already required not to be ``interested

persons'' as that term is defined in Section 2(a)(9) of the

Investment Company Act of 1940 (``1940 Act''). Keller and Rowe

Letter at 5. Moreover, Dorsey supported the application of the

proposed rule change to investment companies. Dorsey Letter at 3.

\41\ ICI Letter at 3-4; MSDW Letter at 2.

\42\ ICI Letter at 3; MSDW Letter at 1. ICI and MSDW also noted

that the independent accountants of investment funds are selected by

the independent directors of the fund.

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IV. Discussion

The Commission finds that the proposed rule change is consistent

with the requirements of the Act and the rules and regulations

thereunder applicable to a national securities exchange,\43\ and, in

particular, the requirements of section 6(b)(5) of the Act.\44\ The

Commission believes that the proposed rule change will protect

investors by improving the effectiveness of audit committees of

companies listed on the Exchange. The Commission also believes that the

new requirements will enhance the reliability and credibility of

financial statement of companies listed on the Exchange by making it

more difficult for companies to inappropriately distort their true

financial performance.

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\43\ In approving the proposal, the Commission has considered

its impact on efficiency, competition, and capital formation. 15

U.S.C. 78c(f).

\44\ 15 U.S.C. 78f(b)(5).

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Specifically, the Commission believes that the proposed definition

of independence will promote the quality and reliability of a company's

financial statements. The Commission believes that directors without

financial, familial, or other material personal ties to management will

be more likely to objectively evaluate the propriety of management's

accounting, internal control, and financial reporting practices. The

Commission also believes that the proposal's prohibition against

employees serving on the audit committee is appropriate and that the

Exchange should not be required to distinguish between executive and

non-executive employees.\45\ In addition, the Commission considers that

the proposed provision permitting a company to appoint one non-

independent director to its audit committee, if the board determines

that membership on the committee by the individual is required by the

best interests of the corporation and its shareholders, adequately

balances the need for objective, independent directors with the

company's need for flexibility in exceptional and unusual

circumstances. The Commission believes that the proposal's requirement

that the company disclose in its next annual proxy statement the nature

of the relationship and the board's reasons for determining that the

appointment was in the best interests of the corporation will

adequately guard against abuse of the proposed exception to the

independence requirement.\46\

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\45\ See Keller and Rowe Letter at 2.

\46\ The Commission does not believe that the Exchange should

require its listed companies to adopt a separate provision on

consultants. See Keller and Rowe Letter at 3.

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The Commission does not believe that venture capital investors

should be excluded from the Exchange's definition of independence. The

Commission does not view the proposed rule change as posing an undue

hardship on venture capital firms or companies listed on the NYSE. The

Commission notes that the proposed rule change will only prohibit

venture capital investors from sitting on a company's audit committee

if the investor does not fall within the Exchange's definition of

independence. The proposed rule change will not prohibit previously

eligible investors from serving on the company's board.

In addition, the Commission believes that requiring boards of

directors of listed companies to adopt formal written charters

specifying the audit committee's responsibilities, and how it carries

out those responsibilities, will help the audit committee, management,

investors, and the company's auditors recognize, and understand the

function of the audit committee and the relationship among the parties.

Moreover, the Commission believes that the proposal's requirement that

companies provide yearly written confirmation regarding the

independence, financial literacy, and financial expertise of directors,

as well as the adequacy of the audit committee charter, will help the

Exchange to ensure that listed companies are complying with the

proposed rule change.

The Commission believes that the proposed rule change's requirement

that each issuer have an audit committee composed of three independent

directors who are able to read and understand fundamental financial

statements will enhance the effectiveness of the audit committee and

help to ensure that audit committee members are able to adequately

fulfill their responsibilities. The Commission believes that requiring

each audit committee member to satisfy this standard will help to

ensure that the committee as a whole is financially literate.\47\

Moreover, the Commission believes that requiring one member of the

audit committee to have past employment experience in financial or

accounting, requisite professional certification in accounting, or any

other comparable experience or background that indicates the

individual's financial sophistication, will further enhance the

effectiveness of the audit committee in carrying out its financial

oversight responsibilities. The Commission does

[[Page 71534]]

not believe that these requirements will discourage qualified

candidates from serving on audit committees. Rather, the Commission

believes that these requirements will better enable companies to

identify and select qualified directors. In addition, the Commission

does not believe that companies will experience undue difficulty

recruiting an audit committee member that satisfies the financial

expertise requirements.

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\47\See APTC Letter at 5.

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Moreover, the Commission considers the Exchange's decision to

exempt Small Business Filers as appropriate.\48\ The Commission notes

that relatively few companies that qualify for listing on the Exchange

would also qualify as Small Business Filers under SEC Regulation S-

B.\49\

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\48\ See NVCA and Airlease Letters.

\49\ Small Business Filer is defined by Regulation S-B as an

issuer that: (i) has revenue of less than $25,000,000; (ii) is a

U.S. or Canadian issuer; and (iii) if a majority owned subsidiary,

the parent corporation is a small business issuer. 17 CFR

228.10(a)(1).

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Furthermore, the Commission does not believe that the Exchange

should be required to adopt the Amex and Nasdaq proposed definitions of

financial literacy and expertise or the test to determine when a

potential director has a significant business relationship with the

company. The Commission notes that the proposed rule change is not

inconsistent with the Act.

Moreover, the Commission has concluded that the Exchange's decision

to include investment companies in the proposed rule change is

warranted. While the Commission recognizes that the opportunity for

some types of financial reporting abuses may be limited by the nature

of fund assets,\50\ it believes that audit committees do play an

important role in overseeing the financial reporting process for

investment companies.

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\50\ See Keller and Rowe Letter at 5; ICI Letter at 3; MSDW

Letter at 1.

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Finally, the Commission does not view the proposed rule change as

circumventing state law.\51\ The Commission notes that the Exchange is

amending its own listing standards, which is a function within the

Exchange's discretion, as long as those changes are consistent with the

Act.

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\51\ Kreider Letter at 2.

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The Commission finds good cause for approving Amendments No. 1 and

No. 2 to the proposed rule change prior to the thirtieth day after

publication in the Federal Register. The Commission notes that

Amendment No. 1 revises the implementation time periods for the

proposed rule change solely to provide greater clarity to issuers and

to investors. The Commission believes that Amendment No. 1 will enable

issuers to determine when they must comply with the new requirements

and will enable investors to determine when to reply on the protections

afforded by the proposed rule change. The Commission notes that

Amendment No. 2 simply codifies the Exchange's existing policy on the

timing of audit committee requirements for IPO's; clarifies that the

company's board must take appropriate action to satisfy itself of the

outside auditor's independence, and is not intended to provide an

absolute guarantee of independence; and requires the board to adopt the

audit committee charter, rather than approving the charter adopted by

the audit committee. The Commission believes that accelerated approval

will allow the Exchange to simultaneously make all relevant

modifications to its Listed Company Manual and will avoid potential

confusion. Accordingly, the Commission finds good cause to accelerate

approval of Amendments No. 1 and No. 2 to the proposed rule change,

consistent with the Sections 6(b)(5)\52\ and 19(b)\53\ of the Act.

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\52\ 15 U.S.C. 78f(b)(5).

\53\ 15 U.S.C. 78s(b).

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V. Solicitation of Comments

Interested persons are invited to submit written data, views and

arguments concerning the foregoing, including whether the proposed rule

change is consistent with the Act. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609.

Copies of the submission, all subsequent amendments, all written

statements with respect to the proposed rule change that are filed with

the Commission, and all written communications relating to the proposed

rule change between the Commission and any person, other than those

that may be witheld from the public in accordance with the provisions

of 5 U.S.C. 552, will be available for inspection and copying in the

Commission's Public Reference Room. Copies of such filing will also be

available for inspection and copying at the principal office of the

Exchange. All submissions should refer to the File No. SR-NYSE-99-39

and should be submitted by January 11, 2000.

VI. Conclusion

For the foregoing reasons, the Commission finds that the Exchange's

proposal to amend its audit committee requirements is consistent with

the requirements of the Act and the rules and regulations thereunder.

It Is Therefore Ordered, pursuant to Section 19(b)(2) of the

Act,\54\ that the amended proposed rule change (SR-NYSE-99-39) is

approved.

\54\ 15 U.S.C. 78s(b)(2).

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For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\55\

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\55\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 99-33052 Filed 12-20-99; 8:45 am]

BILLING CODE 8010-01-M