AMEX Rulemaking:
Order Approving Proposed Rule Change Amending the Audit Committee Requirements and Notice of Filing and Order Granting Accelerated Approval of Amendments No. 1 and No. 2 Thereto

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

I. Introduction

On September 20, 1999, the American Stock Exchange LLC ("Amex" 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.

The Federal Register published the proposed rule change for comment on October 13, 1999.³ In response, the Commission received 12 comment letters.⁴ On November 15, 1999 and December 9, 1999, the Exchange submitted Amendments No. 1⁵ 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.

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 In response to the Blue Ribbon Committee's recommendations, the Exchange proposes to amend its listing standards regarding audit committee requirements. The proposed changes cover three general areas: 1) the definition of independence; 2) the structure and membership of the audit committee; and 3) the audit committee charter.

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.

Section 121. Independent Directors and Audit Committee

A. Independent Directors:

The Exchange requires that domestic listed companies have a sufficient number of independent directors to satisfy the audit committee requirement set forth below. Independent directors are not officers of the company and are, in the view of the company's board of directors, free of any relationship that would interfere with the exercise of independent judgment. The following persons shall not be considered independent:

(a) a director who is employed by the corporation or any of its affiliates for the current year or any of the past three years;

(b) a director who accepts any compensation from the corporation or any of its affiliates in excess of $60,000 during the previous fiscal year, other than compensation for board service, benefits under a tax-qualified retirement plan, or non-discretionary compensation;

(c) a director who is a member of the immediate family of an individual who is, or has been in any of the past three years, employed by the corporation or any of its affiliates as an executive officer. Immediate family includes a person's spouse, parents, children, siblings, mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law, and anyone who resides in such person's home;

(d) a director who is a partner in, or a controlling shareholder or an executive officer of, any for-profit business organization to which the corporation made, or from which the corporation received, payments (other than those arising solely from investments in the corporation's securities) that exceed 5% of the corporation's or business organization's consolidated gross revenues for that year, or $200,000, whichever is more, in any of the past three years;

(e) a director who is employed as an executive of another entity where any of the company's executives serve on that entity's compensation committee.

(a) Charter

Each Issuer must certify that it has adopted a formal written audit committee charter and that the Audit Committee has reviewed and reassessed the adequacy of the formal written charter on an annual basis. The charter must specify the following:

(i) the scope of the audit committee's responsibilities, and how it carries out those responsibilities, including structure, processes, and membership requirements;

(ii) the audit committee's responsibility for ensuring its receipt from the outside auditors of a formal written statement delineating all relationships between the auditor and the company, consistent with Independence Standards Board Standard 1, and the audit committee's responsibility for actively engaging in a dialogue with the auditor with respect to any disclosed relationships or services that may impact the objectivity and independence of the auditor and for taking, or recommending that the full board take, appropriate action to [ensure] oversee the independence of the outside auditor; and

(iii) the outside auditor's ultimate accountability to the board of directors and the audit committee, as representatives of shareholders, and these shareholder representatives' 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).

(b) Composition

(i) Each issuer must have, and certify that it has and will continue to have, an audit committee of at least three members, comprised solely of independent directors, each of whom is able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement or will become able to do so within a reasonable period of time after his or her appointment to the audit committee. Additionally, each issuer must certify that it has, and will continue to have, at least one member of the audit committee that has past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual's financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities.

(ii) Notwithstanding paragraph (i), one director who is not independent as defined in [Rule 4200] Section 121A , and is not a current employee or an immediate family member of such employee, may be appointed to the audit committee, if the board, under exceptional and limited circumstances, determines that membership on the committee by the individual is required by the best interests of the corporation and its shareholders, and the board discloses, in the next annual proxy statement subsequent to such determination, the nature of the relationship and the reasons for that determination.

(iii) Exception for Small Business Filers -- Paragraphs (b)(i) and (b)(ii) do not apply to issuers that file reports under SEC Regulation S-B. Such issuers must establish and maintain an Audit Committee of at least two members, a majority of the members of which shall be independent directors.

B. Independence

The Exchange proposes to narrow its current definition of "independent director" by specifying five new relationships that could impair a director's independent judgment as a result of financial, familial, or other material ties to management or the corporation. The proposed definition will apply to all directors, not just those serving on audit committees. Under the proposed rule change, directors with any of the following five relationships will not be considered independent: (1) employment by the corporation or any of its affiliates for the current year or any of the past three years; (2) acceptance of any compensation from the corporation or any of its affiliates in excess of $60,000 during the previous fiscal year, other than compensation for board service, benefits under a tax-qualified retirement plan, or non-discretionary compensation; (3) member of the immediate family of an individual who is, or has been in any of the past three years, employed by the corporation or any of its affiliates as an executive officer; (4) partnership in, or a controlling shareholder or an executive officer of, any for-profit business organization to which the corporation made, or from which the corporation received, payments (other than those arising solely from investments in the corporation's securities) that exceed five percent of the corporation's or business organization's consolidated gross revenues for that year, or $200,000, whichever is more, in any of the past three years; or (5) employment as an executive of another entity where any of the company's executives serve on that entity's compensation committee.

C. Structure and Membership of the Audit Committee

The Exchange also proposes to change the structure and membership qualifications of the audit committee. Specifically, the Exchange proposes to change the required composition of the audit committee from at least two to at least three members. Furthermore, the audit committee must be comprised solely of independent directors rather than a majority of independent directors. The Exchange is conscious of the fact that, in exceptional circumstances, issuers may appropriately conclude that it would be in the best interests of the corporation for a non-independent director to serve on the audit committee. In such exceptional and limited circumstances, a non-independent director can serve on the audit committee, provided that the board determines that it is required by the best interests of the corporation and its shareholders, and the board discloses its reasons for the determination in the next annual proxy statement. Due to the nature of this exception, however, a corporation could have no more than one non-independent director serving on its audit committee. Also, current employees or officers, or their immediate family members, may not serve on the audit committee under this exception.

As a result of the audit committee's responsibility for a corporation'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 member of the audit committee to be able to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statement, or become able to do so within a reasonable period of time after his or her appointment to the audit committee. Furthermore, in order to further enhance the effectiveness of the audit committee, at least one member of the audit committee must have past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background that results in the individual's financial sophistication, including being or having been a chief executive officer, chief financial officer, or other senior officer with financial oversight responsibilities.

The Exchange is sensitive to the potential burden that the proposed changes to the audit committee composition requirements may place on small companies. Therefore, the Exchange proposes to exempt those corporations that file under SEC Regulation S-B from these proposed changes ("Small Business Filers").⁸ Small Business Filers will be held to the existing Exchange requirements with respect to audit committee composition, that is, they must maintain an audit committee of at least two members, a majority of whom are independent.

D. Charter

The Exchange believes that a written charter will help the audit committee as well as management and the corporation's auditors recognize the function of the audit committee and the relationship among these parties. The proposed rule change requires each issuer to adopt a formal written charter. This charter must specify the scope of the audit committee's responsibilities, and how the committee carries out those responsibilities, including structure, processes, and membership requirements. In addition, the charter must specify the audit committee's responsibility for ensuring its receipt from the outside auditors of a formal written statement delineating all relationships between the auditor and the company, consistent with Independence Standards Board Standard 1.⁹ The charter must specify the audit committee's responsibility for actively engaging in a dialogue with the auditor with respect to any disclosed relationships or services that may impact the objectivity and independence of the auditor and for taking, or recommending that the full board take, appropriate action to oversee the independence of the outside auditor. Finally, it must specify the outside auditor's ultimate accountability to the board of directors and the audit committee, as representatives of shareholders, and these shareholder representatives' ultimate authority and responsibility to select, evaluate, and, where appropriate, replace the outside auditor (or to nominate an outside for shareholder approval in any proxy statement). The proposed rule change requires issuers to review their charter on an annual basis.

E. Implementation

In order to minimize disruption to existing issuer audit committees, to permit current audit committee members to serve out their terms, and to allow adequate time to recruit the requisite members, the Exchange proposes to provide its issuers listed as of the effective date of the proposed rule change eighteen months after the proposed rule change is approved by the Commission to meet the audit committee structure and membership requirements.

Additionally, the Exchange proposes that issuers listed as of the effective date of the rule change be provided six months following the date of Commission approval of the proposed rule change to adopt a formal written audit committee charter as required by proposed Section 121(B)(a) of the Amex Company Guide .¹⁰

Further, for issuers that applied for listing prior to the effective date of the proposed rule change, the Exchange proposes that they be able to qualify for listing under the listing standards in force at the time of their application, and to receive the same grace periods provided to currently listed issuers, as described above. Also, in order to avoid prejudicing issuers that transfer to the Exchange from Nasdaq and the New York Stock Exchange, the Exchange proposes that these issuers be afforded the same grace periods they would have received under their previous market's implementation schedule.

III. Comments

As of December 9, 1999, the Commission received 12 comment letters on the proposed rule change.¹¹ In general, the commenters favored the proposed rule change but recommended certain modifications. One commenter stated that it does not support the new rules.¹²

In particular, the CII supports the new requirements, but stated that the proposed override provision, which allows a company's board to include a non-independent director on the audit committee is not appropriate because companies should not have a problem finding financially literate, truly independent directors.¹³ In addition, the AFL-CIO stated that the restriction period for former employees, or relatives of former employees, should be five years instead of three years.¹⁴ The AFL-CIO also stated that the $60,000 threshold to disqualify a candidate because of a significant business relationship is not stringent enough.¹⁵ Another commenter, on the other hand, stated that a quantitative test is too inflexible.¹⁶ Keller and Rowe stated that former non-executive employment should be treated as a significant business relationship.¹⁷ Keller and Rowe 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.¹⁸ According to this comment letter, the company's board should be permitted to determine that the compensation does not impair the director's objectivity. Keller and Rowe also 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.¹⁹

Deloitte stated that requiring a company's board or audit committee to "ensure" the independence of the outside auditor goes beyond what can reasonably be expected of the board and the audit committee in their oversight role.²⁰ Deloitte suggested that the Exchange replace the word "ensure" with "monitor" or "actively oversee."²¹ E&Y supported the proposed rule change, but stated that the Exchange should not exempt Small Business Filers from the financial literacy and expertise requirements and also should expand its definition of immediate family member to include sons-in-law and daughters-in-law.²² NYSBA stated that the company's board should be required to adopt the audit committee charter, rather than the audit committee adopting the charter subject to board approval.²³ NYSBA also opposed requiring the audit committee to evaluate and reassess the adequacy of the audit committee on an annual basis because there is no standard to measure the adequacy of the charter.²⁴

APTC stated that the proposed rule change will be counter productive to the goal of better audit committees.²⁵ 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.²⁶ Moreover, APTC is opposed to the proposal's financial literacy requirement.²⁷ APTC believes that the financial literacy requirement may deprive audit committees of the service of individuals with "exceptional character and/or operational experience."²⁸ The commenter suggested that the Exchange replace this requirement with a requirement that the committee as a whole possess a certain level of financial acumen.²⁹

In addition, the NVCA stated that the proposed rule change should exclude venture capital investors from the independence qualifications.³⁰ The NVCA also stated that the proposed rule change should give companies that have just completed an initial public offering eighteen months to comply with the new requirements and that the exemption for Small Business Filers should be expanded to apply to companies with less than $50 million in revenue.³¹

Finally, three commenters stated that the proposed rule change should not apply to closed-end investment companies.³² ICI and MSDW noted that closed-end investment companies are adequately regulated under the 1940 Act.³³ 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.³⁴

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,³⁵ and, in particular, the requirements of Section 6(b)(5) of the Act.³⁶ 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 statements of companies listed on the Exchange by making it more difficult for companies to inappropriately distort their true financial performance. Further, 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.

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. For these reasons, the Commission 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.³⁷

The Commission also believes that the proposed provision that permits a company to appoint one director to its audit committee who is not independent, 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 requirement that the company disclose in its next proxy statement the nature of the director's relationship to the issuer and the board's reasons for determining the appointment was in the best interests of the corporation will adequately guard against abuse of the proposed exception to the independence requirement. Moreover, the Commission believes that the $60,000 threshold to determine if a potential audit committee director has a significant business relationship with the company is a reasonable measure to balance the company's need to recruit audit committee members with the independence requirement.³⁸

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 Amex. 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 independent. The proposed rule change will not prohibit previously eligible investors from serving on the company's board. The Commission also notes that a venture capital investor that is not considered independent may serve on the company's audit committee, if the board determines it is in the best interests of the corporation and its shareholders and the company discloses its reasons for the determination and the nature of the director's relationship to the company in its next annual proxy statement.

In addition, the Commission believes that requiring 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 the function of the audit committee and the relationship among the parties. Moreover, the Commission believes that requiring the charter to specify that the audit committee is responsible for taking, or recommending that the company's full board take, appropriate action to oversee the independence of the outside auditor will make it more likely that companies will select objective, unbiased auditors.

The Commission believes that the proposed rule change's compositional 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.³⁹ Moreover, the Commission considers that requiring one member of the audit committee to have past employment experience in finance 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. In addition, the Commission does not believe that companies will experience undue difficulty recruiting an audit committee member that satisfies the financial expertise requirements. Moreover, the Commission believes that the proposed rule change appropriately exempts Small Business Filers from the proposed composition requirements because these companies may experience more difficulty meeting these enhanced requirements. The Commission notes that these companies will remain subject to existing Exchange rules on audit committees, which require an audit committee to have at least two members, a majority of whom are independent.

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,⁴⁰ it believes that audit committees do play an important role in overseeing the financial reporting process for investment companies.

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 rely on the protections afforded by the proposed rule change. The Commission notes that Amendment No. 2 simply clarifies that the audit committee is required to oversee, rather than ensure, the independence of the company's outside auditors; makes a technical correction to Section 121A; and expands the Exchange's definition of "immediate family." The Commission believes that accelerated approval will allow the Exchange to simultaneously make all relevant modifications to the Amex Company Guide 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 Sections 6(b)(5)⁴¹ and 19(b)⁴² of the Act.

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, N.W., Washington, D.C. 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 withheld 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 Amex. All submissions should refer to the File No. SR-Amex-99-38 and should be submitted by [insert date 21 days from the date of publication].

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,⁴³ that the amended proposed rule change (SR-Amex-99-38) is approved.

For the Commission, by the Division of Market Regulation, pursuant to delegated authority.⁴⁴

Jonathan G. Katz
Secretary

Footnotes

¹15 U.S.C. 78s(b)(1).

²17 CFR 240.19b-4.

³Securities Exchange Act Release No. 41981 (Oct. 6, 1999), 64 FR 55505. The Nasdaq Stock Market, Inc. and The New York Stock Exchange, Inc. 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. 41980 (Oct. 6, 1999), 64 FR 55514 (Oct. 13, 1999) ("NYSE Proposal").

⁴Most commenters favored the proposed rule change but recommended certain modifications to the proposed rules. The comment letters are discussed in Section III of this order.

⁵Letter from Robert E. Aber, Senior Vice President and General Counsel, Nasdaq-Amex Market Group, to Richard Strasser, Assistant Director, Division of Market Regulation ("Division"), Commission, dated November 12, 1999 ("Amendment No. 1"). The Exchange submitted Amendment No. 1 to require issuers listed as of the effective date of Commission approval of the proposed rule change 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 required charter within eighteen months of the effective date of the proposed rule change. Amendment No. 1 also states that issuers that applied for listing prior to the effective date of the proposed rule change would qualify for listing under the listing standards in force at the time of their application, and receive the same grace periods provided to currently listed issuers.

⁶Letter from Sara Nelson Bloom, Associate General Counsel, Nasdaq-Amex Market Group, to Richard Strasser, Assistant Director, Division, Commission, dated December 8, 1999 ("Amendment No. 2"). The Exchange submitted Amendment No. 2 to revise proposed Section 121B(a)(ii) of the Amex Company Guide to provide that the audit committee is required to oversee the independence of the outside auditor, rather than ensure the independence of the outside auditor. Amendment No. 2 also revises the Exchange's definition of immediate family found in Section 121A(c) to include sons-in-law and daughters-in-law. Finally, Amendment No. 2 corrects a technical error in proposed Section 121B(b)(ii) by replacing a reference to Rule 4200 with a reference to Section 121A.

⁷ Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999) . A copy of this Report [Webmaster note: in PDF format] can be found on-line at www.nasdaqnews.com.

⁸Small 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).

⁹Independence Standard No. 1, Independence Discussions with Audit Committees (January 1999), which can be found on-line at www.cpaindependence.org.

¹⁰ See Amendment No. 1, supra n. 5 .

¹¹ See letters from: Ernst & Young LLP ("E&Y") 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; 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; 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; 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.

¹²APTC Letter at 2.

¹³CII Letter, at 2; see also AFL-CIO Letter at 2.

¹⁴AFL-CIO Letter at 2.

¹⁵ Id.