[Federal Register Volume 64, Number 244 (Tuesday, December 21, 1999)]
[Notices]
[Pages 71523-71529]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-33050]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42231; File No. SR-NASD-99-48]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Amending 
Its 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 National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association''), through its wholly owned 
subsidiary, the Nasdaq Stock Market, Inc. (``Nasdaq''), 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 Nasdaq'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 fourteen 
comment letters. On November 15, 1999 and December 9, 1999, the 
Association submitted Amendments No. 1 \4\ and No. 2,\5\ 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. 41982 (Oct. 6, 1999), 64 
FR 55510. The American Stock Exchange LLC and The New York Stock 
Exchange, Inc. have proposed rule changes relating to audit 
committees. See Securities Exchange Act Release No. 41981 (Oct. 6, 
1999), 64 FR 55505 (Oct. 13, 1999) (``Amex Proposal''), and 
Securities Exchange Act Release No. 41980 (Oct. 6, 1999), 64 FR 
55514 (Oct. 13, 1999) (``NYSE Proposal'').
    \4\ Letter from Robert E. Aber, Senior Vice President and 
General Counsel, Nasdaq-Amex Market Group, to Richard Strasser, 
Assistant Director, Division of Market Regulation, Commission, dated 
November 12, 1999 (``Amendment No. 1''). The Association 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 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. Finally, Amendment No. 1 modifies proposed 
Rule 4320(e)(21) to provide that the requirement that each issuer 
execute a listing agreement will not be construed to require any 
foreign issuer to do any act that is contrary to a law of any public 
authority exercising jurisdiction over the foreign issuer.
    \5\ Letter 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 Association submitted Amendment No. 2 to revise proposed Rules 
4310(c)(26)(A)(ii), 4320(e)(22)(A)(ii), and 4460(d)(1)(B) 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 Nasdaq's definition of 
immediate family found in Rule 4200(a)(15)(c) to include sons-in-law 
and daughters-in-law.
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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.\6\ In response to the 
Blue Ribbon Committee's recommendations, Nasdaq 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.
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    \6\ 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 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.
Rule 4200. Definitions
    (a) For purposes of the Rule 4000 Series, unless the context 
requires otherwise:
    (1)-(14) No change.
    (15) ``Independent director'' means a person other than an officer 
or employee of the company or its subsidiaries or any other individual 
having a relationship which, in the opinion of the company's board of 
directors, would interfere with the exercise of independent judgment in 
carrying out the responsibilities of a director. 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 for 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 executive's serve on that entity's 
compensation committee.
    (15)-(36) renumbered as (16)-(37).
    (b) No change.
Rule 4310. Qualification Requirements for Domestic and Canadian 
Securities
    To qualify for inclusion in Nasdaq, a security of a domestic or 
Canadian issuer shall satisfy all applicable requirements contained in 
paragraphs (a) or (b), and (c) hereof.
    (a)-(b) No change.

[[Page 71524]]

    (c) In addition to the requirements contained in paragraph (a) or 
(b) above, and unless otherwise indicated, a security shall satisfy the 
following criteria for inclusion in Nasdaq:
    (1)-(24) No change.
    (25) Corporate Governance Requirements.
* * * * *
    (A) No change.
    (B) Independent Directors.
    Each issuer shall maintain a sufficient number of independent 
directors on its board of directors to satisfy the audit committee 
requirement set forth in Rule 4310(c)(26)(B).
    (D)-(H) renumbered as (C)-(G).
    (26) Audit Committee.
    (A) Audit Committee 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) Audit Committee 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, 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.
    (26)-(28) renumbered as (27)-(29).
    (d) No change.
Rule 4320. Qualification Requirements for Non-Canadian Foreign 
Securities and American Depositary Receipts
    To qualify for inclusion in Nasdaq, a security of a non-Canadian 
foreign issuer, an American Depositary Receipt (ADR) or similar 
security issued in respect of a security of a foreign issuer shall 
satisfy the requirements of paragraphs (a), (b) or (c), and (d) and (e) 
of this Rule.
    (a)-(d) No change.
    (e) In addition to the requirements contained in paragraphs (a), 
(b) or (c), and (d), the security shall satisfy the following criteria 
for inclusion in Nasdaq:
    (1)-(20) No change.
    (21) Corporate Governance Requirements--No provisions of this 
subparagraph or of subparagraph (24) shall be construed to require any 
foreign issuer to do any act that is contrary to a law, rule or 
regulation of any public authority exercising jurisdiction over such 
issuer or that is contrary to generally accepted business practices in 
the issuer's country of domicile. Nasdaq shall have the ability to 
provide exemptions from the applicability of these provisions as may be 
necessary or appropriate to carry out this intent.
    Nasdaq shall review the issuer's past corporate governance 
activities. This review may include activities taking place while the 
issuer is listed on Nasdaq or an exchange that imposes corporate 
governance requirements, as well as activities taking place after the 
issuer is no longer listed on Nasdaq or an exchange that imposes 
corporate governance requirements. Based on such review, Nasdaq may 
take any appropriate action, including placing of restrictions on or 
additional requirements for listing, or the denial of listing of a 
security if Nasdaq determines that there have been violations or 
evasions of such corporate governance standards. Determinations under 
this subparagraph shall be made on a case-by-case basis as necessary to 
protect investors and the public interest.
    (A) No change.
    (B) Independent Directors.
    Each issuer shall maintain a sufficient number of independent 
directors on its board of directors to satisfy the audit committee 
requirement set forth in Rule 4320(e)(22)(B).
    (D)-(H) renumbered as (C)-(G).
    (22) Audit Committee.
    (A) Audit Committee 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

[[Page 71525]]

    (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) Audit Committee 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, 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.
    (22)-(24) renumbered as (23)-(25).
    (f) No change.
Rule 4460. Non-Quantitative Designation Criteria for Issuers Excepting 
Limited Partnerships
    (a)-(b) No change.
    (c) Independent Directors.
    Each NNM issuer shall maintain a sufficient number of independent 
directors on its board of directors to satisfy the audit committee 
requirement set forth in Rule 4460(d)(2).
    (d) Audit Committee.
    (1) Audit Committee 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:
    (A) the scope of the audit committee's responsibilities, and how it 
carries out those responsibilities, including structure, processes, and 
membership requirements;
    (B) 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
    (C) 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).
    (2) Audit Committee Composition.
    (A) 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 individual's 
financial sophistication, including being or having been a chief 
executive officer, chief financial officer or other senior officer with 
financial oversight responsibilities.
    (B) Notwithstanding paragraph (i), one director who is not 
independent as defined in Rule 4200, 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.
    (C) Exception for Small Business Filers--Paragraphs (2)(A) and 
(2)(B) 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.
    (e)-(n) No change.

B. Independence

    Nasdaq 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 of 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

[[Page 71526]]

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

    Nasdaq also proposes to change the structure and membership 
qualifications of the audit committee. Specifically, Nasdaq 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. Nasdaq 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, Nasdaq 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 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.
    Nasdaq is sensitive to the potential burden that the proposed 
changes to the audit committee composition requirements may place on 
small companies. Therefore, Nasdaq proposes to exempt those 
corporations that file under SEC Regulation S-B (``Small Business 
Filers'').\7\ Small Business Filers will be held to Nasdaq's existing 
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.
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    \7\ 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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D. Charter

    Nasdaq 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 it 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.\8\ The charter must also 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 auditor for shareholder 
approval in any proxy statement). The proposed rule change requires 
issuers to review their charter on an annual basis.
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    \8\ Independence Standard No. 1, Independence Discussions with 
Audit Committees (January 1999), which can be found on-line at 
www.cpaindependence.org.
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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, Nasdaq 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, Nasdaq 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 in compliance with proposed 
Rules 4310(c)(26)(A), 4320(e)(22)(A), or 4460(d)(1).
    Further, for issuers that applied for listing prior to the 
effective date of the proposed rule change, Nasdaq 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 Nasdaq from the 
American Stock Exchange and the New York Stock Exchange, Nasdaq 
proposed 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 14 comment letters 
on the proposed rule change.\9\ In general, the commenters favored the

[[Page 71527]]

proposed rule change but recommended certain modifications. Two 
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; 
PricewaterhouseCoopers LLP (``Price'') dated November 1, 1999; Gary 
P. Kreider (``Kreider'') dated November 5, 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; Investment 
Company Institute (``ICI'') dated November 3, 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; APTC Letter at 2. Kreider stated that 
the proposed rule change ``represent[s] an awkward attempt to 
circumvent state corporate law and micro-manage the functions of 
audit committees.'' Id. at 2.
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    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.\11\ 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.\12\ The AFL-CIO also stated that the $60,000 threshold to 
disqualify a candidate because of a significant business relationship 
is not stringent enough.\13\ Another commenter, on the other hand, 
stated that a quantitative test is too inflexible.\14\ Keller and Rowe 
stated that former non-executive employment should be treated as a 
significant business relationship.\15\ 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.\16\ According to this comment letter, the company's board 
should be permitted to determine that the compensation does not impair 
the director's objectivity.\17\ 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.\18\
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    \11\ CII Letter, at 2; see also AFL-CIO Letter at 2.
    \12\ AFL-CIO Letter at 2.
    \13\ Id.
    \14\ Profusek Letter at 2. In addition, Keller and Rowe stated 
that this provision might preclude a number of highly qualified 
candidates from serving on audit committees. Keller and Rowe Letter 
at 3.
    \15\ Keller and Rowe Letter at 2.
    \16\ Id. at 3.
    \17\ Id.
    \18\ Id.
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    Deloitte and Price each 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.\19\ Deloitte suggested that Nasdaq 
replace the word ``ensure'' with ``monitor'' or ``actively oversee.'' 
\20\ E&Y supported the proposed rule change, but stated that Nasdaq 
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.\21\ 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.\22\
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    \19\ Deloitte Letter at 1; Price Letter at 1.
    \20\ Id. at 2.
    \21\ E&Y Letter at 4.
    \22\ NYSBA Letter at 2.
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    In addition, the NVCA stated that the proposed rule change should 
exclude venture capital investors form the independence 
qualifications.\23\ 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.\24\
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    \23\ NVCA Letter at 5.
    \24\ Id. at 4.
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    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\
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    \25\ APTC Letter at 2.
    \26\ Id. at 3.
    \27\ Id. at 4-5.
    \28\ Id.
    \29\ Id. at 5.
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    Finally, two commenters stated that the proposed rule change should 
not apply to closed-end investment companies.\30\ These commenters 
noted that closed-end investment companies are adequately regulated 
under the 1940 Act.\31\ The commenters also stated that the potential 
abuses that the proposed rule change is designed to address do not 
exist with closed-end investment funds.\32\ Finally, the commenters 
noted that because the assets of these funds consist exclusively of 
investment securities, there is no opportunity to ``manage'' earnings 
or results through selective application of accounting policies.\33\
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    \30\ ICI Letter at 2; MSDW Letter at 1. 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.
    \31\ ICI Letter at 3-4; MSDW Letter at 2.
    \32\ 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.
    \33\ ICI Letter at 3; MSDW Letter at 1.
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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 association,\34\ and, in 
particular, the requirements of Section 15(A)(b)(6) of the Act.\35\ The 
Commission believes that the proposed rule change will protect 
investors by improving the effectiveness of audit committees of 
companies listed on Nasdaq. The Commission also believes that the new 
requirements will enhance the reliability and credibility of financial 
statements of companies listed on Nasdaq by making it more difficult 
for companies to inappropriately distort their true financial 
performance.
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    \34\ In approving the proposal, the Commission has considered 
its impact on efficiency, competition, and capital formation. 15 
U.S.C. 78c(f).
    \35\ 15 U.S.C. 78o-3(b)(6).
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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 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.\36\ 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

[[Page 71528]]

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 annual proxy statement the nature 
of the director's relationship with the company 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.
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    \36\ See Keller and Rowe Letter at 2.
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    The Commission does not believe that venture capital investors 
should be excluded from Nasdaq's definition of independence. The 
Commission does not believe that the proposed rule change will pose an 
undue hardship on venture capital firms or companies listed on Nasdaq. 
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 Nasdaq'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 the committee 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.\37\ 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 Nasdaq's existing rules on audit committees, which 
require an audit committee to have at least two members, a majority of 
whom are independent.
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    \37\ See APTC Letter at 5.
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    Moreover, the Commission does not believe that the proposed rule 
change circumvents state law.\38\ The Commission notes that Nasdaq is 
amending its own qualification requirements governing an issuer's 
listing on Nasdaq, which is an appropriate function for Nasdaq as long 
as those requirements are consistent with the Act.
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    \38\ Kreider Letter at 2.
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    Moreover, the Commission has concluded that Nasdaq'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,\39\ it believes that audit committees do play an important role 
in overseeing the financial reporting process for investment companies.
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    \39\ See Keller and Rowe Letter at 5; ICI Letter at 3; MSDW 
Letter at 1.
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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 merely revises the implementation time periods for the 
proposed rule change 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, and expands Nasdaq's definition of ``immediate 
family.'' The Commission believes that accelerated approval will allow 
Nasdaq to simultaneously make all relevant modifications to its Rules 
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) \40\ and 19(b) 
\41\ of the Act.
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    \40\ 15 U.S.C. 78f(b)(5).
    \41\ 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 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 
NASD. All submissions should refer to the File No. SR-NASD-99-48 and 
should be submitted by January 11, 2000.

[[Page 71529]]

VI. Conclusion

    For the foregoing reasons, the Commission finds that Nasdaq'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,\42\ that the amended proposed rule change (SR-NASD-99-48) is 
approved.
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    \42\ 15. U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\43\
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    \43\ 17. CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 99-33050 Filed 12-20-99; 8:45 am]
BILLING CODE 8010-01-M