[Federal Register Volume 66, Number 32 (Thursday, February 15, 2001)]
[Notices]
[Pages 10545-10547]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-3803]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43941; File No. SR-PCX-00-40]


Self-Regulatory Organizations; Order Approving a Proposed Rule 
Change by the Pacific Exchange, Inc. Relating to Audit Committee 
Requirements for Listed Companies

    February 7, 2001.

I. Introduction

    On October 23, 2000, the Pacific Exchange, Inc. (``PCX'' or 
``Exchange''), through its wholly-owned subsidiary, PCX Equities, Inc. 
(``PCXE''), submitted to the Secreties 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 PCXE's audit committee requirements. 
PCXE filed Amendment No. 1 to the proposed rule change on November 22, 
2000.\3\ The Federal Register published the proposed rule change for 
comment on December 7, 2000.\4\ The Commission received no comments on 
the proposal. This order approves the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Letter dated November 20, 2000 from Cindy L. Sink, Senior 
Attorney, PCX, to Nancy Sanow, Assistant Director, Division of 
Market Regulation, Commission (``Amendment No. 1''). Amendment No. 1 
specifies an implementation plan for the proposed rule change.
    \4\ Securities Exchange Act Release No. 43641 (Nov. 29, 2000), 
64 FR 55514.
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II. Description of the Proposed Rule Change

    PCXE proposes to modify PCXE Rule 5.3(b), regarding audit committee 
requirements for listed domestic issuers, to conform to recommendations 
made by the Blue Ribbon Committee on Improving Effectiveness of 
Corporate Audit Committees and rule changes adopted by other self-
regulatory organizations (``SROs'').\5\ The proposed rule change 
specifies four requirements for qualified audit committees, defines 
certain terms for purposes of the proposed audit committee 
requirements, and sets forth requirements for companies listing on PCXE 
in conjunction with an initial public offering.
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    \5\ See Securities Exchange Act Release Nos. 42231 (Dec. 14, 
1999), 64 FR 71523 (Dec. 21, 1999) (approving SR-NASD-99-48); 42232 
(Dec. 14, 1999), 64 FR 71518 (Dec. 21, 1999) (approving SR-AMEX-99-
38); 42233 (Dec. 14, 1999), 64 FR 71529 (Dec. 21, 1999) (approving 
SR-NYSE-99-39).
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    First, proposed rule 5.3(b)(1) requires the board of directors of 
companies listed on PCXE to adopt and approve a

[[Page 10546]]

formal written charter for the audit committee. The audit committee 
must review and reassess the adequacy of the formal written charter on 
annual basis. The charter must specify: (i) The scope of the audit 
committee's responsibilities and how it carries out those 
responsibilities, including structure, processes, and membership 
requirements; (ii) that the outside auditor is ultimately accountable 
to the board of directors and the audit committee of the company, and 
that the 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); (iii) 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; (iv) 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 
(v) that the audit committee is responsible for recommending that the 
board of directors take appropriate action in response to the outside 
auditor's report to satisfy itself of the outside auditor's 
independence.
    Second, proposed Rule 5.3(b)(2) sets forth the composition and 
expertise requirements of audit committee members. The proposal 
requires: (i) Each audit committee to consist of at least three 
independent 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''); (ii) each member of the 
audit committee to be financially literate, as such qualification is 
interpreted by the company's board of directors in its business 
judgment, or to become financially literate within a reasonable period 
of time after his or her appointment to the audit committee; and (iii) 
at least one member of the audit committee to have accounting or 
related financial management expertise, as the board of directors 
interprets such qualification in its business judgment.
    Third, proposed Rule 5.3(b)(3) provides the independence 
requirements of audit committee members. In addition to the definition 
of Independent provided in Rule 5.3(b)(2)(i), the following 
restrictions apply to every audit committee member:
    (i) 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. ``Affiliate'' includes a subsidiary, sibling 
company, predecessor, parent company, or former parent company.
    (ii) Business Relationship. A director: (a) who is a partner, 
controlling shareholder, or executive officer of an organization that 
has a business relationship with the company; or (b) who has a direct 
business relationship with the company; or (b) 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 provision, 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 director's 
determination after three years following the termination of, as 
applicable: (a) the relationship between the organization with which 
the director is affiliated and the company; (b) the relationship 
between the director and his or her partnership status, shareholder 
interest or executive officer position; or (c) the direct business 
relationship between the director and the company.
    (iii) 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.
    (iv) 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. ``Immediate 
Family'' includes a person's spouse, parents, children, siblings, 
mothers-in-law and fathers-in-law, sons and daughters-in-law, and 
anyone (other than employees) who shares such person's home.
    (v) Notwithstanding the requirements of subparagraphs (3)(i) and 
(30(iv) of Rule 5.3(b), 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.
    Fourth, proposed Rule 5.3(b)(4) sets forth an ongoing written 
affirmation requirement. The proposal provides that 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 
of directors 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.
    Proposed Rule 5.3(b)(5) defines ``Officer'' to have the meaning 
specified in Rule 16a-1(f) under the Act,\6\ or any successor rule. 
Moreover, proposed Rule 5.3(b)(6) provides that 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

[[Page 10547]]

a third qualified member in place within twelve months of listing.
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    \6\ 17 CFR 240.16a-(f).
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    Finally, PCXE proposes to implement a transition period in order to 
provide its issuers with sufficient time to come into compliance with 
the proposed rule change.\7\ Specifically, PCXE proposes: (i) to 
``grandfather'' all public company audit committee members qualified 
under current PCX rules until they are re-elected or replaced; and (ii) 
give companies eighteen months from the date of Commission approval of 
this rule filing to recruit the requisite members for their audit 
committees. Issuers listed on PCXE as of the effective date of the 
proposed rule change will have six months to adopt a formal written 
audit committee charter.
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    \7\ See Amendment No. 1 supra note 3.
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III. 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.\8\ In 
particular, the Commission finds that the proposed rule change furthers 
the objectives of Section 6(b)(5) of the Act,\9\ in that it is designed 
to promote just and equitable principles of trade, to remove 
impediments to and perfect the mechanism of a free and open market and 
a national market system and, in general, to protect investors and the 
public interest.
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    \8\ In approving the proposal, the Commission has considered its 
impact on efficiency, competition, and capital formation, 15 U.S.C. 
78c(f).
    \9\ 15 U.S.C. 78f(b)(5). Section 6(b)(5) requires the rules of 
an exchange to be designed to prevent fraudulent and manipulative 
acts and practices, to promote just and equitable principles of 
trade, to foster cooperation and coordination with persons engaged 
in facilitating transactions in securities, to remove impediments to 
and perfect the mechanism of a free and open market and a national 
market system, and, in general, to protect investors and the public 
interest.
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    The Commission believes that the proposed rule change will protect 
investors by improving the effectiveness of audit committee of 
companeis listed on PCXE. The Commission also believes that the new 
requirements will enhance the quality and reliability of financial 
statements of companies listed on PCXE by making it more difficult for 
companies to inappropriately distort their true financial performance. 
These new provisions should help to assure that investors have quality 
and reliable financial information regarding PCXE listed issuers, 
including for investors who decide to buy or sell the securities of 
these issuers in secondary market transactions.
    Specifically, the Commission believes that the proposed definition 
of independence will promote the objectivity 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. 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.
    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 on 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. Moreover, 
the Commission believes that requiring one member of the audit 
committee to have accounting or related financial management expertise 
will further enhance the effectiveness of the audit committee in 
carrying out its financial oversight responsibilities.
    Finally, the Commission believes that the proposed transition 
period will enable issuers to determine when they must comply with the 
new requirements and will enable investors to determine when the 
protections afforded by the proposed rule change will be operational.

IV. Conclusion

    For the foregoing reasons, the Commission finds that the proposal 
to amend PCXE's 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,\10\that the proposed rule change (SR-PC-00-40) is approved.
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    \10\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\11\
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    \11\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-3803 Filed 2-14-01; 8:45 am]
BILLING CODE 8010-01-M