[Federal Register Volume 69, Number 121 (Thursday, June 24, 2004)]
[Notices]
[Pages 35408-35420]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-14287]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49881; File No. SR-Phlx-2004-33]


Self-Regulatory Organizations; Notice of Filing and Order 
Granting Accelerated Approval of Proposed Rule Change and Amendment 
Nos. 1 and 2 Thereto by the Philadelphia Stock Exchange, Inc. Relating 
to Corporate Governance

June 17, 2004.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on May 4, 2004, the Philadelphia Stock Exchange, Inc. (``Phlx'' or 
``Exchange'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I and II below, which Items have been prepared by the Exchange. 
On June 8, 2004, the Exchange filed Amendment No. 1 to the proposal.\3\ 
On June 15, 2004, the Exchange filed Amendment No. 2 to the proposed 
rule change.\4\ On June 17, 2004, the Exchange filed Amendment No. 3 to 
the proposed rule change.\5\ The Commission is publishing this notice 
to solicit comments on the proposed rule change from interested persons 
and is approving the proposal on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(l).
    \2\ 17 CFR 240. 19b-4.
    \3\ See letter from Carla Behnfeldt, Director, New Product 
Development Group, Phlx, to Nancy J. Sanow, Assistant Director, 
Division of Market Regulation, Commission, dated June 7, 2004 
(``Amendment No. 1''). In Amendment No. 1, the Phlx made certain 
clarifications with respect to the applicability and compliance 
dates of the proposed rules, and proposed to restate a provision 
currently in Phlx Rule 849, regarding Written Affirmations, in 
proposed new Rule 867.
    \4\ See letter from Carla Behnfeldt, Director, New Product 
Development Group, Phlx, to Nancy J. Sanow, Assistant Director, 
Division of Market Regulation, Commission, dated June 14, 2004 
(``Amendment No. 2''). In Amendment No. 2, the Phlx clarified that 
closed-end funds would be required to comply with proposed Rule 
867.15, which requires issuers to provide to the Exchange written 
affirmations regarding certain enumerated audit committee 
requirements.
    \5\ See letter from Carla Behnfeldt, Director, New Product 
Development Group, Phlx, to Nancy J. Sanow, Assistant Director, 
Division of Market Regulation, Commission, dated June 17, 2004 
(``Amendment No. 3''). Amendment No. 3 was a technical amendment and 
is not subject to notice and comment.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Phlx proposes to adopt new Exchange Rule 867, relating to 
corporate governance standards for listed companies.
    Below is the text of the proposed rule change, as amended. Proposed 
new language is in italics; proposed deletions are in brackets.
* * * * *
Rule 849. Audit Committee/Conflicts of Interest
    Introductory Note: The requirements set forth in this Rule 849 
shall continue to apply pending implementation of Rule 867.
    (a)-(k) No Change.
    Commentary * * *
    (1)-(4) No Change.

867 Corporate Governance

General Application

    Companies listed on the Exchange must comply with certain standards 
regarding corporate governance as codified in this Rule 867. Certain 
provisions of Rule 867 are applicable to some listed companies but not 
to others.

Equity Listings

    Section 867 applies in full to all companies listing common equity 
securities, with the following exceptions:

Controlled Companies

    A company of which more than 50% of the voting power is held by an 
individual, a group or another company need not comply with the 
requirements of Rules 867.01, .04 or .05. A controlled company that 
chooses to take advantage of any or all of these exemptions must 
disclose that choice, that it is a controlled company and the basis for 
the determination in its annual proxy statement or, if the company does 
not file an annual proxy statement, in the company's annual report on 
Form 10-K filed with the SEC. Controlled companies must comply with the 
remaining provisions of Rule 867.

Limited Partnerships and Companies in Bankruptcy--

    Due to their unique attributes, limited partnerships and companies 
in bankruptcy proceedings need not comply with the requirements of 
Rules 867.01, .04 or .05. However, all limited partnerships (at the 
general partner level) and companies in bankruptcy proceedings must 
comply with the remaining provisions of Rule 867.


[[Page 35409]]


    Closed-End Funds and Open-End Funds--
    The Exchange considers many of the significantly expanded standards 
and requirements provided for in Rule 867 to be unnecessary for closed-
end and open-end management investment companies that are registered 
under the Investment Company Act of 1940, given the pervasive federal 
regulation applicable to them. However, registered closed-end funds 
must comply with the requirements of Rules 867.06, .07(a) and (c), .12 
and .15. Note, however, that in view of the common practice to utilize 
the same directors for boards in the same fund complex, closed-end 
funds will not be required to comply with the disclosure requirement in 
the second paragraph of the Commentary to 867.07(a), which calls for 
disclosure of a board's determination with respect to simultaneous 
service on more than three public company audit committees. However, 
the other provisions of that paragraph will apply.
    Business development companies, which are a type of closed-end 
management investment company defined in Section 2(a)(48) of the 
Investment Company Act of 1940 that are not registered under that Act, 
are required to comply with all of the provisions of Rule 867 
applicable to domestic issuers other than Rule 867.02 and .07(b). For 
purposes of Rules 867.01, .03, .04, .05 and .09, a director of a 
business development company shall be considered to be independent if 
he or she is not an ``interested person'' of the company, as defined in 
Section 2(a)(19) of the Investment Company Act of 1940.
    As required by Rule 10A-3 under the Exchange Act, open-end funds 
(which can be listed as Index Fund Shares) are required to comply with 
the requirements of Rules 867.06 and .12(b). Rule 10A-3(b)(ii) under 
the Exchange Act requires that each audit committee must establish 
procedures for the confidential, anonymous submission by employees of 
the listed issuer of concerns regarding questionable accounting or 
auditing matters. In view of the external management structure often 
employed by closed-end and open-end funds, the Exchange also requires 
the audit committees of such companies to establish such procedures for 
the confidential, anonymous submission by employees of the investment 
adviser, administrator, principal underwriter, or any other provider of 
accounting related services for the management company, as well as 
employees of the management company. This responsibility must be 
addressed in the audit committee charter.

Other Entities

    Except as otherwise required by Rule10A-3 under the Exchange Act 
(for example, with respect to open-end funds), Rules 867 does not apply 
to passive business organizations in the form of trusts (such as 
royalty trusts) or to derivatives and special purpose securities. To 
the extent that Rule 10A-3 applies to a passive business organization, 
listed derivative or special purpose security, such entities are 
required to comply with Rules 867.06 and .12(b).

Foreign Private Issuers

    Listed companies that are foreign private issuers (as such term is 
defined in Rule 3b-4 under the Exchange Act) are permitted to follow 
home country practice in lieu of the provisions of this Rule 867, 
except that such companies are required to comply with the requirements 
of Rule 867.06, .11 and .12(b).

Preferred and Debt Listings

    Rule 867 does not generally apply to companies listing only 
preferred or debt securities on the Exchange. To the extent required by 
Rule 10A-3 under the Exchange Act, all companies listing only preferred 
or debt securities on the Phlx are required to comply with the 
requirements of Rules 867.06 and .12(b).

Effective Dates/Transition Periods

    Listed companies will have until the earlier of their first annual 
meeting after July 15, 2004, or October 31, 2004, to comply with the 
new standards contained in Rule 867, although if a company with a 
classified board would be required (other than by virtue of a 
requirement under Rule 867.06) to change a director who would not 
normally stand for election in such annual meeting, the company may 
continue such director in the office until the second annual meeting 
after such date, but no later than December 31, 2005. In addition, 
foreign private issuers and small business issuers will have until July 
31, 2005, to comply with Rule 867. As a general matter, the existing 
audit committee requirements provided for in Rule 849 continue to apply 
to listed companies pending the transition to the new rules.
    Companies listing in conjunction with their initial public offering 
will be permitted to phase in their independent nomination and 
compensation committees on generally the same schedule as is permitted 
pursuant to Rule 10A-3 under the Exchange Act for audit committees, 
that is, one independent member at the time of listing, a majority of 
independent members within 90 days of listing and fully independent 
committees within one year. Such companies will be required to meet the 
majority independent board requirement within 12 months of listing. For 
purposes of Rule 867 other than sections 867.06 and .12(b), a company 
will be considered to be listing in conjunction with an initial public 
offering if, immediately prior to listing, it does not have a class of 
common stock registered under the Exchange Act. The Exchange will also 
permit companies that are emerging from bankruptcy or have ceased to be 
controlled companies within the meaning of Rule 867 to phase in 
independent nomination and compensation committees and majority 
independent boards on the same schedule as companies listing in 
conjunction with an initial public offering. However, for purposes of 
Rules 867.06 and .12(b), a company will be considered to be listing in 
conjunction with an initial public offering only if it meets the 
conditions of Rule 10A-3(b)(1)(iv)(A) under the Exchange Act, namely, 
that the company was not, immediately prior to the effective date of a 
registration statement, required to file reports with the SEC pursuant 
to Section 13(a) or 15(d) of the Exchange Act.
    Companies listing upon transfer from another market have 12 months 
from the date of transfer in which to comply with any requirement to 
the extent the market on which they were listed did not have the same 
requirement. To the extent the other market has a substantially similar 
requirement but also had a transition period from the effective date of 
that market's rule, which period had not yet expired, the company will 
have the same transition period as would have been available to it on 
the other market. This transition period for companies transferring 
from another market will not apply to the requirements of Rule 867.06 
unless a transition period is available pursuant to Rule 10A-3 under 
the Exchange Act.

References to Form 10-K

    There are provisions in this Rule 867 that call for disclosure in a 
company's Form 10-K under certain circumstances. If a company subject 
to such a provision is not a company required to file a Form 10-K, then 
the provision shall be interpreted to mean the annual periodic 
disclosure form that the company does file with the SEC. For example, 
for a closed-end fund, the appropriate form would be the annual Form N-
CSR. If a company is not required to file either an annual proxy 
statement or an annual periodic report with the SEC, the disclosure 
shall be made in the annual

[[Page 35410]]

report required under Rule 837, Annual Reports.
    1. Listed companies must have a majority of independent directors.
    Commentary: Effective boards of directors exercise independent 
judgment in carrying out their responsibilities. Requiring a majority 
of independent directors will increase the quality of board oversight 
and lessen the possibility of damaging conflicts of interest.
    2. In order to tighten the definition of ``independent director'' 
for purposes of these standards:
    (a) No director qualifies as ``independent'' unless the board of 
directors affirmatively determines that the director has no material 
relationship with the listed company (either directly or as a partner, 
shareholder or officer of an organization that has a relationship with 
the company). Companies must disclose these determinations.
    Commentary: It is not possible to anticipate, or explicitly to 
provide for, all circumstances that might signal potential conflicts of 
interest, or that might bear on the materiality of a director's 
relationship to a listed company (references to ``company'' would 
include any parent or subsidiary in a consolidated group with the 
company). Accordingly, it is best that boards making ``independence'' 
determinations broadly consider all relevant facts and circumstances. 
In particular, when assessing the materiality of a director's 
relationship with the company, the board should consider the issue not 
merely from the standpoint of the director, but also from that of 
persons or organizations with which the director has an affiliation. 
Material relationships can include commercial, industrial, banking, 
consulting, legal, accounting, charitable and familial relationships, 
among others. However, as the concern is independence from management, 
the Exchange does not view ownership of even a significant amount of 
stock, by itself, as a bar to an independence finding.
    The basis for a board determination that a relationship is not 
material must be disclosed in the company's annual proxy statement or, 
if the company does not file an annual proxy statement, in the 
company's annual report on Form 10-K filed with the SEC. In this 
regard, a board may adopt and disclose categorical standards to assist 
it in making determinations of independence and may make a general 
disclosure if a director meets these standards. Any determination of 
independence for a director who does not meet these standards must be 
specifically explained. A company must disclose any standard it adopts. 
It may then make the general statement that the independent directors 
meet the standards set by the board without detailing particular 
aspects of the immaterial relationships between individual directors 
and the company. In the event that a director with a business or other 
relationship that does not fit within the disclosed standards is 
determined to be independent, a board must disclose the basis for its 
determination in the manner described above. This approach provides 
investors with an adequate means of assessing the quality of a board's 
independence and its independence determinations while avoiding 
excessive disclosure of immaterial relationships.
    (b) In addition:
    (i) A director who is an employee, or whose immediate family member 
is an executive officer, of the company is not independent until three 
years after the end of such employment relationship.
    Commentary: Employment as an interim Chairman or CEO shall not 
disqualify a director from being considered independent following that 
employment.
    (ii) A director who receives, or whose immediate family member 
receives, more than $100,000 per year in direct compensation from the 
listed company, other than director and committee fees and pension or 
other forms of deferred compensation for prior service (provided such 
compensation is not contingent in any way on continued service), is not 
considered independent until three years after he or she ceases to 
receive more than $100,000 per year in such compensation.
    Commentary: Compensation received by a director for former service 
as an interim Chairman or CEO need not be considered in determining 
independence under this test. Compensation received by an immediate 
family member for service as a non-executive employee of the listed 
company need not be considered in determining independence under this 
test.
    (iii) A director who is affiliated with or employed by, or whose 
immediate family member is affiliated with or employed in a 
professional capacity by, a present or former internal or external 
auditor of the company is not ``independent'' until three years after 
the end of the affiliation or the employment or auditing relationship.
    (iv) A director who is employed, or whose immediate family member 
is employed, as an executive officer of another company where any of 
the listed company's present executives serve on that company's 
compensation committee is not ``independent'' until three years after 
the end of such service or the employment relationship.
    (v) A director who is an executive officer or an employee, or whose 
immediate family member is an executive officer, of company that makes 
payments to, or receives payments from, the listed company for property 
or services in an amount which, in any single fiscal year, exceeds the 
greater of $200,000 ($1 million if the listed company is also listed on 
the New York Stock Exchange), or 5% of such other company's 
consolidated gross revenues, is not ``independent'' until three years 
after falling below such threshold.
    Commentary: In applying the test in Rule 867.02(b)(v), both the 
payments and the consolidated gross revenues to be measured shall be 
those reported in the last completed fiscal year. The look-back 
provision for this test applies solely to the financial relationship 
between the listed company and the director or immediate family 
member's current employer; a listed company need not consider former 
employment of the director or immediate family member.
    Charitable organizations shall not be considered ``companies'' for 
purposes of Rule 867.02(b)(v), provided however that a listed company 
shall disclose in its annual proxy statement, or if the listed company 
does not file an annual proxy statement, in the company's annual report 
on Form 10-K filed with the SEC, any charitable contributions made by 
the listed company to any charitable organization in which a director 
serves as an executive officer if, within the preceding three years, 
contributions in any single fiscal year exceeded the greater of 
$200,000 ($1 million if the listed company is also listed on the New 
York Stock Exchange), or 5% of such charitable organization's 
consolidated gross revenues. Listed company boards are reminded of 
their obligations to consider the materiality of any such relationship 
in accordance with Rule 867.02(a) above.
    General Commentary to Rule 867.02(b): An ``immediate family 
member'' includes a person's spouse, parents, children, siblings, 
mothers and fathers-in-law, sons and daughters-in-law, brothers and 
sisters-in-law, and anyone (other than domestic employees) who shares 
such person's home. When applying the look-back provisions in Rule 
867.02(b), listed companies need not consider individuals who are no 
longer immediate family members as a result of legal separation or 
divorce, or those who have died or become

[[Page 35411]]

incapacitated. In addition, references to the ``company'' would include 
any parent or subsidiary in a consolidated group with the company.
    Transition Rule. Each of the above standards contains a three-year 
``look-back'' provision. In order to facilitate a smooth transition to 
the new independence standards, the Exchange will phase in the ``look-
back'' provisions by applying only a one-year look-back for the first 
year after adoption of these new standards. The three-year look-backs 
provided for in Rule 867.02(b) will begin to apply only from June 17, 
2005 (the ``Three-Year Look-Back Date''). As an example, until the 
Three-Year Look-Back Date, a company need look back only one year when 
testing compensation under Rule 867.02(b)(ii). Beginning on the Three-
Year Look-Back Date, however, the company would need to look back the 
full three years provided in Rule 867.02(b)(ii).
    3. To empower non-management directors to serve as a more effective 
check on management, the non-management directors of each company must 
meet at regularly scheduled executive sessions without management.
    Commentary: To promote open discussion among the non-management 
directors, companies must schedule regular executive sessions in which 
those directors meet without management participation. ``Non-
management'' directors are all those who are not company officers (as 
that term is defined in Rule 16a-1(f) under the Securities Act of 
1933), and includes such directors who are not independent by virtue of 
a material relationship, former status or family membership, or for any 
other reason.
    Regular scheduling of such meetings is important not only to foster 
better communication among non-management directors, but also to 
prevent any negative inference from attaching to the calling of 
executive sessions. There need not be a single presiding director at 
all executive sessions of the non-management directors. If one director 
is chosen to preside at these meetings, his or her name must be 
disclosed in the company's annual proxy statement or, if the company 
does not file an annual proxy statement, in the company's annual report 
on Form 10-K filed with the SEC. Alternatively, a company may disclose 
the procedure by which a presiding director is selected for each 
executive session. For example, a company may wish to rotate the 
presiding position among the chairs of board committees.
    In order that interested parties may be able to make their concerns 
known to the non-management directors, a company must disclose a method 
for such parties to communicate directly with the presiding director or 
with the non-management directors as a group. Companies may, if they 
wish, utilize for this purpose the same procedures they have 
established to comply with the requirements of Rule 10A-3(b)(3) under 
the Exchange Act, as applied to listed companies through Rule 867.06.
    While this Rule 867.03 refers to meetings of non-management 
directors, if that group includes directors who are not independent 
under this Rule 867, listed companies should at least once a year 
schedule an executive session including only independent directors.
    4. (a) Listed companies must have a nominating/corporate governance 
committee composed entirely of independent directors.
    (b) The nominating/corporate governance committee must have a 
written charter that addresses:
    (i) The committee's purpose and responsibilities--which, at 
minimum, must be to: Identify individuals qualified to become board 
members, consistent with criteria approved by the board, and to select, 
or to recommend that the board select, the director nominees for the 
next annual meeting of shareholders; develop and recommend to the board 
a set of corporate governance principles applicable to the corporation; 
and oversee the evaluation of the board and management; and
    (ii) An annual performance evaluation of the committee.
    Commentary: A nominating/corporate governance committee is central 
to the effective functioning of the board. New director and board 
committee nominations are among a board's most important functions. 
Placing this responsibility in the hands of an independent nominating/
corporate governance committee can enhance the independence and quality 
of nominees. The committee is also responsible for taking a leadership 
role in shaping the corporate governance of a corporation.
    If a company is legally required by contract or otherwise to 
provide third parties with the ability to nominate directors (for 
example, preferred stock rights to elect directors upon a dividend 
default, shareholder agreements, and management agreements), the 
selection and nomination of such directors need not be subject to the 
nominating committee process.
    The nominating/corporate governance committee charter should also 
address the following items: Committee member qualifications; committee 
member appointment and removal; committee structure and operations 
(including authority to delegate to subcommittees); and committee 
reporting to the board. In addition, the charter should give the 
nominating/corporate governance committee sole authority to retain and 
terminate any search firm to be used to identify director candidates, 
including sole authority to approve the search firm's fees and other 
retention terms.
    Boards may allocate the responsibilities of the nominating/
corporate governance committee to committees of their own denomination, 
provided that the committees are composed entirely of independent 
directors. Any such committee must have a published committee charter.
    5. (a) Listed companies must have a compensation committee composed 
entirely of independent directors.
    (b) The compensation committee must have a written charter that 
addresses:
    (i) The committee's purpose and responsibilities--which, at 
minimum, must be to have direct responsibility to:
    (A) Review and approve corporate goals and objectives relevant to 
CEO compensation, evaluate the CEO's performance in light of those 
goals and objectives, and either as a committee or together with the 
other independent directors (as directed by the board), determine and 
approve the CEO's compensation level based on this evaluation; and
    (B) Make recommendations to the board with respect to non-CEO 
compensation, incentive-compensation plans and equity-based plans; and
    (C) Produce a compensation committee report on executive 
compensation as required by the SEC to be included in the company's 
annual proxy statement or annual report on Form 10-K filed with the 
SEC;
    (ii) An annual performance evaluation of the compensation 
committee.
    Commentary: In determining the long-term incentive component of CEO 
compensation, the committee should consider the company's performance 
and relative shareholder return, the value of similar incentive awards 
to CEOs at comparable companies, and the awards given to the listed 
company's CEO in past years. To avoid confusion, note that the 
compensation committee is not precluded from approving awards (with or 
without ratification of the board) as may be required to comply with 
applicable tax laws.
    The compensation committee charter should also address the 
following items: Committee member qualifications; committee member 
appointment and removal; committee structure and operations (including 
authority to

[[Page 35412]]

delegate to subcommittees); and committee reporting to the board.
    Additionally, if a compensation consultant is to assist in the 
evaluation of director, CEO or senior executive compensation, the 
compensation committee charter should give that committee sole 
authority to retain and terminate the consulting firm, including sole 
authority to approve the firm's fees and other retention terms.
    Boards may allocate the responsibilities of the compensation 
committee to committees of their own denomination, provided that the 
committees are composed entirely of independent directors. Any such 
committee must have a published committee charter.
    Nothing in this provision should be construed as precluding 
discussion of CEO compensation with the board generally, as it is not 
the intent of this standard to impair communication among members of 
the board.
    6. Listed companies must have an audit committee that satisfies the 
requirements of Rule 10A-3 under the Exchange Act.
    Commentary: The Exchange will apply the requirements of Rule 10A-3 
in a manner consistent with the guidance provided by the Securities and 
Exchange Commission in SEC Release No. 34-47654 (April 1, 2003). 
Without limiting the generality of the foregoing, the Exchange will 
provide companies the opportunity to cure defects provided in Rule 10A-
3(a)(3) under the Exchange Act.
    7. (a) The audit committee must have a minimum of three members.
    Commentary: Each member of the audit committee must be financially 
literate, as such qualification is interpreted by the company's board 
in its business judgment, or must become financially literate within a 
reasonable period of time after his or her appointment to the audit 
committee. In addition, at least one member of the audit committee must 
have accounting or related financial management expertise, as the 
company's board interprets such qualification in its business judgment. 
While the Exchange does not require that a listed company's audit 
committee include a person who satisfies the definition of audit 
committee financial expert set out in Item 401(h) of Regulation S-K, a 
board may presume that such a person has accounting or related 
financial management expertise.
    Because of the audit committee's demanding role and 
responsibilities, and the time commitment attendant to committee 
membership, each prospective audit committee member should evaluate 
carefully the existing demands on his or her time before accepting this 
important assignment. Additionally, if an audit committee member 
simultaneously serves on the audit committees of more than three public 
companies, and the listed company does not limit the number of audit 
committees on which its audit committee members serve, then in each 
case, the board must determine that such simultaneous service would not 
impair the ability of such member to effectively serve on the listed 
company's audit committee and disclose such determination in the 
company's annual proxy statement or, if the company does not file an 
annual proxy statement, in the company's annual report on Form 10-K 
filed with the SEC.
    (b) In addition to any requirement of Rule 10A-3(b)(1), all audit 
committee members must satisfy the requirements for independence set 
out in Rule 867.02.
    (c) The audit committee must have a written charter that addresses:
    (i) The committee's purpose--which, at minimum, must be to:
    (A) Assist board oversight of (1) the integrity of the company's 
financial statements, (2) the company's compliance with legal and 
regulatory requirements, (3) the independent auditor's qualifications 
and independence, and (4) the performance of the company's internal 
audit function and independent auditors; and
    (B) Prepare an audit committee report as required by the SEC to be 
included in the company's annual proxy statement;
    (ii) An annual performance evaluation of the audit committee; and
    (iii) The duties and responsibilities of the audit committee--
which, at a minimum, must include those set out in Rule 10A-3(b)(2), 
(3), (4) and (5) of the Exchange Act, as well as to:
    (A) At least annually, obtain and review a report by the 
independent auditor describing: The firm's internal quality-control 
procedures; any material issues raised by the most recent internal 
quality-control review, or peer review, of the firm, or by any inquiry 
or investigation by governmental or professional authorities, within 
the preceding five years, respecting one or more independent audits 
carried out by the firm, and any steps taken to deal with any such 
issues; and (to assess the auditor's independence) all relationships 
between the independent auditor and the company;
    Commentary: After reviewing the foregoing report and the 
independent auditor's work throughout the year, the audit committee 
will be in a position to evaluate the auditor's qualifications, 
performance and independence. This evaluation should include the review 
and evaluation of the lead partner of the independent auditor. In 
making its evaluation, the audit committee should take into account the 
opinions of management and the company's internal auditors (or other 
personnel responsible for the internal audit function). In addition to 
assuring the regular rotation of the lead audit partner as required by 
law, the audit committee should further consider whether, in order to 
assure continuing auditor independence, there should be regular 
rotation of the audit firm itself. The audit committee should present 
its conclusions with respect to the independent auditor to the full 
board.
    (B) Discuss the company's annual audited financial statements and 
quarterly financial statements with management and the independent 
auditor, including the company's disclosures under ``Management's 
Discussion and Analysis of Financial Condition and Results of 
Operations'';
    (C) Discuss the company's earnings press releases, as well as 
financial information and earnings guidance provided to analysts and 
rating agencies;
    Commentary: The audit committee's responsibility to discuss 
earnings releases as well as financial information and earnings 
guidance may be done generally i.e., discussion of the types of 
information to be disclosed and the type of presentation to be made). 
The audit committee need not discuss in advance each earnings release 
or each instance in which a company may provide earnings guidance.
    (D) Discuss policies with respect to risk assessment and risk 
management;
    Commentary: While it is the job of the CEO and senior management to 
assess and manage the company's exposure to risk, the audit committee 
must discuss guidelines and policies to govern the process by which 
this is handled. The audit committee should discuss the company's major 
financial risk exposures and the steps management has taken to monitor 
and control such exposures. The audit committee is not required to be 
the sole body responsible for risk assessment and management, but, as 
stated above, the committee must discuss guidelines and policies to 
govern the process by which risk assessment and management is 
undertaken. Many companies, particularly financial companies, manage 
and assess their risk through mechanisms other than the audit 
committee. The processes these companies have in place should be 
reviewed in a general manner by the

[[Page 35413]]

audit committee, but they need not be replaced by the audit committee.
    (E) Meet separately, periodically, with management, with internal 
auditors (or other personnel responsible for the internal audit 
function) and with independent auditors;
    Commentary: To perform its oversight functions most effectively, 
the audit committee must have the benefit of separate sessions with 
management, the independent auditors and those responsible for the 
internal audit function. As noted herein, all listed companies must 
have an internal audit function. These separate sessions may be more 
productive than joint sessions in surfacing issues warranting committee 
attention.
    (F) Review with the independent auditor any audit problems or 
difficulties and management's response;
    Commentary: The audit committee must regularly review with the 
independent auditor any difficulties the auditor encountered in the 
course of the audit work, including any restrictions on the scope of 
the independent auditor's activities or on access to requested 
information, and any significant disagreements with management. Among 
the items the audit committee may want to review with the auditor are: 
Any accounting adjustments that were noted or proposed by the auditor 
but were ``passed'' (as immaterial or otherwise); any communications 
between the audit team and the audit firm's national office respecting 
auditing or accounting issues presented by the engagement; and any 
``management'' or ``internal control'' letter issued, or proposed to be 
issued, by the audit firm to the company. The review should also 
include discussion of the responsibilities, budget and staffing of the 
company's internal audit function.
    (G) Set clear hiring policies for employees or former employees of 
the independent auditors; and
    Commentary: Employees or former employees of the independent 
auditor are often valuable additions to corporate management. Such 
individuals' familiarity with the business, and personal rapport with 
the employees, may be attractive qualities when filling a key opening. 
However, the audit committee should set hiring policies taking into 
account the pressures that may exist for auditors consciously or 
subconsciously seeking a job with the company they audit.
    (H) Report regularly to the board of directors.
    Commentary: The audit committee should review with the full board 
any issues that arise with respect to the quality or integrity of the 
company's financial statements, the company's compliance with legal or 
regulatory requirements, the performance and independence of the 
company's independent auditors, or the performance of the internal 
audit function.General Commentary to Rule 867.07(c): While the 
fundamental responsibility for the company's financial statements and 
disclosures rests with management and the independent auditor, the 
audit committee must review: (A) Major issues regarding accounting 
principles and financial statement presentations, including any 
significant changes in the company's selection or application of 
accounting principles, and major issues as to the adequacy of the 
company's internal controls and any special audit steps adopted in 
light of material control deficiencies; (B) analyses prepared by 
management and/or the independent auditor setting forth significant 
financial reporting issues and judgments made in connection with the 
preparation of the financial statements, including analyses of the 
effects of alternative GAAP methods on the financial statements; (C) 
the effect of regulatory and accounting initiatives, as well as off-
balance sheet structures, on the financial statements of the company; 
and (D) the type and presentation of information to be included in 
earnings press releases (paying particular attention to any use of 
``pro forma,'' or ``adjusted'' non-GAAP, information), as well as 
review any financial information and earnings guidance provided to 
analysts and rating agencies.
    (d) Each listed company must have an internal audit function.
    Commentary: Listed companies must maintain an internal audit 
function to provide management and the audit committee with ongoing 
assessments of the company's risk management processes and system of 
internal control. A company may choose to outsource this function to a 
third party service provider other than its independent auditor.
    General Commentary to Rule 867.07: To avoid any confusion, note 
that the audit committee functions specified in Rule 867.07 are the 
sole responsibility of the audit committee and may not be allocated to 
a different committee.
    8. Requirements relating to shareholder approval of equity 
compensation plans and broker voting are set forth in Rule 850.
    9. Listed companies must adopt and disclose corporate governance 
guidelines.
    Commentary: No single set of guidelines would be appropriate for 
every company, but certain key areas of universal importance include 
director qualifications and responsibilities, responsibilities of key 
board committees, and director compensation. Given the importance of 
corporate governance, each listed company's website must include its 
corporate governance guidelines and the charters of its most important 
committees (including at least the audit, and if applicable, 
compensation and nominating committees). Each company's annual report 
on Form 10-K filed with the SEC must state that the foregoing 
information is available on its website, and that the information is 
available in print to any shareholder who requests it. Making this 
information publicly available should promote better investor 
understanding of the company's policies and procedures, as well as more 
conscientious adherence to them by directors and management,
    The following subjects must be addressed in the corporate 
governance guidelines:
     Director qualification standards. These standards should, 
at minimum, reflect the independence requirements set forth in Rules 
867.01 and .02. Companies may also address other substantive 
qualification requirements, including policies limiting the number of 
boards, on which a director may sit, and director tenure, retirement 
and succession.
     Director responsibilities. These responsibilities should 
clearly articulate what is expected from a director, including basic 
duties and responsibilities with respect to attendance at board 
meetings and advance review of meeting materials.
     Director access to management and, as necessary and 
appropriate, independent advisors.
     Director compensation. Director compensation guidelines 
should include general principles for determining the form and amount 
of director compensation (and for reviewing those principles, as 
appropriate). The board should be aware that questions as to directors' 
independence may be raised when directors' fees and emoluments exceed 
what is customary. Similar concerns may be raised when the company 
makes substantial charitable contributions to organizations in which a 
director is affiliated, or enters into consulting contracts with (or 
provides other indirect forms of compensation to) a director. The board 
should critically evaluate each of these matters when determining the 
form and amount of

[[Page 35414]]

director compensation, and the independence of a director.
     Director orientation and continuing education.
     Management succession. Succession planning should include 
policies and principles for CEO selection and performance review, as 
well as policies regarding succession in the event of an emergency or 
the retirement of the CEO.
     Annual performance evaluation of the board. The board 
should conduct a self-evaluation at least annually to determine whether 
it and its committees are functioning effectively.
    10. Listed companies must adopt and disclose a code of business 
conduct and ethics for directors, officers and employees, and promptly 
disclose any waivers of the code for directors or executive officers.
    Commentary: No code of business conduct and ethics can replace the 
thoughtful behavior of an ethical director, officer or employee. 
However, such a code can focus the board and management on areas of 
ethical risk, provide guidance to personnel to help them recognize and 
deal with ethical issues, provide mechanisms to report unethical 
conduct, and help to foster a culture of honesty and accountability.
    Each code of business conduct and ethics must require that any 
waiver of the code for executive officers or directors may be made only 
by the board or a board committee and must be promptly disclosed to 
shareholders. This disclosure requirement should inhibit casual and 
perhaps questionable waivers, and should help assure that, when 
warranted, a waiver is accompanied by appropriate controls designed to 
protect the company. It will also give shareholders the opportunity to 
evaluate the board's performance in granting waivers. Each code of 
business conduct and ethics must also contain compliance standards and 
procedures that will facilitate the effective operation of the code. 
These standards should ensure the prompt and consistent action against 
violations of the code. Each listed company's website must include its 
code of business conduct and ethics. Each company's annual report on 
Form 10-K filed with the SEC must state that the foregoing information 
is available on its website and that the information is available in 
print to any shareholder who requests it. Each company may determine 
its own policies, but all listed companies should address the most 
important topics, including the following:
     Conflicts of interest. A ``conflict of interest'' occurs 
when an individual's private interest interferes in any way--or even 
appears to interfere--with the interests of the corporation as a whole. 
A conflict situation can arise when an employee, officer or director 
takes actions or has interests that may make it difficult to perform 
his or her company work objectively and effectively. Conflicts of 
interest also arise when an employee, officer or director, or a member 
of his or her family, receives improper personal benefits as a result 
of his or her position in the company. Loans to, or guarantees of 
obligations of, such persons are of special concern. The company should 
have a policy prohibiting such conflicts of interest, and providing a 
means for employees, officers and directors to communicate potential 
conflicts to the company.
     Corporate opportunities. Employees, officers and directors 
should be prohibited from (a) taking for themselves personally 
opportunities that are discovered through the use of corporate 
property, information or position; (b) using corporate property, 
information, or position for personal gain; and (c) competing with the 
company. Employees, officers and directors owe a duty to the company to 
advance its legitimate interests when the opportunity to do so arises.
     Confidentiality. Employees, officers and directors should 
maintain the confidentiality of information entrusted to them by the 
company or its customers, except when disclosure is authorized or 
legally mandated. Confidential information includes all non-public 
information that might be of use to competitors, or harmful to the 
company or its customers, if disclosed.
     Fair dealing. Each employee, officer and director should 
endeavor to deal fairly with the company's customers, suppliers, 
competitors and employees. None should take unfair advantage of anyone 
through manipulation, concealment, abuse of privileged information, 
misrepresentation of material facts, or any other unfair-dealing 
practice. Companies may write their codes in a manner that does not 
alter existing legal rights and obligations of companies and their 
employees, such as ``at will'' employment arrangements.
     Protection and proper use of company assets. All 
employees, officers and directors should protect the company's assets 
and ensure their efficient use. Theft, carelessness and waste have a 
direct impact on the company's profitability. All company assets should 
be used for legitimate business purposes.
     Compliance with laws, rules and regulations (including 
insider trading laws). The company should proactively promote 
compliance with laws, rules and regulations, including insider trading 
laws. Insider trading is both unethical and illegal, and should be 
dealt with decisively.
     Encouraging the reporting of any illegal or unethical 
behavior. The company should proactively promote ethical behavior. The 
company should encourage employees to talk to supervisors, managers or 
other appropriate personnel when in doubt about the best course of 
action in a particular situation. Additionally, employees should report 
violations of laws, rules, regulations or the code of business conduct 
to appropriate personnel. To encourage employees to report such 
violations, the company must ensure that employees know that the 
company will not allow retaliation for reports made in good faith.
    11. Listed foreign private issuers must disclose any significant 
ways in which their corporate governance practices differ from those 
followed by domestic companies under Phlx listing standards.
    Commentary: Foreign private issuers must make their U.S. investors 
aware of the significant ways in which their home-country practices 
differ from those followed by domestic companies under Phlx listing 
standards. However, foreign private issuers are not required to present 
a detailed, item-by-item analysis of these differences. Such a 
disclosure would be long and unnecessarily complicated. Moreover, this 
requirement is not intended to suggest that one country's corporate 
governance practices are better or more effective than another. The 
Exchange believes that U.S. shareholders should be aware of the 
significant ways that the governance of a listed foreign private issuer 
differs from that of a U.S. listed company. The Exchange underscores 
that what is required is a brief, general summary of the significant 
differences, not a cumbersome analysis.
    Listed foreign private issuers may provide this disclosure either 
on their web site (provided it is in the English language and 
accessible from the United States) and/or in their annual report as 
distributed to shareholders in the United States (again, in the English 
language). If the disclosure is only made available on the web site, 
the annual report shall so state and provide the web address at which 
the information may be obtained.
    12. (a) Each listed company CEO must certify to the Phlx each year 
that he or she is not aware of any violation by the company of Phlx 
corporate governance listing standards.
    Commentary: The CEO's annual certification to the Phlx that, as of 
the

[[Page 35415]]

date of certification, he or she is unaware of any violation by the 
company of Phlx's corporate governance listing standards will focus the 
CEO and senior management on the company's compliance with the listing 
standards. Both this certification to the Phlx, and any CEO/CFO 
certifications required to be filed with the SEC regarding the quality 
of the company's public disclosure, must be disclosed in the company's 
annual report to shareholders or, if the company does not prepare an 
annual report to shareholders, in the companies annual report on Form 
10-K filed with the SEC.
    (b) Each listed company CEO must promptly notify the Phlx after any 
executive officer of the listed company becomes aware of any material 
non-compliance with any applicable provisions of this Rule 867.
    13. The Phlx may issue a public reprimand letter to any listed 
company that violates a Phlx listing standard.
    Commentary: Suspending trading in or delisting a company can be 
harmful to the very shareholders that the Phlx listing standards seek 
to protect; the Phlx must therefore use these measures sparingly and 
judiciously. For this reason it is appropriate for the Phlx to have the 
ability to apply a lesser sanction to deter companies from violating 
its corporate governance (or other) listing standards. Accordingly, the 
Phlx may issue a public reprimand letter to any listed company, 
regardless of type of security listed or country of incorporation, that 
it determines has violated a Phlx listing standard. For companies that 
repeatedly or flagrantly violate Phlx listing standards, suspension and 
delisting remain the ultimate penalties. For clarification, this lesser 
sanction is not intended for use in the case of companies that fall 
below the financial and other continued listing standards set forth in 
Rules 803, 804 and 805, or that fail to comply with the audit committee 
standards set out in Rule 867.06. The processes and procedures provided 
for in Rule 811, Delisting Policies and Procedures, govern the 
treatment of companies falling below those standards.
    14. Related Party Transactions. Each issuer shall conduct an 
appropriate review of all related party transactions on an ongoing 
basis and all such transactions must be approved by the company's audit 
committee or another independent body of the board of directors. For 
purposes of this rule, the term ``related party transaction'' shall 
refer to transactions required to be disclosed pursuant to SEC 
Regulation S-K, Item 404.
    15. Written Affirmation. As part of the initial listing process, 
and with respect to any subsequent changes to the composition of the 
audit committee, and otherwise approximately once each year, each 
company should provide the Exchange written confirmation regarding:
    (i) Any determination that the company's board of directors has 
made regarding the independence of directors pursuant to Section 867.02 
above;
    (ii) The financial literacy of the audit committee members as 
required by Section 867.07 above;
    (iii) The determination that at least one of the audit committee 
members has accounting or related financial management expertise as 
required by Section 867.07 above; and
    (iv) The annual review and reassessment of the adequacy of the 
audit committee charter as required by Section 867.07 above.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Phlx included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item III below. The Phlx has prepared summaries, set forth in Sections 
A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and the 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The Phlx states that the purpose of the proposed rule change is to 
adopt new Rule 867, Corporate Governance, to conform with corporate 
governance rules recently approved by the Commission for the New York 
Stock Exchange (``NYSE'').
    On November 4, 2003, the Commission approved SR-NYSE-2002-33, a 
proposed rule change amending the NYSE Listed Company Manual to 
implement significant changes to NYSE's listing standards that were 
aimed to ensure the independence of directors of listed companies and 
to strengthen corporate governance practices of listed companies.\6\ In 
the approval order, the Commission stated that in 1998, the NYSE and 
National Association of Securities Dealers, Inc. (``NASD'') sponsored a 
committee to study the effectiveness of audit committees. This 
committee became known as the Blue Ribbon Committee on Improving the 
Effectiveness of Corporate Audit Committees (``Blue Ribbon 
Committee''). In its 1999 report, the Blue Ribbon Committee recognized 
the importance of audit committees and issued ten recommendations to 
enhance their effectiveness. Additionally, in February 2002, in light 
of several high-profile corporate failures, the Commission's Chairman 
at that time requested that the NYSE and NASD, as well as the other 
exchanges, including Phlx, review their listing standards, with an 
emphasis this time on all corporate governance listing standards, and 
not just those provisions relating to audit committees.
---------------------------------------------------------------------------

    \6\ See Securities Exchange Act Release No. 48745 (November 4, 
2003), 68 FR 64154 (November 12, 2003) (approving changes to the 
corporate governance listing standards of the Nasdaq Stock Market, 
Inc. and the NYSE).
---------------------------------------------------------------------------

    In January 2003, pursuant to the Sarbanes-Oxley Act of 2002 
(``Sarbanes-Oxley Act''), the Commission proposed Rule 10A-3 under the 
Exchange Act, which directs each national securities exchange and 
national securities association to prohibit the listing of any security 
of an issuer that is not in compliance with the audit committee 
requirements specified in that rule. The Commission adopted Rule 10A-3 
in April 2003. As noted above, on November 4, 2003, the Commission 
approved the rule changes set forth in SR-NYSE-2002-33, including rule 
changes made in compliance with the requirements of Rule 10A-3, as well 
as additional, extensive changes to other aspects of the NYSE's 
corporate governance listing standards.
    On November 25, 2003, the Commission approved a Phlx proposed rule 
change filed by the Exchange in compliance with the audit committee 
listing standards required by Rule 10A-3 under the Act.\7\ That rule 
change also included additional requirements, but generally did not 
change Phlx's listing standards other than listing standards applicable 
to audit committees. The Exchange is now proposing amendments to its 
listing standards to conform, for the most part, to the listing 
standards adopted by the NYSE in SR-NYSE-2002-33. Those listing 
standards cover a range of corporate governance matters beyond those 
applicable to audit committees. However, the Phlx is also proposing to 
amend its audit committee

[[Page 35416]]

standards, in the interest of conforming more closely to those of the 
NYSE. The Phlx believes that aligning its listing standards more 
closely with the NYSE's will facilitate compliance by most of Phlx's 
listed companies, which are currently also listed at the NYSE.
---------------------------------------------------------------------------

    \7\ See Securities Exchange Act Release No. 48836 (November 25, 
2003), 68 FR 67719 (December 3, 2003) (SR-Phlx-2003-51).
---------------------------------------------------------------------------

    According to the Phlx, the listing standards proposed herein are 
designed to further the ability of honest and well-intentioned 
directors, officers, and employees of listed issuers to perform their 
functions effectively. The Phlx believes that the proposal should also 
allow shareholders to more easily and efficiently monitor the 
performance of companies and directors in order to reduce instances of 
lax and unethical behavior. A summary of the proposal is set forth 
below. The applicability of certain requirements is subject to the 
exceptions discussed at the end of this section.
Independence of Majority of Board Members
    Phlx Rule 867.01 generally would require the board of directors of 
each listed company to consist of a majority of independent 
directors.\8\ Pursuant to Phlx Rule 867.02, no director would qualify 
as ``independent'' unless the board affirmatively determines that the 
director has no material relationship with the company (either directly 
or as a partner, shareholder, or officer of an organization that has a 
relationship with the company). The company would be required to 
disclose the basis for such determination in its annual proxy statement 
or, if the company does not file an annual proxy statement, in the 
company's annual report on Form 10-K filed with the Commission. In 
complying with this requirement, a board would be permitted to adopt 
and disclose standards to assist it in making determinations of 
independence, disclose those standards, and then make the general 
statement that the independent directors meet those standards.
---------------------------------------------------------------------------

    \8\ See infra note 19 and accompanying text regarding entities 
excepted from this requirement.
---------------------------------------------------------------------------

Definition of Independent Director
    In addition, in proposed Rule 867.02(G), the Phlx would tighten its 
current definition of independent director as follows. First, a 
director who is an employee, or whose immediate family member is an 
executive officer, of the company would not be independent until three 
years after the end of such employment relationship. Employment as an 
interim Chairman or CEO would not disqualify a director from being 
considered independent following that employment.
    Second, a director who receives, or whose immediate family member 
receives, more than $100,000 per year in direct compensation from the 
listed company, except for certain permitted payments, would not be 
independent until three years after he or she ceases to receive more 
than $100,000 per year in such compensation.
    Third, a director who is affiliated with or employed by, or whose 
immediate family member is affiliated with or employed in a 
professional capacity by, a present or former internal or external 
auditor of the company would not be independent until three years after 
the end of the affiliation or the employment or auditing relationship.
    Fourth, a director who is employed, or whose immediate family 
member is employed, as an executive officer of another company where 
any of the listed company's present executives serve on that company's 
compensation committee would not be independent until three years after 
the end of such service or the employment relationship.
    Fifth, a director who is an executive officer or an employee, or 
whose immediate family member is an executive officer, of a company 
that makes payments to, or receives payments from, the listed company 
for property or services in an amount which, in any single fiscal year, 
exceeds the greater of $200,000 ($1 million if the listed company is 
also listed on the NYSE), or 5% of such other company's consolidated 
gross revenues, would not be independent until three years after 
falling below such threshold. Charitable organizations would not be 
considered ``companies'' for purposes of this provision, provided that 
the listed company discloses in its annual proxy statement, or if the 
listed company does not file an annual proxy statement, in its annual 
report on Form 10-K filed with the Commission, any charitable 
contributions made by the listed company to any charitable organization 
in which a director serves as an executive officer if, within the 
preceding three years, such contributions in any single year exceeded 
the greater of $200,000 ($1 million if the listed company is also 
listed on the NYSE) or 5% of the organization's consolidated gross 
revenues. Additionally, both the payments and the consolidated gross 
revenues to be measured would need to be those reported in the last 
completed fiscal year. The look-back provision would apply solely to 
the financial relationship between the listed company and the director 
or immediate family member's current employer. A listed company would 
not need to consider former employment of the director or immediate 
family member.
    For purposes of these provisions, ``immediate family member'' would 
be defined to include a person's spouse, parents, children, siblings, 
mothers- and fathers-in-law, sons- and daughters-in-law, brothers- and 
sisters-in-law, and anyone (other than domestic employees) who shares 
such person's home. References to ``company'' would include any parent 
or subsidiary in a consolidated group with the company.
    The Exchange further proposes to phase in the look-back 
requirements discussed above by applying a one-year look-back for the 
first year after adoption of these new standards. The three-year look-
back periods would begin to apply from the date that is the first 
anniversary of Commission approval of the proposed rule change.
Separate Meetings for Board Members
    The Exchange proposes to require the non-management directors of 
each Phlx-listed company to meet at regularly scheduled executive 
sessions without management.\9\
---------------------------------------------------------------------------

    \9\ See id.
---------------------------------------------------------------------------

    In addition, listed companies would be required to disclose a 
method for interested parties to communicate directly with the 
presiding director of such executive sessions, or with the non-
management directors as a group. Companies would be permitted to 
utilize the same procedures they have established to comply with Rule 
10A-3(b)(3) under the Act.
Nominating/Corporate Governance Committee
    The Exchange proposes to require each listed company to have a 
nominating/corporate governance committee composed entirely of 
independent directors.\10\ Such committee would be required to have a 
written charter that addresses, among other items, the committee's 
purpose and responsibilities, and an annual performance evaluation of 
the nominating/corporate governance committee. The Exchange further 
proposes to clarify that the committee would be required to identify 
individuals qualified to become board members, consistent with the 
criteria approved by the board, and to select, or to recommend that the 
board select, the director nominees for the next annual meeting of 
shareholders, among other

[[Page 35417]]

responsibilities that would be required to be specified by the 
committee charter.
---------------------------------------------------------------------------

    \10\ See id.
---------------------------------------------------------------------------

Compensation Committee
    The Exchange proposes to require each listed company to have a 
compensation committee composed entirely of independent directors.\11\ 
Such committee would be required to have a written charter that 
addresses, among other items, the committee's purpose and 
responsibilities--which would need to include, at a minimum, specified 
responsibilities with respect to compensation of the Chief Executive 
Officer (``CEO''), among other responsibilities--and an annual 
performance evaluation of the compensation committee. The compensation 
committee also would be required to produce a compensation committee 
report on executive compensation, as required by Commission rules to be 
included in the company's annual proxy statement or annual report on 
Form 10-K filed with the Commission. Further, the Exchange proposes to 
add a provision to the commentary on this section indicating that 
discussion of CEO compensation with the board generally is not 
precluded.
---------------------------------------------------------------------------

    \11\ See id.
---------------------------------------------------------------------------

Audit Committee
    Under the proposal, Exchange Rules 867.06, 867.07, 867.12(b), 
867.14, and 867.15 would replace and supersede current Rule 849. As 
noted above, the Exchange is proposing to adopt the same format and 
language used by the NYSE in order to facilitate compliance by Phlx-
listed companies that are also listed on the NYSE.\12\
---------------------------------------------------------------------------

    \12\ See also infra note 19 and accompanying text regarding 
applicability of these requirements.
---------------------------------------------------------------------------

a. Composition
    Proposed Rules 867.06 and 867.07 would require each Phlx-listed 
company to have a minimum three-person audit committee composed 
entirely of directors that meet the independence standards of both 
Exchange Rule 867.02, discussed above, and Commission Rule 10A-3. The 
Phlx also proposes to add the following commentary: ``The Exchange will 
apply the requirements of Rule 10A-3 in a manner consistent with the 
guidance provided by the Securities and Exchange Commission in SEC 
Release No. 34-47654 (April 1, 2003). Without limiting the generality 
of the foregoing, the Exchange will provide companies with the 
opportunity to cure defects provided in Rule 10A-3(a)(3).''
    In addition, the Commentary to Exchange Rule 867.07(a) would 
require that each member of the audit committee be financially 
literate, as such qualification is interpreted by the board in its 
business judgment, or become financially literate within a reasonable 
period of time after his or her appointment to the audit committee. In 
addition, at least one member of the audit committee would be required 
to have accounting or related financial management expertise, as the 
company's board interprets such qualification in its business judgment. 
The Exchange also proposes to clarify that while the Exchange does not 
require that a listed company's audit committee include a person who 
satisfies the definition of audit committee financial expert set forth 
in Item 401(e) of Regulation S-K, a board may presume that such a 
person has accounting or related financial management experience.
    If an audit committee member simultaneously serves on the audit 
committee of more than three public companies, and the listed company 
does not limit the number of audit committees on which its audit 
committee members serve, each board would be required to determine that 
such simultaneous service would not impair the ability of such member 
to effectively serve on the listed company's audit committee and to 
disclose such determination.
b. Audit Committee Charter and Responsibilities
    Exchange Rule 867.07(c) would require the audit committee of each 
listed company to have a written audit committee charter that 
addresses: (i) The committee's purpose, including certain specified 
aspects of such purpose; (ii) an annual performance evaluation of the 
audit committee; and (iii) the duties and responsibilities of the audit 
committee.
    The rule would specify the duties and responsibilities of the audit 
committee that must be addressed in the audit committee charter. These 
would include, at a minimum, those set out in Rule 10A-3(b)(2), (3), 
(4) and (5), as well as the responsibility to annually obtain and 
review a report by the independent auditor; discuss the company's 
annual audited financial statement and quarterly financial statements 
with management and the independent auditor; discuss the company's 
earnings press releases, as well as financial information and earnings 
guidance provided to analysts and rating agencies; discuss policies 
with respect to risk assessment and risk management; meet separately, 
periodically, with management, with internal auditors (or other 
personnel responsible for the internal audit function), and with 
independent auditors; review with the independent auditors any audit 
problems or difficulties and management's response; set clear hiring 
policies for employees or former employees of the independent auditors; 
and report regularly to the board.
    The Written Affirmation requirements in current Phlx Rule 849 would 
be restated in proposed new Rule 867.15.\13\
---------------------------------------------------------------------------

    \13\ See Amendment No. 1.
---------------------------------------------------------------------------

Internal Audit Function
    Exchange Rule 867.07(d) generally would require each listed company 
to have an internal audit function.\14\
---------------------------------------------------------------------------

    \14\ See infra note 19 and accompanying text.
---------------------------------------------------------------------------

Cross Reference to Shareholder Approval of Equity Compensation Plans
    New Rule 867.08 would cross-reference Exchange Rule 850, which 
governs requirements relating to shareholder approval of equity 
compensation plans and broker voting.\15\
---------------------------------------------------------------------------

    \15\ Exchange Rule 850 was recently amended. See Securities 
Exchange Act Release No. 48736 (October 31, 2003), 68 FR 63180 
(November 7, 2003).
---------------------------------------------------------------------------

Corporate Governance Guidelines
    Exchange Rule 867.09 generally would require each listed company to 
adopt and disclose corporate governance guidelines.\16\ The following 
topics would be required to be addressed: Director qualification 
standards; director responsibilities; director access to management 
and, as necessary and appropriate, independent advisors; director 
compensation; director orientation and continuing education; management 
succession; and annual performance evaluation of the board. Each 
company's website would be required to include its corporate governance 
guidelines and the charters of its most important committees, and the 
availability of this information on the website or in print to 
shareholders would need to be referenced in the company's annual report 
on Form 10-K filed with the Commission.
---------------------------------------------------------------------------

    \16\ See infra note 19 and accompanying text.
---------------------------------------------------------------------------

Code of Business Conduct and Ethics
    Exchange Rule 867.10 generally would require each listed company to 
adopt and disclose a code of business conduct and ethics for directors, 
officers and employees, and to promptly disclose any waivers of the 
code for directors or executive officers.\17\ The commentary to this 
section would set forth the most important topics that should be 
addressed, including conflicts

[[Page 35418]]

of interest; corporate opportunities; confidentiality of information; 
fair dealing; protection and proper use of company assets; compliance 
with laws, rules and regulations (including insider trading laws); and 
encouraging the reporting of any illegal or unethical behavior. Each 
code would be required to contain compliance standards and procedures 
to facilitate the effective operation of the code. Each listed 
company's website would be required to include its code of business 
conduct and ethics, and the availability of the code on the website or 
in print to shareholders would need to be referenced in the company's 
annual report on Form 10-K filed with the Commission.
---------------------------------------------------------------------------

    \17\ See id.
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CEO Certification
    Exchange Rule 867.12(a) would require the CEO of each listed 
company to certify to the Exchange each year that he or she is not 
aware of any violation by the company of the Exchange's corporate 
governance listing standards.\18\ This certification would be required 
to be disclosed in the company's annual report or, if the company does 
not prepare an annual report to shareholders, in the company's annual 
report on Form 10-K filed with the Commission.
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    \18\ See id.
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    In addition, Exchange Rule 867.12(b) would require the CEO of each 
listed company to promptly notify the Phlx in writing after any 
executive officer of the listed company becomes aware of any material 
non-compliance with any applicable provisions of the new requirements.
Public Reprimand Letter
    Exchange Rule 867.13 would allow the Phlx to issue a public 
reprimand letter to any listed company that violates a Phlx listing 
standard.
Exceptions to the Phlx Corporate Governance Proposals \19\
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    \19\ See the ``General Applicability'' section in the text of 
proposed Rule 867.
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    The Exchange proposes to exempt any listed company of which more 
than 50% of the voting power is held by an individual, a group, or 
another company (``Controlled Company'') from the requirements that its 
board have a majority of independent directors, and that the company 
have nominating/corporate governance and compensation committees 
composed entirely of independent directors. A company that chose to 
take advantage of any or all of these exemptions would be required to 
disclose that choice, that it is a Controlled Company, and the basis 
for the determination in its annual proxy statement or, if the company 
does not file an annual proxy statement, in the company's annual report 
on Form 10-K filed with the Commission. Limited partnerships and 
companies in bankruptcy proceedings also would be exempt from 
requirements that the board have a majority of independent directors 
and that the issuer have nominating/corporate governance and 
compensation committees composed entirely of independent directors.
    The Exchange considers many of the requirements of proposed Rule 
867 to be unnecessary for closed-end and open-end management investment 
companies that are registered under the Investment Company Act of 1940 
(``Investment Company Act''), given the pervasive federal regulation 
applicable to them. However, the Exchange proposes that registered 
closed-end management investment companies (``closed-end funds'') would 
be required to: (1) Have a minimum three-member audit committee that 
satisfies the requirements of Rule 10A-3 under the Act and meets the 
requirements of proposed Phlx Rule 867.07(a); (2) comply with the 
requirements of the proposed Phlx Rule 867.07(c) concerning audit 
committee charter requirements; and (3) comply with the certification 
and notification provisions regarding non-compliance, as well as the 
written affirmation requirements. Closed-end funds would be excluded 
from the disclosure requirement relating to an audit committee member's 
simultaneous service on more than three audit committees, but would be 
subject to the requirement for the board to determine that such 
simultaneous service would not impair the ability of such member to 
effectively serve on the listed company's audit committee.
    The Phlx also proposes to require business development companies, 
which are a type of closed-end management investment company defined in 
Section 2(a)(48) of the Investment Company Act that are not registered 
under the Investment Company Act, to comply with all the provisions of 
Phlx Section 867 applicable to domestic issuers, except that the 
directors of such companies, including audit committee members, would 
not be required to satisfy the independence requirements set forth in 
Phlx Section 867.02 and 867.07(b). For purposes of Phlx Sections 
867.01, .03, .04, .05, and .09, a director of a business development 
company would be considered to be independent if he or she is not an 
``interested person'' of the company, as defined in Section 2(a)(19) of 
the Investment Company Act.
    Open-end management investment companies (``open-end funds''), 
which can be listed as Index Fund Shares, would be required to: (1) 
Have an audit committee that satisfies the requirements of Rule 10A-3 
under the Act, and (2) notify the Exchange in writing of any material 
non-compliance.
    In addition, the Exchange proposes to require the audit committees 
of closed-end and open-end funds to establish procedures for the 
confidential, anonymous submission by employees of the investment 
adviser, administrator, principal underwriter, or any other provider of 
accounting related services for the investment company, as well as 
employees of the investment company, of concerns regarding questionable 
accounting or auditing matters. This responsibility would be required 
to be addressed in the audit committee charter.
    The Exchange proposes that except as otherwise required by Rule 
10A-3 under the Act, the new requirements also would not apply to 
passive business organizations in the form of trusts (such as royalty 
trusts) or to derivatives and special purpose securities. To the extent 
that Rule 10A-3 applies to a passive business organization, listed 
derivative, or special purpose security, the requirement to have an 
audit committee that satisfies the requirements of Rule 10A-3, and the 
requirement to notify the Phlx in writing of any material non-
compliance, also would apply.
    The new requirements generally would not apply to companies listing 
only preferred or debt securities on the Exchange. To the extent 
required by Rule 10A-3, however, all companies listing only preferred 
or debt securities on the Exchange would be required to: (1) Have an 
audit committee that satisfies the requirements of Rule 10A-3, and (2) 
notify the Exchange in writing of any material non-compliance.
Application to Foreign Private Issuers
    Exchange Rule 867 would permit Phlx-listed companies that are 
foreign private issuers, as such term is defined in Rule 3b-4 under the 
Act, to follow home country practice in lieu of the new requirements, 
except that such companies would be required to: (1) Have an audit 
committee that satisfies the requirements of Rule 10A-3 under the Act; 
(2) notify the Exchange in writing after any executive officer becomes 
aware of any non-compliance with any applicable provision; and (3) 
provide a brief, general summary of the significant ways in which its

[[Page 35419]]

governance differs from those followed by domestic companies under 
Exchange listing standards. Listed foreign private issuers would be 
permitted to provide this disclosure either on their website (provided 
it is in the English language and accessible from the United States) 
and/or in their annual report as distributed to shareholders in the 
United States. If the disclosure is made available only on the website, 
the annual report would be required to state this and provide the web 
address at which the information may be obtained.
Proposed Implementation of New Requirements
    Listed companies would have until the earlier of their first annual 
meeting after July 15, 2004, or October 31, 2004, to comply with the 
new standards.\20\ However, if a company with a classified board is 
required to change a director who would not normally stand for election 
in such annual meeting, the company would be permitted to continue such 
director in office until the second annual meeting after such date, but 
no later than December 31, 2005.
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    \20\ The requirements set forth in current Rule 849 would 
continue to apply pending implementation of Rule 867. By the terms 
of Rule 849, listed issuers (other than small business issuers and 
foreign private issuers) are required to be in compliance with the 
applicable requirements set forth in Rules 849(b)-(j) and Commentary 
Sections (1)-(4) of Rule 849 by the earlier of the listed issuer's 
first annual shareholders meeting after January 15, 2004 or October 
31, 2004. The expanded corporate governance provisions of Rule 867--
including paragraphs (6), (7), 12(b), (14), and (15), which replace 
and supersede Rule 849--begin to apply (for listed issuers other 
than small business issuers and foreign private issuers) the earlier 
of the listed issuer's first annual shareholders meeting after July 
15, 2004, or October 31, 2004. Thus, listed issuers whose first 
annual shareholder meeting after January 15, 2004 is held subsequent 
to July 15, 2004 would be required to be in compliance with the 
provisions of Rule 867 (rather than the aforementioned provisions of 
Rule 849) by the time of such annual meeting, but in any event no 
later than October 31, 2004. Listed issuers whose first annual 
shareholder meeting after January 15, 2004 is held before July 15, 
2004, and thus are required to comply with Rule 849(b)-(j) and 
Commentary Sections (1)-(4) by the date of such annual meeting, 
would be required to be in compliance with the expanded, superseding 
provisions of Rule 867 beginning on October 31, 2004. For small 
business issuers and foreign private issuers, Rule 867 would 
supersede Rule 849(b)-(j) and Commentary Sections (1)-(4) and begin 
to apply on July 31, 2005. The first sentence of Rule 849 will 
continue to apply to all listed companies until Rule 849(b)-(j) and 
Commentary Sections (1)-(4) or Rule 867 become applicable.
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    Notwithstanding the foregoing, foreign private issuers and small 
business issuers would have until July 31, 2005, to comply with Rule 
867.
    Companies listing in conjunction with their initial public offering 
would be required to have one independent member at the time of 
listing, a majority of independent members within 90 days of listing, 
and fully independent committees within one year. They would be 
required to meet the majority of independent board requirement within 
12 months of listing.
    Companies listing upon transfer from another market would have 12 
months from the date of transfer in which to comply with any 
requirement to the extent the market on which they were listed did not 
have the same requirement. To the extent the other market has a 
substantially similar requirement but also had a transition period from 
the effective date of that market's rule, which period had not yet 
expired, the company would have the same transition period as would 
have been available to it on the other market. This transition period 
for companies transferring from another market would not apply to the 
audit committee requirements of Rule 10A-3 unless a transition period 
is available under Rule 10A-3.
2. Statutory Basis
    The Exchange believes that the proposed rule change, as amended, is 
consistent with Section 6 of the Act \21\ in general and furthers the 
objectives of Section 6(b)(5) \22\ in particular in that it is 
designed, among other things, to facilitate transactions in securities, 
to prevent fraudulent and manipulative acts and practices, 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, 
and does not permit unfair discrimination among issuers.
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    \21\ 15 U.S.C. 78f(b).
    \22\ 15 U.S.C. 78f(b)(5).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    The Exchange does not believe that the proposed rule change, as 
amended, will impose any inappropriate burden on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    The Exchange did not receive any written comments on the proposed 
rule change.

III. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change, as amended, is consistent with the Act. Comments may be 
submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number SR-Phlx-2004-33 on the subject line.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number SR-Phlx-2004-33. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (http://www.sec.gov/rules/sro.shtml). 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 Section, 450 Fifth 
Street, NW., Washington, DC 20549. Copies of such filing also will be 
available for inspection and copying at the principal office of the 
Phlx. All comments received will be posted without change; the 
Commission does not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly. All submissions should refer to File Number SR-
Phlx-2004-33 and should be submitted on or before July 15, 2004.

IV. Commission's Findings and Order Granting Accelerated Approval of 
Proposed Rule Change

    After careful review, the Commission finds that the proposed rule 
change, as amended, is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities exchange.\23\ In

[[Page 35420]]

particular, the Commission finds that the proposed rule change, as 
amended, is consistent with Section 6(b)(5) of the Act \24\ in that it 
is designed, among other things, to facilitate transactions in 
securities, to prevent fraudulent and manipulative acts and practices, 
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, and does not permit unfair discrimination among 
issuers.
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    \23\ 15 U.S.C. 78f(b). In approving this proposal, the 
Commission has considered the proposed rule's impact on efficiency, 
competition and capital formation. 15 U.S.C. 78c(f).
    \24\ 15 U.S.C. 78f(b)(5).
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    In the Commission's view, the proposed rule change, as amended, 
will foster greater transparency, accountability, and objectivity in 
the oversight by, and decision-making processes of, the boards and key 
committees of Phlx-listed issuers. The proposal, as amended, also will 
promote compliance with high standards of conduct by the issuers' 
directors and management. The Commission notes that the Phlx has 
designed its proposal in a way that largely harmonizes it with rule 
changes recently approved by the Commission for other self-regulatory 
organizations.\25\
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    \25\ See, e.g., Securities Exchange Act Release No. 48745 
(November 4, 2003), 68 FR 64154 (November 12, 2003) (approving 
changes to the corporate governance listing standards of the Nasdaq 
Stock Market, Inc. and the NYSE).
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    The Phlx has requested that the Commission grant accelerated 
approval to the proposed rule change. The Commission believes that the 
proposed rule change will significantly align the corporate governance 
standards proposed for companies listed on the Phlx with the standards 
approved by the Commission for companies listed on other SROs. The 
Commission believes it is appropriate to accelerate approval of the 
proposed rule change so that the comprehensive set of strengthened 
corporate governance standards for companies listed on the Phlx may be 
implemented on generally the same timetable (with some modification of 
certain deadlines) as that for similar standards adopted for issuers 
listed on other SROs. The Commission therefore finds good cause, 
consistent with Section 19(b)(2) of the Act,\26\ to approve the 
proposed rule change, as amended, prior to the thirtieth day after the 
date of publication of notice of filing thereof in the Federal 
Register.
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    \26\ 15 U.S.C. 78s(b)(2).
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V. Conclusion

    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\27\ that the proposed rule change (SR-Phlx-2004-33), as amended, 
is hereby approved on an accelerated basis.
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    \27\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\28\
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    \28\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-14287 Filed 6-23-04; 8:45 am]
BILLING CODE 8010-01-P