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    [Federal Register: July 7, 2006 (Volume 71, Number 130)]

    [Proposed Rules]

    [Page 38739-38751]

    From the Federal Register Online via GPO Access [wais.access.gpo.gov]

    [DOCID:fr07jy06-29]

    [[Page 38739]]

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    Part IV

    Commodity Futures Trading Commission

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    17 CFR Part 38

    Conflict of Interest in Self-Regulation and Self-Regulatory

    Organizations; Proposed Rule

    [[Page 38740]]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Part 38

    RIN 3038-AC28

    Conflicts of Interest in Self-Regulation and Self-Regulatory

    Organizations

    AGENCY: Commodity Futures Trading Commission ("Commission").

    ACTION: Proposed Acceptable Practices for compliance with section

    5(d)(15) of the Commodity Exchange Act ("CEA" or "Act").\1\

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    \1\ Acceptable Practices for the Core Principles reside in

    Appendix B to Part 38 of the Commission's Regulations, 17 CFR part

    38, App. B.

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    SUMMARY: The Commission hereby proposes Acceptable Practices for

    section 5(d)(15) of the Act ("Core Principle 15").\2\ The proposed

    Acceptable Practices would provide designated contract markets

    ("DCMs") with a safe harbor for compliance with selected aspects of

    Core Principle 15's requirement that they minimize conflicts of

    interest in their decisionmaking. The proposed Acceptable Practices are

    summarized as follows.

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    \2\ Core Principle 15 for designated contract markets provides

    as follows: "CONFLICTS OF INTEREST--The board of trade shall

    establish and enforce rules to minimize conflicts of interest in the

    decisionmaking process of the contract market and establish a

    process for resolving such conflicts of interest." CEA Sec.

    5(d)(15), 7 U.S.C. Sec. 7(d)(15).

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    First, the Board Composition Acceptable Practice proposes that

    exchanges minimize potential conflicts of interest by maintaining

    governing boards composed of at least fifty percent "public"

    directors, as defined below. Second, the proposed Regulatory Oversight

    Committee Acceptable Practice calls upon exchanges to establish a

    board-level Regulatory Oversight Committee, composed solely of public

    directors, to oversee regulatory functions. Third, the Disciplinary

    Panel Acceptable Practice proposes that each disciplinary panel at all

    exchanges include at least one public participant, and that no panel be

    dominated by any group or class of exchange members.\3\ Finally, the

    proposed Acceptable Practices provide a definition of "public" for

    exchange directors and for members of disciplinary panels.

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    \3\ See CEA Section 1a(24), 7 U.S.C. 1a(24) (defining the term

    "member" to include both exchange members and non-member market

    participants with trading privileges); see also 17 CFR 1.3(q).

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    Collectively, the proposed Acceptable Practices promote

    independence in decisionmaking by self-regulatory organizations

    ("SROs"),\4\ and constitute a proactive yet measured step toward

    ensuring that SROs maintain fair, vigorous, and effective self-

    regulation in a rapidly evolving futures industry. The Commission

    welcomes comment on the proposed Acceptable Practices.\5\

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    \4\ For purposes of these Acceptable Practices, the term

    "SROs" refers to DCMs and is used interchangeably with the terms

    "exchanges," "boards of trade" and "contract markets." As part

    of its SRO study, the CFTC considered whether the current level of

    "public" representation on boards of registered futures

    associations ("RFAs") is still sufficient. That question and

    related issues concerning RFAs remain under review and will be

    addressed separately.

    \5\ This Release is the latest development in the Commission's

    SRO review that commenced in May 2003. The Acceptable Practices

    proposed herein are based on comments received in response to prior

    requests for comments published in the Federal Register, interviews

    with industry participants, testimony given at a February 15, 2006

    public hearing before the Commission, and other sources identified

    herein as part of the basis for the instant proposals. Prior Federal

    Register releases, responses thereto, the hearing transcript, and a

    summary of interview comments, described with greater specificity

    elsewhere herein, are available on the Commission's Web site at

    http://www.cftc.gov, or are available through the Acting Secretary of the

    Commission, whose name and address are listed above.

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    DATES: Comments should be submitted on or before August 7, 2006.

    ADDRESSES: Comments should be sent to Eileen Donovan, Acting Secretary,

    Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

    Street, NW., Washington, DC 20581. Comments may be submitted via e-mail

    at secretary@cftc.gov. "Regulatory Governance" must be in the subject

    field of responses submitted via e-mail, and clearly indicated in

    written submissions. Comments may also be submitted at http://www.regulations.gov.

    FOR FURTHER INFORMATION CONTACT: Rachel F. Berdansky, Acting Deputy

    Director for Market Compliance, (202) 418-5429; or Sebastian Pujol

    Schott, Special Counsel, (202) 418-5641, Division of Market Oversight,

    Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

    Street, NW., Washington, DC 20581.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Introduction

    II. The SRO Review

    A. Procedural History of the SRO Review

    B. Issues Raised by the SRO Review

    III. Description of Proposed Acceptable Practices

    A. Board Composition; "Public" Director Defined

    B. Regulatory Oversight Committee

    C. Disciplinary Panels

    IV. Analysis of Issues and Rationale for Acceptable Practices

    A. Board Composition; "Public" Director

    B. Regulatory Oversight Committee

    C. Disciplinary Panels

    V. Related Matters

    A. Cost-Benefit Analysis

    B. Regulatory Flexibility Act

    C. Paperwork Reduction Act of 1995

    VI. Text of Proposed Acceptable Practices

    I. Introduction

    Exchanges are "affected with a national public interest" in that

    they "provid[e] a means for managing and assuming price risks,

    discovering prices, or disseminating pricing information through

    trading in liquid, fair, and financially secure trading facilities."

    \6\ Exchanges are also the front-line regulators in the U.S. futures

    industry.\7\ There are potential conflicts of interest inherent in an

    exchange's responsibilities as a regulator of its market and members,

    and the commercial interests embedded in its market operation.

    Nevertheless, with proper checks and balances to address such

    conflicts, coupled with vigilant Commission oversight, self-regulation

    can continue to serve as an effective and efficient means of promoting

    market integrity.

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    \6\ CEA Section 3(a), 7 U.S.C. Sec. 5(a).

    \7\ CEA Section 3(b), 7 U.S.C. Sec. 5(b).

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    Increasing competition,\8\ changing ownership structures,\9\ and

    evolving

    [[Page 38741]]

    business models are dramatically transforming the U.S. futures

    industry. Today U.S. futures exchanges must compete vigorously with

    other exchanges, electronic trading facilities and foreign markets to

    attract order flow, and also must meet customer demand for twenty-four

    hour trading, immediate order execution, lower transaction costs, and

    access to global markets. This heightened competition places strain on

    exchanges' dual roles as regulators and as markets, and raises

    questions about their ability to deal with pressures to subordinate

    regulatory responsibilities to commercial imperatives. The trend

    towards demutualization represents an additional challenge to

    exchanges' performance of self-regulatory duties. Traditional SRO

    conflicts have been joined by the possibility that self-regulatory

    functions may be marginalized by potentially conflicting commercial

    interests.\10\

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    \8\ Increasing competition exists between U.S. and foreign

    exchanges, and between domestic exchanges. The New York Mercantile

    Exchange ("NYMEX") and the IntercontinentalExchange offer

    competing contracts in Brent and WTI crude futures. Euronext.liffe,

    a subsidiary of Euronext, and the Chicago Mercantile Exchange

    ("CME") offer competing Eurodollar contracts. Within the U.S., the

    Chicago Board of Trade ("CBOT") and NYMEX offer several competing

    gold and silver contracts.

    New exchanges comprise a further source of new competition.

    Since 2002, the Commission has designated six new contract markets,

    all of which entered the marketplace as non-mutual, for-profit

    entities. There is also competition between trading formats--open

    outcry and electronic. NYMEX gold and silver contracts, for example,

    trade primarily on the floor of the exchange, while CBOT offers its

    gold and silver contracts only electronically. In addition, the new

    contract markets referred to above trade only electronically, and

    electronic trading now accounts for over 60% of all trading volume

    on U.S. futures exchanges.

    Finally, enhanced competition is evident between exchanges and

    their large, institutional futures commission merchant ("FCM")

    members. They may compete directly, with FCMs internalizing order

    flow or exchanges disintermediating FCMs. They may also compete

    indirectly, as occurs, for example, when FCMs establish or invest in

    new exchanges offering substitutable contracts. Examples include the

    Cantor Financial Futures Exchange (no longer trading), designated in

    1998; BrokerTec Futures Exchange, designated in 2001; and U.S.

    Futures Exchange, designated in 2004. The FCM-owners of new

    exchanges may both compete against, and be subject to the regulation

    of, the established SROs of which they are members.

    \9\ The principal change in ownership structure is the

    demutualization of member-owned exchanges and their conversion to

    publicly traded stock corporations. In December 2002, CME became the

    first U.S. futures exchange to transform from a membership mutual

    organization to a publicly traded, for-profit entity. Class A shares

    of its parent company, CME Holdings, Inc., are now listed on the New

    York Stock Exchange ("NYSE"). In October 2005, after undergoing a

    similar restructuring, the CBOT became the second U.S. futures

    exchange to demutualize and offer its parent's stock for trading on

    the NYSE.

    While demutualization has been an important development for the

    largest and most well-established futures exchanges, the advent of

    exchanges structured as for-profit limited liability companies

    ("LLCs") is another significant trend.

    \10\ Five domestic and international studies reviewed by the

    Commission address this issue, and are noteworthy for the extent to

    which they parallel concerns raised by futures industry

    participants. Although the studies focus primarily on the securities

    industry, some include futures markets as well, and the Commission

    believes that the concerns raised by demutualization and competition

    may be similar for both the futures and securities industries and

    exchanges.

    The Securities Industry Association's ("SIA") White Paper on

    Reinventing Self-Regulation, (Jan. 5, 2000, updated Oct. 14, 2003),

    observed, "the combined roles of SROs as market overseers and as

    competitors may affect SROs" ability and willingness to perform all

    their regulatory functions adequately, fairly, and efficiently"

    (SIA 2003 at 3).

    The International Organization of Securities Commissions"

    ("IOSCO") Issues Paper on Exchange Demutualization, (June 2001),

    determined that although many concerns with respect to self-

    regulation are not new, "demutualization and increased competition

    may exacerbate them" (IOSCO at 5).

    A U.S. Government Accountability Office's ("GAO") report to

    Congress entitled "Securities Markets: Competition and Multiple

    Regulators Heighten Concerns about Self-Regulation (May 2002) found

    that some securities SRO members were "concerned that SROs could

    adopt rules that unfairly impeded the ability of members to compete

    against the SROs." Others were concerned that "an SRO, in its

    regulatory capacity, could obtain proprietary information from a

    member and, in its capacity as a market operator, inappropriately

    use the information" (GAO at 7). Some securities SRO members also

    expressed concern that "a demutualized, for-profit market operator

    might be more likely to misuse its regulatory authority or be less

    diligent in fulfilling its regulatory responsibilities in a desire

    to increase profits" (GAO at 8). Abuse of authority could be

    manifested, for example, through "rules that unfairly disadvantage

    members or other markets or inappropriately sanction or otherwise

    discipline members against which the SROs compete." (Id.)

    A discussion paper prepared for the World Bank's ("WB")

    Financial Sector Strategy Department by an independent consultant,

    Implications of Demutualization for the Self-Regulatory and Public

    Interest Roles of Securities Exchanges (John W. Carson, January

    2003) (not necessarily representing the views or policies of the

    World Bank), identified four "widely accepted" propositions with

    respect to conflicts of interest and demutualization: (1) Conflicts

    of interest in self-regulation have always existed; (2)

    demutualization may increase the degree of those conflicts; (3)

    demutualization introduces new conflicts of interest; and (4)

    demutualization may reduce old conflicts (WB at 8). The World Bank

    Study offered several recommendations with respect to self-

    regulation: (1) "At a minimum, the threat of increased conflict in

    exercising regulatory authority demands that new safeguards be put

    in place to reduce the possibility of either the business units or

    customers attempting to influence regulatory decisions;" (2) it is

    imperative that decisions on opening investigations, when to expand

    or close investigations, when to pursue disciplinary action, and

    what penalty to seek are all made in an independent and unbiased

    manner, without regard to business considerations and impact on

    important customer relationships;" and (3) "strong measures are

    required to ensure that the integrity of an exchange's regulatory

    program is maintained and that it handles regulatory issues and

    decisions in a neutral and unbiased mnaner" (WB at 42-43).

    Finally, an International Monetary Fund ("IMF") Working Paper,

    Demutualization of Securities Exchanges: A Regulatory Perspective

    (Jennifer Elliott, September 2002) (not necessarily representing the

    views of the IMF) identified two broad conflicts of interest

    associated with demutualization. According to the Working Paper,

    "the forces that have generated pressure on exchanges to

    demutualize have also created new conflicts of interest and forced

    regulators and exchanges to reconsider what and how regulatory

    functions are delivered by the exchanges" (IMF at 7). One new

    conflict of interest is that "shareholders, who are interested in

    profit, may under fund the exchange's regulatory function. While in

    theory, the exchange should only benefit from an adequate regulatory

    standards [sic], exchanges may succumb to competitive pressure."

    (IMF at 16). "The second conflict of interest is the disincentive

    to regulate market participants (who represent order flow and are a

    direct source of revenue for the exchange)" (Id).

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    In view of these developments, the Commission conducted a review of

    self-regulation in the futures industry to consider whether, and how,

    SROs can continue to fulfill their statutorily-mandated

    responsibilities as regulators.\11\ Three key principles emerged from

    this review. First, self-regulation continues to be the most effective

    and efficient regulatory model available to the futures industry; the

    self-regulatory system nevertheless must be updated and enhanced, as

    appropriate and necessary, to keep pace with the changing marketplace.

    Second, market forces, driven by global competition and changing

    ownership structures, pose a heightened risk that SROs may fail to

    fairly and vigorously carry out their regulatory responsibilities; such

    conflicts, whether actual or perceived, must be addressed proactively

    in the first instance by the SROs themselves. Third, the current market

    environment mandates enhanced and transparent governance as an

    essential business practice for maintaining market integrity and the

    public trust.\12\

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    \11\ See Section II.A., infra.

    \12\ In recent years, the U.S. financial industry has undertaken

    major initiatives to strengthen corporate governance structures.

    These initiatives respond, for the most part, to a perceived lack of

    effective board oversight and emphasize board independence and

    accountability. See Section II.B., infra.

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    The Acceptable Practices proposed today constitute the Commission's

    considered view of best practices relating to SRO governance and

    administration in order to address the concerns raised by SROs' dual

    roles in light of increasing competition and demutualization. The

    Acceptable Practices promote an optimal SRO governance structure, which

    would minimize the potential for conflicts with the SRO's regulatory

    duties. Specifically, the Acceptable Practices would ensure that there

    is adequate independence within the SRO's board to insulate regulatory

    functions from the interests of the exchange's management, members, and

    other business interests of the market itself. An SRO is not simply a

    corporation, but a corporation charged with the public trust. As such,

    the board--the governing body of the SRO--must be structured in a way

    that best fosters public confidence in the integrity of its

    organization, and further, ensures that SRO functions take no less

    preeminence than that accorded to the exchange's commercial interests.

    The Acceptable Practices also would enhance the role of outside

    impartiality in other key SRO functions, including a board-level

    Regulatory Oversight Committee ("ROC") and disciplinary panels, to

    further enhance the transparency and accountability of SRO decisions

    impacting self-regulation. Finally, the proposed Acceptable Practices

    carefully define "public" directors to identify those who can help

    ensure that SRO regulatory programs remain effective, yet unburdened by

    potential conflicts or pressures from the exchange's commercial or

    member interests.

    In summary, the Acceptable Practices proposed today are measured

    steps--in the form of carefully-tailored internal safeguards and checks

    and balances--to promote the independence of SRO functions. At the same

    time, they ensure that industry expertise, experience, and

    [[Page 38742]]

    knowledge continue to play a vital role in SRO governance and

    administration and thus, preserve the "self" in self-regulation. In

    this manner, these proposed Acceptable Practices keep pace with

    changing market dynamics and proactively ensure that the self-

    regulatory model remains as vigorous, as fair, and as effective as

    required to protect the integrity of U.S. futures markets and the

    public confidence in them for years to come.

    II. The SRO Review

    A. Procedural History of the SRO Review

    The Commission's Acceptable Practices are based on a comprehensive

    review of self-regulation and SROs in the U.S. futures industry ("SRO

    Review"). Phase I of the SRO Review explored the roles,

    responsibilities, and capabilities of SROs in the context of industry

    changes. Staff examined the designated self-regulatory organization

    ("DSRO") system of financial surveillance, the treatment of

    confidential information, the composition of exchanges' disciplinary

    committees and panels, and other aspects of the self-regulatory

    process. At the conclusion of Phase I, the Commission identified two

    issues for immediate attention: (1) An examination of the cooperative

    regulatory agreement by which DSROs coordinate compliance examinations

    of FCMs; and (2) ensuring the confidentiality of certain information

    obtained by SROs and DSROs in the course of their regulatory

    activities. Measures with respect to both issues were announced by the

    Commission in February 2004. These issues are not addressed in this

    release.\13\

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    \13\ The most recent amendments to the DSROs' cooperative

    agreement were submitted to the Commission and published for

    comment. Futures Market Self-Regulation, 69 FR 19166 (Apr. 12,

    2004). See also Press Release, Commodity Futures Trading Commission,

    Commission Progresses with Study of Self-Regulation (Feb. 6, 2004),

    available at: http://www.cftc.gov/opa/press04/opa4890-04.htm.

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    After detailed interviews with an array of industry participants,

    the Commission initiated Phase II of the SRO Review and broadened its

    inquiry to address SRO governance and the interplay between exchanges'

    self-regulatory responsibilities and their commercial interests.

    In June 2004, the Commission issued a Federal Register Request for

    Comments ("Request") on the governance of futures industry SROs.\14\

    The Request sought input on the proper composition of exchange boards,

    optimal regulatory structures, the impact of different business and

    ownership models on self-regulation, the proper composition of exchange

    disciplinary committees and panels, and other issues.

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    \14\ Governance of Self-Regulatory Organizations, 69 FR 32326

    (June 9, 2004). In this release, comment letters ("CLs") in

    response to the SRO Governance Request for Comments are referred to

    by the name of the party submitting the letter and page number.

    These letters are available at: http://www.cftc.gov/foia/comment04/foi04--005_1.htm.

    A summary of interview comments (with names of

    persons interviewed redacted) also is available at this Web site.

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    In November 2005, the Commission updated its previous findings

    through a second Federal Register Request for Comments ("Second

    Request") that focused on the most recent industry developments.\15\

    The Second Request examined the board-level ROCs recently established

    at some SROs in the futures and securities industries. It considered

    the impact of the listing standards of the New York Stock Exchange

    ("NYSE") on publicly-traded futures exchanges; whether the standards

    were relevant to self-regulation; and how the standards might inform

    the Commission's own regulations. The Second Request also explored the

    role of outside regulatory service providers, including RFAs, and SRO

    governance and the composition of boards and disciplinary committees.

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    \15\ Self-Regulation and Self-Regulatory Organizations in the

    Futures Industry, 70 FR 71090 (Nov. 25, 2005). Comment letters

    received in response to this release are available at http://www.cftc.gov/foia/comment05/foi05--007_1.htm.

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    Phase II of the SRO Review concluded with a public Commission

    hearing on "Self-Regulation and Self-Regulatory Organizations in the

    U.S. Futures Industry" ("Hearing"). The day-long Hearing, held at

    Commission headquarters in Washington, DC on February 15, 2006,

    included senior executives and compliance officials from a wide range

    of U.S. futures exchanges, representatives of small and large FCMs,

    academics and other outside experts, and an industry trade group. The

    Hearing afforded the Commission an opportunity to question panelists on

    four broad subject areas: (1) board composition; (2) alternative

    regulatory structures, including ROCs and third-party regulatory

    service providers; (3) transparency and disclosure; and (4)

    disciplinary committees.\16\

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    \16\ The Hearing Transcript ("Hearing Tr.") is available at

    http://www.cftc.gov/files/opa/opapublichearing021506final.pdf.

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    B. Issues Raised by the SRO Review

    The SRO Review provided the Commission staff and industry

    participants and observers a unique opportunity to comment on the

    present state of self-regulation in the U.S. futures industry. Through

    interviews with over 100 industry participants and observers, comments

    received in response to Federal Register notices, and the Hearing, the

    Commission gathered a wide range of views on the successes and

    challenges facing self-regulation now and into the future.

    In general, commenters and interview participants saw continuing

    vitality in the central premise of self-regulation: that regulation

    works best when conducted close to the markets by individuals with

    market-specific expertise. At the same time, though, throughout the

    course of the SRO Review and in the surrounding public debate on the

    merits of self-regulation in the financial sector generally, many

    identified increased competition, evolving business models, and new

    ownership structures as critical changes capable of adversely impacting

    exchanges' regulatory behavior.\17\

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    \17\ See e.g., Futures Industry Association ("FIA"), CL at 2

    (Jan. 23, 2006); Comments of Professor Roberta S. Karmel, Centennial

    Professor of Law, Brooklyn Law School ("Karmel"), Hearing Tr. at

    32 ("[T]echnology and competition are creating more serious

    conflicts and, in fact, it is these forces that propel

    demutualization in the first place"); Comments of Christopher K.

    Hehmeyer, Co-Chairman, Goldenberg Hehmeyer & Co., id. at 151

    ("[E]xchanges have done very well. But it would only take a couple

    of bad quarters, God forbid, on the part of the exchanges, for there

    to be pressures on some of the conflicts that haven't revealed

    themselves in the past."); Comments of Susan M. Phillips, Dean,

    George Washington University School of Business ("Phillips"), id.

    at 116 ("Obviously, the whole exchange environment is changing

    dramatically, probably more so now than at any time in history.

    There are a lot of pressures on exchanges.").

    See also IOSCO at 4. ("[A]s competition increases and exchanges

    move from mutual or cooperative entities to for-profit enterprises,

    new elements enter the environment. The commercial nature of the

    exchange becomes more evident: maximizing profits becomes an

    explicit objective."). Others have noted that, even absent

    demutualization or for-profit exchanges, "intense competition alone

    will * * * increase conflicts due to the need to reduce costs, be

    more responsive to customers, and ensure that competing markets do

    not gain advantage by imposing a lighter regulatory burden." WB at

    31.

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    Specifically, some interview and Hearing participants and

    commenters expressed concern that for-profit, publicly traded exchanges

    may under-invest in regulatory personnel or technology to control costs

    and thereby meet the short-term expectations of stock holders and

    analysts.\18\ The

    [[Page 38743]]

    exchanges' growing conflicts may also manifest themselves in under-

    regulation of those market participants who generate significant income

    or liquidity for the exchange--for example, FCMs that bring significant

    customer volume, market makers that provide significant liquidity, or

    high-volume locals. Conversely, concerns were raised that exchange

    participants who are not favored by, or compete with, the exchange may

    suffer from discriminatory or over-regulation.\19\

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    \18\ See, e.g., FIA CL (Jan. 23, 2006) at 1 (observing that SROs

    may use their regulatory authority for anti-competitive purposes or

    to adopt rules that benefit parochial interests at the expense of

    the public interest); and Citigroup CL (Jan. 23, 2006) at 1-2

    (echoing support for the views expressed in FIA's comment letter);

    see also Comments of Jeffrey Jennings, Managing Director and Global

    Head of Futures, Lehman Brothers ("Jennings"), Hearing Tr. at 53

    ("[A]s the exchanges become for-profit * * * we have to recognize

    the issues that that raises, and the risks of there being some sort

    of conflicts of interest. * * *").

    \19\ Whether stemming from increased competition,

    demutualization, or for-profit structures, potential conflicts of

    interest in self-regulation may be all the more evident when

    exchanges regulate their competitors. For example, when firms

    operate their own market and also are users of an exchange, the

    exchange could discriminate in disciplinary matters, trading rules,

    fees, and other areas in which it has jurisdiction over the

    competitor. It has been suggested that, as with other conflicts of

    interest, "the conflicts inherent in an exchange regulating its

    competitors, while not new, become more apparent where the exchange

    is also a for-profit enterprise." IOSCO at 5.

    ---------------------------------------------------------------------------

    Exchanges, in turn, have argued that increased competition,

    demutualization, and other industry developments will strengthen self-

    regulation, not weaken it.\20\ They stated that their competitive

    advantage rests in offering fair and transparent markets that are free

    from fraud, manipulation, and other abusive practices. Exchanges also

    noted that demutualization and public listing create a new class of

    exchange owners whose long-term interests are aligned with effective

    self-regulation and fair markets.

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    \20\ See, e.g., CME CL (Jan. 23, 2006) at 2 and NYMEX CL (Jan.

    23, 2006) at 3.

    ---------------------------------------------------------------------------

    Against this backdrop of market changes raising implications for

    the SROs" performance of their regulatory functions, the U.S.

    financial industry has seen the emergence of governance "best

    practices" and standards designed to enhance corporate responsibility.

    These best practices and standards are found in a wide spectrum of the

    U.S. business community, ranging from securities self-regulatory

    organizations to major corporations and financial participants. All of

    these initiatives emphasize corporate governance as the key tool for

    the fulfillment of corporate responsibilities.\21\

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    \21\ See, e.g., Fair Administration and Governance of Self-

    Regulatory Organizations, 69 FR 71126 (Dec. 8, 2004) ("Fair

    Administration"); World Bank--Corporate Governance Principles of

    Best Practices, available at: http://www.worldbank.org/html/fpd/privatesector/cg/codes.htm

    ; CalPERS Governance Principles, available

    at: http://www.calpers-governance.org/principles/default.asp.

    ---------------------------------------------------------------------------

    The cumulative impact of an evolving industry, operating in an ever

    more competitive, global environment, and the growing attention to the

    need for enhanced corporate governance, provide the basis for the

    Commission's review of self-regulation in the futures industry and the

    Acceptable Practices proposed herein.\22\

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    \22\ In the face of such developments, a Hearing participant

    observed that "it is incumbent upon us all that the U.S. futures

    industry establish standards that recognize and are responsive to

    the realities of our changing industry and marketplace and are fair

    and without any appearance of conflicts." Jennings, Hearing Tr. at

    28.

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    III. Description of Proposed Acceptable Practices

    Section 5(d)(15) of the CEA ("Core Principle 15") requires that

    exchanges "minimize conflicts of interest in the decision making

    process." \23\ Underlying the Core Principle's mandate is the

    recognition that management of conflicts of interest, which could

    potentially compromise the independence of an exchange's decision

    making, is fundamental to the effective operations of the exchange--no

    less than customer protection and market integrity mandated by other

    Core Principles. Core Principle 15 requires the exchanges to have

    systems in place to address not only an individual's personal conflicts

    of interest, but also the broader potential conflicts of interest

    inherent in self-regulation.

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    \23\ Any board of trade that is registered with the Securities

    and Exchange Commission ("SEC") as a national securities exchange,

    is a national securities association registered pursuant to section

    15(A)(a) of the Securities Exchange Act of 1934, or is an

    alternative trading system, and that operates as a designated

    contract market in securities futures products under Section 5f of

    the Act and SEC Regulation 41.31, is exempt from the core principles

    enumerated in Section 5 of the Act, and the Acceptable Practices

    thereunder.

    ---------------------------------------------------------------------------

    As discussed earlier, with respect to SROs that operate as both

    markets and front-line regulators, these conflicts may be further

    exacerbated by emerging market trends. At present, however, there are

    no Acceptable Practices for Core Principle 15. The Commission's core

    mission is to promote and protect the integrity of the U.S. futures

    markets and to promote public confidence and trust in those markets.

    Now, as the futures industry undergoes one of the most significant

    transformations in its long history, self-regulation must keep pace.

    Accordingly, the Commission believes that it is appropriate and

    necessary to provide guidance to SROs in the form of Acceptable

    Practices for Core Principle 15.

    Core Principle 15 is illustrative of the new regulatory approach

    ushered in by the Commodity Futures Modernization Act of 2000

    ("CFMA"),\24\ which replaced prescriptive rules governing futures

    exchanges with broad, flexible core principles. The core principles set

    standards of performance for the exchanges, and at the same time, allow

    exchanges considerable leeway in how to meet those standards. To

    facilitate compliance, the Commission has adopted Acceptable Practices

    for other core principles. Through its Acceptable Practices, the

    Commission provides exchanges with a safe harbor for complying with

    selected requirements of a core principle, but such Acceptable

    Practices, as stated in the Act, are not the exclusive means for

    compliance.\25\ Once implemented, Acceptable Practices provide

    regulatory certainty that exchanges may rely upon when seeking

    designation as contract markets or when subject to periodic Rule

    Enforcement Reviews by the Commission.\26\

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    \24\ Appendix E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).

    \25\ See CEA Section 5c(a)(2), 7 U.S.C. Sec. 7a-2(a)(2).

    \26\ The Commission has explained that "boards of trade that

    follow the specific practices outlined under [the Acceptable

    Practices] * * * will meet the selected requirements of the

    applicable core principle." 17 CFR part 38, App. B, ] 2.

    ---------------------------------------------------------------------------

    The Acceptable Practices proposed in this Release are designed to

    offer exchanges a roadmap for complying with selected requirements of

    Core Principle 15. The Acceptable Practices that we propose today would

    enable SROs to demonstrate that they are structurally capable of

    protecting their regulatory functions and decision making from

    conflicts of interest.\27\

    As with Acceptable Practices generally, exchanges may choose not to

    comply with the proposed Acceptable Practices for Core Principle 15.

    They still will be required, however, to demonstrate that their

    policies and practices with respect to governance and decision making

    are in compliance with Core Principle 15 by other means.\28\

    ---------------------------------------------------------------------------

    \27\ In recent amendments to Appendix B of Part 38, the

    Commission has explained that "the enumerated acceptable practices

    under each core principle are neither the complete nor the exclusive

    requirements for meeting that core principle. With respect to the

    completeness issue, the selected requirements in the acceptable

    practices section of a particular core principle may not address all

    the requirements necessary for compliance with the core principle."

    Technical and Clarifying Amendments to Rules for Exempt Markets,

    Derivatives Transaction Execution Facilities and Designated Contract

    Markets, and Procedural Changes for Derivatives Clearing

    Organization Registration Applications, 71 FR 1953, 1958 (Jan. 12,

    2006). The Acceptable Practices that we propose today do not reach,

    and are not intended to reach, individual, personal conflicts of

    interest. A contract market must address these conflicts as well as

    the structural conflicts that are the subject of these proposed

    Acceptable Practices in order to demonstrate full compliance with

    Core Principle 15's requirements.

    \28\ In this regard, the CFTC will take into account the

    governance and regulatory conflicts of interests specific to the

    exchange and how they are being managed.

    ---------------------------------------------------------------------------

    [[Page 38744]]

    The elements of the proposed Acceptable Practices under Core

    Principle 15 are summarized below. The Commission proposes as a new

    Acceptable Practice under Core Principle 15 that at least fifty percent

    of the board members of exchanges' boards of directors and executive

    committees (or similarly empowered bodies) be "public" directors, as

    defined below ("Board Composition Acceptable Practice"). Day-to-day

    regulatory operations should be supervised by a Chief Regulatory

    Officer ("CRO") reporting directly to a ROC ("Regulatory Oversight

    Committee Acceptable Practice"). The Acceptable Practices define

    "public director" for persons serving on boards, ROCs, and

    disciplinary panels. An individual may qualify as a public director

    upon an affirmative determination by the board that the individual has

    no material relationship with the exchange.

    In addition, the Acceptable Practices strengthen impartial

    adjudication by providing that SRO disciplinary panels should not be

    dominated by any group or class of SRO participants, and that each

    panel should include at least one public member ("Disciplinary Panel

    Acceptable Practice"). By increasing the public voice on governing

    boards and disciplinary committees and creating an independent board-

    level ROC, combined with Commission oversight, the Acceptable Practices

    seek to maintain the existing high standards of fair and effective

    self-regulation in the futures industry, while proactively adapting

    them to the market and business realities of a new era for the

    industry. Each of these Acceptable Practices is described below.

    A. Board Composition; "Public" Director Defined

    The Board Composition Acceptable Practice provides that exchanges

    should elect governing boards composed of at least fifty percent public

    directors. In addition, it provides that SROs' executive committees (or

    similarly empowered bodies) should be at least fifty percent public.

    The Acceptable Practice offers guidance on the definition of

    "public" director. The proposed definition provides that a director

    is "public" only if the board of directors affirmatively determines

    that the director has no "material relationship" with the exchange.

    The nominating committee of the board of directors should affirmatively

    determine on the record that a director or nominee has no material

    relationship with the exchange, and should state on the record the

    basis for its determination and the scope of its scrutiny. The

    committee should reevaluate that determination at least on an annual

    basis.

    "Material relationships" are those that reasonably could affect

    the independent judgment or decision making of the director. Material

    relationships are not exclusively compensatory or financial. Any

    relationship between a director and the exchange that may interfere

    with a director's ability to deliberate objectively and impartially on

    any matter is a material relationship. In this regard, material

    relationships are not limited to those where a director has an

    immediate interest in a particular matter before him or her.

    In addition to the general materiality test, the proposed

    definition of "public" director identifies specific circumstances or

    relationships that would preclude a determination that a person

    qualifies as a "public" director. Specifically, a director could not

    be "public" if any of the following circumstances existed: \29\

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    \29\ These specific circumstances--or "bright-line" tests--are

    neither exclusive nor exhaustive. A director does not qualify as

    "public" unless the board affirmatively determines that the

    director has no material relationship with the exchange, including

    but not limited to, the bright-line tests identified herein.

    ---------------------------------------------------------------------------

    --The director is an officer or employee of the exchange or a director,

    officer or employee of its affiliate; \30\

    ---------------------------------------------------------------------------

    \30\ As used in this context, an affiliate includes parents or

    subsidiaries of the contract market or entities that share a common

    parent with the contract market.

    ---------------------------------------------------------------------------

    --The director is a member of the exchange, or a person employed by or

    affiliated with a member. In this context, a director is affiliated

    with a member if the director is an officer or director of the member;

    --The director receives more than $100,000 in payments from the

    exchange, any affiliate of the exchange, or a member or anyone

    affiliated with a member; \31\

    --Any of the relationships above apply to a member of the director's

    immediate family, i.e., spouse, parents, children, and siblings.

    ---------------------------------------------------------------------------

    \31\ Compensation for services as a director will not be counted

    towards the $100,000 threshold test.

    ---------------------------------------------------------------------------

    --All of the disqualifying circumstances described above are subject to

    a one-year look back. Thus, for example, a director who, within the

    past year, was a member of the exchange, would not qualify as a

    "public" director.

    Comments are solicited on whether there are additional categories

    of circumstances which should automatically disqualify a person from

    consideration as a "public" director. Also, commenters have suggested

    that members should not be precluded from serving as a "public"

    director. They have offered as examples persons who engage in de

    minimis trading, or members who lease their seats to others. The

    Commission seeks the public's views on whether these or similar

    circumstances could rebut the presumption of member disqualification as

    a "public" director.

    B. Regulatory Oversight Committee

    The Regulatory Oversight Committee Acceptable Practice recognizes

    the importance of insulating core regulatory functions from improper

    influences and pressures stemming from the exchange's commercial

    affairs. To comply with the Regulatory Oversight Committee Acceptable

    Practice, every exchange should establish, as a standing committee of

    its board of directors, a ROC with oversight responsibility for all

    facets of the SRO's regulatory program. This includes broad authority

    to oversee: (1) Trade practice surveillance; (2) market surveillance;

    (3) audits, examinations, and other regulatory responsibilities with

    respect to member firms; \32\ (4) the conduct of investigations; (5)

    the size and allocation of regulatory budgets and resources; (6) the

    number of regulatory officers and staff; (7) the compensation of

    regulatory officers and staff; (8) the hiring and termination of

    regulatory officers and staff; and (9) the oversight of disciplinary

    committees and panels.

    ---------------------------------------------------------------------------

    \32\ SROs' regulatory responsibilities with respect to member

    firms include ensuring compliance with financial integrity,

    financial reporting, sales practice, recordkeeping, and other

    requirements. Commission Regulation 1.52 permits cooperative

    agreements among exchanges to coordinate compliance examinations of

    FCMs such that each FCM is assigned a primary examiner (its DSRO).

    ROCs should have authority over SROs self-regulatory functions, both

    when the SROs are fulfilling SRO responsibilities and when they are

    fulfilling DSRO responsibilities.

    ---------------------------------------------------------------------------

    The ROC's primary role is to assist the board in fulfilling its

    responsibility of ensuring the sufficiency, effectiveness, and

    independence of self-regulatory functions.\33\ In this capacity, the

    ROC should have the authority, discretion and necessary resources to

    conduct its own inquiries; consult directly with regulatory staff;

    interview employees, officers, members, and others; review relevant

    documents; retain independent legal counsel, auditors, and other

    professional services; and otherwise exercise its independent analysis

    and

    [[Page 38745]]

    judgment to fulfill its regulatory obligations.\34\

    ---------------------------------------------------------------------------

    \33\ In its review of exchanges for compliance with Core

    Principles, the Commission will look at board documentation of the

    reasons for its actions and its acceptance or rejection of

    recommendations by the ROC, as well as by other committees.

    \34\ Nevertheless, a ROC should not rely on outside

    professionals or firms that also provide services to the full board,

    other board committees, or other units of the exchange.

    ---------------------------------------------------------------------------

    ROCs would be expected to identify aspects of the regulatory scheme

    that work well and those that need improvement, and, as necessary, to

    make recommendations to the governing board for changes that would

    ensure fair, vigorous, and effective regulation. ROCs should also be

    given an opportunity to review and, if they wish, present formal

    opinions to management and the board on any proposed rule or

    programmatic changes originating outside of the ROCs, but which their

    CROs believe may have a significant regulatory impact.\35\ Exchanges

    should provide their CROs and ROCs with sufficient time to consider

    such proposals before acting on them. In addition to periodic reports

    to the board, ROCs should prepare for the governing board and the

    Commission an annual report assessing the effectiveness, sufficiency,

    and independence of the SRO's regulatory program, including any

    proposals to remedy unresolved regulatory deficiencies. ROCs are also

    expected to keep thorough minutes and records of meetings,

    deliberations, and analyses, and make these available to Commission

    staff upon request.\36\

    ---------------------------------------------------------------------------

    \35\ ROCs' deliberations with respect to such proposed rule

    changes should be memorialized in thorough meeting minutes, and

    their formal opinions made available to Commission staff upon

    request.

    \36\ The Commission's review of Core Principle 15 compliance

    will include, inter alia, the ROC's records, annual reports, meeting

    minutes, analyses conducted or commissioned by the ROC, examinations

    of proposed and existing rules, and evaluations and recommendations

    concerning the effectiveness, sufficiency, and independence of the

    exchange's regulatory programs. See Section 8(a)(1) of the Act, 7

    U.S.C. Sec. 12(a)(1), authorizing the Commission to "make such

    investigations as it deems necessary to ascertain the facts

    regarding the operations of boards of trade and other persons

    subject to the provisions of this Act."

    ---------------------------------------------------------------------------

    Finally, the proposed Acceptable Practice envisions that the CRO of

    the SRO will report directly to, and regularly consult with, the ROC.

    ROCs may delegate their day-to-day authority over self-regulatory

    functions and personnel to the CRO. Although ROCs remain responsible

    for ensuring the sufficiency, effectiveness, and independence of self-

    regulation within their SROs, they are not expected to assume

    managerial roles.

    C. Disciplinary Panels

    The proposed Disciplinary Panel Acceptable Practice would preclude

    any group or class of exchange members from dominating or exercising

    disproportionate influence on any disciplinary panel. In addition, the

    Commission proposes that all disciplinary panels include at least one

    "public" participant. To qualify as "public," panel members should

    meet the same test as public directors.

    For purposes of this Acceptable Practice, "disciplinary panel"

    means any person, panel of persons, or any subgroup thereof, which is

    authorized by an SRO to issue disciplinary charges, to conduct

    proceedings, to settle disciplinary charges, to impose disciplinary

    sanctions, or to hear appeals thereof, except in cases limited to

    decorum, attire, the timely submission of accurate records required for

    clearing or verifying each day's transactions or other similar

    activities. If an exchange's rules provide for an appeal to the board

    of directors, or a committee of the board, then that appellate body

    should include at least one person who meets the qualifications for

    membership on the board's ROC. "Disciplinary panel" does not include

    exchange regulatory staff authorized to issue warning letters or

    summary fines imposed pursuant to established schedules.

    To take advantage of this safe harbor, and thereby comply with Core

    Principle 15's requirement to minimize conflicts of interest in

    decisionmaking, the Commission is proposing that exchanges amend their

    disciplinary panel composition rules and policies to incorporate the

    terms of the Disciplinary Panel Acceptable Practices. Finally, under

    this Acceptable Practice, disciplinary committees and panels would fall

    under the oversight of the ROC.

    IV. Analysis and Rationale for Proposed Acceptable Practices

    A. Board Composition; "Public" Director

    The Board Composition Acceptable Practice is designed to promote

    and safeguard the independence of the board of directors. It reaffirms

    the basic corporate principle that good governance is the cornerstone

    of a strong corporation and that a company's long-term success is best

    secured by enhancing the presence of independent participants at the

    highest level of corporate decisionmaking, the board of directors.

    In any corporation, the paramount duty of the board of directors is

    to act, at all times, in the best interest of the corporation. It is

    the board that has the ultimate decisionmaking authority within a

    corporation and that must be accountable for any failure in the

    fulfillment of its corporate duties. In effect, the board represents

    the first line of defense against corporate misconduct. In the case of

    a corporation that also operates as an SRO, the board may have to make

    decisions in circumstances where its role as a fiduciary to the

    shareholders conflicts with its duty as a custodian of the public

    trust.\37\ Increased competition and demutualization may further

    exacerbate these potentially competing claims and render the board

    susceptible to pressures that may impact its ability to carry out self-

    regulatory duties to their fullest extent.

    ---------------------------------------------------------------------------

    \37\ Any decisions made by SROs' boards of directors, although

    not directly regulatory, implicate the public interest and the

    intersection between regulatory responsibilities and commercial

    imperatives. SROs' boards of directors determine transaction fees;

    market data fees; and membership criteria. They control the

    employment and compensation of senior executives, including the

    president of the exchange, and they are sometimes responsible for

    the appointment of public directors. Boards make fundamental

    governance decisions, including those made with respect to the

    strategic direction of the SRO and the oversight of self-regulation.

    In addition, SROs' public interest obligations are cited in the very

    purposes of the Act, which include "to serve the public interest *

    * * through a system of effective self-regulation of trading

    facilities." CEA Section 3(b), 7 U.S.C. 5(b).

    As noted at the Hearing, "exchanges which also function as for-

    profit institutions as well as SROs are truly occupying an

    absolutely unique space in corporate America." Jennings,

    Hearing.Tr. at 79.

    ---------------------------------------------------------------------------

    The Commission's proposed Board Composition Acceptable Practice

    constitutes a strong, proactive approach to ensuring the continued

    success of self-regulation in the futures industry. With respect to

    exchange boards of directors, their dual regulatory and commercial

    roles suggest that a fifty percent "public" board is an appropriate

    balance and should best enable directors to carry out their

    responsibilities.\38\

    ---------------------------------------------------------------------------

    \38\ Industry participants and observers noted that independence

    of an exchange's board of directors is key to effective and

    impartial self-regulation due to its role as the ultimate arbiter of

    decisions affecting both commercial and regulatory functions of the

    exchange. To address the conflicts of interest inherent in this dual

    role, most participants agreed on the benefits of including

    "public" directors on exchange boards. See e.g., Jennings, Hearing

    Tr. at 29 ("[I]t is a fundamental requirement that exchange boards

    must have a significant representation of independent public

    directors. I believe it is appropriate that at least fifty percent

    of the exchange board must comprise this group."); and Phillips,

    Hearing Tr. at 159 (addressing reviews of exchanges' rulemaking

    authority, "* * * it comes back to the governance process and the

    independence of the board to really make those kinds of reviews

    meaningful."). However, industry participants did not agree on what

    specifically constitutes an appropriate board composition, or

    whether existing exchange board compositions are adequate.

    ---------------------------------------------------------------------------

    The Commission notes that its proposed Board Composition

    [[Page 38746]]

    Acceptable Practice is consistent with the trend of major governance

    initiatives across the corporate and SRO communities in the United

    States. In November 2003, the New York Stock Exchange ("NYSE") and

    NASDAQ both implemented new governance standards for their listed

    companies. Among the most important provisions is the requirement that

    listed companies' boards have a majority of independent directors. In

    addition, listed companies must have fully independent nominating,

    corporate governance, compensation, and audit committees. While the

    conflicts driving these governance initiatives may differ from those

    arising in the futures self-regulatory context, the NYSE and NASDAQ

    standards for listed companies reflect their recognition that good

    corporate governance is founded on strengthening the independence and

    accountability of the board.

    Two futures exchanges, the CME and the CBOT are now subject to the

    NYSE listing standards outlined above, and others may join them as

    futures exchanges continue to demutualize and seek public listing of

    their shares. The Commission is satisfied that the listing standards

    provide a measure of shareholder protection for the owners of publicly-

    traded futures exchanges. However, the Commission is equally satisfied

    that these listing standards are not designed for public companies that

    also bear a special responsibility of public protection and fair and

    effective self-regulation. Although it may be true, as the publicly-

    traded futures SROs have determined, that SRO members are independent

    under the NYSE listing standards, the proposed Board Composition

    Acceptable Practice provides that members are not independent for

    purposes of protecting the public interest against conflicts of

    interest in self-regulation.

    Finally, the fifty percent minimum standard strikes a favorable

    balance between inside expertise and "outside" impartiality and

    ensures that other exchange stakeholders, such as members and exchange

    management, are adequately represented. In this manner, the "self" in

    self-regulation is retained, along with its efficiencies and expertise,

    while the ultimate benefactors of the self-regulatory system--market

    participants and the public--are assured that their interests are well-

    represented at the highest level.

    (i) Definition of "Public" Director

    To facilitate compliance, the Commission has modeled aspects of its

    "public" director definition, and more specifically, the materiality

    test, on what have now become accepted standards for defining

    independent directors. For example, the NYSE governance standards,

    noted above, mandate that to qualify as independent, directors must

    meet both a series of bright-line tests capturing certain present and

    past employment, compensation, business, familial, and other

    relationships; and a categorical "no material relationship" test.

    Similarly, under the Commission's proposed definition, the

    determination of whether a person qualifies as a "public" director

    entails (1) proposed "bright-line" tests, such as membership,

    employment, and business and financial ties with the exchange, aimed at

    identifying many of the circumstances that necessarily impair

    independent decision making; and (2) a facts and circumstances

    analysis. As to the facts and circumstances analysis, the board, taking

    into account all of the relevant factors relating to the person's

    relationship with the exchange, must make a reasonable finding on the

    record that the person is capable of independent decision-making. This

    analysis is broader than the bright-line tests.

    Similar standards have already been implemented in a variety of

    related contexts: by the Public Company Accounting Reform and Investor

    Protection Act of 2002 (Sarbanes-Oxley Act of 2002) with respect to

    independent directors serving on the audit committees of public

    companies;\39\ and by the NYSE for its own board of directors.\40\ The

    SEC has also proposed similar standards for independent directors on

    the boards of securities exchanges.\41\

    ---------------------------------------------------------------------------

    \39\ Pub. L. No. 107-204, 116 Stat. 745 (2002).

    \40\ Constitution of the New York Stock Exchange, Art. IV, Sec.

    2.

    \41\ Fair Administration, supra note 21.

    ---------------------------------------------------------------------------

    The Acceptable Practice addressing board qualifications is named

    the "Public Director Acceptable Practice" rather than the

    "Independent Director Acceptable Practice" to emphasize the national

    public interest in futures trading and the role that SROs play in

    serving and protecting that interest.\42\ The appropriate definition

    of, and qualifications for, an unconflicted director were debated

    vigorously during the SRO Review.\43\ The debate often centered on

    whether the NYSE listing standards are sufficient for self-regulatory

    purposes. Several commenters and Hearing participants noted that the

    NYSE independent director standard principally operates to protect

    shareholder interests against undue management influence, and that more

    is needed to protect the public interest in an institution that

    exercises regulatory duties.\44\ The Commission generally agrees that

    the listing standards are not sufficient for public companies that also

    bear special responsibility to the public to self-regulate fairly and

    effectively. Simply stated, self-regulation and shareholder protection

    are two distinct missions: they may be complementary, but they are not

    substitutes.

    ---------------------------------------------------------------------------

    \42\ See CEA Section 3(b), 7 U.S.C. Sec. 5(b).

    \43\ FIA for example, commented that "[i]ndependent SRO

    directors should be independent not only of management but also of

    all activity on the exchange" because "[t]he special nature of an

    SRO's powers and functions * * * makes it essential to have truly

    independent directors with no direct, current ties to the industry

    the SRO regulates." FIA CL (Jan. 23, 2006) at 3. NYMEX, on the

    other hand, was of the view that active industry participation did

    not impair impartiality so long as a director had no ties to the

    exchange itself. See NYMEX CL (Jan. 23, 2006) at 7: NYMEX stated

    that its "Public Directors would qualify as independent directors"

    under NYSE listing standards and noted that "it is possible for

    markets subject to [NYSE] listing standards to conclude that

    exchange members qualify as independent directors." NYMEX noted the

    "specialized" nature of futures trading and emphasized the

    importance of board expertise. Id. The CME as well stated that

    independence should be determined on a case by case basis. CME CL

    (Jan. 23, 2006) at 7.

    \44\ See, e.g., Karmel, Hearing Tr. at 33 ("The New York Stock

    Exchange and NASDAQ listing standards, as others have already said,

    do not squarely address the key issue of whether exchange members

    should be considered independent or not when they serve as directors

    of an exchange board or a regulatory subsidiary"; and FIA CL (Jan.

    23. 2006) at 3.

    ---------------------------------------------------------------------------

    B. Regulatory Oversight Committee

    ROCs would provide independent oversight of core regulatory

    functions, including trade practice, market, and financial

    surveillance, for all exchanges. ROCs also would oversee the

    performance of disciplinary committees. Because these functions are

    fundamental manifestations of SROs' regulatory authority, the

    Commission believes that they should be overseen in the most impartial

    manner possible within the context of self-regulation--by public

    directors who are neither members of the SRO nor otherwise dependent

    upon the commercial enterprise.\45\

    ---------------------------------------------------------------------------

    \45\ The Commission's proposed Regulatory Oversight Acceptable

    Practice is similar to measures already implemented or recommended

    by some exchanges in response to acknowledged self-regulatory

    concerns. The CME, for example, has formed an advisory board-level

    committee to "ensure the independent exercise" of self-regulatory

    obligations ("Market Regulation Oversight Committee" or "MROC").

    Every member of the committee must be an independent director. The

    MROC reviews and reports to CME's board, on an annual basis, with

    respect to: (1) The independence of CME's regulatory functions from

    its business operations; (2) the independence of CME management and

    regulatory personnel from improper influence by industry directors

    regarding regulatory matters; (3) CME's compliance with its SRO

    responsibilities; (4) appropriate funding and resources to ensure

    effective performance of SRO responsibilities; and (5) appropriate

    compensation for CME employees involved in regulatory activities.

    ---------------------------------------------------------------------------

    [[Page 38747]]

    The public directors on the ROC would be free to consider the

    unique responsibilities of the SRO to act in the public interest, to

    plan for effective self-regulation in the long-term, and to insulate

    regulatory decisions from short-term pressures that may be brought to

    bear in an increasingly competitive environment. The Commission

    believes that SROs generally stand to benefit from establishing ROCs.

    ROCs' determinations with respect to their core competencies would

    be subject to review by the full board of directors, including member

    directors, and ROCs would be free to consult widely within the SRO

    throughout their deliberations, thus ensuring that member expertise

    remains central to self-regulation in the futures industry. At the same

    time, by placing initial oversight responsibility in the hands of

    public directors, arming them with the tools and resources necessary to

    make fully informed decisions, and providing an independent reporting

    line for senior regulatory officers, SROs would ensure that regulatory

    decisions are insulated from improper influences. The ROC structure,

    combined with careful Commission review of the interaction between the

    ROC and the board, fosters the continued integrity of futures self-

    regulation, effective management of conflicts of interest within SRO

    governance, and full consideration of the public interest in every

    decision of regulatory consequence.

    C. Disciplinary Panels

    Diversity in committee and panel composition has long been

    recognized as an effective tool for minimizing conflicts of interest in

    SRO disciplinary adjudication, a long-standing objective of the

    Commission. Prior to enactment of the CFMA, the Act set specific

    standards for the composition of SRO disciplinary committees, requiring

    that: (1) Exchanges provide for a diversity membership on all major

    disciplinary committees and (2) respondents in exchange disciplinary

    actions not be tried exclusively by their peers.

    The CFMA continues the Act's commitment to fair disciplinary

    procedures. The Acceptable Practices for Core Principle 2, for example,

    require that exchanges discipline members and market participants

    pursuant to "clear and fair standards." \46\ As stated earlier, Core

    Principle 15 requires exchanges to "minimize conflicts of interest in

    the decision making process." This requirement extends to disciplinary

    committees and panels, which must be free of both individual and group

    (e.g., floor versus FCM) conflicts of interest.

    ---------------------------------------------------------------------------

    \46\ 17 CFR Part 38, App. B, Core Principle 2, Acceptable

    Practices.

    ---------------------------------------------------------------------------

    The Commission believes that fair disciplinary procedures with

    minimal conflicts of interest require unbiased disciplinary panels

    representing a diversity of opinions and experiences. At the very

    least, this presumes panels that are not weighted in favor of any

    single class of exchange participants. Also, including a public person

    provides an outside perspective and helps to ensure that the public's

    interests are represented and protected. The Commission is confident

    that proper composition can minimize potential conflicts of interest

    and promote fairness on disciplinary panels, as required by Regulation

    170.3 and Core Principles 2 and 15.

    The SRO Review has found no indication of widespread inadequacy in

    exchange disciplinary committees, as many FCMs suggested. To the

    contrary, some exchanges maintain very diverse committees, including

    nonmember representatives. For example, CME's seven-person Probable

    Cause and Business Conduct panels each include three non-members.\47\

    Furthermore, the Commission has found that, at most exchanges, FCMs are

    more likely to appear before clearing house risk committees or

    financial compliance/surveillance committees (where FCMs are typically

    well-represented) than on business conduct committees or similar

    committees (which may include broker, local, commercial, FCM, and

    public panelists).

    ---------------------------------------------------------------------------

    \47\ CME Rules 402, 406.

    ---------------------------------------------------------------------------

    In addition, periodic Rule Enforcement Reviews conducted by the

    Commission's Division of Market Oversight, which carefully examine

    disciplinary sanctions, typically find that they are fair and do not

    discriminate among different classes of exchange participants. Rule

    Enforcement Reviews also examine exchange disciplinary procedures, and

    consistently find that these are adequate.

    The Commission is generally satisfied with the composition and

    performance of most SRO disciplinary committees and panels, and

    believes that significant new measures are not required at this time.

    The Commission has found that disciplinary committees typically have

    adequate diversity, sometimes including FCMs and nonmembers, and seek

    to balance expertise with impartiality. Accordingly, the Commission's

    proposed Disciplinary Panel Acceptable Practice acknowledges SROs'

    current practices and the requirements of the Act, and identifies

    minimal panel composition standards as a means of protecting the

    continued integrity of the disciplinary process. It helps to minimize

    conflicts of interest by ensuring a basic degree of diversity, and the

    inclusion of at least one public person on SRO disciplinary panels.

    To take advantage of the safe harbor offered by the proposed

    Disciplinary Panel Acceptable Practice, and comply with Core Principle

    15's requirement to minimize conflicts of interest in decision making,

    the Commission is proposing that SROs' amend their rules and policies

    to ensure that they preclude any group or class of exchange members

    from dominating or otherwise exercising disproportionate influence on

    any disciplinary panel. The Commission is also proposing that SROs

    ensure that their rules and policies provide for public persons on

    disciplinary panels, except in cases limited to decorum and attire.\48\

    Public panel members should meet the definition of "public" for

    directors serving on Regulatory Oversight Committees.

    ---------------------------------------------------------------------------

    \48\ The proposed Disciplinary Panel Acceptable Practice is

    broader than Regulation 1.64, in that it requires a public member to

    participate in some categories of cases that, under Regulation 1.64,

    may be heard by a panel with no public members. The Commission

    believes the expansion of public participation is an appropriate

    response to the growth in the size and complexity of the futures

    markets, and the new profit element in exchange operations.

    Moreover, a public member's presence on disciplinary panels will

    enhance the appearance as well as the reality of fairness and

    impartiality in exchange disciplinary proceedings, and thus promote

    confidence in our markets among the public and market participants.

    ---------------------------------------------------------------------------

    V. Related Matters

    A. Cost-Benefit Analysis

    Section 15(a) of the Act, as amended by Section 119 of the CFMA,

    requires the Commission to consider the costs and benefits of its

    action before issuing a new regulation or order under the Act. By its

    terms, Section 15(a) does not require the Commission to quantify the

    costs and benefits of its action or to determine whether the benefits

    of the action outweigh its costs. Rather, Section 15(a) simply requires

    the Commission to "consider the costs and benefits" of the subject

    rule or order.

    Section 15(a) further specifies that the costs and benefits of the

    proposed rule or order shall be evaluated in light of five broad areas

    of market and public

    [[Page 38748]]

    concern: (1) Protection of market participants and the public; (2)

    efficiency, competitiveness, and financial integrity of futures

    markets; (3) price discovery; (4) sound risk management practices; and

    (5) other public interest considerations. The Commission may, in its

    discretion, give greater weight to any one of the five enumerated areas

    of concern and may, in its discretion, determine that, notwithstanding

    its costs, a particular rule or order is necessary or appropriate to

    protect the public interest or to effectuate any of the provisions or

    to accomplish any of the purposes of the Act.

    The Acceptable Practices proposed herein are safe harbors for

    compliance with Core Principle 15's conflict of interest provisions.

    They offer exchanges the opportunity to meet the requirements of the

    Core Principle through a regulatory governance structure that insulates

    their regulatory functions from their commercial interests. The

    Acceptable Practices propose that exchanges implement boards of

    directors that are at least fifty percent public. The Acceptable

    Practices further propose that all exchange-SROs place oversight of

    their core regulatory functions in the hands of board-level ROCs

    composed exclusively of "public" directors. They also offer guidance

    on what constitutes a "public" director. In addition, the Acceptable

    Practices suggest minimum composition standards for exchange

    disciplinary committees.

    The proposed Acceptable Practices are consistent with legislative,

    regulatory, and voluntarily undertaken changes in governance

    requirements and practices in other financial sectors, such as the

    securities markets, and are intended to enhance protection of the

    public. The Commission has endeavored, in offering these Acceptable

    Practices to propose the least intrusive safe harbors and regulatory

    requirements that can reasonably be expected to meet the requirements

    of Core Principle 15 of the Act. These Acceptable Practices advance the

    Commission's mandate of assuring the continued existence of competitive

    and efficient markets and to protect the public interest in markets

    free of fraud and abuse.

    They nevertheless may be expected to entail some costs, including,

    among the most foreseeable, those attendant to recruiting and

    appointing additional directors, amending corporate documents, making

    necessary rule changes and certifying them to the Commission, and

    appointing a CRO.

    After considering these factors, the Commission has determined to

    propose the Acceptable Practices with respect to contract markets. The

    Commission specifically invites public comment on its application of

    the criteria contained in the Act. Commenters are also invited to

    submit any quantifiable data that they may have concerning the costs

    and benefits of the proposed Acceptable Practices with their comment

    letter.

    B. Regulatory Flexibility Act

    The Regulatory Flexibility Act, 5 U.S.C. 601 et seq., requires

    federal agencies, in promulgating rules, to consider the impact of

    those rules on small entities. The proposed Acceptable Practices affect

    contract markets. The Commission has previously determined that

    contract markets are not small entities for purposes of the Regulatory

    Flexibility Act.\49\ Accordingly, the Chairman, on behalf of the

    Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that the

    proposed Acceptable Practices will not have a significant economic

    impact on a substantial number of small entities.

    ---------------------------------------------------------------------------

    \49\ Policy Statement and Establishment of Definitions of

    "Small Entities" for Purposes of the Regulatory Flexibility Act,

    47 FR 18618, 18619 (Apr. 30, 1982).

    ---------------------------------------------------------------------------

    C. Paperwork Reduction Act of 1995

    The Acceptable Practices contain information collection

    requirements. As required by the Paperwork Reduction Act of 1995 (44

    U.S.C. 3504(h)), the Commission has submitted a copy of this section to

    the Office of Management and Budget ("OMB") for its review.

    Collection of Information: Rules Relating to Part 38, Establishing

    Procedures for Entities to become designated as Contract Markets, OMB

    Control Number 3038-0052. The Acceptable Practices increase the burden

    previously approved by OMB.

    The estimated burden was calculated as follows:

    Estimated number of respondents: 12.

    Annual responses by each respondent: 1.

    Total annual responses: 12.

    Estimated average hours per response: 70.

    Annual reporting burden: 840.

    Organizations and individuals desiring to submit comments on the

    information collection requirements should direct them to the Office of

    Information and Regulatory Affairs, Office of Management and Budget,

    Room 10202, New Executive Office Building, 725 17th Street, NW.,

    Washington, DC 20503; Attention: Desk Officer for the Commodity Futures

    Trading Commission.

    The Commission considers comments by the public on this proposed

    collection of information in:

    Evaluating whether the proposed collection of information is

    necessary for the proper performance of the functions of the

    Commission, including whether the information will have a practical

    use;

    Evaluating the accuracy of the Commission's estimate of the burden

    of the proposed collection of information, including the validity of

    the methodology and assumptions used;

    Enhancing the quality, usefulness, and clarity of the information to

    be collected; and

    Minimizing the burden of collecting information on those who are to

    respond, including through the use of appropriate automated

    electronic, mechanical, or other technological collection techniques

    or other forms of information technology (e.g., permitting

    electronic submission of responses).

    OMB is required to make a decision concerning the collection of

    information contained in these Acceptable Practices between 30 and 60

    days after publication of this document in the Federal Register.

    Therefore, a comment to OMB is best assured of having its full effect

    if OMB receives it within 30 days of publication. This does not affect

    the deadline for the public to comment to the Commission on the

    Acceptable Practices.

    Copies of the information collection submission to OMB are

    available from the Commission Clearance Officer, Three Lafayette

    Centre, 1155 21st Street, NW., Washington DC 20581, (202) 418-5160.

    VI. Text of Proposed Acceptable Practices

    List of Subjects in 17 CFR Part 38

    Commodity futures, Reporting and recordkeeping requirements.

    In light of the foregoing, and pursuant to the authority in the

    Act, and in particular, Sections 3, 5, 5c(a) and 8a(5) of the Act, the

    Commission proposes to amend Part 38 of Title 17 of the Code of Federal

    Regulations as follows:

    PART 38--DESIGNATED CONTRACT MARKETS

    1. The authority citation for part 38 is revised to read as

    follows:

    Authority: 7 U.S.C. 2, 5, 6, 6c, 7, 7a-2 and 12a, as amended by

    Appendix E of Pub. L. 106-554, 114 Stat. 2763A-365.

    2. In Appendix B to Part 38 amend Core Principle 15 by adding

    paragraph (b) "Acceptable Practices" as follows:

    Appendix B to Part 38--Guidance on, and Acceptable Practices in,

    Compliance With Core Principles

    * * * * *

    [[Page 38749]]

    Core Principle 15 of Section 5(d) of the Act: Conflicts of Interest

    * * * * *

    (b) Acceptable Practices. All designated contract markets

    ("DCMs" or "contract markets") bear special responsibility to

    regulate effectively, impartially, and with due consideration of the

    public interest, as provided for in Section 3 of the Act. Under Core

    Principle 15, they are also required to minimize conflicts of

    interest in their decision making processes. To comply with this

    Core Principle, contract markets should be particularly vigilant for

    conflicts between their self-regulatory responsibilities, their

    commercial interests, and the interests of their management,

    members, owners, customers and market participants, other industry

    participants, and other constituencies.

    Acceptable Practices for minimizing conflicts of interest shall

    include the following elements:

    (1) Board Composition for Contract Markets

    (A) At least fifty percent of the directors on a contract

    market's board of directors shall be public directors; and

    (B) The executive committees (or similarly empowered bodies)

    shall be at least fifty percent public.

    (2) Public Director

    (A) To qualify as a public director of a contract market, an

    individual must first be found, by the board of directors on the

    record, to have no material relationship with the contract market. A

    "material relationship" is one that reasonably could affect the

    independent judgment or decision making of the director.

    (B) In addition, a director shall not be considered "public"

    if any of the following circumstances exist:

    (i) The director is an officer or employee of the contract

    market or a director, officer or employee of its affiliate;

    (ii) The director is a member of the contract market, or a

    person employed by or affiliated with a member. "Member" is

    defined according to Section 1a(24) of the Commodity Exchange Act

    and Commission Regulation 1.3(q). In this context, a director is

    affiliated with a member if the director is an officer or director

    of the member;

    (iii) The director receives more than $100,000 in payments from

    the contract market, any affiliate of the contract market or from a

    member or anyone affiliated with a member, provided that

    compensation for services as a director will not be counted towards

    the $100,000 threshold test;

    (iv) A director shall be precluded from serving as a public

    director if any of the relationships above apply to a member of the

    director's "immediate family," i.e., spouse, parents, children,

    and siblings; and

    (v) An affiliate includes parents or subsidiaries of the

    contract market or entities that share a common parent with the

    contract market.

    (C) All of the disqualifying circumstances described in

    Subsection (2)(B) shall be subject to a one-year look back.

    (D) A contract market shall disclose to the Commission which

    members of its board are public directors, and the basis for those

    determinations.

    (3) Regulatory Oversight Committee

    (A) A board of directors of any contract market shall establish

    a Regulatory Oversight Committee ("ROC") as a standing committee,

    consisting of only public directors as defined in Section (2), to

    assist it in minimizing potential conflicts of interest. The ROC

    shall oversee the contract market's regulatory program on behalf of

    the board. The board shall delegate sufficient authority, dedicate

    sufficient resources, and allow sufficient time for the ROC to

    fulfill its mandate.

    (B) The ROC shall:

    (i) Monitor the contract market's regulatory program for

    sufficiency, effectiveness, and independence;

    (ii) Oversee all facets of the program, including trade practice

    and market surveillance; audits, examinations, and other regulatory

    responsibilities with respect to member firms (including ensuring

    compliance with financial integrity, financial reporting, sales

    practice, recordkeeping, and other requirements); and the conduct of

    investigations;

    (iii) Review the size and allocation of the regulatory budget

    and resources; and the number, hiring and termination, and

    compensation of regulatory personnel;

    (iv) Supervise the contract market's chief regulatory officer,

    who will report directly to the ROC;

    (v) Prepare periodic reports for the board of directors and an

    annual report assessing the contract market's self-regulatory

    program for the board of directors and the Commission, which sets

    forth the regulatory program's expenses, describes its staffing and

    structure, catalogues disciplinary actions taken during the year,

    and reviews the performance of disciplinary committees and panels;

    (vi) Recommend changes that would ensure fair, vigorous, and

    effective regulation; and

    (vii) Review regulatory proposals and advise the board as to

    whether and how such changes may impact regulation.

    (4) Disciplinary Panels

    All contract markets shall minimize conflicts of interest in

    their disciplinary processes through disciplinary panel composition

    rules that preclude any group or class of industry participants from

    dominating or exercising disproportionate influence on such panels.

    Contract markets can further minimize conflicts of interest by

    including at least one person who would qualify as a public director

    as defined in Section (2) above, on disciplinary panels, except in

    cases limited to decorum and attire. If contract market rules

    provide for appeal to the board of directors, or to a committee of

    the board, then that appellate body shall also include at least one

    person who would qualify as a public director as defined in Section

    (2) above.

    * * * * *

    Issued in Washington, DC, on June 28, 2006 by the Commission.

    Eileen A. Donovan,

    Acting Secretary of the Commission.

    Note: The following appendix will not appear in the Code of

    Federal Regulations.

    APPENDIX--STATEMENTS OF COMMISSIONERS HATFIELD AND DUNN

    Commissioner Frederick W. Hatfield, writing separately.

    Since the passage of the Commodity Futures Modernization Act of

    2000 (CFMA), the U.S. futures industry has experienced dynamic

    growth. With rapid growth comes new challenges. U.S. futures

    exchanges are today faced with increased competition, domestically

    and from abroad, changing ownership structures, and new business

    models. As regulators, it is incumbent upon us to ensure that

    regulatory guidelines continue to keep pace with the ever changing

    environment of the industry. Accordingly, I applaud Chairman Jeffery

    and Commission staff for their thoughtful and exhaustive pursuit of

    fair, vigorous and effective self-regulation in this evolving market

    landscape.

    In this review, I have been guided by two questions: have the

    exchanges produced self-regulatory structures that are up to the

    challenges of the changing marketplace and if not, are we as

    regulators suggesting a better model? I look forward to receiving

    comments on the Board Composition Acceptable Practice proposal.

    However, in my view, establishing a board level Regulatory Oversight

    Committee (ROC) comprised of nonmember public directors and a

    disciplinary panel structure, as described in the proposal, goes a

    long way toward ensuring that an exchange's regulatory duties will

    not be compromised by conflicts emanating from commercial goals.

    The primary function of the proposed ROCs is to ensure that

    regulatory programs and staff are free of improper influence from

    exchange owners, management, members, investors, customers, and

    commercial considerations. As the proposal recognizes, "[t]he ROC

    structure, combined with careful Commission review of the

    interaction between the ROC and the board, fosters the continued

    integrity of futures self-regulation, effective management of

    conflicts of interest within SRO governance, and full consideration

    of the public interest in every decision of regulatory

    consequence." Section B. Regulatory Oversight Committee, last

    paragraph. Despite this recognition, the proposed safe harbor would

    require, in addition to public director ROCs, that at least fifty

    percent of the governing boards and exchange executive committees

    also be comprised of public directors.

    Interest in SRO board composition has an established history in

    the Commodity Exchange Act (Act) and in the Commission's

    regulations. Prior to passage of the CFMA, Section 5a(14) of the Act

    mandated diversity of representation on exchanges' boards of

    directors.\1\ With passage of the CFMA, the

    [[Page 38750]]

    requirements of Section 5a(14) were removed for exchanges, as

    Congress and the Commission moved to a more flexible, principles-

    based oversight regime that does not include specific composition

    targets for exchanges' boards of directors.\2\ Mutually owned

    exchanges are still subject to mandatory board composition standards

    under Section 5(c)(16) of the Act (Core Principle 16), which

    requires "that the composition of the governing board reflect

    market participants." The Application Guidance for Core Principle

    16 identifies this as a "diversity of interests" requirement.

    ---------------------------------------------------------------------------

    \1\ This provision of the Act was implemented by Commission

    Regulation 1.64, which required exchanges to establish meaningful

    representation for the following groups: (1) Futures commission

    merchants (FCMs); (2) floor brokers and traders; (3) independent

    non-members; (4) producers, consumers, processors, distributors, and

    merchandisers of commodities traded on the particular exchange

    ("commercials"); (5) participants in a variety of pits or

    principal groups of commodities traded on the exchange; and (6)

    other market users or participants. Specific composition targets

    existed only for commercials (ten percent) and nonmembers (twenty

    percent).

    \2\ Under Commission Regulation 38.2, exchanges are now exempt

    from Regulation 1.64.

    ---------------------------------------------------------------------------

    As part of the SRO Review, Commission staff examined the

    corporate documents of the major exchanges under CFTC authority and

    found that all require diversity of their boards of directors,

    including nonmember directors.\3\ These diversity requirements are

    similar regardless of the exchanges' ownership structures, and they

    are present at all of the major exchanges. The Kansas City Board of

    Trade, for example, requires that nominating committees give

    "special consideration to the desirability of having all interests

    of the Corporation represented on the Board of Directors." \4\ The

    Chicago Mercantile Exchange (CME) requires that its board of

    directors have "meaningful representation of a diversity of

    interests, including floor brokers, floor traders, futures

    commission merchants, [and commercials.]." \5\

    ---------------------------------------------------------------------------

    \3\ The corporate documents included the certificates of

    incorporation, bylaws, and rulebooks of the exchanges and their

    holding companies, if applicable.

    \4\ Kansas City Board of Trade Rulebook, Ch. II, Sec. 210.01.

    \5\ Second Amended and Restated Bylaws of Chicago Mercantile

    Exchange Holdings, Inc., Art. III, Sec. 3.5 (applicable to the

    board of trade through the Certificate of Incorporation of Chicago

    Mercantile Exchange, Inc., Art. V, Sec. 3 (requiring that the board

    of directors of CME, Inc., be identical to that of CME Holdings,

    Inc.).

    ---------------------------------------------------------------------------

    Some exchanges employ specific numerical targets for their

    various participant categories and public directors. For example,

    the New York Mercantile Exchange requires three public directors,

    one FCM, one floor broker, one commercial, and one local trader.\6\

    The New York Board of Trade requires five public directors.\7\ The

    Minneapolis Grain Exchange requires four nonmember directors, and at

    least four commercials, two FCMs, two floor traders, and one floor

    broker.\8\ The CME requires that independent, nonmember directors

    constitute twenty percent of its board and that commercials

    constitute ten percent of the board.\9\ Moreover, the CME currently

    exceeds its own requirements, with seven of its twenty directors

    (thirty-five percent) being independent, nonindustry persons.

    ---------------------------------------------------------------------------

    \6\ Amended and Restated Certificate of Incorporation of NYMEX

    Holdings, Inc., Art. VI, Sec. (c) (applicable to the board of trade

    through the Amended and Restated Certificate of Incorporation of New

    York Mercantile Exchange, Inc., Art. VII (the board of directors

    NYMEX Holdings, Inc., constitutes the board of NYMEX, Inc.).

    \7\ New York Board of Trade Bylaws, Art. II, Sec. 302(c).

    \8\ Minneapolis Grain Exchange Rulebook, Ch. II, Sec. Sec.

    200.00 and 210.00.

    \9\ Note 5, supra.

    ---------------------------------------------------------------------------

    Most of those who commented or testified during the course of

    the SRO study generally agreed that diverse boards best serve the

    needs of exchanges and the public. Participants also agreed on the

    benefits of including public directors on exchange boards, and our

    review demonstrates that this is a model that most exchanges are

    following. In their comments and testimony, however, exchanges

    unanimously opposed having mandatory board composition requirements.

    CME argued, for example, that "no one composition criteria can

    address the individual needs" of the diverse exchanges and business

    models active in the industry.\10\

    ---------------------------------------------------------------------------

    \10\ CME Comment Letter at 2.

    ---------------------------------------------------------------------------

    In my view, having a ROC that serves to insulate the regulatory

    functions of an exchange from its commercial interests, combined

    with a disciplinary panel structure that strengthens impartial

    adjudication and reduces potential conflicts of interest by

    including at least one public person on every panel and ensuring

    that such panels are not dominated by any group or class of exchange

    participants, may well be sufficient to ensure fair, vigorous, and

    effective self-regulation and should demonstrate compliance with

    Core Principle 15. Such an approach would be narrowly tailored to

    focus specifically on regulatory governance and functions, and would

    be in keeping with the flexibility the CFMA intended to afford

    exchanges to conduct business without undue interference from

    regulators.

    I am concerned that the Board Composition proposal also would

    create an additional and perhaps unnecessary layer of regulation for

    publicly traded exchanges, which are already subject to myriad new

    and enhanced corporate governance requirements, including, among

    others, Securities and Exchange Commission registration

    requirements, the audit committee provisions of the Sarbanes-Oxley

    Act of 2002, and the listing standards of the New York Stock

    Exchange (NYSE). I agree that the dual function of exchanges as

    commercial enterprises and self-regulatory organizations sets them

    apart from corporations engaged in business for the sole purpose of

    earning profits for the benefit of shareholders. In my opinion,

    however, the foregoing corporate governance standards, combined with

    properly structured ROCs and disciplinary committees, and the

    Commission's continuing obligation to monitor exchanges through rule

    enforcement reviews and otherwise, have provided multiple levels of

    safeguards that should be sufficient to ensure that exchanges"

    self-regulatory obligations are not compromised.

    I recognize that what the Commission is contemplating is an

    acceptable practice rather than a mandatory requirement. In

    promulgating such guidance, however, the Commission should strive to

    establish standards that that are not overly broad and that are

    viewed as necessary, in most circumstances, to accomplish regulatory

    goals. Accordingly, I welcome comment on the advisability of

    adopting the proposed Board Composition Acceptable Practice,

    especially with respect to the following questions:

    Is there an existing problem that this proposal

    addresses?

    Will those exchanges that are not now subject to

    mandatory diversity requirements feel compelled to sacrifice

    voluntary diversity in order to increase the percentage of public

    directors and still maintain boards that are of manageable size, or

    will boards become larger? Is it feasible to comply with the

    acceptable practice and maintain the proper level of diversity? What

    are the relative costs and benefits of doing so?

    How would the acceptable practice affect mutually owned

    exchanges that are subject to the mandatory diversity requirements

    of Core Principle 16?

    How would the proposed requirement that exchange

    executive committees have at least fifty percent public

    representation affect the day-to-day operations of the exchanges?

    Is there any evidence that the proposed Board

    Composition Acceptable Practice will provide greater regulatory

    assurance than the proposed ROC and Disciplinary Panel Acceptable

    Practices?

    Do the corporate governance requirements currently

    applicable to publicly traded exchanges, combined with properly

    structured ROCs and disciplinary panels and continuing Commission

    oversight, provide sufficient assurance that conflicts of interests

    will be kept to a minimum in the decision making process of those

    exchanges?

    If the Commission adopts the Board Composition

    Acceptable Practice, should it be accompanied by a phase-in period

    and if so, what would be the appropriate length of time for

    exchanges to modify their boards?

    I join with my Chairman and fellow Commissioners in requesting

    comment on this endeavor and look forward to reviewing the responses

    to these questions and any other views the Commission receives as we

    continue to consider the important issues raised in the proposal.

    Commissioner Michael V. Dunn, writing separately.

    The proposed acceptable practices published today represent an

    important step forward in ensuring the fairness and transparency of

    our commodity markets. I wish to comment on two aspects of the

    proposal.

    First, the proposed rule notes that exchanges that elect to

    forgo the safe harbor of the best practices outlined in this

    proposal can still demonstrate compliance with Core Principle 15

    through showing they have procedures and safeguards in place to

    address potential conflicts of interest. For these exchanges, the

    Commission will continue its current practice of reviewing the

    activities of these exchanges to ensure they are in compliance with

    Core Principle 15. Therefore, while the proposed acceptable

    practices offer a safe harbor for complying with Core Principle 15,

    they are not the only method of demonstrating compliance.

    Second, efficient, transparent, and open markets bring great

    benefits to their

    [[Page 38751]]

    participants and the public. The Commodity Futures Modernization Act

    of 2000 (CFMA), sought to safeguard these values by placing a much

    greater emphasis on industry self-regulation: setting out core

    principles registrants have to meet and giving industry flexibility

    in choosing how to comply.

    While the Commission has final responsibility to ensure the

    fairness and transparency of the markets it regulates, its

    effectiveness in doing so relies heavily upon the presence of a

    robust self-regulatory system. Registered Futures Associations

    (RFAs) are provided for in the CEA to complement the Commission's

    oversight of commodities markets and to bring industry knowledge and

    experience to bear on regulatory issues affecting those markets.\1\

    In its June 2004 request for comments on SRO governance that led to

    this proposal, the Commission asked, "Should registered futures

    associations that are functioning as SROs also be subject to

    governance standards?" In its response, the National Futures

    Association ("NFA"), the sole RFA, wrote that "registered futures

    associations should be subject to the same governance standards as

    the other SROs," as long as these standards are flexible.

    ---------------------------------------------------------------------------

    \1\ See generally Section 17 of the Act, 7 U.S.C. 21. An RFA

    must be determined by the Commission to be in the public interest.

    Id. at Section 17(b)(1), 7 U.S.C. 21(b)(1).

    ---------------------------------------------------------------------------

    As the sole RFA, NFA occupies a unique position in the futures

    markets' system of self-regulation. NFA is entrusted with overseeing

    a wide variety of futures market intermediaries, cutting across

    different segments of the futures industry, including futures

    commission merchants, commodity pool operators ("CPOs"), commodity

    trading advisers ("CTA"), and introducing broker-dealers

    ("IBs"). NFA's functions are as varied as the members it oversees.

    NFA performs registration and fitness screening functions, conducts

    audits and surveillance of its members to enforce compliance with

    financial requirements, establishes and enforces rules and standards

    for customer protection, and conducts arbitration of futures-related

    disputes. NFA also has taken certain functions delegated to it by

    the Commission and more recently, has assumed trade practice and

    market surveillance activities for a number of exchanges.\2\

    ---------------------------------------------------------------------------

    \2\ When an RFA extends its sphere of operation beyond

    traditional, self-regulatory roles to include such ancillary

    activities, it appropriately should reexamine the methods it uses to

    manage and minimize conflicts of interests, to determine whether

    these methods remain adequate to meet changed circumstances.

    ---------------------------------------------------------------------------

    In light of the concerns raised in this proposal regarding

    conflicts of interest and self-regulation, I believe the Commission

    needs to review the conflicts of RFAs as well as exchanges. In this

    proposal, the Commission indicates in footnote 4 that we will be

    considering this matter further, and I look forward to that

    consideration.

    [FR Doc. 06-6030 Filed 7-6-06; 8:45 am]

    BILLING CODE 6351-01-P

    Updated July 14, 2006

    Last Updated: June 26, 2007



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