[Federal Register: February 14, 2007 (Volume 72, Number 30)]
[Rules and Regulations]
[Page 6936-6958]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr14fe07-9]
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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 ("SROs")
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commission hereby adopts final acceptable practices for
minimizing conflicts of interest in decision making by designated
contract markets ("DCMs" or "exchanges"),\1\ pursuant to Section
5(d)(15) ("Core Principle 15") \2\ of the Commodity Exchange Act
("CEA" or "Act").\3\ The final acceptable practices are the first
issued for Core Principle 15 and are applicable to all DCMs.\4\ They
focus upon structural conflicts of interest within modern self-
regulation, and offer DCMs a "safe harbor" by which they may minimize
such conflicts and comply with Core Principle 15. To receive safe
harbor treatment, DCMs must implement the final acceptable practices in
their entirety, including instituting boards of directors that are at
least 35% public and establishing oversight of all regulatory functions
through Regulatory Oversight Committees ("ROCs') consisting
exclusively of public directors.
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\1\ The acceptable practices for core principles reside in
Appendix B to Part 38 of the Commission's Regulations, 17 CFR Part
38, App. B.
\2\ Core Principle 15 states: "CONFLICTS OF INTEREST--The board
of trade shall establish and enforce rules to minimize conflicts of
interest in the decision-making process of the contract market and
establish a process for resolving such conflicts of interest." CEA
Sec. 5(d)(15), 7 U.S.C. 7(d)(15).
\3\ The Act is codified at 7 U.S.C. 1 et seq. (2000).
\4\ 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 security futures products under Section 5f of the
Act and Commission Regulation 41.31, is exempt from the core
principles enumerated in Section 5 of the Act, and the acceptable
practices thereunder, including those adopted herein.
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DATES: Effective Date: March 16, 2007.
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, Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
A. Overview of the Acceptable Practices
B. Background
II. Procedural History
III. Public Comments Received and the Commission's Response
A. Legal Comments
1. Overview of Commission's Authority to Issue the Acceptable
Practices
2. Specific Legal Issues Raised by Commenters
B. Policy Comments
1. General Comments
2. Comments With Respect to the Board Composition Acceptable
Practice
3. Comments With Respect to the Public Director Acceptable
Practice
4. Comments With Respect to the ROC Acceptable Practice
[[Page 6937]]
5. Comments With Respect to the Disciplinary Committee
Acceptable Practice
IV. Specific Requests for Modifications and/or Clarifications that
the Commission has Determined to Grant or Deny
A. Phase-in Period for the New Acceptable Practices
B. Selection of Public Directors
C. Compensation of Public Directors
D. Overlapping Public Directors
E. Jurisdiction of Disciplinary Panels and Definition of
"Public" for Persons Serving on Disciplinary Panels
F. "No Material Relationship Test"
G. Elimination of ROCs' Periodic Reporting Requirement
V. Related Matters
VI. Text of Acceptable Practices for Core Principle 15
I. Introduction
A. Overview of the Acceptable Practices
The final acceptable practices recognize DCMs' unique public-
interest responsibilities as self-regulatory organizations ("SROs")
in the U.S. futures industry. They address conflicts of interest that
exist within DCMs as they operate in an increasingly competitive
environment and transform from member-owned, not-for-profit entities
into diverse enterprises with a variety of business models and
ownership structures. While continuing to meet their regulatory
responsibilities, DCMs must now compete effectively to generate
profits, advance their commercial interests, maximize the value of
their stock, and/or serve multiple membership, ownership, customer, and
other constituencies. The presence of these potentially conflicting
demands within a single entity--regulatory authority coupled with
commercial incentives to misuse such authority--constitutes the new
structural conflict of interest addressed by the acceptable practices
adopted herein.
The Commission has determined that the structural conflicts
outlined above are appropriately addressed through reforms within DCMs
themselves, including reforms of DCMs' governing bodies. Accordingly,
the Commission offers the new acceptable practices for Core Principle
15 as an appropriate method for minimizing such conflicts. The
Commission believes that additional public directors on governing
bodies, greater independence at key levels of decision making, and
careful insulation of regulatory functions and personnel from
commercial pressures, are important elements in ensuring vigorous,
effective, and impartial self-regulation now and in the future. The new
acceptable practices incorporate and emphasize each of these elements,
and offer all DCMs clear instruction as to how they may comply with
Core Principle 15.
Although DCMs are free to comply with Core Principle 15 by other
means, the Commission stresses that they all must address structural
conflicts of interest and adopt substantive measures to protect their
regulatory decision making from improper commercial considerations.
DCMs must ensure that regulatory decisions are made on their own
merits, and that they are not compromised by the commercial interests
of the DCMs or the interests of their numerous constituencies.
Likewise, DCMs' regulatory operations and personnel must be insulated
from improper influence and commercial considerations to ensure
appropriate regulatory outcomes.
The new acceptable practices are set forth in four component parts,
and DCMs must meet all four to receive safe harbor treatment under Core
Principle 15. Each component part is summarized as follows:
First, the Board Composition Acceptable Practice calls upon all
DCMs to minimize conflicts of interest in self-regulation by
establishing boards of directors that contain at least 35% "public
directors" (as defined by a separate Public Director Acceptable
Practice discussed below). The Board Composition Acceptable Practice
further requires that DCMs ensure that any executive committees (or
similarly empowered bodies) also meet the 35% public director standard.
This 35% standard in the new acceptable practices represents a
modification from the 50% public director standard in the proposed
acceptable practice.\5\
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\5\ Conflicts of Interest in Self-Regulation and Self-Regulatory
Organizations ("Proposed Rule"), 71 FR 38740 (July 7, 2006).
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Second, the Regulatory Oversight Committee Acceptable Practice
mandates that all DCMs establish Regulatory Oversight Committees,
composed only of public directors, to oversee core regulatory functions
and ensure that they remain free of improper influence. The Commission
notes that ROCs are intended to insulate self-regulatory functions and
personnel from improper influence. In fulfilling this role, however,
ROCs are not expected to assume managerial responsibilities, or to
isolate self-regulatory functions and personnel from others within the
DCM. ROCs' oversight and insulation should be aided by their DCMs'
chief regulatory officers ("CROs"). A full description of the
responsibilities and authority of ROCs may be found in the text of the
final acceptable practices.
Third, the Disciplinary Panel Acceptable Practice states that DCM
disciplinary panels should not be dominated by any group or class of
DCM members or participants, and must include at least one "public
person" on every panel. Under the Disciplinary Panel Acceptable
Practice, disciplinary panels must keep thorough minutes of their
meetings, including a full articulation of the rationale supporting
their disciplinary decisions.
Finally, the Public Director Acceptable Practice establishes
specific definitions of "public" for DCM directors and for members of
disciplinary panels. Public directors are persons who have no
"material relationship" with their DCM, i.e., any relationship which
could reasonably affect their independent judgment or decision making.
In addition, public directors must meet a series of "bright-line
tests" which identify specific circumstances and relationships which
the Commission believes are clearly material. For members of
disciplinary panels, the definition of "public" includes the bright-
line tests, but not the materiality criterion.
The final acceptable practices also include clarifications to the
acceptable practices originally proposed by the Commission on July 7,
2006. For example, the final acceptable practices clarify that a DCM's
public directors may also serve as public directors of its holding
company under certain circumstances. These clarifications were made in
response to public comments on the proposed acceptable practices.
In addition, although the final acceptable practices are effective
30 days after publication in the Federal Register, the Commission will
permit currently established DCMs to implement responsive measures over
a phase-in period of two years or two regularly-scheduled board
elections, whichever occurs sooner.\6\ Responsive measures include
implementing the final acceptable practices or otherwise fully
complying with the requirements of Core Principle 15, including
requirements to minimize the structural conflicts of interest discussed
herein. The phase-in period and the modified public director
requirements for boards and executive committees are the only
significant changes between the proposed acceptable practices and those
adopted today.
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\6\ "Currently established" DCMs are those that are already
designated at the time this release is published in the Federal
Register.
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[[Page 6938]]
B. Background
U.S. futures markets are a critical component of the U.S. and world
economies, providing significant economic benefits to market
participants and the public at large. They provide an important hedging
vehicle to individuals and firms in myriad industries, resulting in
more efficient production, lower costs for consumers, and other
economic benefits. By offering a competitive marketplace and focal
point where traders can freely interact based on their assessments of
supply and demand, futures markets also provide a vital forum for
discovering prices that are generally considered to be superior to
administered prices or prices determined privately. For this reason,
futures markets are widely utilized throughout the global economy.
Participants in the markets include virtually all economic actors, and
the prices discovered on a daily basis materially affect a wide range
of businesses in the agricultural, energy, financial, and other
sectors.
For the reasons outlined above, DCMs are not just typical
commercial enterprises, but are commercial enterprises affected with a
significant national public interest. Actions that distort prices or
otherwise undermine the integrity of the futures markets have broad,
detrimental implications for the economy as a whole and the public in
general. Congress recognized the importance of futures trading in the
Act, when it explicitly stated that futures transactions "are entered
into regularly in interstate and international commerce and are
affected with a national public interest * * *." \7\ It defined the
public interest to include "liquid, fair, and financially secure
trading facilities." \8\ Congress also identified the purposes of the
Act: "to deter and prevent price manipulation or any other disruptions
to market integrity; to ensure the financial integrity of all
transactions subject to this Act and the avoidance of systemic risk;
and to protect all market participants from fraudulent or other abusive
sales practices and misuses of customer assets." \9\ To accomplish
these purposes, Congress established a statutory system of DCM self-
regulation, combined with Commission oversight, to promote
"responsible innovation and fair competition among boards of trade,
other markets and market participants." \10\ Meeting these statutory
obligations and purposes requires DCM self-regulation that is as
vigorous, impartial, and effective as possible.
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\7\ CEA Sec. 3(a), 7 U.S.C. 5(a).
\8\ Id.
\9\ CEA Sec. 3(b), 7 U.S.C. 5(b).
\10\ Id.
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All DCMs face unique and potentially conflicting regulatory
obligations and commercial demands as they work to meet the statutory
requirements outlined above. On the commercial side, they must attract
trading to their markets, maximize the value of their stock, generate
profits, satisfy the financial needs of their numerous stakeholders and
constituencies, and/or meet the diverse business needs of their market
participants. At the same time, as self-regulatory organizations, DCMs
must exercise their authority judiciously, impartially, and in the
public interest. As essential forums for the execution of futures
transactions and for price discovery, DCMs must ensure fair and
financially secure trading facilities. DCMs must also help to "serve"
and "foster" the national public interest through self-regulatory
responsibilities that include ensuring market integrity, financial
integrity, and the strict protection of market participants.\11\
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\11\ Id.
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When DCMs were first entrusted with these extensive regulatory
responsibilities, they were almost exclusively member-owned, not-for-
profit exchanges facing little competition for customers or in their
prominent contracts. Although conflicts of interest in self-regulation
were a concern even then, such conflicts typically centered on
individual exchange members policing one another. Today's DCMs,
however, are vibrant commercial enterprises competing globally in an
industry whose ownership structures, business models, trading
practices, and products are evolving rapidly. As a result, DCMs now
face potential conflicts of interest between their critical self-
regulatory responsibilities and their powerful commercial imperatives.
Specifically, DCMs must: defend and expand their markets against others
offering similar products or services; generate returns for their
owners; and provide liquid markets where their members and customers
may profit. At the same time, they must continue to meet fundamental
public interest responsibilities through vigorous and impartial self-
regulation. To reconcile these obligations, DCMs must acknowledge and
guard against conflicts between their regulatory responsibilities and
their commercial interests, and take measures to prevent improper
influence upon self-regulation by their numerous constituencies,
including members, owners, customers, and others.
As explained in the proposing release, rapid and ongoing changes in
the futures industry have raised concerns as to whether existing self-
regulatory structures are equipped to manage evolving conflicts of
interest. Self-regulation's traditional conflict--that members will
fail to police their peers with sufficient zeal--has been joined by the
possibility that competing DCMs could abuse their regulatory authority
to gain competitive advantage or satisfy commercial imperatives. Such
conflicts of interest must be addressed promptly and proactively to
prevent them from becoming real abuses, and to ensure continued public
confidence in the integrity of the U.S. futures markets.
After three-and-a-half years of careful study, the Commission has
determined that the conflicts of interest identified above are inherent
in any system of self-regulation conducted by competing DCMs, many of
which operate under new ownership structures and business models, and
all of which are possessed of strong commercial imperatives. The
Commission has further determined that successfully addressing such
conflicts, and complying with Core Principle 15, requires appropriate
responses within DCMs. Only by reconciling the inherent tension between
their self-regulatory responsibilities and their commercial interests,
whether via the new acceptable practices or otherwise, can DCMs
successfully minimize conflicts of interest in their decision-making
processes and thereby ensure the integrity of self-regulation in the
U.S. futures industry.
The new acceptable practices for Core Principle 15 are a direct
response to the industry changes outlined above. As required by the
Act, they "promote responsible innovation and fair competition" among
U.S. DCMs, and ensure that self-regulation remains compatible with the
modern business practices of today's DCMs.\12\ The new acceptable
practices embody the Commission's firm belief that effective self-
regulation in an increasingly competitive, publicly traded, for-profit
environment requires independent decision making at key levels of DCMs'
regulatory governance structures. The Commission further believes that
the new acceptable practices constitute an ideal solution to emerging
structural conflicts of interest in self-regulation. Both proactive and
carefully targeted, the new acceptable practices for Core Principle 15
advance the public interest and ensure the continued strength and
[[Page 6939]]
integrity of self-regulation in a rapidly evolving industry.
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\12\ Id.
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The conflicts of interest described above require careful responses
by all DCMs. The Commission believes that DCMs can comply with Core
Principle 15 by minimizing conflicts of interest between their
regulatory responsibilities and their commercial interests or those of
their membership, ownership, management, customer, and other
constituencies. However, whether DCMs choose to comply with Core
Principle 15 via the acceptable practices adopted herein or by other
means, the Commission recognizes that necessary measures may take time
to implement. Accordingly, and at the request of public commenters, the
Commission is adopting a phase-in period for full compliance with Core
Principle 15. Within two years of this document's effective date, or
two regularly-scheduled board elections, whichever occurs first, all
DCMs must be in full compliance with Core Principle 15, either by
availing themselves of the new acceptable practices or undertaking
other effective measures to address the structural conflicts of
interest identified herein. Commission staff will contact all DCMs in
six months of the effective date of these final acceptable practices to
learn of their plans for full compliance. Established DCMs must
demonstrate substantial compliance with Core Principle 15, and plans
for full compliance, well before the phase-in period's expiration. New
candidates for designation as contract markets should be prepared to
demonstrate compliance with Core Principle 15, or a plan for
compliance, upon application.
II. Procedural History
The four acceptable practices for Core Principle 15 adopted today
are the culmination of a comprehensive review of self-regulation in the
U.S. futures industry ("SRO Review" or "Review") launched by the
Commission in May of 2003. Phase I of the Review explored the roles,
responsibilities, and capabilities of SROs in the context of industry
changes. Staff examined the designated self-regulatory organization
system of financial surveillance, the treatment of confidential
information, the composition of DCM disciplinary committees and panels,
and other aspects of the self-regulatory process. Phase I of the Review
also included staff interviews with over 100 persons including
representatives of DCMs, clearing houses, futures commission merchants
("FCMs"), industry associations, and securities-industry entities, as
well as current and retired industry executives, academics, and
consultants.
In June of 2004, the Commission initiated Phase II of the SRO
Review and broadened its inquiry to explicitly address SRO governance
and the interplay between DCMs' self-regulatory responsibilities and
their commercial interests. In June of 2004, the Commission issued a
Federal Register Request for Comments ("Request") on the governance
of futures industry SROs.\13\ The Request sought input on the proper
composition of DCM boards, optimal regulatory structures, the impact of
different business and ownership models on self-regulation, the proper
composition of DCM disciplinary committees and panels, and other
issues.
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\13\ Governance of Self-Regulatory Organizations, 69 FR 32326
(June 9, 2004). Comment letters received are available at: http://www.cftc.gov/foia/comment04/foi04--005_1.htm
.
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In November of 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.\14\
The Second Request examined the board-level ROCs recently established
at some SROs in the futures and securities industries. It also asked
commenters to consider the impact of New York Stock Exchange ("NYSE")
listing standards on publicly traded futures exchanges; whether the
standards were relevant to self-regulation; and how the standards might
inform the Commission's own regulations.\15\
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\14\ Self-Regulation and Self-Regulatory Organizations in the
Futures Industry, 70 FR 71090 (Nov. 25, 2005). Comment letters
received are available at http://www.cftc.gov/foia/comments05/foi05_007_1.htm
.
\15\ The NYSE's corporate governance listing standards require
listed companies to: have a majority of independent directors; meet
materiality and bright-line tests for independence; convene
regularly scheduled executive sessions of the board without
management present; institute nominating/governance, compensation,
and audit committees consisting exclusively of public directors;
etc. See NYSE Listed Company Manual, Sec. Sec. 303A:00-14,
available at: http://www.nyse.com/regulation/listed/1101074746736.html.
The NASDAQ Stock Market has adopted corporate
governance listing standards similar to the NYSE's. See the NASDAQ
Stock Market Listing Standards and Fees, available at: http://www.nasdaq.com/about/nasdaq_listing_req_fees.pdf.
DCMs whose
parent companies are listed on the NYSE include the CBOT, CME,
NYBOT, and NYMEX. Although these DCMs themselves are not required to
comply with the listing standards, they may be in de facto
compliance if they have chosen to name identical boards of directors
for both the listed parent and the DCM.
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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 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 is available at http://www.cftc.gov/files/opa/opapublichearing021506final.pdf
.
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Finally, in July of 2006, the Commission published the Proposed
Rule and sought public comment on new acceptable practices for Core
Principle 15.\17\ The Commission proposed that at least 50% of the
directors on DCM boards and executive committees (or similarly
empowered bodies) be public directors. It also proposed that day-to-day
regulatory operations be overseen and insulated through a CRO reporting
directly to a board-level ROC consisting exclusively of public
directors. The proposed acceptable practices also defined "public
director" for persons serving on boards and ROCs, and defined "public
person" for disciplinary panel members. To qualify as a public
director under the proposal, the director in question would require an
affirmative determination that he or she had no material relationship
with the DCM. In addition, public directors and public persons would
both have been required to meet a series of "bright-line" tests. The
inability to satisfy both the material relationship and bright-line
test requirements would automatically preclude them from serving as
public directors or public disciplinary panel members. Finally, the
proposed acceptable practices called for DCM disciplinary panels that
were not dominated by any group or class of SRO participants, and that
included at least one public person.
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\17\ See supra note 5.
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The proposal's original 30-day comment period, scheduled to close
on August 7, 2006, was extended by an additional 30 days, to September
7, 2006. The Commission received a total of 34 comment letters in
response to the proposed acceptable practices for Core Principle 15,
significant aspects of which are discussed below.\18\
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\18\ Comment letters in response to the Proposed Rules are
available at: http://www.cftc.gov/foia/comment06/foi06_004_1.htm.
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[[Page 6940]]
III. Public Comments Received and the Commission's Response
The 34 comment letters received in response to the proposed
acceptable practices included responses from 10 industry associations
and trade groups, nine individuals (including directors of exchanges
writing separately), eight DCMs, six futures commission merchants
("FCMs"), one group of DCM public directors, one U.S. Senator, and
one U.S. Congressman.\19\
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\19\ The commenters were: Bear Stearns; Citigroup; Morgan
Stanley; the Chicago Mercantile Exchange ("CME"); the New York
Mercantile Exchange ("NYMEX"); U.S. Sen. Pat Roberts and
Congressman Jerry Moran; the National Grain Trade Council; Daniel L.
Gibson; the National Grain and Feed Association; the New York Board
of Trade ("NYBOT"); Public Members of the NYBOT; the Chicago Board
of Trade ("CBOT"); Philip McBride Johnson; the CBOE Futures
Exchange ("CFE"); Dennis M. Erwin; HedgeStreet; Colby Moss;
Horizon Milling, LLC; John Legg; the National Futures Association;
Robert J. Rixey; Michael Braude; Lehman Brothers; the Kansas City
Board of Trade ("KCBT"); the Futures Industry Association
("FIA"); the Florida Citrus Producers Association; the National
Cotton Council of America; Cargill Juice North America; Nickolas
Neubauer; the American Cotton Shippers Association; Barry Bell;
Fimat; J.P. Morgan Futures Inc.; and the Minneapolis Grain Exchange
("MGEX").
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The Commission thoroughly reviewed and considered all comments
received. In response to persuasive arguments by various commenters,
the final acceptable practices include two significant modifications
from those originally proposed. Specifically, the final acceptable
practices include: (1) a reduction in the required number of public
directors on boards and executive committees, from at least 50% public
to at least 35% public; and (2) a phase-in period to implement the
acceptable practices, or otherwise come into full compliance with Core
Principle 15, of two years or two regularly scheduled board elections,
whichever occurs sooner.
In addition, in response to comments received, the Commission has
made several clarifications and non-substantive revisions to the final
acceptable practices. The Commission has also provided further
discussion or elaboration in this preamble in order to provide further
clarification on specific aspects of the acceptable practices,
consistent with the Commission's original intent.
Specifically, in the text of the final acceptable practices, the
Commission has clarified: that a public director may serve on the
boards of both a DCM and of its parent company; that public directors
are allowed deferred compensation in excess of $100,000 under certain
circumstances; and that public persons serving on disciplinary panels
are subject only to the bright-line tests used to define public
directors. The Commission has also clarified that the acceptable
practices do not address the manner in which DCMs select their public
directors, whether by election, appointment, or other means.
Some commenters called for greater requirements than in the
proposed acceptable practices, and others called for less requirements.
The Commission carefully considered those comments, but decided not to
make any changes other than those outlined above. As stated previously,
the Commission believes that adopting the new acceptable practices
strikes a careful balance between an appropriate approach to minimizing
conflicts of interest in self-regulation, as required by Core Principle
15, and the overall flexibility offered by the core principle regime.
Moreover, the Commission believes that the acceptable practices adopted
herein are necessary and appropriate to fulfill the purposes of the Act
and advance the public interest.
The substantive comments received, and the Commission's responses
thereto, are presented below. They are organized as follows:
Legal Comments: comments questioning the Commission's authority
to issue the proposed acceptable practices, including comments with
respect to the meaning of Core Principle 15 and its interaction with
other core principles;
Policy Comments: comments requesting more or stricter guidance
than that proposed by the Commission; comments requesting that the
Commission issue no acceptable practices, or fewer or less detailed
acceptable practices; and comments questioning the rationale behind
the proposed acceptable practices, including:
• General comments;
• Comments with respect to board composition;
• Comments with respect to the definition of public
director;
• Comments with respect to Regulatory Oversight
Committees;
• Comments with respect to disciplinary committees;
Comments Requesting Modifications and Clarifications, including:
• Phase-in period for the new acceptable practices;
• Selection of public directors;
• Compensation of public directors;
• Overlapping public directors;
• Jurisdiction of disciplinary panels and definition of
"public" for persons serving on disciplinary panels;
• "No material relationship" test for public directors;
• elimination of ROCs' periodic reporting requirements.
A. Legal Comments: Public Comments Received and the Commission's
Response.
1. Overview of the Commission's Authority To Issue the Acceptable
Practices
The Commission's issuance of the acceptable practices for Core
Principle 15 respects the letter and spirit of the Act. The
Commission's authority to do so is firmly rooted in Core Principle 15's
mandate to DCMs to minimize conflicts of interest in decision making.
Core Principle 15 requires DCMs to maintain systems to minimize
structural conflicts of interest inherent in self-regulation, as well
as individual conflicts of interest faced by particular persons.\20\
The acceptable practices are rationally related to the purposes of Core
Principle 15.
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\20\ 71 FR 38740, 38743.
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The Board Composition Acceptable Practice recognizes that the
governing board of a DCM is its ultimate decision maker and therefore
the logical place to begin to address conflicts. Participation by
public directors in board decision making is a widely accepted and
effective means to reduce conflicts of interest.\21\ By providing for
significant public participation on the board, the seat of DCM
governance and policymaking, the acceptable practice ensures that
conflicts of interest are minimized at the highest level of decision
making.
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\21\ See, e.g., NYSE Listed Company Manual, Sec. 303A
(commentary).
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The ROC Acceptable Practice recognizes the importance of insulating
core regulatory functions from improper influences and pressures
stemming from a DCM's commercial affairs. It operates to minimize
conflicts of interest in decisions made in the ordinary course of
business. Finally, the Disciplinary Panel Acceptable Practice, by
mandating participation on most disciplinary panels of at least one
person who meets the bright-line tests for public director, minimizes
conflicts of interest that may undermine the fundamental fairness
required of DCM disciplinary proceedings. In sum, these acceptable
practices represent an effective means to implement Core Principle 15
and are fully consistent with its mandate that DCMs minimize conflicts
of interest in all decision making. They therefore lie well within the
Commission's authority.
Congress has determined that there is a national public interest in
risk management and price discovery.\22\ The individual provisions of
the Act operate
[[Page 6941]]
in furtherance of those interests by instituting and enforcing a system
of "effective self-regulation of trading facilities, clearing systems,
market participants and market professionals under the oversight of the
Commission." \23\ Core Principle 15 must be read in light of those
public interests and purposes.
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\22\ CEA Section 3(a), 7 U.S.C. 5(a).
\23\ CEA Section 3(b), 7 U.S.C. 5(a).
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The safe harbor created by the new acceptable practices removes the
guesswork from compliance with Core Principle 15. Congress
intentionally wrote the core principles to be broad and flexible, and
to help DCMs and the Commission to adjust to changing circumstances.
Flexibility, however, may give rise to uncertainty. In order to provide
DCMs with greater certainty in the context of flexible core principles,
Congress, in adopting the Commodity Futures Modernization Act
("CFMA"),\24\ added Section 5c(a)(1) to the CEA, which specifically
authorizes the Commission, consistent with the purposes of the CEA, to
"issue interpretations, or approve interpretations submitted to the
Commission * * * to describe what would constitute an acceptable
business practice for Core Principles." \25\ As a general rule, the
Commission believes that issuing acceptable practices and other
guidance under the core principles is beneficial, given the CFMA's lack
of legislative history that might otherwise have been a source of
guidance. Safe harbors, such as those created by the acceptable
practices being issued today, remove uncertainty while setting high
standards consistent with the purposes of the CEA and the authority
granted by Congress to the Commission to issue such acceptable
practices. Nothing in these acceptable practices, as safe harbors,
infringes upon the Congressional directive in Section 5c(a)(2) of the
CEA that acceptable practices not be the "exclusive means for
complying" with core principles, as DCMs remain free to demonstrate
core principle compliance by other means.\26\
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\24\ The CFMA is published at Appendix E of Pub. L. 106-554, 114
Stat. 2763 (2000).
\25\ 7 U.S.C. 7a-2(a)(1).
\26\ 7 U.S.C. 7a-2(a)(2).
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Pursuant to its duty under the CEA to consider the costs and
benefits of its action in issuing the acceptable practices, as
discussed separately below, the Commission believes that the acceptable
practices will minimize conflicts of interest in DCM decision making
and promote public confidence in the futures markets. These are
significant benefits to the futures industry, market participants, and
the public. While commenters alleged that compliance would be costly,
none of them provided an estimate of those costs in response to the
Commission's specific request for quantitative data. The Commission has
no basis to conclude that compliance would not be a reasonable cost of
doing business in an industry subject to federal oversight--a cost that
may be phased in gradually over two years or two election cycles.
Finally, the Board Composition Acceptable Practice operates without
impeding the duties owed to shareholders by the directors of a public
corporation. Demutualized DCMs typically have reorganized themselves as
subsidiaries of parent holding companies. The acceptable practice
applies to the board of a DCM itself--not to the parent. Accordingly,
the Board Composition Acceptable Practice is unquestionably within the
Commission's authority to issue acceptable practices under the core
principles applicable to DCMs. The composition of a DCM governing board
may be identical to that of its parent--that decision is a matter for
the business judgment of the persons involved. Nevertheless, the boards
are separate bodies, even if their memberships overlap. DCM directors
have a fiduciary duty to stockholders, to be sure, but stockholders of
a DCM own an entity that, as a matter of federal law, is required to
minimize conflicts of interest under Core Principle 15 and that serves
a public interest through its business activity. Stockholders are well
served when the DCMs that they own comply with applicable laws and
regulations.
We now turn to the legal issues raised by the commenters with
respect to the Commission's authority to issue the acceptable
practices.
2. Specific Legal Issues Raised by Commenters
FIA, five major FCMs, and one exchange, CFE, filed comments
generally in favor of the proposed acceptable practices and endorsed
the Commission's analysis of its authority to issue them. CME, CBOT,
NYMEX, and other commenters, in opposition, challenged the Commission's
interpretation of Core Principle 15 and the statutory authority under
which the proposals were issued.
As stated above, Core Principle 15 requires DCMs to establish and
maintain systems that address conflicts of interest inherent in the
structure of self-regulation, as well as personal conflicts faced by
individuals. FIA endorsed this analysis, stating that the proposed
acceptable practices are "well-grounded" in the Commission's
statutory authority and "rationally related" to the purposes of Core
Principle 15.\27\
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\27\ FIA Comment Letter ("CL") 7 at 3-4.
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Commenters challenging the Commission's authority to promulgate the
acceptable practices for Core Principle 15 contend that they: (1)
Conflict with Core Principle 16; (2) are contrary to the text of the
statute; (3) are contrary to Congressional intent in enacting the CFMA;
(4) lack factual support; (5) conflict with guidance for Core Principle
14; and (6) impermissibly shift the burden to DCMs to demonstrate
compliance with Core Principle 15. As discussed below, none of these
contentions is persuasive.
a. The Acceptable Practices For Core Principle 15 Do Not Conflict
With Core Principle 16.
CME challenged Core Principle 15's applicability to the acceptable
practices, contending that because Core Principle 16 is the only core
principle that mentions board composition, it is the only source of
authority the Commission may use for this purpose, and that it is
limited to mutually-owned DCMs.\28\ Similarly, NYBOT and KCBT contended
that as member-owned DCMs, they are subject to Core Principle 16's
requirement to maintain governing boards that "reflect[ ] market
participants," and should not face any other board composition
provision.\29\
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\28\ CME CL 29 at 4-5. Core Principle 16 states: "COMPOSITION
OF BOARDS OF MUTUALLY OWNED CONTRACT MARKETS.--In the case of a
mutually owned contract market, the board of trade shall ensure that
the composition of the governing board reflects market
participants." CEA Sec. 5(d)(16), 7 U.S.C. 7(d)(16).
\29\ NYBOT CL 21 at 4; KCBT CL 8 at 3.
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Core Principle 16 requires a mutually owned board of trade to
ensure that the composition of its governing board reflects market
participants. Based on its plain language, Core Principle 16 is limited
to that goal,\30\ and has no bearing on the entirely separate goal of
Core Principle 15 to "minimize conflicts of interest in the decision-
making process of the contract market," whether or not it is mutually
owned. Core Principle 16 applies only to mutually owned contract
markets and directs that their governing boards must fairly represent
market participants. Core Principle 15 applies to all contract markets,
no matter how organized, and directs them to minimize conflicts of
interest. Conflicts may be structural as well as personal. Core
Principle 15 embraces both and supports the public director membership
requirement for
[[Page 6942]]
boards of DCMs. Accordingly, Core Principle 16 does not limit the
Commission's authority to issue acceptable practices to increase public
director representation on DCM boards in order to minimize conflicts of
interest under Core Principle 15.
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\30\ There is no legislative history concerning Core Principle
16 other than the statutory language itself.
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b. The Acceptable Practices for Core Principle 15 Are Not Contrary
to the CEA's Text.
Other opposing comments based on the text of Core Principle 15
substitute the Commission's straightforward reading of the statute with
targeted interpretations of individual words and phrases. The
Commission believes that these comments do not rise to the stature of
significant questions of statutory interpretation. For instance,
various commenters contended that Core Principle 15 says "minimize"
conflicts of interest, not "eliminate" them, as they argue the
Commission seeks to do with the Board Composition Acceptable
Practice.\31\ However, if the Commission had sought to "eliminate"
conflicts of interest, the Commission could have imposed a 100% public
director requirement. Certainly any less-than-100% public director
requirement may not eliminate all conflicts of interest.
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\31\ See, e.g., KCBT CL 8 at 2 and Roberts & Moran CL 27 at 1-2.
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Another such comment stated that Core Principle 15 applies to
"rules" and "process," but board composition is contained in DCM
"bylaws" (not rules), and a change to board composition is not a
"process." \32\ Contrary to this commenter's restrictive
interpretation of the term, "rule" is defined broadly in Commission
regulations to include by-laws.\33\ Thus, the mere mention of "rules"
in Core Principle 15 has no bearing on the Commission's authority. In
addition, Core Principle 15 provides that a DCM shall establish and
enforce rules to minimize conflicts of interest in the decision-making
process of the contract market and establish a process for resolving
such conflicts of interest. The two requirements are not mutually
exclusive.
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\32\ NYMEX CL 28 at 6.
\33\ See Commission Reg. 40.1(h), 17 CFR 40.1(h).
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Another commenter stated that Core Principle 15 provides that a DCM
shall "enforce" rules, and thereby contemplates action against
individuals rather than the DCM itself.\34\ In fact, Core Principle 15
states "establish and enforce" rules. Use of the conjunctive belies
any contention that Core Principle 15 was intended to be directed
solely to individuals.
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\34\ NYMEX CL 28 at 6.
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Numerous comments of this type were received, none of which
constitutes a serious challenge to the Commission's legal authority and
reasonable interpretation of Core Principle 15.
c. The Acceptable Practices for Core Principle 15 Are Not Contrary
to Congressional Intent in Enacting the CFMA.
Several commenters, including NYMEX and CBOT, contended that the
Board Composition Acceptable Practice is contrary to Congress' intent
in enacting Core Principle 15 and the CFMA.
Specifically, CBOT stated that prior to the CFMA's enactment, the
CEA treated board composition and conflicts of interest in two distinct
provisions of the statute. In passing the CFMA, Congress omitted the
board composition provision and kept the conflicts of interest
provision. CBOT interpreted this as evidence that Congress did not view
board composition as a mechanism to minimize conflict of interests.\35\
We believe that the legal import of silence as a statutory canon of
construction in these circumstances is a weak indicator of
Congressional intent.\36\ Moreover, inclusion of public directors on
company boards is a widely accepted means to reduce conflicts of
interest.\37\ Congress has in other contexts recognized the utility of
public directors in controlling conflicts of interest.\38\ Interpreting
the CFMA as the CBOT advocates would require the Commission to infer
that Congress was unaware of its own enactments, as well as the
aforementioned wide acceptance of public directors for reducing
conflicts, which the Commission is not prepared to do.
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\35\ CBOT CL at 5-6.
\36\ See, e.g., U.S. v. Vonn, 535 U.S. 55, 65 (2002); Pauley v.
Bethenergy Mines, Inc., 501 U.S. 680, 703 (1991) (internal citation
omitted).
\37\ See, e.g., NYSE Corporate Governance Rule 303A
(commentary).
\38\ See Section 10(a) of the Investment Company Act of 1940, 7
U.S.C. 80a-10(a); Burks v. Lasker, 441 U.S. 471, 484 (1979).
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Similarly, NYMEX commented that when the CFMA was enacted there was
a general understanding among DCMs, Commission staff, and legislators
that Congress did not intend the Commission to establish board
composition requirements for demutualized DCMs, which would instead be
subject to corporate governance and NYSE listing standards.\39\ A
congressional comment letter stated that it does not "appear" that
Congress intended the Commission to address board composition in the
instance of small mutually-owned DCMs like KCBT.\40\
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\39\ NYMEX CL 28 at 5-6.
\40\ Roberts & Moran CL 27 at 1-2.
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No commenter, however, cited any legislative history supporting
these views, and no rule of statutory or legal interpretation compels
the Commission to adopt them. The Commission may interpret the CEA
according to its reasoned discretion and agency expertise given the
absence of any contrary indication of Congressional intent at the time
the CFMA was enacted.
Various commenters also asserted that the proposed acceptable
practices in general are counter to the spirit of the CFMA, which
transformed the Commission into an oversight agency.\41\ They contended
also that the 50% public board member requirement in the proposed Board
Composition Acceptable Practice is stricter than the former statutory
requirement that DCM boards have 20% independent directors.\42\ This
comment would apply equally to the minimum 35% requirement contained in
the final acceptable practice. These commenters, however, overlook the
essential fact that the acceptable practices--unlike the pre-CFMA 20%
rule--are safe harbors, not statutory mandates. Persons taking this
view appear to want the Commission to do nothing at all--neither issue
rules nor announce nonbinding acceptable practices that embody high
standards.
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\41\ See, e.g., NYMEX CL 28 at 9-10.
\42\ See, e.g., CME CL 29 at 12.
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One commenter argued that the Commission did not subject DCMs to
Commission Rule 1.64 (containing the board composition requirement for
non-member representation) \43\ when it adopted Commission Rule 38.2
\44\ shortly after the enactment of the CFMA, thus suggesting that the
Commission's interpretation was that Core Principle 15 did not impose a
board composition requirement.\45\
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\43\ 17 CFR 1.64.
\44\ Commission Rule 38.2 contains an exemption for DCMs from
all Commission regulations except those specifically enumerated. 17
CFR 38.2.
\45\ NYMEX CL 28 at 15.
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The Commission did not adopt acceptable practices for all of the
core principles when it promulgated Commission Rule 38.2. Nor did the
Commission permanently reserve from exemption all regulations that are
reflected in core principles. Indeed, in January 2006, the Commission
added Commission Rule 1.60 to the enumerated list of regulations to
which DCMs are subject pursuant to Commission Rule 38.2.\46\
Accordingly,
[[Page 6943]]
the fact that Commission Rule 1.64 was not specifically exempted when
Commission Rule 38.2 was promulgated is not a reliable indicator of the
Commission's interpretation of Core Principle 15. Moreover, not long
after Commission Rule 38.2 was issued, the Commission began the SRO
Review to examine governance issues in order to determine whether
action was warranted. Thus, even if the omission of Commission Rule
1.64 from the enumerated regulations in Commission Rule 38.2 were
somehow indicative of a contemporaneous interpretation by the
Commission of Core Principle 15, a matter that the Commission does not
concede, the Commission's evolving views--based on the extensive record
developed during the course of the SRO Review--support its current
interpretation that Core Principle 15 authorizes it to adopt the Board
Composition Acceptable Practice.
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\46\ See 71 FR 1953 (Jan. 12, 2006).
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d. Acceptable Practices Are Justified As A Prophylactic Measure.
Several commenters contended that the acceptable practices lack
factual support demonstrating a need for their issuance. They argued
that the Commission did not point to any specific event or documented
self-regulatory failure or allegation of such failure in support of the
acceptable practices.\47\ Several commenters contended that the studies
cited by the Commission in the proposing release applied only to the
securities industry, and thus were inapposite to conditions in the
futures industry.\48\
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\47\ See CME CL 29 at 9; NYMEX CL 28 at 11-12; NYBOT CL 22 at 4;
CBOT CL 21 at 3.
\48\ See, e.g., NYMEX CL 28 at 11-13; CME CL 29 at 9; NYBOT CL
22 at 2; Comment of Donald L. Gibson, CL 25 at 1.
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These comments are misplaced. Although the Commission did not
specifically identify futures industry self-regulatory lapses in
support of the acceptable practices, it identified significant trends
in the futures industry, including increased competition and changing
ownership structures, that justify the acceptable practices as a
prophylactic measure to minimize conflicts in decision making and to
promote public confidence in the futures markets in the altered,
demutualized, and more competitive landscape. Commenters pointed to
nothing in the CEA, nor has the Commission found anything, to suggest
that Congress intended to restrict the authority of the Commission to
make "precautionary or prophylactic responses to perceived risks,"
that would render the Commission's action a violation of the CEA.\49\
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\49\ Chamber of Commerce v. SEC, 412 F.3d 133, 141 (D.C. Cir.
2005).
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e. Acceptable Practices for Core Principle 15 Do Not Conflict with
Guidance to Core Principle 14.
Another issue raised is whether the new acceptable practices for
Core Principle 15 conflict with guidance issued for Core Principle
14.\50\ One commenter asserted that guidance to Core Principle 14
suggests that directors of DCMs should, at a minimum, be market
participants, contrary to the proposed "public director"
definition.\51\ This contention misreads the guidance for Core
Principle 14. Minimum standards for directors provided in the guidance
are derived from the bases for refusal to register persons under CEA
Section 8a(2),\52\ and from the types of serious disciplinary offenses
that would disqualify persons from board and committee service under
Commission Rule 1.63.\53\ Nothing in the Application Guidance for Core
Principle 14 requires directors to be market participants. Moreover, a
significant number of DCMs currently have directors on their boards who
are not market participants.
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\50\ Core Principle 14 provides that a "Board of Trade shall
establish and enforce appropriate fitness standards for directors
[and others]." CEA Sec. 5(d)(14), 7 U.S.C. 7(d)(14).
\51\ CME CL 29 at 9.
\52\ 7 U.S.C. 12a(2).
\53\ 17 CFR 1.63. See 17 CFR Part 38, Appendix B, Core Principle
14 ("Application Guidance").
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f. Acceptable Practices for Core Principle 15 Do Not Impermissibly
Shift the Burden to DCMs for Demonstrating Compliance.
Finally, CME, CBOT, and NYMEX contended that the Board Composition
Acceptable Practice impermissibly shifts the burden of demonstrating a
DCM's compliance with Core Principle 15 from the Commission to the DCM
if a DCM elects not to comply with the acceptable practices.
There is no burden shifting here. All DCMs are required to
demonstrate to the Commission how they are complying with the core
principles. Without such a factual demonstration, the Commission could
not determine whether a contract market is in compliance with the core
principles, and thus the Commission could not meet its obligations
under the CEA.\54\ Compliance with these acceptable practices merely
eliminates the need for a DCM to demonstrate to the Commission that it
is complying with certain aspects of Core Principle 15. It follows that
a contract market that does not comply with the acceptable practices
must demonstrate to the Commission that it is complying with Core
Principle 15 by other means, as stated in the release.
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\54\ See CEA Sec. 5c(d), 7 U.S.C. 7a-2(d).
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B. Policy Comments: Public Comments Received and the Commission's
Response
1. General Comments
The Commission received a series of general comments, as discussed
more fully below, both in support of and in opposition to the overall
direction and findings of the proposed acceptable practices.
a. The proposed acceptable practices are inflexible; DCMs should be
free to determine their own methods of core principle compliance.
Several commenters stated that, consistent with the CFMA, DCMs, and
not the Commission, should determine the composition of their boards
and committees, and should have the discretion to establish their own
definition of "public director." One commenter noted that the concept
of membership has evolved as markets have become increasingly
electronic and global, and now encompasses a growing number of new
types of market participants (which consequently reduces the population
of potential public directors). Commenters argued that DCMs should be
permitted to tap these new types of members for service as directors,
bringing market knowledge and differing perspectives to their boards,
rather than adding public directors, who, as defined by the Commission,
will lack experience and expertise. It was further argued that DCMs
should be permitted to decide for themselves how to constitute their
boards in order to obtain the necessary knowledge, experience, and
expertise that will permit them to serve their economic functions and
the public interest.
With respect to the other committees and panels addressed in the
proposal, commenters stated that each DCM should be permitted to
determine the appropriate size and composition of its executive
committee, and likewise should be permitted: To determine whether to
establish an ROC; to determine the extent of an ROC's responsibilities;
and to determine the most appropriate composition for such committee.
Commenters also stated that each DCM should be permitted to determine
the composition and the structure of its disciplinary committees in
order to ensure that decisions are informed by knowledge and
experience.
Numerous commenters opined that the proposals are inflexible,
arbitrary, or
[[Page 6944]]
overly prescriptive. Among other things, commenters stated that the
regulatory proposals: could stifle vital day-to-day market functions;
Could swing the balance too far towards rigid, arbitrary requirements
when there is no demonstrable need for such action; are contrary to the
spirit and intent of the CFMA and the market-oriented, principle-based
structure authorized by that legislation; unnecessarily micromanage the
operations of DCMs; fail to recognize the changing definition and
increasing breadth of the concept of DCM membership; inflexibly impose
uniform requirements upon all DCMs without regard to the nature of a
particular DCM or the products traded on that DCM; and should be
presented not as a model for DCMs to adopt, but rather as examples of
ways for DCMs to meet core principle requirements.
Commenters also expressed concern that a bright-line test regarding
the proper number of public directors will become the de facto
requirement for all DCMs and will severely limit the ability of DCMs to
undertake other approaches to achieving the general performance
standard set by the core principles. Some commenters also contended
that requiring a DCM that does not meet the proposed acceptable
practices to demonstrate compliance with Core Principle 15 through
other means impermissibly shifts the burden of proof to DCMs to justify
departures from the acceptable practices, when the Act gives DCMs
reasonable discretion in how they comply with the core principles.
Another commenter noted that since the Commission has proposed absolute
numerical standards as a means of avoiding conflicts of interest, there
is no legitimate way to prove compliance by other means.
b. Safeguards are already in place to protect against conflicts of
interest at publicly traded, mutually-owned, and other DCMs.
Numerous commenters opined that the proposals are not necessary
because there are sufficient safeguards already in place to ensure that
potential conflicts of interest are adequately identified and
controlled and that self-regulation remains effective. Several
commenters argued that small DCMs already have in place adequate
controls to address potential conflicts of interest, and that the
Commission conducts an independent review of each DCM's compliance
department through its rule enforcement review ("RER") program.\55\
Several commenters noted that their board composition standards already
require public directors (albeit at a level lower than the proposed 50%
requirement). Those commenters opined that their existing procedures
for avoiding conflicts and including public participation are
sufficient and more effective than the proposed 50% public member
requirement.
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\55\ The Commission's Division of Market Oversight conducts
periodic RERs at all DCMs to assess their compliance with particular
core principles over a one-year target period. Staff's analyses,
conclusions, and recommendations regarding any identified deficiency
are included in a publicly available written report.
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Commenters also argued that fear of a possible conflict of interest
between a demutualized DCM's regulatory responsibilities and the
demands of a for-profit company is without foundation. These comments
asserted that demutualization actually encourages rather than
discourages effective self-regulation because market integrity is key
to attracting and retaining business. Commenters stated that large,
publicly traded DCMs already have numerous safeguards in place to
ensure that they act in the best interest of their shareholders and do
not act to the detriment of a particular group of shareholders. In
addition, some commenters opined that corporate governance requirements
currently applicable to publicly traded DCMs, combined with the
reasonable exercise of discretion by DCMs pursuant to Core Principle
1,\56\ provide sufficient assurance that conflicts of interest will be
kept to a minimum in the decision-making process. One DCM commented
that the proposed acceptable practices are unnecessary given, inter
alia, the NYSE and NASDAQ listing standards to which some DCM parent
companies are subject. In addition, it was observed that when a
potential conflict does arise, DCMs have developed specific board
governance procedures to ensure proper disclosure and to remove the
potential conflict from the decision-making process. One commenter
stated that the proposals are unnecessary because, if the Commission's