[Federal Register: June 9, 2004 (Volume 69, Number 111)]
[Page 32326-32329]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]



The Governance of Self-Regulatory Organizations

AGENCY: Commodity Futures Trading Commission.

ACTION: Request for comments.


SUMMARY: This Request for Comments continues the Commodity Futures
Trading Commission's (``CFTC or Commission'') ongoing review of self-
regulatory organizations (``SROs''). The request discusses recent
changes in the U.S. futures industry and the Commission's governance
requirements prior to and after passage of the Commodity Futures
Modernization Act (``CFMA''). Based on this discussion, the request
seeks answers from industry participants and other interested persons
to a series of questions on SRO governance and self-regulation.

DATES: Responses must be received by July 26, 2004.

ADDRESSES: Written responses should be sent to Jean A. Webb, Secretary,
Commodity Futures Trading Commission, Three Lafayette Center, 1155 21st
Street, NW., Washington, DC 20581. Responses may also be submitted via
e-mail at [email protected]. ``SRO Governance'' must be in the subject
field of responses submitted via e-mail, and clearly indicated in
written submissions. This document is also available for comment at
 href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.regulations.gov" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.regulations.gov.

FOR FURTHER INFORMATION CONTACT: Stephen Braverman, Deputy Director,
(202) 418-5487; Rachel Berdansky, Special Counsel, (202) 418-5429; or
Sebastian Pujol Schott, Attorney-Advisor, (202) 418-5641. Division of
Market Oversight, Commodity Futures Trading Commission, Three Lafayette
Center, 1155 21st Street, NW., Washington, DC 20581.


I. Introduction

    The Commodity Exchange Act (``Act''),\1\ among other things, seeks
to enhance regulatory efficiency in the futures industry through self-
regulation by exchanges, clearinghouses, and other organizations
registered with or designated by the Commission.\2\ Simultaneously, the
Act recognizes the public interest inherent in transactions executed on
U.S. futures exchanges and provides for oversight by the Commission.\3\
As the primary industry regulator, the Commission strives for
transparent, competitive, and financially sound futures markets that
operate free from manipulation, and to protect market participants from
fraud and other abusive practices.

    \1\ 7 U.S.C. 1, et seq. (2000).
    \2\ SROs include designated contract markets (``DCMs'' or
``exchanges''), derivatives transaction execution facilities,
registered futures associations, and derivatives clearing
organizations (``DCOs'').
    \3\ 7 U.S.C. 5.

    Acknowledging both the importance of industry self-regulation and
its own obligation to foster and maintain market integrity, CFTC
Chairman James E.

[[Page 32327]]

Newsome announced in May of 2003 that the Commission would review ``the
roles, responsibilities, and capabilities of SROs in the context of
market changes'' \4\ To that end, Commission staff has undertaken a
comprehensive study of self-regulation in the futures industry (``SRO

    \4\ See Address by Commission Chairman James E. Newsome at the
Futures Industry Association Law and Compliance Luncheon (May 28,
2003), available at  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/opa/speeches03/opanewsm-40.htm" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/opa/speeches03/opanewsm-40.htm


    The Commission's review of self-regulation has progressed against a
backdrop of rapid transformation in the futures industry; both the
competitive environment and the industry's business models are evolving
rapidly. For example, in November of 2000, the Chicago Mercantile
Exchange became the first U.S.-based futures exchange to transform from
a not-for profit mutual organization to a demutualized publicly traded
for-profit entity. The New York Mercantile Exchange has also
demutualized, although it is not publicly traded. Other exchanges are
considering demutualization, or are simply entering the market as for-
profit, non-mutualized entities. These structural changes have
coincided with increased competition in futures trading; a dramatic
rise in the volume of trading, both open outcry and electronic; the
entrance of new participants; and expanding roles for others. Each of
these developments may have implications for SROs in the performance of
their regulatory functions.
    Since the initiation of the SRO Study, Commission staff has
interviewed more than 100 individuals representing futures commission
merchants (``FCMs''), DCMs, DCOs and futures industry associations.
Staff also has interviewed industry executives, academics, consultants,
and individuals associated with securities-side entities. The
interviews covered a broad range of issues relevant to self-regulation
in the futures industry, and constituted an important component of the
ongoing SRO Study.
    Based on these interviews, the Commission identified two issues for
immediate attention: (1) Ensuring the confidentiality of certain
information obtained by SROs in the course of their self-regulatory
activities; and (2) examining the cooperative regulatory agreement by
which SROs coordinate compliance examinations of FCMs (``DSRO
System''). Interim measures with respect to both issues were announced
in a February 2004 press release.\5\ First, the Commission encouraged
every SRO to reexamine its policies, procedures, and practices to
confirm that it has adequate safeguards to prevent the inappropriate
use of confidential information obtained during audits, investigations,
and other self-regulatory activities. SROs also were encouraged to
publicize their safeguards. Second, the Commission announced a review
of the DSRO System, including its cooperative agreements and programs.
As a part of that review, the Commission subsequently issued a Request
for Comment on proposed amendments to the cooperative agreement by
which various SROs allocate certain supervisory responsibilities among
themselves so that each FCM has a single designated self-regulatory
organization (``DSRO'').\6\

    \5\ See CFTC Progresses with Study of Self-Regulation, CFTC
Press Release No. 4890-04 (Feb. 6, 2004), available at  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/opa/press04/opa4890-04.htm" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/opa/press04/opa4890-04.htm
    \6\ See CFTC Seeks Comment on How Self-Regulatory Exams of

futures Firms Are Coordinated, CFTC Press Release no. 4910-04 (Apr.
7, 2004), available at  href="http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/opa/press04/opa4910-04.htm" shape="rect">http://frwebgate.access.gpo.gov/cgi-bin/leaving.cgi?from=leavingFR.html&log=linklog&to=http://www.cftc.gov/opa/press04/opa4910-04.htm

    The February press release also reaffirmed that governance is a
central focus of the SRO Study,noting that SRO governance can
substantially impact key aspects of self-regulation and the increased
national attention given to SRO governance issues. Accordingly, the
Commission announced that it would issue this Request for Comments on
the topic of SRO governance.

II. Regulatory Background

    On December 21, 2000, Congress adopted the CFMA, which, among other
things, replaced ``one-size-fits-all'' regulations for futures markets
with flexible core principles and granted the Commission explicit
authority over DCOs.\7\ Prior to the adoption of the CFMA, SRO
governance was addressed primarily through Section 5a of the Act, as
amended by the Futures Trading Practices Act of 1992 (``FTPA''). The
FTPA required greater diversity of representation on SRO boards and
disciplinary committees, imposed fitness standards for service on
boards and disciplinary and oversight committees, and required SROs to
adopt procedures to avoid conflicts of interest in deliberations by
persons serving on such bodies. As directed by Congress, the Commission
promulgated regulations to enact the FTPA's governance provisions.
First, Regulation 1.64 addressed composition requirements for SRO
boards and disciplinary committees.\8\ Second, Regulation 1.69
established specific factors to be considered with respect to barring a
person serving on a board, disciplinary or oversight committee from
voting on a decision if the person had a potential financial or
personal interest. Third, Regulation 1.63, which already established
fitness standards for members of SRO boards and disciplinary
committees, was amended to include individuals serving on SRO oversight

    \7\ Commodity Futures Modernization Act of 2000, Public Law 106-
554, 114 Stat. 2763 (Dec. 21, 2000).
    \8\ Commission Regulation 1.64 required that each exchange
establish meaningful representation for (1) FCMs; (2) floor traders;
(3) floor brokers; (4) commercial interests; (5) participants in a
variety of pits or principal groups of commodities traded on the
exchange; and (6) other market users such as banks and pension
funds. The regulation further required that at least ten percent of
each exchange board consist of commercials and that at least 20
percent of the board include non-members. With respect to
composition of disciplinary committees, each exchange was required
to ensure that the composition of each major disciplinary committee
included sufficient different membership interests. In this
connection, the regulation required that a majority of each
disciplinary committee and hearing panels of those committees
include persons that represented membership interests other than
that of the subject respondent. If a matter involved a member of the
exchange governing board or a member of a disciplinary committee, or
involved manipulation or conduct that caused direct financial harm
to non-member, the exchange was required to include at least one
non-member on the committee or panel considering the case.

    The CFMA struck former Section 5a of the Act and adopted new
statutory provisions with respect to exchange governance. The CFMA
enumerates 18 core principles applicable to DCMs, three of which
directly relate to exchange governance: Core Principle 14- Governance
Fitness Standards; Core Principle 15- Conflicts of Interest; and Core
Principle 16- Composition of Boards Mutually Owned Contract Markets.\9\

    \9\ Core Principle 14 states that a ``board of trade shall
establish and enforce appropriate fitness standards for directors,
members of any disciplinary committee, members of the contract
market, and any other persons with direct access to the facility
(including any persons affiliated with any of the persons in this
paragraph).'' Core Principle 15 states that a ``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.'' Core Principle
16 states, ``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.'' Sections 5(d)(14), (15), and
(16) of the Act.

    The Commission adopted Part 38 of its regulations to implement
those core principles applicable to DCMs.\10\ Appendix B to Part 38
provides ``application guidance'' for the 18 core

[[Page 32328]]

principles.\11\ The guidance for Core Principle 14 provides that a DCM
should have appropriate fitness standards for various categories of
individuals. With respect to members who have voting privileges and
individuals who exercise governing or disciplinary authority, at a
minimum,these fitness standards should include those bases for refusal
to register a person that are enumerated under section 8a(2) of the
Act.\12\ the fitness standards also should require that individuals
with governing authority not have a significant history of disciplinary
violations, such as the disqualifications listed under Commission
Regulation 1.63.\13\

    \10\ Pursuant to section 38.2, DCMs are exempt from regulations
1.63,with the exception of 1.63(c); 1.64; and 1.69. See note 13 for
an explanation guidance to demonstrate core principle compliance.
    \11\ A DCM may use the application guidance to demonstrate core
principle compliance.
    \12\ Section 8a(2) permits the Commission to refuse to register
any person under any of eight enumerated conditions. For example,
the Commission may refuse to register persons (1) whose registration
under suspension or has been revoked; (2) whose registration has
been refused within the preceding five years dud to violations of
the Act or regulations thereunder; (3) who are permanently or
temporarily enjoined from holding certain positions in the futures
or securities industries; or (4) who have been convicted within the
previous 10 years of certain felonies.
    \13\ Regulation 1.63(c) prohibits a person from serving on an
SRO disciplinary committee, arbitration panel, oversight panel, or
governing board if the person is subject to any one of six
enumerated conditions. For example, a person may not serve on an
exchange disciplinary committee if he or she was found within the
prior three years by a final decision of an SRO, administrative law
judge, court, or the Commission to have committed a ``disciplinary
offense.'' A disciplinary offense generally includes any violation
of the rules of a SRO other than those rules relating to decorum or
attire, financial requirements, or reporting or recordkeeping unless
the reporting or recordkeeping violations resulted in fines totaling
more than $5,000 within any calendar year.

    The guidance for Core Principle 15 provides that a DCM should have
procedures to identify and resolve conflicts of interest in decision-
making. A DCM also should have appropriate limitations regarding the
use or disclosure of material non-public information gained through the
performance of official duties by board members, committee members, and
exchange employees or gained through an exchange ownership interest.
Finally, the guidance for Core Principle 16 provides that the board
composition of a mutually-owned DCM should fairly represent the
diversity of interests of the DCM's market participants.\14\

    \14\ Appendix B also lists ``acceptable practices'' for several
of the core principles; however, the Commission has not adopted
acceptable practices for Core Principles 14, 15, or 16.

III. Questions

    The Commission has formulated the following questions based on its
research, the views expressed by interview participants, and industry
developments. Responses from interested parties will advance the
Commission's understanding of issues relevant to SRO governance. Each
enumerated question should be addressed individually; parties also may
address any other topics they believe are relevant to SRO governance.
    Possible conflicts of interest, such as those that may exist
between an SRO's regulatory functions and its business functions, or
between an SRO's members, are central to many of the questions
articulated below. Where appropriate, parties should identify the
specific conflict addressed in their response, and how their proposal
resolves that conflict.

A. Board Composition

    1. What is the appropriate composition of SRO boards to best
protect the public interest and serve SROs' needs? If you believe that
SRO boards should consist of market participants, what participant
communities should be represented and how should representation be
allocated among those communities (e.g., quotas, volume-based)? Should
the composition of SRO boards be different for the various types of
SROs (e.g., DCM or DCO)?
    2. How and by whom should SRO boards be nominated and elected? If
directors should represent particular communities, should each
community nominate and/or elect its representatives to the board? If
the board consists of independent directors, what nomination and
election procedures are necessary to ensure independence?
    3. Should SRO boards include independent directors and, if so, what
level of representation should they have? What are appropriate
definitions of ``independent director'' and ``public director?'' Should
all independent directors be public directors? Please address whether
SRO members can be considered independent. Also, please address whether
the New York Stock Exchange's definition of independent--the
requirements include independence from the exchange's management,
members, and member organizations--is an appropriate model for the
futures industry.\15\

    \15\ Article IV, Section 2, of the New York Stock Exchange's
Constitution states that: The directors elected by the members shall
be independent of management of the Exchange, the members, and
issuers of securities listed on the Exchange and shall include
directors who will enable the Exchange to comply with the
requirements of Section 6(b)(3) of the Act. Among other things, no
director elected by the members shall be (a) a member, allied
member, lessor member or approved person; (b) an officer of employee
of the Exchange; (c) a person employed by an affiliated, directly or
indirectly, with a member organization, or with a broker or dealer
that engages in a business involving substantial direct contact with
securities customers; or (d) an executive officer of an issuer of
securities that are listed on the Exchange. In addition, no director
shall qualify as independent unless the Board affirmatively
determines that the director has no material relationship with the

B. Regulatory Structure

    4. Are the governance standards applicable to listed companies
sufficient for futures exchanges or their listed parent companies? Or,
given that futures exchanges are not typical corporations in that they
bear self-regulatory responsibilities, should they adopt higher
governance standards, particularly with respect to self-regulatory
activities? Please explain.
    5. Should SRO's regulatory functions be overseen by a body that is
internal to the SRO, but independent of management, members, and
business functions? If so, what specific functions should fall within
its purview (e.g., regulatory budget; personnel decisions; compensation
of regulatory staff; compliance and disciplinary programs; other
aspects of self-regulation)?
    6. Please address whether any rule enforcement, disciplinary, or
other functions currently performed by exchanges should be performed
instead by an independent regulatory services provider.

C. Forms of Ownership

    7. What impact do varying business models have on SRO's self-
regulatory behavior? Consider for-profit/not-for profit, member-owned/
shareholder owned, and publicly traded/privately held business models.
    8. More specifically, is an SRO subject to new influences in the
performance of its self-regulatory functions when it converts from a
member-owned, not-for-profit organization to a publicly traded, for-
profit company? Might a for-profit, publicly traded SRO attempt to
attract volume or increase its profits through lax self-regulation? Or,
is ti more likely that the SRO will seek to protects its brand and add
value through effective self-regulation?

D. Disciplinary Committees

    9. How should SRO disciplinary committees be structured so as to
ensure both expertise and impartiality?
    10. Please address whether SRO discplinary committees should have
independent, non-SRO member chairs and/or committee membership. Should
the level of representation for independent, non-SRO members vary

[[Page 32329]]

according to the type of discplinary case?
    11. How and by whom should SRO disciplinary committes be appointed?
Should the terms of committee members be limited? Please explain.

E. Other Issues

    12. What additional information, if any, should SROs make available
to the public to increase transparency with respect to their governance
and regulatory structures (e.g., board member affiliations; regulatory
staffing and budget; disciplinary committee membership and
affiliations, etc.)?
    13. Would additional core principles for SROs help to clarify their
responsibilities with respect to governance, or would regulatory
guidance be more appropriate.
    14. What steps should be taken to manage or eliminate conflicts of
interest involving SRO board and disciplinary committee members?
    15. Should registered futures associations that are functioning as
SROs also be subject to governance standards?

    Issued in Washington, DC, on June 2, 2004, by the Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 04-13027 Filed 6-8-04; 8:45 am]