Daily Rules, Proposed Rules, and Notices of the Federal Government
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.
Collectively, the proposed Acceptable Practices promote independence in decisionmaking by self-regulatory organizations ("SROs"),
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.”
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.
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.
The Securities Industry Association's (“SIA”)
The International Organization of Securities Commissions” (“IOSCO”)
A U.S. Government Accountability Office's (“GAO”) report to Congress entitled “
A discussion paper prepared for the World Bank's (“WB”) Financial Sector Strategy Department by an independent consultant, Implications of
Finally, an International Monetary Fund (“IMF”) Working Paper,
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.
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
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.
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
In November 2005, the Commission updated its previous findings through a second
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.
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
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.
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.
Exchanges, in turn, have argued that increased competition, demutualization, and other industry developments will strengthen self-regulation, not weaken it.
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.
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.
Section 5(d)(15) of the CEA (“Core Principle 15”) requires that exchanges “minimize conflicts of interest in the decision making process.”
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”),
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.
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.
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 (“
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 (“
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:
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
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;
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.
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.
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.
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.
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.
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.
The Commission notes that its proposed Board Composition
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.
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;
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.
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.
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.
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.”
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