Daily Rules, Proposed Rules, and Notices of the Federal Government


17 CFR Part 38

RIN 3038-AC28

Conflicts of Interest in Self-Regulation and Self-Regulatory Organizations

AGENCY: Commodity Futures Trading Commission ("Commission").
ACTION: Proposed Acceptable Practices for compliance with section 5(d)(15) of the Commodity Exchange Act ("CEA" or "Act").1
SUMMARY: The Commission hereby proposes Acceptable Practices for section 5(d)(15) of the Act ("Core Principle 15").2 The proposed Acceptable Practices would provide designated contract markets ("DCMs") with a safe harbor for compliance with selected aspects of Core Principle 15's requirement that they minimize conflicts of interest in their decisionmaking. The proposed Acceptable Practices are summarized as follows.

2Core Principle 15 for designated contract markets provides as follows: "CONFLICTS OF INTEREST--The board of trade shall establish and enforce rules to minimize conflicts of interest in the decisionmaking process of the contract market and establish a process for resolving such conflicts of interest." CEA SS 5(d)(15), 7 U.S.C. SS 7(d)(15).

First, the Board Composition Acceptable Practice proposes that exchanges minimize potential conflicts of interest by maintaining governing boards composed of at least fifty percent "public" directors, as defined below. Second, the proposed Regulatory Oversight Committee Acceptable Practice calls upon exchanges to establish a board-level Regulatory Oversight Committee, composed solely of public directors, to oversee regulatory functions. Third, the Disciplinary Panel Acceptable Practice proposes that each disciplinary panel at all exchanges include at least one public participant, and that no panel be dominated by any group or class of exchange members.3 Finally, the proposed Acceptable Practices provide a definition of "public" for exchange directors and for members of disciplinary panels.

3 SeeCEA Section 1a(24), 7 U.S.C. 1a(24) (defining the term "member" to include both exchange members and non-member market participants with trading privileges);see also17 CFR 1.3(q).

Collectively, the proposed Acceptable Practices promote independence in decisionmaking by self-regulatory organizations ("SROs"),4 and constitute a proactive yet measured step toward ensuring that SROs maintain fair, vigorous, and effective self-regulation in a rapidly evolving futures industry. The Commission welcomes comment on the proposed Acceptable Practices.5

4For purposes of these Acceptable Practices, the term "SROs" refers to DCMs and is used interchangeably with the terms "exchanges," "boards of trade" and "contract markets." As part of its SRO study, the CFTC considered whether the current level of "public" representation on boards of registered futures associations ("RFAs") is still sufficient. That question and related issues concerning RFAs remain under review and will be addressed separately.

5This Release is the latest development in the Commission's SRO review that commenced in May 2003. The Acceptable Practices proposed herein are based on comments received in response to prior requests for comments published in theFederal Register, interviews with industry participants, testimony given at a February 15, 2006 public hearing before the Commission, and other sources identified herein as part of the basis for the instant proposals. PriorFederal Registerreleases, responses thereto, the hearing transcript, and a summary of interview comments, described with greater specificity elsewhere herein, are available on the Commission's Web site,or are available through the Acting Secretary of the Commission, whose name and address are listed above.

DATES: Comments should be submitted on or before August 7, 2006.
ADDRESSES: Comments should be sent to Eileen Donovan, Acting Secretary, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. Comments may be submitted via e-mail"Regulatory Governance" must be in the subject field of responses submitted via e-mail, and clearly indicated in written submissions. Comments may also be submitted at
FOR FURTHER INFORMATION CONTACT: Rachel F. Berdansky, Acting Deputy Director for Market Compliance, (202) 418-5429; or Sebastian Pujol Schott, Special Counsel, (202) 418-5641, Division of Market Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

Table of Contents I. Introduction II. The SRO Review A. Procedural History of the SRO Review B. Issues Raised by the SRO Review III. Description of Proposed Acceptable Practices A. Board Composition; “Public” Director Defined B. Regulatory Oversight Committee C. Disciplinary Panels IV. Analysis of Issues and Rationale for Acceptable Practices A. Board Composition; “Public” Director B. Regulatory Oversight Committee C. Disciplinary Panels V. Related Matters A. Cost-Benefit Analysis B. Regulatory Flexibility Act C. Paperwork Reduction Act of 1995 VI. Text of Proposed Acceptable Practices I. Introduction

Exchanges are “affected with a national public interest” in that they “provid[e] a means for managing and assuming price risks, discovering prices, or disseminating pricing information through trading in liquid, fair, and financially secure trading facilities.”6 Exchanges are also the front-line regulators in the U.S. futures industry.7 There are potential conflicts of interest inherent in an exchange's responsibilities as a regulator of its market and members, and the commercial interests embedded in its market operation. Nevertheless, with proper checks and balances to address such conflicts, coupled with vigilant Commission oversight, self-regulation can continue to serve as an effective and efficient means of promoting market integrity.

6CEA Section 3(a), 7 U.S.C. § 5(a).

7CEA Section 3(b), 7 U.S.C. § 5(b).

Increasing competition,8 changing ownership structures,9 and evolvingbusiness models are dramatically transforming the U.S. futures industry. Today U.S. futures exchanges must compete vigorously with other exchanges, electronic trading facilities and foreign markets to attract order flow, and also must meet customer demand for twenty-four hour trading, immediate order execution, lower transaction costs, and access to global markets. This heightened competition places strain on exchanges’ dual roles as regulators and as markets, and raises questions about their ability to deal with pressures to subordinate regulatory responsibilities to commercial imperatives. The trend towards demutualization represents an additional challenge to exchanges’ performance of self-regulatory duties. Traditional SRO conflicts have been joined by the possibility that self-regulatory functions may be marginalized by potentially conflicting commercial interests.10

8Increasing competition exists between U.S. and foreign exchanges, and between domestic exchanges. The New York Mercantile Exchange (“NYMEX”) and the IntercontinentalExchange offer competing contracts in Brent and WTI crude futures. Euronext.liffe, a subsidiary of Euronext, and the Chicago Mercantile Exchange (“CME”) offer competing Eurodollar contracts. Within the U.S., the Chicago Board of Trade (“CBOT”) and NYMEX offer several competing gold and silver contracts.

New exchanges comprise a further source of new competition. Since 2002, the Commission has designated six new contract markets, all of which entered the marketplace as non-mutual, for-profit entities. There is also competition between trading formats—open outcry and electronic. NYMEX gold and silver contracts, for example, trade primarily on the floor of the exchange, while CBOT offers its gold and silver contracts only electronically. In addition, the new contract markets referred to above trade only electronically, and electronic trading now accounts for over 60% of all trading volume on U.S. futures exchanges.

Finally, enhanced competition is evident between exchanges and their large, institutional futures commission merchant (“FCM”) members. They may compete directly, with FCMs internalizing order flow or exchanges disintermediating FCMs. They may also compete indirectly, as occurs, for example, when FCMs establish or invest in new exchanges offering substitutable contracts. Examples include the Cantor Financial Futures Exchange (no longer trading), designated in 1998; BrokerTec Futures Exchange, designated in 2001; and U.S. Futures Exchange, designated in 2004. The FCM-owners of new exchanges may both compete against, and be subject to the regulation of, the established SROs of which they are members.

9The principal change in ownership structure is the demutualization of member-owned exchanges and their conversion to publicly traded stock corporations. In December 2002, CME became thefirst U.S. futures exchange to transform from a membership mutual organization to a publicly traded, for-profit entity. Class A shares of its parent company, CME Holdings, Inc., are now listed on the New York Stock Exchange (“NYSE”). In October 2005, after undergoing a similar restructuring, the CBOT became the second U.S. futures exchange to demutualize and offer its parent's stock for trading on the NYSE.

While demutualization has been an important development for the largest and most well-established futures exchanges, the advent of exchanges structured as for-profit limited liability companies (“LLCs”) is another significant trend.

10Five domestic and international studies reviewed by the Commission address this issue, and are noteworthy for the extent to which they parallel concerns raised by futures industry participants. Although the studies focus primarily on the securities industry, some include futures markets as well, and the Commission believes that the concerns raised by demutualization and competition may be similar for both the futures and securities industries and exchanges.

The Securities Industry Association's (“SIA”)White Paper on Reinventing Self-Regulation,(Jan. 5, 2000, updated Oct. 14, 2003), observed, “the combined roles of SROs as market overseers and as competitors may affect SROs” ability and willingness to perform all their regulatory functions adequately, fairly, and efficiently” (SIA 2003 at 3).

The International Organization of Securities Commissions” (“IOSCO”)Issues Paper on Exchange Demutualization,(June 2001), determined that although many concerns with respect to self-regulation are not new, “demutualization and increased competition may exacerbate them” (IOSCO at 5).

A U.S. Government Accountability Office's (“GAO”) report to Congress entitled “Securities Markets: Competition and Multiple Regulators Heighten Concerns about Self-Regulation(May 2002) found that some securities SRO members were “concerned that SROs could adopt rules that unfairly impeded the ability of members to compete against the SROs.” Others were concerned that “an SRO, in its regulatory capacity, could obtain proprietary information from a member and, in its capacity as a market operator, inappropriately use the information” (GAO at 7). Some securities SRO members also expressed concern that “a demutualized, for-profit market operator might be more likely to misuse its regulatory authority or be less diligent in fulfilling its regulatory responsibilities in a desire to increase profits” (GAO at 8). Abuse of authority could be manifested, for example, through “rules that unfairly disadvantage members or other markets or inappropriately sanction or otherwise discipline members against which the SROs compete.” (Id.)

A discussion paper prepared for the World Bank's (“WB”) Financial Sector Strategy Department by an independent consultant, Implications ofDemutualization for the Self-Regulatory and Public Interest Roles of Securities Exchanges(John W. Carson, January 2003) (not necessarily representing the views or policies of the World Bank), identified four “widely accepted” propositions with respect to conflicts of interest and demutualization: (1) Conflicts of interest in self-regulation have always existed; (2) demutualization may increase the degree of those conflicts; (3) demutualization introduces new conflicts of interest; and (4) demutualization may reduce old conflicts (WB at 8). The World Bank Study offered several recommendations with respect to self-regulation: (1) “At a minimum, the threat of increased conflict in exercising regulatory authority demands that new safeguards be put in place to reduce the possibility of either the business units or customers attempting to influence regulatory decisions;” (2) it is imperative that decisions on opening investigations, when to expand or close investigations, when to pursue disciplinary action, and what penalty to seek are all made in an independent and unbiased manner, without regard to business considerations and impact on important customer relationships;” and (3) “strong measures are required to ensure that the integrity of an exchange's regulatory program is maintained and that it handles regulatory issues and decisions in a neutral and unbiased mnaner” (WB at 42-43).

Finally, an International Monetary Fund (“IMF”) Working Paper,Demutualization of Securities Exchanges: A Regulatory Perspective(Jennifer Elliott, September 2002) (not necessarily representing the views of the IMF) identified two broad conflicts of interest associated with demutualization. According to the Working Paper, “the forces that have generated pressure on exchanges to demutualize have also created new conflicts of interest and forced regulators and exchanges to reconsider what and how regulatory functions are delivered by the exchanges” (IMF at 7). One new conflict of interest is that “shareholders, who are interested in profit, may under fund the exchange's regulatory function. While in theory, the exchange should only benefit from an adequate regulatory standards [sic], exchanges may succumb to competitive pressure.” (IMF at 16). “The second conflict of interest is the disincentive to regulate market participants (who represent order flow and are a direct source of revenue for the exchange)” (Id).

In view of these developments, the Commission conducted a review of self-regulation in the futures industry to consider whether, and how, SROs can continue to fulfill their statutorily-mandated responsibilities as regulators.11 Three key principles emerged from this review. First, self-regulation continues to be the most effective and efficient regulatory model available to the futures industry; the self-regulatory system nevertheless must be updated and enhanced, as appropriate and necessary, to keep pace with the changing marketplace. Second, market forces, driven by global competition and changing ownership structures, pose a heightened risk that SROs may fail to fairly and vigorously carry out their regulatory responsibilities; such conflicts, whether actual or perceived, must be addressed proactively in the first instance by the SROs themselves. Third, the current market environment mandates enhanced and transparent governance as an essential business practice for maintaining market integrity and the public trust.12

11 SeeSection II.A.,infra.

12In recent years, the U.S. financial industry has undertaken major initiatives to strengthen corporate governance structures. These initiatives respond, for the most part, to a perceived lack of effective board oversight and emphasize board independence and accountability.SeeSection II.B.,infra.

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, andknowledge continue to play a vital role in SRO governance and administration and thus, preserve the “self” in self-regulation. In this manner, these proposed Acceptable Practices keep pace with changing market dynamics and proactively ensure that the self-regulatory model remains as vigorous, as fair, and as effective as required to protect the integrity of U.S. futures markets and the public confidence in them for years to come.

II. The SRO Review A. Procedural History of the SRO Review

The Commission's Acceptable Practices are based on a comprehensive review of self-regulation and SROs in the U.S. futures industry (“SRO Review”). Phase I of the SRO Review explored the roles, responsibilities, and capabilities of SROs in the context of industry changes. Staff examined the designated self-regulatory organization (“DSRO”) system of financial surveillance, the treatment of confidential information, the composition of exchanges’ disciplinary committees and panels, and other aspects of the self-regulatory process. At the conclusion of Phase I, the Commission identified two issues for immediate attention: (1) An examination of the cooperative regulatory agreement by which DSROs coordinate compliance examinations of FCMs; and (2) ensuring the confidentiality of certain information obtained by SROs and DSROs in the course of their regulatory activities. Measures with respect to both issues were announced by the Commission in February 2004. These issues are not addressed in this release.13

13The most recent amendments to the DSROs’ cooperative agreement were submitted to the Commission and published for comment. Futures Market Self-Regulation, 69 FR 19166 (Apr. 12, 2004).See alsoPress Release, Commodity Futures Trading Commission, Commission Progresses with Study of Self-Regulation (Feb. 6, 2004), available at:

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 aFederal RegisterRequest for Comments (“Request”) on the governance of futures industry SROs.14 The Request sought input on the proper composition of exchange boards, optimal regulatory structures, the impact of different business and ownership models on self-regulation, the proper composition of exchange disciplinary committees and panels, and other issues.

14Governance of Self-Regulatory Organizations, 69 FR 32326 (June 9, 2004). In this release, comment letters (“CLs”) in response to the SRO Governance Request for Comments are referred to by the name of the party submitting the letter and page number. These letters are available at: summary of interview comments (with names of persons interviewed redacted) also is available at this Web site.

In November 2005, the Commission updated its previous findings through a secondFederal RegisterRequest for Comments (“Second Request”) that focused on the most recent industry developments.15 The Second Request examined the board-level ROCs recently established at some SROs in the futures and securities industries. It considered the impact of the listing standards of the New York Stock Exchange (“NYSE”) on publicly-traded futures exchanges; whether the standards were relevant to self-regulation; and how the standards might inform the Commission's own regulations. The Second Request also explored the role of outside regulatory service providers, including RFAs, and SRO governance and the composition of boards and disciplinary committees.

15Self-Regulation and Self-Regulatory Organizations in the Futures Industry, 70 FR 71090 (Nov. 25, 2005). Comment letters received in response to this release are available at

Phase II of the SRO Review concluded with a public Commission hearing on “Self-Regulation and Self-Regulatory Organizations in the U.S. Futures Industry” (“Hearing”). The day-long Hearing, held at Commission headquarters in Washington, DC on February 15, 2006, included senior executives and compliance officials from a wide range of U.S. futures exchanges, representatives of small and large FCMs, academics and other outside experts, and an industry trade group. The Hearing afforded the Commission an opportunity to question panelists on four broad subject areas: (1) board composition; (2) alternative regulatory structures, including ROCs and third-party regulatory service providers; (3) transparency and disclosure; and (4) disciplinary committees.16

16The Hearing Transcript (“Hearing Tr.”) is available at

B. Issues Raised by the SRO Review

The SRO Review provided the Commission staff and industry participants and observers a unique opportunity to comment on the present state of self-regulation in the U.S. futures industry. Through interviews with over 100 industry participants and observers, comments received in response toFederal Registernotices, and the Hearing, the Commission gathered a wide range of views on the successes and challenges facing self-regulation now and into the future.

In general, commenters and interview participants saw continuing vitality in the central premise of self-regulation: that regulation works best when conducted close to the markets by individuals with market-specific expertise. At the same time, though, throughout the course of the SRO Review and in the surrounding public debate on the merits of self-regulation in the financial sector generally, many identified increased competition, evolving business models, and new ownership structures as critical changes capable of adversely impacting exchanges’ regulatory behavior.17

17 See e.g., Futures Industry Association (“FIA”), CL at 2 (Jan. 23, 2006); Comments of Professor Roberta S. Karmel, Centennial Professor of Law, Brooklyn Law School (“Karmel”), Hearing Tr. at 32 (“[T]echnology and competition are creating more serious conflicts and, in fact, it is these forces that propel demutualization in the first place”); Comments of Christopher K. Hehmeyer, Co-Chairman, Goldenberg Hehmeyer & Co., 151 (“[E]xchanges have done very well. But it would only take a couple of bad quarters, God forbid, on the part of the exchanges, for there to be pressures on some of the conflicts that haven't revealed themselves in the past.”); Comments of Susan M. Phillips, Dean, George Washington University School of Business (“Phillips”), 116 (“Obviously, the whole exchange environment is changing dramatically, probably more so now than at any time in history. There are a lot of pressures on exchanges.”).

See alsoIOSCO at 4. (“[A]s competition increases and exchanges move from mutual or cooperative entities to for-profit enterprises, new elements enter the environment. The commercial nature of the exchange becomes more evident: maximizing profits becomes an explicit objective.”). Others have noted that, even absent demutualization or for-profit exchanges, “intense competition alone will * * * increase conflicts due to the need to reduce costs, be more responsive to customers, and ensure that competing markets do not gain advantage by imposing a lighter regulatory burden.” WB at 31.

Specifically, some interview and Hearing participants and commenters expressed concern that for-profit, publicly traded exchanges may under-invest in regulatory personnel or technology to control costs and thereby meet the short-term expectations of stock holders and analysts.18 Theexchanges’ growing conflicts may also manifest themselves in under-regulation of those market participants who generate significant income or liquidity for the exchange—for example, FCMs that bring significant customer volume, market makers that provide significant liquidity, or high-volume locals. Conversely, concerns were raised that exchange participants who are not favored by, or compete with, the exchange may suffer from discriminatory or over-regulation.19

18 See, e.g., FIA CL (Jan. 23, 2006) at 1 (observing that SROs may use their regulatory authority for anti-competitive purposes or to adopt rules that benefit parochial interests at the expense of the public interest); and Citigroup CL (Jan. 23, 2006) at 1-2 (echoing support for the views expressed in FIA's comment letter);see alsoComments of Jeffrey Jennings, Managing Director and Global Head of Futures, Lehman Brothers (“Jennings”), Hearing Tr. at 53 (“[A]s the exchanges become for-profit * * * we have to recognize the issues that that raises, andthe risks of there being some sort of conflicts of interest. * * *”).

19Whether stemming from increased competition, demutualization, or for-profit structures, potential conflicts of interest in self-regulation may be all the more evident when exchanges regulate their competitors. For example, when firms operate their own market and also are users of an exchange, the exchange could discriminate in disciplinary matters, trading rules, fees, and other areas in which it has jurisdiction over the competitor. It has been suggested that, as with other conflicts of interest, “the conflicts inherent in an exchange regulating its competitors, while not new, become more apparent where the exchange is also a for-profit enterprise.” IOSCO at 5.

Exchanges, in turn, have argued that increased competition, demutualization, and other industry developments will strengthen self-regulation, not weaken it.20 They stated that their competitive advantage rests in offering fair and transparent markets that are free from fraud, manipulation, and other abusive practices. Exchanges also noted that demutualization and public listing create a new class of exchange owners whose long-term interests are aligned with effective self-regulation and fair markets.

20 See, e.g., CME CL (Jan. 23, 2006) at 2 and NYMEX CL (Jan. 23, 2006) at 3.

Against this backdrop of market changes raising implications for the SROs” performance of their regulatory functions, the U.S. financial industry has seen the emergence of governance “best practices” and standards designed to enhance corporate responsibility. These best practices and standards are found in a wide spectrum of the U.S. business community, ranging from securities self-regulatory organizations to major corporations and financial participants. All of these initiatives emphasize corporate governance as the key tool for the fulfillment of corporate responsibilities.21

21 See, e.g., Fair Administration and Governance of Self-Regulatory Organizations, 69 FR 71126 (Dec. 8, 2004) (“Fair Administration”); World Bank—Corporate Governance Principles of Best Practices, available at:;CalPERS Governance Principles, available at:

The cumulative impact of an evolving industry, operating in an ever more competitive, global environment, and the growing attention to the need for enhanced corporate governance, provide the basis for the Commission's review of self-regulation in the futures industry and the Acceptable Practices proposed herein.22

22In the face of such developments, a Hearing participant observed that “it is incumbent upon us all that the U.S. futures industry establish standards that recognize and are responsive to the realities of our changing industry and marketplace and are fair and without any appearance of conflicts.” Jennings, Hearing Tr. at 28.

III. Description of Proposed Acceptable Practices

Section 5(d)(15) of the CEA (“Core Principle 15”) requires that exchanges “minimize conflicts of interest in the decision making process.”23 Underlying the Core Principle's mandate is the recognition that management of conflicts of interest, which could potentially compromise the independence of an exchange's decision making, is fundamental to the effective operations of the exchange—no less than customer protection and market integrity mandated by other Core Principles. Core Principle 15 requires the exchanges to have systems in place to address not only an individual's personal conflicts of interest, but also the broader potential conflicts of interest inherent in self-regulation.

23Any board of trade that is registered with the Securities and Exchange Commission (“SEC”) as a national securities exchange, is a national securities association registered pursuant to section 15(A)(a) of the Securities Exchange Act of 1934, or is an alternative trading system, and that operates as a designated contract market in securities futures products under Section 5f of the Act and SEC Regulation 41.31, is exempt from the core principles enumerated in Section 5 of the Act, and the Acceptable Practices thereunder.

As discussed earlier, with respect to SROs that operate as both markets and front-line regulators, these conflicts may be further exacerbated by emerging market trends. At present, however, there are no Acceptable Practices for Core Principle 15. The Commission's core mission is to promote and protect the integrity of the U.S. futures markets and to promote public confidence and trust in those markets. Now, as the futures industry undergoes one of the most significant transformations in its long history, self-regulation must keep pace. Accordingly, the Commission believes that it is appropriate and necessary to provide guidance to SROs in the form of Acceptable Practices for Core Principle 15.

Core Principle 15 is illustrative of the new regulatory approach ushered in by the Commodity Futures Modernization Act of 2000 (“CFMA”),24 which replaced prescriptive rules governing futures exchanges with broad, flexible core principles. The core principles set standards of performance for the exchanges, and at the same time, allow exchanges considerable leeway in how to meet those standards. To facilitate compliance, the Commission has adopted Acceptable Practices for other core principles. Through its Acceptable Practices, the Commission provides exchanges with a safe harbor for complying with selected requirements of a core principle, but such Acceptable Practices, as stated in the Act, are not the exclusive means for compliance.25 Once implemented, Acceptable Practices provide regulatory certainty that exchanges may rely upon when seeking designation as contract markets or when subject to periodic Rule Enforcement Reviews by the Commission.26

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

25 SeeCEA Section 5c(a)(2), 7 U.S.C. § 7a-2(a)(2).

26The Commission has explained that “boards of trade that follow the specific practices outlined under [the Acceptable Practices] * * * will meet the selected requirements of the applicable core principle.” 17 CFR part 38, App. B, ¶ 2.

The Acceptable Practices proposed in this Release are designed to offer exchanges a roadmap for complying with selected requirements of Core Principle 15. The Acceptable Practices that we propose today would enable SROs to demonstrate that they are structurally capable of protecting their regulatory functions and decision making from conflicts of interest.27

As with Acceptable Practices generally, exchanges may choose not to comply with the proposed Acceptable Practices for Core Principle 15. They still will be required, however, to demonstrate that their policies and practices with respect to governance and decision making are in compliance with Core Principle 15 by other means.28

27In recent amendments to Appendix B of Part 38, the Commission has explained that “the enumerated acceptable practices under each core principle are neither the complete nor the exclusive requirements for meeting that core principle. With respect to the completeness issue, the selected requirements in the acceptable practices section of a particular core principle may not address all the requirements necessary for compliance with the core principle.” Technical and Clarifying Amendments to Rules for Exempt Markets, Derivatives Transaction Execution Facilities and Designated Contract Markets, and Procedural Changes for Derivatives Clearing Organization Registration Applications, 71 FR 1953, 1958 (Jan. 12, 2006). The Acceptable Practices that we propose today do not reach, and are not intended to reach, individual, personal conflicts of interest. A contract market must address these conflicts as well as the structural conflicts that are the subject of these proposed Acceptable Practices in order to demonstrate full compliance with Core Principle 15's requirements.

28In this regard, the CFTC will take into account the governance and regulatory conflicts of interestsspecific to the exchange and how they are being managed.

The elements of the proposed Acceptable Practices under Core Principle 15 are summarized below. The Commission proposes as a new Acceptable Practice under Core Principle 15 that at least fifty percent of the board members of exchanges’ boards of directors and executive committees (or similarly empowered bodies) be “public” directors, as defined below (“Board Composition Acceptable Practice”). Day-to-day regulatory operations should be supervised by a Chief Regulatory Officer (“CRO”) reporting directly to a ROC (“Regulatory Oversight Committee Acceptable Practice”). The Acceptable Practices define “public director” for persons serving on boards, ROCs, and disciplinary panels. An individual may qualify as a public director upon an affirmative determination by the board that the individual has no material relationship with the exchange.

In addition, the Acceptable Practices strengthen impartial adjudication by providing that SRO disciplinary panels should not be dominated by any group or class of SRO participants, and that each panel should include at least one public member (“Disciplinary Panel Acceptable Practice”). By increasing the public voice on governing boards and disciplinary committees and creating an independent board-level ROC, combined with Commission oversight, the Acceptable Practices seek to maintain the existing high standards of fair and effective self-regulation in the futures industry, while proactively adapting them to the market and business realities of a new era for the industry. Each of these Acceptable Practices is described below.

A. Board Composition; “Public” Director Defined

The Board Composition Acceptable Practice provides that exchanges should elect governing boards composed of at least fifty percent public directors. In addition, it provides that SROs’ executive committees (or similarly empowered bodies) should be at least fifty percent public.

The Acceptable Practice offers guidance on the definition of “public” director. The proposed definition provides that a director is “public” only if the board of directors affirmatively determines that the director has no “material relationship” with the exchange. The nominating committee of the board of directors should affirmatively determine on the record that a director or nominee has no material relationship with the exchange, and should state on the record the basis for its determination and the scope of its scrutiny. The committee should reevaluate that determination at least on an annual basis.

“Material relationships” are those that reasonably could affect the independent judgment or decision making of the director. Material relationships are not exclusively compensatory or financial. Any relationship between a director and the exchange that may interfere with a director's ability to deliberate objectively and impartially on any matter is a material relationship. In this regard, material relationships are not limited to those where a director has an immediate interest in a particular matter before him or her.

In addition to the general materiality test, the proposed definition of “public” director identifies specific circumstances or relationships that would preclude a determination that a person qualifies as a “public” director. Specifically, a director could not be “public” if any of the following circumstances existed:29

29These specific circumstances—or “bright-line” tests—are neither exclusive nor exhaustive. A director does not qualify as “public” unless the board affirmatively determines that the director has no material relationship with the exchange, including but not limited to, the bright-line tests identified herein.

—The director is an officer or employee of the exchange or a director, officer or employee of its affiliate;30

30As used in this context, an affiliate includes parents or subsidiaries of the contract market or entities that share a common parent with the contract market.

—The director is a member of the exchange, or a person employed by or affiliated with a member. In this context, a director is affiliated with a member if the director is an officer or director of the member; —The director receives more than $100,000 in payments from the exchange, any affiliate of the exchange, or a member or anyone affiliated with a member;31 —Any of the relationships above apply to a member of the director's immediate family,i.e., spouse, parents, children, and siblings.

31Compensation for services as a director will not be counted towards the $100,000 threshold test.

—All of the disqualifying circumstances described above are subject to a one-year look back. Thus, for example, a director who, within the past year, was a member of the exchange, would not qualify as a “public” director.

Comments are solicited on whether there are additional categories of circumstances which should automatically disqualify a person from consideration as a “public” director. Also, commenters have suggested that members should not be precluded from serving as a “public” director. They have offered as examples persons who engage inde minimistrading, or members who lease their seats to others. The Commission seeks the public's views on whether these or similar circumstances could rebut the presumption of member disqualification as a “public” director.

B. Regulatory Oversight Committee

The Regulatory Oversight Committee Acceptable Practice recognizes the importance of insulating core regulatory functions from improper influences and pressures stemming from the exchange's commercial affairs. To comply with the Regulatory Oversight Committee Acceptable Practice, every exchange should establish, as a standing committee of its board of directors, a ROC with oversight responsibility for all facets of the SRO's regulatory program. This includes broad authority to oversee: (1) Trade practice surveillance; (2) market surveillance; (3) audits, examinations, and other regulatory responsibilities with respect to member firms;32 (4) the conduct of investigations; (5) the size and allocation of regulatory budgets and resources; (6) the number of regulatory officers and staff; (7) the compensation of regulatory officers and staff; (8) the hiring and termination of regulatory officers and staff; and (9) the oversight of disciplinary committees and panels.


SROs' regulatory responsibilities with respect to member firms include ensuring compliance with financial integrity, financial reporting, sales practice, recordkeeping, and other requirements. Commission Regulation 1.52 permits cooperative agreements among exchanges to coordinate compliance examinations of FCMs such that each FCM is assigned a primary examiner (its DSRO). ROCs should have authority over SROs self-regulatory functions, both when the SROs are fulfilling SRO responsibilities and when they are fulfilling DSRO responsibilities.

The ROC's primary role is to assist the board in fulfilling its responsibility of ensuring the sufficiency, effectiveness, and independence of self-regulatory functions.33 In this capacity, the ROC should have the authority, discretion and necessary resources to conduct its own inquiries; consult directly with regulatory staff; interview employees, officers, members, and others; review relevant documents; retain independent legal counsel, auditors, and other professional services; and otherwise exercise its independent analysis andjudgment to fulfill its regulatory obligations.34


In its review of exchanges for compliance with Core Principles, the Commission will look at board documentation of the reasons for its actions and its acceptance or rejection of recommendations by the ROC, as well as by other committees.


Nevertheless, a ROC should not rely on outside professionals or firms that also provide services to the full board, other board committees, or other units of the exchange.

ROCs would be expected to identify aspects of the regulatory scheme that work well and those that need improvement, and, as necessary, to make recommendations to the governing board for changes that would ensure fair, vigorous, and effective regulation. ROCs should also be given an opportunity to review and, if they wish, present formal opinions to management and the board on any proposed rule or programmatic changes originating outside of the ROCs, but which their CROs believe may have a significant regulatory impact.35 Exchanges should provide their CROs and ROCs with sufficient time to consider such proposals before acting on them. In addition to periodic reports to the board, ROCs should prepare for the governing board and the Commission an annual report assessing the effectiveness, sufficiency, and independence of the SRO's regulatory program, including any proposals to remedy unresolved regulatory deficiencies. ROCs are also expected to keep thorough minutes and records of meetings, deliberations, and analyses, and make these available to Commission staff upon request.36


ROCs' deliberations with respect to such proposed rule changes should be memorialized in thorough meeting minutes, and their formal opinions made available to Commission staff upon request.

36The Commission's review of Core Principle 15 compliance will include, inter alia, the ROC's records, annual reports, meeting minutes, analyses conducted or commissioned by the ROC, examinations of proposed and existing rules, and evaluations and recommendations concerning the effectiveness, sufficiency, and independence of the exchange's regulatory programs.SeeSection 8(a)(1) of the Act, 7 U.S.C. § 12(a)(1), authorizing the Commission to “make such investigations as it deems necessary to ascertain the facts regarding the operations of boards of trade and other persons subject to the provisions of this Act.”

Finally, the proposed Acceptable Practice envisions that the CRO of the SRO will report directly to, and regularly consult with, the ROC. ROCs may delegate their day-to-day authority over self-regulatory functions and personnel to the CRO. Although ROCs remain responsible for ensuring the sufficiency, effectiveness, and independence of self-regulation within their SROs, they are not expected to assume managerial roles.

C. Disciplinary Panels

The proposed Disciplinary Panel Acceptable Practice would preclude any group or class of exchange members from dominating or exercising disproportionate influence on any disciplinary panel. In addition, the Commission proposes that all disciplinary panels include at least one “public” participant. To qualify as “public,” panel members should meet the same test as public directors.

For purposes of this Acceptable Practice, “disciplinary panel” means any person, panel of persons, or any subgroup thereof, which is authorized by an SRO to issue disciplinary charges, to conduct proceedings, to settle disciplinary charges, to impose disciplinary sanctions, or to hear appeals thereof, except in cases limited to decorum, attire, the timely submission of accurate records required for clearing or verifying each day's transactions or other similar activities. If an exchange's rules provide for an appeal to the board of directors, or a committee of the board, then that appellate body should include at least one person who meets the qualifications for membership on the board's ROC. “Disciplinary panel” does not include exchange regulatory staff authorized to issue warning letters or summary fines imposed pursuant to established schedules.

To take advantage of this safe harbor, and thereby comply with Core Principle 15's requirement to minimize conflicts of interest in decisionmaking, the Commission is proposing that exchanges amend their disciplinary panel composition rules and policies to incorporate the terms of the Disciplinary Panel Acceptable Practices. Finally, under this Acceptable Practice, disciplinary committees and panels would fall under the oversight of the ROC.

IV. Analysis and Rationale for Proposed Acceptable Practices A. Board Composition; “Public” Director

The Board Composition Acceptable Practice is designed to promote and safeguard the independence of the board of directors. It reaffirms the basic corporate principle that good governance is the cornerstone of a strong corporation and that a company's long-term success is best secured by enhancing the presence of independent participants at the highest level of corporate decisionmaking, the board of directors.

In any corporation, the paramount duty of the board of directors is to act, at all times, in the best interest of the corporation. It is the board that has the ultimate decisionmaking authority within a corporation and that must be accountable for any failure in the fulfillment of its corporate duties. In effect, the board represents the first line of defense against corporate misconduct. In the case of a corporation that also operates as an SRO, the board may have to make decisions in circumstances where its role as a fiduciary to the shareholders conflicts with its duty as a custodian of the public trust.37 Increased competition and demutualization may further exacerbate these potentially competing claims and render the board susceptible to pressures that may impact its ability to carry out self-regulatory duties to their fullest extent.


Any decisions made by SROs’ boards of directors, although not directly regulatory, implicate the public interest and the intersection between regulatory responsibilities and commercial imperatives. SROs’ boards of directors determine transaction fees; market data fees; and membership criteria. They control the employment and compensation of senior executives, including the president of the exchange, and they are sometimes responsible for the appointment of public directors. Boards make fundamental governance decisions, including those made with respect to the strategic direction of the SRO and the oversight of self-regulation. In addition, SROs’ public interest obligations are cited in the very purposes of the Act, which include “to serve the public interest * * * through a system of effective self-regulation of trading facilities.” CEA Section 3(b), 7 U.S.C. 5(b).

As noted at the Hearing, “exchanges which also function as for-profit institutions as well as SROs are truly occupying an absolutely unique space in corporate America.” Jennings, Hearing.Tr. at 79.

The Commission's proposed Board Composition Acceptable Practice constitutes a strong, proactive approach to ensuring the continued success of self-regulation in the futures industry. With respect to exchange boards of directors, their dual regulatory and commercial roles suggest that a fifty percent “public” board is an appropriate balance and should best enable directors to carry out their responsibilities.38

38Industry participants and observers noted that independence of an exchange's board of directors is key to effective and impartial self-regulation due to its role as the ultimate arbiter of decisions affecting both commercial and regulatory functions of the exchange. To address the conflicts of interest inherent in this dual role, most participants agreed on the benefits of including “public” directors on exchange boards.See e.g., Jennings, Hearing Tr. at 29 (“[I]t is a fundamental requirement that exchange boards must have a significant representation of independent public directors. I believe it is appropriate that at least fifty percent of the exchange board must comprise this group.”); and Phillips, Hearing Tr. at 159 (addressing reviews of exchanges’ rulemaking authority, “* * * it comes back to the governance process and the independence of the board to really make those kinds of reviews meaningful.”). However, industry participants did not agree on what specifically constitutes an appropriate board composition, or whether existing exchange board compositions are adequate.

The Commission notes that its proposed Board CompositionAcceptable Practice is consistent with the trend of major governance initiatives across the corporate and SRO communities in the United States. In November 2003, the New York Stock Exchange (“NYSE”) and NASDAQ both implemented new governance standards for their listed companies. Among the most important provisions is the requirement that listed companies’ boards have a majority of independent directors. In addition, listed companies must have fully independent nominating, corporate governance, compensation, and audit committees. While the conflicts driving these governance initiatives may differ from those arising in the futures self-regulatory context, the NYSE and NASDAQ standards for listed companies reflect their recognition that good corporate governance is founded on strengthening the independence and accountability of the board.

Two futures exchanges, the CME and the CBOT are now subject to the NYSE listing standards outlined above, and others may join them as futures exchanges continue to demutualize and seek public listing of their shares. The Commission is satisfied that the listing standards provide a measure of shareholder protection for the owners of publicly-traded futures exchanges. However, the Commission is equally satisfied that these listing standards are not designed for public companies that also bear a special responsibility of public protection and fair and effective self-regulation. Although it may be true, as the publicly-traded futures SROs have determined, that SRO members are independent under the NYSE listing standards, the proposed Board Composition Acceptable Practice provides that members are not independent for purposes of protecting the public interest against conflicts of interest in self-regulation.

Finally, the fifty percent minimum standard strikes a favorable balance between inside expertise and “outside” impartiality and ensures that other exchange stakeholders, such as members and exchange management, are adequately represented. In this manner, the “self” in self-regulation is retained, along with its efficiencies and expertise, while the ultimate benefactors of the self-regulatory system—market participants and the public—are assured that their interests are well-represented at the highest level.

(i) Definition of “Public” Director

To facilitate compliance, the Commission has modeled aspects of its “public” director definition, and more specifically, the materiality test, on what have now become accepted standards for defining independent directors. For example, the NYSE governance standards, noted above, mandate that to qualify as independent, directors must meet both a series of bright-line tests capturing certain present and past employment, compensation, business, familial, and other relationships; and a categorical “no material relationship” test. Similarly, under the Commission's proposed definition, the determination of whether a person qualifies as a “public” director entails (1) proposed “bright-line” tests, such as membership, employment, and business and financial ties with the exchange, aimed at identifying many of the circumstances that necessarily impair independent decision making; and (2) a facts and circumstances analysis. As to the facts and circumstances analysis, the board, taking into account all of the relevant factors relating to the person's relationship with the exchange, must make a reasonable finding on the record that the person is capable of independent decision-making. This analysis is broader than the bright-line tests.

Similar standards have already been implemented in a variety of related contexts: by the Public Company Accounting Reform and Investor Protection Act of 2002 (Sarbanes-Oxley Act of 2002) with respect to independent directors serving on the audit committees of public companies;39 and by the NYSE for its own board of directors.40 The SEC has also proposed similar standards for independent directors on the boards of securities exchanges.41

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

40Constitution of the New York Stock Exchange, Art. IV, § 2.

41Fair Administration,supranote 21.

The Acceptable Practice addressing board qualifications is named the “Public Director Acceptable Practice” rather than the “Independent Director Acceptable Practice” to emphasize the national public interest in futures trading and the role that SROs play in serving and protecting that interest.42 The appropriate definition of, and qualifications for, an unconflicted director were debated vigorously during the SRO Review.43 The debate often centered on whether the NYSE listing standards are sufficient for self-regulatory purposes. Several commenters and Hearing participants noted that the NYSE independent director standard principally operates to protect shareholder interests against undue management influence, and that more is needed to protect the public interest in an institution that exercises regulatory duties.44 The Commission generally agrees that the listing standards are not sufficient for public companies that also bear special responsibility to the public to self-regulate fairly and effectively. Simply stated, self-regulation and shareholder protection are two distinct missions: they may be complementary, but they are not substitutes.

42 SeeCEA Section 3(b), 7 U.S.C. § 5(b).

43FIA for example, commented that “[i]ndependent SRO directors should be independent not only of management but also of all activity on the exchange” because “[t]he special nature of an SRO's powers and functions * * * makes it essential to have truly independent directors with no direct, current ties to the industry the SRO regulates.” FIA CL (Jan. 23, 2006) at 3. NYMEX, on the other hand, was of the view that active industry participation did not impair impartiality so long as a director had no ties to the exchange itself.SeeNYMEX CL (Jan. 23, 2006) at 7: NYMEX stated that its “Public Directors would qualify as independent directors” under NYSE listing standards and noted that “it is possible for markets subject to [NYSE] listing standards to conclude that exchange members qualify as independent directors.” NYMEX noted the “specialized” nature of futures trading and emphasized the importance of board expertise.Id.The CME as well stated that independence should be determined on a case by case basis. CME CL (Jan. 23, 2006) at 7.

44 See, e.g., Karmel, Hearing Tr. at 33 (“The New York Stock Exchange and NASDAQ listing standards, as others have already said, do not squarely address the key issue of whether exchange members should be considered independent or not when they serve as directors of an exchange board or a regulatory subsidiary”; and FIA CL (Jan. 23. 2006) at 3.

B. Regulatory Oversight Committee

ROCs would provide independent oversight of core regulatory functions, including trade practice, market, and financial surveillance, for all exchanges. ROCs also would oversee the performance of disciplinary committees. Because these functions are fundamental manifestations of SROs’ regulatory authority, the Commission believes that they should be overseen in the most impartial manner possible within the context of self-regulation—by public directors who are neither members of the SRO nor otherwise dependent upon the commercial enterprise.45

45The Commission's proposed Regulatory Oversight Acceptable Practice is similar to measures already implemented or recommended by some exchanges in response to acknowledged self-regulatory concerns. The CME, for example, has formed an advisory board-level committee to “ensure the independent exercise” of self-regulatory obligations (“Market Regulation Oversight Committee” or “MROC”). Every member of the committee must be an independent director. The MROC reviews and reports to CME's board, on an annual basis, with respect to: (1) The independence of CME's regulatory functions from its business operations; (2) the independence of CME management and regulatory personnel fromimproper influence by industry directors regarding regulatory matters; (3) CME's compliance with its SRO responsibilities; (4) appropriate funding and resources to ensure effective performance of SRO responsibilities; and (5) appropriate compensation for CME employees involved in regulatory activities.

The public directors on the ROC would be free to consider the unique responsibilities of the SRO to act in the public interest, to plan for effective self-regulation in the long-term, and to insulate regulatory decisions from short-term pressures that may be brought to bear in an increasingly competitive environment. The Commission believes that SROs generally stand to benefit from establishing ROCs.

ROCs’ determinations with respect to their core competencies would be subject to review by the full board of directors, including member directors, and ROCs would be free to consult widely within the SRO throughout their deliberations, thus ensuring that member expertise remains central to self-regulation in the futures industry. At the same time, by placing initial oversight responsibility in the hands of public directors, arming them with the tools and resources necessary to make fully informed decisions, and providing an independent reporting line for senior regulatory officers, SROs would ensure that regulatory decisions are insulated from improper influences. The ROC structure, combined with careful Commission review of the interaction between the ROC and the board, fosters the continued integrity of futures self-regulation, effective management of conflicts of interest within SRO governance, and full consideration of the public interest in every decision of regulatory consequence.

C. Disciplinary Panels

Diversity in committee and panel composition has long been recognized as an effective tool for minimizing conflicts of interest in SRO disciplinary adjudication, a long-standing objective of the Commission. Prior to enactment of the CFMA, the Act set specific standards for the composition of SRO disciplinary committees, requiring that: (1) Exchanges provide for a diversity membership on all major disciplinary committees and (2) respondents in exchange disciplinary actions not be tried exclusively by their peers.

The CFMA continues the Act's commitment to fair disciplinary procedures. The Acceptable Practices for Core Principle 2, for example, require that exchanges discipline members and market participants pursuant to “clear and fair standards.”46 As stated earlier, Core Principle 15 requires exchanges to “minimize conflicts of interest in the decision making process.” This requirement extends to disciplinary committees and panels, which must be free of both individual and group (e.g., floor versus FCM) conflicts of interest.

4617 CFR Part 38, App. B, Core Principle 2, Acceptable Practices.

The Commission believes that fair disciplinary procedures with minimal conflicts of interest require unbiased disciplinary panels representing a diversity of opinions and experiences. At the very least, this presumes panels that are not weighted in favor of any single class of exchange participants. Also, including a public person provides an outside perspective and helps to ensure that

ACTION: 1Acceptable Practices for the Core Principles reside in Appendix B to Part 38 of the Commission's Regulations, 17 CFR part 38, App. B.