[Federal Register Volume 71, Number 130 (Friday, July 7, 2006)]
[Proposed Rules]
[Pages 38740-38751]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-6030]



[[Page 38739]]

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Part IV





Commodity Futures Trading Commission





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17 CFR Part 38



Conflict of Interest in Self-Regulation and Self-Regulatory 
Organizations; Proposed Rule

  Federal Register / Vol. 71, No. 130 / Friday, July 7, 2006 / Proposed 
Rules  

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 38

RIN 3038-AC28


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

AGENCY: Commodity Futures Trading Commission (``Commission'').

ACTION: Proposed Acceptable Practices for compliance with section 
5(d)(15) of the Commodity Exchange Act (``CEA'' or ``Act'').\1\

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    \1\ Acceptable Practices for the Core Principles reside in 
Appendix B to Part 38 of the Commission's Regulations, 17 CFR part 
38, App. B.
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SUMMARY: The Commission hereby proposes Acceptable Practices for 
section 5(d)(15) of the Act (``Core Principle 15'').\2\ The proposed 
Acceptable Practices would provide designated contract markets 
(``DCMs'') with a safe harbor for compliance with selected aspects of 
Core Principle 15's requirement that they minimize conflicts of 
interest in their decisionmaking. The proposed Acceptable Practices are 
summarized as follows.
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    \2\ Core Principle 15 for designated contract markets provides 
as follows: ``CONFLICTS OF INTEREST--The board of trade shall 
establish and enforce rules to minimize conflicts of interest in the 
decisionmaking process of the contract market and establish a 
process for resolving such conflicts of interest.'' CEA Sec.  
5(d)(15), 7 U.S.C. Sec.  7(d)(15).
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    First, the Board Composition Acceptable Practice proposes that 
exchanges minimize potential conflicts of interest by maintaining 
governing boards composed of at least fifty percent ``public'' 
directors, as defined below. Second, the proposed Regulatory Oversight 
Committee Acceptable Practice calls upon exchanges to establish a 
board-level Regulatory Oversight Committee, composed solely of public 
directors, to oversee regulatory functions. Third, the Disciplinary 
Panel Acceptable Practice proposes that each disciplinary panel at all 
exchanges include at least one public participant, and that no panel be 
dominated by any group or class of exchange members.\3\ Finally, the 
proposed Acceptable Practices provide a definition of ``public'' for 
exchange directors and for members of disciplinary panels.
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    \3\ See CEA Section 1a(24), 7 U.S.C. 1a(24) (defining the term 
``member'' to include both exchange members and non-member market 
participants with trading privileges); see also 17 CFR 1.3(q).
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    Collectively, the proposed Acceptable Practices promote 
independence in decisionmaking by self-regulatory organizations 
(``SROs''),\4\ and constitute a proactive yet measured step toward 
ensuring that SROs maintain fair, vigorous, and effective self-
regulation in a rapidly evolving futures industry. The Commission 
welcomes comment on the proposed Acceptable Practices.\5\
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    \4\ For purposes of these Acceptable Practices, the term 
``SROs'' refers to DCMs and is used interchangeably with the terms 
``exchanges,'' ``boards of trade'' and ``contract markets.'' As part 
of its SRO study, the CFTC considered whether the current level of 
``public'' representation on boards of registered futures 
associations (``RFAs'') is still sufficient. That question and 
related issues concerning RFAs remain under review and will be 
addressed separately.
    \5\ This Release is the latest development in the Commission's 
SRO review that commenced in May 2003. The Acceptable Practices 
proposed herein are based on comments received in response to prior 
requests for comments published in the Federal Register, interviews 
with industry participants, testimony given at a February 15, 2006 
public hearing before the Commission, and other sources identified 
herein as part of the basis for the instant proposals. Prior Federal 
Register releases, responses thereto, the hearing transcript, and a 
summary of interview comments, described with greater specificity 
elsewhere herein, are available on the Commission's Web site at 
www.cftc.gov, or are available through the Acting Secretary of the 
Commission, whose name and address are listed above.

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

ADDRESSES: Comments should be sent to Eileen Donovan, Acting Secretary, 
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st 
Street, NW., Washington, DC 20581. Comments may be submitted via e-mail 
at [email protected]. ``Regulatory Governance'' must be in the subject 
field of responses submitted via e-mail, and clearly indicated in 
written submissions. Comments may also be submitted at http://www.regulations.gov.

FOR FURTHER INFORMATION CONTACT: Rachel F. Berdansky, Acting Deputy 
Director for Market Compliance, (202) 418-5429; or Sebastian Pujol 
Schott, Special Counsel, (202) 418-5641, Division of Market Oversight, 
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st 
Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION: 

Table of Contents

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

I. Introduction

    Exchanges are ``affected with a national public interest'' in that 
they ``provid[e] a means for managing and assuming price risks, 
discovering prices, or disseminating pricing information through 
trading in liquid, fair, and financially secure trading facilities.'' 
\6\ Exchanges are also the front-line regulators in the U.S. futures 
industry.\7\ There are potential conflicts of interest inherent in an 
exchange's responsibilities as a regulator of its market and members, 
and the commercial interests embedded in its market operation. 
Nevertheless, with proper checks and balances to address such 
conflicts, coupled with vigilant Commission oversight, self-regulation 
can continue to serve as an effective and efficient means of promoting 
market integrity.
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    \6\ CEA Section 3(a), 7 U.S.C. Sec.  5(a).
    \7\ CEA Section 3(b), 7 U.S.C. Sec.  5(b).
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    Increasing competition,\8\ changing ownership structures,\9\ and 
evolving

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business models are dramatically transforming the U.S. futures 
industry. Today U.S. futures exchanges must compete vigorously with 
other exchanges, electronic trading facilities and foreign markets to 
attract order flow, and also must meet customer demand for twenty-four 
hour trading, immediate order execution, lower transaction costs, and 
access to global markets. This heightened competition places strain on 
exchanges' dual roles as regulators and as markets, and raises 
questions about their ability to deal with pressures to subordinate 
regulatory responsibilities to commercial imperatives. The trend 
towards demutualization represents an additional challenge to 
exchanges' performance of self-regulatory duties. Traditional SRO 
conflicts have been joined by the possibility that self-regulatory 
functions may be marginalized by potentially conflicting commercial 
interests.\10\
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    \8\ Increasing competition exists between U.S. and foreign 
exchanges, and between domestic exchanges. The New York Mercantile 
Exchange (``NYMEX'') and the IntercontinentalExchange offer 
competing contracts in Brent and WTI crude futures. Euronext.liffe, 
a subsidiary of Euronext, and the Chicago Mercantile Exchange 
(``CME'') offer competing Eurodollar contracts. Within the U.S., the 
Chicago Board of Trade (``CBOT'') and NYMEX offer several competing 
gold and silver contracts.
    New exchanges comprise a further source of new competition. 
Since 2002, the Commission has designated six new contract markets, 
all of which entered the marketplace as non-mutual, for-profit 
entities. There is also competition between trading formats--open 
outcry and electronic. NYMEX gold and silver contracts, for example, 
trade primarily on the floor of the exchange, while CBOT offers its 
gold and silver contracts only electronically. In addition, the new 
contract markets referred to above trade only electronically, and 
electronic trading now accounts for over 60% of all trading volume 
on U.S. futures exchanges.
    Finally, enhanced competition is evident between exchanges and 
their large, institutional futures commission merchant (``FCM'') 
members. They may compete directly, with FCMs internalizing order 
flow or exchanges disintermediating FCMs. They may also compete 
indirectly, as occurs, for example, when FCMs establish or invest in 
new exchanges offering substitutable contracts. Examples include the 
Cantor Financial Futures Exchange (no longer trading), designated in 
1998; BrokerTec Futures Exchange, designated in 2001; and U.S. 
Futures Exchange, designated in 2004. The FCM-owners of new 
exchanges may both compete against, and be subject to the regulation 
of, the established SROs of which they are members.
    \9\ The principal change in ownership structure is the 
demutualization of member-owned exchanges and their conversion to 
publicly traded stock corporations. In December 2002, CME became the 
first U.S. futures exchange to transform from a membership mutual 
organization to a publicly traded, for-profit entity. Class A shares 
of its parent company, CME Holdings, Inc., are now listed on the New 
York Stock Exchange (``NYSE''). In October 2005, after undergoing a 
similar restructuring, the CBOT became the second U.S. futures 
exchange to demutualize and offer its parent's stock for trading on 
the NYSE.
    While demutualization has been an important development for the 
largest and most well-established futures exchanges, the advent of 
exchanges structured as for-profit limited liability companies 
(``LLCs'') is another significant trend.
    \10\ Five domestic and international studies reviewed by the 
Commission address this issue, and are noteworthy for the extent to 
which they parallel concerns raised by futures industry 
participants. Although the studies focus primarily on the securities 
industry, some include futures markets as well, and the Commission 
believes that the concerns raised by demutualization and competition 
may be similar for both the futures and securities industries and 
exchanges.
    The Securities Industry Association's (``SIA'') White Paper on 
Reinventing Self-Regulation, (Jan. 5, 2000, updated Oct. 14, 2003), 
observed, ``the combined roles of SROs as market overseers and as 
competitors may affect SROs'' ability and willingness to perform all 
their regulatory functions adequately, fairly, and efficiently'' 
(SIA 2003 at 3).
    The International Organization of Securities Commissions'' 
(``IOSCO'') Issues Paper on Exchange Demutualization, (June 2001), 
determined that although many concerns with respect to self-
regulation are not new, ``demutualization and increased competition 
may exacerbate them'' (IOSCO at 5).
    A U.S. Government Accountability Office's (``GAO'') report to 
Congress entitled ``Securities Markets: Competition and Multiple 
Regulators Heighten Concerns about Self-Regulation (May 2002) found 
that some securities SRO members were ``concerned that SROs could 
adopt rules that unfairly impeded the ability of members to compete 
against the SROs.'' Others were concerned that ``an SRO, in its 
regulatory capacity, could obtain proprietary information from a 
member and, in its capacity as a market operator, inappropriately 
use the information'' (GAO at 7). Some securities SRO members also 
expressed concern that ``a demutualized, for-profit market operator 
might be more likely to misuse its regulatory authority or be less 
diligent in fulfilling its regulatory responsibilities in a desire 
to increase profits'' (GAO at 8). Abuse of authority could be 
manifested, for example, through ``rules that unfairly disadvantage 
members or other markets or inappropriately sanction or otherwise 
discipline members against which the SROs compete.'' (Id.)
    A discussion paper prepared for the World Bank's (``WB'') 
Financial Sector Strategy Department by an independent consultant, 
Implications of Demutualization for the Self-Regulatory and Public 
Interest Roles of Securities Exchanges (John W. Carson, January 
2003) (not necessarily representing the views or policies of the 
World Bank), identified four ``widely accepted'' propositions with 
respect to conflicts of interest and demutualization: (1) Conflicts 
of interest in self-regulation have always existed; (2) 
demutualization may increase the degree of those conflicts; (3) 
demutualization introduces new conflicts of interest; and (4) 
demutualization may reduce old conflicts (WB at 8). The World Bank 
Study offered several recommendations with respect to self-
regulation: (1) ``At a minimum, the threat of increased conflict in 
exercising regulatory authority demands that new safeguards be put 
in place to reduce the possibility of either the business units or 
customers attempting to influence regulatory decisions;'' (2) it is 
imperative that decisions on opening investigations, when to expand 
or close investigations, when to pursue disciplinary action, and 
what penalty to seek are all made in an independent and unbiased 
manner, without regard to business considerations and impact on 
important customer relationships;'' and (3) ``strong measures are 
required to ensure that the integrity of an exchange's regulatory 
program is maintained and that it handles regulatory issues and 
decisions in a neutral and unbiased mnaner'' (WB at 42-43).
    Finally, an International Monetary Fund (``IMF'') Working Paper, 
Demutualization of Securities Exchanges: A Regulatory Perspective 
(Jennifer Elliott, September 2002) (not necessarily representing the 
views of the IMF) identified two broad conflicts of interest 
associated with demutualization. According to the Working Paper, 
``the forces that have generated pressure on exchanges to 
demutualize have also created new conflicts of interest and forced 
regulators and exchanges to reconsider what and how regulatory 
functions are delivered by the exchanges'' (IMF at 7). One new 
conflict of interest is that ``shareholders, who are interested in 
profit, may under fund the exchange's regulatory function. While in 
theory, the exchange should only benefit from an adequate regulatory 
standards [sic], exchanges may succumb to competitive pressure.'' 
(IMF at 16). ``The second conflict of interest is the disincentive 
to regulate market participants (who represent order flow and are a 
direct source of revenue for the exchange)'' (Id).
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    In view of these developments, the Commission conducted a review of 
self-regulation in the futures industry to consider whether, and how, 
SROs can continue to fulfill their statutorily-mandated 
responsibilities as regulators.\11\ Three key principles emerged from 
this review. First, self-regulation continues to be the most effective 
and efficient regulatory model available to the futures industry; the 
self-regulatory system nevertheless must be updated and enhanced, as 
appropriate and necessary, to keep pace with the changing marketplace. 
Second, market forces, driven by global competition and changing 
ownership structures, pose a heightened risk that SROs may fail to 
fairly and vigorously carry out their regulatory responsibilities; such 
conflicts, whether actual or perceived, must be addressed proactively 
in the first instance by the SROs themselves. Third, the current market 
environment mandates enhanced and transparent governance as an 
essential business practice for maintaining market integrity and the 
public trust.\12\
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    \11\ See Section II.A., infra.
    \12\ In recent years, the U.S. financial industry has undertaken 
major initiatives to strengthen corporate governance structures. 
These initiatives respond, for the most part, to a perceived lack of 
effective board oversight and emphasize board independence and 
accountability. See Section II.B., infra.
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    The Acceptable Practices proposed today constitute the Commission's 
considered view of best practices relating to SRO governance and 
administration in order to address the concerns raised by SROs' dual 
roles in light of increasing competition and demutualization. The 
Acceptable Practices promote an optimal SRO governance structure, which 
would minimize the potential for conflicts with the SRO's regulatory 
duties. Specifically, the Acceptable Practices would ensure that there 
is adequate independence within the SRO's board to insulate regulatory 
functions from the interests of the exchange's management, members, and 
other business interests of the market itself. An SRO is not simply a 
corporation, but a corporation charged with the public trust. As such, 
the board--the governing body of the SRO--must be structured in a way 
that best fosters public confidence in the integrity of its 
organization, and further, ensures that SRO functions take no less 
preeminence than that accorded to the exchange's commercial interests.
    The Acceptable Practices also would enhance the role of outside 
impartiality in other key SRO functions, including a board-level 
Regulatory Oversight Committee (``ROC'') and disciplinary panels, to 
further enhance the transparency and accountability of SRO decisions 
impacting self-regulation. Finally, the proposed Acceptable Practices 
carefully define ``public'' directors to identify those who can help 
ensure that SRO regulatory programs remain effective, yet unburdened by 
potential conflicts or pressures from the exchange's commercial or 
member interests.
    In summary, the Acceptable Practices proposed today are measured 
steps--in the form of carefully-tailored internal safeguards and checks 
and balances--to promote the independence of SRO functions. At the same 
time, they ensure that industry expertise, experience, and

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

II. The SRO Review

A. Procedural History of the SRO Review

    The Commission's Acceptable Practices are based on a comprehensive 
review of self-regulation and SROs in the U.S. futures industry (``SRO 
Review''). Phase I of the SRO Review explored the roles, 
responsibilities, and capabilities of SROs in the context of industry 
changes. Staff examined the designated self-regulatory organization 
(``DSRO'') system of financial surveillance, the treatment of 
confidential information, the composition of exchanges' disciplinary 
committees and panels, and other aspects of the self-regulatory 
process. At the conclusion of Phase I, the Commission identified two 
issues for immediate attention: (1) An examination of the cooperative 
regulatory agreement by which DSROs coordinate compliance examinations 
of FCMs; and (2) ensuring the confidentiality of certain information 
obtained by SROs and DSROs in the course of their regulatory 
activities. Measures with respect to both issues were announced by the 
Commission in February 2004. These issues are not addressed in this 
release.\13\
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    \13\ The most recent amendments to the DSROs' cooperative 
agreement were submitted to the Commission and published for 
comment. Futures Market Self-Regulation, 69 FR 19166 (Apr. 12, 
2004). See also Press Release, Commodity Futures Trading Commission, 
Commission Progresses with Study of Self-Regulation (Feb. 6, 2004), 
available at: http://www.cftc.gov/opa/press04/opa4890-04.htm.
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    After detailed interviews with an array of industry participants, 
the Commission initiated Phase II of the SRO Review and broadened its 
inquiry to address SRO governance and the interplay between exchanges' 
self-regulatory responsibilities and their commercial interests.
    In June 2004, the Commission issued a Federal Register Request for 
Comments (``Request'') on the governance of futures industry SROs.\14\ 
The Request sought input on the proper composition of exchange boards, 
optimal regulatory structures, the impact of different business and 
ownership models on self-regulation, the proper composition of exchange 
disciplinary committees and panels, and other issues.
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    \14\ Governance of Self-Regulatory Organizations, 69 FR 32326 
(June 9, 2004). In this release, comment letters (``CLs'') in 
response to the SRO Governance Request for Comments are referred to 
by the name of the party submitting the letter and page number. 
These letters are available at: http://www.cftc.gov/foia/comment04/foi04-005_1.htm. A summary of interview comments (with names of 
persons interviewed redacted) also is available at this Web site.
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    In November 2005, the Commission updated its previous findings 
through a second Federal Register Request for Comments (``Second 
Request'') that focused on the most recent industry developments.\15\ 
The Second Request examined the board-level ROCs recently established 
at some SROs in the futures and securities industries. It considered 
the impact of the listing standards of the New York Stock Exchange 
(``NYSE'') on publicly-traded futures exchanges; whether the standards 
were relevant to self-regulation; and how the standards might inform 
the Commission's own regulations. The Second Request also explored the 
role of outside regulatory service providers, including RFAs, and SRO 
governance and the composition of boards and disciplinary committees.
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    \15\ Self-Regulation and Self-Regulatory Organizations in the 
Futures Industry, 70 FR 71090 (Nov. 25, 2005). Comment letters 
received in response to this release are available at http://www.cftc.gov/foia/comments05/foi05-007_1.htm.
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    Phase II of the SRO Review concluded with a public Commission 
hearing on ``Self-Regulation and Self-Regulatory Organizations in the 
U.S. Futures Industry'' (``Hearing''). The day-long Hearing, held at 
Commission headquarters in Washington, DC on February 15, 2006, 
included senior executives and compliance officials from a wide range 
of U.S. futures exchanges, representatives of small and large FCMs, 
academics and other outside experts, and an industry trade group. The 
Hearing afforded the Commission an opportunity to question panelists on 
four broad subject areas: (1) board composition; (2) alternative 
regulatory structures, including ROCs and third-party regulatory 
service providers; (3) transparency and disclosure; and (4) 
disciplinary committees.\16\
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    \16\ The Hearing Transcript (``Hearing Tr.'') is available at 
http://www.cftc.gov/files/opa/opapublichearing021506.final.pdf.
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B. Issues Raised by the SRO Review

    The SRO Review provided the Commission staff and industry 
participants and observers a unique opportunity to comment on the 
present state of self-regulation in the U.S. futures industry. Through 
interviews with over 100 industry participants and observers, comments 
received in response to Federal Register notices, and the Hearing, the 
Commission gathered a wide range of views on the successes and 
challenges facing self-regulation now and into the future.
    In general, commenters and interview participants saw continuing 
vitality in the central premise of self-regulation: that regulation 
works best when conducted close to the markets by individuals with 
market-specific expertise. At the same time, though, throughout the 
course of the SRO Review and in the surrounding public debate on the 
merits of self-regulation in the financial sector generally, many 
identified increased competition, evolving business models, and new 
ownership structures as critical changes capable of adversely impacting 
exchanges' regulatory behavior.\17\
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    \17\ See e.g., Futures Industry Association (``FIA''), CL at 2 
(Jan. 23, 2006); Comments of Professor Roberta S. Karmel, Centennial 
Professor of Law, Brooklyn Law School (``Karmel''), Hearing Tr. at 
32 (``[T]echnology and competition are creating more serious 
conflicts and, in fact, it is these forces that propel 
demutualization in the first place''); Comments of Christopher K. 
Hehmeyer, Co-Chairman, Goldenberg Hehmeyer & Co., id. at 151 
(``[E]xchanges have done very well. But it would only take a couple 
of bad quarters, God forbid, on the part of the exchanges, for there 
to be pressures on some of the conflicts that haven't revealed 
themselves in the past.''); Comments of Susan M. Phillips, Dean, 
George Washington University School of Business (``Phillips''), id. 
at 116 (``Obviously, the whole exchange environment is changing 
dramatically, probably more so now than at any time in history. 
There are a lot of pressures on exchanges.'').
    See also IOSCO at 4. (``[A]s competition increases and exchanges 
move from mutual or cooperative entities to for-profit enterprises, 
new elements enter the environment. The commercial nature of the 
exchange becomes more evident: maximizing profits becomes an 
explicit objective.''). Others have noted that, even absent 
demutualization or for-profit exchanges, ``intense competition alone 
will * * * increase conflicts due to the need to reduce costs, be 
more responsive to customers, and ensure that competing markets do 
not gain advantage by imposing a lighter regulatory burden.'' WB at 
31.
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    Specifically, some interview and Hearing participants and 
commenters expressed concern that for-profit, publicly traded exchanges 
may under-invest in regulatory personnel or technology to control costs 
and thereby meet the short-term expectations of stock holders and 
analysts.\18\ The

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exchanges' growing conflicts may also manifest themselves in under-
regulation of those market participants who generate significant income 
or liquidity for the exchange--for example, FCMs that bring significant 
customer volume, market makers that provide significant liquidity, or 
high-volume locals. Conversely, concerns were raised that exchange 
participants who are not favored by, or compete with, the exchange may 
suffer from discriminatory or over-regulation.\19\
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    \18\ See, e.g., FIA CL (Jan. 23, 2006) at 1 (observing that SROs 
may use their regulatory authority for anti-competitive purposes or 
to adopt rules that benefit parochial interests at the expense of 
the public interest); and Citigroup CL (Jan. 23, 2006) at 1-2 
(echoing support for the views expressed in FIA's comment letter); 
see also Comments of Jeffrey Jennings, Managing Director and Global 
Head of Futures, Lehman Brothers (``Jennings''), Hearing Tr. at 53 
(``[A]s the exchanges become for-profit * * * we have to recognize 
the issues that that raises, and the risks of there being some sort 
of conflicts of interest. * * *'').
    \19\ Whether stemming from increased competition, 
demutualization, or for-profit structures, potential conflicts of 
interest in self-regulation may be all the more evident when 
exchanges regulate their competitors. For example, when firms 
operate their own market and also are users of an exchange, the 
exchange could discriminate in disciplinary matters, trading rules, 
fees, and other areas in which it has jurisdiction over the 
competitor. It has been suggested that, as with other conflicts of 
interest, ``the conflicts inherent in an exchange regulating its 
competitors, while not new, become more apparent where the exchange 
is also a for-profit enterprise.'' IOSCO at 5.
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    Exchanges, in turn, have argued that increased competition, 
demutualization, and other industry developments will strengthen self-
regulation, not weaken it.\20\ They stated that their competitive 
advantage rests in offering fair and transparent markets that are free 
from fraud, manipulation, and other abusive practices. Exchanges also 
noted that demutualization and public listing create a new class of 
exchange owners whose long-term interests are aligned with effective 
self-regulation and fair markets.
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    \20\ See, e.g., CME CL (Jan. 23, 2006) at 2 and NYMEX CL (Jan. 
23, 2006) at 3.
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    Against this backdrop of market changes raising implications for 
the SROs'' performance of their regulatory functions, the U.S. 
financial industry has seen the emergence of governance ``best 
practices'' and standards designed to enhance corporate responsibility. 
These best practices and standards are found in a wide spectrum of the 
U.S. business community, ranging from securities self-regulatory 
organizations to major corporations and financial participants. All of 
these initiatives emphasize corporate governance as the key tool for 
the fulfillment of corporate responsibilities.\21\
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    \21\ See, e.g., Fair Administration and Governance of Self-
Regulatory Organizations, 69 FR 71126 (Dec. 8, 2004) (``Fair 
Administration''); World Bank--Corporate Governance Principles of 
Best Practices, available at: http://www.worldbank.org/html/fpd/privatesector/cg/codes.htm; CalPERS Governance Principles, available 
at: http://www.calpers-governance.org/principles/default.asp.
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    The cumulative impact of an evolving industry, operating in an ever 
more competitive, global environment, and the growing attention to the 
need for enhanced corporate governance, provide the basis for the 
Commission's review of self-regulation in the futures industry and the 
Acceptable Practices proposed herein.\22\
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    \22\ In the face of such developments, a Hearing participant 
observed that ``it is incumbent upon us all that the U.S. futures 
industry establish standards that recognize and are responsive to 
the realities of our changing industry and marketplace and are fair 
and without any appearance of conflicts.'' Jennings, Hearing Tr. at 
28.
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III. Description of Proposed Acceptable Practices

    Section 5(d)(15) of the CEA (``Core Principle 15'') requires that 
exchanges ``minimize conflicts of interest in the decision making 
process.'' \23\ Underlying the Core Principle's mandate is the 
recognition that management of conflicts of interest, which could 
potentially compromise the independence of an exchange's decision 
making, is fundamental to the effective operations of the exchange--no 
less than customer protection and market integrity mandated by other 
Core Principles. Core Principle 15 requires the exchanges to have 
systems in place to address not only an individual's personal conflicts 
of interest, but also the broader potential conflicts of interest 
inherent in self-regulation.
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    \23\ Any board of trade that is registered with the Securities 
and Exchange Commission (``SEC'') as a national securities exchange, 
is a national securities association registered pursuant to section 
15(A)(a) of the Securities Exchange Act of 1934, or is an 
alternative trading system, and that operates as a designated 
contract market in securities futures products under Section 5f of 
the Act and SEC Regulation 41.31, is exempt from the core principles 
enumerated in Section 5 of the Act, and the Acceptable Practices 
thereunder.
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    As discussed earlier, with respect to SROs that operate as both 
markets and front-line regulators, these conflicts may be further 
exacerbated by emerging market trends. At present, however, there are 
no Acceptable Practices for Core Principle 15. The Commission's core 
mission is to promote and protect the integrity of the U.S. futures 
markets and to promote public confidence and trust in those markets. 
Now, as the futures industry undergoes one of the most significant 
transformations in its long history, self-regulation must keep pace. 
Accordingly, the Commission believes that it is appropriate and 
necessary to provide guidance to SROs in the form of Acceptable 
Practices for Core Principle 15.
    Core Principle 15 is illustrative of the new regulatory approach 
ushered in by the Commodity Futures Modernization Act of 2000 
(``CFMA''),\24\ which replaced prescriptive rules governing futures 
exchanges with broad, flexible core principles. The core principles set 
standards of performance for the exchanges, and at the same time, allow 
exchanges considerable leeway in how to meet those standards. To 
facilitate compliance, the Commission has adopted Acceptable Practices 
for other core principles. Through its Acceptable Practices, the 
Commission provides exchanges with a safe harbor for complying with 
selected requirements of a core principle, but such Acceptable 
Practices, as stated in the Act, are not the exclusive means for 
compliance.\25\ Once implemented, Acceptable Practices provide 
regulatory certainty that exchanges may rely upon when seeking 
designation as contract markets or when subject to periodic Rule 
Enforcement Reviews by the Commission.\26\
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    \24\ Appendix E of Pub. L. No. 106-554, 114 Stat. 2763 (2000).
    \25\ See CEA Section 5c(a)(2), 7 U.S.C. Sec.  7a-2(a)(2).
    \26\ The Commission has explained that ``boards of trade that 
follow the specific practices outlined under [the Acceptable 
Practices] * * * will meet the selected requirements of the 
applicable core principle.'' 17 CFR part 38, App. B, ] 2.
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    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\
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    \27\ In recent amendments to Appendix B of Part 38, the 
Commission has explained that ``the enumerated acceptable practices 
under each core principle are neither the complete nor the exclusive 
requirements for meeting that core principle. With respect to the 
completeness issue, the selected requirements in the acceptable 
practices section of a particular core principle may not address all 
the requirements necessary for compliance with the core principle.'' 
Technical and Clarifying Amendments to Rules for Exempt Markets, 
Derivatives Transaction Execution Facilities and Designated Contract 
Markets, and Procedural Changes for Derivatives Clearing 
Organization Registration Applications, 71 FR 1953, 1958 (Jan. 12, 
2006). The Acceptable Practices that we propose today do not reach, 
and are not intended to reach, individual, personal conflicts of 
interest. A contract market must address these conflicts as well as 
the structural conflicts that are the subject of these proposed 
Acceptable Practices in order to demonstrate full compliance with 
Core Principle 15's requirements.
    \28\ In this regard, the CFTC will take into account the 
governance and regulatory conflicts of interests specific to the 
exchange and how they are being managed.

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[[Page 38744]]

    The elements of the proposed Acceptable Practices under Core 
Principle 15 are summarized below. The Commission proposes as a new 
Acceptable Practice under Core Principle 15 that at least fifty percent 
of the board members of exchanges' boards of directors and executive 
committees (or similarly empowered bodies) be ``public'' directors, as 
defined below (``Board Composition Acceptable Practice''). Day-to-day 
regulatory operations should be supervised by a Chief Regulatory 
Officer (``CRO'') reporting directly to a ROC (``Regulatory Oversight 
Committee Acceptable Practice''). The Acceptable Practices define 
``public director'' for persons serving on boards, ROCs, and 
disciplinary panels. An individual may qualify as a public director 
upon an affirmative determination by the board that the individual has 
no material relationship with the exchange.
    In addition, the Acceptable Practices strengthen impartial 
adjudication by providing that SRO disciplinary panels should not be 
dominated by any group or class of SRO participants, and that each 
panel should include at least one public member (``Disciplinary Panel 
Acceptable Practice''). By increasing the public voice on governing 
boards and disciplinary committees and creating an independent board-
level ROC, combined with Commission oversight, the Acceptable Practices 
seek to maintain the existing high standards of fair and effective 
self-regulation in the futures industry, while proactively adapting 
them to the market and business realities of a new era for the 
industry. Each of these Acceptable Practices is described below.

A. Board Composition; ``Public'' Director Defined

    The Board Composition Acceptable Practice provides that exchanges 
should elect governing boards composed of at least fifty percent public 
directors. In addition, it provides that SROs' executive committees (or 
similarly empowered bodies) should be at least fifty percent public.
    The Acceptable Practice offers guidance on the definition of 
``public'' director. The proposed definition provides that a director 
is ``public'' only if the board of directors affirmatively determines 
that the director has no ``material relationship'' with the exchange. 
The nominating committee of the board of directors should affirmatively 
determine on the record that a director or nominee has no material 
relationship with the exchange, and should state on the record the 
basis for its determination and the scope of its scrutiny. The 
committee should reevaluate that determination at least on an annual 
basis.
    ``Material relationships'' are those that reasonably could affect 
the independent judgment or decision making of the director. Material 
relationships are not exclusively compensatory or financial. Any 
relationship between a director and the exchange that may interfere 
with a director's ability to deliberate objectively and impartially on 
any matter is a material relationship. In this regard, material 
relationships are not limited to those where a director has an 
immediate interest in a particular matter before him or her.
    In addition to the general materiality test, the proposed 
definition of ``public'' director identifies specific circumstances or 
relationships that would preclude a determination that a person 
qualifies as a ``public'' director. Specifically, a director could not 
be ``public'' if any of the following circumstances existed: \29\
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    \29\ These specific circumstances--or ``bright-line'' tests--are 
neither exclusive nor exhaustive. A director does not qualify as 
``public'' unless the board affirmatively determines that the 
director has no material relationship with the exchange, including 
but not limited to, the bright-line tests identified herein.
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--The director is an officer or employee of the exchange or a director, 
officer or employee of its affiliate; \30\
---------------------------------------------------------------------------

    \30\ As used in this context, an affiliate includes parents or 
subsidiaries of the contract market or entities that share a common 
parent with the contract market.
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--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.
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    \31\ Compensation for services as a director will not be counted 
towards the $100,000 threshold test.
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--All of the disqualifying circumstances described above are subject to 
a one-year look back. Thus, for example, a director who, within the 
past year, was a member of the exchange, would not qualify as a 
``public'' director.

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

B. Regulatory Oversight Committee

    The Regulatory Oversight Committee Acceptable Practice recognizes 
the importance of insulating core regulatory functions from improper 
influences and pressures stemming from the exchange's commercial 
affairs. To comply with the Regulatory Oversight Committee Acceptable 
Practice, every exchange should establish, as a standing committee of 
its board of directors, a ROC with oversight responsibility for all 
facets of the SRO's regulatory program. This includes broad authority 
to oversee: (1) Trade practice surveillance; (2) market surveillance; 
(3) audits, examinations, and other regulatory responsibilities with 
respect to member firms; \32\ (4) the conduct of investigations; (5) 
the size and allocation of regulatory budgets and resources; (6) the 
number of regulatory officers and staff; (7) the compensation of 
regulatory officers and staff; (8) the hiring and termination of 
regulatory officers and staff; and (9) the oversight of disciplinary 
committees and panels.
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    \32\ SROs' regulatory responsibilities with respect to member 
firms include ensuring compliance with financial integrity, 
financial reporting, sales practice, recordkeeping, and other 
requirements. Commission Regulation 1.52 permits cooperative 
agreements among exchanges to coordinate compliance examinations of 
FCMs such that each FCM is assigned a primary examiner (its DSRO). 
ROCs should have authority over SROs self-regulatory functions, both 
when the SROs are fulfilling SRO responsibilities and when they are 
fulfilling DSRO responsibilities.
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    The ROC's primary role is to assist the board in fulfilling its 
responsibility of ensuring the sufficiency, effectiveness, and 
independence of self-regulatory functions.\33\ In this capacity, the 
ROC should have the authority, discretion and necessary resources to 
conduct its own inquiries; consult directly with regulatory staff; 
interview employees, officers, members, and others; review relevant 
documents; retain independent legal counsel, auditors, and other 
professional services; and otherwise exercise its independent analysis 
and

[[Page 38745]]

judgment to fulfill its regulatory obligations.\34\
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    \33\ In its review of exchanges for compliance with Core 
Principles, the Commission will look at board documentation of the 
reasons for its actions and its acceptance or rejection of 
recommendations by the ROC, as well as by other committees.
    \34\ Nevertheless, a ROC should not rely on outside 
professionals or firms that also provide services to the full board, 
other board committees, or other units of the exchange.
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    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\
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    \35\ ROCs' deliberations with respect to such proposed rule 
changes should be memorialized in thorough meeting minutes, and 
their formal opinions made available to Commission staff upon 
request.
    \36\ The Commission's review of Core Principle 15 compliance 
will include, inter alia, the ROC's records, annual reports, meeting 
minutes, analyses conducted or commissioned by the ROC, examinations 
of proposed and existing rules, and evaluations and recommendations 
concerning the effectiveness, sufficiency, and independence of the 
exchange's regulatory programs. See Section 8(a)(1) of the Act, 7 
U.S.C. Sec.  12(a)(1), authorizing the Commission to ``make such 
investigations as it deems necessary to ascertain the facts 
regarding the operations of boards of trade and other persons 
subject to the provisions of this Act.''
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    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.
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    \37\ Any decisions made by SROs' boards of directors, although 
not directly regulatory, implicate the public interest and the 
intersection between regulatory responsibilities and commercial 
imperatives. SROs' boards of directors determine transaction fees; 
market data fees; and membership criteria. They control the 
employment and compensation of senior executives, including the 
president of the exchange, and they are sometimes responsible for 
the appointment of public directors. Boards make fundamental 
governance decisions, including those made with respect to the 
strategic direction of the SRO and the oversight of self-regulation. 
In addition, SROs' public interest obligations are cited in the very 
purposes of the Act, which include ``to serve the public interest * 
* * through a system of effective self-regulation of trading 
facilities.'' CEA Section 3(b), 7 U.S.C. 5(b).
    As noted at the Hearing, ``exchanges which also function as for-
profit institutions as well as SROs are truly occupying an 
absolutely unique space in corporate America.'' Jennings, 
Hearing.Tr. at 79.
---------------------------------------------------------------------------

    The Commission's proposed Board Composition Acceptable Practice 
constitutes a strong, proactive approach to ensuring the continued 
success of self-regulation in the futures industry. With respect to 
exchange boards of directors, their dual regulatory and commercial 
roles suggest that a fifty percent ``public'' board is an appropriate 
balance and should best enable directors to carry out their 
responsibilities.\38\
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    \38\ Industry participants and observers noted that independence 
of an exchange's board of directors is key to effective and 
impartial self-regulation due to its role as the ultimate arbiter of 
decisions affecting both commercial and regulatory functions of the 
exchange. To address the conflicts of interest inherent in this dual 
role, most participants agreed on the benefits of including 
``public'' directors on exchange boards. See e.g., Jennings, Hearing 
Tr. at 29 (``[I]t is a fundamental requirement that exchange boards 
must have a significant representation of independent public 
directors. I believe it is appropriate that at least fifty percent 
of the exchange board must comprise this group.''); and Phillips, 
Hearing Tr. at 159 (addressing reviews of exchanges' rulemaking 
authority, ``* * * it comes back to the governance process and the 
independence of the board to really make those kinds of reviews 
meaningful.''). However, industry participants did not agree on what 
specifically constitutes an appropriate board composition, or 
whether existing exchange board compositions are adequate.
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    The Commission notes that its proposed Board Composition

[[Page 38746]]

Acceptable Practice is consistent with the trend of major governance 
initiatives across the corporate and SRO communities in the United 
States. In November 2003, the New York Stock Exchange (``NYSE'') and 
NASDAQ both implemented new governance standards for their listed 
companies. Among the most important provisions is the requirement that 
listed companies' boards have a majority of independent directors. In 
addition, listed companies must have fully independent nominating, 
corporate governance, compensation, and audit committees. While the 
conflicts driving these governance initiatives may differ from those 
arising in the futures self-regulatory context, the NYSE and NASDAQ 
standards for listed companies reflect their recognition that good 
corporate governance is founded on strengthening the independence and 
accountability of the board.
    Two futures exchanges, the CME and the CBOT are now subject to the 
NYSE listing standards outlined above, and others may join them as 
futures exchanges continue to demutualize and seek public listing of 
their shares. The Commission is satisfied that the listing standards 
provide a measure of shareholder protection for the owners of publicly-
traded futures exchanges. However, the Commission is equally satisfied 
that these listing standards are not designed for public companies that 
also bear a special responsibility of public protection and fair and 
effective self-regulation. Although it may be true, as the publicly-
traded futures SROs have determined, that SRO members are independent 
under the NYSE listing standards, the proposed Board Composition 
Acceptable Practice provides that members are not independent for 
purposes of protecting the public interest against conflicts of 
interest in self-regulation.
    Finally, the fifty percent minimum standard strikes a favorable 
balance between inside expertise and ``outside'' impartiality and 
ensures that other exchange stakeholders, such as members and exchange 
management, are adequately represented. In this manner, the ``self'' in 
self-regulation is retained, along with its efficiencies and expertise, 
while the ultimate benefactors of the self-regulatory system--market 
participants and the public--are assured that their interests are well-
represented at the highest level.
(i) Definition of ``Public'' Director
    To facilitate compliance, the Commission has modeled aspects of its 
``public'' director definition, and more specifically, the materiality 
test, on what have now become accepted standards for defining 
independent directors. For example, the NYSE governance standards, 
noted above, mandate that to qualify as independent, directors must 
meet both a series of bright-line tests capturing certain present and 
past employment, compensation, business, familial, and other 
relationships; and a categorical ``no material relationship'' test. 
Similarly, under the Commission's proposed definition, the 
determination of whether a person qualifies as a ``public'' director 
entails (1) proposed ``bright-line'' tests, such as membership, 
employment, and business and financial ties with the exchange, aimed at 
identifying many of the circumstances that necessarily impair 
independent decision making; and (2) a facts and circumstances 
analysis. As to the facts and circumstances analysis, the board, taking 
into account all of the relevant factors relating to the person's 
relationship with the exchange, must make a reasonable finding on the 
record that the person is capable of independent decision-making. This 
analysis is broader than the bright-line tests.
    Similar standards have already been implemented in a variety of 
related contexts: by the Public Company Accounting Reform and Investor 
Protection Act of 2002 (Sarbanes-Oxley Act of 2002) with respect to 
independent directors serving on the audit committees of public 
companies;\39\ and by the NYSE for its own board of directors.\40\ The 
SEC has also proposed similar standards for independent directors on 
the boards of securities exchanges.\41\
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    \39\ Pub. L. No. 107-204, 116 Stat. 745 (2002).
    \40\ Constitution of the New York Stock Exchange, Art. IV, Sec.  
2.
    \41\ Fair Administration, supra note 21.
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    The Acceptable Practice addressing board qualifications is named 
the ``Public Director Acceptable Practice'' rather than the 
``Independent Director Acceptable Practice'' to emphasize the national 
public interest in futures trading and the role that SROs play in 
serving and protecting that interest.\42\ The appropriate definition 
of, and qualifications for, an unconflicted director were debated 
vigorously during the SRO Review.\43\ The debate often centered on 
whether the NYSE listing standards are sufficient for self-regulatory 
purposes. Several commenters and Hearing participants noted that the 
NYSE independent director standard principally operates to protect 
shareholder interests against undue management influence, and that more 
is needed to protect the public interest in an institution that 
exercises regulatory duties.\44\ The Commission generally agrees that 
the listing standards are not sufficient for public companies that also 
bear special responsibility to the public to self-regulate fairly and 
effectively. Simply stated, self-regulation and shareholder protection 
are two distinct missions: they may be complementary, but they are not 
substitutes.
---------------------------------------------------------------------------

    \42\ See CEA Section 3(b), 7 U.S.C. Sec.  5(b).
    \43\ FIA for example, commented that ``[i]ndependent SRO 
directors should be independent not only of management but also of 
all activity on the exchange'' because ``[t]he special nature of an 
SRO's powers and functions * * * makes it essential to have truly 
independent directors with no direct, current ties to the industry 
the SRO regulates.'' FIA CL (Jan. 23, 2006) at 3. NYMEX, on the 
other hand, was of the view that active industry participation did 
not impair impartiality so long as a director had no ties to the 
exchange itself. See NYMEX CL (Jan. 23, 2006) at 7: NYMEX stated 
that its ``Public Directors would qualify as independent directors'' 
under NYSE listing standards and noted that ``it is possible for 
markets subject to [NYSE] listing standards to conclude that 
exchange members qualify as independent directors.'' NYMEX noted the 
``specialized'' nature of futures trading and emphasized the 
importance of board expertise. Id. The CME as well stated that 
independence should be determined on a case by case basis. CME CL 
(Jan. 23, 2006) at 7.
    \44\ See, e.g., Karmel, Hearing Tr. at 33 (``The New York Stock 
Exchange and NASDAQ listing standards, as others have already said, 
do not squarely address the key issue of whether exchange members 
should be considered independent or not when they serve as directors 
of an exchange board or a regulatory subsidiary''; and FIA CL (Jan. 
23. 2006) at 3.
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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\
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    \45\ The Commission's proposed Regulatory Oversight Acceptable 
Practice is similar to measures already implemented or recommended 
by some exchanges in response to acknowledged self-regulatory 
concerns. The CME, for example, has formed an advisory board-level 
committee to ``ensure the independent exercise'' of self-regulatory 
obligations (``Market Regulation Oversight Committee'' or ``MROC''). 
Every member of the committee must be an independent director. The 
MROC reviews and reports to CME's board, on an annual basis, with 
respect to: (1) The independence of CME's regulatory functions from 
its business operations; (2) the independence of CME management and 
regulatory personnel from improper influence by industry directors 
regarding regulatory matters; (3) CME's compliance with its SRO 
responsibilities; (4) appropriate funding and resources to ensure 
effective performance of SRO responsibilities; and (5) appropriate 
compensation for CME employees involved in regulatory activities.

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[[Page 38747]]

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

C. Disciplinary Panels

    Diversity in committee and panel composition has long been 
recognized as an effective tool for minimizing conflicts of interest in 
SRO disciplinary adjudication, a long-standing objective of the 
Commission. Prior to enactment of the CFMA, the Act set specific 
standards for the composition of SRO disciplinary committees, requiring 
that: (1) Exchanges provide for a diversity membership on all major 
disciplinary committees and (2) respondents in exchange disciplinary 
actions not be tried exclusively by their peers.
    The CFMA continues the Act's commitment to fair disciplinary 
procedures. The Acceptable Practices for Core Principle 2, for example, 
require that exchanges discipline members and market participants 
pursuant to ``clear and fair standards.'' \46\ As stated earlier, Core 
Principle 15 requires exchanges to ``minimize conflicts of interest in 
the decision making process.'' This requirement extends to disciplinary 
committees and panels, which must be free of both individual and group 
(e.g., floor versus FCM) conflicts of interest.
---------------------------------------------------------------------------

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

    The Commission believes that fair disciplinary procedures with 
minimal conflicts of interest require unbiased disciplinary panels 
representing a diversity of opinions and experiences. At the very 
least, this presumes panels that are not weighted in favor of any 
single class of exchange participants. Also, including a public person 
provides an outside perspective and helps to ensure that the public's 
interests are represented and protected. The Commission is confident 
that proper composition can minimize potential conflicts of interest 
and promote fairness on disciplinary panels, as required by Regulation 
170.3 and Core Principles 2 and 15.
    The SRO Review has found no indication of widespread inadequacy in 
exchange disciplinary committees, as many FCMs suggested. To the 
contrary, some exchanges maintain very diverse committees, including 
nonmember representatives. For example, CME's seven-person Probable 
Cause and Business Conduct panels each include three non-members.\47\ 
Furthermore, the Commission has found that, at most exchanges, FCMs are 
more likely to appear before clearing house risk committees or 
financial compliance/surveillance committees (where FCMs are typically 
well-represented) than on business conduct committees or similar 
committees (which may include broker, local, commercial, FCM, and 
public panelists).
---------------------------------------------------------------------------

    \47\ CME Rules 402, 406.
---------------------------------------------------------------------------

    In addition, periodic Rule Enforcement Reviews conducted by the 
Commission's Division of Market Oversight, which carefully examine 
disciplinary sanctions, typically find that they are fair and do not 
discriminate among different classes of exchange participants. Rule 
Enforcement Reviews also examine exchange disciplinary procedures, and 
consistently find that these are adequate.
    The Commission is generally satisfied with the composition and 
performance of most SRO disciplinary committees and panels, and 
believes that significant new measures are not required at this time. 
The Commission has found that disciplinary committees typically have 
adequate diversity, sometimes including FCMs and nonmembers, and seek 
to balance expertise with impartiality. Accordingly, the Commission's 
proposed Disciplinary Panel Acceptable Practice acknowledges SROs' 
current practices and the requirements of the Act, and identifies 
minimal panel composition standards as a means of protecting the 
continued integrity of the disciplinary process. It helps to minimize 
conflicts of interest by ensuring a basic degree of diversity, and the 
inclusion of at least one public person on SRO disciplinary panels.
    To take advantage of the safe harbor offered by the proposed 
Disciplinary Panel Acceptable Practice, and comply with Core Principle 
15's requirement to minimize conflicts of interest in decision making, 
the Commission is proposing that SROs' amend their rules and policies 
to ensure that they preclude any group or class of exchange members 
from dominating or otherwise exercising disproportionate influence on 
any disciplinary panel. The Commission is also proposing that SROs 
ensure that their rules and policies provide for public persons on 
disciplinary panels, except in cases limited to decorum and attire.\48\ 
Public panel members should meet the definition of ``public'' for 
directors serving on Regulatory Oversight Committees.
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    \48\ The proposed Disciplinary Panel Acceptable Practice is 
broader than Regulation 1.64, in that it requires a public member to 
participate in some categories of cases that, under Regulation 1.64, 
may be heard by a panel with no public members. The Commission 
believes the expansion of public participation is an appropriate 
response to the growth in the size and complexity of the futures 
markets, and the new profit element in exchange operations. 
Moreover, a public member's presence on disciplinary panels will 
enhance the appearance as well as the reality of fairness and 
impartiality in exchange disciplinary proceedings, and thus promote 
confidence in our markets among the public and market participants.
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V. Related Matters

A. Cost-Benefit Analysis

    Section 15(a) of the Act, as amended by Section 119 of the CFMA, 
requires the Commission to consider the costs and benefits of its 
action before issuing a new regulation or order under the Act. By its 
terms, Section 15(a) does not require the Commission to quantify the 
costs and benefits of its action or to determine whether the benefits 
of the action outweigh its costs. Rather, Section 15(a) simply requires 
the Commission to ``consider the costs and benefits'' of the subject 
rule or order.
    Section 15(a) further specifies that the costs and benefits of the 
proposed rule or order shall be evaluated in light of five broad areas 
of market and public

[[Page 38748]]

concern: (1) Protection of market participants and the public; (2) 
efficiency, competitiveness, and financial integrity of futures 
markets; (3) price discovery; (4) sound risk management practices; and 
(5) other public interest considerations. The Commission may, in its 
discretion, give greater weight to any one of the five enumerated areas 
of concern and may, in its discretion, determine that, notwithstanding 
its costs, a particular rule or order is necessary or appropriate to 
protect the public interest or to effectuate any of the provisions or 
to accomplish any of the purposes of the Act.
    The Acceptable Practices proposed herein are safe harbors for 
compliance with Core Principle 15's conflict of interest provisions. 
They offer exchanges the opportunity to meet the requirements of the 
Core Principle through a regulatory governance structure that insulates 
their regulatory functions from their commercial interests. The 
Acceptable Practices propose that exchanges implement boards of 
directors that are at least fifty percent public. The Acceptable 
Practices further propose that all exchange-SROs place oversight of 
their core regulatory functions in the hands of board-level ROCs 
composed exclusively of ``public'' directors. They also offer guidance 
on what constitutes a ``public'' director. In addition, the Acceptable 
Practices suggest minimum composition standards for exchange 
disciplinary committees.
    The proposed Acceptable Practices are consistent with legislative, 
regulatory, and voluntarily undertaken changes in governance 
requirements and practices in other financial sectors, such as the 
securities markets, and are intended to enhance protection of the 
public. The Commission has endeavored, in offering these Acceptable 
Practices to propose the least intrusive safe harbors and regulatory 
requirements that can reasonably be expected to meet the requirements 
of Core Principle 15 of the Act. These Acceptable Practices advance the 
Commission's mandate of assuring the continued existence of competitive 
and efficient markets and to protect the public interest in markets 
free of fraud and abuse.
    They nevertheless may be expected to entail some costs, including, 
among the most foreseeable, those attendant to recruiting and 
appointing additional directors, amending corporate documents, making 
necessary rule changes and certifying them to the Commission, and 
appointing a CRO.
    After considering these factors, the Commission has determined to 
propose the Acceptable Practices with respect to contract markets. The 
Commission specifically invites public comment on its application of 
the criteria contained in the Act. Commenters are also invited to 
submit any quantifiable data that they may have concerning the costs 
and benefits of the proposed Acceptable Practices with their comment 
letter.

B. Regulatory Flexibility Act

    The Regulatory Flexibility Act, 5 U.S.C. 601 et seq., requires 
federal agencies, in promulgating rules, to consider the impact of 
those rules on small entities. The proposed Acceptable Practices affect 
contract markets. The Commission has previously determined that 
contract markets are not small entities for purposes of the Regulatory 
Flexibility Act.\49\ Accordingly, the Chairman, on behalf of the 
Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that the 
proposed Acceptable Practices will not have a significant economic 
impact on a substantial number of small entities.
---------------------------------------------------------------------------

    \49\ Policy Statement and Establishment of Definitions of 
``Small Entities'' for Purposes of the Regulatory Flexibility Act, 
47 FR 18618, 18619 (Apr. 30, 1982).
---------------------------------------------------------------------------

C. Paperwork Reduction Act of 1995

    The Acceptable Practices contain information collection 
requirements. As required by the Paperwork Reduction Act of 1995 (44 
U.S.C. 3504(h)), the Commission has submitted a copy of this section to 
the Office of Management and Budget (``OMB'') for its review.
    Collection of Information: Rules Relating to Part 38, Establishing 
Procedures for Entities to become designated as Contract Markets, OMB 
Control Number 3038-0052. The Acceptable Practices increase the burden 
previously approved by OMB.
    The estimated burden was calculated as follows:
    Estimated number of respondents: 12.
    Annual responses by each respondent: 1.
    Total annual responses: 12.
    Estimated average hours per response: 70.
    Annual reporting burden: 840.
    Organizations and individuals desiring to submit comments on the 
information collection requirements should direct them to the Office of 
Information and Regulatory Affairs, Office of Management and Budget, 
Room 10202, New Executive Office Building, 725 17th Street, NW., 
Washington, DC 20503; Attention: Desk Officer for the Commodity Futures 
Trading Commission.
    The Commission considers comments by the public on this proposed 
collection of information in:

Evaluating whether the proposed collection of information is 
necessary for the proper performance of the functions of the 
Commission, including whether the information will have a practical 
use;
Evaluating the accuracy of the Commission's estimate of the burden 
of the proposed collection of information, including the validity of 
the methodology and assumptions used;
Enhancing the quality, usefulness, and clarity of the information to 
be collected; and
Minimizing the burden of collecting information on those who are to 
respond, including through the use of appropriate automated 
electronic, mechanical, or other technological collection techniques 
or other forms of information technology (e.g., permitting 
electronic submission of responses).

    OMB is required to make a decision concerning the collection of 
information contained in these Acceptable Practices between 30 and 60 
days after publication of this document in the Federal Register. 
Therefore, a comment to OMB is best assured of having its full effect 
if OMB receives it within 30 days of publication. This does not affect 
the deadline for the public to comment to the Commission on the 
Acceptable Practices.
    Copies of the information collection submission to OMB are 
available from the Commission Clearance Officer, Three Lafayette 
Centre, 1155 21st Street, NW., Washington DC 20581, (202) 418-5160.

VI. Text of Proposed Acceptable Practices

List of Subjects in 17 CFR Part 38

    Commodity futures, Reporting and recordkeeping requirements.

    In light of the foregoing, and pursuant to the authority in the 
Act, and in particular, Sections 3, 5, 5c(a) and 8a(5) of the Act, the 
Commission proposes to amend Part 38 of Title 17 of the Code of Federal 
Regulations as follows:

PART 38--DESIGNATED CONTRACT MARKETS

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

    Authority: 7 U.S.C. 2, 5, 6, 6c, 7, 7a-2 and 12a, as amended by 
Appendix E of Pub. L. 106-554, 114 Stat. 2763A-365.

    2. In Appendix B to Part 38 amend Core Principle 15 by adding 
paragraph (b) ``Acceptable Practices'' as follows:

Appendix B to Part 38--Guidance on, and Acceptable Practices in, 
Compliance With Core Principles

* * * * *

[[Page 38749]]

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

* * * * *
    (b) Acceptable Practices. All designated contract markets 
(``DCMs'' or ``contract markets'') bear special responsibility to 
regulate effectively, impartially, and with due consideration of the 
public interest, as provided for in Section 3 of the Act. Under Core 
Principle 15, they are also required to minimize conflicts of 
interest in their decision making processes. To comply with this 
Core Principle, contract markets should be particularly vigilant for 
conflicts between their self-regulatory responsibilities, their 
commercial interests, and the interests of their management, 
members, owners, customers and market participants, other industry 
participants, and other constituencies.
    Acceptable Practices for minimizing conflicts of interest shall 
include the following elements:
    (1) Board Composition for Contract Markets
    (A) At least fifty percent of the directors on a contract 
market's board of directors shall be public directors; and
    (B) The executive committees (or similarly empowered bodies) 
shall be at least fifty percent public.
    (2) Public Director
    (A) To qualify as a public director of a contract market, an 
individual must first be found, by the board of directors on the 
record, to have no material relationship with the contract market. A 
``material relationship'' is one that reasonably could affect the 
independent judgment or decision making of the director.
    (B) In addition, a director shall not be considered ``public'' 
if any of the following circumstances exist:
    (i) The director is an officer or employee of the contract 
market or a director, officer or employee of its affiliate;
    (ii) The director is a member of the contract market, or a 
person employed by or affiliated with a member. ``Member'' is 
defined according to Section 1a(24) of the Commodity Exchange Act 
and Commission Regulation 1.3(q). In this context, a director is 
affiliated with a member if the director is an officer or director 
of the member;
    (iii) The director receives more than $100,000 in payments from 
the contract market, any affiliate of the contract market or from a 
member or anyone affiliated with a member, provided that 
compensation for services as a director will not be counted towards 
the $100,000 threshold test;
    (iv) A director shall be precluded from serving as a public 
director if any of the relationships above apply to a member of the 
director's ``immediate family,'' i.e., spouse, parents, children, 
and siblings; and
    (v) An affiliate includes parents or subsidiaries of the 
contract market or entities that share a common parent with the 
contract market.
    (C) All of the disqualifying circumstances described in 
Subsection (2)(B) shall be subject to a one-year look back.
    (D) A contract market shall disclose to the Commission which 
members of its board are public directors, and the basis for those 
determinations.
    (3) Regulatory Oversight Committee
    (A) A board of directors of any contract market shall establish 
a Regulatory Oversight Committee (``ROC'') as a standing committee, 
consisting of only public directors as defined in Section (2), to 
assist it in minimizing potential conflicts of interest. The ROC 
shall oversee the contract market's regulatory program on behalf of 
the board. The board shall delegate sufficient authority, dedicate 
sufficient resources, and allow sufficient time for the ROC to 
fulfill its mandate.
    (B) The ROC shall:
    (i) Monitor the contract market's regulatory program for 
sufficiency, effectiveness, and independence;
    (ii) Oversee all facets of the program, including trade practice 
and market surveillance; audits, examinations, and other regulatory 
responsibilities with respect to member firms (including ensuring 
compliance with financial integrity, financial reporting, sales 
practice, recordkeeping, and other requirements); and the conduct of 
investigations;
    (iii) Review the size and allocation of the regulatory budget 
and resources; and the number, hiring and termination, and 
compensation of regulatory personnel;
    (iv) Supervise the contract market's chief regulatory officer, 
who will report directly to the ROC;
    (v) Prepare periodic reports for the board of directors and an 
annual report assessing the contract market's self-regulatory 
program for the board of directors and the Commission, which sets 
forth the regulatory program's expenses, describes its staffing and 
structure, catalogues disciplinary actions taken during the year, 
and reviews the performance of disciplinary committees and panels;
    (vi) Recommend changes that would ensure fair, vigorous, and 
effective regulation; and
    (vii) Review regulatory proposals and advise the board as to 
whether and how such changes may impact regulation.
    (4) Disciplinary Panels
    All contract markets shall minimize conflicts of interest in 
their disciplinary processes through disciplinary panel composition 
rules that preclude any group or class of industry participants from 
dominating or exercising disproportionate influence on such panels. 
Contract markets can further minimize conflicts of interest by 
including at least one person who would qualify as a public director 
as defined in Section (2) above, on disciplinary panels, except in 
cases limited to decorum and attire. If contract market rules 
provide for appeal to the board of directors, or to a committee of 
the board, then that appellate body shall also include at least one 
person who would qualify as a public director as defined in Section 
(2) above.
* * * * *

    Issued in Washington, DC, on June 28, 2006 by the Commission.
Eileen A. Donovan,
Acting Secretary of the Commission.

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

APPENDIX--STATEMENTS OF COMMISSIONERS HATFIELD AND DUNN

Commissioner Frederick W. Hatfield, writing separately.

    Since the passage of the Commodity Futures Modernization Act of 
2000 (CFMA), the U.S. futures industry has experienced dynamic 
growth. With rapid growth comes new challenges. U.S. futures 
exchanges are today faced with increased competition, domestically 
and from abroad, changing ownership structures, and new business 
models. As regulators, it is incumbent upon us to ensure that 
regulatory guidelines continue to keep pace with the ever changing 
environment of the industry. Accordingly, I applaud Chairman Jeffery 
and Commission staff for their thoughtful and exhaustive pursuit of 
fair, vigorous and effective self-regulation in this evolving market 
landscape.
    In this review, I have been guided by two questions: have the 
exchanges produced self-regulatory structures that are up to the 
challenges of the changing marketplace and if not, are we as 
regulators suggesting a better model? I look forward to receiving 
comments on the Board Composition Acceptable Practice proposal. 
However, in my view, establishing a board level Regulatory Oversight 
Committee (ROC) comprised of nonmember public directors and a 
disciplinary panel structure, as described in the proposal, goes a 
long way toward ensuring that an exchange's regulatory duties will 
not be compromised by conflicts emanating from commercial goals.
    The primary function of the proposed ROCs is to ensure that 
regulatory programs and staff are free of improper influence from 
exchange owners, management, members, investors, customers, and 
commercial considerations. As the proposal recognizes, ``[t]he ROC 
structure, combined with careful Commission review of the 
interaction between the ROC and the board, fosters the continued 
integrity of futures self-regulation, effective management of 
conflicts of interest within SRO governance, and full consideration 
of the public interest in every decision of regulatory 
consequence.'' Section B. Regulatory Oversight Committee, last 
paragraph. Despite this recognition, the proposed safe harbor would 
require, in addition to public director ROCs, that at least fifty 
percent of the governing boards and exchange executive committees 
also be comprised of public directors.
    Interest in SRO board composition has an established history in 
the Commodity Exchange Act (Act) and in the Commission's 
regulations. Prior to passage of the CFMA, Section 5a(14) of the Act 
mandated diversity of representation on exchanges' boards of 
directors.\1\ With passage of the CFMA, the

[[Page 38750]]

requirements of Section 5a(14) were removed for exchanges, as 
Congress and the Commission moved to a more flexible, principles-
based oversight regime that does not include specific composition 
targets for exchanges' boards of directors.\2\ Mutually owned 
exchanges are still subject to mandatory board composition standards 
under Section 5(c)(16) of the Act (Core Principle 16), which 
requires ``that the composition of the governing board reflect 
market participants.'' The Application Guidance for Core Principle 
16 identifies this as a ``diversity of interests'' requirement.
---------------------------------------------------------------------------

    \1\ This provision of the Act was implemented by Commission 
Regulation 1.64, which required exchanges to establish meaningful 
representation for the following groups: (1) Futures commission 
merchants (FCMs); (2) floor brokers and traders; (3) independent 
non-members; (4) producers, consumers, processors, distributors, and 
merchandisers of commodities traded on the particular exchange 
(``commercials''); (5) participants in a variety of pits or 
principal groups of commodities traded on the exchange; and (6) 
other market users or participants. Specific composition targets 
existed only for commercials (ten percent) and nonmembers (twenty 
percent).
    \2\ Under Commission Regulation 38.2, exchanges are now exempt 
from Regulation 1.64.
---------------------------------------------------------------------------

    As part of the SRO Review, Commission staff examined the 
corporate documents of the major exchanges under CFTC authority and 
found that all require diversity of their boards of directors, 
including nonmember directors.\3\ These diversity requirements are 
similar regardless of the exchanges' ownership structures, and they 
are present at all of the major exchanges. The Kansas City Board of 
Trade, for example, requires that nominating committees give 
``special consideration to the desirability of having all interests 
of the Corporation represented on the Board of Directors.'' \4\ The 
Chicago Mercantile Exchange (CME) requires that its board of 
directors have ``meaningful representation of a diversity of 
interests, including floor brokers, floor traders, futures 
commission merchants, [and commercials.].'' \5\
---------------------------------------------------------------------------

    \3\ The corporate documents included the certificates of 
incorporation, bylaws, and rulebooks of the exchanges and their 
holding companies, if applicable.
    \4\ Kansas City Board of Trade Rulebook, Ch. II, Sec.  210.01.
    \5\ Second Amended and Restated Bylaws of Chicago Mercantile 
Exchange Holdings, Inc., Art. III, Sec.  3.5 (applicable to the 
board of trade through the Certificate of Incorporation of Chicago 
Mercantile Exchange, Inc., Art. V, Sec.  3 (requiring that the board 
of directors of CME, Inc., be identical to that of CME Holdings, 
Inc.).
---------------------------------------------------------------------------

    Some exchanges employ specific numerical targets for their 
various participant categories and public directors. For example, 
the New York Mercantile Exchange requires three public directors, 
one FCM, one floor broker, one commercial, and one local trader.\6\ 
The New York Board of Trade requires five public directors.\7\ The 
Minneapolis Grain Exchange requires four nonmember directors, and at 
least four commercials, two FCMs, two floor traders, and one floor 
broker.\8\ The CME requires that independent, nonmember directors 
constitute twenty percent of its board and that commercials 
constitute ten percent of the board.\9\ Moreover, the CME currently 
exceeds its own requirements, with seven of its twenty directors 
(thirty-five percent) being independent, nonindustry persons.
---------------------------------------------------------------------------

    \6\ Amended and Restated Certificate of Incorporation of NYMEX 
Holdings, Inc., Art. VI, Sec.  (c) (applicable to the board of trade 
through the Amended and Restated Certificate of Incorporation of New 
York Mercantile Exchange, Inc., Art. VII (the board of directors 
NYMEX Holdings, Inc., constitutes the board of NYMEX, Inc.).
    \7\ New York Board of Trade Bylaws, Art. II, Sec.  302(c).
    \8\ Minneapolis Grain Exchange Rulebook, Ch. II, Sec. Sec.  
200.00 and 210.00.
    \9\ Note 5, supra.
---------------------------------------------------------------------------

    Most of those who commented or testified during the course of 
the SRO study generally agreed that diverse boards best serve the 
needs of exchanges and the public. Participants also agreed on the 
benefits of including public directors on exchange boards, and our 
review demonstrates that this is a model that most exchanges are 
following. In their comments and testimony, however, exchanges 
unanimously opposed having mandatory board composition requirements. 
CME argued, for example, that ``no one composition criteria can 
address the individual needs'' of the diverse exchanges and business 
models active in the industry.\10\
---------------------------------------------------------------------------

    \10\ CME Comment Letter at 2.
---------------------------------------------------------------------------

    In my view, having a ROC that serves to insulate the regulatory 
functions of an exchange from its commercial interests, combined 
with a disciplinary panel structure that strengthens impartial 
adjudication and reduces potential conflicts of interest by 
including at least one public person on every panel and ensuring 
that such panels are not dominated by any group or class of exchange 
participants, may well be sufficient to ensure fair, vigorous, and 
effective self-regulation and should demonstrate compliance with 
Core Principle 15. Such an approach would be narrowly tailored to 
focus specifically on regulatory governance and functions, and would 
be in keeping with the flexibility the CFMA intended to afford 
exchanges to conduct business without undue interference from 
regulators.
    I am concerned that the Board Composition proposal also would 
create an additional and perhaps unnecessary layer of regulation for 
publicly traded exchanges, which are already subject to myriad new 
and enhanced corporate governance requirements, including, among 
others, Securities and Exchange Commission registration 
requirements, the audit committee provisions of the Sarbanes-Oxley 
Act of 2002, and the listing standards of the New York Stock 
Exchange (NYSE). I agree that the dual function of exchanges as 
commercial enterprises and self-regulatory organizations sets them 
apart from corporations engaged in business for the sole purpose of 
earning profits for the benefit of shareholders. In my opinion, 
however, the foregoing corporate governance standards, combined with 
properly structured ROCs and disciplinary committees, and the 
Commission's continuing obligation to monitor exchanges through rule 
enforcement reviews and otherwise, have provided multiple levels of 
safeguards that should be sufficient to ensure that exchanges'' 
self-regulatory obligations are not compromised.
    I recognize that what the Commission is contemplating is an 
acceptable practice rather than a mandatory requirement. In 
promulgating such guidance, however, the Commission should strive to 
establish standards that that are not overly broad and that are 
viewed as necessary, in most circumstances, to accomplish regulatory 
goals. Accordingly, I welcome comment on the advisability of 
adopting the proposed Board Composition Acceptable Practice, 
especially with respect to the following questions:
     Is there an existing problem that this proposal 
addresses?
     Will those exchanges that are not now subject to 
mandatory diversity requirements feel compelled to sacrifice 
voluntary diversity in order to increase the percentage of public 
directors and still maintain boards that are of manageable size, or 
will boards become larger? Is it feasible to comply with the 
acceptable practice and maintain the proper level of diversity? What 
are the relative costs and benefits of doing so?
     How would the acceptable practice affect mutually owned 
exchanges that are subject to the mandatory diversity requirements 
of Core Principle 16?
     How would the proposed requirement that exchange 
executive committees have at least fifty percent public 
representation affect the day-to-day operations of the exchanges?
     Is there any evidence that the proposed Board 
Composition Acceptable Practice will provide greater regulatory 
assurance than the proposed ROC and Disciplinary Panel Acceptable 
Practices?
     Do the corporate governance requirements currently 
applicable to publicly traded exchanges, combined with properly 
structured ROCs and disciplinary panels and continuing Commission 
oversight, provide sufficient assurance that conflicts of interests 
will be kept to a minimum in the decision making process of those 
exchanges?
     If the Commission adopts the Board Composition 
Acceptable Practice, should it be accompanied by a phase-in period 
and if so, what would be the appropriate length of time for 
exchanges to modify their boards?
    I join with my Chairman and fellow Commissioners in requesting 
comment on this endeavor and look forward to reviewing the responses 
to these questions and any other views the Commission receives as we 
continue to consider the important issues raised in the proposal.

Commissioner Michael V. Dunn, writing separately.

    The proposed acceptable practices published today represent an 
important step forward in ensuring the fairness and transparency of 
our commodity markets. I wish to comment on two aspects of the 
proposal.
    First, the proposed rule notes that exchanges that elect to 
forgo the safe harbor of the best practices outlined in this 
proposal can still demonstrate compliance with Core Principle 15 
through showing they have procedures and safeguards in place to 
address potential conflicts of interest. For these exchanges, the 
Commission will continue its current practice of reviewing the 
activities of these exchanges to ensure they are in compliance with 
Core Principle 15. Therefore, while the proposed acceptable 
practices offer a safe harbor for complying with Core Principle 15, 
they are not the only method of demonstrating compliance.
    Second, efficient, transparent, and open markets bring great 
benefits to their

[[Page 38751]]

participants and the public. The Commodity Futures Modernization Act 
of 2000 (CFMA), sought to safeguard these values by placing a much 
greater emphasis on industry self-regulation: setting out core 
principles registrants have to meet and giving industry flexibility 
in choosing how to comply.
    While the Commission has final responsibility to ensure the 
fairness and transparency of the markets it regulates, its 
effectiveness in doing so relies heavily upon the presence of a 
robust self-regulatory system. Registered Futures Associations 
(RFAs) are provided for in the CEA to complement the Commission's 
oversight of commodities markets and to bring industry knowledge and 
experience to bear on regulatory issues affecting those markets.\1\ 
In its June 2004 request for comments on SRO governance that led to 
this proposal, the Commission asked, ``Should registered futures 
associations that are functioning as SROs also be subject to 
governance standards?'' In its response, the National Futures 
Association (``NFA''), the sole RFA, wrote that ``registered futures 
associations should be subject to the same governance standards as 
the other SROs,'' as long as these standards are flexible.
---------------------------------------------------------------------------

    \1\ See generally Section 17 of the Act, 7 U.S.C. 21. An RFA 
must be determined by the Commission to be in the public interest. 
Id. at Section 17(b)(1), 7 U.S.C. 21(b)(1).
---------------------------------------------------------------------------

    As the sole RFA, NFA occupies a unique position in the futures 
markets' system of self-regulation. NFA is entrusted with overseeing 
a wide variety of futures market intermediaries, cutting across 
different segments of the futures industry, including futures 
commission merchants, commodity pool operators (``CPOs''), commodity 
trading advisers (``CTA''), and introducing broker-dealers 
(``IBs''). NFA's functions are as varied as the members it oversees. 
NFA performs registration and fitness screening functions, conducts 
audits and surveillance of its members to enforce compliance with 
financial requirements, establishes and enforces rules and standards 
for customer protection, and conducts arbitration of futures-related 
disputes. NFA also has taken certain functions delegated to it by 
the Commission and more recently, has assumed trade practice and 
market surveillance activities for a number of exchanges.\2\
---------------------------------------------------------------------------

    \2\ When an RFA extends its sphere of operation beyond 
traditional, self-regulatory roles to include such ancillary 
activities, it appropriately should reexamine the methods it uses to 
manage and minimize conflicts of interests, to determine whether 
these methods remain adequate to meet changed circumstances.
---------------------------------------------------------------------------

    In light of the concerns raised in this proposal regarding 
conflicts of interest and self-regulation, I believe the Commission 
needs to review the conflicts of RFAs as well as exchanges. In this 
proposal, the Commission indicates in footnote 4 that we will be 
considering this matter further, and I look forward to that 
consideration.

[FR Doc. 06-6030 Filed 7-6-06; 8:45 am]
BILLING CODE 6351-01-P