# Fair Administration and Governance of Self-Regulatory Organizations; Disclosure and Regulatory Reporting by Self-Regulatory Organizations; Recordkeeping Requirements for Self-Regulatory Organizations; Ownership and Voting Limitations for Members of Self-Regulatory Organizations; Ownership Reporting Requirements for Members of Self-Regulatory Organizations; Listing and Trading of Affiliated Securities by a Self-Regulatory Organization > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A04-26153 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** December 8, 2004 - **Citation:** 69 FR 71126 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240, 242, and 249 [Release No. 34-50699; File No. S7-39-04] RIN 3235-AJ33 Fair Administration and Governance of Self-Regulatory Organizations; Disclosure and Regulatory Reporting by Self-Regulatory Organizations; Recordkeeping Requirements for Self-Regulatory Organizations; Ownership and Voting Limitations for Members of Self-Regulatory Organizations; Ownership Reporting Requirements for Members of Self-Regulatory Organizations; Listing and Trading of Affiliated Securities by a Self-Regulatory Organization AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission (“Commission”) is proposing to adopt new rules and amend existing rules and forms under the Securities Exchange Act of 1934 (“Exchange Act”). The proposals pertain to the governance, administration, transparency and ownership of self-regulatory organizations (“SROs”) that are national securities exchanges or registered securities associations and the periodic reporting of information by these SROs regarding their regulatory programs. The proposals also relate to the listing and trading by SROs of their own or affiliated securities. First, the proposals would impose new governance standards on national securities exchanges and registered securities associations by requiring a majority of the members of the exchange's or association's board of directors to be independent. In addition, key committees of the board would be required to be composed solely of independent directors. The proposals would define the term “independent director.” The proposals also would require exchanges and associations to establish policies and procedures to maintain a separation between their regulatory functions and their market operations and other commercial interests, and require that funds received from regulatory fines, fees, and penalties be used for regulatory purposes. Further, the proposals would require national securities exchanges and registered securities associations to prohibit any member that is a broker or dealer from owning and voting more than 20% of the ownership interest in the exchange or the association, or a facility of the exchange or association. To supplement these ownership and voting provisions, the proposals also would require each member of an exchange or association that is a broker or dealer to file a report with the Commission when the member acquires ownership of more than 5% of any interest in the exchange or association, or any facility thereof. Also, the Commission proposes to require national securities exchanges and national securities associations to maintain their books and records in the United States. Together, these proposals are designed to strengthen the governance and administration of SROs and address the possible concentration of ownership by member firms. In addition, the Commission proposes to amend its forms for registration as a national securities exchange or registered securities association to require that these SROs file with the Commission and publicly disclose enhanced information relating to their governance, regulatory programs, finances, ownership structure, and other matters. Further, the Commission's rules governing the procedures for filing amendments to these registration forms would be revised to require more frequent updating of the required information and the posting of the required information on the SROs' Internet Web sites. These proposals are designed to provide greater transparency to key aspects of the governance, ownership structure, and regulatory operations of national securities exchanges and registered securities associations. The Commission also proposes to require national securities exchanges and registered securities associations to file with the Commission, in an electronic format, quarterly and annual reports on particular aspects of their regulatory programs. This proposal is intended to enhance the Commission's oversight and surveillance of exchanges and associations by requiring them to provide the Commission with detailed regulatory information on a regular basis, thereby assisting the Commission to oversee more effectively the SROs' regulatory programs and better identify any trends or issues that may arise. Finally, the Commission proposes to impose requirements on a national securities exchange or registered securities association that chooses to list or trade its own security, the security of any trading facility, or the security of an affiliate of itself or a facility. The proposed requirements are designed to assure that these SROs are able to enforce effectively their listing standards with respect to, and supervise trading in, their own or a facility's securities, or the securities of affiliates of the SRO or a facility. DATES: Comments should be submitted on or before January 24, 2005. ADDRESSES: Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed.shtml ); or • Send an e-mail to rule-comments@sec.gov. Please include File Number S7-39-04 on the subject line; or • Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments. Paper Comments • Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. All submissions should refer to File Number S7-39-04. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: SRO Governance and Disclosure: Nancy J. Sanow, Assistant Director, at (202) 942-0796, Susie Cho, Special Counsel, at (202) 942-0748, Leah Mesfin, Special Counsel, at (202) 942-0196, Geraldine Idrizi, Attorney, at (202) 942-7317, and A. Michael Pierson, Attorney, at (202) 942-0192; Reporting Requirements for SROs: Nancy J. Sanow, Assistant Director, at (202) 942-0796, and Richard Holley III, Attorney, at (202) 942-8086; and SRO Ownership and Voting Restrictions, SRO Self-Listing, and Reporting Requirements for Members: Heather Seidel, Attorney Fellow, at (202) 942-0788, Sonia Trocchio, Special Counsel, at (202) 942-0753, David Hsu, Special Counsel, at (202) 942-0731, and Jennifer Dodd, Attorney, at (202) 824-5471; all of whom are in the Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street NW, Washington DC 20549-1001. SUPPLEMENTARY INFORMATION: We are proposing to add new Rules 3b-19, 6a-5, 17a-26, 17a-27, and Regulation AL under the Exchange Act; amend Rules 6a-2, 15Aa-1, and 17a-1 under the Exchange Act; redesignate Rule 15Aj-1 under the Exchange Act as Rule 15Aa-2 and amend redesignated Rule 15Aa-2; amend Form 1 under the Exchange Act; redesignate Form X-15AA-1 under the Exchange Act as Form 2 and amend redesignated Form 2; and remove Forms X-15AJ-1 and X-15AJ-2 under the Exchange Act. Table of Contents I. Background A. Self-Regulation under the Exchange Act B. Overview of Recent Developments 1. Governance Concerns 2. Concerns Relating to Weaknesses of SRO Regulatory Programs 3. Competitive Concerns 4. Concerns Relating to New Ownership Structures II. Fair Administration and Governance of National Securities Exchanges and Registered Securities Associations A. Background and Need for Proposed Rules 6a-5 and 15Aa-3 B. Description of Proposed Rules 6a-5 and 15Aa-3 1. Scope of Proposed Rules 6a-5 and 15Aa-3 2. Board Consisting of a Majority of Independent Directors a. Determination of Independence b. Independent Board Requirements c. Fair Representation 3. Standing Committees 4. Other Committees of the Board 5. Other Requirements Applicable to Directors and Officers 6. Executive Sessions of the Board 7. Separation of Chairman of the Board and CEO Positions 8. Separation of Regulatory and Market Operations a. Independence of Regulatory Program b. Use of Regulatory Fees, Fines, and Penalties c. Confidentiality of Regulatory and Trading Information 9. Member Voting and Ownership Limitations a. Members' Interests Aggregated with Their Related Persons b. Solicitation of Revocable Proxies c. Requirement to Divest Ownership Interest and Restrict Voting d. Ability to Obtain Information 10. Code of Conduct and Ethics and Governance Guidelines 11. Exemption Provision 12. Implementation C. Request for Comment III. Proposed Regulation AL—National Securities Exchanges and Registered Securities Associations Listing Affiliated Securities A. Background and Need for Proposed Regulation AL B. Description of Proposed Regulation AL 1. Definition of Affiliated Security 2. Initial Listing 3. Continued Listing and Trading 4. Parity in Application of Listing and Trading Rules 5. Exemption Provision C. Request for Comment IV. Disclosure by Eros A. Overview of Proposed Amendments to Registration Forms for Exchanges and Associations B. Description of Registration Processes 1. Registration as a National Securities Exchange or Exemption from Such Registration Based on Limited Volume 2. Registration as a Registered Securities Association or Affiliated Securities Association C. Proposed Revisions to Form 1 and New Form 2 1. Scope of Disclosures Required by Revised Form 1 and New Form 2 2. Composition, Structure, and Responsibilities of the Board 3. Composition, Structure, and Responsibilities of Committees and Executive Boards 4. Governance a. Governance Guidelines b. Code of Conduct and Ethics 5. Organizational Charts 6. Regulatory Program 7. Audited Financial Statements and Other Financial Information a. Budget and Revenues Devoted to Regulatory Activities b. Revenues and Expenses c. Other Financial Disclosures 8. Relationship between SROs, Facilities, and Their Affiliates 9. Ownership 10. Listing and Trading of Affiliated Securities 11. Location of Books and Records 12. Miscellaneous Matters Specific to New Form 2 13. Current Disclosures to be Retained in Revised Form 1 and Added to New Form 2 a. Constitution, Articles of Incorporation, Bylaws, and Rules b. Rulings and Interpretations c. Officers d. Financial Statements of Affiliates e. General Information Relating to Affiliates and SRO Trading Facilities f. Operation of SRO Trading Facilities g. Membership Forms h. Financial Responsibility and Minimum Capital Requirements of Members i. Listing Applications j. Criteria for Membership k. List of Members l. Securities Listed and Traded D. Timing and Format of Revised Form 1 and New Form 2 E. Proposed Changes to Rule 15Aa-1 F. Proposed Repeal of Forms X-15AJ-1 and X-15AJ-2 G. Request for Comment V. Periodic Reporting Obligations of Exchanges and Associations A. Background and Need for Proposed Rule 17a-26 B. Scope and Timing of Reports Required by Proposed Rule 17a-26 1. Quarterly Reports 2. Annual Reports C. Format of Reports D. Quarterly Reporting of Regulatory Information 1. Information on the SRO's Surveillance Program 2. Information on Complaints Received 3. Investigations, Examinations, and Enforcement Actions 4. Information on Listings Programs 5. Copies of Board and Committee Meeting Agenda E. Annual Reporting of Regulatory Information 1. Cumulative Summary of Quarterly Information 2. Processes for Carrying Out Regulatory Responsibilities 3. Evaluation of the Regulatory Program 4. Internal Controls 5. Employment Arrangements with Regulatory Personnel 6. Copies of Standing Committee Evaluations 7. Compliance with Regulatory Plans F. Audit Report of Electronic SRO Trading Facilities G. Certifications H. Interim Changes I. Confidentiality of Reports J. Compliance Date K. Exemptions and Extensions of Time for Filing Reports L. Filing of Reports M. Request for Comment VI. Proposed Rule 17a-27 A. Background and Need for Proposed Rule 17a-27 B. Description of Proposed Rule 17a-27 1. Brokers and Dealers Subject to the Rule 2. Information Required to be Filed 3. Timing of Filing 4. Filings with the Exchange or Association 5. Exemptions C. Request for Comment VII. Implementation VIII. General Request for Comment IX. Paperwork Reduction Act Analysis A. Proposed Rule 3b-19 B. Proposed Amendments to Rule 6a-2, Revised Form 1, Rule 15Aa-2, and New Form 2 1. Summary of Collections of Information 2. Proposed Use of Information 3. Respondents 4. Reporting and Recordkeeping Burden 5. Collections of Information are Mandatory 6. Record Retention Period C. Proposed Rules 6a-5 and 15Aa-3 1. Summary of Collection of Information 2. Proposed Use of Information 3. Respondents 4. Reporting and Recordkeeping Burden 5. Collection of Information is Mandatory 6. Record Retention Period D. Proposed Regulation AL 1. Summary of Collection of Information 2. Proposed Use of Information 3. Respondents 4. Reporting and Recordkeeping Burden 5. Collection of Information is Mandatory 6. Record Retention Period E. Proposed Amendments to Rule 17a-1 F. Proposed Rule 17a-26 1. Summary of Collection of Information 2. Proposed Use of Information 3. Respondents 4. Reporting and Recordkeeping Burden 5. Collection of Information is Mandatory 6. Record Retention Period G. Proposed Rule 17a-27 1. Summary of Collection of Information 2. Proposed Use of Information 3. Respondents 4. Reporting and Recordkeeping Burden 5. Collection of Information is Mandatory 6. Record Retention Period H. Request for Comment X. Consideration of Costs and Benefits A. Costs and Benefits of Proposed Rules 6a-5 and 15Aa-3 1. Benefits 2. Costs 3. Request for Comment B. Costs and Benefits of Proposed Regulation AL 1. Benefits 2. Costs 3. Request for Comment C. Costs and Benefits of Proposed Rule 6a-2 and Revised Form 1, and Rule 15Aa-2 and New Form 2 1. Benefits 2. Costs 3. Request for Comment D. Costs and Benefits of Proposed Amendments to Rule 17a-1 1. Benefits 2. Costs 3. Request for Comment E. Costs and Benefits of Proposed Rule 17a-26 1. Benefits 2. Costs 3. Request for Comment F. Costs and Benefits of Proposed Rule 17a-27 1. Benefits 2. Costs 3. Request for Comment XI. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation XII. Consideration of Impact on the Economy XIII. Regulatory Flexibility Act Certification XIV. Statutory Authority and Text of Proposed Rules I. Background A. Self-Regulation Under the Exchange Act The system of regulation for our Nation's securities markets and market participants is grounded on the principle of self-regulation. Thus, the Exchange Act 1 sets forth a regulatory model that combines both industry and government responsibility, based on the notion that regulation is most effective when it is done as closely as possible to the regulated activity. Congress enhanced this framework for the regulation of securities markets and market participants since the adoption of the Exchange Act, most notably in the Securities Acts Amendments of 1975. 2 While Congress at that time again weighed the risks of permitting the securities industry to regulate itself against the burdens of attempting to assure regulation directly through the government on a wide scale, 3 it refrained from changing the underlying principle of self-regulation. Thus, although the Commission has ultimate responsibility for oversight of the U.S. securities markets and their participants, the SROs continue to have “front-line” responsibility for overseeing trading on their markets and their members' compliance with applicable statutory and regulatory provisions. 4 1 15 U.S.C. 78a, et seq. 2 Securities Acts Amendments of 1975, Pub. L. 94-29, 89 Stat. 97 (1975). 3 S. Rep. No. 75, 94th Cong., 1st Sess. (1975) at 201. 4 Section 3(a)(26) of the Exchange Act, 15 U.S.C. 78c(a)(26), defines a self-regulatory organization as any national securities exchange, registered securities association, or registered clearing agency, or (solely for purposes of Sections 19(b), 19(c), and 23(b) of the Exchange Act, 15 U.S.C. 78s(b), 78s(c), and 78w(b)), the Municipal Securities Rulemaking Board. The proposed rulemaking would apply only to those SROs that are national securities exchanges registered under Section 6(a) of the Exchange Act, 15 U.S.C. 78f(a), and securities associations registered under Section 15A(a) of the Exchange Act, 15 U.S.C. 78 o -3(a). Congress, however, gave the Commission a wide range of tools to oversee this self-regulatory system and to compel SROs to act when they fail to provide adequate protection to investors. 5 For example, the Commission is empowered to approve SRO rules 6 and to abrogate, add to, or delete from SRO rules. 7 The Commission also is authorized to review disciplinary actions taken by SROs against their members. 8 In addition, the Commission has the authority to require exchanges and associations to keep records and to file reports with the Commission. 9 All records of exchanges and associations are subject, at any time, or from time to time, to reasonable periodic, special, or other examinations by the Commission. 10 If the Commission identifies deficiencies, it will bring them to the attention of the SRO and can inspect the SRO to ascertain whether corrective action has been taken. Moreover, the Commission has the authority to impose limitations on the operations of an SRO if it finds that the SRO has violated or is unable to comply with any provisions of the Exchange Act or rules or regulations thereunder, or with any of the SRO's own rules, or has failed to enforce compliance with any such provision by its members. 11 Further, the Commission has the authority to suspend or revoke the registration of an SRO, 12 and remove from office or censure any officer or director of an SRO. 13 5 See supra note 2. 6 Section 19(b)(1) of the Exchange Act, 15 U.S.C. 78s(b)(1), requires an SRO to file with the Commission copies of any proposed rule or any proposed change in, addition to, or deletion from the rules of such SRO, accompanied by a concise general statement of the basis and purpose of such proposed rule change, for Commission approval. This filing requirement is supplemented by Rule 19b-4 under the Exchange Act, 17 CFR 240.19b-4. 7 Section 19(c) of the Exchange Act, 15 U.S.C. 78s(c), permits the Commission, by rule, to abrogate, add to, or delete from the rules of an SRO as the Commission deems necessary or appropriate to insure the fair administration of the SRO, to conform its rules to requirements of the Exchange Act and the rules and regulations thereunder applicable, or otherwise in furtherance of the purposes of the Exchange Act. 8 Section 19(d)(2) of the Exchange Act, 15 U.S.C. 78s(d)(2), states that notice of any final disciplinary sanction, denial of membership or participation, or limitation of access to services to a person, member, or person associated with a member shall be subject to review by the appropriate regulatory agency for such member, participant, applicant, or other person. Section 3(a)(34)(E) of the Exchange Act, 15 U.S.C. 78c(a)(34)(E), states that when used with respect to a member of a national securities exchange or registered securities association, the appropriate regulatory authority is the Commission. 9 Section 17(a)(1) of the Exchange Act, 15 U.S.C. 78q(a)(1), states that exchanges and associations, among others, are required to make, keep and furnish any records, and make and disseminate any reports, that the Commission, by rule, prescribes as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Exchange Act. 10 Section 17(b) of the Exchange Act, 15 U.S.C. 78q(b), states that all records of a national securities exchange or registered securities association, among others, are subject at any time, or from time to time, to such reasonable periodic, special, or other examinations by representatives of the Commission, as the Commission deems necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Exchange Act. 11 Section 19(h)(1) of the Exchange Act, 15 U.S.C. 78s(h)(1). 12 Id. 13 Section 19(h)(4) of the Exchange Act, 15 U.S.C. 78s(h)(4). As part of its duties, an SRO must conduct surveillance of trading in its markets and examine the operations of its members. In addition, an exchange or association may not be registered with the Commission unless it is so organized and has the capacity to carry out the purposes of the Exchange Act and to comply with, and enforce its members' compliance with, the federal securities laws and rules thereunder, as well as its own rules. 14 An exchange or association also may not be registered unless the rules of the exchange or association, among other things: (1) Provide for a fair representation of its members on the board of directors; 15 (2) provide for an equitable allocation of dues, fees, and charges among its members; 16 (3) are designed to prevent fraudulent and manipulative acts and practices; 17 (4) are designed to promote just and equitable principles of trade; 18 (5) are designed to perfect the mechanism of a free and open market and a national market system; 19 (6) protect investors and the public interest; 20 and (7) provide a process for disciplining its members. 21 Accordingly, the Exchange Act makes clear that SROs are charged with an important public trust to carry out their self-regulatory responsibilities effectively and fairly, while fostering free and open markets, protecting investors, and promoting the public trust. 22 14 Sections 6(b)(1) and 15A(b)(2) of the Exchange Act, 15 U.S.C. 78f(b)(1) and 78 o -3(b)(2). 15 Sections 6(b)(3) and 15A(b)(4) of the Exchange Act, 15 U.S.C. 78f(b)(3) and 78 o -3(b)(4). 16 Sections 6(b)(4) and 15A(b)(5) of the Exchange Act, 15 U.S.C. 78f(b)(4) and 78 o -3(b)(5). 17 Sections 6(b)(5) and 15A(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(5) and 78 o -3(b)(6). 18 Id. 19 Id. 20 Id. 21 Sections 6(b)(7) and 15A(b)(7) of the Exchange Act, 15 U.S.C. 78f(b)(7) and 78 o -(b)(7). 22 See Sections 6(b)(5) and 15A(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(5) and 78 o -3(b)(6). B. Overview of Recent Developments Recent developments have prompted the Commission to review aspects of its oversight and regulation of national securities exchanges and registered securities associations and to consider whether changes are necessary to respond to those developments. 1. Governance Concerns In the wake of corporate scandals that threatened investor confidence in the securities markets, 23 the governance of companies listed on securities exchanges and The Nasdaq Stock Market (“Nasdaq”) became the focus of attention. 24 After allegations of improprieties by several issuers and their executives, Congress enacted the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) 25 to improve the accuracy and reliability of corporate disclosures and the effective oversight of the financial reporting process. 26 During this period, the New York Stock Exchange, Inc. (“NYSE”) and Nasdaq each undertook a review of its own corporate governance listing standards and proposed changes to strengthen those standards. 27 The new NYSE and Nasdaq corporate governance listing rules, which were approved by the Commission in November 2003, establish a more comprehensive definition of “independence” for directors and require the majority of members on listed companies' boards to satisfy the new independence standard. 28 In addition, the new NYSE and Nasdaq rules include a number of provisions that mandate and facilitate independent director oversight of functions relating to corporate governance, auditing, director nominations, and compensation. 29 23 See , e.g. , John Waggoner and Thomas A. Fogarty, Scandals Shred Investors' Faith: Because of Enron, Andersen, and Rising Gas Prices, the Public Is More Wary Than Ever of Corporate America , USA Today, May 5, 2002, and Louis Aguilar, Scandals Jolting Faith of Investors , Denver Post, June 27, 2002. 24 Nasdaq is a facility of the National Association of Securities Dealers, Inc. (“NASD”). Pursuant to proposed Rule 15Aa-3(b)(11), which would define the term “facility” with regard to a registered securities association, Nasdaq would continue to be a facility of the NASD. 25 Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat. 745 (2002). 26 H.R. Conf. Rep. No. 610, 107th Cong., 2nd Sess. (2002). 27 See Securities Exchange Act Release Nos. 47672 (April 11, 2003), 68 FR 19051 (April 17, 2003) (publishing for comment File No. SR-NYSE-2002-23); 48137 (July 8, 2003), 68 FR 42152 (July 16, 2003) (publishing for comment File No. SR-NASD-2002-80); 48123 (July 2, 2003), 68 FR 41191 (July 10, 2003) (publishing for comment File No. SR-NASD-2002-77); 48124 (July 2, 2003), 68 FR 41193 (July 10, 2003) (publishing for comment File No. SR-NASD-2002-138); 48125 (July 2, 2003), 68 FR 41194 (July 10, 2003) (publishing for comment File No. SR-NASD-2002-139); and 47516 (March 17, 2003), 68 FR 14451 (March 25, 2003) (publishing for comment File No. SR-NASD-2002-141). 28 See Securities Exchange Act Release No. 48745 (November 4, 2003), 68 FR 64154 (November 12, 2003) (order approving File Nos. SR-NYSE-2002-33, SR-NASD-2002-77, SR-NASD-2002-80, SR-NASD-2002-138, SR-NASD-2002-139, and SR-NASD-2002-141). 29 See id. In light of the governance changes proposed by the NYSE and Nasdaq for their listed issuers, in March 2003, the Commission's Chairman requested that the SROs review the adequacy of their own governance practices. 30 In his letter to each SRO, the Chairman noted that the SROs play a critical role in our securities markets as standard setters for listed companies, operators of trading markets, and front-line regulators of securities firms. 31 Further, the Chairman referred to the enhanced corporate governance listing standards proposed by the NYSE and Nasdaq as a high standard that the SROs should demand not only of listed issuers, but also of themselves. 32 30 See Letters from William H. Donaldson, Chairman, Commission, to Salvatore F. Sodano, Chairman & CEO, American Stock Exchange LLC (“Amex”); Kenneth R. Leibler, Chairman & CEO, Boston Stock Exchange, Inc. (“BSE”); William J. Brodsky, Chairman & CEO, Chicago Board Options Exchange, Inc. (“CBOE”); David A. Herron, CEO, Chicago Stock Exchange, Inc. (“CHX”); David Colker, President & CEO, Cincinnati Stock Exchange, Inc. (“CSE”); David Krell, CEO, International Securities Exchange, Inc. (“ISE”); Philip D. DeFeo, Chairman & CEO, Pacific Exchange, Inc. (“PCX”); Meyer S. Frucher, Chairman & CEO, Philadelphia Stock Exchange, Inc. (“Phlx”); Robert R. Glauber, Chairman & CEO, NASD; Richard G. Ketchum, President & Deputy Chairman, Nasdaq; and Richard A. Grasso, Chairman & CEO, NYSE (March 26, 2003). Copies of these letters are available in the Commission's Public Reference Room under File No. S7-39-04. 31 See id. 32 See id. Several months later, while the NYSE was reviewing its own governance practices, the media published reports of the proposed extension of the employment agreement of its then Chairman and Chief Executive Officer (“CEO”), as well as an anticipated substantial payout of his accrued compensation. In response, the Commission's Chairman sent a letter to the Chairman of the NYSE's Compensation and Human Resources Committee and Special Governance Committee requesting information regarding the compensation of the NYSE Chairman and CEO and the decision-making processes at the NYSE that led to the pay package. 33 Shortly thereafter, the Commission's Chairman sent letters to the other SROs requesting that they provide details about the extent of public representation on their boards and key committees (including the Compensation Committee); the decision-making processes with respect to the nomination of directors, their assignment to committees, and the compensation of executives; and the SROs' past practices and current plans for public disclosure of these processes and the compensation arrangements of key executives. 34 33 See Letter from William H. Donaldson, Chairman, Commission, to The Honorable H. Carl McCall, Chairman, Human Resources and Compensation Committee, Chairman, Special Committee on Governance of the NYSE, NYSE, dated September 2, 2003. A copy of this letter is available in the Commission's Public Reference Room under File No. S7-39-04. 34 See Letters from William H. Donaldson, Chairman, Commission, to Salvatore F. Sodano, Chairman & CEO, Amex; Kenneth R. Leibler, Chairman & CEO, BSE; William J. Brodsky, Chairman & CEO, CBOE; Robert; David A. Herron, CEO, CHX; David Colker, President & CEO, CSE; David Krell, President & CEO, ISE; Philip D. DeFeo, Chairman & CEO, PCX; Meyer S. Frucher, Chairman & CEO, Phlx; Robert R. Glauber, Chairman & CEO, NASD; and Robert Greifeld, President & CEO, Nasdaq (September 23, 2003). Copies of these letters are available in the Commission's Public Reference Room under File No. S7-39-04. During this period, the NYSE announced the resignation of its Chairman and CEO and shortly thereafter named an interim Chairman. In November 2003, the NYSE filed with the Commission a proposal to amend the NYSE Constitution to implement a series of governance changes at the NYSE. 35 The proposal called for the establishment of a new board of directors composed wholly of independent directors; an advisory board of executives that would be representative of the exchange's various constituencies; independent board committees with specific oversight authority for compensation, audit functions, the nominations process and regulatory matters; and an autonomous regulatory unit that would report directly to the regulatory oversight committee. The Commission approved the NYSE's governance revisions in December 2003. 36 35 See Securities Exchange Act Release No. 48764 (November 7, 2003), 68 FR 64380 (November 13, 2003). 36 See Securities Exchange Act Release No. 48946 (December 17, 2003), 68 FR 74678 (December 24, 2003). 2. Concerns Relating to Weaknesses of SRO Regulatory Programs In addition to the enhanced focus on SRO governance, recent Commission enforcement actions involving SROs have highlighted weaknesses in the effectiveness of certain SRO regulatory programs. In September 2003, for example, the Commission settled an administrative enforcement action against the CHX for failure to enforce its trading rules. 37 The Commission's order, among other things, included findings that the CHX's surveillance program failed adequately to detect violations by its members of the firm quote rule, 38 trading ahead prohibitions, 39 and the limit order display rule 40 from 1998 through 2001. As part of the undertakings imposed by the settlement, the CHX was required, among other things, to create a regulatory oversight committee comprised almost exclusively of individuals with no material business relationship with the exchange. 41 In addition, the CHX was required to file with the Commission various certifications by its officials confirming its ongoing compliance with its statutory obligations. 37 See In the Matter of Chicago Stock Exchange, Securities Exchange Act Release No. 48566 (September 30, 2003) (“CHX Order”). 38 See CHX Article XX, Rule 7.01; see also Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1. 39 See CHX Article XXX, Rule 2. 40 See CHX Article XX, Rule 7.05; see also Exchange Act Rule 11Ac1-4, 15 CFR 240.11Ac1-4. 41 The CHX's regulatory oversight committee must advise the CHX's board of governors about regulatory, compliance, and enforcement matters and assist the board in monitoring the design, implementation, and effectiveness of the CHX's compliance program. See CHX Order, supra note 37. Also, recent Commission enforcement actions involving SRO members have pointed to weaknesses in the effectiveness of SROs' regulatory programs. In 2004, for example, the Commission settled enforcement actions against the seven NYSE specialist firms. The Commission found that, between 1999 and 2003, these specialist firms violated federal securities laws and NYSE rules by executing orders for their dealer accounts ahead of executable public customer orders. 42 As part of the settlement, the firms agreed to pay a total of more than $247 million in penalties and disgorgement, and agreed to implement steps to improve their compliance procedures and systems. 42 See In the Matter of Bear Wagner Specialists LLC, Securities Exchange Act Release No. 49498 (March 30, 2004); In the Matter of Fleet Specialist, Inc., Securities Exchange Act Release No. 49499 (March 30, 2004); In the Matter of LaBranche & Co. LLC, Securities Exchange Act Release No. 49500 (March 30, 2004); In the Matter of Spear, Leeds & Kellogg Specialists LLC, Securities Exchange Act Release No. 49501 (March 30, 2004); and In the Matter of Van der Moolen Specialists USA, LLC, Securities Exchange Act Release No. 49502 (March 30, 2004). These five firms agreed to pay a total of $241.8 million in penalties and disgorgement, and agreed to implement steps to improve their compliance procedures and systems. In July 2004, the Commission and the NYSE settled enforcement actions against two other NYSE specialist firms. See In the Matter of SIG Specialists, Inc., Securities Exchange Act Release No. 50076 (July 26, 2004); and In the Matter of Performance Specialist Group LLC, Securities Exchange Act Release No. 50075 (July 26, 2004). These firms agreed to pay a total of $5.2 million in penalties and disgorgement, consisting of $1.7 million in civil money penalties and $3.5 million in disgorgement, and agreed to implement steps to improve their compliance procedures and systems. Moreover, the Commission's staff recently has conducted inspections of SROs that have raised questions regarding whether, in certain circumstances, SROs have governance structures that are sufficiently independent, or whether SROs have maintained regulatory programs that are sufficiently rigorous to detect, deter, and discipline for members' violations of the federal securities laws and rules and SRO rules. Taken together, developments involving SRO governance, as well as the concerns raised by recent enforcement actions 43 and inspections involving SROs, have prompted the Commission to consider new regulatory measures with respect to SROs. The Commission therefore has determined to propose rules that would strengthen the governance of national securities exchanges and registered securities associations and the independence of their regulatory programs. Moreover, the Commission is proposing to enhance the level of information that would be publicly available about SROs, including with respect to their governance structures, finances, regulatory programs, and significant owners. Finally, the Commission believes that oversight of SROs would be enhanced, and inspections could be better targeted to problematic areas, if the Commission were to receive more extensive and frequent data about SRO regulatory programs in a systematic fashion. Therefore, the Commission is proposing a new SRO reporting rule that is intended to facilitate more effective Commission monitoring of SROs' regulatory programs. While the Commission is proposing other measures that would increase the transparency of SROs' operations, the information submitted under this proposed rule is intended to be used as part of the Commission's examination program and thus may not be publicly available. 43 See, e.g. , CHX Order, supra note 37; In the Matter of Certain Activities of Options Exchanges, Securities Exchange Act Release No. 43268 (September 11, 2000) (proceeding against Amex, CBOE, PCX, and Phlx for engaging in anticompetitive activities and for failing adequately to enforce compliance with their own rules); and In the Matter of NYSE, Inc., Securities Exchange Act Release No. 41574 (June 29, 1999) (proceeding against NYSE for failure to enforce compliance with federal securities laws and NYSE rules prohibiting proprietary and on-floor trading by NYSE floor broker members in violation of Section 19(g) of the Exchange Act, 15 U.S.C. 78s(g)). 3. Competitive Concerns More broadly, the Commission's review of SROs also was prompted by marketplace developments and the increasingly competitive environment faced by SROs that operate trading facilities. For example, in recent years, market participants have developed a variety of alternative trading systems (“ATSs”) that furnish execution services historically provided by exchanges. 44 Under Regulation ATS, 45 ATSs may choose whether (a) to register as national securities exchanges, and thus assume the responsibilities of SROs; or (b) to register as broker-dealers under Sections 15(b) or 15C of the Exchange Act, 46 subject to certain additional reporting and conduct requirements. 47 Regulation ATS was designed to impose essential elements of market-oriented regulation on ATSs, while maintaining sufficient regulatory flexibility to foster market innovation. 48 44 Alternative trading systems include electronic communications networks (“ECNs”) such as INET ATS (“INET”), a subsidiary of Instinet Group, Inc. An ECN is an electronic system that widely disseminates to third parties orders entered therein by an exchange market maker or over-the-counter (“OTC”) market maker, and permits such orders to be executed against in whole or in part. The term specifically excludes internal broker-dealer order routing systems and crossing systems, i.e. , systems that cross multiple orders at one or more specified times at a single price set by the ECN and do not allow orders to be crossed or executed against directly by participants outside of such times. 17 CFR 240.11Ac1-1(a)(8). 45 See Regulation ATS, 17 CFR 242.300, et seq. 46 15 U.S.C. 78 o (b) and 78 o -5. 47 See Regulation ATS, 17 CFR 242.300, et seq. 48 See Securities Exchange Act Release No. 40760 (December 8, 1998), 63 FR 70844 (December 22, 1998) (adopting Regulation ATS). The highly-competitive environment of recent years also has induced alliances among particular SROs and ATSs to combine the regulatory status of the SRO with the market share of the ATS. In 2001, for example, the Commission approved a proposal by PCX to establish the Archipelago Exchange (“Arca-Ex”) as a facility of its subsidiary, PCX Equities, Inc. (“PCX Equities”). 49 In addition, several ECNs have made arrangements to execute and report trades through a particular exchange, and to share the market data revenues generated thereby. 50 49 See Securities Exchange Act Release No. 44983 (October 25, 2001), 66 FR 55225 (November 1, 2001) (establishing Arca-Ex as the equities trading facility of PCX Equities). 50 For example, INET has arranged to execute and report its trades through the National Stock Exchange, Inc. (“NSX”) (formerly known as CSE). Moreover, the SROs face increased competition from foreign trading markets that operate under regulatory regimes that differ from the U.S. regulatory model. These foreign markets may not be subject to the same kind of regulatory requirements that markets operated by U.S. SROs must satisfy. For example, issuers listed on U.S. exchanges or Nasdaq generally are subject to different disclosure standards than issuers whose securities are listed and traded solely on foreign markets. These differences in the U.S. reporting regime may deter some foreign issuers from U.S. registration, with the result that their securities cannot be traded on U.S. exchanges or Nasdaq, but can be traded on foreign markets or on U.S. trading systems (such as ECNs) that are not operated by SROs. The effect of these developments is that markets operated by SROs have faced increased competition from foreign trading markets and from electronic trading systems, such as ECNs, that have made substantial inroads into the market share of the traditional SRO markets, especially with respect to Nasdaq securities. Furthermore, historic differences in the securities traded by particular SROs are disappearing. For example, the NYSE and Amex historically dominated trading in their listed securities, and market makers dominated trading in Nasdaq stocks. Today, however, for Nasdaq stocks, automated order-driven market centers (such as Nasdaq's SuperMontage, Arca-Ex, and INET) have captured more than 50% of share volume. 51 For Amex-listed stocks (for which approximately 39% of share volume now is represented by two extremely active exchange-traded funds (“ETFs”)—the QQQ and SPDR), Amex now handles approximately 21% of the volume, with the remaining balance split among Arca-Ex, INET, and others. 52 The NYSE has retained approximately 80% of the volume in its listed stocks, but other market centers are attempting to raise the level of competition and increase their share of trading. 53 Moreover, the NYSE and Amex have sought to add automated facilities that are integrated with and complement their traditional exchange floors. 54 51 The figure is based on Nasdaq/UTP Plan market data (as of September 2004). Copies of this data are available in the Commission's Public Reference Room under File No. S7-39-04. 52 The figure is based on Network B, CTS Activity market data (as of September 2004). Copies of this data are available in the Commission's Public Reference Room under File No. S7-39-04. 53 The figure is based on Network A, CTS Activity market data (as of September 2004). Copies of this data are available in the Commission's Public Reference Room under File No. S7-39-04. 54 See Securities Exchange Act Release Nos. 50173 (August 10, 2004), 69 FR 50407 (August 16, 2004) (notice of proposed rule change proposing improvements to NYSE's existing automatic execution facility, NYSE Direct+®) and 49921 (June 25, 2004), 69 FR 40690 (July 6, 2004) (approval of proposed rule change by Amex to enhance its Auto-Ex technology for exchange-traded funds and Nasdaq stocks traded on the exchange). The historic differences between SROs that operate options trading markets have also eroded. From 1977 until 1999, most actively traded options were traded on only one exchange. In 1989, the Commission adopted Rule 19c-5 under the Exchange Act, prohibiting exchanges from having rules that limit their ability to list any stock options class because that options class is listed on another options exchange. 55 The options exchanges, however, did not widely implement multiple listing of options until 1999. By that time, the U.S. Department of Justice (“DOJ”) and the Commission had begun to investigate the four floor-based options exchanges (Amex, CBOE, PCX, and Phlx) for engaging in anticompetitive activities—in particular, for refraining from listing options listed on another exchange—and for failing to enforce adequately compliance with their own rules. 56 In addition, during that period the ISE had filed an application with the Commission to register as a national securities exchange that would trade options. 57 55 See Securities Exchange Act Release No. 26870 (May 26, 1989), 54 FR 23963 (June 5, 1989). 56 See Securities Exchange Act Release No. 43268, supra note 43. See also U.S. v. American Stock Exchange LLC, et al. , 2000 WL 33400154 (D.D.C. 2000). 57 See Securities Exchange Act Release No. 41439 (May 24, 1999), 64 FR 29367 (June 1, 1999). The Commission approved the ISE's registration application in 2000. See Securities Exchange Act Release No. 42455 (February 24, 2000), 65 FR 11388 (March 2, 2000). As part of their settlement with the Commission, the floor-based options exchanges were ordered to collectively spend $77 million on surveillance and enforcement. The settlement of the Commission's enforcement action and the entry of a consent decree in the DOJ case, along with the proposed entry of the ISE as a national securities exchange that intended to trade options, were the catalysts for the expansion of multiple listing of equity options. Today, virtually all actively traded equity options trade on multiple markets, a development that has enhanced competition among the options exchanges. 58 The entry of electronic options trading markets has further raised the level of competition. 59 58 In August 1999, 32% of equity options were traded on more than one exchange. By September 2000, that number had risen to 45%. Securities Exchange Act Release No. 43085 (July 28, 2000), 65 FR 47918 (August 4, 2000) (proposing to extend Exchange Act Rule 11Ac1-1 to options). Over the same period, the percentage of aggregate option volume traded on only one exchange fell from 60% to 15%. Id. According to the Options Clearing Corporation, by September 2003, 98.3% of equity options classes traded on more than one exchange. Id. 59 For example, the Boston Options Exchange (“BOX”), a facility of the BSE, commenced trading in 2004. See Securities Exchange Act Release No. 49067 (January 14, 2004), 64 FR 2761 (January 21, 2004) (order approving the operating agreement of BOX). The recent developments outlined above have led the Commission to consider whether the increasing competitive pressures placed on SROs that operate trading facilities warrant additional measures that are designed to focus the SROs on their statutorily-mandated responsibilities as market regulators. Pursuant to the Exchange Act, SROs are charged with a public trust to implement and enforce the federal securities laws and rules, as well as their own rules with respect to their members. 60 Yet, as membership organizations, and in some cases as shareholder-owned organizations, SROs are expected to promote the economic interests of their members and their owners. In addition, SROs, as operators of trading markets, are critical to the success and viability of our capital markets. In this capacity, SROs play a key role in the price discovery process, are innovators of new products, and, through the listing mechanism, provide issuers with an opportunity to access capital. This business model understandably would prompt SROs to be concerned with preserving and enhancing their competitive positions. As competition increases among marketplaces and SROs actively pursue strategies to increase their market share, there is a possibility that SROs could face increasing pressure from members and owners with respect to the degree of emphasis placed on their regulatory obligations. In the Commission's view, this factor underscores the need to consider measures that foster and enhance the independence of SROs' governance, the transparency of their processes, and the effectiveness of their regulatory programs. 60 See Sections 6(b)(1) and 15A(b)(2) of the Exchange Act, 15 U.S.C. 78f(b)(1) and 78 o -3(b)(2). 4. Concerns Relating to New Ownership Structures Finally, SROs have been challenged by the recent trend to demutualize and reorganize as shareholder-owned entities. 61 SROs historically have been structured as mutual, not-for-profit organizations owned, for the most part, by members that are registered broker-dealers. In 1998, the Commission expressed the view that exchanges could be organized as for-profit entities. 62 Since that time, and especially over the past few years, a number of SROs have demutualized and explicitly separated the right to trade in their markets from the economic ownership rights in those SROs. SROs have put forth various reasons for demutualizing, but common themes are an increased ability to more quickly respond to competitive pressures and additional potential sources of capital. 63 61 See Securities Exchange Act Release Nos. 45803 (April 23, 2002), 67 FR 21306 (April 30, 2002) (order approving the restructuring of ISE from a limited liability company to a corporation); 49718 (May 17, 2004), 69 FR 29611 (May 24, 2004) (order approving the demutualization of PCX); and 49098 (January 16, 2004), 69 FR 3974 (January 27, 2004) (order approving the demutualization of Phlx). 62 See supra note 48 (citing to the adopting release for Regulation ATS). 63 See Securities Exchange Act Release Nos. 49451 (March 19, 2004), 69 FR 16305 (March 29, 2004) (PCX stating that by “restructuring its business as a stock corporation with business control and management vested in a Board of Directors, the entity will have greater flexibility to develop and execute strategies designed to improve its competitive position than it has under the current membership-cooperative structure” and that it anticipates that “by restructuring as a stock corporation, PCX management will be better able to respond quickly to competitive pressures and to make changes to its operations as market conditions warrant, without diminishing the integrity of its regulatory programs.”) and 49098, supra note 61 (stating that Phlx proposed to effect a demutualization for a number of reasons, including to “expand its sources of capital and revenue; to facilitate its ability to enter into relationships with strategic or financial partners who may be crucial for the Exchange's future development, capital formation and viability; to facilitate the introduction of new products and thus potentially increase transaction volume and Exchange revenues; and to better position itself to react to new opportunities and challenges”). In addition, some SROs have trading facilities that are owned and operated by persons other than the SRO itself or its members. For example, Archipelago Holdings, Inc. (“Archipelago Holdings”) operates Arca-Ex, the equities trading facility of PCX Equities, and BOX, an options trading facility of the BSE, is operated by the Boston Options Exchange Group, LLC. 64 Demutualized SROs, and separate facilities of SROs, also may choose to become publicly traded companies. For instance, Archipelago Holdings, the parent company of Arca-Ex, recently completed an initial public offering, and ISE has filed a registration statement under the Securities Act of 1933 (“Securities Act”) with regard to its intended initial public offering. 65 In addition, Nasdaq's common stock is publicly traded in the OTC market. 64 See Securities Exchange Act Release Nos. 44983, supra note 49 and 49067, supra note 59. 65 See Securities Exchange Act Release No. 50170 (August 9, 2004), 69 FR 50419 (August 16, 2004) (order approving PCX rule filing relating to the Certificate of Incorporation and Bylaws of Archipelago Holdings) and ISE Registration Statement on Form S-1, File No. 333-117145. The impact of demutualization is the creation of another SRO constituency—a dispersed group of public shareholders—with a natural tendency to promote business interests. To the extent that a well-regulated market is considered by an SRO's owners to be in their commercial interest, demutualization could better align the goals of SRO owners with their statutory obligations. On the other hand, it could also exacerbate the concern, discussed above, that SROs may put their commercial interests ahead of their responsibilities as regulators. The trend toward demutualization of SROs is yet another reason why the Commission is proposing regulatory changes to better assure the ability of SROs to carry out effectively their regulatory obligations. The Commission believes that the proposals—summarized above and discussed in detail below—to enhance the governance, administration, transparency and oversight of all SROs would effectively address many of the concerns raised by the demutualization of SROs. In addition, the Commission believes that it is appropriate to consider limits on member ownership of an exchange, association or facility, and heightened procedures in the case of SRO “self-listing.” Finally, while the Commission believes that the proposals contained herein would significantly enhance the governance, administration, transparency, and oversight of SROs, legitimate questions remain as to whether more radical structural changes are warranted. Indeed, in addition to the proposals contained in this release, the Commission is today issuing a Concept Release that discusses in detail the strengths and weaknesses of the self-regulatory model and seeks commenters' views on a wide range of issues relating to self-regulation. 66 The Concept Release examines the attributes of the current self-regulatory system, explores additional changes that could be made to the existing system to address the weaknesses of self-regulation, and discusses other models that, if implemented, would require a more extensive restructuring—or elimination—of the current system of self-regulation. 67 66 See Securities Exchange Act Release No. 50700 (November 18, 2004). 67 See id. II. Fair Administration and Governance of National Securities Exchanges and Registered Securities Associations A. Background and Need for Proposed Rules 6a-5 and 15Aa-3 As operators of trading markets, front-line regulators of securities firms, and standard-setters for listed issuers, national securities exchanges and registered securities associations are critical to the integrity of the U.S. securities markets. Recent events have highlighted, however, that the securities industry's system of self-regulation has not always worked as effectively or fairly as it should. 68 In addition, the dual roles of exchanges and associations as both market overseers and market operators, the increased competition among markets, and the growing trend of exchanges to demutualize have raised concerns about their ability and efforts to fulfill their regulatory duties vigorously and impartially. 69 As exchanges and associations continue to face these and other new challenges, the Commission is proposing to address issues of SRO governance and administration, and to explore changes that could foster robust fulfillment of SROs' self-regulatory duties. 68 See supra Section I.B. 69 Congress was aware of the conflicting roles faced by exchanges when it designed the regulatory scheme for U.S. securities markets. See, e.g. , S. Rep. No. 73-792, at 4-5 (1934); H.R. Rep. No. 73-1383, at 14-16 (1934); and S. Rep. No. 73-1455, at 80-81 (1934). Accordingly, the Commission is proposing new Rule 6a-5 under the Exchange Act, which pertains to the fair administration and governance of national securities exchanges, and new Rule 15Aa-3 under the Exchange Act, which pertains to the fair administration and governance of registered securities associations. 70 The proposals would apply to exchanges and associations minimum governance standards that are commensurate with standards required of listed issuers. Among other provisions, the proposed rules would require an exchange's or association's governing board to be composed of a majority of independent directors, with key board committees to be composed solely of independent directors. The Commission believes that the proposed rules would promote a structure that would facilitate the ability of SROs to perform their responsibilities under the Exchange Act with objectivity and vigor. In the Commission's view, proposed Rules 6a-5 and 15Aa-3 would further the goals of the Exchange Act, which, among other things, requires national securities exchanges and registered securities associations to be so organized and have the capacity to carry out the purposes of the Exchange Act. 71 The Commission also believes that by mandating a governance structure that is less susceptible to competing internal interests, proposed Rules 6a-5 and 15Aa-3 would help promote investor confidence in the way in which our securities markets are administered. 70 Proposed Rules 6a-5 and 15Aa-3 are substantially similar. Rule 15Aa-3(b)(11), however, proposes to define the term “facility” for purposes of associations. Currently, the only securities association registered under Section 15A(a) of the Exchange Act, 15 U.S.C. 78o-3(a), is the NASD. 71 See Sections 6(b)(1) and 15A(b)(2) of the Exchange Act, 15 U.S.C. 78f(b)(1) and 78o-3(b)(2). The proposed governance rules also would require each exchange and association to separate its regulatory function from its market operations and other commercial interests, whether through functional or organizational separation. Although a premise underlying self-regulation is that regulation works best when it is carried out in proximity to the regulated activity, it is equally important that there be sufficient independence within the self-regulatory process to adequately check undue interference or influence from the persons or entities being regulated. In the Commission's view, the proposed rules would help insulate the regulatory activities of an exchange or association from the conflicts of interest that otherwise may arise by virtue of its market operations. In addition, the proposed rules would require an exchange or association to establish ownership and voting limitations on the interest of its members that are brokers or dealers in the exchange, association, or a facility of the exchange or association through which the member is permitted to effect transactions. Members who trade on an exchange or through a facility of an exchange or association have traditionally had ownership interests in such exchange or facility. Recent developments, including the trend towards demutualization, have raised the concern that a member's interest could become so large as to cast doubt on whether the exchange or association could fairly and objectively exercise its self-regulatory responsibilities with respect to that member. For example, an exchange may hesitate to diligently monitor and surveil the trading conduct of a member that is a controlling shareholder of the exchange or a facility of the exchange, or to diligently enforce its rules and the federal securities laws with regard to conduct by such member that violates these provisions. The Commission believes that the proposed rules would help mitigate the conflicts of interest that could occur if a member were to control a significant stake in its regulator, and are necessary and appropriate to help ensure that an exchange or association can effectively carry out its statutory obligations under Section 6(b) or 15A(b) of the Exchange Act, respectively. 72 72 15 U.S.C. 78f(b) and 78o-3(b). Finally, the Commission believes that the proposed rules are consistent with, and should enhance, the “fair representation” requirements applicable to exchanges and associations. As more fully discussed below, the proposals are designed to reinforce the Exchange Act requirement that the rules of an exchange or association “assure a fair representation of its members in the selection of its directors and administration of its affairs and provide that one or more directors shall be representative of issuers and investors and not be associated with a member of the exchange [or association], broker, or dealer.” 73 73 15 U.S.C. 78f(b)(3) and 78o-3(b)(4). B. Description of Proposed Rules 6a-5 and 15Aa-3 1. Scope of Proposed Rules 6a-5 and 15Aa-3 Under proposed Rules 6a-5 and 15Aa-3, each national securities exchange and registered securities association, respectively, would be required to comply with, have rules that comply with, and have the capacity to carry out the purposes of, the provisions of the applicable governance rule. 74 A national securities exchange registered pursuant to Section 6(g)(1) of the Exchange Act, 75 and a limited purpose national securities association registered pursuant to Section 15A(k)(1) of the Exchange Act, 76 would not be subject to these requirements. 77 While the proposed rules would establish minimum standards for the governance and administration of an exchange or association, an exchange or association, of course, could determine to establish more rigorous standards. 74 See proposed Rules 6a-5(a) and 15Aa-3(a). 75 15 U.S.C. 78f(g)(1). 76 15 U.S.C. 78o-3(k)(1). 77 See proposed Rules 6a-5(s)(1) and 15Aa-3(s)(1). The Commission does not have primary responsibility for regulating exchanges registered under Section 6(g)(1) of the Exchange Act and national securities associations registered under Section 15A(k)(1) of the Exchange Act (“limited purpose national securities associations”). See 15 U.S.C. 78f(g)(1) and 78o-3(k)(1). This responsibility instead lies with the Commodity Futures Trading Commission (“CFTC”). For this reason, such exchanges and associations are exempt from the requirements to file with the Commission proposed rule changes, except for certain specified types of rules. Importantly, exchanges registered under Section 6(g)(1) of the Exchange Act and limited purpose national securities associations are not required to file with the Commission proposed changes to rules related to their governance, ownership, or fulfillment of their self-regulatory responsibilities. Because the Commission does not have primary responsibility for the regulation of these exchanges and associations, the Commission is proposing to exempt such exchanges and associations from proposed Rules 6a-5 and 15Aa-3. Certain provisions of the proposed rules would be applied to any “regulatory subsidiary” of the exchange or association in the same manner as they would apply to the exchange or association. 78 The term “regulatory subsidiary” would be defined in proposed Rules 6a-5(b)(18) and 15Aa-3(b)(19) as any person that, directly or indirectly, is controlled by the exchange or association and that provides, whether pursuant to contract, agreement or rule, regulatory services 79 to or on behalf of the exchange or association. In recent years, several exchanges, as well as the NASD, have formed subsidiaries and have delegated, pursuant to rules approved by the Commission, to those subsidiaries certain regulatory functions historically conducted by the exchange or the NASD directly. 80 These subsidiaries remain subject to the self-regulatory authority of the SRO and the SRO ultimately retains responsibility for fulfilling the self-regulatory duties imposed on it by the Exchange Act. To account for the fact that some SROs have delegated regulatory responsibilities under specified conditions to their subsidiaries, exchanges and associations would be required to apply various provisions of the proposed rules to any such subsidiaries, but only to the extent that the subsidiary has a separate governing board and key board committees. Accordingly, this proposal recognizes that a regulatory subsidiary of an exchange or association is an integral part of the SRO, and by carrying out certain self-regulatory duties on behalf of the exchange or association, it should be subject to the same governance standards applicable to the SRO itself. 81 78 Under paragraph (a) of proposed Rules 6a-5 and 15Aa-3, paragraphs (c), (d), (e), (f), (g), (h), (i), (j), (k), (l), (m), (n), (p), and (q) of the proposed rules would apply to regulatory subsidiaries. 79 Regulatory services are intended to cover any of those activities that generally would fall within the scope of the SRO's regulatory obligations. 80 See, e.g., Securities Exchange Act Release Nos. 42759 (May 5, 2000), 65 FR 30654 (May 12, 2000) (order approving creation of PCX Equities, a wholly-owned subsidiary of PCX) and 49065 (January 13, 2004), 69 FR 2768 (January 20, 2004) (order approving creation of Boston Options Exchange Regulation, LLC (“BOXR”), a wholly-owned subsidiary of the BSE). For example, NASD Regulation, Inc. is responsible for carrying out most regulatory functions otherwise within the jurisdiction of the NASD; and the NASD's subsidiary, Nasdaq, pursuant to a plan of delegation, carries out certain regulatory functions on behalf of the NASD. Nasdaq would be subject to proposed Rule 15Aa-3 on two bases: It is both a facility of an association and it is an affiliate that provides regulatory services to or on behalf of the NASD. In addition, the BSE's subsidiary, BOXR, carries out certain regulatory functions on behalf of the BSE; and PCX's subsidiary, PCX Equities, carries out certain regulatory functions on behalf of PCX. 81 To date, the Commission has permitted an SRO to delegate its regulatory responsibilities only to a subsidiary of the SRO or to another SRO. The SRO that delegates such responsibilities, however, retains primary responsibility for ensuring compliance with the Exchange Act, and rules thereunder, and the rules of the SRO. Each SRO subject to Rule 6a-5 or 15Aa-3 would implement the applicable rule's requirements through rule filings with the Commission pursuant to Section 19(b) of the Exchange Act. 82 SROs are required to file any proposed change in, addition to, or deletion from its rules. 83 A “stated policy, practice, or interpretation,” as defined in Rule 19b-4(b)(1) under the Exchange Act, 84 is deemed a proposed rule change, and includes “any material aspect of the operation of the facilities of the [SRO].” 85 The Commission believes that any changes made by an SRO to its or any facility's 86 articles of incorporation, constitution, bylaws, and rules, or any instrument corresponding to the foregoing, that relate to or are made to comply with proposed Rules 6a-5 or 15Aa-3 would relate to a material aspect of the operation of the facilities of the exchange or association and therefore would be required to be filed under Section 19(b). 87 82 15 U.S.C. 78s(b). 83 Id. 84 17 CFR 240.19b-4(b)(1). 85 Id. 86 The term “facility” is defined in Section 3(a)(2) of the Exchange Act and, when used with respect to an exchange, includes its premises, tangible or intangible property whether on the premises or not, any right to the use of such premises or property or any service thereof for the purpose of effecting or reporting a transaction on an exchange (including, among other things, any system of communication to or from the exchange, by ticker or otherwise, maintained by or with the consent of the exchange), and any right of the exchange to the use of any property or service. See 15 U.S.C. 78c(a)(2). In many cases, a facility of the exchange is within the same legal entity as the exchange itself and thus only the exchange would need to meet the proposed governance rule's requirements. The term “facility,” when used with respect to an association, would be defined in new Rule 15Aa-3(b)(11) as its premises, tangible or intangible property whether on the premises or not, any right to the use of such premises or property or any service thereof for the purpose of effecting or reporting a transaction (including, among other things, any system of communication to or from the association, by ticker or otherwise, maintained by or with the consent of the association), and any right of the association to the use of any property or service. If a facility of the association is within the same legal entity as the association itself, only the association would need to meet the proposed governance rule's requirements. 87 For instance, as discussed below in Section II.B.9., an exchange or association would be required to limit its members' interest in a facility of the exchange or association, as well as the exchange or association itself, which may involve changes to the rules of the SRO, including any of the governing documents of the exchange or association, or a facility of the exchange or association. 2. Board Consisting of a Majority of Independent Directors Rules 6a-5 and 15Aa-3 would impose a series of substantive requirements with respect to the composition of the exchange's and association's board 88 that are designed to assure the independence of the board and the fair administration and governance of the exchange or association. To this end, the Commission proposes that the board of each exchange and association be composed of a majority of independent directors. 89 This provision would further the statutory goals that an exchange and association be so organized and have the capacity to carry out the Exchange Act's purposes and to comply, and enforce compliance by members and their associated persons, with the Exchange Act and rules thereunder and the SRO's own rules. 90 We note that this proposal is consistent with accepted corporate governance “best practices” regarding board independence. 91 The requirement to have a majority of independent directors also comports with exchange and association rules applicable to listed companies that recently were approved by the Commission to address similar governance concerns and the conflicts of interest that can arise between a company's management and its public shareholders. 92 88 The term “board” would be defined in the proposed rules as the Board of Directors or Board of Governors of the exchange or association, or any equivalent body. See proposed Rules 6a-5(b)(5) and 15Aa-3(b)(6). 89 See proposed Rules 6a-5(c)(1) and 15Aa-3(c)(1). The term “director” would be defined in proposed Rules 6a-5(b)(8) and 15Aa-3(b)(9) as any member of the board. 90 See Sections 6(b)(1) and 15A(b)(2) of the Exchange Act, 15 U.S.C. 78f(b)(1) and 78 o -3(b)(2). 91 See, e.g., James H. Cheek III, et al., Report of the American Bar Association Task Force on Corporate Responsibility (2003) (“ABA Task Force Report”); Derek Higgs, Review of the Role and Effectiveness of Non-Executive Directors (2003) (“Higgs Report”); and The Business Roundtable, Principals of Corporate Governance (May 2002) (“Business Roundtable Report”). 92 See, e.g. , Securities Exchange Act Release No. 48745, supra note 28; NYSE Listed Company Manual Section 303A.01; and NASD Rule 4350(c)(1). The Commission's proposed approach to SRO governance is multi-faceted and multi-pronged. It combines public disclosure of important governance information with guidelines for independent board representation and reliance on totally independent board committees for oversight of critical SRO functions and responsibilities. 93 The proposed rules are designed to enhance the governance of exchanges and associations, while at the same time providing them with a measure of flexibility in determining their own governance models, so long as the minimum requirements are satisfied. SROs, of course, can elect to implement a greater proportion of independent directors. 94 93 Because of the unique role played by the SROs and the related conflicts, and in the context of the package of proposals in this release, the Commission at this time has determined to propose a majority independent director requirement for SROs. We are soliciting comment on this proposal. See also infra note 191. 94 The NYSE Constitution, for example, requires that the NYSE's board of directors be entirely independent of the management of the exchange, the membership of the exchange, and issuers of securities listed on the exchange. See NYSE Constitution, Article IV, Sec. 2. The Commission believes that requiring SRO boards to have a majority of independent directors, in combination with the other proposed requirements “ for example, the proposed requirement mandating completely independent Standing Committees (as defined below) of the board 95 “ should help address the conflicts of interest that otherwise might arise when persons with a nexus to the SRO are involved in key decisions. 96 These proposals together also should increase the likelihood that exchange and association boards will act in accordance with the mandates of the Exchange Act and in the best interests not only of the SRO and its members or shareholders, but also of the investing public. The Exchange Act sets broad parameters regarding the composition of an exchange's or association's governing body. 97 The proposed rules are intended to provide greater clarity to those statutory provisions. 95 See infra Section II.B.3. for a discussion on the Standing Committees of the board. 96 See, e.g. , ABA Task Force Report, supra note 91, at 31. 97 See Sections 6(b) and 15A(b) of the Exchange Act, 15 U.S.C. 78f(b) and 78 o -3(b). The exchanges, the NASD, and Nasdaq generally divide their boards between industry 98 and non-industry 99 (including public) 100 directors, with a number of exchanges requiring that at least 50% of the board be composed of public or non-industry directors. 101 The proposed governance rules' definition of independence is based largely on the current notion of a “public” director. Like the recently-adopted NYSE and NASD rules for listed issuers, 102 the proposed governance rules also would include specific circumstances that preclude a director from being considered an independent director. 103 The Commission believes that requiring exchanges and associations to adhere to the high standards set forth in the proposed rules should help foster a greater degree of independent decision-making by the exchanges' and associations' governing bodies. In the Commission's view, the proposed rules should promote the goals of the Exchange Act that SROs be so organized and have the capacity to carry out their purposes. 104 98 An “industry” director is generally an individual who is an officer, director or employee of a broker or dealer or an affiliate of a broker or dealer, a consultant or employee of the exchange itself, or an exchange permit holder. See, e.g. , NASD Bylaws, Articles I(n) and I(o) and Phlx Bylaws, Article I, Section 1-1(m). 99 A “non-industry” director may be an individual who has some relationship with the SRO or the financial services industry; thus, a non-industry director could not be considered truly “public.” For example, officers and employees of issuers listed on the exchange are considered non-industry directors. See, e.g. , Phlx Bylaws, Article I, Section 1-1(t) and CHX Bylaws, Article III, Section 10(1). 100 A “public” director is generally an individual who has no material business relationship with a broker or dealer or with the exchange or association. See, e.g. , NASD Bylaws, Articles I(ee) and I(ff); Phlx Bylaws, Article I, Section 1-1(y); and CHX Bylaws, Article III, Section 10(2). 101 For example, the BSE's board is composed of the Chairman, the Vice-Chairman and twenty other directors, ten of whom must represent the securities industry and ten of whom must represent the public. See BSE Constitution, Article II, Section 1. At least 50% of the directors on PCX's board are required to be persons from the public and cannot be affiliated with a broker or dealer or employed by, or involved in any material business relationship with, PCX or its affiliates. See PCX Bylaws, Article III, Section 3.02(a). 102 See Securities Exchange Act Release No. 48745, supra note 28; NYSE Listed Company Manual Section 303A.02(b); and NASD Rules 4350, 4200(a)(15), and IM-4200. 103 See proposed Rules 6a-5(b)(12) and 15Aa-3(b)(13). 104 See Sections 6(b) and 15A(b) of the Exchange Act, 15 U.S.C. 78f(b) and 78o-3(b). a. Determination of Independence. The proposals would specify that no director may qualify as an independent director unless the board affirmatively determines that the director has no material relationship with the exchange or association. 105 The term “material relationship” would be defined as a relationship, whether compensatory or otherwise, that reasonably could affect the independent judgment or decision-making of the director. 106 The proposals would require the board to make this independence determination upon the director's nomination and thereafter no less frequently than annually and as often as necessary in light of the director's circumstances ( e.g. , a job change or marriage that would disqualify the director from being considered independent). 107 The Commission believes that requiring an exchange's or association's board to make an affirmative determination of independence, and to reevaluate that decision at least annually, would increase the accountability of such board and would further the proposals' goal of requiring the board to be composed of a majority of truly independent directors. 108 The proposed rules would define the term “independent director” as a director who has no material relationship with the exchange or association or any affiliate of the exchange or association, any member 109 of the exchange or association or any affiliate of such member, or any issuer of securities that are listed or traded on the exchange or a facility of the exchange or association. 110 The Commission believes that the rigorous proposed definitions of “independent director” and “material relationship” should help assure that SRO boards are controlled by persons not subject to potential conflicts of interest, and thereby further the goals of Sections 6(b)(1) and 15A(b)(2) of the Exchange Act. 111 105 See proposed Rules 6a-5(c)(2) and 15Aa-3(c)(2). 106 See proposed Rules 6a-5(b)(13) and 15Aa-3(b)(14). 107 See proposed Rules 6a-5(c)(2) and 15Aa-3(c)(2). 108 Moreover, pursuant to proposed changes to exchange and association registration forms, this determination would be required to be disclosed, thereby fostering greater transparency of the SROs' governance processes. See proposed revised Form 1 and proposed new Form 2, infra Section IV. 109 For purposes of the proposed governance rules, the term “member” has the same meaning as set forth in Section 3(a)(3) of the Exchange Act, 15 U.S.C. 78c(a)(3). See proposed Rules 6a-5(b)(14) and 15Aa-3(b)(15). 110 See proposed Rules 6a-5(b)(12) and 15Aa-3(b)(13). See also infra note 230 (for a definition of “affiliate”). 111 15 U.S.C. 78f(b)(1) and 78 o -3(b)(2). See generally Sections 6(b) and 15A(b) of the Exchange Act, 15 U.S.C. 78f(b) and 78 o -3(b). In addition to the general criteria of no material relationship, the proposed rules would identify certain specific circumstances when a director would not be considered independent. 112 A director would not be considered independent if any of the following circumstances existed: 112 See proposed Rules 6a-5(b)(12) and 15Aa-3(b)(13). • The director, or an immediate family member, 113 is, or within the past three years was, employed by or otherwise has or had a material relationship with the exchange or association or any affiliate of the exchange or association; 114 113 The term “immediate family member” would be defined in the proposed rules as a person's spouse, parents, children, and siblings, whether by blood, marriage, or adoption, or anyone residing in such person's house. See proposed Rules 6a-5(b)(11) and 15Aa-3(b)(12). 114 See proposed Rules 6a-5(b)(12)(i) and 15Aa-3(b)(13)(i). • The director is, or within the past three years was, a member or employed by or affiliated with a member or any affiliate of a member, or the director has an immediate family member that is, or within the past three years was, an executive officer of a member or any affiliate of a member; 115 115 See proposed Rules 6a-5(b)(12)(ii) and 15Aa-3(b)(13)(ii). • The director, or an immediate family member, has received during any twelve month period within the past three years more than $60,000 in payments from the exchange or association, any affiliate of the exchange or association or from a member or any affiliate of a member; however, payments received in the form of compensation 116 for board or board committee services, compensation to an immediate family member who is not an executive officer of the exchange or association, any affiliate of the exchange or association or of a member or any affiliate of a member, and pension and other forms of deferred compensation for prior services, not contingent on continued service, would not disqualify a director as independent; 117 116 See proposed Rules 6a-5(b)(6) and 15Aa-3(b)(7) for the definition of the term “compensation.” 117 See proposed Rules 6a-5(b)(12)(iii) and 15Aa-3(b)(13)(iii). The Commission believes that compensation received as deferred compensation for prior service should not by itself exclude a director from being considered independent. However, the director would still need to satisfy the core definition of independence contained in the proposed rules. • The director, or an immediate family member, is a partner in, or controlling 118 shareholder or executive officer of, any organization to which, or from which, the exchange or association or any affiliate of the exchange or association made or received payments for property or services in the current or any of the past three full fiscal years that exceed 2% of the recipient's consolidated gross revenues for that year, or $200,000, whichever is more, other than certain payments arising solely from investments in the securities of the exchange or association or any facility or affiliate of the exchange or association or payments under non-discretionary charitable contribution matching programs; 119 118 See proposed Rules 6a-5(b)(7) and 15Aa-3(b)(8) for the definition of the term “control.” 119 See proposed Rules 6a-5(b)(12)(iv) and 15Aa-3(b)(13)(iv). • The director, or an immediate family member, is, or within the past three years was, an executive officer of an issuer of securities listed or primarily traded on the exchange or a facility of the exchange or association; 120 120 See proposed Rules 6a-5(b)(12)(v) and 15Aa-3(b)(13)(v). • The director, or an immediate family member, is, or within the past three years was, employed as an executive officer of another entity where any of the exchange's or association's executive officers serve on that entity's compensation committee; 121 121 See proposed Rules 6a-5(b)(12)(vi) and 15Aa-3(b)(13)(vi). • The director, or an immediate family member, is a current partner of the outside auditor of the exchange or association or any affiliate of the exchange or association, or was a partner or employee of the outside auditor of the exchange or association or any affiliate of the exchange or association who worked on the audit of the exchange or association or any affiliate of the exchange or association, at any time within the past three years; 122 or 122 See proposed Rules 6a-5(b)(12)(vii) and 15Aa-3(b)(13)(vii). • In the case of a director that is a member of the Audit Committee, 123 such director (other than in his or her capacity as a member of the Audit Committee, the board, or any other board committee), accepts, directly or indirectly, any consulting, advisory, or other compensatory fee from the exchange or association, any affiliate of the exchange or association, or a member or any affiliate of a member, other than fixed amounts of pension and other forms of deferred compensation for prior service, provided such compensation is not contingent in any way on continued service. 124 123 See infra Section II.B.3. for a discussion of the Audit Committee. 124 See proposed Rules 6a-5(b)(12)(viii) and 15Aa-3(b)(13)(viii). This requirement is commensurate with an independence requirement for non-investment company issuers contained in Rule 10A-3(b)(1)(ii) under the Exchange Act, 17 CFR 240.10A-3(b)(1)(ii), which pertains to listing standards relating to audit committees. The proposed requirement is designed to help assure that there are no fee arrangements between the exchange or association or any of its affiliates and the Audit Committee member that would impair the independence of the Audit Committee member. The Commission believes that the proposed circumstances that would preclude a determination of a director's independence—in effect, concluding that a “material relationship” exists under certain circumstances—should better assure that a majority of an SRO's board is truly independent, and thus should promote the statutory requirement that SROs be so organized and have the capacity to carry out the Exchange Act's purposes. 125 The proposed circumstances that would preclude a director from being considered independent are similar to criteria that are contained in SRO listing standards, which recently were approved by the Commission and are designed to address similar governance concerns and the conflicts of interest that can arise between a company's management and its public shareholders. 126 For example, the three-year look-back provision 127 is a feature of NYSE, NASD, and Amex rules for listed issuers; 128 the $60,000 restriction on payments received and the 2%/$200,000 threshold for payments received or made for property or services 129 are similar to factors contained in NASD and Amex listing rules; 130 and the definition of “immediate family member 131 is substantially the same as the definition of the term “family member” in the NASD's listing rules. 132 The Commission further notes that because SROs are member organizations and operate markets with listing requirements, the proposed rules would take into account specific relationships between the director and a member or listed company that could challenge the impartiality of the director. 133 125 See Sections 6(b)(1) and 15A(b)(2) of the Exchange Act, 15 U.S.C. 78f(b)(1) and 78o-3(b)(2). 126 See, e.g. , Securities Exchange Act Release Nos. 48745, supra note 28 and 48863 (December 1, 2003), 68 FR 68432 (December 8, 2003) (order approving governance standards for issuers of securities listed on Amex). 127 See proposed Rules 6a-5(b)(12)(i) through (vii) and 15Aa-3(b)(13)(i) through (vii). 128 See NYSE Listed Company Manual Section 303A.02(b); NASD Rules 4350, 4200(a)(15), and IM-4200; and Amex Company Guide, Part I, Section 121A. 129 See proposed Rules 6a-5(b)(12)(iii) and (iv) and 15Aa-3(b)(13)(iii) and (iv). 130 See NASD Rules 4350, 4200(a)(15), and IM-4200 and Amex Company Guide, Part I, Section 121A. 131 See proposed Rules 6a-5(b)(11) and 15Aa-3(b)(12). 132 See NASD Rule 4200(a)(14). 133 For example, the proposed governance rules state that a director would not be considered independent in the circumstance where a director is, or within the past three years was, a member or employed by or affiliated with a member, or the director has an immediate family member that is, or within the past three years was, an executive officer of a member or any affiliate of a member. Similarly, a director would not be considered independent in the circumstance where a director, or an immediate family member, is or within the past three years was an executive officer of an issuer of securities listed or primarily traded on the exchange or a facility of the association. See proposed Rules 6a-5(b)(12)(ii) and (iv) and 15Aa-3(b)(13)(ii) and (iv). In the Commission's view, the proposed relationship tests that would preclude a determination that a director is independent strike an appropriate balance and promote the goal of providing clear standards regarding the determination of independence. 134 The Commission believes that these criteria are indicative of whether directors can reach independent decisions that affect the SRO without competing pressures or conflicts of interest. For example, the fact that a director was an executive officer of a listed issuer more than three years prior to his or her nomination to the board is unlikely to have an influence on his or her decisions as a board member. On the other hand, a director's recent employment with a member does raise such concerns and would preclude a finding that he or she is independent. The Commission believes that these specific circumstances appropriately identify those relationships, such as recent employment, a business or financial relationship, or family ties, that are likely to impair the independence of a director. Further, there are practical reasons for relying on criteria that are similar to factors currently in place at the SROs for their listed issuers, as the SROs already are experienced in interpreting and applying those standards. The Commission emphasizes that the absence of any of the proposed relationship tests, of course, would not necessarily result in a determination of independence, as the board must still affirmatively determine that the director has no material relationship with the SRO. 134 See, e.g. , Higgs Report, supra note 91, at 37 and Richard C. Breeden, Restoring Trust: Report on Corporate Governance for the Future of MCI, Inc. (August 2002) (“Breeden Report”), at 61. b. Independent Board Requirements. The proposed governance rules would require exchanges and associations to establish policies and procedures to require each director, on his or her own initiative and upon request of the exchange or association, to inform the exchange or association of the existence or establishment of any relationship or interest that may reasonably be considered to bear on whether such director is an independent director. 135 Exchanges and associations also would be required to establish procedures for interested persons to communicate their concerns relating to any matter within the authority or jurisdiction of a Standing Committee directly to the independent directors. 136 135 See proposed Rules 6a-5(c)(3) and 15Aa-3(c)(3). 136 See proposed Rules 6a-5(c)(9) and 15Aa-3(c)(9). The proposed governance rules also would require that at least 20% of the total number of directors be selected by members. 137 In addition, the proposed governance rules would require that at least one director be representative of issuers and at least one director be representative of investors and, in each case, such director must not be associated with a member or broker or dealer. 138 The Commission believes that these provisions are consistent with the “fair representation” and “issuer and investor representation” requirements of the Exchange Act, which are discussed below. 139 137 See proposed Rules 6a-5(c)(4) and 15Aa-3(c)(4). See infra Section II.B.2.c. for a discussion of the statutory “fair representation” requirement. 138 See proposed Rules 6a-5(c)(5) and 15Aa-3(c)(5). 139 See infra Section II.B.2.c. Further, the proposed governance rules would require that when the board of an exchange or association considers any matter that is recommended by or otherwise is within the authority or jurisdiction of a Standing Committee, a majority of the directors who vote on the matter must be independent directors. 140 For example, assume an exchange has a board composed of nine independent directors and eight non-independent directors. If two independent directors do not participate in a board meeting but all the non-independent directors participate in such meeting, the matter could be voted upon only by the seven independent directors present and six of the eight non-independent directors present. 141 This proposal is intended to preserve and bolster the requirement that the majority of the board be independent, and is designed to assure that matters before the board that are within the authority or jurisdiction of the fully-independent Standing Committees are considered by and voted on by a majority of independent directors. 140 See proposed Rules 6a-5(c)(6) and 15Aa-3(c)(6). See infra Section II.B.3. for a discussion of the Standing Committees of the board. 141 Each SRO with non-independent directors would have to establish procedures for determining which non-independent directors would vote under such circumstances, consistent with the “fair representation” requirements discussed below. In addition, the proposed governance rules would require that if the exchange or association fails to comply with the requirement that the board be composed of a majority of independent directors because there is a vacancy on the board or a director ceases to be independent, the exchange or association must remedy such non-compliance by the earlier of the exchange's or association's next annual meeting or one year from the date of the occurrence of the event that caused the non-compliance. 142 This provision is consistent with the standard imposed on listed issuers and, in our view, should assure prompt remediation, yet provide exchanges and associations with a reasonable period of time, consistent with their governance procedures, to cure any failure to satisfy the majority independence requirement. 142 See proposed Rules 6a-5(c)(8) and 15Aa-3(c)(8). c. Fair Representation. Section 6(b)(3) of the Exchange Act requires that the rules of an exchange assure a fair representation of its members in the selection of its directors and administration of its affairs (“fair representation requirement”), and must provide that one or more directors be representative of issuers and investors and not be associated with a member of the exchange, broker or dealer (“issuer and investor representation requirements”). 143 Section 15A(b)(4) of the Exchange Act contains an identical requirement with respect to the rules of an association. 144 143 15 U.S.C. 78f(b)(3). 144 15 U.S.C. 78 o -3(b)(4). Consistent with the fair representation requirement, the proposed governance rules would require that the Nominating Committee 145 administer a fair process that provides members 146 with the opportunity to select at least 20% of the total number of directors (“member candidates”). 147 This requirement is not intended to prohibit exchanges and associations from having boards composed solely of independent directors. If an exchange's or association's board is composed wholly of independent directors, the candidate or candidates selected by members would have to be independent. This “20% standard” for member candidates comports with previously-approved SRO rule changes that raised the issue of fair representation. 148 The Commission preliminarily believes that the proposed 20% requirement strikes a proper balance by giving members a practical voice in the governance of the exchange or association and the administration of its affairs, without jeopardizing the overall independence of the board. 145 See infra Section II.B.3. for a discussion of the fully-independent Nominating Committee. 146 See supra note 109 for the definition of the term “member.” 147 See proposed Rules 6a-5(f)(3) and 15Aa-3(f)(3). 148 See Securities Exchange Act Release Nos. 48946, supra note 36 and 49718, supra note 61. The Commission notes that it previously has taken the position that the fair representation requirement could be satisfied if the exchange's or association's rules provided that members constitute at least 20% of the individuals serving on the Nominating Committee. See, e.g. , Securities Exchange Act Release Nos. 49098 and 49718, supra note 61. Because the proposed governance rules would mandate that the Nominating Committee consist solely of independent directors, an exchange or association no longer would have the option of satisfying the fair representation requirement by having at least 20% member representation on its Nominating Committee. Although the Commission previously approved SRO proposals that allowed members to constitute at least 20% of the exchange's or association's Nominating Committee, the Commission now believes that the governance of exchanges and associations would be strengthened by requiring a fully independent Nominating Committee. An exchange or association would have some leeway in implementing the fair process for members to select board candidates. For example, the Commission believes that the exchange or association would have a fair process if it established an advisory panel of members that reports to the Nominating Committee, and that is directly responsible for nominating member candidates for the board. Another type of fair process would be for the member advisory panel to make recommendations to the Nominating Committee, with the Nominating Committee required to nominate the member candidates identified by the member advisory panel. The member candidates, of course, would be required to satisfy all relevant eligibility criteria for directors (including independence requirements, if applicable). The fair process must also ensure that the member candidates actually are provided seats on the board. To further address the fair representation requirement, proposed Rules 6a-5(c)(7) and 15Aa-3(c)(7) would require exchanges and associations to adopt rules to establish a fair process for the nomination of alternative candidates by members through a petition process. This requirement would provide members with the means to nominate one or more alternative candidates representative of members. The percentage of members that is necessary to put forth such alternative member candidate or candidates would be required to be specified in the exchange's or association's rules, and could not exceed 10% of the total number of members. 149 The Commission believes that this 10% requirement strikes an appropriate balance in that it provides members a practical mechanism to put forth alternative candidates, without jeopardizing the overall integrity of the nominating process. The Nominating Committee would be required to administer the petition process established by the exchange's or association's rules. 150 149 See proposed Rules 6a-5(c)(7) and 15Aa-3(c)(7). SROs currently have rules that permit members to engage in a petition process to nominate candidates. For example, pursuant to Phlx rules, members representing not less than 50 votes may, by written petition, independently nominate an individual for the position of on-floor governor, and members representing not less than 75 votes may propose an entire ticket, or any portion thereof, for on-floor governor positions which are vacant. See Phlx Bylaws, Article III, Section 3-7. A similar process is employed at the NYSE where members may propose by written petition potential nominees for positions to be filled at elections. Any such nominee must be endorsed by not less than 40 members, and not less than 100 members may petition for an entire ticket, or any portion thereof. See NYSE Constitution, Article III, Section 1. 150 See proposed Rules 6a-5(f)(3) and 15Aa-3(f)(3). To address the issuer and investor representation requirement, the Nominating Committee would be required to nominate at least one director who is representative of issuers and at least one director who is representative of investors and who, in each case, is not associated with a member or broker or dealer. 151 This provision simply would codify in Commission rules the requirements set forth in Sections 6(b)(3) and 15A(b)(4) of the Exchange Act. 152 151 See proposed Rules 6a-5(f)(4) and 15Aa-3(f)(4). For example, the Nominating and Governance Committee of the NYSE currently is required to recommend to the board at least one individual who is representative of issuers and at least one individual who is representative of investors. See NYSE Constitution, Article IV, Sections 2 and 12. 152 15 U.S.C. 78f(b)(3) and 78 o -3(b)(4). The Commission notes that it recently approved the NYSE's proposal to establish a fully independent board, finding that such a board could be consistent with the Exchange Act and the fair representation and issuer and investor representation requirements. 153 As discussed above, the Commission only is proposing to require exchanges and associations to elect majority-independent boards, although an SRO may elect to impose a more rigorous requirement. The Commission believes that an exchange's or association's board could be wholly-independent based on the independence criteria contained in the proposed governance rules, provided that its rules satisfy the fair representation requirement and issuer and investor representation requirements ( i.e. , by requiring that at least 20% of the independent directors are selected by members, that at least one independent director is representative of issuers, and at least one independent director is representative of investors). 153 See Securities Exchange Act Release No. 48946, supra note 36. 3. Standing Committees Recent developments have highlighted the critical role that board committees play in the governance of exchanges and associations and the importance of having key committees function independently of the pressures that otherwise could be exerted on them by management, members or other interested parties. 154 The Commission is proposing that each exchange and association, at a minimum, have the following standing committees, or their equivalent: Nominating Committee; Governance Committee; Compensation Committee; Audit Committee; and Regulatory Oversight Committee (collectively, “Standing Committees”). 155 The proposed governance rules also would require that each Standing Committee be composed solely of independent directors. 156 The Commission preliminarily believes that the functions to be performed by these committees are important to the effective administration of an exchange or association. Moreover, these are the committees that generally are charged with overseeing the SRO's regulatory responsibilities, including the SRO's commitment of financial resources to fund those responsibilities. Thus, the Commission believes that requiring all of the members of these Standing Committees to be independent would result in a greater degree of objective decision-making with respect to the exchange's or association's core responsibilities and would further the Exchange Act's goal that SROs be so organized and have the capacity to carry out their self-regulatory obligations. 157 154 See supra Section I.B. 155 See proposed Rules 6a-5(b)(21) and (e)(1) and 15Aa-3(b)(22) and (e)(1). An SRO would not be precluded from allowing a single committee to carry out the functions of two Standing Committees as long as the committee consisted solely of independent directors, e.g. , the functions of the Nominating Committee and the Governance Committee could be carried out by a single committee. Also, to the extent that a Standing Committee of the exchange or association carries out responsibilities on behalf of a regulatory subsidiary, the regulatory subsidiary would not be required to have a Standing Committee that performs the same functions. See proposed Rules 6a-5(a) and 15Aa-3(a). 156 See proposed Rules 6a-5(f)(1), (g)(1), (h)(1), (i)(1), and (j)(1) and 15Aa-3(f)(1), (g)(1), (h)(1), (i)(1), and (j)(1). This provision is consistent with the recommendations in the Higgs Report, ABA Task Force Report and the Breeden Report. See Higgs Report, supra note 91, at 60-61; ABA Task Force Report, supra note 91, at 63-67; and Breeden Report, supra note 134, at 103. 157 See Sections 6(b)(1) and 15A(b)(2) of the Exchange Act, 15 U.S.C. 78f(b)(1) and 78 o -3(b)(2). The proposed governance rules would require each Standing Committee to have the authority to direct and supervise inquiries into any matter brought to its attention within the scope of its duties and to obtain advice and assistance from independent legal counsel and other advisors as it determines necessary to carry out its duties. 158 In addition, each Standing Committee, other than the Governance Committee, would be required to conduct an annual performance self-evaluation. 159 Rather than conduct an annual self-evaluation of the committee's performance, the Governance Committee would be required to conduct an annual performance evaluation of the governance of the exchange or association as a whole, including the effectiveness of the board and its committees. 160 The Commission believes that these self-evaluations should assist the exchange or association in identifying strengths and deficiencies in the governance, administration, regulatory programs, and financial matters of the exchange or association. 161 158 See proposed Rules 6a-5(e)(2) and 15Aa-3(e)(2). The Business Roundtable Report noted that it may be appropriate for boards and committees to seek advice from outside advisors and that board and committee access to outside advisors is an important element of corporate governance. See Business Roundtable Report, supra note 91, at 27-28. 159 See proposed Rules 6a-5(f)(5), (h)(3), (i)(3) and (j)(6) and 15Aa-3(f)(5), (h)(3), (i)(3) and (j)(6). The proposed rules would require each exchange and association to provide sufficient funding and other resources, as determined by each Standing Committee, to permit the Standing Committees to fulfill their responsibilities and to retain independent legal counsel and other advisors. See proposed Rules 6a-5(e)(3) and 15Aa-3(e)(3). 160 See proposed Rules 6a-5(g)(3) and 15Aa-3(g)(3). 161 The ABA Task Force Report recommended periodic evaluations by the directors of the effectiveness and adequacy of meetings of the board and its committees. See ABA Task Force Report, supra note 91, at 72. The Business Roundtable Report similarly recommended that the “performance of the full board should be evaluated annually, as should the performance of its committees,” to allow the board to determine whether it and its committees were following the procedures necessary to function effectively. See Business Roundtable Report, supra note 91, at 28. In order to function effectively, each Standing Committee would need to be clear as to its role. Accordingly, the proposed rules would require that each Standing Committee have a written charter that addresses such committee's purpose and responsibilities, which, at a minimum, must be as follows: • Nominating Committee: to identify individuals qualified to become board members, consistent with criteria approved by the board and administer a process for the nomination of individuals to the board. 162 162 See proposed Rules 6a-5(f)(2) and 15Aa-3(f)(2). • Governance Committee: to develop and recommend to the board a set of governance principles applicable to the exchange or association and to oversee the evaluation of the board and management. 163 163 See proposed Rules 6a-5(g)(2) and 15Aa-3(g)(2). • Compensation Committee: to have direct responsibility to review and approve corporate goals and objectives relevant to the compensation of the executive officers of the exchange or association; evaluate the performance of the executive officers in light of those goals and objectives; and consider and approve recommendations with respect to the compensation level of the executive officers, based on this evaluation. 164 164 See proposed Rules 6a-5(h)(2) and 15Aa-3(h)(2). • Audit Committee: to assist the board in oversight of the integrity of the exchange's or association's financial statements; the exchange's or association's compliance with related legal and regulatory requirements; the qualifications and independence of the exchange's or association's auditor, including direct responsibility for the hiring, firing, and compensation of the auditor, overseeing the auditor's engagement, meeting regularly in executive session with the auditor, reviewing the auditor's reports with respect to the exchange's or association's internal controls, and pre-approving all audit and non-audit services performed by the auditor; determining the budget and staffing of the exchange's or association's internal audit department; and establishing procedures for the receipt of complaints regarding accounting, internal accounting controls, or auditing matters of the exchange or association and the confidential submission by employees of the exchange or association of concerns regarding questionable accounting or auditing matters. 165 165 See proposed Rules 6a-5(i)(2) and 15Aa-3(i)(2). The complaint procedures for the Audit Committee are commensurate with the complaint procedures contained in Rule 10A-3(b)(3) under the Exchange Act, 17 CFR 240.10A-3(b)(3), which pertain to audit committees of listed issuers. • Regulatory Oversight Committee: to assure the adequacy and effectiveness of the exchange's or association's regulatory program; assess the exchange's or association's regulatory performance; determine the regulatory plan, programs, budget, and staffing for the regulatory functions of the exchange or association; assess the performance of, and recommend compensation and personnel actions involving, the Chief Regulatory Officer 166 and other senior regulatory personnel 167 to the Compensation Committee; monitor and review regularly with the Chief Regulatory Officer matters relating to the exchange's or association's surveillance, examination, and enforcement units; assure that the exchange's or association's disciplinary and arbitration proceedings are conducted in accordance with the exchange's or association's rules and policies and any other applicable laws or rules, including those of the Commission; prior to the exchange's or association's approval of an affiliated security 168 for listing, certify that such security meets the exchange's or association's rules for listing; and approve any reports filed with the Commission as required by proposed Regulation AL (§ 242.800). 169 166 See proposed Rules 6a-5(n)(3) and 15Aa-3(n)(3), which would require exchanges and associations to appoint a Chief Regulatory Officer. See also infra Section II.B.8.a. 167 “Senior regulatory personnel” means those individuals, including the proposed Chief Regulatory Officer, who are the senior managers of the SRO's regulatory program. 168 The term “affiliated security” is proposed to be defined as any security issued by an affiliated issuer, except that it would not include any option exempt from the Securities Act pursuant to Rule 238 thereunder, 17 CFR 230.238, and any security futures product exempt from the Securities Act pursuant to Section 3(a)(14) thereof, 15 U.S.C. 77c(a)(14). See proposed Rules 6a-5(b)(3) and 15Aa-3(b)(3). An “affiliated issuer” is proposed to be defined to mean an exchange, an association, an SRO trading facility of the exchange or association, an affiliate of the exchange or association, or an affiliate of an SRO trading facility of the exchange or association. See proposed Rules 6a-5(b)(2) and 15Aa-3(b)(2). “SRO trading facility” is proposed to be defined in proposed Rules 6a-5(b)(20) and 15Aa-3(b)(21) as any facility of a national securities exchange or registered securities association, respectively, that executes orders in securities. 169 See proposed Rules 6a-5(j)(2) and 15Aa-3(j)(2). See infra Section III. for a discussion of proposed Regulation AL. The Commission believes that the foregoing proposed responsibilities of the Standing Committees would foster the effectiveness of such committees and further the objective of good governance on the part of SROs. Exchanges and associations, of course, could elect to assign additional responsibilities to the Standing Committees, as long as they were otherwise consistent with the proposed governance rules. In addition, any committee, subcommittee, or panel that is responsible for conducting hearings, rendering decisions, and imposing sanctions with respect to disciplinary matters would be subject to the jurisdiction of the Regulatory Oversight Committee. 170 Although the Regulatory Oversight Committee would be required to be composed solely of independent directors, 171 the Commission believes that, to satisfy the fair representation requirement, the exchange or association must provide for member participation on any committee, subcommittee, or panel that is responsible for conducting hearings, rendering decisions, and imposing sanctions with respect to member disciplinary matters. 172 In order to satisfy this requirement, the proposal would require that at least 20% of the members of any such committee, subcommittee, or panel be members of the exchange or association. 173 The Commission believes that this provision furthers the requirement of the Exchange Act that an exchange or association assure a fair representation of members in the administration of its affairs. 174 By proposing to require members to be represented on bodies that consider disciplinary matters relating to members, members would be assured input into a key aspect of SRO administration that is of critical importance to them. The Commission believes that the proposed 20% requirement would provide members with a practical voice in disciplinary matters without compromising the overall independence of the disciplinary process, which would be overseen by the fully independent Regulatory Oversight Committee, or the ability of the exchange or association to carry out its obligations under the Exchange Act. The Commission notes that this 20% standard is consistent with prior SRO proposals that were approved by the Commission and that provided members with a voice in the exchange's or association's disciplinary process. 175 The Commission notes, however, that unlike previously-approved structures, the proposal would require any committee, subcommittee, or panel containing members to report to the fully-independent Regulatory Oversight Committee. This requirement would be necessary because the Regulatory Oversight Committee, which is proposed to be fully independent, is intended to be the committee responsible for oversight of regulatory matters, including disciplinary matters. 170 See proposed Rules 6a-5(j)(4) and 15Aa-3(j)(4). 171 See proposed Rules 6a-5(j)(1) and 15Aa-3(j)(1). 172 See proposed Rules 6a-5(j)(3) and 15Aa-3(j)(3). 173 See id. 174 See Sections 6(b)(3) and 15A(b)(4) of the Exchange Act, 15 U.S.C. 78f(b)(3) and 78 o -3(b)(4). 175 See, e.g. , Securities Exchange Act Release Nos. 50057 (July 22, 2004), 69 FR 45091 (July 28, 2004) (notice of filing of proposed rule change including to require that the Amex Adjudicatory Council, which has the authority to act for the Amex Board of Governors with respect to, among other things, any appeal or review of a disciplinary proceeding, be composed of three industry governors and three independent governors) and 49718, supra note 61 (order approving the proposed rules pertaining to the demutualization of PCX and finding that permit holders would retain a voice in the administration of the affairs of the reorganized PCX, including the rulemaking and the disciplinary process, through participation on various committees). The Regulatory Oversight Committee also would be required to oversee the preparation of the exchange's or association's annual regulatory report, as required by proposed Rule 17a-26 of the Exchange Act. 176 176 See proposed Rules 6a-5(j)(5) and 15Aa-3(j)(5); proposed Rule 17a-26. See infra Section V. for a discussion of proposed Rule 17a-26. 4. Other Committees of the Board The proposed governance rules would permit an exchange or association to establish such other committees of the board as it determines to be appropriate; however, if such committee has the authority to act on behalf of the board, that committee would be required to be composed of a majority of independent directors. 177 For example, if the exchange or association has established an Executive Committee that is empowered to act on the board's behalf, such committee would be required to be composed of a majority of independent directors. Further, the exchange or association could not delegate to any committee not consisting solely of independent directors the authority to act on matters that otherwise are within the jurisdiction of a Standing Committee. 178 177 See proposed Rules 6a-5(k)(1) and 15Aa-3(k)(1). 178 See id. In addition, the Commission is proposing that at least 20% of the persons serving on any committee that is not a Standing Committee and any committee, subcommittee, or panel that is subject to the jurisdiction of a Standing Committee, and that is responsible for providing advice with respect to trading rules or disciplinary rules, be members of the exchange or association. 179 The Commission believes that, consistent with the Exchange Act's fair representation requirement, members should be provided with the opportunity to formally provide input on the development of, or changes to, trading and disciplinary rules. Rulemaking in this area is a key aspect of SRO administration and can have a significant impact on members. The Commission preliminarily believes that, as in prior contexts, the 20% requirement affords members a practical voice in the formulation of rules important to them. The Commission notes that it has previously approved SRO proposed rule changes that provide members with a role in developing rules relating to trading and disciplinary matters. 180 179 See proposed Rules 6a-5(k)(2) and 15Aa-3(k)(2). 180 See, e.g. , Securities Exchange Act Release No. 49718, supra note 61 (order approving the PCX Options Trading Permit Advisory Committee, which among other things, acts in an advisory capacity regarding rule changes related to disciplinary matters and trading rules and which must be made up entirely of options trading permit holders). 5. Other Requirements Applicable to Directors and Officers The duties and responsibilities imposed by the Exchange Act on exchanges and associations make clear that these SROs are charged with an important public trust and play an integral role in, among other things, maintaining securities markets that are free from fraudulent or manipulative acts or practices and that promote just and equitable principles of trade. 181 Exchanges and associations also are charged with appropriately disciplining their members pursuant to fair procedures. 182 To further these and other statutorily-imposed requirements applicable to exchanges and associations, the proposed governance rules would require that the rules of the exchange or association prohibit a person subject to any statutory disqualification, within the meaning of Section 3(a)(39) of the Exchange Act, 183 from being a director or officer of the exchange or association. 184 The Commission believes that the integrity of the exchange or association—as well as its ability to perform its statutorily required functions—could be seriously undermined if individuals subject to these serious regulatory or legal sanctions were permitted to serve on the board or as an officer of the exchange or association. 181 See Sections 6(b)(5) and 15A(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(5) and 78 o -3(b)(6). 182 See Sections 6(b)(6)-(7) and 15A(b)(7)-(8) of the Exchange Act, 15 U.S.C. 78f(b)(6)-(7) and 78 o -3(b)(7)-(8). 183 15 U.S.C. 78c(a)(39). 184 See proposed Rules 6a-5(l)(1) and 15Aa-3(l)(1). In addition, the proposed rules would require exchanges and associations to explicitly mandate that each director, in discharging his or her responsibilities as a member of the board, reasonably consider all requirements applicable to the exchange or association under the Exchange Act. 185 Exchanges and associations, as regulated entities, have certain obligations under the Exchange Act, 186 and their directors must take these obligations into account when discharging their responsibilities. We note that directors have fiduciary obligations under state law. The Commission believes, however, that expressly requiring directors to take into account the exchange's or association's obligations under the Exchange Act should help promote greater awareness and accountability on the part of directors, thus furthering the objectives of the Exchange Act. 185 See proposed Rules 6a-5(l)(2) and 15Aa-3(l)(2). 186 See, e.g. , 15 U.S [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A04-26153. Public record. Not legal advice.