[18389]
January 6, 2005
TO: EQUITY MARKETS ADVISORY COMMITTEE No. 2-05
SEC RULES MEMBERS No. 3-05
RE: SEC PROPOSALS RELATING TO SELF-REGULATORY ORGANIZATIONS
The Securities and Exchange Commission has proposed new rules and amendments to
existing rules and forms under the Securities Exchange Act of 1934 relating to: (1) the
governance, administration, transparency and ownership of self-regulatory organizations
(“SROs”) that are national securities exchanges or registered securities associations; (2) the
periodic reporting of information by SROs regarding their regulatory programs; and (3) the
listing and trading by SROs of their own or affiliated securities.1 The Release states that
developments involving SRO governance, as well as concerns raised by recent enforcement
actions and inspections involving SROs, have prompted the Commission to consider new
regulatory measures with respect to SROs. The most significant aspects of the proposals are
summarized below.
Governance Standards
The proposals would impose new governance standards on national securities
exchanges and registered securities associations. In particular, the proposals would require an
exchange’s or association’s board of directors to be composed of a majority of independent
directors. 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.2 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. 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. In
1 Securities Exchange Act Release No. 50699 (November 18, 2004), 69 FR 71126 (December 8, 2004) (“Release”).
Comments on the proposals are due to the SEC no later than January 24, 2005. The Release can be found on the SEC’s
website at http://www.sec.gov/rules/proposed/34-50699.htm.
2 A director also must not have any material relationship with any affiliate of the exchange or association, any
member 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.
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addition to the general requirements regarding material relationships, the proposed rules
identify certain specific circumstances when a director would not be considered independent.3
The proposals would require that each exchange and association have several standing
committees of the board including, at a minimum, the following committees: Nominating
Committee; Governance Committee; Compensation Committee; Audit Committee; and
Regulatory Oversight Committee (“Standing Committees”). Each Standing Committee would
be composed solely of independent directors. In addition, each Standing Committee, other than
the Governance Committee, would be required to conduct an annual performance self-
evaluation. 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.
The proposals would not require that an exchange’s or association’s Chairman of the
board be an independent director in all circumstances. However, if the exchange’s or
association’s CEO also is not the Chairman, the proposals would require that the Chairman be
an independent director. If the Chairman and CEO were the same individual, the board would
be required to designate an independent director as a “lead director” to preside over executive
sessions of the board.
Separation of Regulatory Functions and Market Operations
The proposals would require that each exchange and association separate its regulatory
function from its market operations and other commercial interests in order to help insulate its
regulatory activities from conflicts of interest that may arise by virtue of its market operations.
Specifically, the proposals would require that the exchange’s or association’s regulatory
program be either: (1) structurally separated from the exchange’s or association’s market
operations and other commercial interests by means of separate legal entities; or (2) functionally
separated within the same legal entity from the exchange’s or association’s market operations
and other commercial interests. In either case, the proposals would require that the board
appoint a Chief Regulatory Officer to administer the regulatory program and that the Chief
Regulatory Officer report directly to the proposed independent Regulatory Oversight
Committee.
Use of Funds from Regulatory Fees, Fines or Penalties
The proposals would require that an exchange or association direct funds collected from
regulatory fees, fines or penalties exclusively to fund the regulatory operations and other
programs of the exchange or association related to its regulatory responsibilities. Regulatory
fees would include all member fees, dues and assessments charged and collected by an
exchange or association that are assessed for the purpose of funding the operation of the
regulatory program. Regulatory fines or penalties would include any revenue received from
fines or penalties resulting from disciplinary or enforcement actions.
3 The proposals also would require that at least 20 percent of the total number of directors be selected by the
exchange’s or association’s members and that at least one director be representative of issuers and at least one
director be representative of investors.
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Ownership Restrictions
The proposals would require that an exchange or association prohibit any member that
is a broker or dealer from owning and voting more than 20 percent of the ownership interest in
the exchange or the association, or a facility of the exchange or association. 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 percent of
any interest in the exchange or association, or any facility thereof.
Code of Ethics
The proposals would require that the rules of each exchange and association provide for
a code of ethics for directors, officers and employees, and provide that any waiver of the code of
ethics must be approved by the board, or the appropriate board committee. The code of ethics,
at a minimum, would establish policies and procedures regarding: conflicts of interest;
corporate opportunities; confidentiality; fair dealing; protection and proper use of the
exchange’s or association’s assets; compliance with laws, rules, and regulations by directors,
officers and employees; and the reporting of illegal or unethical behavior. The proposals also
would require that each exchange and association adopt governance guidelines that, at a
minimum, establish policies regarding: director qualification standards; director
responsibilities; director access to management and independent advisors; director
compensation; director orientation and continuing education; management succession; and
annual performance evaluations of the board.
Disclosure by SROs
The proposals would amend the forms for registration as an exchange or 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. Specifically, the 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’ web sites.
Exchanges and Associations Listing Affiliated Securities
The proposals would prohibit an exchange or association from approving for listing an
affiliated security unless the exchange’s or association’s Regulatory Oversight Committee
certified that the security satisfies the exchange’s or association’s rules for listing. In addition, if
an affiliated security is listed on, approved for trading on, or trades pursuant to the rules of, an
exchange or association, the proposals would impose reporting and notice obligations on the
exchange or association. Specifically, the proposal would require the exchange or association to
file a quarterly report with the Commission summarizing its monitoring of the affiliated
security’s compliance with its listing rules. The exchange or association would be required to
include in the quarterly report a summary of its surveillance of the trading of affiliated
securities by its members. Finally, the proposals would require the exchange’s or association’s
Regulatory Oversight Committee to approve the report before it is filed with the Commission.
In addition to the quarterly report, the exchange or association would be required to file with
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the Commission annually a report prepared by a third party analyzing compliance by the
affiliated security with applicable listing rules of the exchange or association.
Periodic Reporting Obligations
In order to enhance the oversight of SROs’ compliance with, and enforcement of, federal
statutory and regulatory provisions, as well as SROs’ own rules, the proposals would establish
a system of quarterly and annual reporting by exchanges and associations with respect to key
aspects of their regulatory programs. The information required by the proposals would
encompass all surveillance, examination, and disciplinary programs. In addition, the proposals
would compel exchanges and associations to review, on a quarterly and annual basis, the
operation and performance of their regulatory programs.
Ari Burstein
Associate Counsel