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

1. Background
    
1. Self-Regulation under the Exchange Act
    
2. 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
    
2. Fair Administration and Governance of National Securities Exchanges and Registered Securities Associations
    
1. Background and Need for Proposed Rules 6a-5 and 15Aa-3
    
2. 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
    
1. Determination of Independence
    
2. Independent Board Requirements
    
3. 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
    
1. Independence of Regulatory Program
    
2. Use of Regulatory Fees, Fines, and Penalties
    
3. Confidentiality of Regulatory and Trading Information
    
9. Member Voting and Ownership Limitations
    
1. Members’ Interests Aggregated with Their Related Persons
    
2. Solicitation of Revocable Proxies
    
3. Requirement to Divest Ownership Interest and Restrict Voting
    
4. Ability to Obtain Information
    
10. Code of Conduct and Ethics and Governance Guidelines
     
11. Exemption Provision
     
12. Implementation
     
3. Request for Comment
    
3. Proposed Regulation AL – National Securities Exchanges and Registered Securities Associations Listing Affiliated Securities
    
1. Background and Need for Proposed Regulation AL
    
2. 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
    
3. Request for Comment
    
4. Disclosure by SROs
    
1. Overview of Proposed Amendments to Registration Forms for Exchanges and Associations
    
2. 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
    
3. 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
    
1. Governance Guidelines
    
2. Code of Conduct and Ethics
    
5. Organizational Charts
    
6. Regulatory Program
    
7. Audited Financial Statements and Other Financial Information
    
1. Budget and Revenues Devoted to Regulatory Activities
    
2. Revenues and Expenses
    
3. 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
     
1. Constitution, Articles of Incorporation, Bylaws, and Rules
    
2. Rulings and Interpretations
    
3. Officers
    
4. Financial Statements of Affiliates
    
5. General Information Relating to Affiliates and SRO Trading Facilities
    
6. Operation of SRO Trading Facilities
    
7. Membership Forms
    
8. Financial Responsibility and Minimum Capital Requirements of Members
    
9. Listing Applications
    
10. Criteria for Membership
     
11. List of Members
     
12. Securities Listed and Traded
     
4. Timing and Format of Revised Form 1 and New Form 2
    
5. Proposed Changes to Rule 15Aa-1
    
6. Proposed Repeal of Forms X-15AJ-1 and X-15AJ-2
    
7. Request for Comment
    
5. Periodic Reporting Obligations of Exchanges and Associations
    
1. Background and Need for Proposed Rule 17a-26
    
2. Scope and Timing of Reports Required by Proposed Rule 17a-26
    
1. Quarterly Reports
    
2. Annual Reports
    
3. Format of Reports
    
4. 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
    
5. 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
    
6. Audit Report of Electronic SRO Trading Facilities
    
7. Certifications
    
8. Interim Changes
    
9. Confidentiality of Reports
    
10. Compliance Date
     
11. Exemptions and Extensions of Time for Filing Reports
     
12. Filing of Reports
     
13. Request for Comment
     
6. Proposed Rule 17a-27
    
1. Background and Need for Proposed Rule 17a-27
    
2. 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
    
3. Request for Comment
    
7. Implementation
    
8. General Request for Comment
    
9. Paperwork Reduction Act Analysis
    
1. Proposed Rule 3b-19
    
2. 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
    
3. 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
    
4. 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
    
5. Proposed Amendments to Rule 17a-1
    
6. 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
    
7. 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
    
8. Request for Comment
    
10. Consideration of Costs and Benefits
     
1. Costs and Benefits of Proposed Rules 6a-5 and 15Aa-3
    
1. Benefits
    
2. Costs
    
3. Request for Comment
    
2. Costs and Benefits of Proposed Regulation AL
    
1. Benefits
    
2. Costs
    
3. Request for Comment
    
3. 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
    
4. Costs and Benefits of Proposed Amendments to Rule 17a-1
    
1. Benefits
    
2. Costs
    
3. Request for Comment
    
5. Costs and Benefits of Proposed Rule 17a-26
    
1. Benefits
    
2. Costs
    
3. Request for Comment
    
6. Costs and Benefits of Proposed Rule 17a-27
    
1. Benefits
    
2. Costs
    
3. Request for Comment
    
11. Consideration of Burden on Competition, and Promotion of Efficiency, Competition, and Capital Formation
     
12. Consideration of Impact on the Economy
     
13. Regulatory Flexibility Act Certification
     
14. 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 Act¹ 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

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 rules⁶ 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

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

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

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

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

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

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 rule⁴⁰ 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.

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.

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 actions⁴³ 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.

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

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

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

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

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

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.

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

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.

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

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.

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.

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

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

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.

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 services⁷⁹ 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

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

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 board⁸⁸ 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

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

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 board⁹⁵ – 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.

The exchanges, the NASD, and Nasdaq generally divide their boards between industry⁹⁸ and non-industry⁹⁹ (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

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 member¹⁰⁹ 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

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:

• 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
   
• 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
   
• 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 compensation¹¹⁶ 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
   
• the director, or an immediate family member, is a partner in, or controlling¹¹⁸ 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
   
• 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
   
• 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

• 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
   
• 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

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 provision¹²⁷ 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 services¹²⁹ 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

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.

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

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

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.

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.

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

Consistent with the fair representation requirement, the proposed governance rules would require that the Nominating Committee¹⁴⁵ administer a fair process that provides members¹⁴⁶ 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.

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

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

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).

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

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

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

• 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

• 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

• 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

• 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 Officer¹⁶⁶ and other senior regulatory personnel¹⁶⁷ 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 security¹⁶⁸ 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

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.

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

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

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

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.

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.

6. Executive Sessions of the Board

The Commission believes that independent directors must be provided with the opportunity to discuss any important matters regarding the exchange or association in a frank and open manner, free from the presence of management.¹⁸⁷ Therefore, the Commission proposes that the independent directors of the exchange’s or association’s board meet regularly in executive session.¹⁸⁸ The Commission, however, is not proposing a minimum frequency for the independent directors to meet regularly in executive session; rather, it is leaving this decision to the board, to be based on the facts and circumstances of the particular exchange or association.

The proposed governance rules also would require that independent directors have the authority to direct and supervise inquiries into any matter brought to their attention within the scope of their duties, and to obtain advice and assistance from independent legal counsel and other advisors, as they determine necessary to carry out their duties.¹⁸⁹ Accordingly, the proposed governance rules would require that the exchange or association provide sufficient funding and other resources, as determined by the independent directors, to permit the independent directors to fulfill their responsibilities and to retain independent legal counsel and other advisors.¹⁹⁰ The Commission believes that the proposed governance rules should provide independent directors with the ability to serve effectively, including assuring that they have adequate resources and funding to perform their duties. In addition, authorizing independent directors to utilize independent legal counsel and other advisors is important to permit them to have access to advice from independent sources before acting on significant matters affecting the exchange or association.

7. Separation of Chairman of the Board and CEO Positions

The Commission is not proposing to require that an exchange’s or association’s Chairman of the board be an independent director in all circumstances.¹⁹¹ However, if the exchange’s or association’s CEO is not also the Chairman, we are proposing that the Chairman must be an independent director.¹⁹²

The proposed rules, including the provisions related to the Chairman and CEO, are designed to foster a greater degree of independent decision-making by the governing body of an exchange or association. However, while recognizing the benefits of independence, the Commission understands that some SROs may perceive efficiencies in having one person serve as Chairman and CEO, and therefore the Commission is not proposing to prohibit this arrangement. In this regard, the Commission notes that both the NYSE and BSE currently have separate individuals serving as the Chairman and as the CEO of the exchange, although the exchanges’ governing documents do not expressly require this separation.¹⁹³ Nevertheless, in the event that an exchange or association elects to have a single individual serve as Chairman and CEO, the proposed governance rules would prohibit that person—who, as the CEO, would not be “independent”—from participating in any executive sessions of the board and from serving on the Nominating, Governance, Compensation, Audit, or Regulatory Oversight Committees.¹⁹⁴

The Commission also proposes that 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, and the board would be required to publicly disclose the lead director’s name and a means by which interested parties may communicate with the lead director.¹⁹⁵ This requirement should benefit exchanges and associations by providing that an independent director would head executive sessions, and thereby encourage an open climate of decision-making.

8. Separation of Regulatory and Market Operations

There is an inherent tension between an exchange’s or association’s role as a regulator and as the operator of a market, and between its role as a regulator and as a membership organization.¹⁹⁶ The existence of a shareholder class separate from membership adds yet another constituency with interests potentially in conflict with the regulatory responsibilities of the SRO. In recent years, some exchanges, as well as the NASD, have attempted to address this tension by separating, to varying degrees, their regulatory functions from their market operations.¹⁹⁷

As discussed below, the Commission is proposing to require exchanges and associations, among other things, to effectively separate their regulatory function from their market operations and other commercial interests, to use regulatory funds only to fund regulatory obligations, and to establish procedures to prevent the dissemination of regulatory information other than to persons carrying out the exchange’s or association’s regulations obligations.¹⁹⁸ The Commission believes that these requirements should allow SROs to better manage the conflicts of interest inherent in any self-regulatory structure. In addition, the Commission believes that these provisions, along with other features of the proposed governance rules, would help promote greater accountability on the part of exchanges and associations with respect to their regulatory programs and strengthen their ability to meet their statutory obligations.

a. Independence of Regulatory Program

The proposed rules would require exchanges and associations to establish policies and procedures that provide for the independence of their regulatory programs from the operation or administration of their trading facilities and other businesses.¹⁹⁹ 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.²⁰⁰ In the Commission’s view, such separation must be designed to permit the regulatory program to function independently from the market operations and other commercial interests of the exchange or association. In either case, the proposed governance rules 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.²⁰¹

The Commission believes that its proposal to require the structural or functional separation of the regulatory functions and the market operations and other commercial interests of the exchange or association, together with the creation of a fully independent Regulatory Oversight Committee and the appointment of a Chief Regulatory Officer who would administer the regulatory program and report directly to the Regulatory Oversight Committee, are designed to manage more effectively the inherent conflicts of interest in our self-regulatory system and bolster the effectiveness of exchanges’ and associations’ regulatory programs. By not mandating a particular structure for this separation – focusing on the ends rather than the means – the proposed rules would provide exchanges and associations with a measure of flexibility in determining how best to achieve the result of functional independence of the regulatory program.

In addition, the proposed requirement that each exchange and association appoint a Chief Regulatory Officer is designed to assure that all regulatory matters are subject to oversight by a person independent of the SRO’s commercial interests. Further, the proposal to require the Chief Regulatory Officer to report directly to a committee composed solely of independent directors is intended to fortify the independence of the Chief Regulatory Officer. In the Commission’s view, these requirements to enhance the independence of the regulatory function further the objectives of Sections 6(b)(1) and 15A(b)(2) of the Exchange Act,²⁰² which require exchanges and associations, respectively, to be so organized and have the capacity to carry out the purposes of the Exchange Act, and comply, and enforce compliance by their members, and persons associated with their members, with the Exchange Act and rules thereunder and the rules of the exchange or association.

b. Use of Regulatory Fees, Fines, and Penalties

The proposed governance rules also would require an exchange or association to direct monies collected from regulatory fees, fines or penalties (“regulatory funds”) exclusively to fund the regulatory operations and other programs of the exchange or association related to its regulatory responsibilities, and to keep such books and records as are necessary to evidence compliance with this requirement.²⁰³ Consistent with the proposed rules, an exchange or association could not use such regulatory funds to pay dividends or make distributions to its shareholders. The scope of the categories of regulatory funds included in this requirement, as well as the limitation on use of such funds, is intended to be broad. As discussed in Section IV.C. below, 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 exchange’s or association’s regulatory program.²⁰⁴ Regulatory fines or penalties also would include any revenue received from fines or penalties resulting from disciplinary or enforcement actions.

This proposed restriction on the use of regulatory funds is intended to preclude an SRO from using its authority to raise regulatory funds for the purpose of benefiting its shareholders, or for other non-regulatory purposes, such as to fund executive compensation. SROs have an obligation to be so organized and have the capacity to be able to carry out the purposes of the Exchange Act, and to enforce compliance by their members with the Exchange Act and their rules.²⁰⁵ SRO rules must provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities.²⁰⁶ SRO rules also must provide that their members and persons associated with their members are appropriately disciplined for violations of the Exchange Act or SRO rules.²⁰⁷ SROs collect various fees, dues and assessments from their members on the basis that they need to fund a program to carry out these statutory obligations. The Commission believes that these proposed requirements to use regulatory funds only to fund regulatory activities would further advance the SROs’ ability to effectively comply with these statutory requirements, by helping to ensure that an SRO’s regulatory activities are properly funded and that the SRO is not abusing its regulatory authority.

c. Confidentiality of Regulatory and Trading Information

Proposed Rules 6a-5(n)(5)(i)(A) and 15Aa-3(n)(5)(i)(A) would require exchanges and associations to establish policies and procedures reasonably designed to prevent the dissemination of regulatory information²⁰⁸ to any person other than those officers, directors, employees, and agents of the exchange or association directly involved in carrying out the exchange’s or association’s regulatory obligations under the Exchange Act. This means that an exchange’s or association’s policies and procedures would be required to establish that regulatory information could only be available to officers and employees that are responsible for regulatory functions, directors that are involved in regulatory functions, such as an appeal of a disciplinary matter, or agents to the extent necessary to perform the regulatory function for which they have been hired. In addition, the proposed rules would require that an exchange’s or association’s policies and procedures be reasonably designed to prevent the use of regulatory information for any purpose other than for carrying out the exchange’s or association’s regulatory obligations.²⁰⁹ The Commission also is proposing that an exchange’s or association’s policies and procedures would have to require that its officers, directors, employees and agents agree to comply with these requirements.²¹⁰

In addition, proposed Rules 6a-5(n)(5)(i)(c) and 15Aa-3(n)(5)(i)(c) would require exchanges and associations to have policies and procedures reasonably designed to maintain the confidentiality of information that must be submitted to the exchange or association to effect a transaction on or through the exchange, association or a facility.²¹¹ The proposed rules would, however, allow an exchange or association to make available such information in an aggregated form, if the information is aggregated to such an extent that the recipient is unable to identify (such as by reverse engineering) any person whose data is included in the aggregate information, or if the person consents.²¹² Exchanges’ and associations’ policies and procedures also would have to require exchange and association officers, directors, employees and agents to agree to maintain the confidentiality of this information consistent with the proposed rules.²¹³

The Commission believes that the requirement that exchanges and associations keep regulatory and certain other information confidential, and not use information collected in the course of performing regulatory obligations for business or other non-regulatory purposes would help to assure an independent and effective regulatory function and is implicit in the exchange’s or association’s responsibilities under the Exchange Act.²¹⁴ As competitive pressures on SROs increase, however, and the tensions between their regulatory obligations and commercial interests increase, the Commission believes that an explicit prohibition on this conduct may be necessary and appropriate.

9. Member Voting and Ownership Limitations

As discussed above in Section II.A., to further the ability of an exchange or association to effectively carry out its statutory obligations under Sections 6(b) and 15A(b) of the Exchange Act,²¹⁵ the Commission is proposing to require an exchange or association to limit the ability of its members that are brokers or dealers to own or vote a significant interest in the exchange, association or any separate facility.²¹⁶

Several exchanges that have converted to shareholder-owned structures have limited the ability of any person, including their members, to directly or indirectly own or vote more than a certain percentage of the interest in the exchange.²¹⁷ Similar limits have been approved for separate SRO facilities.²¹⁸ The Commission approved these limits on a case-by-case basis under the rule filing process of Section 19(b) of the Exchange Act and Rule 19b-4 thereunder.²¹⁹

For example, in the case of the public offering of Archipelago Holdings (the parent company of Arca-Ex, the equities trading facility of PCX Equities), the Commission approved a PCX rule prohibiting any person and its related persons from directly or indirectly owning more than 40% and voting more than 20% of the securities of Archipelago Holdings.²²⁰ If a person wanted to exceed these limits, the rules require PCX to file a proposed rule change with the Commission and the Commission would need to approve such action. Similarly, in connection with the demutualizations of Phlx and PCX, the Commission approved a comparable prohibition under the exchanges’ rules on any person and its related persons directly or indirectly owning more than 40% or voting more than 20% of the applicable securities without first receiving Commission approval of a proposed rule change.²²¹ In each of these three instances, the limitations applied not only to members,²²² but to any person owning securities of the applicable SRO or a facility.²²³

By proposing to require SROs only to limit the ownership and voting of their members, the Commission today is proposing a less restrictive approach than the rules adopted by the exchanges discussed above. The proposal is designed only to address the specific conflict of interest that could exist if a member were to own a significant interest in the exchange or association of which it was a member or a facility through which the member is permitted to effect transactions, by requiring an exchange or association to impose ownership and voting limits on members that are brokers or dealers.²²⁴ The Commission believes that the conflict with respect to members creates a risk that a member could use its controlling interest in its regulator to influence the regulatory process to its benefit. Accordingly, because of the risk presented by the prospect of member control of its regulator, and the significant incentives for a member to attempt to exercise undue influence in such a case, the Commission is proposing to require an SRO to impose ownership and voting restrictions on members that are brokers or dealers.

The Commission recognizes that there is also the potential for any person that controls an exchange or association or facility of an exchange or association to direct its operation so as to cause the SRO to neglect its regulatory obligations under the Exchange Act. In light of the substantive governance and other standards being proposed today to strengthen the independence of SROs and their regulatory functions, the Commission is not at this time proposing to require an exchange or association to impose ownership and voting restrictions on persons other than members. For the time being, however, the Commission intends to maintain its current policies in this area while it considers whether to adopt ownership and voting restrictions that apply only to members.

The proposed rules would apply to all exchanges and associations, not just demutualized ones. Although the proliferation of demutualized exchanges and shareholder-owned facilities has highlighted the concern with member control of an SRO, the Commission believes these concerns are equally applicable to SROs that continue to be mutual organizations.²²⁵

Specifically, proposed Rules 6a-5(o)(1) and 15Aa-3(o)(1) would require the rules of a national securities exchange and a registered securities association to prohibit any member that is a broker or dealer, alone or together with its related persons, from either:

• Directly or indirectly beneficially owning²²⁶ any interest in the exchange or association, or a facility of the exchange or association through which the member is permitted to effect transactions, that exceeds 20% of any class of securities or other ownership interest of the exchange, association or facility; or

• Voting any interest in such exchange, association or facility of the exchange or association through which the member is permitted to effect transactions, that exceeds 20% of the voting power of any class of securities or other ownership interest of such exchange, association or facility.²²⁷

Thus, a member that is a broker or dealer would not be able to, alone or together with its related persons, own more than 20% of the exchange or association of which it is a member or a facility through which the member is permitted to effect transactions. A member that is a broker or dealer, and its related persons, also would not be able to vote or cause the voting of more than 20%. The rules of the SRO would be required to prohibit both; they would not be able to prohibit only one or the other.

The Commission preliminarily believes that a member ownership and voting limit of 20% is an appropriate threshold because it precludes situations where a member would have a realistic probability of being able to exert undue influence over its SRO, yet refrains from interfering in an SRO’s organizational processes or the desire by members to acquire equity interests in their markets. In some Commission rules, a 10% ownership threshold is used to determine “control.”²²⁸ Accordingly, the Commission considered whether 10% would be a more appropriate threshold to propose for member ownership and voting limitations, given the concerns regarding the conflict of interest if a member were to control its regulator. The Commission recognizes, however, that generally the existing standard that exchanges have in place with respect to limits on their member’s ownership in and voting of interests in the exchange or a facility is 20%, and that members that currently own more than 10% would have to divest themselves of any excess interest. The Commission therefore is proposing 20% as the ownership and voting threshold. The Commission requests specific comment on whether the threshold should be lower than 20%, given the concern that a member with a lesser interest may be able to influence or control the exchange or association.²²⁹

a. Members’ Interests Aggregated with Their Related Persons

For purposes of calculating a member’s ownership and voting interests, the proposed rules would aggregate a member’s ownership and voting interests with those of its “related persons.” An exchange or association has members over which the exchange or association has regulatory authority, and these members participate in the governance and disciplinary process of the exchange or association. The Commission therefore believes that it is important to aggregate the members’ ownership and voting interests with the interest of any person with whom the member may be able to act together to influence or control the exchange, association or facility. As such, the proposed rules would define “related person” to mean, with respect to a member

that is a broker or dealer: (i) any affiliate of the member;²³⁰ (ii) any person(s) associated with the member;²³¹ (iii) any immediate family member of the member, or any immediate family member of the member’s spouse, who, in each case, has the same home as the member or who is a director or officer of the exchange, association or facility or any of its parents or subsidiaries; and (iv) any immediate family member of a person associated with the member or any immediate family member of such person’s spouse, who, in each case, has the same home as the person associated with the member or who is a director or officer of the exchange, association or facility or any of its parents or subsidiaries.²³²

For example, the parent company of a member would be considered a “related person” of the member. A sister affiliated company of the member also would be a “related person” of the member. The definition of “related person” also would include all members that are natural persons, either because they are registered brokers or dealers, or because they are “related persons” of the broker or dealer with which they are associated.

It is important to note that the proposed rules would require an exchange or association to restrict the indirect ownership and voting interests of a member that is a broker or dealer in an exchange, association or facility. The Commission believes that it is crucial to restrict the indirect ownership and voting interests of these members because if the Commission were to require an exchange or association to establish requirements only for direct – but not indirect – ownership and voting rights, the limitations could be easily circumvented. For example, if an exchange only prohibited a member from directly owning or voting shares, the member could hold its ownership interests in the exchange, association or facility through multiple subsidiaries of a holding company, thus easily circumventing the intent of the proposed rules. In addition, the ownership and voting limitations would apply to ownership and voting of interests in a parent company of the exchange or association. For example, if the exchange, association or facility was wholly-owned by a holding company, a member (alone or together with its related persons) would be prohibited from owning or voting more than 20% of the interest in the parent company because that would be an indirect ownership or voting interest in the exchange, association or facility. The proposed limitations also would apply to a member (either alone or together with its related persons) that beneficially owned more than 20% of an entity that itself owned more than 20% of an exchange, association or facility, if the person (and the entity) had the ability to vote or cause the vote, or dispose of, or cause the disposition of, the interest in the exchange, association, or facility.

b. Solicitation of Revocable Proxies

The Commission is proposing to make clear in the proposed rules that the 20% voting limitation – which includes “causing the vote” of more than 20% of the interests in an exchange, association or facility – would not apply to any solicitation or receipt of revocable proxies by a member, if conducted pursuant to Regulation 14A under the Exchange Act.²³³ Thus, an exchange or association would be required to preserve the ability of a member to solicit and receive revocable proxies from other shareholders on such issues as alternative nominees for the board of directors, or a particular shareholder proposal. The solicitation or receipt of a revocable proxy does not transfer voting (or investment) power—i.e. beneficial ownership—to the person soliciting or receiving the proxy.²³⁴ Therefore, the act of soliciting or receiving a revocable proxy should not undermine the purpose of the voting limitation because it would not constitute an agreement or other arrangement between the shareholder soliciting the proxy and a shareholder being solicited to vote a particular way. In particular, any shareholder so solicited would remain free to choose whether or not to grant a proxy, and the proxy would remain revocable up until the vote that is the subject of the proxy. The Commission notes, however, that if a member and one or more persons banded together to solicit proxies, and in addition that group agreed to vote a particular way, the agreement to vote would go beyond the soliciting or receipt of proxies and be considered to be causing the vote, or giving a consent or proxy with respect to voting, that would be in violation of the proposed voting limitation, if the aggregate amount of ownership or voting interests controlled by the group of persons so agreeing exceeded 20%.

The Commission is concerned, however, that allowing a member to solicit an “open-ended” proxy - one with no end date and one not for a particular purpose or meeting - from one or more shareholders would allow a member to obtain the ability to vote more than 20%. As such, the proposed rules would require an exchange or association to prohibit a member subject to the voting limitation from soliciting a proxy pursuant to an exemption contained in Rule 14a-2(b)(2) under the Exchange Act²³⁵ with regard