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Notice I-12-19

August 31, 2012

Proposed Amendments to NFA's Articles of Incorporation to Integrate Swap Dealers and Major Swap Participants into NFA's Membership and Governance Structure

Important: Ballot Enclosed

INTRODUCTION

In January 2012, the Commodity Futures Trading Commission (CFTC) issued final rules that require each registered swap dealer (SD) and major swap participant (MSP, and with SD, Swap Participant) to become a Member of a registered futures association (i.e. NFA). In anticipation of this final rulemaking, in May 2011, NFA's Board of Directors (Board) appointed a Special Committee on NFA Governance (Special Committee) to review NFA's current governance structure; explore alternatives for structurally realigning NFA's Board, Executive Committee and other committees to include Swap Participants; and make formal recommendations on these governance issues to NFA's Swap Dealer Advisory Committee (SDAC), the Executive Committee, and ultimately the Board. In addition, the Board requested that the Special Committee consider adding a Retail Foreign Exchange Dealer (RFED) representative to NFA's Board. The Special Committee is comprised of representatives from NFA's current Board and potential Swap Participants, and the SDAC is comprised of potential Swap Participants and swap end-users.

The Special Committee withheld making formal recommendations to integrate Swap Participants into NFA's current governance structure until the CFTC issued the final entity definitional rules relating to Swap Participants. The CFTC finalized these definitional rules in May 2012 and both the SDAC and the Executive Committee reviewed and recommended Board approval of the Special Committee's recommendations to integrate Swap Participants into NFA's governance structure and Membership.

On August 16, 2012, NFA's Board unanimously ratified a proposal to amend NFA's Articles of Incorporation (Articles) to adopt the Special Committee's recommendations in their entirety and the proposed Articles' amendments specifically provide:

  • Increase the Board's size to thirty-nine directors by adding additional representatives to the Board to include seven Swap Participants, and four Public Directors (Article VII);

  • Within the Swap Participant category, allocate three seats to "large financial institution" SDs included in a well-defined, publicly available and independent list of financial institutions that the Board identifies by resolution from time to time, three seats to other SDs and one seat to an MSP; provided, however, that if no MSP is willing to serve, then this seat will be an at-large SD seat. The Board approved a resolution defining the term "large financial institution" to mean the over-the-counter (OTC) derivatives dealer signatories on the commitment letters executed with the OTC Derivatives Supervisors Group (Articles VII and XVIII);

  • Substitute an RFED seat for an FCM seat on the Board thereby reducing the total number of FCM seats to seven, allocating three seats to top ten FCMs, three seats to non-top ten FCMs, and one at-large seat (Articles VII);

  • Adopt special category voting rules so that Board actions would require a majority vote by the Swap Participant Directors and the Public Directors as one voting category, a majority vote by the futures Directors and the Public Directors as another voting category and then a majority vote by the Board as a whole (Article XVIII);

  • Prohibit the Member affiliates of a single corporate group entity from having more than one Board representative. For these purposes, an affiliate is a Member that directly or indirectly owns more than 50% of, or is owned more than 50% by, or has more than 50% ownership in common with another Member (Articles VII and XVIII);

  • Phase-in the increase in Public Directors over a four-year Board election cycle by electing an additional Public Director each year so that Public Directors comprise 35% of the Board's overall composition at the conclusion of this four-year period (Article VII); and

  • Slightly enlarge the Executive Committee to thirteen members, with Public Directors continuing to comprise 35% (i.e. five members) of the Committee's composition (Article VIII).

Pursuant to Article XVII, upon the Board's ratification of amendments to the Articles, the proposed Article changes shall be submitted to a ballot vote of the Members and shall be adopted after the affirmative vote of a majority of those Members actually voting in each Member category-Contract Market, FCM/LTM/IB/FDM, and CPO/CTA.

EXPLANATION OF PROPOSED GOVERNANCE CHANGES

NFA's Board of Directors

The proposed amendments to Article VII increase the Board's size from 28 directors to 39 directors by adding seven Swap Participant and four Public Director representatives to the Board. The Board considered several alternatives to integrate Swap Participants into NFA's current governance structure. For example, the Board considered adding Swap Participants while at the same time maintaining the Board's current size but concluded that this alternative would necessitate a significant reduction in the current number of Member directors thereby diluting the specialized knowledge, expertise, and experience that Member directors bring to the Board, attributes that are essential for the proper governance of NFA. Therefore, the Board decided to maintain the same overall number of current Member directors and increase the Board's size by adding Swap Participant and Public Director representatives to the existing Board.

    The Addition of Swap Participants

In structurally realigning the Board to provide fair and adequate representation to Swap Participants, the Board decided to add seven Swap Participant seats thereby creating numerical parity with FCM Board representation - which the Board proposes to reduce from eight seats to seven. The Board felt that the addition of seven Swap Participant seats is consistent with NFA's governance principles, which recognize that the representation of Membership categories must be based on a variety of factors, including the number of Members in a category, the contribution the category's Members make to NFA and the industry, and the impact of NFA's regulation on the category's Members. Moreover, NFA must provide for meaningful representation of a diversity of membership interests-diversity that exists among Member categories and also within Member categories. The Board noted that these concepts have promoted effective and efficient governance and are applicable to determine how many and what type of seats should be allocated to Swap Participants.

Applying these governance principles, the Board's approved amendments to Article VII provide that three of the seven Swap Participant seats be designated for "large financial institution" SDs. In approving this apportionment scheme, the Board felt that the term "large financial institution" should be reflective of the industry group comprising the largest financial derivatives dealers (i.e. the G-14, and with the recent addition of two more firms, the G-16). The Board sought an objective, well-defined criterion to define "large financial institution" and decided to define "large financial institution" by reference to the major OTC dealer signatories to the commitment letters executed with the OTC Derivatives Supervisors Group (DSG). These letters (the latest of which is dated March 31, 2011) are publicly available on the Federal Reserve Bank of New York's website on a designated webpage entitled "OTC Derivatives Supervisors Group."

The Board further decided to adopt a flexible approach to the definition of "large financial institution" in order to address future changes in the swaps markets. Therefore, the Articles' amendments provide that this definition may be changed in the future by Board resolution, without having to go through the process of amending NFA's Articles each time. NFA will subsequently provide public notice via our website as to the well-defined, publicly available and independent list of financial institutions used by the Board to define "large financial institution," and further notice will be provided in the future if the Board elects by resolution to change this metric.

The Board also concluded that if three of the seven Swap Participant seats are designated for "large financial institution" SDs, then three seats should be designated for other types of SDs. The Board expects this sub-category to include non-large financial institutions and different types of SDs that represent different asset classes, including SDs that are energy firms and agricultural firms. Finally, the Board decided that one seat be designated for MSPs, but if no MSPs are willing to serve on the Board, then this seat would be an at-large SD seat.

    The Addition of Public Director Representatives

Section 17(b)(11) of the Commodity Exchange Act (CEA) states, in part, that a registered futures association's governing board must provide that no less than 20% of its regular voting members must be comprised of qualified non-members of or persons who are not regulated by such association. In February 2007, the CFTC issued Acceptable Practices (APs) for exchange governance and conflicts of interest. The APs offer exchanges a safe harbor by which they can minimize conflicts of interest and requires that at least 35% of an exchange's board and executive committee be "public directors," as defined in the APs. In April 2009, the CFTC finalized the definition of "public director" for purposes of the APs and they became effective.

To promote effective governance practices, NFA decided to voluntarily comply with the CFTC's board composition AP and, therefore, over a two-year Board election cycle recently completed in February 2011 NFA added five additional Public Directors to the Board and currently ten (i.e., 35.7%) of NFA's twenty-eight Directors are public directors. If, as proposed, NFA's Board were to increase in size to thirty-five members by adding seven Swap Participants and continue to voluntarily meet the 35% requirement, then NFA would have to add four additional Public Directors bringing the overall size of the Board to thirty-nine members.

The proposed amendments to Article VII add four additional public directors to NFA's Board. In approving these amendments, the Board felt proper governance practices and the desire to engender public confidence in the Board's composition mandate that NFA maintain 35% public representation on the Board. Moreover, in order for NFA to find qualified individuals who are willing to serve as Public Directors, the Articles' amendments provide that the four additional Public Directors be added over a four-year Board election cycle-adding one Public Director a year.

    FCM and RFED Representation

The proposed amendments to Article VII provide that one Board seat be allocated to an RFED. The Board determined that it is appropriate to formally add an RFED seat to reflect the fact that the retail forex community may have interests not entirely represented by other Member categories. Those Forex Dealer Members that are registered solely as FCMs would continue to be represented in the FCM category. To accomplish this result, the Articles' amendments do not increase the Board's overall size by the addition of an RFED but rather add this seat by eliminating a seat from the FCM category, reducing the number of FCM representatives on the Board from eight to seven.

The proposed Articles' amendments seek to harmonize the scheme for apportioning seats within the Swap Participant and FCM categories. Specifically, since the Articles' amendments provide that three "large financial institution" SDs be allocated seats within the Swap Participant category and that three seats be allocated to other SDs, the amendments to Article VII applicable to the FCM category provide for a similar structure so seats within the FCM category will be allocated as follows: three top ten FCM seats, three non-top ten FCM seats, and one at-large FCM seat. The method of determining what constitutes a top ten FCM-based upon total segregated funds and secured amounts-has not changed.

The Executive Committee

To complete the integration of Swap Participants into NFA's governance structure, the amendments to Article VIII change the size and composition of NFA's Executive Committee to ensure Swap Participant representation. Specifically, the proposed Articles' amendments increase the Executive Committee from eleven to thirteen members and change its composition as follows:

  • Two seats are designated for Swap Participants;

  • Public Directors seats are increased from four to five to maintain 35% public representation;

  • The number of FCM/IB/LTM/RFED seats are reduced from three to two;

  • The two seats for CTA/CPO Members remain unchanged; and

  • The two seats for contract markets remain unchanged.

Since the Board's size is proposed to increase, a relatively small Executive Committee takes on even greater importance for purposes of maintaining a nimble governing body. Additionally, the Board has always placed a high value on Member Directors' expertise on this Committee. The Board believes that the proposed small increase in size of the Committee should not adversely impact the Committee's decision-making and will continue to ensure a breadth of industry experience on the Committee.

Special Category Voting

Over the years, the principal method of managing Board conflicts of interest is through a system of appropriate checks and balances. In adding Swap Participants to NFA's Board, NFA needs to maintain the "self" in self-regulation and at the same time ensure that representatives of either the swaps or futures industry do not have unfettered discretion to write rules favorable to their constituents at the expense of sound public policy. In general, NFA's Articles currently require a simple majority vote on most matters. However, a voting supermajority of two-thirds is required for certain matters, including adopting, amending, or repealing the Articles or any Bylaw regarding dues and assessments, and delegating or otherwise granting authority to any NFA Committee, officer, employee or agent, or any other person, to adopt, amend, or repeal any Bylaw.

Prior to October 2001, however, the Articles required category votes for changes to dues and assessments and NFA's Articles. NFA adopted the category voting requirements at its inception to ensure that no one membership category could dictate changes to the Articles or dominate certain actions taken by the Board to the detriment of the other categories. Since Swap Participants will become NFA Members newly subject to NFA's regulation and are unfamiliar with the governance dynamics of NFA's Board, the amendments to Article XVII reinstitute a form of category voting. The category voting rules are designed to provide Swap Participants with confidence that the futures industry's representatives can not dominate the swaps industry's representatives. For purposes of governing Board structure symmetry, the same category voting structure is replicated with regard to futures industry participants.

To eliminate any uncertainty regarding what particular Board actions are subject to the special voting rules, the Articles' amendments require that all Board actions be subject to these special category voting requirements. Consequently, the Articles' amendments provide that all Board actions require the approval of the Swap Participant directors and Public Directors voting together as a group, the futures directors and Public Directors voting as a group, and then a majority of the Board as a whole. By including the Public Directors with each industry's Member Directors for category voting purposes, the Public Directors, who are disinterested from a business perspective, provide an important check on each industry's Member Directors by representing the public interest.

Corporate Entity Board Representation

Article VII currently prohibits a single corporate entity Member from having more than one Board representative. However, the Articles would not prohibit a Member and one of its Member affiliates from each having a representative on the Board so long as the representative of each complies with certain restrictions. The Board recognizes that many large financial institutions may have both a registered FCM Member and a separately registered SD Member. Consequently, under the current Articles, if a single entity is both registered as an SD and FCM, it cannot have both an SD and FCM Board representative. However, if instead the SD Member is an affiliate of the FCM Member and both affiliates are separately registered, then both the FCM and SD could in certain circumstances have different Board representatives, even though such representatives are from the same affiliated corporate entity group.

The proposed Articles' amendments contemplate that at least three SD seats (and the one possible at-large seat) may be allocated to "large financial institutions." This structure highlights the fact that the same large financial institutions and/or their affiliates may fall within the ranking of top-ten FCMs and "large financial institution" SDs. In the extreme case, affiliated SD and FCM Members could essentially hold all three top-ten FCM seats, the three "large financial institution" SD seats, and the one at-large FCM and SD seats. As a result, eight of the Board's thirty-nine seats could be held by four large financial firms. The Board believes that this potential voting and representative concentration is inconsistent with self-regulatory governance principles and lessens possible Board diversity since other top-ten FCMs and "large financial institution" SDs may be unable to participate in the governance process by having a representative on the Board.

Accordingly, the amendments to Article VII prohibit the Member affiliates of a single corporate group from having more than one Board representative. This type of prohibition avoids one or more corporate groups from having Member affiliates with a concentration of voting power on the Board, creates the optimal diversity of representation on the Board, and engenders public confidence. The proposed Articles' amendments provide that a Member is deemed to be affiliated with another Member if it owns more than 50% of, is owned more than 50% by, or has more than 50% ownership in common with another Member.

The Election of New Board Members

Once the membership adopts the proposed Articles' amendments, NFA will submit the Articles' amendments to the CFTC for approval. Given the current time schedule, it is not possible to elect the initial SD, MSP and RFED Directors in this coming year's election process (which begins in early October 2012 and culminates in late January 2013). Therefore, the Articles' amendments provide that the newly-created SD and MSP Director positions be treated as vacancies that the Board will fill based upon the recommendations of the SDAC. The RFED vacancy will be filled in a similar manner based upon the recommendation of the Forex Dealer Member Advisory Committee. Accordingly, the initial SD and RFED Directors will be elected by the Board at its February 2013 Board Annual Meeting and their terms will expire as of the Board's Annual Meeting in February 2014, by which time their successors will have been elected pursuant to NFA's standard election process that commences in the fall of 2013.

As part of these governance changes, the Articles' amendments adopt a process for electing SD, MSP, and RFED Directors to the Board following the election of the initial Directors. Specifically, the amendments to Article X create a Swap Participant subcommittee of the Nominating Committee, which shall include one "large financial institution" SD, one other type of SD, and an at-large SD or MSP. In addition, the RFED director will be elected annually by a plurality vote of the RFED Members rather than through a nominating committee process.

MISCELLANEOUS CHANGES

In addition to the substantive Articles' amendments necessary to integrate Swap Participants into NFA's Membership and governance structure, the Board also approved minor revisions to the Articles in order to accomplish this objective.

CONCLUSION

NFA's Board has unanimously ratified a proposal to amend Articles III (Purposes), VI (Members), VII (Board of Directors), VIII (Executive Committee), X (Nominating Committee), XI (Bylaws), XV (Financing), XVI (Miscellaneous), XVII (Adoption, Amendment and Repeal of Articles) and XVIII (Definitions) to integrate Swap Participants into NFA's membership and governance structure. NFA has posted this Notice to Members on its website and for reference purposes attached to the on-line Notice are the proposed amendments to the Articles.

Amendments to NFA's Articles require the affirmative vote of a majority of those Members actually voting in each Member category - Contract Market, FCM/LTM/IB/FDM, and CPO/CTA. Please use the enclosed ballot to vote and fax it to NFA by September 28, 2012. Should you have any questions, please contact Tom Sexton, NFA's General Counsel, at (312) 781-1413 or at tsexton@nfa.futures.org.


NATIONAL FUTURES ASSOCIATION

BALLOT

Printable Ballot

Please Fax This Ballot to NFA,
Attention Tom Sexton
(Fax Number: 312-781-1467)

or

Mail to:
Tom Sexton
National Futures Association
300 South Riverside Plaza
Suite 1800
Chicago, IL 60606

To Be Received or Postmarked
No Later Than September 28, 2012

Amendments to the following NFA Articles of Incorporation to change the size and composition of NFA's Board of Directors and Executive Committee; to adopt special category voting rules for Board actions; and to provide for no more than one Board representative from affiliates of a single corporate group entity.

Article III (Purposes), Sections 1 and 2
Article VI (Members), Sections 1 and 2
Article VII (Board of Directors), Sections 2, 3, 4, 5, and 8
Article VIII (Executive Committee), Sections 2, 3 and 4
Article X (Nominating Committee), Sections 1 and 2
Article XI (Bylaws), Section 1
Article XV (Financing), Sections 2 and 3
Article XVI (Miscellaneous), Section 4
Article XVII (Adoption, Amendment and Repeal of Articles)
Article XVIII (Definitions)

______ APPROVE ______ DISAPPROVE

Please Check Your Member Category:

____ Contract Market Member
____ FCM/LTM/IB/FDM Member
____ CPO/CTA Member

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