Acting on a mandate in Section 765 of the Dodd-Frank Act, the SEC proposed Regulation MC to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities, and national securities exchanges that post security-based swaps or make them available for trading. Regulation MC would require the swap clearing agencies, execution facilities, and exchanges to adopt ownership and voting limitations as well as governance requirements. The proposed regulation has a relatively short public comment period of 30 days.
According to SEC Chair Mary Schapiro, the concern about conflicts of interest stems from the fact that the over-the-counter derivatives markets have a relatively high concentration of market activity through a limited number of dealers who earn significant revenues from their transactions. By creating a structure that would promote more independent voices within clearing organizations and trading venues, proposed Regulation MC is intended to make these entities less susceptible to promoting the interests of a few participants.
There was congressional concern throughout the process of passing Dodd-Frank that, with derivatives trading required to be conducted through clearinghouses, large financial institutions would own and control the clearinghouses and effectively set rules for their own derivatives deals. The Lynch Amendment in the bill the House passed last December would have prevented large financial institutions and major swap participants from taking over these new clearinghouses by imposing a 20-percent-voting-stake limitation on ownership interest in those institutions and the governance of the clearing and trading facilities.
The Lynch Amendment specifically provided that these restricted owners, which are defined as swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, cannot own more than a 20 percent voting stake in derivatives-clearing organization, a swap-execution facility, or a board of trade. Further, the rules of the clearing organization, swap-execution facility and board of trade must provide that a majority of the directors cannot be associated with a restricted owner.
The Lynch Amendment was not in the final legislation. Instead, in provisions some have called Lynch Lite, Sections 726 and 765, the CFTC and SEC must adopt rules on conflicts of interest. Specifically, for example, the SEC may include numerical limits on the control of clearing agencies and security-based swap execution facilities. In addition, in a colloquy with Rep. Lynch on the day the House passed the conference bill, Financial Services Chair Barney Frank (D-MA) agreed that Sections 726 and 765 of the Dodd-Frank Act require the SEC and CFTC to adopt rules eliminating the conflicts of interest arising from the control of clearing and trading facilities by entities such as swap dealers, security-based swap dealers, and major swap and security-based swap participants. (Cong. Record, June 30, 2010, H5217).
Regulation MC is proposed in the alternative with regard to security-based swap clearing agencies. Under the first alternative, an individual clearing agency participant could not own or vote more than 20 percent of any voting interest in the swap clearing agency or more than 40 percent of any voting interest in the clearing agency in the aggregate with any other clearing agency participants. In addition, the board of directors and any board committee must be composed of 35 percent independent directors; and the nominating committee must be composed of a majority of independent directors. Under the second alternative, an individual clearing agency participant could not own or vote more than 5 percent of any voting interest in the swap clearing agency. Also, the board and any committee thereof must be composed of a majority of independent directors; and the nominating committee must be composed solely of independent directors.
Although the Commission proposed two separate alternatives for swap clearing agencies, the Commission said it could adopt only one alternative or could combine aspects of each proposed alternative and adopt it as a single regulation. Also, Regulation MC would require a swap clearing agency to have an effective mechanism to obtain information relating to voting interests in the agency by any participant in the clearing agency. In order to assure that a swap clearing agency maintains the requisite voting interest limitations, the SEC would that agencies have an enforceable mechanism in place for the divestiture of voting interests exceeding the set limits.
For security-based swap executive facilities and swap exchanges, the regulation would restrict participants or members from owning or holding more than 20 percent of any voting interest of such entity. In addition, the board of directors of a swap execution facility or swap exchange, any executive committee of the board, and any board committee must be composed of a majority of independent directors; and the nominating committee must consist solely of independent directors.
Even more, the board must establish a regulatory oversight committee consisting solely of independent directors to oversee the execution facility or exchange’s regulatory program. A national securities exchange that posts or makes available for trading security-based swaps through a facility of the exchange would also have to set up a regulatory oversight committee. The SEC envisions that a regulatory oversight committee would monitor a facility or exchange’s regulatory program for sufficiency, effectiveness, and independence; oversee all facets of the regulatory program; review the size and allocation of the regulatory budget and resources; and review regulatory proposals and advise the Board as to whether and how such changes may affect regulation. Any recommendation of a regulatory oversight committee that is not adopted by the board must be reported promptly to the SEC.
More broadly, the disciplinary panels of a swap clearing agency, swap execution facility or swap exchange must be compositionally balanced and include one person who would qualify as an independent director.