Clearing agencies registered with the Securities and Exchange Commission (SEC) will have to make changes to the governance of their boards of directors under a new rule proposed by the SEC on August 8, 2022.
The SEC proposed the new rule1 mitigate conflicts of interest inherent in relationships with clearing houses. The rule follows episodes of market volatility in 2021 that included big swings surrounding COVID-19 and the meme equities craze.
The new rule would amend Section 17Ad-25 of the Securities Exchange Act of 1934 (Exchange Act) to require additional management and governance requirements for clearing houses that register with the SEC. The proposed rules provide specific new governance requirements regarding the composition of the compensation board, independent directors, nominating committees and risk management committees. The rule also requires the board to oversee relationships with essential service providers and includes a requirement for the board to consider the views and contributions of various stakeholders.
The SEC’s rationale for proposing Rule 17Ad-25, titled Clearing Agency Governance and Conflicts of Interest, is to reduce the risk that conflicts of interest inherent in various relationships with clearing agencies will materially harm swaps on securities or to the broader financial market. The SEC is proposing this rule to mitigate conflicts of interest, promote fair representation of owners and participants in clearinghouse governance, identify board responsibilities, and increase transparency in clearinghouse governance compensation.
The SEC noted that these episodes of heightened market volatility have revealed certain vulnerabilities in the U.S. securities market and the critical role that clearing agencies play in managing risk if securities transactions go uncleared.
The SEC observed three potential sets of conflicts of interest that the proposed rule attempts to address.
- The proposed rule addresses the different perspectives that the various stakeholders involved in clearinghouses might have. In particular, the potential interest of the owner of a clearing house in protecting the capital and the continuation of the activities of the clearing house differs from the potential interest of a participant in avoiding the distribution of the losses of another participant. failing. For example, in the event of a loss, participants in a clearing agency might prefer to limit access to compensation, while owners might choose to expand the range of products offered to collect the commissions.
- The priorities of large clearinghouse participants may differ materially from the interests of small clearinghouse participants. In particular, where a small number of dominant participants exercise control over a registered clearing house with respect to the services provided by that clearing house, such participants may promote margin requirements that are not commensurate with the risks they take, thereby indirectly limiting competition and increasing the profit margins of themselves. In other words, a registered clearing house dominated by a small number of large participants could make decisions aimed at giving them a competitive advantage.
- Some participants may exercise undue influence to limit access to the clearinghouse based on their own interests, and thereby limit the benefits of the clearinghouse to indirect participants.
The proposed rule would impose these seven requirements:
- define independence in the context of a director serving on the board of a registered clearing house and require that a majority of directors on the board be independent, unless a majority of the voting rights distributed to registered shareholders are held directly or indirectly by participants of the registered clearing house, in which case at least 34% of the board must be independent directors;
- establish requirements for a nominating committee, including with respect to the composition of the nominating committee, standards of suitability for serving on the board and documenting the process for evaluating board candidates;
- establish the requirements relating to the functioning, composition and reconstitution of the risk management committee;
- require policies and procedures that identify, mitigate or eliminate, and document the identification and mitigation or elimination of conflicts of interest;
- require policies and procedures that require directors to promptly report potential conflicts;
- require policies and procedures for the board to oversee relationships with service providers for essential services; and
- require policies and procedures to solicit, review and document the registered clearing agency’s consideration of the views of its participants and other relevant stakeholders regarding its governance and operations.
The proposed release will be posted on SEC.gov and in the
Federal Register. The public comment period will remain open for 60 days after the proposed release is posted on the SEC’s website or 30 days after the proposed release is posted on the Federal Registeraccording to the longest period.
Jacob C. Setton, a partner in the Capital Markets and Funds practice and a candidate for the New York State Bar, contributed this opinion.
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