November 15, 2010
David A. Stawick Elizabeth M. Murphy
Secretary of the Commission Secretary
Commodity Futures Trading Commission Securities and Exchange Commission
Three Lafayette Centre, 1155 21st Street NW 100 F Street NE
Washington, DC 20581 Washington DC 20549
Re: Requirements for Derivatives Clearing Organizations, Designated Contract
Markets, and Swap Execution Facilities Regarding the Mitigation of Conflicts of
Interest, 75 Fed. Reg. 63,732 (RIN 3038–AD01); Ownership Limitations and
Governance Requirements for Security-Based Swap Clearing Agencies, Security-
Based Swap Execution Facilities, and National Securities Exchanges with Respect
to Security-Based Swaps under Regulation MC, 75 Fed. Reg. 65,882 (SEC File
No. S7-27-10, RIN 3235-AK74)
Dear Mr. Stawick and Ms. Murphy:
The Committee on Capital Markets Regulation (Committee) appreciates the
opportunity to comment on the proposed rules of the Commodity Futures Trading
Commission (CFTC) and the Securities and Exchange Commission (SEC) regarding
conflicts of interest under Sections 726 and 765, respectively, of the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act).1 The Committee wishes
to comment in unison on the proposed rules of both the CFTC (CFTC Proposed Rules)2
and the SEC (SEC Proposed Rules)3 as it encourages the agencies to adopt a uniform
approach to conflicts of interest rulemaking—and, where possible, rulemaking under the
Dodd-Frank Act more generally. Indeed, the CFTC and SEC Proposed Rules are already
quite similar, and the Committee sees no reason why they should not be identical.
Since 2005, the Committee has been dedicated to improving the regulation of
U.S. capital markets. Our research has provided an independent and empirical foundation
for public policy. In May 2009, the Committee released a comprehensive report entitled
The Global Financial Crisis: A Plan for Regulatory Reform, which contains fifty-seven
recommendations for making the U.S. financial regulatory structure more integrated,
more effective, and more protective of investors in the wake of the financial crisis of
1
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 726(a), 765(a)
[hereinafter Dodd-Frank Act].
2
Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution
Facilities Regarding the Mitigation of Conflicts of Interest, 75 Fed. Reg. 63,732 (Oct. 18, 2010)
[hereinafter CFTC Proposed Rules].
3
Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies,
Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-
Based Swaps under Regulation MC, 75 Fed. Reg. 65,882 (Oct. 26, 2010) [hereinafter SEC Proposed
Rules].
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2008.4 Since then, the Committee has continued to make recommendations for regulatory
reform of major areas of the U.S. financial system.5
At the outset, the Committee is concerned that both agencies have unnecessarily
rushed the rulemaking process. Although we recognize the aggressive deadlines imposed
by the Dodd-Frank Act, these proposals do not reflect a careful consideration of the
existing governance structures of the entities the rules affect, nor are they based upon any
analysis of their effectiveness or efficiency, as required by law.6 Courts routinely
overturn agency actions that lack such bases, as the D.C. Circuit did to SEC rules
regarding corporate governance of mutual funds.7
Turning to the statute, § 726 the Dodd-Frank Act, “[i]n order to mitigate conflicts
of interest,” authorizes, but does not compel, the CFTC to adopt rules imposing
numerical limits on the extent to which certain enumerated entities (i.e., bank holding
companies with assets of at least $50 billion, nonbank financial companies supervised by
the Board of Governors of the Federal Reserve System, swap dealers, major swap
participants, and affiliates and associates of the same)8 can control, or exercise voting
rights over, derivatives clearing organizations (DCOs), designated contract markets
(DCMs), and swap execution facilities (SEFs).9 Section 765 of the Act similarly
authorizes the SEC to adopt such rules with respect to security-based swap (SBS)
clearing agencies, SBS execution facilities (SB SEFs), and SBS exchanges.10 The
agencies are directed to exercise these rulemaking powers if they find “that such rules are
necessary…to improve the governance of, or to mitigate systemic risk, promote
competition, or mitigate conflicts of interest” with respect to the trading and clearing
facilities that they oversee under Title VII.11 Should they deem such rules necessary, the
CFTC and SEC are instructed to consider conflicts of interest arising from equity
ownership interests, voting abilities, and governance arrangements.12
The CFTC and SEC Proposed Rules focus on two key sets of issues: (A)
ownership and voting limits and (B) governance requirements.13 In short, the Committee
4
COMM. ON CAPITAL MKTS. REG., THE GLOBAL FINANCIAL CRISIS: A PLAN FOR REGULATORY REFORM
(May 2009), http://www.capmktsreg.org/research.html.
5
See, e.g., Letter from the Comm. on Capital Mkts. Regulation to Christopher Dodd, Chairman, Richard
Shelby, Ranking Member, S. Comm. on Banking, Hous. & Urban Affairs and Barney Frank, Chairman,
Spencer Bachus, Ranking Member, H. Comm. on Fin. Servs. (Mar. 4, 2010) [hereinafter Mar. 4 Letter]
(proposing a comprehensive approach to reducing systemic risk from over-the-counter derivatives).
6
Both the CFTC and the SEC are required by statute to evaluate the efficiency of their rules. See 7 U.S.C. §
19(a) (CFTC); 15 U.S.C. §§ 78c(f), 78w(a)(2) (SEC); see also 5 U.S.C. §§ 553, 706(2) (requirements of the
Administrative Procedure Act).
7
See Chamber of Commerce v. SEC, 412 F.3d 133, 143–44 (D.C. Cir. 2005); see also Am. Equity Inv.
Life Ins. Co. v. SEC, 613 F.3d 166, 177–78 (D.C. Cir. 2010).
8
Dodd-Frank Act § 726(a); CFTC Proposed Rules at 63,732 n.6; see also Dodd-Frank Act §§
102(a)(4)(D), 113(a)(1) (discussing Fed supervision and FSOC determination, respectively).
9
Dodd-Frank Act § 726(a).
10
Id. § 765(a).
11
Id. §§ 726(b), 765(b).
12
Id. §§ 726(c), 765(c).
13
See, e.g., CFTC Proposed Rules at 63,737 (“To mitigate, on a prophylactic basis, the conflicts of interest
identified above, the Commission sets forth below proposed (i) structural governance requirements and (ii)
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believes that: (1) the Proposed Rules should emphasize governance requirements over
ownership and voting limits, (2) both the ownership and voting limits suffer from
conceptual, structural, and—in some members’ views—numerical problems, and (3) the
governance requirements risk sacrificing director expertise for director independence.
Ownership and Voting Limits
The Committee is to some degree split on the wisdom of having any ownership
and voting limits, but all members nonetheless agree that there are certain shortcomings
in the proposals. The Proposed Rules contemplate two types of restrictions: individual
and aggregate caps. The CFTC Proposed Rules impose only individual caps on DCM and
SEF members, restricting them from individually owning or voting more than 20% of any
class of equity in their respective registered entities.14 The CFTC Proposed Rules,
however, give DCOs the choice between a framework with just an individual cap (a 5%
limit on the equity and voting interests of each member and “enumerated entity”15) and
one with an individual as well as an aggregate cap (a 20% limit on individual member
equity and voting interests16 alongside a 40% upper bound on the equity and voting
interests that enumerated entities can hold in aggregate17). The SEC Proposed Rules are
similar to the CFTC Proposed Rules with respect to both the types of caps that it
contemplates and the specific numerical limits that these caps impose.
The Committee has three concerns with these proposals. First, all Committee
members agree that to the extent conflicts of interest actually do pose a problem,
ownership and voting restrictions are in many ways ill-suited to address the problem. If
potential conflicts exist, then the focus should be on control, as a party can exercise
control without either ownership or voting power simply by providing a central value-
added service or by establishing legal forms that give it access to profits.18 Thus, even
those Committee members who are concerned about the potential for conflicts do not
advocate across-the-board ownership and voting limitations. All members are concerned
that because the capital for the entities subject to these rulemakings comes largely from
market participants and there is sufficient competition among these participants to create
and fund such entities, ownership and voting restrictions risk detrimentally limiting
capital flows into these entities without providing an offsetting benefit.19 Committee
members who are more wary of conflicts problems believe that such a net detriment is
liable to occur only with respect to exchanges and exchange-like facilities whereas
members who view conflicts to be less problematic stress that clearinghouses could also
be adversely starved of capital.
limits on the ownership of voting equity and the exercise of voting power.”); SEC Proposed Rules at
65,882 (“[T]he Commission seeks to mitigate the potential conflicts of interest through conditions and
structures relating to ownership, voting, and governance . . .”).
14
CFTC Proposed Rules §§ 37.19(d)(2), 38.851(d)(2).
15
Id. § 39.25(b)(2)(ii).
16
CFTC Proposed Rules § 39.25(b)(2)(i)(A).
17
Id. § 39.25(b)(2)(i)(B).
18
Mar. 4 Letter, supra note 5, at 23.
19
See id.
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The Committee is also concerned with the specific limitation in the Proposed
Rules. Members are divided on whether there should be mandatory aggregate limits for
clearinghouses. By making aggregate limits optional for clearinghouses, the Proposed
Rules therefore adopt an approach that falls between these different views.
If clearinghouses do adopt mandatory limits, some Committee members are
concerned that the 5% individual caps will be ineffective at limiting conflicts. In contrast,
other Committee members argue that individual caps are unnecessary if aggregate caps
are adopted.
Governance Requirements
Most members of the Committee believe that governance requirements are more
important than ownership and voting limits. As with ownership and voting limits, the
CFTC and SEC Proposed Rules on governance are quite similar. However, there is one
important, and we believe unwarranted, difference. The SEC Proposed Rules mandate
that a higher percentage of board directors be independent but provides for fewer
mandatory committees.
The CFTC Proposed Rules require that DCO, DCM, and SEF boards of directors
be composed of at least 35%, but no fewer than two, public directors.20 (For these
purposes, the CFTC’s term “public director” is substantively the same as the SEC’s term
“independent director.”)21 It further mandates that these boards have a nominating
committee composed of at least 51% public directors and a public director chair22 and
have a minimum of one disciplinary panel with a chair who could qualify as a public
director.23 Under the CFTC Proposed Rules, SEFs and DCMs must also appoint a
regulatory oversight committee composed entirely of public directors,24 and DCOs must
have a risk management committee at least 35% and 10% of whose members must be
public directors and customer representatives, respectively.25 The SEC Proposed Rules
are similar, but have a few differences. First, for SB SEFs, SBS exchanges, and (under
one alternative) SBS clearing agencies, the SEC Proposed Rules require the boards to
consist of a majority of independent directors26 and the nominating committees to be
composed solely of independent directors. 27 Under the other alternative for SBS clearing
agencies, the SEC Proposed Rules require the boards to consist of 35% of independent
directors and the nominating committees to have a majority of independent directors.28
Moreover, unlike the CFTC, the SEC would not require a disciplinary panel or risk
20
CFTC Proposed Rules § 40.9(b)(1)(i).
21
The CFTC itself suggests in noting that its expanded definition of “public director” “attempts to
harmonize the ‘public director’ definition with the SEC 2004 Release and currently accepted practices.” Id.
at 63,742.
22
Id. § 40.9(c)(1)(iii).
23
Id. § 40.9(c)(3)(ii).
24
Id. §§ 37.19(b)(1), (3), 38.851(b)(1), (3).
25
Id. § 39.13(g)(1), (3)(i).
26
SEC Proposed Rules §§ 242.701(b)(3)(i), 242.702(d)(1).
27
Id. §§ 242.701(b)(4)(i), 242.702(f)(1).
28
Id. §§ 242.701(a)(3)(i), 242.701(a)(4)(i).
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committee but would require SB SEFs and SBS exchanges to establish a regulatory
oversight committee consisting entirely of independent directors.29
The Committee does not believe that the CFTC and SEC Proposed Rules should
differ on these matters. For example, the SEC Proposed Rules, unlike the CFTC Proposed
Rules, have alternatives for SBS clearing agencies, the Voting and Governance
Alternatives. Explaining its reduced 35% requirement for SBS clearing agency boards
under the Voting Alternative, the SEC notes that it sought “to address potential concerns
that requiring a majority independent Board for security-based swap clearing agencies
would affect the Board’s ability to effectively perform risk management functions,”
functions that the SEC believes to be more critical for SBS clearing agencies than for SB
SEFs and SBS exchanges because the former pose a greater level of systemic risk.30 But
if clearing agencies are more systemically important than exchanges and exchange-like
facilities—and the Committee agrees that they are—a strong case can be made that DCOs
should similarly be subject to different independence requirements than SEFs and DCMs.
The Committee also believes, however, that both DCOs and SBS clearing agencies—the
clearinghouses—should be subject to a special risk committee requirement.
The Committee has also considered the potential lack of expertise on boards
subject to these rulemakings. We agree with the SEC that there can be a tradeoff between
the ability of a systemically important institution to manage its risk with experts and the
independence of its board. Although the Committee is split on the inherent value of board
independence in this context—with some members arguing that independent directors
can play an important oversight role and others questioning whether such directors are in
fact best suited to mitigate conflicts of interest31—all members agree on the importance
of mitigating systemic risk, which, after all, is one of the overarching objectives of the
Dodd-Frank Act.
Given this objective and the SEC’s own recognition that clearing agencies pose
systemic risk, it is unclear why SBS clearing agencies, unlike DCOs, need not appoint a
risk management committee. But even under the CFTC Proposed Rules, which do call for
such a group, the Committee fears that risk management may suffer. With a 35% public
director and 10% customer representative requirement, the risk management committee
may lack the necessary expertise to make informed decisions on the complex, far-
reaching matters that clearinghouses confront. Recognizing this possibility, certain
Committee members nonetheless express concern that a risk management committee
without a critical mass of independent parties might have to defer to self-interested
entities.
29
Id. § 242.702(e).
30
SEC Proposed Rules at 65,909.
31
See, e.g., CFTC Proposed Rules at 63,738 & n.49 (noting that participants in its August 20 Public
Roundtable on Governance and Conflicts of Interest in the Clearing and Listing of Swaps “raised
the
possibility
that
conflicts
of
interest
may
also
be
mitigated
by
providing
for
fair
representation
of
all
constituencies
in
the governance of a DCO, DCM, or SEF”).
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Finally, the Committee as a whole is of the view that the CFTC and SEC
Proposed Rules fall short in not encouraging enough openness at the board level. The
SEC Proposed Rules in particular give directors a large amount of latitude in the
committees that they can appoint, not to mention the activities that they or their delegates
carry out through these committees. Thus, whether or not the CFTC and SEC opt to
lower the independence minimums for the board as a whole or specific groups on it, the
Committee supports a provision that would require all major board and committee
decisions to be made public. Such a requirement would go far in promoting the
transparency and accountability that the Dodd-Frank Act seeks.32
Thank you for considering our comments. Please do not hesitate to contact us at
(617) 384-5364 if we can be of any further assistance.
Respectfully submitted,
R. Glenn Hubbard John L. Thornton Hal S. Scott
CO-CHAIR CO-CHAIR DIRECTOR
32
See Dodd-Frank Act pmbl. (providing that the Act is intended, inter alia, “[t]o promote the financial
stability of the United States by improving accountability and transparency in the financial system”).
