Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities Regarding the Mitigation of Conflicts of Interest

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Commodity Futures Trading Commission (the “Commission”) hereby proposes rules to implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Specifically, the proposed rules contained herein impose new requirements on derivatives clearing organizations (“DCOs”), designated contract markets (“DCMs”), and swap execution facilities (“SEFs”) with respect to mitigation of conflicts of interest.

DATES:

Submit comments on or before November 17, 2010.

ADDRESSES:

You may submit comments, identified by RIN number, by any of the following methods:

• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.
• Agency Web Site: http://www.cftc.gov. Follow the instructions for submitting comments on the Web site.
• E-mail: dcodcmsefGovernance@cftc.gov.
• Fax: 202-418-5521.
• Mail: David A. Stawick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.
• Hand Delivery/Courier: Same as mail above.

FOR FURTHER INFORMATION CONTACT:

Nancy Liao Schnabel, Special Counsel, Division of Clearing and Intermediary Oversight (DCIO), at 202-418-5344 or nschnabel@cftc.gov; Lois Gregory, Assistant Deputy Director for Market Review, the Division of Market Oversight (DMO), at 202-418-5569 or lgregory@cftc.gov; Andrea Musalem, Special Counsel, DCIO, at 202-418-5167 or amusalem@cftc.gov; Jordan O'Regan, Attorney-Advisor, DCIO, at 202-418-5984 or joregan@cftc.gov; Cody Alvarez, Attorney-Advisor, DMO, at 202-418-5404 or calvarez@cftc.gov; Dana Brown, Law Clerk, DMO, at 202-418-5093 or dbrown@cftc.gov; Jolanta Sterbenz, Counsel, Office of the General Counsel, at 202-418-6639 or jsterbenz@cftc.gov; David Reiffen, Senior Economist, Office of the Chief Economist, at 202-418-5602 or dreiffen@cftc.gov; or Alicia Lewis, Attorney-Advisor, DCIO, at 202-418-5862 or alewis@cftc.gov; in each case, also at the Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

On July 21, 2010, President Obama signed the Dodd-Frank Act. Title VII of the Dodd-Frank Act amended the Commodity Exchange Act (“CEA”) to establish a comprehensive new regulatory framework for swaps and certain security-based swaps. The legislation was enacted to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (i) Providing for the registration and comprehensive regulation of swap dealers and major swap participants; (ii) imposing mandatory clearing and trade execution requirements on clearable swap contracts; (iii) creating robust recordkeeping and real-time reporting regimes; and (iv) enhancing the rulemaking and enforcement authorities of the Commission with respect to, among others, all registered entities and intermediaries subject to the oversight of the Commission.

In order to ensure the proper implementation of the comprehensive new regulatory framework, especially with respect to (ii) above, the Dodd-Frank Act requires the Commission to promulgate rules to mitigate conflicts of interest in the operation of certain DCOs, DCMs, and SEFs. First, Section 726(a) of the Dodd-Frank Act specifically empowers the Commission to adopt “numerical limits * * * on control” or “voting rights” that enumerated entities may hold with respect to such DCOs, DCMs, and SEFs. Second, Section 726(b) of the Dodd-Frank Act directs the Commission to determine the manner in which its rules may be deemed necessary or appropriate to improve the governance of certain DCOs, DCMs, or SEFs or to mitigate systemic risk, promote competition, or mitigate conflicts of interest in connection with the interaction between swap dealers and major swap participants, on the one hand, and such DCOs, DCMs, and SEFs. Finally, Section 726(c) of the Dodd-Frank Act directs the Commission to consider the manner in which its rules address conflicts of interest in the abovementioned interaction arising from equity ownership, voting structure, or other governance arrangements of the relevant DCOs, DCMs, and SEFs. The Commission must complete a rulemaking under Section 726 of the Dodd-Frank Act within 180 days after enactment—i.e., by January 14, 2011.

In carrying out Section 726 of the Dodd-Frank Act, the Commission identifies in Section II below the following potential conflicts of interest:

• Conflicts of interest that a DCO may confront when determining (i) whether a swap contract is capable of being cleared, (ii) the minimum criteria that an entity must meet in order to become a swap clearing member, and (iii) whether a particular entity satisfies such criteria; and

• Conflicts of interest that a DCM or SEF may confront in balancing advancement of commercial interests and fulfillment of self-regulatory responsibilities.

The Commission proposes in Section III below (i) structural governance requirements and (ii) limits on the ownership of voting equity and the exercise of voting power, and describes, in each case, the manner in which such proposals may mitigate conflicts of interest in the operation of a DCO, DCM, or SEF.

In general, the proposed rules include strengthened versions of the acceptable practices that the Commission previously adopted for the DCM core principle on conflicts of interest. The proposed rules impose structural governance requirements and limits on the ownership of voting equity and the exercise of voting power. They impose specific composition requirements on DCO, DCM, or SEF Boards of Directors and require each DCO, DCM, or SEF to have a nominating committee and one or more disciplinary panels. Each DCO must have a risk management committee and each DCM or SEF must have a regulatory oversight committee and a membership or participation committee, subject to specific composition requirements.

The proposed rules limit DCM or SEF members (and related persons) from beneficially owning more than twenty (20) percent of any class of voting equity in the registered entity or from directly or indirectly voting an interest exceeding twenty (20) percent of the voting power of any class of equity interest in the registered entity. With respect to a DCO only, the proposed rules require a DCO to choose one of two alternative limits on the ownership of voting equity or the exercise of voting power. Under the first alternative, no individual member may beneficially own more than twenty (20) percent of any class of voting equity in the DCO or directly or indirectly vote an interest exceeding twenty (20) percent of the voting power of any class of equity interest in the DCO. In addition, the enumerated entities, whether or not they are DCO members, may not collectively own on a beneficial basis more than forty (40) percent of any class of voting equity in a DCO, or directly or indirectly vote an interest exceeding forty (40) percent of the voting power of any class of equity interest in the DCO.

Under the second alternative, no DCO member or enumerated entity, regardless of whether it is a DCO member, may own more than five (5) percent of any class of voting equity in the DCO or directly or indirectly vote an interest exceeding five (5) percent of the voting power of any class of equity interest in the DCO.

Notwithstanding the foregoing, the proposed rules recognize that circumstances may exist where neither alternative would be appropriate for a DCO. Consequently, the proposed rules provide a procedure for the DCO to apply for, and the Commission to grant, a waiver of the limits specified in the first and second alternative.

The proposed rules reflect consultation with staff of the following agencies: (i) The Securities and Exchange Commission (the “SEC”); (ii) the Board of Governors of the Federal Reserve, (iii) the Office of the Comptroller of the Currency; (iv) the Federal Deposit Insurance Corporation; and (v) the Treasury Department. Staff from each of these agencies has provided verbal and/or written comments, and the proposed rules incorporate elements of the comments provided. The proposed rules have been further informed by (i) the joint roundtable that Commission and SEC staff conducted on August 20, 2010 (the “Roundtable”) and (ii) public comments posted to the Web site of the Commission. Finally, mindful of the importance of international harmonization, the proposed rules incorporate certain elements of: (i) The Proposal for a Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties, and Trade Depositories (the “European Commission Proposal”); and (ii) the latest draft of the Principles for Financial Market Infrastructures, which would ultimately be reviewed by the Committee on Payment and Settlement Systems of the Bank for International Settlements and the Technical Committee of the International Organization of Securities Commissions.

The Commission anticipates conducting at least one other rulemaking that may impose requirements on DCOs, DCMs, and SEFs with respect to governance and mitigation of conflicts of interest. The Commission expects to finish such rulemaking by the statutory deadline of July 15, 2011.

The Commission requests comment on all aspects of this release.

II. Conflicts of Interest

As mentioned above, Title VII of the Dodd-Frank Act amended the CEA to establish a comprehensive new framework for swaps and security-based swaps. This framework imposes mandatory clearing and trade execution requirements with respect to clearable swap contracts. Some market participants, investor advocates, and academics have expressed a concern that the enumerated entities have economic incentives to minimize the number of swap contracts subject to mandatory clearing and trading. They contend that control of a DCO by the enumerated entities, whether through ownership or otherwise, constitutes the primary means for keeping swap contracts out of the mandatory clearing requirement, and therefore also out of the trading requirement. The Commission addresses these arguments below. The Commission also examines the contention that sustained competition between DCMs or SEFs with respect to the same swap contracts may exacerbate certain structural conflicts of interest, as the DCM Conflicts of Interest Release defines such term.

a. DCOs

In general, in the commodity futures and options markets, the DCM decides which contracts to list, whereas the DCO manages the risk of guaranteeing such contracts. Clearing members exercise significant control over the manner in which a DCO manages risk, whether the members own the DCO or not. Based on Commission experience, such control has generally permitted the DCO to serve the purposes of the CEA, especially with respect to “ensur[ing] the financial integrity of all transactions subject to [the CEA] and the avoidance of systemic risk.” Clearing members contribute substantial financial resources to the DCO default or guarantee fund. If a clearing member defaults, and the DCO holds insufficient performance bond from such member to cover its losses, then the DCO would access the default or guarantee fund. Thus, the DCO spreads its losses across all clearing members. This mechanism creates an incentive for each clearing member to ensure that (i) other clearing members meet certain financial requirements and (ii) the DCO adopt a conservative approach towards risk management, especially in determining whether a particular contract would be acceptable for clearing.

This same mechanism also creates a disincentive for clearing members to act collectively (i) to exclude other entities from becoming clearing members or (ii) to bar a DCO from accepting new commodity futures or options contracts. After all, each new clearing member must contribute to the default or guarantee fund. Such contribution would result in a pro rata decrease in the potential exposure of each other clearing member to a default. Moreover, clearing members generally had little incentive to prevent the DCO from accepting a particular contract, absent a risk-based objection. In fact, the more different types of contracts that a DCO accepts, the more the intermediation services that such clearing member offers would likely be in demand.

The regulated market structure that the Dodd-Frank Act contemplates for swap contracts is, in many ways, the mirror image of the market structure for commodity futures and option contracts. Currently, most swap contracts are privately negotiated between two parties, and are generally not cleared. Section 723 of the Dodd-Frank Act requires: (i) Swap contracts meeting certain criteria to be cleared with a DCO; and (ii) such contracts to be executed on a DCM or SEF (unless no DCM or SEF lists such contracts). Therefore, a DCO has unprecedented influence over the manner in which a swap contract can be executed.

Certain market participants and academics believe that Section 723 of the Dodd-Frank Act does not introduce any new incentives for clearing members to act collectively (i) to exclude other entities from becoming clearing members or (ii) to bar a DCO from accepting new contracts. First, they argue that clearing does not make a bilateral swap contract less profitable. Second, they contend that, because clearing does not impact the profitability of a bilateral swap contract, swap clearing members that are enumerated entities have specific, risk-based justifications for (i) setting membership criteria that exclude certain entities and (ii) determining that certain swap contracts cannot be cleared. Third, they assert that such swap clearing members must have the right to cause the DCO to act on such justifications, since ultimately, the capital of such clearing members (i.e., their contributions to the default or guarantee fund) may be accessed if a fellow clearing member defaults.

Others do not agree. They maintain that certain enumerated entities are active in the over-the-counter swap markets and that they earn significant revenues from this line of business. Such entities may experience substantial decreases in revenues if swap contracts were required to be (i) cleared with a DCO and (ii) executed on a DCM or SEF. Therefore, some contend that such entities may have an incentive to represent that certain swap contracts do not meet the mandatory clearing criteria under Section 723 of the Dodd-Frank Act. Such swap contracts would also not be subject to the trading requirement under Section 723 of the Dodd-Frank Act.

Although Section 723 of the Dodd-Frank Act grants the Commission ultimate authority to determine whether a swap contract must be cleared with a DCO, it also anticipates that the Commission would consider the risk assessment of DCOs. Currently, DCOs that clear large volumes of swap contracts tend to have swap clearing members that consist exclusively of enumerated entities. Therefore, some argue that the risk assessment of such DCOs may be compromised. Moreover, some contend that the swap clearing members of such DCOs may exclude non-enumerated entities from becoming clearing members, because non-enumerated entities may influence risk assessments of DCOs in favor of clearing more swap contracts. Some market participants maintain that such practices may have systemic implications.

The framers of the Dodd-Frank Act observe that the clearing of swap contracts constitutes a key means for managing systemic risk, because clearing removes the type of interconnectedness between financial institutions that contributed to the financial crisis resulting from the failure and bankruptcy of firms such as Bear Stearns, Lehman Brothers, and AIG. Therefore, it is important to mitigate potential conflicts of interest that may prevent clearable swap contracts from becoming subject to mandatory clearing. At the same time, the Commission recognizes that the safety and soundness of a DCO should not be compromised. A DCO must not only have the ability to appropriately manage the risk associated with each and every contract that it guarantees, it must be able to decline accepting contracts for clearing if they pose unacceptable risks. In addition, DCO members must have input in setting membership criteria, because they bear the risk of loss in the event of member default. Nevertheless, the Commission does not believe that (i) subjecting more swap contracts to mandatory clearing is incompatible with (ii) DCO safety and soundness. Rather, the Commission intends to ensure, through the proposed rules below, that a DCO takes action to achieve both (i) and (ii), and that the private, competitive interests of certain DCO members do not capture DCO risk assessments.

b. DCMs and SEFs

The main function of a DCM, as well as a SEF, is to provide a facility for: (i) The discovery of prices; and (ii) the execution of transactions. However, in order to obtain and maintain a license to perform such a function, each DCM and SEF must fulfill self-regulatory obligations under the CEA and the Dodd-Frank Act. Therefore, although each DCM or SEF is a commercial enterprise, the fact that each entity has self-regulatory obligations means that each entity “is not simply a corporation, but a corporation charged with the public trust.” Section 3(b) of the CEA confers on the Commission the responsibility for ensuring that each DCM or SEF appropriately prioritizes its self-regulatory obligations. Such obligations include appropriately implementing the comprehensive new framework that the Dodd-Frank Act sets forth, as well as meeting existing requirements under the CEA.

As the DCM Conflicts of Interest Release notes, increased competition may exacerbate conflicts of interest, causing a DCM to (i) prioritize commercial interests over self-regulatory responsibilities; and (ii) restrict access or impose burdens on access in a discriminatory manner. The Dodd-Frank Act attempts to create conditions favorable to sustained competition between DCMs and SEFs with respect to the same swap contract. For example, the Dodd-Frank Act contemplates that either a DCM or a SEF may list swap contracts. It also contemplates that multiple DCMs or SEFs may list the same swap contract, and that such swap contracts may be offset at the same DCO. Also, in requiring certain swap contracts to be listed on a DCM or SEF, the Dodd-Frank Act may encourage competition between standardized swap contracts and commodity futures and options.

Such sustained competition, if it occurs, would constitute an increase to the competition that most DCMs currently face with respect to commodity futures and options. As described below, the Commission intends to ensure through the proposed rules that each DCM or SEF implements appropriate systems to manage such conflicts.

c. Questions on Conflicts of Interest

The Commission seeks comment on the questions set forth below on potential conflicts of interest.

• Has the release correctly identified the conflicts of interest that a DCO, DCM, or SEF may confront?
• Has the release accurately specified the possible effects of such conflicts of interest on DCO, DCM, or SEF operations? What are other possible effects?
• What other conflicts of interest may exist? What are the effects of such conflicts?

III. Mitigation of Conflicts of Interest

To mitigate, on a prophylactic basis, the conflicts of interest identified above, the Commission sets forth below proposed (i) structural governance requirements and (ii) limits on the ownership of voting equity and the exercise of voting power. As explained in greater detail below, the Commission views (ii) as a method of enhancing (i), in that (ii) limits the influence that certain shareholders may exert over the DCO, DCM, or SEF Board of Directors. The Commission believes that such influence may affect, among other things, the independent perspective of public directors. The Commission does not believe that stricter structural governance requirements (e.g., a higher percentage of public directors) justify more lenient limits on the ownership of voting equity and the exercise of voting power, or vice versa. However, the Commission requests comment on the proper relationship between such requirements and limits. The Commission also requests comment on whether both (i) structural governance requirements and (ii) limits on the ownership of voting equity and the exercise of voting power are necessary or appropriate to mitigate the conflicts of interest described in Section II, or whether one or the other (or neither) would be effective.

In applying such requirements and limits, the Commission does not propose to distinguish between DCMs and SEFs listing swap contracts. As mentioned above, such DCMs and SEFs may experience sustained competition with respect to the same swap contract, and therefore would face the same pressures on self-regulation. Additionally, the Commission does not propose to distinguish between (i) DCMs listing swap contracts and (ii) DCMs listing only commodity futures and options. As mentioned above, clearable swap contracts may share sufficiently similar characteristics with certain commodity futures and options as to compete with respect to execution. Therefore, a DCM listing only commodity futures and options may face competition from a SEF with fewer self-regulatory requirements, in the same manner as a DCM listing swap contracts. Given that the same conflicts of interest may concern both types of DCM, it would appear that the same (i) structural governance requirements and (ii) limits on the ownership of voting equity and the exercise of voting power should apply.

In addition, the Commission does not propose to distinguish between (i) DCOs clearing swap contracts and (ii) DCOs clearing only commodity futures and options. Certain standardized swap contracts have sufficiently similar risk profiles to commodity futures and options that the Commission has, on occasion, permitted such products to be commingled and margined within the segregated customer account under Section 4d of the CEA. If the Commission applied differential (i) structural governance requirements and (ii) limits on the ownership of voting equity and the exercise of voting power, the Commission risks creating an incentive for regulatory arbitrage between the two types of DCO.

The Commission requests comment on holding the two types of (i) DCMs and (ii) DCOs to the same requirements regarding the mitigation of conflicts of interest. The Commission also requests comment on holding DCMs and SEFs listing swap contracts to the same requirements. The Commission is specifically interested in the costs and benefits of its approach.

a. Structural Governance Requirements

i. Independence

In general, the structural governance requirements mitigate conflicts of interest at a DCO, DCM, or SEF by introducing a perspective independent of competitive, commercial, or industry considerations to the deliberations of governing bodies (i.e., the Board of Directors and committees). Such independent perspective would more likely encompass regulatory considerations, and to accord such considerations proper weight. Such independent perspective also would more likely contemplate the manner in which a decision might affect all constituencies, as opposed to concentrating on the manner in which a decision affects the interests of one constituency.

In the DCM Conflicts of Interest Release, the Commission emphasized the importance of independent decision-makers in protecting DCM self-regulatory functions from DCM commercial interests and that of its constituencies. However, the Commission notes that participants in the Roundtable 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. Theoretically, all constituencies would act in their own commercial, competitive, or industry interests, but no one interest would dominate. The Commission specifically requests comment regarding whether fair representation would be preferable to, or would complement, director independence in mitigating the DCO, DCM, and SEF conflicts of interest described in Section II. The Commission would particularly welcome factual examples. The Commission also requests comment on how the proposed structural governance requirements should change if the Commission adopts a fair representation standard as either an alternative to, or a complement of, rules emphasizing an independent perspective.

ii. Board Requirements

1. Composition

As the DCM Conflicts of Interest Release states, “the governing board * * * is [the] ultimate decision maker and therefore the logical place to begin to address conflicts.” The Commission proposes (i) maintaining the requirement that DCM Boards of Directors be composed of at least 35 percent “public directors” and (ii) extending this requirement to SEF and DCO Boards of Directors. In the DCM Conflicts of Interest Release, the Commission stated that the 35 percent requirement struck an appropriate balance between (i) the need to minimize conflicts of interest in DCM decision-making processes with (ii) the need for expertise and efficiency in such processes. Such rationale would appear to apply to SEF and DCO Boards of Directors as well.

In addition to the 35 percent composition requirement, the Commission proposes specifying that DCO, DCM, and SEF Boards of Directors may not have less than two public directors. Such a requirement is also contained in the European Commission Proposal. As the Commission has observed that most DCO and DCM Boards of Directors contain more than three members, the Commission does not believe that such a requirement imposes additional burden. However, the Commission welcomes comment on this proposal.

In order to prevent evasion of the abovementioned composition requirements through corporate structuring or internal reorganization, the Commission proposes extending the composition requirements to any committee of the Board of Directors that may exercise delegated authority with respect to the management of a DCO, DCM, or SEF. Further, the Commission proposes prohibiting a DCO, DCM, or SEF from permitting itself to be operated by another entity, unless such entity agrees to comport with such requirements in the same manner as the DCO, DCM, or SEF.

The Commission would like to clarify that it does not intend to extend the abovementioned composition requirements to an entity that does not exert active and recurrent control over the operations of a DCO, DCM, or SEF. Consequently, the Commission proposes to deem an entity to “operate” a DCO, DCM, or SEF only if it engages in “the direct exercise of control (including through the exercise of veto power) over the day-to-day business operations” of the registered entity.

In addition to the abovementioned composition requirements, the Commission proposes prohibiting a DCO, DCM, or SEF from permitting itself to be operated by an entity unless such entity agrees to subject (i) its officers, directors, employees, and agents to Commission authority, and (ii) its books and records to Commission inspection and copying. The Commission believes that such proposals are necessary to ensure effective audits of DCO, DCM, or SEF operations, given the corporate structure of the DCO, DCM, or SEF.

2. Questions on Composition

The Commission seeks comment on the questions set forth below on DCO, DCM, and SEF Boards of Directors composition requirements:

• Would such composition requirements be equally valid in mitigating conflicts of interest concerning a privately-held DCO, DCM, and SEF, as opposed to a publicly-held DCO, DCM, and SEF?
• As mentioned above, would providing for fair representation on DCO, DCM, or SEF Boards of Directors be preferable to, or complementary to, mandating specific percentages of public directors? Also, if the main purpose of the 35 percent composition requirement is to introduce an independent perspective into DCO, DCM, and SEF governance, would requiring one or two public directors be sufficient, regardless of the size of the DCO, DCM, or SEF Board of Directors?
• As mentioned above, the Commission is seeking to mitigate potential conflicts of interest that may influence a DCO regarding (i) whether a swap contract is capable of being cleared, (ii) the minimum criteria that an entity must meet in order to become a swap clearing member, and (iii) whether a particular entity satisfies such criteria. Because the DCO Board of Directors would make ultimate decisions implicating (i), (ii), and (iii), is the 35 percent composition requirement sufficient to ensure that the private, competitive interests of certain DCO members do not capture DCO risk assessments with respect to both products and membership? Or should the Commission increase the required percentage of public directors to 51 percent? Or is there a number less than 51 percent but greater than 35 percent that would be more appropriate?
• As described above, the Dodd-Frank Act envisions (i) a DCM competing with a SEF to list the same swap contract, and (ii) a DCM listing a commodity futures or options contract that competes with a swap contract listed on a SEF. In both cases, a DCM would be competing against an entity with lesser self-regulatory obligations. Such competition may place increased stress on the manner in which the DCM aims to satisfy its self-regulatory responsibilities. In light of such stress, is the 35 percent composition requirement still sufficient to protect the DCM self-regulatory function?
• As referenced above, the Dodd-Frank Act anticipates that a SEF would face a more competitive environment at inception than a DCM currently listing commodity futures and options. As the DCM Conflicts of Interest Release notes, increased competition may be detrimental to self-regulation. Therefore, is the 35 percent composition requirement appropriate to ensure that a SEF discharges its self-regulatory functions in the first instance?

3. Substantive Requirements

In addition to the abovementioned composition requirements, the Commission proposes the substantive requirements set forth below, which aim to enhance the accountability of the DCO, DCM, or SEF Board of Directors to the Commission regarding the manner in which such Board of Directors causes the DCO, DCM, or SEF to discharge all statutory, regulatory, or self-regulatory responsibilities under the Dodd-Frank Act and the existing CEA.

• The roles and responsibilities of a DCO, DCM, or SEF Board of Directors must be clearly articulated, especially in respect of the manner in which such Board of Directors ensures that the DCO, DCM, or SEF complies with all statutory, regulatory, and self-regulatory responsibilities under the Dodd-Frank Act and the existing CEA.
• A DCO, DCM, or SEF Board of Directors shall review its performance and that of its individual members annually. It should consider periodically using external faciliators for such reviews.
• A DCO, DCM, or SEF must have procedures to remove a member from the Board of Directors, where the conduct of such member is likely to be prejudicial to the sound and prudent management of the DCO, DCM, or SEF.

Because of the highly specialized nature of DCO, DCM, or SEF operation, the Commission proposes requiring that each member of a DCO, DCM, or SEF Board of Directors have sufficient expertise, where applicable, in financial services, risk management, and clearing services. Roundtable participants generally agreed that a DCO, DCM, or SEF Board of Directors must have sufficient expertise.

To ensure that members of a DCO, DCM, or SEF Board of Directors are not incented to accord undue consideration to the commercial interests of a DCO, DCM, or SEF in relation to regulatory interests, the Commission proposes to prohibit linking the compensation of public directors and other non-executive members of the Board of Directors to the business performance of the DCO, DCM, or SEF.

The abovementioned substantive requirements are in accord with certain provisions in the European Commission Proposal.

4. Questions on Substantive Requirements

The Commission seeks comment on the questions set forth below on the substantive requirements applicable to a DCO, DCM, or SEF Board of Directors:

• What substantive requirements, other than those identified above, should the Commission consider imposing on a DCO, DCM, or SEF Board of Directors to mitigate the potential conflicts of interest described in Section II, as well as any potential conflicts of interest not specified herein? For example, should the Commission consider any additional requirements related to (i) the fiduciary duties that a DCO, DCM, or SEF Board of Directors may owe or (ii) policies or charters that the DCO, DCM, or SEF Board of Directors may adopt?

iii. Committees

1. Requirements for Each DCO, DCM, and SEF

a. Nominating Committee

As stated above, the structural governance requirements contained herein focus on mitigating conflicts of interest through introducing a perspective independent of competitive, commercial, or industry considerations to the deliberations of DCO, DCM, and SEF governing bodies. Public director composition requirements are not, in and of themselves, sufficient to ensure the representation of such independent perspective. The Commission also must protect the integrity of the process by which the DCO, DCM, or SEF selects public directors.

To this end, the Commission proposes requiring each DCO, DCM, or SEF to have a Nominating Committee. The role of the Nominating Committee would be to: (i) Identify individuals qualified to serve on the Board of Directors, consistent with the criteria that the Board of Directors require and any composition requirement that the Commission promulgates; and (ii) administer a process for the nomination of individuals to the Board of Directors. The Commission proposes that (i) public directors comprise at least 51 percent of the Nominating Committee, and (ii) a public director chair the Nominating Committee.

b. Disciplinary Panels

As stated above, each DCM and SEF must fulfill self-regulatory obligations under the CEA and the Dodd-Frank Act. Also, each DCO has certain self-regulatory obligations. The Commission proposes requiring each DCO, DCM, or SEF to have one or more disciplinary panels. The role of such disciplinary panels would be to conduct hearings, render decisions, and impose sanctions with respect to disciplinary matters.

The Commission believes that it is imperative for each DCO, DCM, or SEF to exercise its disciplinary authority in an impartial manner. In the DCM Conflicts of Interest Release, the Commission acknowledged the value of fair representation in maintaining such impartiality. To ensure that fair representation results in impartiality, the Commission proposes (i) maintaining the requirement that each DCM adopt rules that would preclude any group or class of participants from dominating or exercising disproportionate influence on the disciplinary panel, and (ii) extending such requirement to each DCO or SEF. The Commission also proposes mandating that each DCO, DCM, or SEF adopt rules that would prohibit any member of a disciplinary panel from participating in deliberations or voting on any matter in which the member knowingly has a financial interest.

In the DCM Conflicts of Interest Release, the Commission also acknowledged the importance of an independent perspective. The Commission proposes retaining and strengthening the role that such perspective plays in DCO, DCM, or SEF disciplinary processes. First, the Commission proposes (i) maintaining the requirement that each DCM disciplinary panel include at least one “public participant,” and (ii) extending such requirement to each DCO or SEF disciplinary panel. Second, the Commission proposes requiring that the chair of each disciplinary panel be a public participant.

2. Requirements for Each DCO Only

a. Risk Management Committee (and Subcommittee)

The central purpose of a DCO is to guarantee the performance of each derivatives contract that it clears. In order to fulfill such guarantee, each DCO must appropriately manage the risks associated with such contract. In general, a DCO convokes a committee to oversee risk management. The Commission proposes to require each DCO to have a Risk Management Committee.

Swap contracts, as well as commodity futures and options, are complex instruments. Managing the risks of such instruments requires expertise. In general, clearing members constitute the main source of such expertise, as they (i) routinely execute trades in such instruments and (ii) have experience in managing risks posed by customer trades. Because of the lack of a centralized market for swap contracts, swap clearing members also perform the function of (i) pricing a swap contract and (ii) participating in an auction to liquidate the swap contract in the event of member default.

However, as discussed above, swap clearing members at DCOs that currently clear large volumes of swap contracts are exclusively enumerated entities. Some have argued that the enumerated entities have an incentive to influence DCO risk assessments regarding (i) whether a swap contract is capable of being cleared, (ii) the appropriate membership criteria for a swap clearing member, and (iii) whether a particular entity meets such criteria. Therefore, the Commission must carefully consider the composition of the Risk Management Committee, in order to achieve (i) the increased clearing of swap contracts that the Dodd-Frank Act contemplates without compromising (ii) DCO safety and soundness.

The Commission proposes a three-pronged approach to mitigating the potential conflict of interest identified above, while still ensuring that the Risk Management Committee retains sufficient expertise. First, the Commission proposes requiring that 35 percent of the Risk Management Committee be composed of public directors, with sufficient expertise in, among other things, clearing services. Second, the Commission proposes requiring that 10 percent of the Risk Management Committee be composed of customers of clearing members, who also routinely execute swap contracts (as well as commodity futures and options) and who have experience in using pricing models for such contracts (if only to ensure that they receive a fair price from the enumerated entities). Because customers benefit from a wider pool of swap clearing members and greater competition between such members, customers have an incentive to ensure that the membership criteria of a DCO are risk-based, and do not reflect the private, competitive interests of the enumerated entities. Third, the Commission proposes to permit a DCO Risk Management Committee to delegate to a subcommittee (the “Risk Management Subcommittee”) the responsibility to: (i) Determine the standards and requirements for initial and continuing clearing membership eligibility; (ii) approve or deny (or review approvals or denials of) clearing membership applications; and (iii) determine products eligible for clearing. If the Risk Management Committee effects such a delegation, then it would free itself of the composition requirements. The decisions of the Risk Management Subcommittee would be subject to review by the Risk Management Committee. Therefore, if the Risk Management Committee determines that a particular decision by the Risk Management Subcommittee is overly risky, then the Risk Management Committee may overrule that decision.

In order to prevent evasion of the above-mentioned composition requirements through internal reorganization, the Commission proposes to prohibit:

• A decision of the Risk Management Subcommittee from being subject to the approval of, or otherwise restricted or limited by, a body other than the DCO Board of Directors or the DCO Risk Management Committee, including, without limitation, any advisory committee; and
• Certain decisions of the Risk Management Committee from being subject to the approval of, or otherwise restricted or limited by, a body other than the DCO Board of Directors, including, without limitation, any advisory committee.

The Commission requests comment on its three-pronged approach, including any alternatives to such approach. The Commission also requests comment on (i) the specific percentages set forth above, and (ii) the prohibitions on certain bodies approving of, or otherwise restricting or limiting, the decisions of the Risk Management Committee (or Risk Management Subcommittee, as applicable).

3. Requirements for Each DCM or SEF Only

a. Membership or Participation Committee

As mentioned above, increased competition may exacerbate conflicts of interest, causing a DCM or SEF to (i) prioritize commercial interests over self-regulatory responsibilities; and (ii) restrict access or impose burdens on access in a discriminatory manner. Roundtable participants identified a specific example of (ii), where swap clearing members may seek to limit access to SEF execution and pricing to customers executing through such members. The rationale of such example would apply to a DCM as well. To protect decisions regarding access from DCM or SEF commercial interests, or the interests of the enumerated entities, the Commission proposes requiring a DCM or SEF to have a Membership or Participation Committee, composed of thirty-five percent public directors. Such committee would have the responsibility to: (i) Determine the standards and requirements for initial and continuing membership or participation eligibility; (ii) review appeals of staff denials of membership or participation applications; and (iii) approve rules that would result in different categories or classes of members or participants receiving disparate access. The Commission proposes prohibiting the Membership or Participation Committee from upholding any staff denial if the relevant application meets the standards and requirements that such committee sets forth. Further, the Commission proposes prohibiting the Membership or Participation Committee from restricting access or imposing burdens on access in a discriminatory manner, within each category or class of members or participants or between similarly situated categories or classes of members or participants. Nothing in this preamble is meant to prohibit the Commission from issuing substantive proposals regarding access to a DCM or SEF in any subsequent proposed rulemaking.

b. Regulatory Oversight Committee

In the DCM Conflicts of Interest Release, the Commission emphasized the importance of a DCM Regulatory Oversight Committee (“ROC”):

Properly functioning ROCs should be robust oversight bodies capable of firmly representing the interests of vigorous, impartial, and effective self-regulation. ROCs should also represent the interests and needs of regulatory officers and staff; the resource needs of regulatory functions; and the independence of regulatory decisions. In this manner, ROCs will insulate DCM self-regulatory functions, decisions, and personnel from improper influence, both internal and external.

The Commission also underscored the importance of the DCM ROC being composed of 100 percent public directors:

The Commission strongly believes that new structural conflicts of interest within self-regulation require an appropriate response within DCMs. The Commission further believes that ROCs, consisting exclusively of public directors, are a vital element of any such response * * *. ROCs make no direct commercial decisions, and therefore, have no need for industry directors as members. The public directors serving on ROCs are a buffer between self-regulation and those who could bring improper influence to bear upon it.

The Commission proposes (i) maintaining the requirement that DCMs have a ROC composed of only public directors, and (ii) extending such requirement to SEFs, which also have self-regulatory obligations. However, the Commission recognizes that SEFs—but not DCMs—must have a chief compliance officer (i) to monitor SEF adherence to statutory, regulatory, and self-regulatory requirements and (ii) to resolve conflicts of interest that may impede such adherence. The chief compliance officer must report to the SEF Board of Directors (or similar governing body) or the senior SEF officer. Since the Dodd-Frank Act charges the SEF Board of Directors (or similar governing body) or the senior SEF officer with the responsibility for overseeing the chief compliance officer (including with respect to the resolution of conflicts of interest), the Commission requests comment on whether requiring a SEF to also have a ROC is necessary.

iv. Definition of Public Director

The proposed rules include a definition of “public director” that makes several modifications to the definition of “public director” that the Commission adopted in 2009. Such modifications bring several aspects of the definition in line with the definition of “independent director” that the SEC proposed in 2004. Since the Commission is currently, or will in the future, be regulating some of the same entities as the SEC, the modifications to the definition of “public director” are intended to allow for greater harmonization with the SEC and currently accepted practices.

First, the proposed rules include a new bright-line test that prohibits any director that is an officer of another entity, which entity has a compensation committee, on which any officer of the registered entity serves, from being a public director. This test is a part of the independence tests of most listing standards and prevents a public director from having a financial relationship that would likely impair his independence. In light of the obvious conflicts that could arise as a result of such a financial relationship, the Commission proposes that this additional bright-line test be included in the definition of “public director.”

Second, the proposed rules would preclude directors that are employees of members of DCOs, DCMs, and SEFs from being public directors. The proposed rules would also preclude a director, or an entity with which the director is an employee, from being a public director if certain payments are made to such director. In 2009, the Commission moved the evaluation of employment relationships from the bright-line test to an analysis under the overarching materiality standard. The Commission is re-evaluating such move in light of current concerns regarding further protecting regulatory functions from directors that are conflicted due to industry ties. The Commission notes that CBOE Futures Exchange, LLC (“CFE”) submitted a comment letter to this effect in 2009. In particular, CFE expressed concern that, as a result of the removal of employment relationships from the bright-line tests, all required public directors could be member employees. At the time, the Commission felt that such a situation would be incompatible with the overarching materiality test, even if such prohibition against employment was not included in the bright-line test. The Commission seeks comments regarding the re-insertion of employment relationships in the bright-line tests.

Third, the proposed “public director” definition includes an expanded definition of “immediate family” that includes certain family members, whether by blood, marriage or adoption, and also includes any person residing in the home of the director or his immediate family. Such change attempts to harmonize the “public director” definition with the SEC 2004 Release and currently accepted practices.

Finally, the Commission notes that the proposed rules retain the one-year look-back period. The Commission seeks comment as to whether such period should be increased, given (i) current concerns regarding further protecting regulatory functions from directors that are conflicted due to industry ties, and (ii) the goal of achieving harmony with the SEC and currently accepted practices.

v. Questions on Committees and the Definition of Public Director

In addition to any questions that the Commission may have posed above, the Commission seeks comment on the following questions regarding DCO, DCM, or SEF committees, and the attendant composition requirements, as well as the definition of public director:

• Is each of the committees or panels specified above necessary or appropriate for the mitigation of the conflicts of interest described in Section II, or of any conflict of interest not identified herein? If so, are the composition requirements applicable to such committees necessary or appropriate to effect such mitigation?
• What other ways should the Commission consider defining “public director”? Are there other circumstances that the Commission should include in the bright-line materiality tests? Are there circumstances that the Commission should remove from such tests?

b. Ownership and Voting Limits

As mentioned above, the structural governance requirements mitigate DCO, DCM, or SEF conflicts of interest by introducing a perspective independent of competitive, commercial, or industry considerations to the deliberations of governing bodies. The Commission believes that limits on ownership of voting equity and the exercise of voting rights would enhance the structural governance requirements. In general, individuals are compensated for service on the Board of Directors (and the committees thereof). Voting shareholders elect, directly or indirectly, members of the Board of Directors. Such members serve as fiduciaries to all shareholders under state law. Therefore, to ensure that DCO, DCM, or SEF public directors maintain their independent perspective (rather than solely representing the competitive, commercial, or industry considerations of shareholders), the Commission believes that limits on ownership of voting equity and the exercise of voting rights are necessary.

i. DCOs

According to the DCM Conflicts of Interest Release, “[t]oday's DCMs * * * are vibrant commercial enterprises competing globally in an industry whose ownership structures, business models, trading practices, and products are evolving rapidly.” The same evolution, and the diversity in ownership structures that it engenders, may be observed in DCOs. Therefore, in acknowledgement of the different DCO ownership structures that currently or may in the future exist, the Commission proposes that a DCO choose between one of two alternative limitations on ownership of voting equity and the exercise of voting rights. However, the Commission recognizes that circumstances may exist where neither alternative may be appropriate. Consequently, the Commission also proposes a waiver procedure.

1. First Alternative

For the first alternative, the Commission proposes a combination of a single-member limitation and an aggregate limitation (the “First Alternative”).

a. Single-Member Limitation

First, the Commission proposes requiring a 20 percent limitation on the voting equity that any single member (and related persons) may own. Economic research suggests that holding 20 percent voting equity of an entity may be sufficient for exerting control over an entity, especially if that entity has otherwise diffuse ownership.

As described above, based on Commission experience, control of a DCO by members collectively has generally permitted the DCO to serve the purposes of the CEA. However, such description does not necessarily hold true if, for example, the DCO has demutualized but one member retains sufficient voting ownership to dominate the DCO. Such domination may result in the DCO relaxing risk management standards with respect to that member, but imposing more stringent standards on others.

Given the increased importance of the DCO in managing systemic risk, the Commission believes that limiting the amount of voting equity that any one member may own is appropriate to ensure impartiality in risk assessment, especially in a DCO with otherwise diffuse ownership. To prevent evasion of the 20 percent limitation, the Commission proposes requiring an identical limit on voting rights; and if the DCO is a subsidiary, extending the limitation to the shareholders of its direct or indirect parent. If any parent is publicly-listed, then that parent would have to comply with shareholder voting requirements promulgated by the SEC or the exchange on which the parent is listed.

b. Aggregate Limitation

Further, the Commission proposes a 40 percent limitation on the voting equity that the enumerated entities (and their related persons) may own in the aggregate, regardless of whether such entities are DCO members. As mentioned above, some market participants, investor advocates, and academics have argued that the enumerated entities may have commercial incentives to influence DCO risk assessments regarding (i) whether a swap contract is capable of being cleared, (ii) the appropriate membership criteria for a swap clearing member, and (iii) whether a particular entity meets such criteria. The enumerated entities may directly influence such assessments through participation on the Risk Management Committee as clearing members, or indirectly influence such assessments as voting shareholders. In general, the Commission believes that the enumerated entities would attempt to influence such assessments as voting shareholders only if the DCO has a mutualized structure with concentrated ownership. In such a structure, the percentage necessary for control would be higher than the abovementioned 20 percent, which is sufficient for a diffuse ownership structure.

In counterweight to the commercial incentives that the enumerated entities may have to influence DCO risk assessments regarding (i), (ii), and (iii) above, the Commission acknowledges that the enumerated entities have the capital and expertise necessary to manage the risks of clearing swap contracts. Therefore, the Commission believes that a 40 percent aggregate limitation is appropriate, assuming that the DCO has a mutualized structure with concentrated ownership, because it permits the enumerated entities to influence, directly or indirectly, but not control, DCO risk assessments.

In conjunction with the 40 percent aggregate limitation, the Commission proposes requiring a majority vote for the passage of any shareholder resolution; and if the DCO is a subsidiary, extending the aggregate limitation and the requirement for a majority vote to the shareholders of its direct or indirect parent. If any parent is publicly-listed, then that parent would have to comply with shareholder voting requirements promulgated by the SEC or the exchange on which the parent is listed.

2. Second Alternative

For the second alternative, the Commission proposes a 5 percent limitation on the voting equity that any DCO member or enumerated entity (whether or not such entity is a DCO member), and the related persons thereof in each case, may own (the “Second Alternative”). Such a limitation effectively ensures that neither a DCO member nor an enumerated entity would have sufficient power, in a concentrated or diffuse ownership structure, to exert undue influence, as a voting shareholder, over DCO operations (including with respect to risk assessments regarding (i), (ii), and (iii) above). Certain Roundtable participants favor a similar approach.

To prevent evasion of the 5 percent limitation, the Commission proposes requiring an identical limit on voting rights; and if the DCO is a subsidiary, extending the limitation to the shareholders of its direct or indirect parent. If any parent is publicly-listed, then that parent would have to comply with shareholder voting requirements promulgated by the SEC or the exchange on which the parent is listed.

3. Waiver

As mentioned above, the Commission believes that there may be circumstances where the imposition of rigid limitations on ownership or voting rights may not be appropriate for certain DCO ownership structures. To provide flexibility, a DCO may request that the Commission waive individual and/or aggregate ownership or voting rights limitations by any entity for a reasonable period of time.

The Commission may grant the requested waiver if it determines that ownership or voting rights limitations are not necessary or appropriate to:

• Improve the governance of the DCO;
• Mitigate systemic risk;
• Promote competition;
• Mitigate conflicts of interest in connection with a swap dealer's or major swap participant's conduct of business with the DCO with respect to fair and open access and participation and product eligibility; and
• Otherwise accomplish the purposes of the Act.

The Commission may, at any time, revoke the waiver. Upon such revocation, or at the expiration of the waiver period, any such DCO shall require divestiture of any relevant entity's ownership or voting rights percentages to an individual and/or aggregate level that is consistent with the First or Second Alternative, or such other level that the Commission deems appropriate based on the foregoing factors as set forth in Section 726(b) of the Dodd-Frank Act.

4. Questions on the First and Second Alternatives and the Waiver

The Commission seeks comment on the questions set forth below on the First and Second Alternatives, as well as the Waiver:

a. First and Second Alternatives

• Are the First and Second Alternatives effective for mitigating, on a prophylactic basis, conflicts of interest arising from the control that (i) one member may exert as a dominant voting shareholder of a DCO and (ii) the enumerated entities may collectively exert as voting shareholders of a DCO (specifically with respect to the DCO risk assessments referenced above)? What methods, other than the First and Second Alternatives, should the Commission consider to mitigate such conflicts of interest? What are the advantages and disadvantages of such methods?
• Under what circumstances would the First and Second Alternatives not be appropriate for a DCO? For example, should the First and Second Alternatives apply equally to established DCOs and start-up DCOs?

• Are the percentages that the Commission specifies in the First and Second Alternatives effective for mitigating conflicts of interest arising from the control that (i) one member may exert as a dominant voting shareholder of a DCO and (ii) the enumerated entities may collectively exert as voting shareholders of a DCO? If not, what alternative percentages should the Commission consider to achieve such mitigation?
• Would the First and Second Alternatives be effective to mitigate any potential conflicts of interest not discussed herein? If not, then what other equity ownership and voting limits should the Commission consider?
• Should the limits in the First and Second Alternatives only apply to clearing members, and not enumerated entities that are not clearing members? Should the limits in the First and Second Alternatives apply only to DCOs, and not to their parent companies?

b. Waiver

• The Commission seeks comment on (i) the circumstances which may require an alternative ownership structure for a DCO, (ii) the types of alternative ownership structures of DCOs that may require flexibility in setting ownership or voting rights levels consistent with achieving the goal of Section 726 of the Dodd-Frank Act to mitigate conflicts of interest, and (iii) the appropriate means to provide such flexibility to the Commission during the DCO application process if such an organization were to adopt an alternative structure.

ii. DCMs or SEFs

The Commission proposes a 20 percent limitation on the voting equity that any single member (and related persons) may own in a DCM or SEF. As mentioned above, economic research suggests that holding 20 percent voting equity of an entity would be sufficient for control, especially if such entity has otherwise diffuse ownership. Such a limitation would prevent any one member of a DCM or SEF from dominating the decision-making process. The Commission also proposes an identical limitation on voting rights; and if the DCM or SEF is a subsidiary, extending the limitation to the shareholders of its direct or indirect parent. If any parent is publicly-listed, then that parent would have to comply with shareholder voting requirements promulgated by the SEC or the exchange on which the parent is listed.

The Commission, however, does not propose imposing a limitation on the voting equity that the enumerated entities may own in the aggregate. As mentioned above, the Dodd-Frank Act specifically attempts to encourage sustained competition between multiple DCMs and SEFs over listing the same swap contract. Based on comments from Roundtable participants, the enumerated entities would be the most likely source of funding for a new DCM or SEF. In this instance, the Commission believes that the benefits of sustained competition between new DCMs and SEFs outweigh the incremental benefit of better governance through limitations on the aggregate influence of the enumerated entities.

1. Questions on DCM or SEF Limits on Ownership and Voting Power

The Commission seeks comment on the questions set forth below on the DCM or SEF limits on ownership and voting power:

• Are the single-member limits on ownership and voting power effective for mitigating, on a prophylactic basis, the conflicts of interest that Section II identifies? What methods, other than such limits, should the Commission consider to mitigate such conflicts of interest? What are the advantages and disadvantages of such methods?
• Should the Commission also consider instituting a waiver procedure for DCMs and SEFs with respect to the single-member limitation?
• Should the single-member limitation be extended to the parent company of a DCM or SEF?

IV. Effectiveness and Transition Period

As noted above, the Commission is contemplating rulemakings on further defining certain entities implicated by the proposed rules (e.g., swap dealers, major swap participants, and swap execution facilities). The Commission anticipates that such rulemakings would be completed by the statutory deadline of July 15, 2011. Therefore, the Commission is proposing a staggered effective date for the final rules on mitigation of conflicts of interest. Any portion of the final rules implicating entities subject to further definition would not become effective until sixty (60) days after July 15, 2011. Portions of the final rules not involving such entities would become effective sixty (60) days after the Federal Register publication of the final rules.

Although the Commission proposes that the final rules become effective within the time periods specified above, consistent with the DCM Conflicts of Interest Release, the Commission will permit each existing DCO, DCM, and SEF to phase-in implementation of the final rules over two (2) years or two regularly-scheduled Board of Directors elections. The Commission expects, however, all new DCO, DCM, and SEF applicants to fully comply with the final rules.

The Commission requests comment on the (i) timing of effectiveness for the final rules, and (ii) the length of the phase-in implementation period. The Commission further requests comment on whether new DCO, DCM, and SEF applicants should have to demonstrate compliance with the final rules to receive registration.

V. Numbering

As the proposed rules constitute amendments or additions to Regulation Parts 1, 37, 38, 39, and 40, the Commission anticipates that the numbering of such proposed rules will change upon completion of other rulemakings concerning such parts.

VI. Related Matters

a. Regulatory Flexibility Act

The Regulatory Flexibility Act (“RFA”) requires that agencies, in proposing rules, consider the impact of those rules on “small entities.” The term “small entity” has the same meaning as the term “small business” under the RFA and the term “small business” generally has the same meaning as the term “small business concern” under section 3 of the Small Business Act.

The proposed rules detailed in this release would only affect DCOs, DCMs, and SEFs. The Commission has previously determined that DCOs and DCMs are not “small entities” for purposes of the RFA. In contrast, SEFs constitute a new category of registrant that the Dodd-Frank Act created. Accordingly, the Commission has not addressed the question of whether SEFs are, in fact, “small entities” for purposes of the RFA.

The Dodd-Frank Act defines a SEF to mean a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that facilitates the execution of swaps between persons and is not a designated contract market. The Commission is hereby proposing that SEFs not be considered to be “small entities” for essentially the same reasons that DCMs and DCOs have previously been determined not to be small entities. These reasons include the fact that the Commission designates a contract market or registers a derivatives clearing organization only when it meets specific criteria including expenditure of sufficient resources to establish and maintain adequate self-regulatory programs. Likewise, the Commission will register an entity as a SEF only after it has met specific criteria including the expenditure of sufficient resources to establish and maintain an adequate self-regulatory program. Accordingly, the Commission does not expect the rules, as proposed herein, to have a significant impact on a substantial number of small entities. Therefore, the Chairman, on behalf of the Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the proposed amendments will not have a significant economic impact on a substantial number of small entities. The Commission invites the public to comment on whether SEFs covered by these rules should be considered small entities for purposes of the RFA.

b. Paperwork Reduction Act

The Paperwork Reduction Act (“PRA”) imposes certain requirements on Federal agencies in connection with their conducting or sponsoring any collection of information as defined by the PRA. The proposed rules do not require a new collection of information on the part of any entities that would be subject to the proposed rules. Accordingly, for purposes of the PRA, the Commission certifies that the proposed rules, if promulgated in final form, would not impose any new reporting or recordkeeping requirements.

c. Cost-Benefit Analysis

Section 15(a) of the CEA requires that the Commission, before promulgating a regulation or issuing an order, to consider the costs and benefits of its action. By its terms, Section 15(a) of the CEA does not require the Commission to quantify the costs and benefits of a new regulation or to determine whether the benefits of the regulation outweigh its costs. Rather, Section 15(a) of the CEA simply requires the Commission to “consider the costs and benefits” of its action.

Section 15(a) of the CEA further specifies that costs and benefits shall be evaluated in light of the following considerations: (1) Protection of market participants and the public; (2) efficiency and competition; (3) financial integrity of the futures markets and price discovery; (4) sound risk management practices; and (5) other public interest considerations. Accordingly, the Commission could, in its discretion, give greater weight to any one of the five considerations and could determine that, notwithstanding its costs, a particular regulation was necessary or appropriate to protect the public interest or to effectuate any of the provisions or to accomplish any of the purposes of the Act.

The Commission has evaluated the costs and benefits of the proposed rules, in light of the specific provisions of Section 15(a) of the CEA, as follows:

1. Protection of market participants and the public. The proposed rules concern governance and conflicts of interest and seek to improve governance arrangements to prevent conflicts of interest that if not addressed, would serve the interests of one group of constituents over other groups, including other market participants and the public. The proposed rules require governance arrangements that allow the registered entities to better serve the public interest.

2. Efficiency and competition. The proposed rules provide for the identification and mitigation of conflicts of interest, which improves efficiency in decision-making and increases fair access to clearing and markets which improves competition.

3. Financial integrity of futures markets and price discovery. The proposed rules facilitate transparency in governance which, in turn, facilitates transparency in matters governed including increased fair access to clearing and trading which, in turn, facilitates price discovery. This decreases risk which, in turn, increases financial integrity.

4. Sound risk management practices. The proposed rules provide for participation in decision-making by those who share in the risk presented by the operation of the registered entity. The governance arrangements provided by the proposed rules provide for a balance among different interests (including the public interest) so that risks presented by one group's interests will not dominate decision-making in the organization. This balance should prevent excess risk associated with any one group's interests from affecting operations.

5. Other public interest considerations. The proposed rules provide for governance arrangements for DCOs, DCMs, and SEFs, as well as methods of mitigating the presence of conflicts of interest, that should, for the reasons, cited above, operate in the best interests of the public.

Accordingly, after considering the five factors enumerated above, the Commission has determined to propose the regulations set forth below. The Commission invites public comment on its evaluation of the costs and benefits of the proposed rules. Specifically, commenters are invited to submit data quantifying the costs and benefits of the proposed rules with their comment letters.

VII. Text of Proposed Rules

List of Subjects

17 CFR Part 1

• Definitions
• Directors
• Committees

17 CFR Part 37

• Swap execution facility
• Conflict of Interest
• Membership
• Access
• Voting
• Ownership

17 CFR Part 38

• Designated contract markets
• Conflict of interest
• Membership
• Access
• Voting
• Ownership

17 CFR Part 39

• Registered clearing organization
• Conflict of interest
• Membership
• Access
• Voting
• Ownership

17 CFR Part 40

• Governance
• Directors
• Committees
• Conflict of interest

For the reasons stated in this release, the Commission hereby amends 17 CFR parts 1, 37, 38, 39, and 40 as follows:

PART 1—GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

1. Revise the authority citation for part 1 to read as follows:

Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 60, 6p, 7, 7a, 7b, 8, 9, 12, 12c, 13a, 13a-1, 16, 16a, 19, 21, 23, and 24 and Sec. 726, Pub. L. 111-203, 124 Stat. 1376.

2. Section 1.3 is amended by adding paragraphs (zz) through (aaa) to read as follows:

PART 37—SWAP EXECUTION FACILITIES

3. Revise the authority citation for part 37 to read as follows:

Authority: Sec. 726, Pub. L. 111-203, 124 Stat. 1376.

4. Revise the heading to Part 37 to read as set forth above.

5. Add § 37.19 to read as follows:

PART 38—DESIGNATED CONTRACT MARKETS

6. Revise the authority citation for part 38 to read as follows:

Authority: 7 U.S.C. 2, 5, 6, 6c, 7, 7a-2 and 12a and Sec. 726, Pub. L. 111-203, 124 Stat. 1376.

7. Section 38.1 is amended by adding a new sentence to the end of the section to read as follows:

PART 39—DERIVATIVES CLEARING ORGANIZATIONS

9. Revise the authority citation for part 39 read as follows:

Authority: 7 U.S.C. 7b and Sec. 726, Pub. L. 111-203, 124 Stat. 1376.

10. Add § 39.13 to read as follows:

PART 40—PROVISIONS COMMON TO REGISTERED ENTITIES

1. Revise the authority citation for part 40 to read as follows:

Authority: 7 U.S.C. 1a, 2, 5, 6, 7, 7a, 8, and 12a, and Sec. 726, Pub. L. 111-203, 124 Stat. 1376. 2. Add § 40.9 to read as follows:

Concurring Statement of Commissioner Scott D. O'Malia

October 1, 2010 Public Meeting

I concur in the Commission's proposal of rules pursuant to Section 726 of the Dodd-Frank Act (the “Act”). However, I have a number of concerns associated with the prescriptiveness of the proposed conflict of interest rules. I believe, given the goals of the Act, it is appropriate to consider more flexible ownership structures and voting rights levels as well as the availability of waivers for derivatives clearing organizations (“DCOs”).

Ownership and Voting Limits on DCOs

A main goal of the Act is to mitigate systemic risk in the U.S. financial system by imposing a mandatory clearing requirement on swaps. Additionally, the business of clearing is serious and financially complex. I am concerned that the proposed rules may not properly consider the effect on mitigation of systemic risk, competition, and capital formation in the DCO space, or afford the Commission with the necessary flexibility to achieve those outcomes. Given that the Commission has yet to consider any new DCO applications under the Act, it is extremely unwise to conduct an experiment with the ownership structure of DCOs.

Second, a stated goal of the Act was to provide all market participants with fair, open, and non-discriminatory access to DCOs. To achieve that end, Congress included Open Access and Participant and Product Eligibility provisions in the Act. Each provision addresses and attempts to eliminate the potential for clearing entities to use ownership control to obstruct market participants from gaining access to a DCO. Rather than utilizing the limited and inflexible ownership caps in the proposed rules, I believe that the open access and eligibility provisions will be more effective in achieving the Act's goals of fair, open, and non-discriminatory access to DCOs.

Third, an overarching goal of the Act is the international harmonization of financial regulation. I believe that it's especially important for the Commission to harmonize its rules with those of foreign regulators in order to prevent regulatory arbitrage. With that said, the European Commission released (September 15, 2010) a proposal on financial reform which does not place individual or aggregate ownership limits on DCOs under European Union jurisdiction.

For the aforementioned reasons, I am in favor of a more flexible approach to limitations on DCO ownership and voting rights, including the availability of a full waiver for individual and aggregate ownership or voting limits on swap dealers or major swap participants that hold or desire to hold debt or equity positions in DCOs.

Public Directors

I fully support the Commission's decision to require a registered entity to have its board of directors and certain other committees composed of thirty-five percent (35%) public directors. This standard is consistent with the Commission's previous core principle 15 for designated contract markets (“DCMs”). The Commission thoroughly vetted this percentage with the public in a recent rulemaking and it concluded that having a board of directors for DCMs composed of thirty-five percent (35%) public directors was neither overly burdensome nor cost prohibitive. Today's proposed rulemaking also raises the question as to whether it is desirable to expand the existing rule from thirty-five percent (35%) up to fifty-one percent (51%) for DCMs, DCOs, and swap execution facilities. I am interested to know how this proposal would enhance the governance of the existing board structures of certain registered entities, and more specifically, how it would expand the clearing and risk management expertise of a DCO.

I strongly encourage the public to closely analyze the language of each proposed rule and to provide the Commission with constructive and detailed comments on each of them. In particular, I am interested to know (i) what effect the Commission's proposed rules on voting and ownership limitations will have on competition, raising capital, and managing risk, and (ii) whether or not the open access and eligibility provisions in Sections 2(h)(1)(B) and 5b(c)(2)(c) of the Act would be a more effective method for the Commission to expand access to clearing, rather than placing limits on the voting and ownership of DCOs.

Proposed Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities Regarding the Mitigation of Conflicts of Interest

Commissioner Jill E. Sommers, Dissenting

The Commission is voting today on a proposal to implement two sections of the Dodd-Frank Act regarding the governance of CFTC regulated trading venues and clearinghouses that trade or clear swaps and how to mitigate conflicts of interest that may arise in connection with ownership interests that certain entities may have in these registrants. Specifically, Section 725(d) of the Act directs the Commission to:

Adopt rules mitigating conflicts of interest in connection with the conduct of business by a swap dealer or a major swap participant with at [DCO], [DCM], or a [SEF] that clears or trades swaps in which the swap dealer or major swap participant has a material debt or material equity investment.

Section 726 of the Act provides that the Commission shall adopt rules which “may” include numerical limits on the degree of control or voting rights that certain enumerated entities may possess with respect to DCOs, DCMs and SEFs if the Commission determines, after a review:

That such rules are necessary or appropriate to improve the governance of, or to mitigate systemic risk, promote competition, or mitigate conflicts of interest in connection with a swap dealer or major swap participant's conduct of business with, a [DCO], [DCM], or [SEF] that clears or posts swaps or makes swaps available for trading and in which such swap dealer or major swap participant has a material debt or equity investment.

I recognize that these provisions direct the Commission to adopt strong governance rules to mitigate conflicts of interest in connection with the interaction between swap dealers and major swap participants and DCOs, DCMs and SEFs in which they have a material debt or equity investment. In my opinion, however, the voting equity restrictions being proposed are not necessary or appropriate to mitigate the perceived conflicts and in fact, may do more harm than good to the emerging marketplace for trading and clearing swaps.

In 2009, after more than two years of study, the Commission finalized acceptable practices to provide a safe harbor for complying with Core Principle 15 for DCMs dealing with conflicts of interest. I support making those acceptable practices mandatory for DCMs, DCOs and SEFs, as augmented by some of the additional provisions being proposed today, such as the Risk Management Committee for DCOs. I believe that strong governance rules, coupled with the Commission's ultimate authority to determine which swaps must be cleared, under Section 723 of Dodd-Frank, is sufficient to ensure that swaps that should be listed for trading and cleared will be listed for trading and cleared.

I have grave concerns that the proposed limitations on voting equity, especially those proposed for enumerated entities in the aggregate with respect to DCOs, may stifle competition by preventing new DCMs, DCOs and SEFs that trade or clear swaps from being formed. The Commission recognizes in the preamble to the proposal that the enumerated entities will be the most likely source of funding for new DCMs and SEFs and thus chose not to propose the aggregate limits for trading venues. I believe the same logic applies with even greater force for DCOs. I am equally concerned that a number of recent entrants into the swaps trading and clearing space will potentially be required to disband their operations if they are unable to attract the required amount of non-voting equity within the two-year/two board election cycles proposed. I also note that the European Commission explicitly rejected ownership limitations in its proposal for regulating OTC derivatives announced September 15th because such limitations may have negative consequences for market structures. I agree. And I hope that we will be mindful of global consistency as we move forward. The marketplace for trading and clearing swaps is in its infancy. I strongly believe that the limitations the Commission is proposing will have the effect of inhibiting emerging competition rather than promoting it. I therefore cannot support today's proposal.