On October 1, 2010, the CFTC issued proposed rules on financial resource requirements for derivative clearing organizations (“DCOs”) and systematically important DCOs (“SIDCOs”). The CFTC also issued proposed rules on conflicts of interest. The rulemaking is permitted under the Dodd-Frank Act. Each proposed rule is analyzed below.

Financial Resource Requirements

Section 725(c) of the Dodd-Frank Act amends Section 5b(c)(2) of the Commodity Exchange Act (“CEA”) by revising certain core principles and adding new ones. The Dodd-Frank Act also allows the CFTC to adopt implementing rules and regulations for the core principles pursuant to its rulemaking authority under Section 8a(5) of the CEA. Section 805(a) of the Dodd-Frank Act allows the CFTC to prescribe regulations for those DCOs that the Financial Stability Oversight Council has determined are systemically important.

The proposed rule would require a DCO to maintain sufficient financial resources to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions. For purposes of determining the largest financial exposure, the exposures of affiliated clearing members would be combined and treated as those of a single clearing member.

Because the failure of a SIDCO to meet its obligations would have a greater impact on the financial system than the failure of other DCOs, the proposed rule would require a DCO that is also a SIDCO to maintain sufficient financial resources to meet its financial obligations to its clearing members notwithstanding a default by the clearing members creating the two largest financial exposures for the SIDCO in extreme but plausible market conditions.

Conflicts of Interest

The proposed rules implement Section 726 of the Dodd-Frank Act, which requires the CFTC to mitigate conflicts of interest in the operation of certain DCOs, designated contract markets (DCMs”), and swap execution facilities (“SEFs”). Specifically, Section 726(a) of the Dodd-Frank Act expressly empowers the CFTC to adopt “numerical limits…on control” or “voting rights” that enumerated entities may hold with respect to such DCOs, DCMs, and SEFs. Section 726(b) of the Dodd-Frank Act directs the CFTC 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. Section 726(c) of the Dodd-Frank Act directs the CFTC 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.

In carrying out Section 726 of the Dodd-Frank Act, the CFTC identified potential conflicts of interest that DCOs, DCMs, or SEFs may face. With respect to a DCO, the CFTC recognized that a DCO may confront conflicts of interest in, among other things, 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. For a DCM or SEF, the CFTC identified the conflicts of interest that these entities may confront in, among other things, balancing the advancement of commercial interests and the fulfillment of self-regulatory responsibilities, including with respect to determinations on access.

To mitigate such potential conflicts of interest in the operation of DCOs, DCMs, and SEFs, the CFTC is proposing (i) structural governance requirements and (ii) limits on the ownership of voting equity and the exercise of voting power. The CFTC views the latter as a method of enhancing the former, in that the latter limits the influence that certain shareholders may exert over the DCO, DCM, or SEF Board of Directors. The CFTC believes that such influence may affect, among other things, the independent perspective of public directors.

The proposed rules impose specific composition requirements on DCO, DCM, or SEF Boards of Directors. Also, the proposed rules require that each DCO, DCM, or SEF have a nominating committee and one or more disciplinary panels. Further, the proposed rules require that (i) each DCO have a risk management committee and (ii) each DCM or SEF have a regulatory oversight committee and a membership or participation committee. In each case, the proposed rules impose specific composition requirements on such committees or panels.

In addition to the composition requirements, the CFTC is proposing certain substantive requirements on DCO, DCM, or SEF Board of Directors to enhance accountability to the CFTC regarding the discharge of statutory, regulatory, or self-regulatory responsibilities. Such substantive requirements include annual self-review of the Board of Directors; board member expertise in financial services, risk management, and clearing; and procedures for board member removal.

The proposed rules do not place any restrictions on ownership of non-voting equity in a DCO, DCM, or SEF. The proposed rules do limit DCM or SEF members from (i) beneficially owning more than twenty (20) percent of any class of voting equity in the registered entity or (ii) directly or indirectly voting (e.g., through proxy or shareholder agreement) 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, the CFTC is proposing that certain individual and aggregate limits be met. Under the individual limit, no individual DCO member (and its related persons) may (i) beneficially own more than twenty (20) percent of any class of voting equity in the DCO or (ii) directly or indirectly vote (e.g., through proxy or shareholder agreement) an interest exceeding twenty (20) percent of the voting power of any class of equity interest in the DCO.

Under the aggregate limit for the first alternative, the enumerated entities (and their related persons), regardless of whether they are DCO members, may not collectively (i) own on a beneficial basis more than forty (40) percent of any class of voting equity in a DCO, or (ii) directly or indirectly vote (e.g., through proxy or shareholder agreement) an interest exceeding forty (40) percent of the voting power of any class of equity interest in the DCO.

Under the second alternative, the CFTC is proposing an individual limit. Specifically, no DCO member or enumerated entity (whether or not such entity is a DCO member), and their related persons, may (i) beneficially own more than five (5) percent of any class of voting equity in the DCO or (ii) directly or indirectly vote (e.g., through proxy or shareholder agreement) an interest exceeding five (5) percent of the voting power of any class of equity interest in the DCO.

The CFTC recognizes that circumstances may exist where neither the first nor second alternative would be appropriate for a DCO. Consequently, the CFTC is proposing a procedure for the DCO to apply for, and the CFTC to grant, a waiver of the limits specified in the first and second alternatives.

The CFTC is also proposing modifications to the definition of “public director” to allow for greater harmonization with the definition of “independent director” proposed by the SEC in 2004 and with currently accepted practices. The modifications include expanding the definition of “immediate family” and adding new bright-line tests that would prohibit certain directors from being deemed “public directors.”

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