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SEC Proposes To Clear-Up Clearing Agencies’ Governance To Mitigate Directors’ Potential Conflicts Of Interest – Securities



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Clearing agencies registered with the Securities and Exchange
Commission (SEC) will have to make governance changes to their
boards of directors under a new rule proposed by the SEC on August
8, 2022.

The SEC proposed the new rule1 to mitigate the conflicts
of interests inherent in clearing agency relationships. The rule
follows episodes of market volatility in 2021 that included large
fluctuations surrounding COVID-19 and the meme stock craze.

The new rule would amend Section 17Ad-25 of the Securities
Exchange Act of 1934 (Exchange Act) to require additional
management and governance requirements for clearing agencies that
register with the SEC. The proposed rules provide specific new
governance requirements on clearing board composition, independent
directors, nominating committees and risk management committees.
The rule also requires the board to oversee relationships with
critical service providers and includes a board obligation to
consider various stakeholder views and inputs.

Rationale

The SEC’s rationale for proposing Rule 17Ad-25, titled
Clearing Agency Governance and Conflicts of Interest, is to reduce
the risk that conflicts of interest inherent in various clearing
agency relationships substantially harm the security-based swaps or
larger financial market. The SEC is proposing this rule to mitigate
conflicts of interest, promote the fair representation of owners
and participants in the governance of a clearing agency, identify
responsibilities of the board, and increase transparency into
clearing agency governance.

The SEC noted that those episodes of increased market volatility
revealed certain vulnerabilities in the US securities market and
the essential role clearing agencies play in managing the risk if
securities transactions fail to clear.

The SEC observed three potential sets of conflicts of interest
that the proposed rule attempts to address.

  1. The proposed rule addresses the different perspectives the
    various stakeholders involved in clearing agencies might have. In
    particular, a clearing agency owner’s potential interest in
    protecting the equity and continued operation of the clearing
    agency diverges from a participant’s potential interest in
    avoiding the allocation of losses from another defaulting
    participant. For instance, in the event of a loss, clearing agency
    participants might prefer to limit access to clearing, while owners
    may choose to expand the scope of products offered to collect
    fees.

  2. Larger clearing agency participants’ priorities may diverge
    significantly from the interests of smaller clearing agency
    participants. In particular, when a small number of dominant
    participants exercise control over a registered clearing agency
    concerning services provided by that clearing agency, those
    participants might promote margin requirements that are not
    commensurate with the risks they take, thereby indirectly limiting
    competition and increasing profit margins for themselves. In other
    words, a registered clearing agency dominated by a small number of
    large participants might make decisions designed to provide them
    with a competitive advantage.

  3. Certain participants may exert undue influence to limit access
    to the clearing agency based on their own interests, and thus could
    limit the benefits of the clearing agency to indirect
    participants.

Rule Requirements

The proposed rule would impose these seven requirements:

  1. define independence in the context of a director serving on the
    board of a registered clearing agency and require that a majority
    of directors on the board be independent, unless a majority of the
    voting rights distributed to shareholders of record are directly or
    indirectly held by participants of the registered clearing agency,
    in which case at least 34 percent of the board must be independent
    directors;

  2. establish requirements for a nominating committee, including
    with respect to the composition of the nominating committee,
    fitness standards for serving on the board, and documenting the
    process for evaluating board nominees;

  3. establish requirements for the function, composition, and
    reconstitution of the risk management committee;

  4. require policies and procedures that identify, mitigate or
    eliminate, and document the identification and mitigation or
    elimination of conflicts of interest;

  5. require policies and procedures that obligate directors to
    report potential conflicts promptly;

  6. require policies and procedures for the board to oversee
    relationships with service providers for critical services;
    and

  7. require policies and procedures to solicit, consider, and
    document the registered clearing agency’s consideration of the
    views of its participants and other relevant stakeholders regarding
    its governance and operations.

The proposing release will be published on SEC.gov and in the
Federal Register. The public comment period will remain
open for 60 days following publication of the proposing release on
the SEC’s website or 30 days following publication of the
proposing release in the Federal Register, whichever
period is longer.

Footnote

1. https://www.sec.gov/rules/proposed/2022/34-95431.pdf

Jacob C. Setton, an associate in the Financial Markets and
Funds practice and candidate for admission to the New York State
bar, contributed to this advisory.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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