# Clearing Agency Governance and Conflicts of Interest > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2023-25807 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** December 5, 2023 - **Citation:** 88 FR 84454 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34-98959; File No. S7-21-22] RIN 3235-0695 Clearing Agency Governance and Conflicts of Interest AGENCY: Securities and Exchange Commission. ACTION: Final rule. SUMMARY: The Securities and Exchange Commission (“Commission”) is adopting rules under the Securities Exchange Act of 1934 (“Exchange Act”) to improve the governance of clearing agencies registered with the Commission (“registered clearing agencies”) by reducing the likelihood that conflicts of interest may influence the board of directors or equivalent governing body (“board”) of a registered clearing agency. The rules identify certain responsibilities of the board, increase transparency into board governance, and, more generally, improve the alignment of incentives among owners and participants of a registered clearing agency. In support of these objectives, the rules establish new requirements for board and committee composition, independent directors, management of conflicts of interest, and board oversight. DATES: Effective date : February 5, 2024. Compliance date: The applicable compliance dates are discussed in Part III of this release. FOR FURTHER INFORMATION CONTACT: Matthew Lee, Assistant Director, Stephanie Park, Senior Special Counsel, Claire Noakes, Special Counsel, Jenny Ogasawara, Branch Chief, and Haley Holliday, Attorney-Adviser, at (202) 551-5710, Office of Clearance and Settlement, Division of Trading and Markets; Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-7010. SUPPLEMENTARY INFORMATION: The Commission is adopting 17 CFR 240.17ad-25 (“Rule 17Ad-25”) under the Exchange Act to establish new requirements for the board governance of registered clearing agencies and for the management of conflicts of interest by registered clearing agencies. 1 Below is a table of citations to the rules being adopted in this release: 1 This adopting release also modifies the proposed CFR designations to ensure the regulatory text conforms with section 2.13 of the Document Drafting Handbook. See 1 CFR 21.11; Office of the Federal Register, Document Drafting Handbook (Aug. 2018 Edition, Revision 2.1, dated Oct. 2023), https://www.archives.gov/files/federal-register/write/handbook/ddh.pdf. Because the Commission proposed the new rules to contain an uppercase letter in their CFR citations, the Commission is modifying the CFR section designations at adoption to replace each such uppercase letter with the corresponding lowercase letter. Accordingly, 17 CFR 240.17Ad-25 will be designated at adoption as 17 CFR 240.17ad-25. Commission reference CFR citation (17 CFR) Securities Exchange Act of 1934 (“Exchange Act”): Rule 17Ad-25 § 240.17ad-25. Rule 17Ad-25(a) § 240.17ad-25(a). Rule 17Ad-25(b) § 240.17ad-25(b). Rule 17Ad-25(b)(1) § 240.17ad-25(b)(1). Rule 17Ad-25(b)(2) § 240.17ad-25(b)(2). Rule 17Ad-25(b)(2)(i) § 240.17ad-25(b)(2)(i). Rule 17Ad-25(b)(2)(ii) § 240.17ad-25(b)(2)(ii). Rule 17Ad-25(b)(2)(iii) § 240.17ad-25(b)(2)(iii). Rule 17Ad-25(c) § 240.17ad-25(c). Rule 17Ad-25(c)(1) § 240.17ad-25(c)(1). Rule 17Ad-25(c)(2) § 240.17ad-25(c)(2). Rule 17Ad-25(c)(3) § 240.17ad-25(c)(3). Rule 17Ad-25(c)(4) § 240.17ad-25(c)(4). Rule 17Ad-25(c)(4)(i) § 240.17ad-25(c)(4)(i). Rule 17Ad-25(c)(4)(ii) § 240.17ad-25(c)(4)(ii). Rule 17Ad-25(c)(4)(iii) § 240.17ad-25(c)(4)(iii). Rule 17Ad-25(c)(4)(iv) § 240.17ad-25(c)(4)(iv). Rule 17Ad-25(d) § 240.17ad-25(d). Rule 17Ad-25(d)(1) § 240.17ad-25(d)(1). Rule 17Ad-25(d)(2) § 240.17ad-25(d)(2). Rule 17Ad-25(e) § 240.17ad-25(e). Rule 17Ad-25(f) § 240.17ad-25(f). Rule 17Ad-25(f)(1) § 240.17ad-25(f)(1). Rule 17Ad-25(f)(2) § 240.17ad-25(f)(2). Rule 17Ad-25(f)(3) § 240.17ad-25(f)(3). Rule 17Ad-25(f)(3)(i) § 240.17ad-25(f)(3)(i). Rule 17Ad-25(f)(3)(ii) § 240.17ad-25(f)(3)(ii). Rule 17Ad-25(f)(4) § 240.17ad-25(f)(4). Rule 17Ad-25(f)(4)(i) § 240.17ad-25(f)(4)(i). Rule 17Ad-25(f)(4)(ii) § 240.17ad-25(f)(4)(ii). Rule 17Ad-25(f)(5) § 240.17ad-25(f)(5). Rule 17Ad-25(f)(6) § 240.17Ad-2525(f)(6). Rule 17Ad-25(g) § 240.17ad-25(g). Rule 17Ad-2525(g)(1) § 240.17Ad-2525(g)(1). Rule 17Ad-25(g)(2) § 240.17ad-25(g)(2). Rule 17Ad-25(h) § 240.17ad-25(h). Rule 17Ad-25(i) § 240.17ad-25(i). Rule 17Ad-25(i)(1) § 240.17ad-25(i)(1). Rule 17Ad-25(i)(2) § 240.17ad-25(i)(2). Rule 17Ad-25(i)(3) § 240.17ad-25(i)(3). Rule 17Ad-25(i)(4) § 240.17ad-25(i)(4). Rule 17Ad-25(j) § 240.17ad-25(j). With respect to board governance, Rules 17Ad-25(b), (e), and (f) establish requirements for board composition and independent directors, as discussed in Part II.A. Rules 17Ad-25(c) and (d) establish requirements for the nominating and risk management committees of the board, as discussed in Parts II.B and II.C respectively. With respect to conflicts of interest, Rules 17Ad-25(g) and (h) establish requirements for policies and procedures to identify, document, and mitigate or eliminate such conflicts of interest, as well as an obligation of directors to report such conflicts to the registered clearing agency, as discussed in Part II.D. In addition, Rules 17Ad-5(i) and (j) establish obligations of the board to oversee the management of risks from relationships with service providers for core services, as discussed in Part II.E, and to solicit, consider and document the views of stakeholders, as discussed in Part II.F. As discussed further in Part III, the compliance date for Rule 17Ad-25 is December 5, 2024, except that the compliance date for the independence requirements of the board and board committees in Rules 17Ad-25(b)(1), (c)(2), and (e) is December 5, 2025. Table of Contents I. Introduction II. Discussion of Comments Received and Final Rules A. Board Composition and Requirements for Independent Directors 1. Proposed Rules 17Ad-25(b), (e), and (f) 2. Overall Views 3. Criteria for Independence 4. Incentive Structures 5. Ownership Structures 6. Circumvention B. Nominating Committee 1. Proposed Rule 17Ad-25(c) 2. As “Exclusive Venue” for Considering Nominees 3. Approach to Representation of Small and Medium-Sized Firms 4. Percent of Directors That Are Independent Directors C. Risk Management Committee 1. Proposed Rule 17Ad-25(d) 2. RMC of the Board 3. Annual Requirement To Re-Evaluate RMC Membership 4. Harmonization With CFTC and EMIR Requirements 5. Other Comments D. Conflicts of Interest 1. Proposed Rules 17Ad-25(g) and (h) 1. Mitigation or Elimination of Conflicts 2. Use of “Reasonably Designed” Policies and Procedures Approach E. Management of Risks From Relationships With Service Providers for Core Services 1. Proposed Rule 17Ad-25(i) 2. Definition of Service Provider for Core Services 3. Roles of Senior Management and the Board F. Obligation To Formally Consider Stakeholder Viewpoints 1. Proposed Rule 17Ad-25(j) 2. Concern Regarding Duplicative Requirements 3. Proposed Scope of “Governance and Operations” 4. Frequency and Method of Outreach 5. Use of Fora To Satisfy the Rule 6. Documentation of Stakeholder Views 7. Harmonization With CFTC Requirements for RWG III. Compliance Dates IV. Economic Analysis A. Introduction B. Economic Baseline 1. Description of Market 2. Overview of the Existing Regulatory Framework 3. Divergent Incentives of Registered Clearing Agency Stakeholders 4. Current Governance Practices C. Consideration of Benefits and Costs as Well as the Effects on Efficiency, Competition, and Capital Formation 1. Economic Considerations for Final Rule Regarding Board Composition 2. Economic Considerations for Final Rules Regarding the Nominating Committee 3. Economic Considerations for Final Rules Regarding the Risk Management Committee 4. Economic Considerations for Final Rules Regarding Conflicts of Interest Involving Directors or Senior Managers 5. Economic Considerations for Final Rules Regarding Management of Risks From Relationships With Service Providers for Core Services 6. Economic Considerations for Final Rules Regarding Formalized Solicitation, Consideration, and Documentation of Stakeholders' Viewpoints D. Reasonable Alternatives to the Final Rules 1. Allow More Flexibility in Governance, Operations, and Risk Management 2. Adopt More Prescriptive Governance Requirements 3. Establish Limits on Participant Voting Interests 4. Increase Shareholders' At-Risk Capital (“Skin in the Game”) 5. Increase Public Disclosure 6. Require Risk Working Group in Addition to Risk Committee V. Paperwork Reduction Act A. Rule 17Ad-25(b) B. Rule 17Ad-25(c) C. Rule 17Ad-25(d) D. Rule 17Ad-25(g) E. Rule 17Ad-25(h) F. Rule 17Ad-25(i) G. Rule 17Ad-25(j) H. Chart of Total PRA Burdens VI. Regulatory Flexibility Act A. Registered Clearing Agencies B. Certification VII. Other Matters Statutory Authority I. Introduction Clear and transparent governance arrangements are integral to ensuring that a clearing agency is resilient because, among other things, such arrangements promote accountability and reliability in decision-making. 2 Since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) in 2010, 3 the Commission has adopted a series of rules intended to promote the resilience of registered clearing agencies, 4 with the goal of establishing an evolving regulatory framework. 5 As discussed in greater detail in the Governance Proposing Release, 6 the Commission has continued to observe and learn from the recurring tensions that exist in the incentive structure of a clearing agency, including their potential effect on the participants of the clearing agency and the broader financial system. 7 Accordingly, the Governance Proposing Release included new rules designed to help ensure that a registered clearing agency can effectively balance the differing incentives that exist among the clearing agency, its participants, and other key stakeholders. 8 The proposed rules included more specific and defined parameters and requirements for governance intended to build upon and strengthen the existing requirements in Rule 17Ad-22 that have a broader and principles-based focus. 9 2 Release No. 34-95431 (Aug. 8, 2022), 87 FR 51812, 51813 (Aug. 23, 2022) (“Governance Proposing Release”). 3 Public Law 111-203, 124 Stat. 1376 (2010). 4 See, e.g., 17 CFR 240.17Ad-22 (“Rule 17Ad-22”); see also Release No. 34-88616 (Apr. 9, 2020), 85 FR 28853, 28855 (May 14, 2020) (“CCA Definition Adopting Release”); Release No. 34-78961 (Sept. 28, 2016), 81 FR 70786 (Oct. 13, 2016) (“CCA Standards Adopting Release”); Release No. 34-68080 (Oct. 22, 2012), 77 FR 66219 (Nov. 2, 2012) (“Clearing Agency Standards Adopting Release”). 5 Governance Proposing Release, supra note 2, at 51814. 6 Id. at 51814-51819. 7 Id. at 51814 (describing the same as “clearing members and the larger financial community”). 8 Id. 9 Id. The Commission received comments on the Governance Proposing Release from registered clearing agencies, participants of registered clearing agencies and their customers, industry groups representing clearing agencies, their participants, and other market participants, academics, individual investors, and other interested parties. 10 Many commenters were supportive of the proposed rules, though some commenters also expressed concerns regarding specific elements of certain rules. In Part II below, the Commission discusses these comments in detail and modifications made in response to the comments. In addition, the Commodity Futures Trading Commission (“CFTC”) recently adopted new requirements applicable to risk management committees (“RMCs”) and risk working groups (“RWGs”) of derivatives clearing organizations (“DCOs”), 11 topics which are also addressed in the context of registered clearing agencies by the Commission's final rules discussed below. The Commission's final rules promote similar outcomes as the CFTC's rules, such as ensuring robust board oversight of senior management, and informing the board of stakeholder views, though in some cases the Commission has taken a different approach as to specific requirements because Rule 17Ad-25 also addresses additional topics, including board composition, director independence, and conflicts of interest. The differing approaches are explained further in Parts II.C.4 and II.F.7. Finally, these rules are being adopted pursuant to section 765 of the Dodd-Frank Act with respect to clearing of security-based swaps, 12 which specifically directs the Commission to adopt rules to mitigate conflicts of interest for security-based swap clearing agencies. 13 10 The Commission voted to issue the Governance Proposing Release on August 8, 2022. The release was posted on the Commission website that day, and comment letters were received beginning the following day. The comment period closed on October 7, 2022. Comments received are available on the Commission's website at https://www.sec.gov/comments/s7-21-22/s72122.htm. The Commission has considered all comments received since August 8, 2022. 11 See Governance Requirements for Derivatives Clearing Organizations, Final Rule, 88 FR 44675 (July 13, 2023). 12 Public Law 111-203, 124 Stat. 1376 (2010). 13 See Governance Proposing Release, supra note 2, at 51819 & n.49 (stating “the targeted set of proposed rules for governance included in this release can help ensure that the framework effectively addresses the considerations set forth in Section 765 with respect to clearing of security-based swaps. Although Section 765 directed the Commission to focus on conflicts of interest specifically with respect to security-based swap clearing agencies, the Commission believes that conflicts of interest concerns can arise across all registered clearing agencies regardless of the asset classes served.”). II. Discussion of Comments Received and Final Rules A. Board Composition and Requirements for Independent Directors 1. Proposed Rules 17Ad-25(b), (e), and (f) Proposed Rules 17Ad-25(b), (e), and (f) would establish requirements related to independent directors serving on the board of a registered clearing agency. First, proposed Rule 17Ad-25(b)(1) would require that a majority of the directors be independent directors, as defined in proposed Rule 17Ad-25(a). The proposed rule would also provide that, if a majority of the voting interests issued as of the immediately prior record date are directly or indirectly held by participants of the registered clearing agency, then at least 34 percent of directors must be independent directors. Proposed Rule 17Ad-25(a) would define an “independent director” to mean a director that has no material relationship with the registered clearing agency, or any affiliate thereof. Proposed Rule 17Ad-25(a) also would define “material relationship” to mean a relationship, whether compensatory or otherwise, that reasonably could affect the independent judgment or decision- making of the director, and includes relationships that existed during a lookback period of one year counting back from making the initial independence determination made in accordance with proposed Rule 17Ad-25(b)(2). In addition, proposed Rule 17Ad-25(a) would define “affiliate” to mean a person that directly or indirectly controls, is controlled by, or is under common control with the registered clearing agency. Proposed Rule 17Ad-25(b)(2) would require that a registered clearing agency broadly consider all the relevant facts and circumstances, including under proposed Rule 17Ad-25(g), on an ongoing basis, to affirmatively determine that a director does not have a material relationship with the registered clearing agency or an affiliate of the registered clearing agency, and is not precluded from being an independent director under proposed Rule 17Ad-25(f), in order to qualify as an independent director. In making such determination, a registered clearing agency must: (i) identify the relationships between a director, the registered clearing agency, and any affiliate thereof, along with the circumstances set forth in proposed Rule 17Ad-25(f); (ii) evaluate whether any relationship is likely to impair the independence of the director in performing the duties of director; and (iii) document this determination in writing. Such documentation requirements would be subject to the recordkeeping and retention requirements that apply to all self-regulatory organizations (“SROs”) under Exchange Act section 17(a)(2) and rules thereunder. Proposed Rule 17Ad-25(e) would require that, if any committee has the authority to act on behalf of the board, the composition of that committee must have at least the same percentage of independent directors as is required under these rules for the board, as set forth in proposed paragraph (b)(1). Proposed Rule 17Ad-25(f) would describe certain circumstances that would always exclude a director from being an independent director. These circumstances would include: (1) the director is subject to rules, policies, and procedures by the registered clearing agency that may undermine the director's ability to operate unimpeded, such as removal by less than a majority vote of shares that are entitled to vote in such director's election; (2) the director, or a family member, has an employment relationship with or otherwise receives compensation, other than as a director, from the registered clearing agency or any affiliate thereof, or the holder of a controlling voting interest of the registered clearing agency; (3) the director, or a family member, is receiving payments from the registered clearing agency, or any affiliate thereof, or the holder of a controlling voting interest of the registered clearing agency that reasonably could affect the independent judgment or decision-making of the director, other than the following: (i) compensation for services as a director to the board or a committee thereof; or (ii) pension and other forms of deferred compensation for prior services not contingent on continued service; (4) the director, or a family member, is a partner in, or controlling shareholder of, any organization to or from which the registered clearing agency, or any affiliate thereof, or the holder of a controlling voting interest of the registered clearing agency, is making or receiving payments for property or service, other than the following: (i) payments arising solely from investments in the securities of the registered clearing agency, or affiliate thereof; or (ii) payments under non-discretionary charitable contribution matching programs; (5) the director, or a family member is employed as an executive officer of another entity where any executive officers of the registered clearing agency serve on that entity's compensation committee; or (6) the director, or a family member, is a partner of the outside auditor of the registered clearing agency, or any affiliate thereof, or an employee of the outside auditor who is working on the audit of the registered clearing agency, or any affiliate thereof. Proposed Rules 17Ad-25(f)(2) through (6) would be subject to a lookback period of one year, counting back from making the initial determination required by proposed Rule 17Ad-25(b)(2). Proposed Rule 17Ad-25(a) would define “family member” to include any child, stepchild, grandchild, parent, stepparent, grandparent, spouse, sibling, niece, nephew, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, including adoptive relationships, any person (other than a tenant or employee) sharing a household with the director or a nominee for director, a trust in which these persons (or the director or a nominee for director) have more than fifty percent of the beneficial interest, a foundation in which these persons (or the director or a nominee for director) control the management of assets, and any other entity in which these persons (or the director or a nominee for director) own more than fifty percent of the voting interests. The Commission is adopting Rules 17Ad-25(b), (e), and (f) generally as proposed but with technical changes to Rule 17Ad-25(a), Rule 17Ad-25(b)(1), Rule 17Ad-25(b)(2), Rule 17Ad-25(b)(2)(i), and Rule 17Ad-25(b)(2)(iii), for the reasons discussed below. In making the technical change to the definition of “material relationship” in Rule 17Ad-25(a), the Commission is embedding the reference to a lookback period that was proposed in a standalone sentence into the initial sentence relating to relationships that could affect the independent judgment or decision-making of a director, in order to clarify that the lookback period is part of the overall reference to these relationships. In making the technical change to Rule 17Ad-25(b)(1), the Commission is replacing the term “voting rights” with “voting interests,” which would be consistent with the terms used elsewhere in the rule text, and which remains consistent with the concept as proposed. In making the technical change to Rule 17Ad-25(b)(2), the Commission is deleting the last proviso that stated, “in order to qualify as an independent director,” because this reference is unnecessary and does not describe all of the requirements for qualifying as an independent director. In making the technical change to Rule 17Ad-25(b)(2)(i), the Commission is reordering the language requiring identification of the relationships between a director and a registered clearing agency, and a director and any affiliate of a registered clearing agency. The proposed rule text implied that there needed to be identification of relationships between the registered clearing agency and its affiliates, which is not intended. In making the technical change to Rule 17Ad-25(b)(2)(iii), the Commission is specifying that the documentation requirement applies to both the registered clearing agency's evaluation of director independence and its ultimate determination ( i.e., whether the director qualifies as an independent director or is not an independent director). Under the proposed text, the phrase “this determination” was intended to encompass broad consideration of all the relevant facts and circumstances on an ongoing basis. The Commission is modifying the text in adopted Rule 17Ad-25(b)(2)(iii) to be “the evaluation and determination” to specify that the documentation requirement applies to both the evaluation of independence and the ultimate determination regarding independence. In the Governance Proposing Release, the Commission stated that an independent director can bolster a board's ability to perform effectively by reducing the potential for financial or other relationships between directors and those persons who are overseen by directors, such as management. 14 Even the appearance of conflicts of interest can reduce confidence in the functioning of the registered clearing agency among direct and indirect participants of the registered clearing agency, other stakeholders, and the public, particularly during periods of market stress when general confidence in market resilience may be low. 15 Indeed, as discussed in the Governance Proposing Release, each of the registered clearing agencies already requires a portion of their directors to have some characteristics of independence (establishing, for example, “nonexecutive” or “public” directors). 16 Further, the structure of a registered clearing agency and the risk management tools that it employs affect how the interests of owners, participants, and other types of stakeholders align. For example, as discussed in the Governance Proposing Release, the risk mutualizing and trade guaranty features provided by many registered clearing agencies provide for the shift of the consequences of one party's actions to another in certain circumstances, such as after a participant default. 17 These features both affect how different stakeholders maximize their own self-interest and also distinguish the governance of a registered clearing agency from other corporate entities. The Commission stated its belief that registered clearing agency processes involving risk management or director nominations are also implicated in managing the dynamics between owners and participants. 18 The ability of a registered clearing agency to help ensure effective risk management and loss allocation in the event of a default or non-default loss is linked to the interests of the owners of the clearing agency, who may also have financial relationships with the participants (or be the participants) of such registered clearing agency. The Commission stated its belief that requiring a certain percentage of independent directors helps promote the ability of the board to perform its oversight of management function and to support a plurality of viewpoints voiced at the board level. 19 Independent directors would help ensure that, when the interests between owners and participants diverge, the balancing of interests is more manageable because the board would not be composed entirely of directors who have material relationships either to management (such as under a situation where managers approve payments from the registered clearing agency to such director), owners, or participants of the registered clearing agency. Achieving balance between stakeholders with divergent views could help the board adequately consider the respective needs of all such stakeholders and help promote the integrity of, and public confidence in, the registered clearing agency's risk management function. 14 See Governance Proposing Release, supra note 2, at 51821. 15 See id. at 51819; see also id. at 51812 n.3 (explaining that examples of indirect participants are customers or clients of direct participants or clearing members since they rely on services provided by a direct participant to access the services of the clearing agency). 16 See id. at 51844. 17 See id. at 51822. 18 See id. 19 See id. at 51823. Comments on the proposed board composition requirements and requirements for independent directors are discussed below. 2. Overall Views Of the comments received on the Governance Proposing Release, the majority were from individuals. Several expressed high-level views either in support or against the proposal, 20 referencing, for example, their concerns that retail investors are being cheated due to clearing agency greed or conflicts of interest, or requesting retail investor representation on the board. Several commenters were specifically concerned with incidents of failures to deliver with their transactions, but did not discuss the rule proposals in the Governance Proposing Release. 21 Many commenters were under the mistaken impression that the proposal would alter the status of certain entities as SROs. 22 However, the Exchange Act clearly defines registered clearing agencies as SROs, 23 and the proposed rule would have no impact on this status. As a general matter, the concerns expressed by these commenters regarding the perception of conflicts of interest at a registered clearing agency highlight the need to adopt Rule 17Ad-25, including the provisions for independent directors and to address conflicts of interest, to promote confidence in registered clearing agency governance through requirements intended to ensure transparency, fair representation, and effective decision-making at the board level. 20 See, e.g., Timothy Washington (Aug. 12, 2022) (“Washington”); Andres Loubriel (Aug. 12, 2022) (“Loubriel”); Gerald (Aug. 12, 2022) (“Gerald”); Dylan Crosby (Aug. 12, 2022) (“Crosby”); Anonymous (Aug. 12, 2022) (“Anonymous 1”); Josh Zimmerman (Aug. 12, 2022) (“Zimmerman”); Nathan Rohde (Aug. 13, 2022) (“Rohde”); Ian Marshall (Aug. 17, 2022) (“Marshall”); Anonymous (Aug. 26, 2022) (“Anonymous 4”); Harun Krishnan (Aug. 26, 2022) (“Krishnan”); Matthew Fry (Aug. 26, 2022) (“Fry”); the Delois Albert Brassell Estate (Sept. 3, 2022) (“Delois Albert Brassell Estate”); Kaleab Tesema (Sept. 7, 2022) (“Tesema”); Jamario (Oct. 6, 2022) (“Jamario”); Ben Passlow (May 11, 2023) (“Passlow”) (each expressing views in support); see also Val Ayrapetov (Aug. 9, 2022) (“Ayrapetov”); George (Aug. 12, 2022) (“George”); Anonymous (Aug. 12, 2022) (“Anonymous 2”); M.B. (Oct. 6, 2022) (“M.B.”) (requesting creation of a retail-specific board member) (each expressing views against). 21 See, e.g., Crosby, Loubriel; Zimmerman. 22 See Anonymous 1; Christopher Hewitt (Aug. 12, 2022) (“Hewitt”); Mason Smith (Aug. 12, 2022) (“Smith”); Samuel Ryan (Aug. 12, 2022) (“Ryan”); Keith Clark (Aug. 12, 2022) (“Clark”); Dillon (Aug. 12, 2022) (“Dillon”); Evan (Aug. 12, 2022) (“Evan Letter”); John J. Kozubal (Oct. 6, 2022) (“Kozubal”); James Fox (Oct. 6, 2022) (“Fox”); Joe (Oct. 7, 2022) (“Joe”); Anonymous (Oct. 12, 2022) (“Anonymous 5”); Anonymous (Oct. 13, 2022) (“Anonymous 6”); Kens Bane (Jan. 16, 2023) (“Bane”). 23 See 15 U.S.C. 78c(a)(23), (26). Several comments from representatives of trade groups or registered clearing agencies expressed general support for having an independent director requirement as a “good first step,” 24 appropriately designed to reduce the risk of conflicts of interest 25 and provide diverse viewpoints 26 in a “pragmatic” 27 way. One commenter supported the independent director requirement because it was consistent with public company listing rules and would be particularly useful in capturing a range of perspectives when combined with the requirement of a nominating committee to consider a broad range of views. 28 Another commenter viewed the requirements as consistent with independent director requirements that were already incorporated into its governance structure. 29 Another group of commenters supported the independent director requirement because it was consistent with a whitepaper issued by the group in 2019 concerning the need for enhanced governance at clearing agencies to address their risk-related concerns. 30 24 See Thomas Price, Managing Director, Operations/Technology, Robert Toomey, Managing Director, Associate General Counsel, Head of Capital Markets, Joseph Corcoran, Managing Director, Associate General Counsel, Securities Industry and Financial Markets Association (Oct. 28, 2022) (“SIFMA”) at 2. 25 See Chris Barnard (Sept. 9, 2022) (“Barnard”); Stephen W. Hall, Legal Director and Securities Specialist, and Houston Shaner, Senior Counsel, Better Markets, Inc. (Oct. 7, 2022) (“Better Markets”) at 5; Murray Pozmanter, Managing Director, President, Clearing Agency Services & Head of Global Business Operations, Depository Trust & Clearing Corporation (Oct. 7, 2022) (“DTCC”) at 2. 26 William C. Thum, Managing Director and Assistant General Counsel, SIFMA Asset Management Group (Oct. 13, 2022) (“SIFMA AMG”) at 8. 27 Ulrich Karl, Head of Clearing, International Swaps and Derivatives Association, Inc. (Oct. 28, 2022) (“ISDA”) at 6. 28 Paolo Saguato, Assistant Professor of Law, George Mason University Antonin Scalia Law School (Oct. 6, 2022) (“Saguato”) at 3. 29 Kara Dutta, Assistant General Counsel, Intercontinental Exchange, Inc. (Nov. 11, 2022) (“ICE”) at 2. 30 See Frank Baldi, Managing Director, Head of Financial Institutions and Emerging Markets Credit Risk, Barclays, et al. (Oct. 18, 2022) (“Barclays et al.”) at 1. One commenter cautioned against “completely” independent directors ( i.e., independent from owners and participants, such as academics) creating a situation where clearing agency participants could be under-represented. 31 As discussed further below, the Exchange Act requires that the rules of the clearing agency assure a fair representation of its shareholders and participants in the selection of its directors and administration of its affairs. Another commenter that supported the proposed requirements cautioned against going any further than the proposal—such as by requiring certain types of stakeholders to be represented—stating that a board's effectiveness comes from the skills, personal attributes (including leadership and integrity), and relevant business and risk management experience of its directors, and not simply by drawing directors from various stakeholder groups. 32 As discussed further below, Rules 17Ad-25(b) and (e) address the composition of the board and board committees, and does not go further to address the composition of an advisory group (the constitution of which can serve a wider set of stakeholders because its members need not already be serving on the board to serve on such an advisory group). Exchange Act section 17A(b)(3)(c) directs the Commission to only register clearing agencies whose rules assure a fair representation of participants in, among other things, the selection of directors. 33 In terms of the skills and effectiveness of a board, other requirements of Rule 17Ad-25 help promote highly qualified and effective candidates serving as independent directors. For example, as discussed in Part II.B below, Rule 17Ad-25(c) as adopted requires policies and procedures for a registered clearing agency's nominating committee to have a written process for evaluating directors and nominees for director, including taking into account each nominee's expertise, availability, and integrity, and demonstrating that the board of directors, taken as a whole, has a diversity of skills, knowledge, experience, and perspectives. 31 ISDA at 6. 32 ICE at 2-3. 33 See 15 U.S.C. 78q-1(b)(3)(c). Another commenter did not see the problem that the proposed rules would solve, indicating the group's belief that the approach to board composition and board independence was too prescriptive, which could prevent a registered clearing agency from having governance measures that are uniquely suited to manage risks particular to the registered clearing agency. 34 As stated in the Governance Proposing Release, the requirements regarding the representation of independent directors are appropriate to facilitate the consideration and management of diverse stakeholder interests by the board in the overall decision-making process of the registered clearing agency. 35 Regarding the level of prescriptiveness, Rule 17Ad-25(f) identifies situations that, in the Commission's judgment, create material relationships with the registered clearing agency that are incompatible with being an independent director but, other than these specific exclusions, registered clearing agencies would have discretion to evaluate whether a director's relationships to the registered clearing agency are material. Because Rule 17Ad-25 provides registered clearing agencies with such discretion, the Commission set forth the list of specific exclusions in Rule 17Ad-25(f) to ensure a consistent, minimum standard for independent directors across registered clearing agencies. 36 Therefore, the Commission disagrees that the rules are overly prescriptive because of the levels of discretion that are allowed, and disagrees that unique governance measures could not be adopted by registered clearing agencies. 34 Global Association of Central Counterparties (Oct. 7, 2022) (“CCP12”) at 1; see also SIFMA at 3; ICE at 3. 35 See Governance Proposing Release, supra note 2, at 51821. 36 See id. at 51824 (“Establishing a materiality and reasonableness threshold for such relationships provides a registered clearing agency with discretion to apply this requirement across a range of fact patterns while ensuring that they ultimately facilitate the fair representation of owners and participants.”). 3. Criteria for Independence One commenter supported the requirement for establishing an overall level of independent directors at 34 percent for participant-owned registered clearing agencies as being sufficient and without the drawbacks of too many independent directors. 37 Another commenter disagreed with the proposal, stating that the Commission should not impose any percentage of independent directors given the differences in organizational structure, markets, and products cleared, among other things, across registered clearing agencies. 38 A separate commenter supported the requirement for independent directors because it would mitigate potential conflicts and also provide better board oversight of the registered clearing agency's risk management and other functions. 39 The proposed requirements for the percentage of independent directors strike a reasonable balance between the competing interests of management, owners, participants, and any parties falling into more than one of those categories. In the Governance Proposing Release, the Commission considered whether a clearing agency's particular organizational structures, markets served, or products cleared support differing minimum levels of independence, and stated that the percentage of participant ownership of the clearing agency is an important factor against which to set the minimum standard for director independence. Commenters have not identified another specific factor that would support modifying the proposed threshold. Further, Rule 17Ad-25 does not impede registered clearing agencies from considering a broad pool of potential candidates to serve as independent directors, to appropriately reflect their different organizational structures, markets served, and products cleared. Therefore, the Commission is adopting the percentages as proposed. 37 Joseph P. Kamnik, Senior Special Advisor and Regulatory Counsel, Options Clearing Corporation (Oct. 7, 2022) (“OCC”) at 23. 38 CCP12 at 3. 39 SIFMA AMG at 8. One commenter supported aspects of the “independent director” definition but stated that the proposed requirement that a majority of directors be independent is unlikely to resolve all conflicts of interest because registered clearing agency owners will still have ultimate approval of, and influence over, independent directors. The commenter also explained that independent directors still have fiduciary duties to the registered clearing agency and are constrained to act in service of shareholder value when reviewing risk priorities. 40 The value of a particular element of Rule 17Ad-25 is not diminished even though it does not address all potential conflicts of interest. Rule 17Ad-25 is intended to bolster the overall quality of governance (and therefore risk management) at a registered clearing agency. The same commenter also requested clarification that material relationship would include director compensation that is tied to registered clearing agency equity, revenue, volume, or scope of products. 41 While Rule 17Ad-25(f) identifies specific circumstances that establish a material relationship, the definition of “material relationship” in Rule 17Ad-25(a) is broad. Circumstances where director compensation includes elements that generate potential conflicts of interest, such as those tying monetary compensation to equity, revenue, volume of activity, or scope of products, generally could create a material relationship under Rule 17Ad-25(a). 40 Better Markets at 13. 41 Id. at 12. The same commenter also suggested that the definition of “material relationship” be modified to include any interests that create a reasonable appearance of clouding the judgment of a director, on the basis that even the appearance of a bias erodes trust. 42 Trust is important, especially during times of market stress, but the proposed definition does not need to be modified to address this concern. The definition of “material relationship” already contains a “reasonableness” element, requiring that such relationships be assessed as they would be perceived by a reasonable person, which would allow a clearing agency to consider and address relationships that create the appearance of a conflict. This reasonableness requirement applies even to relationships or situations that are otherwise not among the exclusions in Rule 17Ad-25(f), because Rule 17Ad-25(f) applies in addition to how the definition of independent director is applied by a registered clearing agency. In this regard, clearing agencies generally should consider this reasonableness element in the context of participants, vendors, or non-controlling shareholders of the clearing agency or its affiliates. Employees of participants may be subject to disqualification under this reasonableness requirement, even if they are not subject to disqualification under Rule 17Ad-25(f). The reasonableness element would apply to an evaluation of the qualifications necessary for being an independent director, which will be contingent on the broad set of facts and circumstances under consideration. The definition also includes relationships that reasonably could affect the independent judgment or decision-making of the director, which seeks to address outcomes that reasonably could happen, even if they have not yet in fact happened. Therefore, the Commission is not modifying the rule in response to this comment. 43 42 Id. at 18-19. 43 See infra Part II.D.2 (similarly addressing comments with respect to the “reasonableness” requirement in Rule 17Ad-25(g)). The commenter further suggested expanding the definition of “family member” to include first cousins. 44 The Commission considered this expansion, and also reviewed prior Commission rationales on the appropriate scope of “family member” definitions under other Commission rules. 45 In those prior rulemakings, the Commission concluded that the scope of family members included there (which is identical to the scope proposed in the Governance Proposing Release) provides adequate coverage to address regulatory interests because any close ties between a director and a relative that are not already within the definition of “family member” (such as cousins of various degrees) can be addressed by using the other provision that applies to all persons who share a household with the director, as a proxy for such close ties rather than serving as a generalized proxy for a particular category of relatives. Moreover, the exclusions that relate to family member activities in Rule 17Ad-25(f) are designed to be a floor, not a ceiling, meaning that other fact patterns may preclude a director from meeting the independence requirement pursuant to the general requirements in Rule 17Ad-25(b) instead of a specific exclusion in Rule 17Ad-25(f). 44 Better Markets at 20. 45 See, e.g., Disclosure of Certain Relationships and Transactions Involving Management, Securities Act Release No. 6441, Exchange Act Release No.19290, Investment Company Act No. 12865 (Dec. 2, 1982), 47 FR 55661, 55663 (Dec. 14, 1982) (discussing whether to apply a rule to a class of relatives that is broader than those who live in a household with a reporting person, because there is not complete overlap between the two categories. The Commission considered whether to apply the rule to relatives who could take advantage of financial transactions with a reporting person without living in that reporting person's household. As a corollary, some members of a household may not be relatives either, but both categories were contemplated as a proxy for the existence of close ties between two people). One commenter stated that many of the prohibitions in Rule 17Ad-25(f)(4) were “overbroad” and that not all payments from participants should preclude an independence determination; rather, in the commenter's view, Rule 17Ad-25(f)(4) should include a de minimis threshold and an exemption for the payment of clearing fees. 46 The commenter stated that, in the absence of a de minimis threshold, the rule could exclude registered clearing agency participants that are only receiving a nominal sum for a small service provided to the registered clearing agency. The commenter further stated that clearing fees are a relatively inconsequential component of market participants' cost of business, and it is unlikely that a director could reduce clearing fees without oversight because clearing fee changes must be filed with the Commission. In particular, the commenter stated that its fee refunds should not be covered by this exclusion (which the Commission understands to apply when accrued clearing fees exceed the registered clearing agency's targeted capital amount, so refunding an overpayment does not implicate the same potential conflict as does receiving a payment). Another commenter stated that, in the absence of a de minimis threshold, the rule could exclude candidates for independent director who are only receiving de minimis payments or remuneration or clearing fees. 47 46 OCC at 6. 47 CCP12 at 3. The exclusion in Rule 17Ad-25(f)(4) would apply to directors who are partners or controlling shareholders of a registered clearing agency participant. 48 The scope of this exclusion is narrow, however; employees, managers, and non-controlling shareholders of a participant could still qualify, allowing for a broad range of potential candidates who have experience with the participant's business. Additionally, although the payments received or made between, for example, a participant and a registered clearing agency may be inconsequentially small from the perspective of the registered clearing agency or the participant as a business entity, that same payment may be meaningful to an individual who is a director and who is a controlling shareholder of the participant. For example, that individual's equity stake in the participant may result in extra personal income for every dollar saved or earned. Due to the potential for personal enrichment, the Commission is not adopting a de minimis amount of payments that would allow a participant's controlling shareholder to serve as an independent director. Because the Commission is not incorporating any de minimis carve out, it is not addressing how to calculate such de minimis amount. Accordingly, the Commission also is not addressing whether fee refunds should be included in calculations to establish a de minimis amount of such payments. Nonetheless, and regardless of the circumstances, such controlling shareholder of a participant could still serve on the board as a non-independent director. 48 Specifically, Rule 17Ad-25(f)(4) applies to directors who are partners or controlling shareholders of any organization to or from which the registered clearing agency is making or receiving payments, which would include clearing fee payments made by a participant as a clearing member. A commenter also suggested, as an alternative to explicitly carving out payments for clearing fees from the exclusion in Rule 17Ad-25(f)(4), that the Commission specify that the term “partner” therein only refers to someone who has an equity ownership stake in the organization. 49 The term “partner,” as used in Rule 17Ad-25(f)(4) as adopted, refers to those with an equity ownership stake in an organization such as an limited partnership or limited liability partnership and does not include any person who simply has the term “partner” in her job title without also holding an equity ownership stake in the organization that is sending or receiving payments to or from a registered clearing agency, an affiliate thereof, or a holder of a controlling voting interest of the registered clearing agency. 49 OCC at 7. One commenter suggested that the Commission require board representation by customers of registered clearing agency participants because such customers are bound to registered clearing agency obligations that are theoretically uncapped, bear mutualized risk, and could provide unique perspectives on risk management issues. 50 Another commenter requested that the Commission add a requirement for registered clearing agency boards to have representatives from customers of registered clearing agency participants, such as buy-side market participants, due to their understanding of the risks and impacts of registered clearing agency decisions on a wide variety of such market participants and their clients. 51 50 SIFMA AMG at 8. 51 Sarah A. Bessin, Associate General Counsel, and Nhan Nguyen, Assistant General Counsel, Investment Company Institute (Oct. 7, 2022) (“ICI”) at 7. In considering the application of the rule, it is important to distinguish the contractual obligations and liabilities that exist between registered clearing agency participants and the registered clearing agency itself on the one hand, and between registered clearing agency participants and their own customers on the other. The Commission does not agree that customers of registered clearing agency participants are bound to the clearing agency for uncapped obligations. Customers of registered clearing agency participants do face contractual performance risk vis-à-vis their counterparty to a given transaction when they rely on a registered clearing agency participant to facilitate the clearing of such transaction on the customer's behalf, but the risk of non-performance in this case differs from the risk that parties to contracts generally assume. Notably, because the registered clearing agency may guarantee the transaction, the risk to the customer may be lower than other types of contractual relationships due to this extra layer of protection (notwithstanding the particular arrangements that may exist between the participant and its customer in the event of a default). The risk exposure between a participant and its customer is thus different in nature and scope than the risk exposure between a registered clearing agency and its participant. Consequently, the nature of these contractual obligations does not support extending by Commission rule representation on the board of a registered clearing agency to the customers of registered clearing agency participants. However, the Commission recognizes the importance of the board considering the views of stakeholders, including customers of registered clearing agency participants, and the Commission has provided opportunities for such views to be considered under Rule 17Ad-25(c) when nominating directors, and when soliciting viewpoints and feedback consistent with Rule 17Ad-25(j). 52 52 See infra Parts II.B.3 (discussing the requirements in Rule 17Ad-25(c)(4)(ii) for the nominating committee to demonstrate that it has considered whether a particular nominee would complement the other board members, such that, if elected, the board, taken as a whole, would represent the views of the owners and participants, including a selection of directors that reflects the range of different business strategies, models, and sizes across participants, as well as the range of customers and clients the participants serve) and II.F (discussing the requirements in Rule 17Ad-25(j) to solicit, consider, and document stakeholder viewpoints). One commenter agreed with the Commission's approach to allow registered clearing agencies (and in particular, nominating committees thereof) to exercise judgment to determine what constitutes materiality under the “material relationship” definition, rather than have it further defined, such as by numerical thresholds of financial compensation. 53 The commenter stated that such numerical thresholds would not be useful if established in advance. Likewise, the commenter stated that the concept of “control” should be left to the determination of the nominating committee of the registered clearing agency, as long as the analysis is documented and auditable. 54 The Commission agrees that numerical thresholds may not reflect the potential intersection of a director's personal finances and the “material relationship” definition, particularly when such thresholds have been formulated ex ante, and that, more generally, it is appropriate for the nominating committee to determine whether a director qualifies as an independent director, as further discussed in Part II.B.2 below. 55 53 Claire O'Dea, Director, Government Relations and Regulatory Strategy, Americas, London Stock Exchange Group (Oct. 7, 2022) (“LSEG”) at 3-4. 54 Id. at 4. 55 See infra Part II.B.2 (further discussing the purview of the nominating committee and the comment regarding “control”). One commenter drew a comparison between the Commission's required levels of independent directors and the levels of a related category under the European Market Infrastructure Regulation (“EMIR”) 56 called Independent Non-Executive Directors (“INEDs”). 57 The commenter stated that currently EMIR requires at least one-third (and no fewer than two) of clearing agency board members to be INEDs. The commenter stated that requiring more INEDs would not result in greater transparency or objective governance, and that requiring a majority of the board to be INEDs would result in large boards that are “functionally inefficient.” 58 The commenter also pointed out that the INED definition excluded representatives of clearing agency participants, regardless of whether those clearing agency participants were shareholders or not. Consequently, the commenter requested greater alignment between EMIR and the Commission's proposal. The Commission supports alignment where practicable and concludes that the two provisions are not in conflict with one another as currently structured based on the following: although the EMIR standard has a lower percentage requirement, it also defines independence more strictly than the Commission's proposal, and so the pool of eligible directors under EMIR is smaller than under Rule 17Ad-25. For example, if a clearing agency dually registered under EMIR and with the Commission had a board with six persons, with two persons representing a controlling shareholder, two persons who were risk management professionals at two participants, and two persons who were independent academics, then that board could (with all other factors being met) comply with both the Commission's requirement of a majority of independent directors (four out of six), and the EMIR requirement of one-third INEDs (two out of six). Therefore, the requirements for INEDs under EMIR and for independent directors under the Commission's proposal do not conflict with each other. 56 See Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, as amended, https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:02012R0648-20200101. 57 LSEG at 3. 58 Id. The commenter also stated that operating under two definitions of “independent director” would require a dual registrant to undertake two sets of analyses because a director could qualify as independent under one standard but not the other, though the commenter also stated that the Commission's approach would not raise any compliance issues by itself. 59 The commenter encouraged alignment where possible. In this situation, the additional burden of conducting evaluations under these two standards is insignificant, because the evaluation process of a director's material relationships is highly fact-specific. The evaluation of whether a director meets the standard for independence generally should be broad and thorough, and it generally should turn on the specific facts of each director's individual circumstances. A broad inquiry that satisfies the requirement to determine whether material relationships exist will likely already reveal whether a candidate meets the criteria set forth in each respective jurisdiction, so it is unlikely that fully aligning the Commission's rules with the EMIR standard will result in cost or time savings. 59 Id. at 6. In connection with the request for harmonization, the commenter stated that EMIR's limited INED requirement helps ensure that the board retains expertise sufficient to make decisions about budget, investments, and commercial strategy. 60 As discussed above, the Commission's definition of “independent director” would allow participants with experience on these strategic matters to also qualify as an independent director, so the concern from the commenter that a majority of the board being independent directors would result in inexperienced decision makers is misplaced, due to the differences in the scope of the respective definitions of INED and the Commission's proposal. 60 Id. at 4. With respect to the inclusion of affiliates of the registered clearing agency in the definition of “material relationship” and in Rule 17Ad-25(f), the commenter expressed preference for consistency with how EMIR handles affiliates. 61 The commenter stated that under the EMIR regulatory framework, a clearing agency that is part of a group must evaluate whether it has the necessary level of independence to meet its regulatory obligations as a distinct legal person, and whether its independence could be compromised by the group structure or by any board member also being a member of the board of other entities of the same group. Therefore, under EMIR, if a clearing agency has the necessary level of independence to meet its regulatory requirements, a director could be considered independent even if she held a non-executive role at another clearing agency within the same group, which allows for consistency in risk management and cross-fertilization of ideas within a group. 61 Id. at 5. The Commission used the term “affiliates” in the definition of “independent director” with respect to material relationships, and the exclusions in Rule 17Ad-25(f), to ensure an appropriate minimum standard across clearing agencies with respect to the board composition requirements in the rule. If affiliate relationships were excluded from the definition of “independent director” with respect to material relationships, a registered clearing agency could create an organizational structure where a majority of the board is aligned—such as through compensation—with an affiliate of the clearing agency. Benefits associated with the exchange of ideas can be obtained in other manners, such as information sharing agreements among affiliated companies. At the clearing agency, risk management should be tailored to the specific risks facing a particular registrant consistent with the statutory requirements for registration as a clearing agency, not with respect to its overall corporate group or affiliates. While affiliate relationships may, in some instances, enable a clearing agency to see risks outside of its own particular clearing agency function or services, consistency across affiliates is not per se an important risk management goal. A registered clearing agency generally should focus on identifying and managing the risks that it faces, rather than risks to its affiliates. Therefore, the Commission is adopting the definition of “material relationship” and the exclusions in Rule 17Ad-25(f) to include affiliates of a clearing agency as proposed. As to the adequacy of the Commission's use of one-year lookback periods in Rule 17Ad-25(f), one commenter recommended a longer period of three to five years as an adequate lookback period. 62 The commenter stated that there is a five-year requirement under EMIR, and that a one-year requirement could be considered too short because some payments may not be received by a director for a while ( e.g., some payments may be deferred for up to four years), some projects to which a person has played a key role may not yet be delivered, and informal relationships may continue. The obligation not to have a material relationship applies in an ongoing manner, not simply to a moment in time. Although the lookback period that applies to the “material relationship” definition and to the list of exclusions in Rule 17Ad-25(f) covers the one-year period prior to the date that a determination of independence is made, delayed payments that a director might receive while serving as an independent director would be addressed due to the ongoing application of Rule 17Ad-25(f). For instance, if an independent director received payments in the third year of his or her term, such payments were related to relationships that existed two years prior to the start of that term, and such payments precluded a director from being independent under Rule 17Ad-25(f), then the director would cease to qualify as an independent director at the time of the payment—irrespective of the lookback period. Consequently, extending the lookback period is not necessary to address any delayed or deferred activity because a director must meet the standard for an “independent director” on an ongoing basis under the requirements of Rule 17Ad-25(b). 62 LSEG at 5. Several commenters stated that the possible inclusion of employees of clearing agency participants as independent directors on registered clearing agency boards would bring several benefits, including increasing the candidate pool, providing industry expertise, promoting a strong alignment between the risk management and operational integrity of the registered clearing agency, and bringing diverse perspectives. 63 One commenter disagreed, stating that the definition of “material relationship” should be expanded to ensure that employees or other representatives of participants be excluded from qualifying as independent, 64 while another commenter stated that the candidate pool from among employees of clearing agency participants would shrink under the proposed rules. 65 Having qualified, experienced persons serving in these director roles promotes sound risk management practices at the registered clearing agency because such persons bring necessary technical experience in clearing agency risk management. The Commission supports the inclusion of employees of participants in the potential pool of candidates for independent director in order to make such experienced personnel available for consideration as candidates, provided that such personnel do not have relationships that would preclude them from being independent directors. The Commission acknowledges that the candidate pool would shrink to the extent that experienced employees of participants also have material relationships that pose a conflict of interest (for example, if such employees' judgment or independent decision-making could be affected by their relationships with a participant), other than being an employee of a participant. 63 See DTCC at 4; Saguato at 3 (supporting the inclusion of employees of participants because they have substantial financial exposure and a commitment to the resilience of the participant). 64 James Tabacchi, Chairman, Independent Dealer and Trader Association (Oct. 7, 2022) (“IDTA”) at 1; see also Zimmerman (expressing general concerns about potential conflicts of interest among directors and senior managers). 65 CCP12 at 3. Additionally, a separate commenter requested that the independent director definition explicitly require independence from dominant market participants. 66 The commenter stated that the derivatives markets, within which the Commission regulates clearing agencies for security-based swaps, continue to be dominated by a few market participants, thereby concentrating risk and skewing incentives towards the largest clearing agency participants, at the expense of appropriate risk management and competition. 67 The commenter suggested that the lowering of the majority requirement to 34 percent of independent directors when participants are a majority of owners should have restrictions as to the size of the clearing agency participants that can qualify, to exclude dominant market participants. 68 The commenter disagreed with the Commission that existing regulations, such as Rule 17Ad-22, have adequately addressed market dominance by certain participants, and stated that anecdotal evidence from abroad suggests that clearing agencies hold such dominant participants to less scrutiny with respect to risk management requirements, while small and medium-sized entities struggle to maintain access to central clearing. 69 66 Better Markets at 16. 67 Id. at 10. 68 Id. at 17. 69 Id. at 16-17. The liability inherent to being a clearing agency participant, to which participants of all sizes subject themselves, aligns their interests with the goal of a well-managed registered clearing agency, even if incentives to free-ride, and thereby have the costs of managing the clearing agency borne by other participants, remain. Because Exchange Act section 17A(b)(3)(C) states that “the Commission may determine that the representation of participants is fair if they are afforded a reasonable opportunity to acquire voting stock of the clearing agency, directly or indirectly, in reasonable proportion to their use of such clearing agency,” 70 it remains appropriate to not summarily restrict representation based on volume of use, which is what the commenter is requesting. Therefore, the Commission is not removing the ability of employees or other representatives of certain sizes of clearing agency participants to qualify as independent directors, provided all other requirements of Rule 17Ad-25 are met. 70 15 U.S.C. 78q-1(b)(3)(C). 4. Incentive Structures One commenter requested that the Commission undertake a comprehensive study of how various ownership models allocated incentives among owners and participants of registered clearing agencies, stating that different ownership models might each require a special regulatory approach to ensure a full alignment of incentives among stakeholders. 71 In particular, the commenter stated that conflicts of interest arise in the investor-owned model, where some participants are not owners but still face mutualized risk at the clearing agency, as compared to a participant-owned model. The rule already addresses the distinction between clearing agencies that are majority-owned by participants and other types of clearing agencies by applying a 34 percent independent director requirement to the former category. The commenter expressed the view that applying a different standard for independent directors between participant-owned and investor-owned clearing agencies is unnecessary, in part, because the commenter read the economic analysis in the Governance Proposing Release to state that all participant-owned clearing agencies already have boards with a majority of independent directors. 72 However, Table 3 in the Governance Proposing Release discussed different criteria that applied to certain directors, 73 and the Governance Proposing Release did not discuss the extent to which these criteria may differ from the proposed definition of and proposed requirements for independent directors. Importantly, although registered clearing agencies may currently label some directors as “independent,” such directors may not meet the requirements for an “independent director” under Rule 17Ad-25. Application of Rule 17Ad-25 to existing registered clearing agencies will impose composition standards that better serve the goals of Exchange Act section 17A than current practice. Additionally, Rule 17Ad-25 will apply to prospective applicants that may seek to be registered clearing agencies in the future—not only the current set—and so establishing a standard that existing registered clearing agencies may already satisfy can nonetheless still ensure a certain minimum standard across potential future applicants and registrants. Therefore, the Commission is not modifying the application of the 34 percent independent directors versus a majority of independent directors in the final rule. 71 Saguato at 2. 72 Id. at 3. 73 See Governance Proposing Release, supra note 2, at 51844. The same commenter also stated that, if a requirement for a majority of independent directors leads to effective board oversight of management, then all registered clearing agencies—not just those that are investor-owned—should be subject to that standard. 74 However, the “independent director” requirement in Rule 17Ad-25 considers, in addition to a director's independence from management, a director's material relationships with a registered clearing agency's affiliates, owners, vendors, customers, and controlling interests of participants. Because the requirements in Rule 17Ad-25 preclude an individual from serving as an independent director when such material relationships reasonably could affect the independent judgment or decision-making of the director, a registered clearing agency that is majority-owned by participants could determine that an employee of an owner-participant has relationships that preclude the employee from serving as an independent director—not on the basis of her employment relationship to the participant but rather other potential entanglements that may emerge from the employee's other material relationships with the clearing agency. For example, if an employee of an owner of a clearing agency received stock options as part of a compensation package, that employee has interests tied to the profits of the clearing agency distinct from an employee who receives stock options of a clearing agency participant that is not also an owner of a clearing agency. The existence of such interests tied to profit that carry through ownership structures back to the clearing agency poses a potential conflict of interest for a director of that clearing agency. In this way, a registered clearing agency may determine that employees of owners are less likely than employees of participants to satisfy the independent director requirement. Applying a 51 percent requirement to registered clearing agencies that are majority-owned by their participants could, in the view of a registered clearing agency evaluating the material relationships of its nominees for independent directors, result in minority representation of owners and participants. Therefore, the rule applies a lower threshold to participant-owned clearing agencies to provide the shareholders of such a registered clearing agency greater discretion to nominate, as independent directors, candidates from among, for example, the employees of participant-owners. Applying the higher standard to all clearing agencies, solely to insulate the board from influence by management, could restrict access to representatives of participant-owners in a way that may impair the board's ability to oversee the clearing agency's risk management function effectively. 74 Saguato at 3. One commenter agreed that the proposed requirements for independent directors address conflicts of interest, but the commenter also stated that the solution was incomplete to address the problem and so recommended that the Commission also adopt a “skin-in-the-game” requirement. 75 Specifically, this commenter stated its belief that it is necessary to align the incentives between a clearing agency and its participants by requiring the clearing agency to subject a meaningful amount of its own capital to potential loss after a default of a participant, in particular after the defaulting participant's margin and guaranty fund contributions are used to satisfy its obligations, but before any margin or guaranty fund contributions of other non-defaulting participants are used to satisfy the obligations of the defaulting participant. This idea seeks to encourage a clearing agency to manage risks well, to prevent its own capital from being lost during a default. This commenter's suggestion is beyond the scope of the present rulemaking. 75 Better Markets at 5-6, 12-14. One commenter expressed concern that employees of participants who are acting as independent directors and representing the interests of the clearing agency could have conflicts of interest between these two roles. 76 The commenter recommended that the Commission impose a requirement for such persons to have due regard to market stability in their role at the clearing agency. Directors do not need to have a specific obligation applied to them in their individual capacity to consider market stability. Rules 17Ad-22(e)(2)(ii) and (iii) require covered clearing agencies to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide for governance arrangements that clearly prioritize the safety and efficiency of the covered clearing agency and support the public interest requirements in Exchange Act section 17A. 77 These existing requirements are sufficient to ensure a registered clearing agency has due regard for financial stability. 76 See ISDA at 6. 77 See 17 CFR 240.17Ad-22(e)(2)(ii), (iii); see also 17 CFR 240.17Ad-22(d)(8) (requiring registered clearing agencies that are not covered clearing agencies to establish, implement, maintain and enforce governance arrangements that are clear and transparent to fulfill the public interest requirements in Exchange Act section 17A). One commenter agreed with the Commission's concerns that a small number of participants—if allowed to exercise control over a clearing agency—can promote margin or other requirements that are not commensurate with the risks of a participant's specific products, portfolio market, business model, and size, which could lead to a concentration of risk in a few dominant market participants who benefit. 78 The commenter suggested that the Commission adopt rules that would address non-independent directors and would require diversity among participant representation on the board, based on size and level of specialization by said participants. Otherwise, the commenter suggested, the representation among participants will be lopsided, leading to greater concentration of risk among the clearing agency's largest participants. The Commission agrees that the interests of participants are not always homogenous or aligned, and therefore, the interests of smaller participants can diverge from those of the largest. However, the Exchange Act requirement for fair representation allows for the consideration of proportionality as an element. 79 Although all participants are equally exposed to default risk, larger firms may be more impacted by policies that apply based on transaction volume. Thus, it can be appropriate to apportion representation according to use of the clearing agency, even if an effect of this approach is to be disproportionate as to the number of small, medium, or large participants represented on the board relative to the total number of small, medium, or large participants in a clearing agency's customer base at any particular time. Further, there could be arguments that reducing the degree of proportionality of representation relative to use of the clearing agency could lead to negative externalities that disproportionately impact larger participants. Accordingly, the Commission is declining to expand the scope of this rule to develop participant categories and to require certain level of participant representation on the board as non-independent directors among those categories. 78 IDTA at 2-3. 79 See 15 U.S.C. 78q-1(b)(3)(C) (“The Commission may determine that the representation of participants is fair if they are afforded a reasonable opportunity to acquire voting stock of the clearing agency, directly or indirectly, in reasonable proportion to their use of such clearing agency.”). 5. Ownership Structures One commenter stated that the largest clearing agency participants do not necessarily need personal influence over a director because they possess economic leverage over the clearing agency. 80 Additionally, the commenter requested that special attention be paid towards participants at registered clearing agencies that clear derivatives products because of the risk posed to effective governance by an “oligopoly” of market power exercised by certain derivatives dealers. 81 Instead of relying on independent directors as a bulwark against conflicts of interest, the commenter suggested restoration of the ownership limits that were previously proposed in Regulation MC to address market concentration. 82 The commenter further suggested that the Commission go beyond what was originally proposed in Regulation MC and add restrictions on commercial arrangements for volume, such as volumetric discounts, rebates, or revenue sharing. This suggestion goes beyond the scope of this rulemaking because they concern restrictions on commercial arrangements rather than requirements for board composition and governance. 80 Better Markets at 14. 81 Id. at 10. 82 Id. at 15; see also Exchange Act Release No. 63107 (Oct. 14, 2010), 75 FR 65882 (Oct. 26, 2010) (proposing Regulation MC). The commenter also suggested expanding the definition of “affiliate” to deem all owners and shareholders as affiliates, under the reasoning that a handful of dominant shareholders could “collude” among one another to exercise constructive control over a clearing agency, even if each individual shareholder did not meet the definition for control itself. 83 Many participants are also shareholders of a clearing agency, and so if the affiliate definition were to be expanded, it would restrict employees of many participants from meeting the independent director definition as a result of the exclusion in Rule 17Ad-25(f)(2). The Commission is concerned that such an expanded definition could interfere with the ability of a clearing agency to afford fair representation to participants, as contemplated by Exchange Act section 17A(b)(3)(C), which discusses the ability of participants to participate in board governance. In addition, Rule 17Ad-25 includes elements directed at the problems of “collusion” in multiple ways, and Rules 17Ad-25(g) and (h), and the associated requirements to address and disclose conflicts of interest, are better suited to address such potential “collusion” among certain shareholders because they are broad-based and not restricted to one potential source of conflicts ( i.e., affiliates). 84 83 Better Markets at 19. 84 See infra Part II.D (further discussing final Rules 17Ad-25(g) and (h)). 6. Circumvention One commenter expressed concern that the proposal did not specify who at the clearing agency should determine whether a fact pattern meets the definition of “material relationship,” reasoning that if the board can make that determination, there could be an incentive on the board of directors to give each other a “free pass” as to their potentially objectionable relationships. 85 Instead, the commenter suggested an explicit requirement for disinterested compliance officers or qualified outside professionals to determine whether material relationships exist. The proposed rules did not specify who at the clearing agency should evaluate relationships under this definition, and the Commission has modified the final rules to specify that the nominating committee is required to evaluate all board members under the independent director standard, as discussed further in Part II.B.2. 85 Better Markets at 19. Some commenters provided recommendations that went beyond the composition of the board and instead addressed the authority of a board more generally. Specifically, some commenters requested that the Commission apply more rigorous governance procedures to clearing agencies with respect to their emergency powers as set forth in their rulebooks, which the commenters stated were broad and vaguely defined. 86 But emergency powers exist at two levels for many clearing agencies: those provisions that impact the rights and obligations of the board, as set forth in the organizational documents of the legal entity itself (such as the ability of the board to act without a quorum in the event of an emergency, such as a terrorist attack), 87 and those provisions that impact the clearing agencies' rights and obligations with respect to the clearing members. 88 Although the Commission's rules do not directly impact the parameters around which emergency powers can be exercised, either at the board level or under the rules of the clearing agency, they do address who will make decisions when exercising such emergency powers. Ensuring that decision-making processes are clear, transparent, and fair, and that market participants have confidence in those processes in an emergency—including that neither clearing agency owners nor participants will dominate the decision-making process to achieve their own ends—can help reassure those who may be significantly impacted by such decisions. Rule 17Ad-25 meaningfully addresses such generalized concerns about the fair and even-handed use of emergency powers by establishing new standards for board governance applicable to registered clearing agencies. 86 Barclays et al. at 3; see also SIFMA at 4 (stating that “greater transparency and a more rigorous governance process, including consultation with primary regulators, regarding the use of emergency powers should help further confidence in the overall financial system and ensure that affected stakeholders are aware and have buy-in when such powers are used.”); ISDA at 2. 87 See, e.g., Bylaws, The Option Clearing Corporation, at Article II, Section 15 (stating, “During any emergency which results, directly or indirectly, from an attack (including a terrorist attack) on the United States or on a locality in which the Corporation maintains an office or customarily holds meetings of the Board of Directors, or from a war, armed hostilities, insurrection or other calamity involving the United States or any such locality, or from any nuclear or atomic disaster, or from any other catastrophe, disaster, (including any environmental or natural disaster), communications systems failure, or other similar condition, in which a quorum (as specified in Article III of the By-Laws) of the Board of Directors or a standing committee thereof cannot readily be convened for action (an “Emergency”), the following provisions of this Section 15 shall be operative notwithstanding any other provision in any of the sections (other than Section 110) of the Delaware Corporation Law or in the Certificate of Incorporation, By-Laws or Rules of the Corporation. The Chairman, Chief Executive Officer, Chief Operating Officer or, if it is not feasible for the Chairman, Chief Executive Officer, or Chief Operating Officer to take such action, then another officer who is a Designated Officer is authorized to declare the existence of such Emergency and to declare this By-Law to be in effect.”), https://www.theocc.com/company-information/documents-and-archives/by-laws-and-rules. 88 See, e.g., “Rule 38: Market Disruption and Force Majeure,” DTC Rulebook, https://www.dtcc.com/-/media/Files/Downloads/legal/rules/dtc_rules.pdf. Finally, one commenter suggested that the majority independent director requirement could be evaded by any supermajority requirement for voting or quorums of the board. 89 The Commission is aware that some registered clearing agencies currently apply supermajority requirements in certain scenarios, such as a requirement that three-fourths of an entire board shall constitute a quorum for purposes of electing the board chair. 90 Policies and procedures to identify, mitigate, or eliminate existing or potential conflicts of interest required under Rule 17Ad-25(g) generally should provide for the clearing agency to evaluate whether any supermajority requirements in any of the registered clearing agency's rules, policies, and procedures would allow directors with potential conflicts of interest to steer the clearing agency in service of those personal interests by avoiding any mechanisms that might require mitigation or elimination ( e.g., recusal by the director on the matter at hand) of the conflict of interest. A registered clearing agency generally should consider whether its policies and procedures under Rule 17Ad-25(g) are “reasonably designed” if provisions of its rules, policies or procedures would allow non-independent directors to exercise disproportionately greater control of certain board decisions beyond what their numbers would otherwise allow. 91 89 Better Markets at 18. 90 See Organizational Certificate of the Depository Trust Corporation, https://www.dtcc.com/legal/rules-and-procedures. 91 See infra Part II.D.2 (further discussing the “reasonably designed” and “reasonableness” elements of Rules 17Ad-25(g) and (h)). B. Nominating Committee 1. Proposed Rule 17Ad-25(c) Proposed Rule 17Ad-25(c)(1) would require each registered clearing agency to establish a nominating committee and a written evaluation process whereby such nominating committee shall evaluate individual nominees to serve as directors. Proposed Rule 17Ad-25(c)(2) would require that (i) independent directors compose a majority of the nominating committee, and (ii) an independent director chair the nominating committee. Proposed Rule 17Ad-25(c)(3) would require the nominating committee to specify and document fitness standards, which must be approved by the board. Such fitness standards for serving as a director would need to be consistent with all the requirements of proposed Rule 17Ad-25, and also would include that the individual nominee is not subject to any statutory disqualification as defined under section 3(a)(39) of the Exchange Act. 92 Proposed Rule 17Ad-25(c)(4) would require the nominating committee to document the outcome of the clearing agency's written evaluation process in a manner that is consistent with the written fitness standards required under proposed Rule 17Ad-25(c)(3). The process would require the nominating committee to: (i) take into account each nominee's expertise, availability, and integrity, and demonstrate that the board, taken as a whole, has a diversity of skills, knowledge, experience, and perspectives; (ii) demonstrate that the nominating committee has considered whether a particular nominee would complement the other board members, such that, if elected, the board, taken as a whole, would represent the views of the owners and participants, including a selection of directors that reflects the range of different business strategies, models, and sizes across participants, as well as the range of customers and clients the participants serve; (iii) demonstrate that the nominating committee considered the views of other stakeholders who may be affected by the decisions of the registered clearing agency, including transfer agents, settlement banks, nostro agents, liquidity providers, technology or other service providers; and (iv) identify whether each selected nominee would meet the definition of independent director in proposed Rules 17Ad-25(a) and (f), and whether each selected nominee has a known material relationship with the registered clearing agency or any affiliate thereof, an owner, a participant, or a representative of another type of stakeholder of the registered clearing agency described in (iii) above. 92 As explained in the Governance Proposing Release, supra note 2, at 51828 & n.107, 15 U.S.C. 78q-1(a)(3)(C) identifies the circumstances that subject a person to “statutory disqualification” with respect to membership or participation in, or association with a member of, a self-regulatory organization, such as a registered clearing agency. In the Governance Proposing Release, the Commission explained that some registered clearing agencies currently use governance arrangements other than a nominating committee to select certain directors. 93 It also explained that, while the proposed rule would not prohibit such approaches, it would require that any such nominees be submitted first to the nominating committee for evaluation—before being considered by the boardpursuant to a written evaluation process established by the registered clearing agency. 94 93 Governance Proposing Release, supra note 2, at 51829 (describing these arrangements other than a nominating committee as “other governing bodies and/or constituents of their organizational structure”). 94 Id. With respect to proposed Rule 17Ad-25(c)(4)(iii), which would give the nominating committee discretion to determine how to consider the views of other stakeholders, the Commission stated that relevant stakeholders generally would include persons and entities that access the national system for clearance and settlement indirectly ( e.g., institutional and retail investors), entities that rely on the national system for clearance and settlement to more effectively provide services to investors and market participants, and other market infrastructures. 95 95 Id. at 51830. Commenters generally supported the proposed rules addressing the nominating committee. 96 As discussed in more detail below, commenters sought clarity regarding discussion in the Governance Proposing Release stating that the nominating committee would be the “exclusive venue” for considering director nominees, as discussed further below. In addition, some commenters recommended modifying the proposed approach to participation by small and medium-sized firms on the board, and regarding the percent of directors that are independent directors serving on the nominating committees. The Commission addresses each of these topics in Parts II.B.2 through II.B.4. 96 See, e.g., Better Markets at 4; DTCC at 5; IDTA at 4; ISDA at 6; LSEG at 8; OCC at 3; Saguato at 3. But see ICE at 3 (describing the proposed approach as “too prescriptive”). 2. As “Exclusive Venue” for Considering Nominees Several commenters sought clarity regarding statements in the Governance Proposing Release that the nominating committee be the “exclusive” venue for considering nominees. 97 As discussed further below, the Commission is modifying the rule being adopted to address more clearly scenarios in which directors may be nominated or appointed directly by shareholders pursuant to the organizational documents of the registered clearing agency outside of the process established by the nominating committee. 97 DTCC at 5; LSEG at 8; OCC at 7; Saguato at 4; see also Governance Proposing Release, supra note 2, at 51830 (requesting comment on the following: “Is it appropriate for the Commission to require that the nominating committee be the exclusive venue for evaluating nominees for director to the board of directors? What alternative arrangements or processes might also be appropriate for evaluating director nominees?”). First, one commenter recommended that the Commission modify the rule so that the nominating committee only conduct written evaluation of nominees and not appointees that may be selected via other mechanisms in the governance structure. 98 For example, OCC allows certain participant exchanges to select “Exchange Director” nominees for election to OCC's board. The proposed rule text does not address this specific type of selection process, but as discussed in the Governance Proposing Release, 99 proposed Rule 17Ad-25(c) would not prohibit the selection of such directors appointed pursuant to such a process. Nonetheless, as previously discussed in the Governance Proposing Release, it would require that any such nominees be submitted first to the nominating committee for evaluation—before being considered by the board—pursuant to a written evaluation process established by the registered clearing agency. 100 This proposed requirement would help ensure that nominees are evaluated in a manner consistent with the requirements for independent directors and other qualifications to serve. 98 OCC at 7-8. 99 See Governance Proposing Release, supra note 2, at 51829. 100 See id. Accordingly, as proposed, Rule 17Ad-25(c) was intended to ensure that, with respect to all nominees and appointed directors, the nominating committee would evaluate each nominee or appointee for director, no matter the source of her nomination or equivalent selection as director, against the standards for fitness and independence established by Rule 17Ad-25. 101 This ensures that the board, the participants of the registered clearing agency, and ultimately other stakeholders and the public, have confidence in the fitness of directors generally and in the independence standard applied to directors to qualify as independent directors. The commenter's recommended approach would be inconsistent with the purpose and intent of proposed Rule 17Ad-25 because proposed Rule 17Ad-25(c) was intended to ensure that, with respect to all directors, the nominating committee would evaluate each nominee, no matter the source of their nomination, against the standards for fitness and independence established by Rule 17Ad-25. To the extent that any directors are “appointed,” it is appropriate to subject such “appointees” to the same standards as other nominees for director. Doing so would not slow or otherwise stymie the appointment of such directors because, regardless of how they are selected to serve on the board, all directors are subject to the same fitness standards and also would be subject to disclosure requirements regarding the reporting of potential conflicts of interest and material relationships. 102 Specifically, Rule 17Ad-25(c)(4)(ii) requires the nominating committee to demonstrate that it has considered whether a particular nominee would complement the other board members, such that, if elected, the board of directors, taken as a whole, would represent the views of the owners and participants, including a selection of directors that reflects the range of different business strategies, models, and sizes across participants, as well as the range of customers and clients the participants serve. Because this requirement is focused on board composition, excluding any directors from the requirement would undermine the purpose of the rule and the ability of the nominating committee to evaluate board composition as a whole. 101 See Governance Proposing Release, supra note 2, at 51829 n.110 (providing the same example). 102 See infra Part II.D (further discussing both a clearing agency's entity-wide obligations and a director's specific obligations relating to potential conflicts of interest and the evaluation of material relationships). Similarly, proposed Rule 17Ad-25(c)(4)(iv) requires the nominating committee to identify whether each nominee has a known material relationship with the registered clearing agency or any affiliate thereof, an owner, a participant, or a representative of another stakeholder of the registered clearing agency. Because this requirement establishes a baseline against which the registered clearing agency will need to evaluate potential conflicts of interest, regardless of whether a director is intended to be independent, the nominating committee should evaluate appointed directors as well. Such requirement helps ensure that the clearing agency can evaluate potential conflicts of interest that may require a director to recuse as to certain matters before the board. The Commission therefore is not modifying the rule to exclude from evaluation by the nominating committee nominees or directors who are appointed by other means pursuant to the organizing documents of the registered clearing agency. Notwithstanding the above, the Commission is modifying Rule 17Ad-25(c) in two ways: (a) the Commission is modifying paragraph (1) to add that the nominating committee shall also “evaluate the independence of nominees and directors,” in addition to evaluating nominees for serving as directors, and (b) the Commission is modifying paragraph (4)(iv) in two places to specify that the evaluation process applies to nominees as well as directors. Pursuant to the latter modification, the written evaluation process required by the rule shall identify whether each nominee “or director” would meet the definition of independent director and whether each “such nominee or director” has a known material relationship with the registered clearing agency (or an affiliate thereof). 103 These changes ensure that the final rule addresses the role of the nominating committee in evaluating directors which it did not itself nominate because their nominations came through different processes specified in the organizing documents of the registered clearing agency. Separately, the Commission is also modifying paragraph (4)(iii) to replace the term “impacted” with “affected.” This is a technical correction to avoid the use of informal language in the rule text. 103 See Rule 17Ad-25(b)(2) (requiring, among other things, that the registered clearing agency broadly consider all the relevant facts and circumstances on an ongoing basis to affirmatively determine that a director does not have a material relationship with the registered clearing agency or an affiliate of the registered clearing agency). Second, as previously discussed in Part II.A.3, one commenter stated that the concept of “control” as used in certain definitions in and requirements of Rule 17Ad-25, should be left to the determination of the nominating committee of the registered clearing agency, as long as the analysis is documented and auditable. 104 The Commission agrees and Rule 17Ad-25(c)(1) accordingly includes a requirement for a written evaluation process, so that the clearing agency has documentation as to its determinations of control. 104 LSEG at 4. Third, one commenter sought clarity as to whether the nominating committee can perform other functions. 105 Specifically, the commenter explained that a registered clearing agency might establish one committee that performs the entire function and role of the nominating committee but also consider other governance functions more broadly. Such an approach can be appropriate and consistent with the adopted rule. Rule 17Ad-25(c), as discussed above and modified, requires that the nominating committee evaluate each nominee for serving as a director and evaluate the independence of nominees and directors. A committee that performs these functions would satisfy the requirements of the rule, even if it also performed additional functions as specified in the organizing documents of the registered clearing agency. A registered clearing agency, however, generally should take account of the overall workload imposed on the nominating committee in the organizing documents and ensure that the nominating committee has sufficient time and resources to fulfill the functions required by Rule 17Ad-25(c), which include evaluating nominees and directors as explained above and establishing the fitness standards for serving on the board. 105 DTCC at 5. Fourth, one commenter asked whether the board could take on the functions of the nominating committee if it met all requirements applicable to the nominating committee. 106 Such an approach can be appropriate and consistent with the rule. Consistent with the requirements in Rule 17Ad-25(c)(2), such an approach would require that a majority of the directors serving on the board be independent directors—regardless of the ownership structure of the clearing agency—and that the chair of the board be an independent director. 106 ICE at 3. 3. Approach to Representation of Small and Medium-Sized Firms In addition to comments discussed in Part II.A.4 regarding establishing a “right of participation” generally on the board by small and medium-sized participants of the registered clearing agency, commenters also expressed similar views specific to participation on the nominating committee. Two commenters recommended that the Commission specifically authorize such a right of participation on the nominating committee. 107 107 Better Markets at 20 (recommending that the Commission mandate participation from smaller clearing members to guard against a board that finds diversity within the “oligopoly of large dealers”); IDTA at 4 (recommending that the Commission be more prescriptive in requiring that certain types of stakeholders, such as “not FSOC designated SIFIs” be afforded a right to participate). Exchange Act section 17A(b)(3)(C) directs the Commission to ensure the fair representation of owners and participants in the selection of directors and the administration of affairs. As previously discussed in Part II.A.4, it can be appropriate to apportion representation according to use of the clearing agency, even if an effect of this approach is to be disproportionate as to the number of small, medium, or large participants represented on the board relative to the total number of small, medium, or large participants that use the clearing agency. In addition, reducing the degree of proportionality of representation relative to use of the clearing agency could lead to negative externalities. For these same reasons, the Commission is not modifying the proposed rule to require a “right of participation” on the nominating committee specific to small and medium-sized participants. 108 In proposing Rule 17Ad-25(c), the Commission stated its belief that smaller participants and clients of participants generally should be represented on clearing agency boards and board committees, such that their views and perspectives are formally considered in board decisions that may impact them. 109 In particular, the Commission explained that the diverse perspectives and expertise that smaller participants and clients of participants can provide will help inform a clearing agency's operations and thereby improve the resilience of the registered clearing agency. Consistent with these views, board governance, and through it the risk management function of the clearing agency, benefits from diverse perspectives on risk management issues from across the range of stakeholders—owners, direct participants, and indirect participants—in a registered clearing agency. Accordingly, proposed Rules 17Ad-25(c)(4)(i), (ii), and (iii) require that clearing agencies take steps to facilitate diverse perspectives and expertise on the board, including a requirement in Rule 17Ad-25(c)(4)(ii) for the nominating committee to demonstrate that it has considered whether a particular nominee would complement the other board members, such that, if elected, the board of directors, taken as a whole, would represent—among other things—the range of different business strategies, models, and sizes across participants, as well as the range of customers and clients the participants serve. These requirements ensure that the nominating committee considers a diverse set of backgrounds, experience, and skills in selecting and evaluating nominees for the board. 110 In this regard, a registered clearing agency generally should provide in its governance arrangements that the nominating committee explicitly consider some nominees that represent the views of medium and small participants, but, in the Commission's view, it is appropriate to leave discretion to the clearing agency and its board to evaluate and select the appropriate mix of nominees and directors mindful of its organizational documents, markets served, and products cleared. 108 See supra notes 76-78 and accompanying text (not modifying the rule to designate certain seats on the board for specific types of clearing agency participants or their customers). 109 Governance Proposing Release, supra note 2, at 51829. 110 See infra Part II.F (further discussing Rule 17Ad-25(j), which imposes an obligation on the board to formally consider stakeholder viewpoints, also helps ensure that the board is actively soliciting the views of those stakeholders who do not participate in the board directly so that the views of such stakeholders can be considered and incorporated into the board's risk management and operations). For the above reasons, the Commission is not modifying Rule 17Ad-25(c) in response to these comments. 4. Percent of Directors That Are Independent Directors Some commenters expressed support for the proposed approach to require that the chair of the nominating committee be an independent director and that a majority of the directors serving on the nominating committee be independent directors. 111 One commenter recommended that the Commission modify the proposal to require that all directors serving on the nominating committee be independent directors. 112 The commenter stated that such an approach would help maintain the standard for director independence and improve the overall quality of nominees. 111 DTCC at 5; ISDA at 6; LSEG at 9; Saguato at 3; see also ICE at 3 (observing that, in its view, requiring written evaluations of nominees is unnecessary if the committee is also composed of a majority of independent directors). 112 IDTA at 4. The Commission is not requiring all directors serving on the nominating committee be independent directors for two reasons. First, as a general matter, the proposal sought to ensure an approach to board governance that facilitates fair representation of both owners and participants in the selection of directors and the administration of a clearing agency's affairs. 113 The proposed approach is consistent with this requirement in part because it enables any individual director, whether independent or not, to serve on the nominating committee. Second, and mindful of the concern raised by the commenter, the proposed rule would require that a majority of the directors serving on the nominating committee be independent directors regardless of the ownership structure of the registered clearing agency. 114 A majority of independent directors and a chair of the nominating committee that is also an independent director is sufficient to ensure the thoughtful consideration, evaluation, and selection of nominees, particularly for nominees to serve as independent directors on the board of a registered clearing agency. Given the definition of “independent director” used in Rule 17Ad-25, modifying the rule further to require that only independent directors can serve on the nominating committee would not clearly improve the functioning of the nominating committee. Independent directors would already be a majority of the nominating committee when making determinations, and as such, directors intended to represent owners of the clearing agency cannot comprise a majority of the nominating committee without also obtaining support from independent directors as to particular decisions. Because clearing agencies perform a unique and often systemically important function that facilitates effective risk management in the U.S. securities markets, enabling a wide range of stakeholders in the registered clearing agency to serve on the nominating committee, including directors who are not independent directors, can provide expertise, experience, and skills useful to the nominating committee's overall purpose. 113 Governance Proposing Release, supra note 2 at 51818 (“Specifically, the Commission believes that addressing the composition of a board and its committees will help ensure effective governance, help promote transparency into decision-making processes, facilitate fair representation of owners and participants, and mitigate the potential effects of conflicts of interest between owners and participants, large and small participants, and direct and indirect participants.”). 114 See supra Part II.A (further discussing Rule 17Ad-25(b), which sets the general requirement for the number of independent directors required to serve on the board based on the percentage of ownership held by participants in the registered clearing agency). C. Risk Management Committee 1. Proposed Rule 17Ad-25(d) Proposed Rule 17Ad-25(d)(1) would require each registered clearing agency to establish a risk management committee (or committees) (“RMC”) to assist the board in overseeing the risk management of the registered clearing agency. Proposed Rule 17Ad-25(d)(1) would also require each RMC to reconstitute its membership on a regular basis and at all times include representatives from the owners and participants of the registered clearing agency. Proposed Rule 17Ad-25(d)(2) would require that the RMC, in the performance of its duties, be able to provide a risk-based, independent, and informed opinion on all matters presented to it for consideration in a manner that supports the safety and efficiency of the registered clearing agency. In the Governance Proposing Release, the Commission explained that because all registered clearing agencies are currently covered clearing agencies and, as such, are required to have RMCs as a part of their governance arrangements under Rule 17Ad-22(e)(3)(iv), 115 no parallel requirement exists for registered clearing agencies that are subject to Rule 17Ad-22(d). 116 The Commission stated that because future registered clearing agencies that are not covered clearing agencies and, as a result, are subject to Rule 17Ad-22(d), will also likely face risk management issues related to their activities, any clearing agency subject to Rule 17Ad-22(d) will likely benefit from having a RMC. 117 Accordingly, the Commission proposed Rule 17Ad-25(d) so that clearing agencies subject to Rule 17Ad-22(d) will also be required to have RMCs as a part of their governance arrangements. 118 Additionally, the Commission stated that proposed Rule 17Ad-25(d) would establish more defined requirements related to the purpose and function of RMCs that Rule 17Ad-22(e)(3)(iv) does not and that specific requirements imposed by proposed Rule 17Ad-25(d) would help enhance risk management governance across all registered clearing agencies. 119 115 See 17 CFR 240.17Ad-22(e)(3)(iv); see also CCA Standards Adopting Release, supra note 4, at 70807-09 (discussing that, under Rule 17Ad-22(e)(3)(iv), a registered clearing agency's risk management framework must provide risk management personnel with a direct reporting line to, and oversight by, a RMC of the board of directors). 116 See Governance Proposing Release, supra note 2, at 51831. 117 See id. 118 See id. 119 See id. In the Governance Proposing Release, the Commission also stated that it recognizes the importance of enabling the board to assign certain tasks to a board committee to assist the board in discharging its ultimate responsibility of ensuring the sound risk management of the clearing agency. 120 The Commission stated that for the RMC itself to be effective, it must have a clearly defined purpose and obligations to the board; therefore, the proposed rule would require the RMC to provide a risk-based, independent, and informed opinion on all matters presented to it in a way that supports the safety and efficiency of the registered clearing agency. 121 120 See id. 121 See id. Commenters generally supported the proposed approach to Rule 17Ad-25(d). 122 However, some commenters requested clarifications 123 or modifications to the rule. 124 Other commenters disagreed with certain aspects of the rule. 125 Proposed Rule 17Ad-25(d) balances more defined requirements with principles-based requirements relating to a registered clearing agency's RMC. In keeping with this approach and to address requests for clarifications and revisions to the rule, the Commission adopts Rule 17Ad-25(d) as proposed, with certain modifications. Specifically, Rule 17Ad-25(d)(1) has been modified to reflect that: (1) the RMC is “of the board” of the registered clearing agency; and (2) the RMC's membership must be “re-evaluated annually.” Additionally, Rule 17Ad-25(d)(2) has been modified to reflect that the RMC's work must support the “overall risk management, safety and efficiency of the registered clearing agency.” Rule 17Ad-25(d) establishes specific requirements as a minimum bar for RMCs across all registered clearing agencies while also providing registered clearing agencies with discretion to consider when and how to re-evaluate the RMC membership annually and regarding the choice of the RMC chair. 122 See, e.g., SIFMA at 3 (stating that it “supports this part of the rule and urges the Commission to adopt it . . .”); Barclays et al. at 2 (stating that “[w]hile it is reassuring that all seven of the current clearing agencies include participant representatives on their RMCs, we believe that the codification of this practice into a requirement will be beneficial”); DTCC at 5 (stating that “DTCC generally supports the requirements set forth in proposed Rule 17Ad-25(d) regarding the establishment and function of a board risk committee . . .”); ICI at 2 (stating that “[w]hile RMCs currently exist at some clearing entities, the proposed requirements would promote greater consistency and a defined role for these committees.”). 123 See, e.g., DTCC at 5-6; OCC at 8-9. 124 See, e.g., SIFMA AMG at 4-6; Barclays et al. at 2. 125 See, e.g., OCC at 8-9 (stating that “[a] requirement that forces a registered clearing agency to replace well-informed risk management experts with directors relatively unfamiliar with a particular matter or the broader risk management framework would rob the registered clearing agency of critical risk management continuity.”); CCP12 at 4-5 (stating that “[w]hile we agree that it can be beneficial for a risk management committee to be a board committee . . . we do not support making this a requirement . . .”); ICE at 4 (stating that “ICE supports the Commission's proposal to require a SEC Registered CA to establish a risk management committee but disagrees with the requirement that a risk management committee be a committee of the board.”). 2. RMC of the Board Many commenters had understood the proposed rule to require a board-level RMC, as the Commission had intended the rule to require, and supported the Commission's approach. 126 A commenter requested that the Commission clarify in a final rule that the board-level RMC is “not merely an advisory body that only develops opinions or recommendations for full board consideration and action.” 127 Another commenter stated that because risk management should be a critical focus of the RMC, the RMC should have adequate representation by clearing agency participants, and the proposed requirement would help formalize such a structure and foster further consistency across clearing agencies. 128 126 See, e.g., LSEG at 10 (stating that “this would be an effective way to structure the committee. As a board sub-committee, the RMC can be formally delegated certain authorities and would be subject to the same corporate governance regime of the company.”); Saguato at 4 (stating that “[a] [c]learing agency should have one or more risk committee to support the board in its operation.”). 127 DTCC at 6. 128 See SIFMA at 3 (stating that “the Commission's specific proposal in this regard will help formalize this structure and further foster consistent practices across such clearing agencies.”). Two commenters, however, objected to the Commission's approach that would require the RMC to be a board-level committee. 129 For example, one commenter stated that registered clearing agencies should be given the discretion to structure their RMCs as they see fit, whether as a board committee or an advisory group with a broader membership than the board and with requisite expertise in risk management matters, stating it does not view that “a board level risk management committee . . . improve[s] the board's engagement with clearing agency risk management, nor is there any evidence that it makes a board's oversight of management's decisions more effective.” 130 129 See ICE at 4 (stating that it “supports the Commission's proposal to require a SEC Registered CA to establish a risk management committee but disagrees with the requirement that a risk management committee be a committee of the board.”); CCP12 at 4 (stating that “we do not support making this a requirement for all clearing agencies, as there are other models that clearing agencies use that are also effective.”). 130 ICE at 4 (also stating that “[a] risk committee that is not board level can benefit from the expertise of a wider range of individuals and thus better inform the board than a board level risk committee would.”). In response to commenters, the Commission is modifying Rule 17Ad-25(d)(1) to specify that the RMC is “of the board” to make clear that the RMC is not merely an advisory board. The Commission is modifying Rule 17Ad-25(d)(2) to specify that the RMC's work supports the “overall risk management, safety and efficiency of the clearing agency.” 131 The Commission disagrees with the commenter's suggestion that requiring registered clearing agencies to structure their RMCs as board-level committees would not make a board's oversight of management's decisions more effective. As stated in the Governance Proposing Release, a RMC of the board is a more effective way to help ensure that the board is engaged with and informed of the ongoing risk management of the clearing agency, because a dedicated committee of the board remains focused exclusively on matters related to risk management. 132 One reason that a board-level RMC is a more effective structure for the registered clearing agency's risk management decisions lies in the fact that such RMC is directly answerable to the board; requiring registered clearing agencies to establish a RMC of the board would help ensure that the board can more effectively oversee management's decisions concerning matters that implicate the clearing agency's risk management, including its policies, procedures, and tools for mitigating risk. 133 As one commenter stated, board-level RMCs of registered clearing agencies “do not function in such a passive manner, but instead act pursuant to delegated authority from the full board to evaluate and take risk management decisions directly . . . . allowing for this balancing of roles and responsibilities between the two bodies [of the RMC and the board] enhances the clearing agency's ability to evaluate and respond in a timely manner to evolving risks and other changes in the relevant cleared market.” 134 While the board may or may not take the recommendations of an advisory group, RMCs generally have delegated authority from the board to conduct oversight and make decisions regarding risk management, as most commenters have observed, 135 pursuant to a charter or other governing document specifying its purpose and its delegation of authority from the board. Notwithstanding the above, the requirement for a board-level RMC in no way precludes the establishment or use of an advisory committee composed of non-board members, as the commenter has suggested. 136 131 To address the concern that the board can also benefit from input and expertise reflecting a broader set of potential stakeholders in the registered clearing agency, the Commission is separately adopting Rule 17Ad-25(j), as discussed in Part II.F, which requires a registered clearing agency to seek input from other relevant stakeholders, such as the customers of clearing agency participants, regarding its risk management and operations. 132 See Governance Proposing Release, supra note 2, at 51831. 133 See id. 134 DTCC at 6. 135 See LSEG at 10 (stating that “. . . this would be an effective way to structure the committee. As a board sub-committee, the RMC can be formally delegated certain authorities . . .”); CCP12 at 5 (stating that “[o]ur view is that board-level RMCs may be delegated authority by the board to proactively address certain aspects of risk management. This is in line with generally accepted corporate governance principles.”). 136 See ICE at 4. In addition, Rule 17Ad-25(d) specifies that, in the performance of its duties, the RMC must be able to provide a risk-based, independent, and informed opinion on all matters presented to it in a manner that supports the overall risk management, safety and efficiency of the registered clearing agency. As discussed in the Governance Proposing Release, 137 this requirement helps ensure that the RMC has a clear scope and sufficient direction to effectively address risk management-related [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2023-25807. Public record. Not legal advice.