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There doesn't appear to be a constraint prohibiting circular substitution groups. See: http://lists.w3.org/Archives/Public/www-xml-schema-comments/2001OctDec/0018.html
An erratum will be created to include a constraint prohibiting circular substitution groups. Proposed text: http://lists.w3.org/Archives/Member/w3c-xml-schema-ig/2002Oct/0175.html reviewed at Oct. 11 telecon. Approved with suggested ammendments (see meeting minutes for details). Erratum E1-23 added