SEC Adopts Security-Based Swap Anti-Fraud Rules

Commentary by Nihal Patel

The SEC adopted final rules aimed at preventing fraud and manipulation involving security-based swaps ("SBS") transactions and an amendment to prohibit undue influence on security-based swap dealers' ("SBSD") chief compliance officers.

The adopted rules incorporate revisions from the SEC's initial proposal (see previous coverage). In summary:

  • Exchange Act Rule 9j-1 ("Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps")
    • Rule 9j-1(a) prohibits persons from (1) effecting or attempting to effect SBS or (2) "purchasing" or "selling" or attempting to purchase or sell SBS - including partial executions and terminations (prior to scheduled maturity), assignments, exchanges, or similar actions or extinguishing rights or obligations under an SBS if a person:
      • employs a device, scheme or artifice to defraud or manipulate;
      • makes or attempts to make certain types of misstatements or omissions;
      • obtains money or property by means of certain types of misstatements or omissions;
      • engages in an act or practice that operates or would operate as a fraud or deceit upon any person;
      • attempts to engage in conduct described in (3)-(4); or
      • manipulates or attempts to manipulate the price or valuation of any SBS or any payment or delivery related thereto.
    • Rule 9j-1(b) provides that a person who takes actions while in possession of material non-public information in connection with securities (other than SBS) that would violate the Securities Act or Exchange Act shall also be in violation with respect to purchases or sales of SBS;
    • Rule 9j-1(c) provides the inverse to 9j-1(b) - i.e., applying liability for actions taken that would violate 9j-1(a) in connection with non-SBS securities;
    • Rule 9j-1(e) provides affirmative defenses to 9j-1(a)-(e) for (i) actions taken consistent with binding contractual rights if taken before becoming aware of MNPI and made in good faith and (ii) actions taken by legal entities that show that the individual making decisions was not aware of MNPI and consistent with implemented policies and procedures reasonably designed to ensure relevant individuals would not violate 9j-1(a)-(5).
  • Exchange Act Rule 15Fh-4 ("Antifraud provisions for security-based swap dealers")
    • Rule 15fh-4(c) prohibits personnel of a security-based swap entity from coercing, manipulating, misleading or fraudulently influencing the entity’s chief compliance officer ("CCO"). The SEC stated that the final rule is aimed at maintaining the "independence and objectivity" of an security-based swap entity’s CCO by preventing personnel from fraudulently influencing a CCO during the performance of the CCO's duties.

The rules will become effective 60 days after publication in the Federal Register.

Statements

  • SEC Chair Gary Gensler. Mr. Gensler emphasized that it is "critical" to prevent fraud and manipulation relating to security-based swaps given the "size, scale and importance" of the swaps market.
  • SEC Commissioner Caroline A. Crenshaw. Ms. Crenshaw said the final rules (i) address, among other types of misconduct, manufactured credit events and opportunistic strategies in the credit derivatives market and (ii) implement a "common-sense safeguard" to "empower and support CCOs in establishing a strong and committed culture of compliance."
  • SEC Commissioner Jaime Lizárraga. Mr. Lizárraga commended the final rules for implementing anti-fraud and anti-manipulation provisions but also for "taking an important step to preserve and protect the integrity of CCOs at security-based swap entities."
  • SEC Commissioner Mark T. Uyeda. Mr. Uyeda dissented and criticized the final rules for "not sufficiently tak[ing] into account and address[ing] the special features of various types of security-based swaps." He argued that the purpose of the rulemaking is "questionable" given that existing anti-fraud rules "already cover security-based swaps." Mr. Uyeda also pointed out that the final rule lacks a safe harbor for hedging activities arising out of lending activities.

Commentary

Rule 9j-1 is a relatively small amount of text with a potentially massive impact. The SEC wrote a proposal that went beyond the existing anti-fraud laws that apply to securities (including SBS) and did so without getting too specific about how it differs in application from those laws. It has now adopted a rule that essentially does the same with little added clarity. As Commissioner Uyeda points out in a well written dissent, the rule is light on specific prohibitions and heavy on general statements of stopping bad things from happening. While the discussion contained in the final rule highlights some differences for SBS - in particular, by covering various actions taken apart from entering into a transaction - the overall thrust is fairly light on indicating to market participants what can and should be done differently in response to this rule versus what is already required under Exchange Act Section 10 and Securities Act Section 17.

The discussion on application of 9j-1(a)(6) - for which no affirmative defense is provided - is particularly lacking. The SEC places emphasis on the need to respond to "manufactured credit events and other opportunistic CDS strategies" (a debatable need in the first place) while providing few examples of conduct that actually would violate the rule and repeatedly emphasizing the "facts and circumstances" nature of the analysis. The discussion attempts to reassure market participants by repeatedly saying actions taken outside "the ordinary course of a typical lender-borrower relationship" are not intended to be covered, but does not apply this statement in the context of distressed debt, where "ordinary" and "typical" are less known and the rule is most likely to be relevant.

Finally, as previously noted, it is difficult to discern a raison d'etre for the new provision in Rule 15fh-4(c) (which was adopted as proposed). The provision was suggested by a commenter (Better Markets) when the business conduct rules were proposed, and rejected when they were adopted. In the short time since the current rule has been in effect, there have been no particular events to suggest the rule is insufficient. There is also no similar provision in place for other SEC (or CFTC) registrants that have CCOs.

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