On June 7, 2023, the U.S. Securities and Exchange Commission (SEC or Commission), in a 3–2 vote along party lines, adopted rules to prevent fraud in connection with security-based swaps (SBS) and prevent undue influence over chief compliance officers (CCOs) of certain SBS market participants (Final Rules).1 First, the SEC adopted Rule 9j-1, which is designed to prevent misconduct in connection with effecting transactions in, attempting to effect any transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any SBS transaction. Second, the SEC adopted Rule 15fh-4(c) to protect the independence and objectivity of the CCO of an SBS dealer or major SBS participant (SBS Entities).
The Final Rules follow the SEC’s December 2021 reproposal of antifraud and antimanipulation rules under Section 9(j) of the Securities Exchange Act of 1934 (Exchange Act), which the Commission pursued at that time in part due to a rise of “manufactured credit events” or other opportunistic strategies in the credit default swap (CDS) market, in addition to a recognition of the important role CCOs of SBS Entities play in preventing fraud and manipulation.2 Together, the Final Rules address potential misconduct in the SBS market that can harm both direct counterparties and reference entities and investors.
On June 20, 2023, the SEC reopened the comment period regarding its December 15, 2021, proposing release regarding large SBS position reporting (Proposed Rule 10B-1)3, and SEC staff in the Division of Economic and Risk Analysis took the further step of submitting a memorandum to the comment file “to provide supplemental analysis related to the economic effects of proposed Rule 10B-1.” The length of the reopened comment period for Proposed Rule 10B-1 is the later of August 21, 2023, or 30 calendar days after publication of the reopening release in the Federal Register. As described in the initial Sidley client update concerning Proposed Rule 10B-1, market participants should be very interested in the expansive and complex SBS position reporting regime that the proposal would create, which would make large position information publicly available.4 If adopted, Proposed Rule 10B-1 would also create a dragnet for data regarding large SBS positions that the SEC could then, among other things, use in investigating potential fraud, manipulation, or deception under newly adopted Rule 9j-1 as described below.
Antifraud/Manipulation Related to SBS — Rule 9j-1
Final Rule 9j-1 includes prohibitions on categories of misconduct prohibited by Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933 when effecting any transaction in, or attempting to effect any transaction in, any SBS or when purchasing or selling, or inducing or attempting to induce the purchase or sale of, any SBS. Final Rule 9j-1 also includes prohibitions on the manipulation or attempted manipulation of the price or valuation of any SBS, antifraud provisions related to underlying reference securities, and two affirmative defenses.
General Antifraud and Antimanipulation
Rule 9j-1(a) makes it unlawful for any person, directly or indirectly, to effect any transaction in, or attempt to effect any transaction in, any SBS or to purchase or sell5, or induce or attempt to induce the purchase or sale of, any SBS, in connection with
- employing or attempting to employ any device, scheme, or artifice to defraud or manipulate (Rule 9j-1(a)(1))
- making or attempting to make any untrue statement of a material fact or omitting a material fact necessary to make statements not misleading in light of the circumstances under which they were made (Rule 9j-1(a)(2))
- obtaining money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make statements not misleading in light of the circumstances under which they were made (Rule 9j-1(a)(3))
- engaging in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person (Rule 9j-1(a)(4))
- attempting to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make statements not misleading in light of the circumstances under which they were made or attempting to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person (Rule 9j-1(a)(5))
- manipulating or attempting to manipulate the price or valuation of any SBS, including any payment or delivery related thereto ((Rule 9j-1(a)(6))
Violations of Rules 9j-1(a)(1), (2), (5), and (6) require a showing of scienter. Violations of Rules 9j-1(a)(3) and (4) do not require a showing of scienter and extend to conduct that is at least negligent. Importantly, as described below, the SEC also adopted under Rules 9j-1(e)(1) and (2) two affirmative defenses to liability under Rules 9j-1(a)(1) through (5) that apply to situations in which a person can demonstrate that material nonpublic information did not factor into their investment decision.
Affirmative Defenses to the General Antifraud Rule
Finally, Rule 9j-1(e) includes two affirmative defenses to liability under Rules 9j-1(a)(1) through (5) that are modeled on Rule 10b5-1 and apply to situations in which a person can demonstrate that material nonpublic information did not factor into investment decisions. Consistent with analogous provisions in Rule 10b5-1, Rule 9j-1 does not provide an affirmative defense for violations of the antimanipulation provision in Rule 9j-1(a)(6).
Rule 9j-1(e)(1) provides an affirmative defense for actions taken by a person in accordance with binding contractual rights and obligations under an SBS (as reflected in the written SBS documentation governing such transaction or any amendment thereto). A market participant may take action when aware of material nonpublic information and avoid liability if the person demonstrates that (1) the SBS was entered into, or the amendment made, before the person became aware of such material nonpublic information, and (2) the SBS was entered into in good faith and not as part of a plan or scheme to evade prohibitions of Rule 9j-1.
Rule 9j-1(e)(2) provides an affirmative defense for actions taken by a person, other than a natural person, who demonstrates that (1) the individual making the investment decision on behalf of the person was not aware of the material nonpublic information, and (2) the person had implemented reasonable policies and procedures, taking into consideration the nature of the person’s business, to ensure that individuals making investment decisions would not be in violation of Rule 9j-1(a)(1) through (5).
Preventing Undue Influence Over CCOs — Rule 15fh-4(c)
Final Rule 15fh-4(c) is aimed at protecting the independence and objectivity of the SBS Entity’s CCO. The rule prohibits any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person’s direction, to take any action to coerce, manipulate, mislead, or fraudulently induce the SBS Entity’s CCO in the performance of their duties under the federal securities laws.
The Final Rules become effective 60 days after the date of publication of the adopting release in the Federal Register.
1 Securities Exchange Act Release No. 34-97656, June 7, 2023.
2 For more information about the SEC’s December 15, 2021, rule proposal, please see our client alert here. For more information regarding manufactured credit events, please see our Bloomberg Law article Regulatory Scrutiny of Manufactured Credit Events, December 2019.
3 Securities Exchange Act Release No. 34-99762 (June 20, 2023) (reopening the comment period for Securities Exchange Act Release No. 34-93784, December 15, 2021).
4 Rule 10B-1 was initially proposed with Rules 9j-1 and 15fh-4(c), but the SEC has bifurcated these rules, reopening the comment period for the former while adopting the latter. See infra n.2 for a link to our client alert describing Rule 10B-1.
5 Rule 9j-1(d) provides that for purposes of Rule 9j-1, the terms “purchase” and “sale” shall have the same meanings as set forth in Sections 3(a)(13) (15 U.S.C. 78c(a)(13)) and 3(a)(14) (15 U.S.C. 78c(a)(14)) of the Exchange Act.
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