SEC Proposes Rules to Prevent Fraud/Manipulation in Security-Based Swaps and Undue Influence Over Chief Compliance Officers

Antifraud/Manipulation Related to SBS — Proposed Rule 9j-1

A much simpler version of proposed Rule 9j-1 was proposed in 2010 but never adopted.⁴ Some commenters to the 2010 proposed Rule 9j-1 suggested that the proposed rule exceeded the SEC’s authority by addressing activities involving the exercise of any rights and the performance of any obligations during the life of a SBS, as opposed to addressing only misconduct in connection with the “purchase” or “sale” of an SBS.⁵ Nonetheless, the SEC has reproposed Rule 9j-1 to be even more expansive than the 2010 proposal. 

General Antifraud

Proposed Rule 9j-1(a) would make it unlawful for any person, directly or indirectly, to engage in the following specified activities that meet the specified conditions. 

Specified Activities

• Purchase or sell, or attempt to induce the purchase or sale of, any SBS;⁶
• effect any transaction in, or attempt to effect any transaction in, any SBS;
• take any action to exercise any right, or any action related to performance of any obligation, under any SBS, including in connection with any (i) payments, (ii) deliveries, rights or (iii) obligations or alteration of any rights thereunder; or
• terminate (other than on its schedule maturity date) or settle any SBS. 

Specified Conditions

The foregoing specified activities would be unlawful if the person engaged in them: 

1. uses or attempts to use any device, scheme or artifice to defraud or manipulate;
2. makes or attempts to make any untrue statement of a material fact, or omits to state a material fact necessary to make statements not misleading in the light of the circumstances under which they were made;⁷
3. obtains or attempts 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 the statements made, in light of the circumstances under which they were made, not misleading; or
4. engages or attempts to engage in any act, practice or course of business that operates or would operate as a fraud or deceit upon any person.

Antimanipulation of SBS Price or Valuation

Proposed Rule 9j-1(b) is modeled on existing CFTC Regulation 180.2. It would make it unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price or valuation of any SBS or any payment or delivery related thereto. 

According to the SEC, this provision is intended to address manufactured or other opportunistic CDS strategies, including situations where a party intentionally distorts any payment related to an SBS for the benefit of one of the SBS counterparties.⁸ The SEC states that this provision is also intended to prohibit a situation where a person improperly and intentionally causes or avoids the purchase or sale of an SBS for the benefit of a counterparty, such as intentionally and improperly orphaning a CDS, avoiding termination of a CDS for a period or causing the termination of a CDS.⁹

The result of these types of activities, according to the SEC, is that CDS buyers continue to pay (and CDS sellers continue to receive) premiums on CDS that will never default, or, similarly, a CDS protection seller might offer financing to the company to avoid a credit event and subsequent CDS payout, with the financing timed so that the company’s bankruptcy is merely delayed until after the CDS expires.

The SEC states that it does not intend for proposed Rule 9j-1(b) to apply to taking “affirmative actions in the ordinary course of a security-based swap transaction or the underlying referenced security.” However, the SEC does not explain what is meant by “affirmative actions in the ordinary course.” The SEC states that proposed Rule 9j-1(b) is intended to capture situations where a payment under an SBS is “intentionally distorted” such as when a party takes action for the “purposes of avoiding or causing, or increasing or decreasing, a payment under a security-based swap in a manner that would not have occurred, but for such actions.”¹⁰

Antifraud Related to the Underlying Reference Security

The SEC proposed Rule 9j-1(c) and (d) to make clear that market participants cannot avoid liability under the rule by effecting a fraudulent scheme through the purchase or sale of an underlying security, rather than the purchase or sale of the SBS on which it is based, and vice versa.¹¹ Proposed Rule 9j-1(c) would provide that a person could not escape liability for trading based on possession of material nonpublic information about a security by purchasing or selling an SBS on that security (as opposed to trading in the security itself), while Proposed Rule 9j-1(d) provides that a person could not escape liability under Section 9(j) or reproposed Rule 9j-1 by purchasing or selling the underlying security (as opposed to purchasing or selling a SBS based on that security).

Specifically, proposed Rule 9j-1(c), which is modeled after Section 20(d) of the Securities Exchange Act of 1934 (Exchange Act), would provide that

Wherever communicating, or purchasing or selling a security (other than a security-based swap) while in possession of, material nonpublic information would violate, or result in liability to any purchaser or seller of the security under either the [Exchange] Act or the Securities Act of 1933, or any rule or regulation thereunder, such conduct in connection with a purchase or sale of a SBS with respect to such security or with respect to a group or index of securities including such security shall also violate, and result in comparable liability to any purchaser or seller of that security under, such provision, rule, or regulation.

Proposed Rule 9j-1(d) would provide that 

Whenever taking any of the actions set forth in paragraphs (a) or (b) of this section involving a security-based swap would violate, or result in liability under Section 9(j) of the [Exchange] Act or this section, when taken by a counterparty to such security-based swap (or any affiliate of, or a person acting in concert with, such security-based swap counterparty in furtherance of such prohibited activity), in connection with a purchase or sale of a security or group or index of securities on which such security-based swap is based, shall also violate, and shall be deemed a violation of, Section 9(j) of the [Exchange] Act or paragraphs (a) or (b) of this section.

The SEC noted that proposed Rule 9j-1(d) is not intended “to create a separate category of prohibited activity” but is instead designed to specify that “many of the activities that would be considered fraud, manipulation, or deceit with respect to a security-based swap are typically effected through transactions in the underlying reference entity, security, loan, or group or index of securities or loans.”¹²

Limited Safe Harbor Regarding the General Antifraud Rule

Proposed Rule 9j-1(f) would create a limited safe harbor for certain activity, providing that a person shall not be liable under Rule 9j-1(a) solely for reason of being aware of material nonpublic information while taking the following actions:

1. 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) so long as
   • the SBS was entered, or the amendment was made, before the person came into possession of such material nonpublic information
   • the entry into, and the terms of, the SBS are themselves not a violation of any provision of Rule 9j-1
2. SBS transactions effected by a person pursuant to a bilateral portfolio compression exercise (as defined in Rule 15Fi-1(a))¹³ or a multilateral portfolio compression exercise (as defined in Rule 15Fi-1(j))¹⁴ so long as
   • any such transactions are consistent with all of the terms of a bilateral portfolio compression exercise or multilateral portfolio compression exercise, including as it relates to, without limitation, the transactions to be included in the exercise, the risk tolerances of the persons participating in the exercise and the methodology used in the exercise
   • all such terms were agreed to by all participants of the bilateral portfolio compression exercise or multilateral portfolio compression exercise prior to the commencement of the applicable exercise

This safe harbor is intended to help address certain operational concerns in situations when a counterparty to a SBS is required to take certain actions while in possession of material nonpublic information.¹⁵

Preventing Undue Influence Over CCOs — Proposed Rule 15Fh-4(c)

The SEC also proposes to adopt Rule 15Fh-4(c), which is aimed at protecting the independence and objectivity of the CCO of an SBS dealer or major SBS participant. The SEC previously considered whether to adopt a similar requirement when it adopted business conduct standards for SBS Entities in 2016, but it ultimately determined not to do so.¹⁶

Proposed Rule 15Fh-4(c) would make it unlawful for any officer, director, supervised person or employee of an SBS dealer or major SBS participant, or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the SBS dealer’s or major SBS participant’s CCO in the performance of her or his duties under the federal securities laws or the rules and regulations thereunder.

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¹ Securities Exchange Act Release No. 93784 (December 15, 2021), https://www.sec.gov/rules/proposed/2021/34-93784.pdf. In addition, the SEC proposed a reporting regime for large SBS transactions under new Rule 10B-1. For more information on proposed Rule 10B-1, please see the Sidley client alert available here.

² Proposal at 14.

³ For more information regarding manufactured credit events, please see our article here: https://www.sidley.com/-/media/uploads/bloomberg-law_regulatory-scrutiny-of-manufactured-credit-events.pdf?la=en.

⁴ Securities Exchange Act Release No. 63236, 75 FR 68560 (Nov. 8, 2010), https://www.govinfo.gov/content/pkg/FR-2010-11-08/pdf/2010-28136.pdf. The 2010 proposed rule would have made it unlawful for any person, directly or indirectly, in connection with the offer, purchase or sale of any SBS, in the exercise of any right or performance of any obligation under a SBS, or the avoidance of such exercise or performance (a) to employ any device, scheme or artifice to defraud or manipulate; (b) to knowingly or recklessly make any untrue statement of a material fact, or to knowingly or recklessly omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; (c) 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 the statements made, in light of the circumstances under which they were made, not misleading; or (d) to engage in any act, practice or course of business that operates or would operate as a fraud or deceit upon any person.

⁵ Proposal at 26.

⁶ Proposed Rule 9j-1(e) would provide 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.

⁷ Proposed Rule 9j-1(a)(1) and (2) would require scienter, while proposed Rule 9j-1(a)(3) and (4) would not require scienter for liability.

⁸ Proposal at 46.

⁹ Proposal at 47. According to the SEC, “orphaning” a CDS refers to a situation where the debt of a reference entity is eliminated or reduced for the purposes of moving the price of CDS.

¹⁰ Proposal at 47–48. The SEC states that it acknowledges that financing for a reference entity may come from parties that hold CDS positions but that the purpose of proposed Rule 9j-1(b) is to account for actions “taken outside the ordinary course of a typical lender-borrow (or prospective lender-borrow) relationship,” such as where an action appears to be designed “almost exclusively to harm one or more CDS counterparties.”

¹¹ Proposal at 49.

¹² Proposal at 51. The SEC clarified that proposed Rule 9j-1(d) is not intended to suggest that a person could be liable for violations of Section 9(j) and Rule 9j-1 based solely on the impact of its transactions on the equity, debt or loan markets, and the rule therefore provides that the person must be a counterparty to a SBS that references such equity or debt securities or loans (or an affiliate of, or a person acting in concert with, such SBS counterparty).

¹³ 17 CFR 240.15Fi-1(a).

¹⁴ 17 CFR 240.15Fi-1(j).

¹⁵ Proposal at 42.

¹⁶ See Securities Exchange Act Release No. 77617 (Apr. 14, 2016), 81 FR 29960 (May 13, 2016).