Part 1 2021 Proposed Security-Based Swap Antifraud and Position Reporting Rules

Part One: Rule 9j-1 Is Back, Bigger Than Ever

In a December 15th release, the U.S. Securities and Exchange Commission (the "SEC"), among other things, (a) re-proposed Rule 9j-1¹  under the Securities and Exchange Act of 1934, as amended (the "Exchange Act"), which is designed to be a new antifraud, anti-manipulation rule specifically applicable to security-based swaps, and (b) proposed Rule 10B-1², which would require reporting of large security-based swap positions and underlying security or loan positions. Although the release did not come as a complete surprise, as the SEC Chair Gensler all but promised to propose rules on these topics earlier in the year,³  and recent instances of allegedly manufactured credit events and other transactions may have conditioned the market to welcome some regulatory action, the sweeping nature of the proposals and the potentially steep costs of compliance would likely have a significant impact, even a chilling effect, on the market.

This is Part One of a two-part series regarding the rule proposals. In this piece, we outline the salient features of the re-proposed Rule 9j-1, including our initial thoughts on how the rule, as re-proposed, may affect security-based swap market participants as well as the impact on the security-based swap markets overall.

Background

The SEC initially proposed Rule 9j-1 on November 3, 2010 (the "2010 Proposal"), under the authority provided in Section 9(j) of the Exchange Act, which prohibits fraudulent and manipulative practices in connection with the "purchase or sale" of security-based swaps. As originally proposed, the rule would have made it unlawful to engage in fraudulent, deceptive or manipulative practices, or to knowingly or recklessly make or omit any material information not just in connection with a purchase or sale of a security-based swap, but also "in the exercise of any right or performance of any obligation under a security-based swap, or the avoidance of such exercise or performance."⁴   The breadth of the prohibitions under the 2010 Proposal drew criticism from major industry groups and market participants, some arguing it exceeded the SEC's authority under Section 9(j) of the Exchange Act⁵, and the SEC never finalized the rule as proposed in 2010.

Despite industry criticism of the original proposal, the re-proposed Rule 9j-1(a) not only follows the general approach of the 2010 proposal with respect to antifraud standards and insider trading prohibitions, but further expands the applicability of the prohibitions, albeit with some limited safe harbors. Newly proposed paragraphs (b) through (d) of Rule 9j-1 go on to add an anti-manipulation provision similar to Regulation 180.2 promulgated by the Commodity Futures Trading Commission (the "CFTC"),⁶ make antifraud rule violations with respect to securities automatically violations with respect to related security-based swaps, and apply the proposed expanded antifraud and anti-manipulation rules to the securities transactions. The re-proposed Rule 9j-1 aims to address manufactured credit events or other opportunistic strategies that involve fraudulent, deceptive, or manipulative activity, or that involve fictitious quotations, without impairing the proper functioning of the security-based swap market. In the SEC's view, the provisions of the re-proposed rule are sufficiently tailored to balance the concerns of credit default swap ("CDS") buyers and sellers engaging in legitimate interactions with reference entities and those parties using CDS as an important means to hedge their underlying debt instruments.⁷ 

Re-proposed Prohibition Against Fraud and Insider Trading

Paragraph (a) of the re-proposed Rule 9j-1 builds upon the 2010 Proposal, and would make it unlawful for any person, directly or indirectly, (i) to purchase or sell, or attempt to induce the purchase or sale, any security-based swap, (ii) to effect any transaction in, or attempt to effect any transaction in, any security-based swap, (iii) to take any action to exercise any right, or any action related to performance of any obligation, under any security based swap, or (iv) to terminate (other than on its scheduled maturity date) or settle any security-based swap, in connection with which such person:

1.  employs or attempts to employ any device, scheme, or artifice to defraud or manipulate; or
2.  makes or attempts to make any untrue statement of a material fact, or omits 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; or
3. obtains or attempts to obtain money or property by means of an 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 which operates or would operate as a fraud or deceit upon any person.

The operative paragraphs describing the fraudulent, manipulative or deceptive conduct that the rule prohibits rely on the antifraud and anti-manipulation provisions in Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 17(a)(2) and (3) of the Securities Act of 1933, as amended (the "Securities Act"), which provisions apply to all securities and security-based swaps. While both Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, on the one hand, and Section 17(a) of the Securities Act, on the other, address material misstatements and omissions, the two sets of provisions require different mental state for purposes of establishing liability, with the Exchange Act provision and rule require "scienter,"⁸  but Section 17(a) of the Securities Act only requires negligence. Accordingly, paragraphs (a)(1) and (2) of the re-proposed Rule 9j-1, which are based on Section 10(b) and Rule 10b-5, would require "scienter" as an element for liability. The large body of case law based on Section 10(b) and Rule 10b-5 would inform the interpretation and application of these two paragraphs. On the other hand, paragraphs (a)(3) and (4) of the re-proposed Rule 9j-1 are based on Sections 17(a)(2) and (3), and therefore would only require a showing of negligent conduct (e.g., when a party to a security-based swap knows or reasonably should know that a statement was false or misleading and directly or indirectly obtains money or property by means of such statement). Given the overlap of prohibitions in the proposed rule, particularly under paragraphs (a)(2) and (3), the "scienter" requirement may potentially become less relevant in an enforcement action or private civil litigation based on the re-proposed Rule 9j-1(a) (if adopted as currently proposed) than it is under a traditional insider (securities) trading action.

In reliance on the additional antifraud and anti-manipulation provisions under Section 9(j) of the Exchange Act, the re-proposed Rule 9j-1(a) extends the traditional prohibitions on fraud and manipulative practices. For one thing, the prohibitions now also apply to attempts at a prohibited act or omission, for which liabilities are not expressly limited to criminal ones. Additional clarity from the SEC or the courts may be needed as to whether this rule would give rise to private cause of action for attempted violations. Attempts do not generally form basis for violation under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, although the CFTC's swap antifraud rules, do provide for liability for attempted violation. It remains to be seen how liability for an attempted violation would be found in the context of insider trading where, as a general matter, traditionally no antifraud liability would be found where no trade occurs.

The SEC interprets the scope of prohibitions under Section 9(j) of the Exchange Act — in connection with "a purchase or sale" of, or effecting a transaction in, a security-based swap – very broadly, though it is unclear how exercise of existing rights or performance of existing obligations fit into that scope. Nonetheless, re-proposed Rule 9j-1 extends to taking action to exercise any right or action related to performance of any obligation under any security-based swap (including any payments, deliveries, rights, or obligations, or alteration of any rights thereunder). To be sure, the re-proposal tweaks the 2010 Proposal by adding the words "taking actions to," therefore seemingly carving out some rights and obligations of the parties under a security-based swap which do not require specific actions. In practice, however, the exercise of most rights and performance of most obligations arguably involve taking some form of an action and thus may well fall in scope. In this regard, the SEC proposes a safe harbor⁹ to help provide some comfort to parties, though as discussed below under "Limited Safe Harbor," by the SEC's own analysis the safe harbor is narrowly drawn.

The prohibitions set forth in the re-proposed Rule 9j-1(a) also apply to the termination or settlement of a security-based swap, with the exception of any scheduled maturity. Thus, for example, when cash settlement of all CDS referencing an entity occurs as a result of a credit event, if the parties to receive the cash settlement amount is then in possession of material non-public information which is not disclosed to the other party, arguably paragraph (a)(3) of the re-proposed rule may be violated to the extent that the party with information continues to receive (or, indeed, attempts to receive) payment of the cash settlement amount.

Limited Safe Harbor

The SEC proposes a pair of limited safe harbors to the re-proposed Rule 9j-1(a). ¹⁰ Of particular interest is the safe harbor under Rule 9j-1(f)(1) which would carve out liability based solely on one being aware of material non-public information while taking certain action (in accordance with binding contractual rights and obligations under a security-based swap), so long as the person can demonstrate that (i) the security-based swap was entered into prior to such person came into possession of material non-public information, and (ii) the entry into, and the terms of, the security-based swap are themselves not a violation of Rule 9j-1. The SEC cautions that the proposed safe harbor does not cover a scenario where a party to a security-based swap takes some action to (fraudulently) increase or decrease the amount of any payment or collateral transfer. Given the potentially broad interpretation of what would constitute "taking action" for the purposes of the rule, it is unclear when the safe harbor would be useful in practice.

The absence of a safe harbor or affirmative defense similar to Rule 10b5-1(c)(2) promulgated under the Exchange Act is particularly problematic for an institution that has been relying on the affirmative defense provided by Rule 10b5-1(c)(2) in implementing reasonable policies and procedures to prevent insider trading violations. To protect itself from claims under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the institution may have implemented policies and procedures to restrict trading of securities by personnel who have become aware of material non-public information and to establish information barriers that separate parts of the organization that routinely come into possession of material non-public information, such as the investment banking division, from other parts of the organization that trade securities, thus preventing individuals making investment decisions to trade securities from becoming aware of material non-public information. These policies and procedures, however, may not, without further SEC rulemaking, be effective defenses against a claim of fraud and manipulation under Section 9(j) of the Exchange Act and the re-proposed Rule 9j-1.

Prohibition Against Price Manipulation

To address concerns regarding manufactured credit events and other opportunistic strategies in CDS markets, the SEC proposes a new paragraph (b) to Rule 9j-1 to make it unlawful for any person to, directly or indirectly, manipulate or attempt to manipulate the price or valuation of any security-based swap, or any payment or delivery related thereto, such as intentionally and improperly orphaning a CDS, avoiding termination of a CDS for a period of time, or causing the termination of a CDS. In an effort to explain the scope of this prohibition, the SEC clarifies that it is intended to capture situations where a payment is intentionally distorted, and that simply profiting from a CDS position after a company's bankruptcy when the swap party could have prevented it by participating in a financing, without more, is not improper.¹¹ These clarifications, however, may provide little solace to CDS parties who, for example, are asked to participate in a financing that could lead to the company avoiding a default, and therefore a decrease of payment under the CDS. If a CDS seller participates in the financing, it may arguably be taking actions with an intent to decrease payment under the CDS. Conversely, if a CDS buyer declines to participate in the financing, it may be interpreted as acting with intent to increase payment under the CDS. Even when the party contemplating the financing transaction does not have a CDS position, as discussed below under "Transactions in Underlying Securities," liability under proposed Rule 9j-1(b) could still be found as a result of the extension under Rule 9j-1(d).

Transactions in Underlying Securities

The SEC proposes new paragraphs (c) and (d) under Rule 9j-1 with the stated purpose of making it 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 a security-based swap, and vice versa.¹²  Specifically, proposed 9j-1(c) would provide that wherever communicating, or purchasing or selling a security while in possession of material non-public information would violate, or result in liability under, the Exchange Act or the Securities Act or any rule or regulation thereunder, such conduct in connection with the purchase or sale of a security-based swap with respect to such security or with respect to a group or index of securities including such security would also violate, and result in comparable liability under, such provision, rule or regulation. Whether or not by design, this paragraph (c) presumes that any information material to a securities transaction is automatically material to a security-based swap with respect to the security or a group or index of securities including the security. This presumption of materiality is curious, given that as the SEC acknowledges, security-based swaps and the underlying securities behave differently, and in particular given that the reference to securities index under this paragraph is not limited to narrow-based index of securities (even though the SEC's discussion of the proposed rule specifies "narrow-based index").

Similarly, proposed Rule 9j-1(d) would provide that whenever taking any action involving a security-based swap would violate or result in liability under Section 9(j) of the Exchange Act or Rule 9j-1 thereunder, such conduct, when taken by a counterparty to such security-based swap (or any affiliate of or any person acting in concert with such counterparty), 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 Section 9(j) of the Exchange Act and Rule 9j-1. Much of the re-proposed Rule 9j-1 expressly relies on the SEC's antifraud and anti-manipulation authority specifically provided under Section 9(j) of the Exchange Act and applicable to security-based swap only. In particular, the prohibitions against price manipulation as formulated under paragraph (b) of the re-proposed 9j-1 do not have a parallel in the context of securities transactions. The purported exporting of those prohibitions to securities transactions under the proposed Rule 9j-1(d), therefore, arguably goes beyond the SEC's statutory authority.

Conclusion

The re-proposed Rule 9j-1 includes, at its core, an expanded version of the 2010 Proposal. But it also goes much beyond the 2010 Proposal, adding new prohibitions against price manipulation, providing for at least a presumption that insider trading with respect to a security is also a violation of antifraud and anti-manipulation provisions with respect to a security-based swap based on such security or group or index of securities of which the security is a component, and extending the prohibitions under Rule 9j-1 with respect to a security-based swap to purchase and sale of the underlying security or index of securities. The proposed safe harbors from insider trading claims are very narrow and fall far short of what the market is accustomed to in the securities trading context.

The re-proposal comes at a time when recent instances of narrowly-tailored or other opportunistic strategies may have changed the market sentiment, and market participants may be more receptive to antifraud and anti-manipulation rules specifically intended for security-based swaps. Nonetheless, if adopted in current form, the re-proposed Rule 9j-1 will likely lead to increased regulatory risks, and therefore significant compliance costs, for parties participating in both the security-based swap market and financing and restructuring transactions.

Parties should closely examine, and consider submitting comments to the SEC on, features of the proposals such as, among other things, the lower liability standard for an insider security-based swap trading claim, the overly broad prohibition on price manipulation, the potential liability for attempted violations, the extension of prohibition on security-based swap price manipulation to purchases and sales of securities, and the absence of safe harbor or affirmative defense essential to legitimate business operations and transactions.

_{1.  To become 17 CFR 240.9j-1.}

 _{2.  To become 17 CFR 240.10B-1.}

 _{3.  Gensler, Prepared Remarks before the American Bar Association Derivatives and Futures Law Committee Virtual Mid-Year Program, available at https://www.sec.gov/news/speech/gensler-remarks-aba-derivatives-futures-law-committee-virtual-mid-year-program-072121 (Jul. 21, 2021).}

 _{4.  Release No. 34-63236, Prohibition Against Fraud, Manipulation, and Deception in connection with Security-Based Swaps (Nov. 3, 2010), 75 Fed Reg. 68560 (Nov. 8, 2010)}

 _{5.  See, e.g., Release, note 52 and accompanying text.}

 _{6.   17 CFR 180.2.}

_{7.  Release Section I.C.1.}

 _{8.  "Scienter" is "the mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).}

 _{9.  The SEC also proposes a safe harbor with respect to required portfolio compression process, which is not discussed in this article.}

 _{10.  Release Section II.B.2.}

 _{11.  Release Section II.B.3.}

 _{12.   Release Section II.C.}