Part 2 2021 Proposed SecurityBased Swap Antifraud and Position Reporting Rules
12 January 2022
Part Two: Proposed Rule 10B-1 – First Ever Large Position Reporting Regime
In a December 15th release1, the U.S. Securities and Exchange Commission (the "SEC"), among other things, (a) re-proposed Rule 9j-12 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-13, 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 last the year4, 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 Two of a two-part series. In Part One, we have outlined the salient features of the re-proposed Rule 9j-1 and our initial thoughts on the potential impact on the market. In this Part Two, we summarize the new reporting requirements under the proposed Rule 10B-1, and point out some interpretational issues and practical considerations.
General
The SEC proposes Rule 10B-1 under Section 10B of the Exchange Act which gives the SEC authority to establish position limits for security-based swaps and require reporting of large security-based swap positions. As proposed, the rule would require any person with a security-based swap position that exceeds a certain threshold to promptly file with the SEC a schedule disclosing (1) the applicable security-based swap position, (2) positions in any security or loan underlying the security-based swap position, and (3) any other instrument relating to the security-based swap position or the underlying security or loan, or group or index of securities or loans. Among other things, the SEC believes that the transparency afforded by this rule would enable issuers and the market at large to take appropriate action to limit any potential harmful consequences from activities such as the so-called "net-short debt activism" – where a market participant with a large CDS position and a (controlling) voting interest in the debt of a reference entity votes against its interest as a debt holder to ensure that a credit event occurs under the CDS5.
Reporting Person and Ownership
The reporting obligation applies to a person (and a control person) who directly or indirectly owns or sells, or participates in a group pursuant to any contract, arrangement, understanding or relationship, and the group directly or indirectly owns or sells, a Security-Based Swap Position (as defined below) that exceeds the Reporting Threshold Amount (as defined below). The reporting obligation would apply to all security-based swap parties, whether or not they are regulated by or registered with the SEC in any capacity or even qualify as a U.S. person (for the cross border application of the proposed rule, see "Cross Border Issues" below).
Similar to Section 13(d) of the Exchange Act, which requires reporting of beneficial ownership interest in equity securities, the proposed Rule 10B-1 would aggregate ownership by multiple persons if they participate in a "group." Although not identical to that under Section 13(d), a "group" analysis here would also be factual, potentially with gray areas. Like in the Section 13(d) context, the aggregation rules are critically important to institutions that may have a multitude of businesses engaged in trading, investing and holding of securities, loans and security-based swaps.
Security-Based Swap Position
A "Security-Based Swap Position" under the proposed rule means all security-based swaps based on:
(i) a single security or loan, or a narrow-based security index, or any interest therein or based on the value thereof;
(ii) any securities issued by the same issuer (each, an "issuing entity") [of] the securities, loans, or securities included in the narrow-based index (including any interest therein or based on the value thereof) described in (i) above; or
(iii) any narrow-based security index that includes any of those issuing entities or their securities (including any interest therein or based on the value thereof).
To the extent a person holds a position in security-based swaps based on a narrow-based security index, that position is both a Security-Based Swap Position with respect to the index swap, and a Security-Based Swap Position with respect to a single-name security-based swap on each component in the index (multiplied by the weighting). Each single-name Security-Based Swap Position would, in turn, be aggregated with all other Security-Based Swap Positions with respect to the same issuer.
It is worth noting that, while the Security-Based Swap Position for equity security-based swaps is calculated separately by class of equity, the proposed rule does not distinguish between senior and subordinated debt securities or between loans and bonds.
The Security-Based Swap Position under the proposed Rule 10B-1 is calculated on a gross basis, without permitting the netting of long and short positions. That is not surprising given that the SEC's stated goal is to identify positions that may have a significant impact on the reporting person's counterparties, companies whose securities are referenced by a security-based swap and the market as a whole. But this calculation would make it much more likely for market-makers' trading activities to reach the reporting threshold, even if the trades are executed on the basis of a matched book.
Reporting Threshold Amount
The SEC explains that the Security-Based Swap Position is calculated separately for (i) CDS, (ii) other debt security-based swaps, and (iii) equity security-based swaps, in each case referencing a single debt or equity security or a narrow-based security index, therefore the Reporting Threshold Amount is defined differently for each of CDS, other debt security-based swaps and equity security-based swaps.
CDS and Debt Security-Based Swaps
For CDS, the proposed reporting threshold is the lesser of (i) $150 million in long position (net of the principal amount of debt securities deliverable into the CDS), (ii) $150 million in short position, or (iii) $300 million in gross position. The long position threshold is specifically designed to address the so-called "net short" debt holders, whose long position in CDS protection exceeds their holdings in the debt security, if any.
For other debt security-based swaps, the SEC proposes a reporting threshold of $300 million in gross position, without taking into account securities held as a hedge against the security-based swap. The SEC's discussion on the rationale for this threshold is somewhat puzzling, as it seems to relate to CDS specifically, and does not explain why the threshold for non-CDS positions should also be calculated on a gross basis6.
Equity Security-Based Swaps
For equity security-based swaps, the SEC proposes to define the Reporting Threshold Amount to mean the lesser of the two thresholds: one based on the notional amount of the security-based swaps and the other one based on the total number of shares attributable to the security-based swaps as a percentage of the outstanding number of shares of that class of equity securities.
The notional amount threshold would be $300 million, calculated on a gross basis. The SEC also proposes that, if the notional amount of security-based swaps exceeds $150 million, the Security-Based Swap Position would include the value of all of the underlying equity securities owned by the holder of the Security-Based Swap Position, as well as the delta-adjusted notional amount of any options, security futures, or any other derivative instruments based on the same class of equity securities7. This is particularly significant for dealers that offer equity derivatives products, as they typically hedge their positions in these products by holding underlying equity securities. Not only are the reporting thresholds for these security-based swaps effectively much lower than $300 million, but a sudden rise in the value of the securities could put the Security-Based Swap Position over the threshold unexpectedly.
The percentage threshold would be reached if the number of shares attributable to the security-based swap, or the Security-Based Swap Equivalent Position, exceeds 5% of the same class of equity security. Similarly to the notional amount threshold, the SEC proposes that if the Security-Based Swap Equivalent Position exceeds 2.5% of the same class of equity security, it would also include all of the underlying equity securities owned by the holder of the Security-Based Swap Position, as well as the number of shares attributable to any options, security futures, or any other derivative instruments based on the same class of equity securities8.
A number of interpretational issues are in need of additional SEC guidance. For example, for an institution that has a multitude of businesses, would positions in underlying securities in respect of a Security-Based Swap be distinguished from securities positions held for other purposes or by other businesses, with the latter excluded from the ambit of the position reporting rule? If so, how would that distinction be drawn? In addition, for an equity security-based swap based on a narrow-based security index, how would one calculate the value of the underlying securities, or apply either notional amount or percentage threshold?
When to Report
Under the proposed Rule 10B-1, a Schedule 10B is required to be filed with the SEC no later than the end of the first business day following the day of execution of the security-based swap transaction that results in the Security-Based Swap Position first exceeding the Reporting Threshold Amount.9 Compliance with this timing requirement is only practical if internal controls are in place to constantly monitor the security-based swap and underlying securities positions, and information required to be reported is readily available for filing.
Proposed Rule 10B-1(c) would require filing of an amendment of Schedule 10B to reflect any material changes, including any material (i.e. 10% or more) increase or decrease in the Security-Based Swap Position or if a Security-Based Swap Position falls back below the Reporting Threshold Amount.10 Thus a further consequence of including the value of securities underlying a security-based swap in the Security-Based Swap Position calculation, as discussed in "Reporting Threshold Amount – Equity Security-Based Swaps", is that the volatility of the value of those securities could potentially trigger the reporting person's obligations to file an amendment to a previous report, even if the notional amount of the security-based swaps held by that person has not changed.
What to Report
The proposed Schedule B requires the reporting of the following items:
Items (1) through (4) – information about the reporting person, such as identity, jurisdiction and type of entity.
Item (5) – information about the Security-Based Swap Position, such as notional amount, tenor, direction, unique product ID.
Item (6) – if a Security-Based Swap Position is based on debt securities (including CDS): ownership of the loans or securities underlying that position, such as the Financial Instrument Global Identifier, and the Legal Entity Identifier of the issuer, and all security-based swaps based on equity securities issued by the same reference entity.
Item (7) – if a Security-Based Swap Position is based on equity securities: ownership of all equity securities underlying that position, and other security-based swaps based on debt securities issued by the same reference entity.
Item (8) – ownership of any other instrument relating to the Security-Based Swap Position and/or any underlying security or loan or group or index of securities or loans , or any security or group of index of securities, the price, yield, value, or volatility of which, or of which any interest therein, is the basis for a material term of a security-based swap in the Security-Based Swap Position.
Item (9) – to the extent that the Reporting Threshold Amount is based on the number of shares corresponding to a Security-Based Swap Position based on equity securities, the number of shares attributable to the Security-Based Swap Position, and closing price used in the calculation and the date of such closing price.11
Under Items (6) and (7), a reporting party that is required to file a Schedule 10B with respect to a Security-Based Swap Position must also report on the same schedule positions in other security-based swaps that are related to the applicable Security-Based Swap Position, even if such other positions are not otherwise required to be reported (because, for example, they do not exceed the Reporting Threshold Amount).
Item (8) could potentially be interpreted extremely broadly, particularly because it is not limited to instruments subject to the regulatory jurisdiction of the SEC. The industry will likely need to seek substantially more clarity on what this item is intended to address, before assessing how to comply.
Cross Border Issues
- The SEC proposes a two-part approach to the large position reporting involving a cross border security-based swap:
- First, a security-based swap is subject to the proposed Rule 10B-1 if it is required to be reported under Rule 908 of Regulation SBSR.12 Rule 908 requires a security-based swap to be reported if (1) at least one counterparty is a U.S. person, a registered security-based swap dealer or registered major security-based swap participant, or (2) the security-based swap is accepted for clearing by a U.S. clearing agency.13
- Second, a security-based swap is subject to the proposed Rule 10B-1 if the holder of the security-based swap owns any reference securities underlying the security-based swap (or would be deemed to have beneficial ownership of such securities under Section 13(d) of the Exchange Act), and the securities are either (1) issued by an entity formed under the laws of the U.S. or having its principal place of business in the U.S.), or (2) registered under Section 12 or 15(d) of the Exchange Act.14
Conclusion
- The proposed Rule 10B-1 introduces the first large position reporting regime for security-based swaps, and would have far-reaching impact on the business practices and compliance infrastructure of security-based swap parties – whether regulated or not, and whether U.S. Persons or not. Not surprisingly, some interpretation issues still need to be resolved before market participants can determine comprehensive approaches to compliance.
- As proposed, several aspects of the rule would likely impose significant compliance burden on security-based swap parties to collect, organize and evaluate information in ways that may be new to them. For example, parties would be required to calculate Security-Based Swap Positions on a gross basis and in some cases to include positions in the underlying securities or loans. The proposed reporting requirements would cover not only positions of securities or loans underlying reportable Security-Based Swap Positions, but also security-based swap and other positions related to reportable Security-Based Swap Positions and their underlying securities. Market participants should closely examine the proposed rule, and consider seeking guidance and clarification from the SEC regarding any requirements that are subject to overly broad interpretations or too onerous to be practical.
Authors: Julia Lu, Partner, Inna Zaychik, Counsel
2. To become 17 CFR 240.9j-1.
3. To become 17 CFR 240.10B-1.
4. Gensler, Prepared Remarks before the American Bar Association Derivatives and Futures Law Committee Virtual Mid-Year Program (Jul. 21, 2021).
5. Release, n. 36 and accompanying text.
6. See Release, note 133 and accompanying text.
7. Proposed Rule 10B-1(b)(1)(iii)(A).
8. Proposed Rule 10B-1(b)(1)(iii)(B).
9. Proposed Rule 10B-1(a)(2).
10. Release Section III.A.3.
11. Proposed Rule 10B-101.
12. Proposed Rule 10B-1(d).
13. 17 CFR 242.908(a).
14. Proposed Rule 10B-1(d).
