Client Alerts

SEC Adopts Final Rules Intended to Prevent Fraud and Undue Influence in connection with Security-Based Swaps

Client Alerts | July 13, 2023 | Derivatives | Securities and Corporate Finance

On June 7, 2023, the Securities and Exchange Commission (the “SEC”) adopted two new rules (the “Rules”) targeting (i) fraud, manipulation and deception in security-based swap transactions, including a new prohibition on manipulation or attempted manipulation of the value of security-based swaps or payments or deliveries thereunder, and (ii) the potential for undue influence over the Chief Compliance Officer (the “CCO”) of security-based swap dealers and major security-based swap participants1 (together, “SBS Entities”). The adoption of the Rules follow the December 15, 2021 SEC proposing release regarding large security-based swap position reporting (“Proposed Rule 10B-1”), which would essentially make large position information publicly available and potentially facilitate the gathering of information relevant to combat fraud.2

Security-based swaps are essentially instruments pursuant to which parties gain exposure to a single security, loan or narrow-based security index without actual ownership, and may receive payments based on credit or other events.

The SEC’s rulemaking sets forth a new framework for enforcement against market manipulation and fraud, but the broad scope of the adopted rules may create ambiguity and consequently present challenges to ensure compliance.

The Rules will become effective August 29, 2023.

Fraud, Manipulation and Deception (Rule 9j-1)

New Rule 9j-1 enumerates certain categories of misconduct, which are similar to those prohibited by Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Section 17 of the Securities Act of 1933, as amended (the “Securities Act”), in connection with transactions or purchases or sales of any security-based swap. It also includes prohibitions on manipulating or attempting to manipulate the price or valuation of any security-based swap, general antifraud provisions regarding the securities referenced by the swap and two affirmative defenses.

Rule 9j-1(a) prohibits the following actions, whether taken directly or indirectly, in connection with any transaction or attempt to effect any transaction in any security-based swap:

  1. Employing or attempting to employ any device, scheme, or artifice to defraud or manipulate;
  2. Making or attempting to make any untrue statement of material fact or omission of a material fact necessary to make the statements made, in light of the circumstances, not misleading;
  3. Obtaining money or property by means of any untrue statement of material fact or omission as described in (2);
  4. Engaging in any fraud or deceit;
  5. Attempting to obtain money or property by means of any untrue statement of material fact or omission as described in (2);
  6. Manipulating or attempting to manipulate the price or valuation of any security-based swap or any payment or delivery related to any such swap.

Negligence and Knowledge.

It is notable that Rule 9j-1 only requires a finding of negligence with respect to liability under subsections (a)(3) and (4). Liability under subsections (a)(1), (2), (5) and (6) of Rule 9j-1, as further described below, will require actual scienter, including reckless as well as intentional misconduct. These standards are consistent with the requirements for negligence or knowledge under Section 10(b) and Rule 10b-5 of the Exchange Act and Section 17 of the Securities Act.

Attempt Liability.

Rule 9j-1(a)(5) expressly covers conduct where a party attempts to obtain property or money, even if not successful. Similarly, Rule 9j-1(a)(2) creates liability for attempted misstatement and omissions, the meaning of which is unclear. The scienter requirement may provide some comfort for market participants concerned about inadvertently tripping an unsuccessful “attempt”, and the body of law under the corresponding Exchange Act and Securities Act provisions may provide some guidance, but ultimately the market will have to wait and see to learn the contours of liability for attempts in the context of security-based swaps.

Manufactured Credit Events.

Rule 9j-1(a)(6) is targeted at manipulations such as engineered credit events, which can be created when, for example, a swap participant enters into an arrangement with the reference entity of the swap in order to trigger a credit event, such as a temporary failure to pay outstanding debt, which triggers payments under the swap while having minimal impact on the actual creditworthiness of the reference entity, or when a swap participant “orphans” a swap by arranging for the reference entity to undergo a restructuring that moves its debt to a subsidiary or affiliate not referenced in the text of the swap.

ISDA adopted its Narrowly Tailored Credit Events supplement in 2019 to prevent the types of manipulation contemplated by the SEC. While it is clear that Rule 91-j(a)(6) intends to cover the same ground that ISDA attempted to cover through its 2019 supplement, it is unclear from the broadly-written text of the rule just how far the SEC intends to go.

Although the adopting release states that (a)(6) will apply only to actions taken outside of the ordinary course of a typical borrower-lender relationship (with respect to credit default swaps), it also makes clear that the analysis of a potential violation under (a)(6) will be heavily dependent on specific facts and circumstances, and the text of the rule itself provides no clear guardrails. This will certainly give the SEC the flexibility it wants to enforce against many forms of manipulation in the swaps market, but may worry participants who desire to engage with distressed borrowers or other reference entities, and must now wait for clarity to emerge as the SEC brings enforcement actions and begins to build a doctrine on top of the new rule.

Material Non-Public Information.

Rule 9j-1(b) expands liability under the Exchange Act and Securities Act in connection with any communication, purchase or sale of a security while in possession of material non-public information (“MNPI”) to include security-based swaps alongside securities.

The SEC has, however, also provided two new affirmative defenses to liability under the new 9j-1. A person is not liable for an action taken under (a)(1) – (5) if the liability is based solely on awareness of MNPI if:

  • 9j-1(e)(1) – the action in question was taken pursuant to such person’s contractual rights and obligations in the swap documentation, provided that the transaction occurred before the relevant person became aware of the MNPI and was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 9j-1.
  • 9j-1(e)(2) – if the person is an entity and can demonstrate that the individual who made the investment decision was not aware of the MNPI and there were reasonable policies/procedures in place to prevent violations of (a)(1) – (5).

While these affirmative defenses provide some limited protection with respect to (a)(1) – (5), at least in the realm of MNPI, (a)(6) does not come with any such affirmative defense. As single-loan and single-equity delta-one total return swaps are often used to obtain exposure and to hedge, investors should be particularly cautious when partially or fully unwinding or upsizing if in possession of more information than their counterparties.

Rule 15fh-4(c)

The new Rule 15fh-4(c), as adopted, prohibits any officer, director, supervised person, or employee of an SBS Entity or anyone acting at such a person’s direction from, directly or indirectly, coercing, manipulating, misleading or fraudulently influencing the SBS Entity’s CCO in the performance of the CCO’s duties.

In its adopting release, the SEC acknowledged the broad scope of this rule, stating that it is intended to protect the CCO’s independence and objectivity, and calling out specifically attempts by officers, directors or employees to hide transactions or submit false valuations to the CCO as concerns. While the broad language should certainly give the SEC latitude to bring enforcement against behavior that threatens to interfere with the CCO’s performance of their role, it will also heighten scrutiny of and potential concerns about interactions with the CCO, putting pressure on SBS Entities to ensure all such communications are managed appropriately.

Next Steps

We note that the Rules, in conjunction with Proposed Rule 10B-1 regarding large security-based swap reporting (if adopted), may provide increased information for purposes of detection and investigation of potential fraud, manipulation or deception.

Given the potential breadth and scope of the Rules, investors in security-based swaps should carefully consider the impact of these new rules on their business operations and investment strategies and compliance programs and practices, and consult with counsel experienced in the security-based swaps market to ensure compliance, and no inadvertent missteps, going forward.

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If you have any questions regarding the final rules adopted by the SEC on security-based swaps, please reach out to your primary Kleinberg Kaplan contact or a member of the team listed below.

1 “Security-based swap dealer” and “major security based swap participant” are defined in Title VII, subtitle B of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

2 Proposed Rule 10B-1 is open for comment until August 21, 2023.