Only one thing is certain about new Rule 9j-1, proposed by the Securities and Exchange Commission (the “SEC”) on November 3, 2010 – in its current form, it has the potential to create regulatory uncertainty in the derivatives markets for years to come.
Proposed Rule 9j-1 under the Securities Exchange Act of 1934 (the “Exchange Act”) prohibits fraud, manipulation and deception in connection with “security-based swaps”1 and applies the existing antifraud and anti-manipulation prohibitions under the federal securities laws to security-based swaps as securities. The SEC is seeking comment on the proposed Rule, and comments are due by December 23, 2010.
Mirroring the familiar framework for standard securities, proposed Rule 9j-1 applies to offers, purchases and sales of security-based swaps. The terms “purchase” and “sale” are defined in Dodd-Frank more broadly in the context of security-based swaps to include events such as execution, early termination, assignment, exchange, transfer, or extinguishment of rights and obligations under the swap.
More importantly, proposed Rule 9j-1 significantly expands prohibitions against fraudulent, manipulative and deceptive conduct to encompass the ongoing “exercise of any right and performance of any obligation” under a security-based swap. It governs counterparty conduct pursuant to the swap contract throughout the entire term of a security-based swap. The key issue is how to apply a regulatory framework structured for the offer, purchase or sale of a security such as a bond, which is a discrete event, to the more complex synthetic derivatives market – where counterparties continuously interact in direct and indirect ways throughout the life of the swap.
This memorandum summarizes key provisions of the proposed rule and its potential effect on the security-based swap markets, highlighting the unintended consequences and uncertainty the new rule, if adopted as proposed, will create in those markets. For example, it is common for a market participant to hedge its risk exposure to an entity (or a particular instrument) by entering into a credit default that references that entity (or the relevant instrument). During the life of the swap, that party may – in the ordinary course of its business – come into possession of material non-public information relating to the reference entity or reference instrument under the swap. Similarly, such parties may be entitled to exercise certain voting rights or make other decisions with respect to the reference entity or reference instrument, the outcome of which may affect the rights and obligations of the parties under the swap. Proposed Rule 9j-1 raises significant and novel issues in relation to how these parties may act with respect to such information or an exercise of an entitlement in connection with their swap.
It is possible that after receiving comments from the public and the derivatives markets the SEC will clarify or limit the scope of proposed Rule 9j-1. Absent such clarification the courts may ultimately be called upon to resolve many of these issues. Accordingly, while the rule is still out for comment, market participants should consider urging the SEC to clarify, if not narrow, the rule’s scope and application, which will permit more informed regulation and organization of business conduct and compliance relating to swaps.
PROPOSED RULE 9J-1
In the proposing release that accompanies and explains proposed Rule 9j-1, the SEC articulates its view that a key characteristic of most security-based swaps is the obligation to make, and the right to receive, ongoing payments or deliveries throughout the life of the swap. The SEC posits that a swap counterparty’s exercise of rights and performance of obligations under a security-based swap present opportunities and incentives for fraudulent, deceptive, or manipulative conduct, including illicit actions to increase or decrease the price or value of the underlying reference instrument. Proposed Rule 9j-1 is intended to address these potential problems. Under the SEC’s framework, the proposed rule necessarily affects the rights and obligations of the parties long after a purchase or sale transaction has been effected.
Proposed Rule 9j-1 specifies that it is unlawful for any person to engage in fraudulent, manipulative or deceptive conduct “directly or indirectly, in connection with the offer, purchase or sale of any security-based swap, the exercise of any right or performance of any obligation under a security-based swap, or the avoidance of such exercise or performance.” Specifically,
- Paragraph (a) of the proposed rule prohibits any person from “employ[ing] any device, scheme, or artifice to defraud or manipulate.” The SEC’s proposing release states that scienter (i.e., intent or recklessness) is required for a violation of this provision.
- Paragraph (b) of the proposed rule prohibits any person from “knowingly or recklessly mak[ing] any untrue statement of a material fact, or … knowingly or recklessly omit[ing] 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.” The SEC indicates in the proposing release that this is intended to make clear that scienter is required for a violation of this provision.
- Paragraph (c) of the proposed rule prohibits any person from “obtain[ing] 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.” The SEC’s proposing release specifies that scienter is not a necessary element for a violation of proposed Rule 9j-1(c).
- Paragraph (d) of the proposed rule prohibits any person from “engag[ing] in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.” The SEC’s proposing release specifies that scienter is not a necessary element for a violation of proposed Rule 9j-1(d).
STATUTORY AUTHORITY UNDER DODD-FRANK
The SEC’s rulemaking follows on Congress’s determination earlier this year to subject security-based swaps to SEC regulation. Title VII of Dodd-Frank2 confers SEC jurisdiction over security-based swaps and participants in the security-based swap markets. It amends the Securities Act of 1933 (the “Securities Act”) and the Exchange Act to make security-based swaps “securities” within the meaning of those statutes. Previously, security-based swaps were excluded from the definition of a security, but the SEC had antifraud and anti-manipulation jurisdiction over such instruments.
By including security-based swaps in the definition of a security, Dodd-Frank subjects security-based swaps to all of the existing antifraud and anti-manipulation provisions of the Securities Act and the Exchange Act, and the rules and regulations promulgated thereunder, including Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 17(a) of the Securities Act.
In addition, Dodd-Frank adds a new subparagraph (j) to Section 9 of the Exchange Act aimed specifically at security-based swaps. The new provision broadly prohibits fraudulent, manipulative, and deceptive practices in connection with security-based swap transactions. It also authorizes the SEC to adopt rules and regulations to define more precisely what constitutes such practices and to prescribe means “reasonably designed” to prevent such practices.
Specifically, new Section 9(j) of the Exchange Act makes it unlawful for
“any person, directly or indirectly, by … means of … interstate commerce… to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security-based swap, in connection with which such person engages in any fraudulent, deceptive, or manipulative act or practice, makes any fictitious quotation, or engages in any transaction, practice, or course of business which operates as a fraud or deceit upon any person.” (Emphasis supplied)
This provision of Dodd-Frank also directs the SEC to “define, and prescribe means reasonably designed to prevent, such transactions, acts, practices, and courses of business as are fraudulent, deceptive, or manipulative, and such quotations as are fictitious.”
The italicized phrase, however, when contrasted with proposed Rule 9j-1, raises the question whether Section 9(j) provides adequate authority for the SEC to regulate conduct that does not clearly fall within the statutory definition of an offer, purchase or sale of a securitybased swap, but, rather, relates to the performance of contractual obligations and the assertion of entitlements created by the swap. Case law dealing with SEC rules adopted under other statutory provisions has established that an SEC rule cannot be broader in scope than the provision of the statute authorizing the SEC to issue the rule.
Since the proposed rule would apply to conduct not linked to effecting, or inducing or attempting to induce the purchase or sale of a security-based swap, one may argue that the SEC may have exceeded its authority under Section 9(j) in promulgating Rule 9j-1 as proposed. The SEC, on the other hand, believes that liability for misconduct to trigger, avoid, or affect the value of ongoing payments or deliveries is an appropriate means to prevent fraud, manipulation, and deception in connection with security-based swaps and that the statute’s direction that the SEC promulgate rules to prevent fraud and other misconduct is sufficient to support proposed Rule 9j-1 in its present form. While it is likely that the SEC’s rulemaking authority will eventually be tested in the courts if proposed Rule 9j-1 is adopted as currently written, market participants must now proceed with caution.
PRACTICAL IMPACT OF PROPOSED RULE 9J-1
If proposed Rule 9j-1 is adopted in its current form, then a host of practical interpretive issues arise, many of which focus on the “exercise [or avoidance] of any right or performance of any obligation” in the context of a security-based swap. The issues described below hint at the difficulty of applying the broad temporal reach of proposed Rule 9j-1 to security-based swaps. Ultimately, these issues illustrate that analogies between fraud, manipulation or deception in the securities market and such misconduct in the security-based swap markets, while tempting, are not easily drawn for at least two reasons: (i) the structures of security-based swaps are much more complex, and (ii) the touch-points between counterparties’ rights and obligations in a transaction and in the broader market (including the reference instrument or entity) are more nuanced, bespoke and unpredictable.
Material Non-Public Information
What constitutes “material non-public information” in the context of the “exercise of any right or performance of any obligation under a security-based swap” or the avoidance thereof? Does materiality relate to the exercise or performance of rights or obligations, or is it enough if the information is material to the underlying reference instrument or entity? Materiality assessments are already difficult under the existing securities purchase-and-sale regime. Applying a materiality standard to the exercise of rights or performance of obligations under a security-based swap will be even more challenging.
The interpretation of “materiality” in this new context is elusive partially because proposed Rule 9j-1 does not specify which, and whose, rights and obligations “materiality” relates to. At its broadest, proposed Rule 9j-1 could be interpreted to cover any right or obligation under a security-based swap, however insubstantial, whether or not in the nature of payment or delivery, whether belonging to the party who possesses the material non-public information, the counterparty, or, indeed, a third party such as a credit support provider. But such a broad interpretation would exclude nothing and could potentially erode the materiality standard.
A related ambiguity arises when deciding what to do once in possession of “material non-public information.” The proposed rule is in part modeled on Section 10(b) of and Rule 10b-5 under the Exchange Act, which require a holder of material non-public information to disclose or abstain from trading. How does the “disclose-orabstain” duty apply in the context of an ongoing and continuously appearing stream of rights and obligations? What if a counterparty in possession of the material non-public information simply complies with the contractual provisions of the security-based swap without using the information to change the flow of payments and obligations already established by the security-based swap agreement? Arguably, a counterparty does not “use” material nonpublic information if mere possession of the information does not cause an act or decision that differs from an act or decision that would have occurred without the information. On the other hand, can a counterparty in possession of material non-public information sit in silence while the other party acts without the benefit of such information? These questions will not be resolved readily or quickly. Until they are resolved, security-based swap counterparties will likely err on the side of caution and over-disclosure, which will potentially increase cost, diminish volume and slow the completion of security-based swap transactions.
Linkage to Reference Instrument or Entity
Linking a security-based swap and the underlying reference instrument or entity creates other regulatory uncertainties. The proposed rule covers misconduct that affects (i) the market value of a security-based swap for purposes of posting collateral or making payments or deliveries under the security-based swap and (ii) the reference instrument or entity underlying a securitybased swap to the extent the misconduct is “in connection” with the exercise of a right or the performance of an obligation, or the avoidance of such exercise or performance, under a security-based swap.
How direct the link must be between the effect on the reference underlying and rights and obligations of the security-based swap would be defined by the courts and by the SEC. It seems possible, however, that conduct affecting the value of a security – which would not otherwise be a violation of the securities laws for want of a “purchase or sale” of a security – may nonetheless constitute a violation of Rule 9j-1 as proposed if that security is the underlying reference instrument of a security-based swap and the effect on its value affects the rights and obligations of the parties under the swap.
Manipulation in the Context of Security-Based Swaps
In addition, it will be a challenge to identify “manipulation,” which is a broad and fact-dependent concept, in connection with security-based swaps. Current case law interpretation on “manipulation” in the context of securities may be hard to apply to the exercise of rights or performance obligations of securitybased swaps. The specter of “manipulation” liability may deter common activities in the security-based swap markets and subject them to (perhaps unwarranted) second-guessing with hindsight.
EXAMPLES OF MARKET IMPACT
The questions relating to the interpretation and application of the proposed rule present significant practical difficulties to security-based swaps market participants. The examples below illustrate some of the more obvious impacts the proposed rule may have:
- Holders of debt or equity of an issuer often enter into security-based swaps to hedge their risk. In some cases, a holder may have a large enough stake in the related issuer to be in direct dialogue with that issuer and its management, or otherwise receive material non-public information which they are under a duty not to disclose, even to the counterparties of swap or other transactions. If the new rule is interpreted to require disclosure of the information, receipt of this type of information would result in an almost automatic violation of either the antifraud provisions of the federal securities laws or the contractual undertaking.3 If that were the case, there could only be one rational result: stakeholders would avoid hedging their financial risks with security-based swaps for fear that they would find themselves in possession of information deemed material under the proposed rule. It would be helpful if the SEC would address this issue in its adopting release.
- If proposed Rule 9j-1 gives rise to a duty to disclose or abstain when a party to a security-based swap comes into possession of material non-public information, the party in possession of the information may be required to forfeit its rights or other economic entitlements under the securitybased swap by “abstaining” from exercising its rights if it is contractually prohibited from disclosing the information. For example, if a protection buyer under a bespoke credit default swap has a contractual right to physically settle the swap by delivering an instrument that it selects from several deliverable instruments, and it comes into possession of material information (under confidentiality restrictions) relating to the potential future value of the instruments, is it able to exercise the right, without disclosing the information, to select (the cheapest) instrument to deliver to the protection seller in exchange for the protection payment at par? To answer no would seem to deprive the knowing party of a contractual right that it has bargained for at arms-length with sophisticated counterparties.
- A related question arises with respect to the meaning of abstention in the situation where the counterparty who does not have the information is entitled to exercise a right under a swap. Does the knowing party have an affirmative duty to disclose the information, or can it let the counterparty exercise its right without knowing the information, even though the knowing party is aware that the right would have been exercised differently had the counterparty known the information? Suppose, for example, that the party who knows the information in the paragraph above is the protection seller. Does it have to tell the protection buyer the information indicative of future value of the various deliverable instruments? To answer yes would seem to require the protection seller to assist its counterparty in selecting the cheapest instrument for physical settlement.
- Parties to a security-based swap who have the ability to influence or vote on corporate events involving the reference underlying have traditionally been allowed to exert such influence in whatever way they deem fit, including with a bias toward a favorable outcome on the security-based swap, e.g., to ensure or eliminate a successor reference entity, credit event or deliverable obligation. If proposed Rule 9j-1 is interpreted to prohibit this type of activity as manipulation, it may have a chilling effect on stakeholders’ exercise of voting rights, or, again, on their ability or willingness to hedge risk with security-based swaps. While critics of this type of hedging, sometimes called “decoupling,” may celebrate this result, this approach might hinder risk reduction in the financial system.
- When a party calls large amounts of collateral from its counterparty or otherwise exercise its contractual (including termination) rights under a security-based swap in a distressed market, that call or exercise can produce a downward spiral and worsen the financial condition of its counterparty, which may in turn lead to other systematic ramifications. Would proposed Rule 9j-1 prohibit that behavior as manipulation? As participants in the security-based swap markets vividly remember, a financial crisis results in a market in shock. Actions in those circumstances may be taken in good faith applying reasonable judgment but on the basis of imperfect information, and may not withstand regulatory challenge with the benefit of perfect hindsight. The risk of being accused of manipulative conduct may diminish the effectiveness of the credit support arrangements and other contractual provisions that serve as the foundation for the derivatives markets and for which the markets have a particular need in a time of distress and rising risks.4
Seeking informed public comments to proposed Rule 9j-1 is a first step taken by the SEC to promulgate rules to exercise its expanded antifraud and anti-manipulation jurisdiction over security-based swaps. While the parallel to antifraud and anti-manipulation concerns in connection with standard securities is evident, the application of similar provisions in the context of security-based swaps will be much more complex and likely uncertain for many years. If the rule is adopted as proposed, a host of unintended consequences to the security-based swap markets will result – legitimate and prudent risk-hedging with security-based swaps may be undermined by the current draft of the proposed rule because parties may find new legal dilemmas and potentials for liability; certain actions that are the bedrock of the security-based swap markets may also be subject to challenge under the proposed rule. Market participants should consider urging the SEC to clarify, if not narrow, the scope of the proposed rule to provide needed certainty and reduce the possibilities of unintended consequences to the derivatives markets.