SEC Proposes Rules for Security-Based Swaps Prohibiting Fraud and Manipulation

The US Securities and Exchange Commission proposed new rules on December 15, 2021, with respect to security-based swaps that, if adopted as proposed, would prohibit fraud and manipulation, require reporting of large security-based swap positions, and protect the chief compliance officer of security-based swap dealers and major security-based swap participants.

FRAUD AND MANIPULATION

Proposed Rule 9j-1(a) under the Securities Exchange Act of 1934 (Exchange Act), as amended, would make it unlawful for a person to purchase or sell, or attempt to induce the purchase or sale of, any security-based swap; effect any transaction in, or attempt to effect any transaction in, any security-based swap; take any action to exercise any right, or any action related to performance of any obligation, under any security-based swap; or terminate or settle any security-based swap if in connection with the act the person does at least one of the following:

• Employs or attempts to employ any device, scheme, or artifice to defraud or manipulate.
• 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.
• 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.
• 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.

Proposed Rule 9j-1(b) further makes it unlawful for any person to manipulate or attempt to manipulate the price or valuation of any security-based swap, or any payment or delivery related to the security-based swap. These prohibitions capture direct and indirect activity and are modeled on Section 10(b) of the Exchange Act, Rule 10b-5 under the Exchange Act, and Section 17(a)(1) under the Securities Act of 1933, as amended (Securities Act).

Proposed Rule 9j-1 also seeks to impose liability for trading while in possession of material nonpublic information on counterparties to security-based swaps. Whenever 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, proposed Rule 9j-1 would deem such conduct in connection with a 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 to also violate, and result in comparable liability to any purchaser or seller of that security under, such provision. Furthermore, whenever taking any of the actions involving a security-based swap described in proposed Rule 9j-1(a) or (b) would violate, or result in liability, proposed Rule 9j-1 would deem such conduct, when taken by a party to such security-based swap (or any affiliate) in connection with a purchase or sale of a security or group or index of securities on which such security-based swap is based, to also violate Section 9(j) of the Exchange Act and proposed Rule 9j-1. These additional provisions of proposed Rule 9j-1 seek to address problems with manufactured credit events and other opportunistic strategies that were used in the credit default swap market, but the proposed rule’s provisions are not limited to the credit default swap market and have general applicability.

If adopted, the provisions of Rule 9j-1 will require counterparties to security-based swaps to interact with each other with greater caution. Dealers will need to carefully review all product pitch books and monitor conversations between their sales teams and counterparties in order to be able to raise defenses to any possible claims based upon an alleged violation of these new rules. Private funds, family offices, and other traders will have to be careful not to engage in practices that might be considered to be abusive.

REPORTING LARGE POSITIONS IN SWAPS

Proposed Rule 10B-1 under the Exchange Act, if adopted, will require any person or group having a security-based swap position that exceeds a threshold amount to publicly report such position on proposed Schedule 10B promptly, and no later than the end of the first business day following the day of execution of the security-based swap that results in the person or group exceeding the threshold. It is important to note that the deadline for such a filing is shorter than the deadline to file a Form 4 report under Section 16 of the Exchange Act.

The threshold amount related to such reporting is a variable amount based upon the type of transaction subject to the security-based swap and is calculated as follows:

• With respect to credit default swaps, the lesser of the following:

• A long notional amount of $150 million, calculated by subtracting the notional amount of any long positions in a deliverable debt security underlying a security-based swap included in the security-based swap position from the long notional amount of the security-based swap position.
• A short notional amount of $150 million.
• A gross notional amount of $300 million.

• With respect to security-based swap positions based on debt securities that are not credit default swaps, a gross notional amount of $300 million.
• With respect to security-based swap positions based on equity securities, the lesser of the following:

• A gross notional amount of $300 million; provided, however, that if the gross notional amount of the security-based swap position exceeds $150 million, the calculation of the security-based swap position must also include the value of all of the underlying equity securities owned by the holder of the security-based swap position (based on the most recent closing price of shares), 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 securities.
• A security-based swap equivalent position that represents more than 5% of a class of equity securities; provided, however, that if the security-based swap equivalent position represents more than 2.5% of a class of equity securities, the calculation of the security-based swap equivalent position must also include in the numerator 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 securities.

For purposes of this rule, the term “delta” means the ratio that that is obtained by comparing (x) the change in the value of a derivative instrument to (y) the change in the value of the reference equity security. The delta should be calculated daily if it is not fixed for a particular security-based swap.

Schedule 10B is a form that requires disclosure of the following:

• The reporting person’s identity, jurisdiction of organization, and legal entity identifier (LEI).
• The notional amount of the applicable security-based swap position(s), summary information about the composition of the position as it relates to the direction (i.e., long or short) and the tenor/expiration of the underlying security-based swap transactions and the product ID of the security-based swap(s) included in the position.
• In the case of a security-based swap position based on debt securities (including credit default swaps), the ownership of: (1) all debt securities underlying a security-based swap included in the security-based swap position, including the Financial Instrument Global Identifier (FIGI) of each underlying debt security, if applicable, and the LEI of the issuer of each underlying debt security, if the issuer has an LEI; and (2) all security-based swaps based on equity securities issued by the same reference entity, including the FIGI of each underlying equity security, if applicable.
• In the case of a security-based swap position based on equity securities, the ownership of: (1) all equity securities underlying a security-based swap included in the security-based swap position, including the FIGI of each underlying equity security, if applicable, and the LEI of the issuer of each underlying equity security, if the issuer has an LEI; and (2) all security-based swaps based on debt securities issued by the same reference entity (including credit default swaps), including the FIGI of each underlying debt security, if applicable.
• The 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 or 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 included in the security-based swap position.
• 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, along with the closing price used in the calculation and the date of such closing price.

Some of the disclosures required by Schedule 10B may include information that may have otherwise been reportable in Schedule 13D or Schedule 13G, but Schedule 10B is required to be filed sooner than such other schedules. The SEC’s expectation is that the proposed reporting rule will only cover those entities that have the ability and resources to comply with the rule.

PROTECTING THE CCO

A security-based swap dealer and major security-based swap participant is required to have a chief compliance officer (CCO) who is charged with ensuring that the entity complies with federal laws applicable to security-based swaps. The SEC has proposed Rule 15Fh-4(c) under the Exchange Act in order to protect the independence and objectivity of the CCO by preventing the personnel of the entity from taking actions to coerce, mislead, or otherwise interfere with the CCO. If adopted, Rule 15Fh-4(c) would make it unlawful for any officer, director, supervised person, or employee of a security-based swap dealer or major security-based swap participant, or any person acting under such entity’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the CCO in the performance of his or her duties under the federal securities laws, rules, and regulations.

IMPACT OF PROPOSED RULES

The proposed rules significantly alter the regulation of security-based swaps and will require market participants to analyze and adjust their actions when entering into such products.

CONTACTS

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Katherine Dobson Buckley

Chicago
Michael M. Philipp

New York
Thomas V. D’Ambrosio

Philadelphia
G. Jeffrey Boujoukos
Justin W. Chairman

Washington, DC
Ivan P. Harris
Amy Natterson Kroll
Steven W. Stone