On December 15, the Securities and Exchange Commission (SEC) proposed a series of potentially far-reaching changes to the regulation of the security-based swap (SBS) markets. Among other changes, the proposed rules would impose, for the first time, public reporting requirements for large positions of SBSs above a defined threshold (which in some cases may be lower than existing reporting thresholds in the cash market). The proposal would also adopt new antifraud and antimanipulation rules that could, if applied broadly, affect the risks and benefits of using SBSs, particularly in the credit default swap (CDS) market.
According to SEC Chair Gary Gensler, the proposed rules "would improve the transparency and integrity of the security-based swaps market."1 The proposals were approved by a 3-2 vote, with Commissioners Hester M. Peirce and Elad L. Roisman dissenting. Certain aspects of the proposals are expected to be controversial among market participants as well.
The new rules are the latest proposal by the SEC concerning SBS markets. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), Congress granted the SEC broad regulatory authority over SBSs. The principal set of SEC regulations for SBSs, including required registration for SBS dealers and related reporting and business conduct requirements, came into effect for the first time in late 2021.
The proposed rules address three particular areas: (1) new large trader reporting for SBSs, under Section 10B of the Securities Exchange Act of 1934 (Exchange Act), (2) stronger antifraud and antimanipulation rules relating to SBSs and related securities transactions, under Section 9(j) of the Exchange Act, and (3) certain additional protections from undue influence for chief compliance officers (CCOs) of SBS dealers, under Section 15F(h) of the Exchange Act.
Based on the SEC's statements, the proposals are, in part, intended to address certain concerning developments in SBS markets, including (1) allegations concerning so-called "manufactured" credit events and other misconduct in the CDS market2, (2) certain longstanding concerns about disclosure around large positions obtained through equity swaps, and (3) more recently, large losses that were incurred by some financial institutions arising from concentrated equity swap positions with a single counterparty. The new rules are designed to extend existing requirements, particularly around fraud and manipulation, to take into account the unique features of SBSs and would explicitly reach misconduct in connection with the ongoing payments and deliveries that may occur throughout the life of an SBS.3
Public Disclosure Requirements: Proposed New Schedule 10B
The Commission has proposed new Rule 10B-1, which would require larger trader reporting for SBSs. Proposed Rule 10B-1 would require public reporting of, among other things: certain large SBS positions, positions in any security or loan underlying such an SBS position and positions in any other instrument relating to the underlying security or loan or group or index of securities or loans. Rule 10B-1 would include specific quantitative thresholds above which public reporting is required, based on the type of SBS involved.
Proposed Rule 10B-1(a)(1) would require a report where any person (and any entity controlling, controlled by or under common control with such person), or group of persons, who, through any contract, arrangement or relationship, after acquiring or selling, directly or indirectly, any SBS, is directly or indirectly the owner or seller of an SBS position that exceeds the reporting threshold. The reporting thresholds, which would depend on whether the SBS is based on equity or debt, with a further delineation for CDS, would be as follows:
- For Credit Default Swaps: The threshold is the lesser of:
- A long (i.e., purchase of credit protection) notional amount of $150 million, calculated by subtracting the notional amount of any long positions in a deliverable debt security underlying an SBS included in the SBS position from the long notional amount of the SBS position;
- A short (i.e., sale of credit protection) notional amount of $150 million; or
- A gross notional amount (long and/or short) of $300 million.4
- For Other Security-Based Swaps on Debt (that are not CDS): The threshold is a gross notional amount of $300 million.
- For Security-Based Swaps on Equity: The threshold would be bifurcated, with both a threshold based on the notional amount of the SBS position ("Notional Threshold"), and a threshold based on the total number of shares attributable to the SBS position as a percentage of the outstanding shares of that class of equity securities ("Percentage Threshold"). The reporting threshold would be the lesser of the Notional and Percentage thresholds:
- Notional Threshold - a person would be required to file a Schedule 10B once an SBS position based on equity meets or exceeds $300 million, calculated on a gross basis (i.e., including both long and short positions). In addition, once an SBS position exceeds a gross notional amount of $150 million, the calculation of the SBS position must also include the value of all the underlying equity securities owned by the holder of the SBS 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 instrument based on the same class of equity securities.5
- Percentage Threshold - a person would be required to file a Schedule 10B once the SBS Equivalent Position represents more than five percent of a class of equity securities. For the purposes of this threshold, the term "SBS Equivalent Position" would mean the number of shares attributable to all the SBSs composing an SBS position.6
These calculations would apply not only to all SBSs based on a single equity security, but also to SBSs based on a narrow-based security index containing that reference security.
The report would be made on a new Schedule 10B, which would have to be filed with the Commission promptly, but in no event later than the end of the first business day following the day of execution of the SBS transaction that results in the SBS exposure exceeding the reporting threshold. Filing would be made electronically through the Commission's EDGAR system.7 These reports would be publicly available immediately upon filing.
Proposed Rule 10B-1(c) would require a person who has previously filed a Schedule 10B to file an amendment if any material change occurs in the facts in a previously filed Schedule 10B including, but not limited to, any material increase or decrease in SBS positions. An acquisition or disposition in an amount equal to 10 percent or more of the position previously disclosed in Schedule 10B would be deemed "material" for the purposes of this requirement. An amendment filing would also be required if a reported SBS position falls below the applicable reporting threshold amount. Any Schedule 10B amendment would be required to be filed promptly, but in no event later than the end of the first business day following the material change.
The reporting requirement is intended to apply to certain persons outside the United States and to SBS transactions involving underlying securities that may not otherwise be registered under the Exchange Act. Specifically, as proposed, the reporting requirements under Rule 10B-1 would apply to transactions where (1) the SBS is subject to reporting under Rule 908 of Regulations SBSR (which includes SBS where either party is a U.S. person or the swap is effected using certain U.S.-based intermediaries), or (2) the reporting person holds any amount of the securities underlying the SBS position (or would be deemed to be a beneficial holder) and either (A) the issuer of the underlying securities is a U.S. person or (B) the underlying securities are part of a class registered under Section 12 or 15(d) of the Exchange Act.
Although suggestions for public disclosure of SBS positions have been made by market participants over the years, the Commission has previously declined to propose rules with respect to either position limits or reporting of large SBS positions. With this proposal, the SEC has now stated that there would be several benefits from required reporting, including (1) providing market participants and regulators with access to information; (2) alerting market participants and regulators to the existence of concentrated exposures to a limited number of counterparties; and (3) in the case of manufactured or other opportunistic strategies in the CDS market, providing market participants and regulators with advance notice that a person is building up a large CDS position which could create an incentive to vote against their interests as a debt holder.8 While the SEC believes the reporting of these positions should be publicly available, it also recognizes that certain aspects of an SBS transaction concerning the market participant's relationship with its counterparties may be sensitive or proprietary. The proposed rule would not require reporting persons to publicly disclose information about their counterparties, including their identities.
Anti-Fraud and Anti-Manipulation for SBS: Re-Proposed Rule 9j-1
The Commission has re-proposed Rule 9j-1, which was previously proposed in 2010 but never adopted. The new proposed rule follows the general approach of the 2010 proposal, but with certain expansions in coverage. Rule 9j-1 would prohibit fraud or deceptive conduct in connection with entering into, or terminating, an SBS. Although Rule 9j-1 is modeled on Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and Section 17(a) of the Securities Act, it would go beyond those provisions in that it addresses misconduct in connection with the exercise of any right or performance of any obligation under an SBS (as opposed to only in connection with the inception or termination of an SBS).9
Unlike the 2010 proposed rule, the new proposal also includes a prohibition on manipulation or attempted manipulation of the price or valuation of an SBS.10 Further, Rule 9j-1 would expressly provide that:
- A person with material non-public information about a security cannot avoid liability under the securities laws by making purchases or sales in an SBS (as opposed to purchasing or selling the underlying security), and
- A person cannot avoid liability under Section 9(j) or re-proposed Rule 9j-1 in connection with a fraudulent scheme involving an SBS by instead making purchases or sales in the underlying security (as opposed to purchases or sales in the SBS).11
With respect to the original Rule 9j-1 proposal, commenters had raised concerns about how the prohibitions would apply in the context of the exercises of rights or remedies under transactions, particularly about whether actions such as calls for margin and similar ordinary course activities could be questioned under the Rule. In response to those comments, re-proposed Rule 9j-1 provides for two safe harbors for individuals engaged in SBS transactions while aware of material non-public information (MNPI):
- Rule 9j-1(f)(1) - a person would not be liable under re-proposed Rule 9j-1(a) solely by reason of being aware of MNPI while taking actions in accordance with binding contractual rights and obligations under an SBS (as reflected in the written SBS documentation governing such transaction), so long as the person can demonstrate that: (1) the SBS was entered into before the person became aware of such MNPI; and (2) that entry into, and the terms of, the SBS are themselves not a violation of any provision of re-proposed Rule 9j-1(a).
- Rule 9j-1(f)(2) - a person would not be liable under re-proposed Rule 9j-1(a) solely for reason of being aware of MNPI when effecting SBS transactions pursuant to a bilateral portfolio compression exercise (as defined in 17 CFR 240.15Fi-1(a) of the Exchange Act) or a multilateral portfolio compression exercise (as defined in 17 CFR 240.15Fi-1(j)) so long as: (1) any such transactions are consistent with all of the terms of a bilateral portfolio compression exercise, or multilateral portfolio exercise, including as it relates to, without limitation, the transactions to be included in the exercise, the risk tolerances of the persons participating in the exercise, and the methodology used in the exercise, and (2) all such terms were agreed to by all participants prior to the commencement of the applicable exercise.
The proposing release discusses in some detail alleged market conduct relating to CDSs that the SEC is seeking to address through Rule 9j-1, including so-called manufactured credit events and other similar strategies that have been used in the CDS market. The scope of re-proposed Rule 9j-1, however, is not limited to SBSs that are CDSs. In the proposing release, the SEC indicates a broader concern that fraudulent, deceptive or manipulative conduct, such as providing false or incomplete information to a counterparty to secure better terms or pricing, or to alter the performance of ongoing rights and obligations, has the potential to harm counterparties to all forms of SBSs, including equity SBSs and non-CDS debt total return swaps. The Commission also notes a concern that in some cases, particularly instances involving SBS transactions that are effected over the internet, there is a potential for trading software to distort pricing and payouts on SBSs.12 Rule 9j-1 would be intended to apply to such cases as well.
Chief Compliance Officer Independence: Proposed Rule 15Fh-4(c)
The Commission is proposing a rule aimed at protecting the independence and objectivity of the chief compliance officer (CCO) of an SBS dealer or major SBS participant (SBS Entities) by preventing the personnel of an SBS Entity from taking actions to coerce, mislead or otherwise interfere with their CCO. Rule 15Fh-4(c) would make it unlawful for any officer, director, supervised person or employee of an SBS Entity, or any person acting under such person's direction, to directly or indirectly take any action to coerce, manipulate, mislead or fraudulently influence the SBS Entity's CCO in the performance of its duties under the Federal securities law or the rules and regulations thereunder.
The proposed rules, if adopted, could affect several aspects of SBS markets. The proposed disclosure requirements would, for the first time, require prompt public disclosure of SBS positions (both equity-related and debt-related), in some cases, potentially even those relating to unregistered securities. The proposal reflects some longstanding concerns about acquisition of significant economic positions through equity swaps, as well as more recent concerns around the effect of CDS positions on corporate restructuring. Some market participants, however, are likely to be concerned about the scope of disclosure (which in some cases may exceed disclosure requirements in the cash markets), the disclosure thresholds and the impact of disclosure on market pricing and the ability to conduct hedging and other market activity. The deadlines to report positions under the proposed rule are shorter than the beneficial reporting required under the Exchange Act.
The re-proposal of Rule 9j-1 is likely to raise some of the same concerns expressed with the original proposal. Although the SEC has recognized concerns about the breadth of the rule, particularly as it applies to the exercise of contractual rights under an SBS, there will likely be questions about whether the proposed safe harbors provide enough protection or certainty for market participants. There may be additional questions about whether it will be sufficiently clear as to whether conduct is permissible or prohibited under the rule, particularly in the context of debt restructurings or negotiations where parties have CDS positions. Some market participants may view the proposal as likely to chill the use of legitimate trading and hedging strategies involving SBSs or the securities that underlie them. The broad scope of the rule, if adopted, may also lead to additional compliance responsibilities for market participants, including for the supervision of trading and other personnel responsible for taking actions under SBSs.
With respect to chief compliance officer independence, while there may be support for the general concept, there are likely to be questions about whether additional protections of this type are needed, whether the rule is designed to prohibit specific conduct that currently is not, and what would be the practical implications of the rule on the operations of SBS Entities.
The SEC has requested public comment on all aspects of the new proposed rules. The comment period will be open for 45 days after publication of the proposals in the Federal Register.
1 See U.S. Securities and Exchange Commission, "Statement on Exchange Act 10B and Rule 9j-1" (Dec. 15, 2021).
2 See Shearman and Sterling, "ISDA Proposes Amendments To The 2014 ISDA Credit Derivatives Definitions Relating To Narrowly Tailored Credit Events," (Apr. 11, 2019); see also CFTC, "Statement on Manufactured Credit Events by CFTC Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight," (Apr. 24, 2018), "Update to June 2019 Joint CFTC-SEC-FCA Statement on Opportunistic Strategies in the Credit Derivatives Market," (Sept. 19, 2019).
3 See U.S. Securities and Exchange Commission, "Proposed Rule," (Dec. 15, 2021).
4 See id., citing proposed Rule 10B-1(b)(1)(i).
5 See id., citing proposed Rule 10B-1(b)(1)(iii)(A).
6 The SBS Equivalent Position would be determined based on the larger of (in each case as applicable):
i. The number of shares of the reference equity security that may be delivered upon on the exercise of the rights under the derivative instrument, as determined in accordance with the terms of the applicable documentation;
ii. The number of shares of the reference equity security determined by multiplying the number of shares by reference to which the amount payable under the derivative instrument is determined by the delta of the applicable derivative instrument; and
iii. The number of shares of the reference equity security determined by dividing the notional amount of such derivative instrument by the most recent closing price of shares of the reference equity security, and then multiplying such quotient by the delta of the applicable derivative instrument.
7 See Proposed Rule at 73.
8 See Proposed Rule at 63.
9 Id. at 18.
10 This prohibition is modeled after the Commodity Futures Trading Commission's prohibition on manipulation (including for swaps and futures) in 17 C.F.R. 180.2
11 See id., citing re-proposed Rule 9j(c), (d).
12 See e.g., "SEC Investor Alert: Binary Options Fraud" (2020).
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