SEC Proposes Rules to Prevent Fraud in Security-Based Swaps (SBS) Transactions and Require Reporting of Large SBS Positions | Practical Law

SEC Proposes Rules to Prevent Fraud in Security-Based Swaps (SBS) Transactions and Require Reporting of Large SBS Positions | Practical Law

The SEC has proposed new rules designed to prevent fraud, manipulation, and deception in connection with security-based swaps (SBS), to prevent undue influence over the chief compliance officers (CCOs) of security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs), and to require large SBS position holders to publicly report certain information.

SEC Proposes Rules to Prevent Fraud in Security-Based Swaps (SBS) Transactions and Require Reporting of Large SBS Positions

by Practical Law Corporate and Securities
Published on 17 Dec 2021 • USA (National/Federal)
The SEC has proposed new rules designed to prevent fraud, manipulation, and deception in connection with security-based swaps (SBS), to prevent undue influence over the chief compliance officers (CCOs) of security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs), and to require large SBS position holders to publicly report certain information.
On December 15, 2021, the SEC published a release for public comment the following related proposed rules under the Securities Exchange Act of 1934 (Exchange Act):
The SEC also issued a related fact sheet on SBS fraud and manipulation, CCO independence, and position reporting under the proposed rules.
Public comment on the proposed rules must be received by March 21, 2022. Note comment period was subsequently reopened and again closed on November 1, 2022, then again reopened until August 21, 2023 (see Update: Comment Periods Reopened).

Re-proposed new Rule 9j-1: Prohibiting SBS Fraud and Manipulation

On November 3, 2010, the SEC originally proposed Rule 9j-1 under the Exchange Act, which would have:
  • Prohibited the same categories of misconduct as Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and Section 17(a) of the Securities Act of 1933 (Securities Act), in the context of SBS.
  • Explicitly addressed misconduct that is in connection with the "exercise of any right or performance of any obligation under" an SBS.
  • Applied to offers, purchases, and sales of SBS in the same way that the general antifraud provisions apply to all securities.
  • Explicitly applied to the cash flows, payments, deliveries, and other ongoing obligations and rights that are specific to SBS (see, Legal Update, SEC Proposes Security-based Swaps Antifraud Rule under Dodd-Frank).
According to the SEC, re-proposed Rule 9j-1 follows the same general approach as the 2010 proposed rule by prohibiting the same categories of misconduct as Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act in the context of SBS, including misconduct that is in connection with the exercise of any right or performance of any obligation under an SBS.
In addition to the regulatory developments since 2010, the SEC noted that there have been market developments and a number of press reports and academic articles since 2010 that have discussed manufactured credit events or other opportunistic strategies in the credit default swap (CDS) market (see Practice Note, Understanding Credit Default Swaps (CDS): Opportunistic Strategies). The SEC recognizes in the proposed rule that:
  • CDS buyers and sellers regularly engage in legitimate interactions with reference entities, and often offer critical means of restructuring and funding for reference entities.
  • CDS transactions are an important means by which debt holders hedge their underlying debt instruments.
  • The absence of such hedging opportunities could impact the willingness and ability of prospective investors to invest in that underlying market.
According to the SEC, the scope of re-proposed Rule 9j-1 is not limited to CDS because 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 swaps, including equity and non-CDS debt SBS. Re-proposed Rule 9j-1 has therefore been designed specifically to take into account the unique features of an SBS and would explicitly reach misconduct in connection with ongoing payments and deliveries that typically occur throughout the life of an SBS.
Re-proposed Rule 9j-1 would provide both that a person:
  • Cannot avoid liability under the securities laws with material non-public information about a security by making purchases or sales in the SBS (as opposed to purchasing or selling the underlying security).
  • Cannot avoid liability under Section 9(j) or re-proposed Rule 9j-1 in connection with a fraudulent scheme involving a SBS by instead making purchases or sales in the underlying security (as opposed to purchases or sales in the SBS).
Public comment on the proposed rule must be received by March 21, 2022.

Proposed new Rule 15Fh-4(c): Prohibiting Interference with SBSD CCOs

Proposed Rule 15Fh-4(c) under the Exchange Act, would make it unlawful for any officer, director, supervised person, or employee of a SBSD or MSBSP, or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the chief compliance officer (CCO) of a SBSD or MSBSP in the performance of their duties under the federal securities laws or the rules and regulations thereunder.
Public comment on the proposed rule is due on or before March 21, 2022. Note comment period was subsequently reopened and again closed on November 1, 2022, then again reopened until August 21, 2023 (see Update: Comment Periods Reopened).

Proposed new Rule 10B-1: Disclosure of Material SBS Positions

Proposed Rule 10B-1 under the Exchange Act would require that any person or group of persons who own an SBS position that exceeds the threshold amount set by the rule to promptly file with the SEC on the SEC’s EDGAR filing system a statement containing the information required by Schedule 10B, disclosing among other things:
  • The applicable SBS position;
  • Positions in any security or loan underlying the SBS position.
  • Any other instrument relating to the underlying security or loan, or group or index of securities or loans.
Proposed Rule 10B-1 sets out a definition of "Reporting Threshold Amount" that would include different reporting thresholds for SBS tied to debt securities and SBS tied to equity securities, as follows:
  • For single-name CDS and for narrow index–based CDS the threshold is the lesser of:
    • a long 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 CDS from the long notional amount of the CDS, netting out any other SBS;
    • a short notional amount of $150 million, without adding or subtracting the notional amount of any positions in a deliverable underlying debt security, and netting out any other SBS; or
    • a gross notional amount of $300 million.
  • With respect to all other SBS positions based on debt securities (which are not CDS), the SEC is proposing a gross notional threshold amount of $300 million without:
    • regard to direction of the person's CDS positions (whether net long, net short, or net neutral); and
    • excluding any debt securities underlying an SBS that are included in the SBS position.
  • For SBS positions based on equity securities, (as the term equity security is defined by the SEC (17 CFR 240.3a11-1), the SEC is proposing that the Reporting Threshold Amount in proposed Rule 10B-1(b)(1) be bifurcated, such that it would be defined to include a threshold based on each of the following:
    • the notional amount of the SBS position; and
    • the total number of shares attributable to the SBS position as a percentage of the outstanding number of shares of that class of equity securities.
Under the proposed Rule 10B-1, a person would be required to file a Schedule 10B once the security-based swap equivalent position (as described in the rule) represents more than 5.0% of a class of equity securities. The SEC notes that parties may attempt to evade the reporting requirements under proposed Rule 10B-1 by keeping a security-based swap equivalent position below the threshold, while also building up a position in the underlying equity securities and/or other types of non-security-based swap derivatives on such underlying security.
Accordingly, proposed Rule 10B-1(b)(1)(iii)(B) would provide that once a 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 shall 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.
All filings received by the SEC pursuant to proposed Rule 10B-1 would be made available to the public, with the goal of increasing transparency and oversight in the SBS market by providing relevant parties with advanced notice that certain market participants are building large positions and enabling such parties with such notice to facilitate risk management and inform pricing of SBS.
The SEC states in the proposed rule release that it is proposing Rule 10B-1 because the SEC both:
  • Recognizes that transparency can be beneficial to market participants so that they can act in an informed manner to protect their own interests.
  • Believes that public reporting of large CDS positions would help to provide advance notice to enable market participants to protect those interests.
According to the SEC additional transparency regarding large SBS positions also could alert market participants, including counterparties, as well as issuers of securities and their security holders, to the risk posed by the concentrated exposure of a counterparty. In a related press release issued by the SEC in connection with the proposed rules, SEC Chairman Gary Gensler noted the role of CDS in the 2008 financial crisis as well as the role of total return swaps (TRS) in the March 2021 collapse of Archegos Capital Management.
Public comment on the proposed rule must be received by March 21, 2022. Note comment period was subsequently reopened and again closed on November 1, 2022, then again reopened until August 21, 2023 (see Update: Comment Periods Reopened).

Update: Comment Periods Reopened

On October 7, 2022, the SEC reopened the comment periods for several rulemaking releases due to a technical error that resulted in the SEC not receiving comments submitted through its online form between June 2021 and August 2022, including the proposed rules discussed above. The reopened comment period will remain open until November 1, 2022. For more information, see Legal Update, SEC Reopens Comment Periods for Several Proposed Rules.
On June 20, 2023, the SEC reopened the comment period for proposed new Rule 10B-1 under the Exchange Act, on disclosure of material SBS positions (see Proposed new Rule 10B-1: Disclosure of Material SBS Positions). The deadline for public comment on this proposed rule is August 21, 2023. Note the other two proposed rules discussed above have been adopted as final rules (see Legal Update, SEC Adopts Final Rules on Security-Based Swap (SBS) Fraud Prevention and CCO Independence).