The SEC’s New Proposed Rule To Regulate Credit Derivatives and Other Security-Based Swaps Raises Practical Concerns for the Industry and May Exceed the SEC’s Authority

On Dec. 15, 2021, the U.S. Securities and Exchange Commission (SEC or Commission) proposed Rule 240.9j-1 (the Rule), intended “to prevent fraud, manipulation, and deception in connection with effecting transactions in, or inducing or attempting to induce the purchase or sale of, any security-based swap” (SBS).^[1] The Rule purports to effectuate Section 9(j) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The Rule is still in the notice-and-comment period, with comments due on March 21.

Background

This is not the Commission’s first crack at Rule 9(j). In 2010, the SEC proposed a different version of Rule 240.9j-1 (the 2010 Rule).^[2] Critics observed that the 2010 Rule reached conduct beyond that which takes place “in connection with the ‘purchase’ and ‘sale’ of a[n SBS]” and would “unintentionally prohibit … the legitimate exercise of rights and performance of obligations” such as those “dictated by the contract underlying the [SBS] and which bear no relation to execution, termination, assignment, exchange and transfer or extinguishment of rights.”^[3] Ultimately, the 2010 Rule was never adopted.

The Commission is now back, and the Rule raises many of the concerns levied against the 2010 Rule. The Rule is notable for its breadth; on its face, the Rule regulates not only the purchase and sale of SBSs, but virtually any transaction under a swap contract, including periodic payments and deliveries. The Rule prohibits the following types of transactions in SBSs if done “in connection with” four types of fraudulent conduct:

• Purchasing or selling or attempting to induce the purchase or sale of an SBS.
• Effecting or attempting to effect any transaction in an SBS.
• Taking any action to exercise any right, or any action related to the performance of any obligation, under any SBS, including in connection with any payments, deliveries, rights, or obligations or alterations of any rights thereunder; or terminating (other than on its scheduled maturity date) or settling any SBS.^[4]

Such transactions are prohibited if done in connection with one of four types of fraudulent conduct:

• Employing or attempting to employ any device, scheme or artifice to defraud or manipulate.
• Making or attempting to make any untrue statement of a material fact, or omitting 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.
• Obtaining or attempting 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.
• Engaging or attempting to engage in any act, practice or course of business that operates or would operate as a fraud or deceit upon any person.^[5]

According to the Commission, the Rule “combine[s] the antifraud and anti-manipulation provisions in Rule 10b-5 that apply to all securities ... with the additional antifraud and anti-manipulative authority specific to [SBSs]” authorized by Dodd-Frank.^[6] The first two types of fraudulent conduct are patterned on Rule 10b-5 and would thus require proof that they were done knowingly or recklessly. By contrast, the third and fourth types of fraudulent conduct are based on Section 17(a) of the Securities Act and thus would only require proof of negligence.^[7]

In addition, the Rule prohibits any person from manipulating or attempting to manipulate “the price or valuation of any [SBS], or any payment or delivery related thereto.”^[8] This provision is targeted at “opportunistic strategies” in the credit default swap (CDS) market, in which a CDS buyer or seller manipulates the reference entity “to avoid, trigger, delay, accelerate, decrease, and/or increase payouts on CDS.”^[9] As the Commission’s proposal notes, such practices have been an area of regulatory focus for the SEC and the Commodity Futures Trading Commission for the past several years; in June 2019, the agencies issued a public statement jointly with the U.K. Financial Conduct Authority indicating that these “manufactured credit events” may “adversely affect the integrity, confidence, and reputation of the credit derivatives markets.”^[10]

Practical Implications and Perceived Risk for CDS Market Participants

For market participants holding both cash (i.e., bonds or loans) and credit derivatives positions on a company, the Rule creates a significant amount of risk. For instance, if a CDS holder engages with the company to effectuate a refinancing, restructuring or other debt reorganization and the company proceeds to reorganize its debt in a manner that impacts the CDS contract — for instance, by creating an orphan CDS or a succession event (whereby the CDS references another entity) — the SEC would likely consider the changes to the CDS to be material enough to constitute a covered “purchase” or “sale” of the CDS. At that time, such market participant could be viewed as holding inside information (by obtaining material nonpublic inside information from the company as a bondholder or a lender), subjecting the market participant to the antifraud provisions and potential insider trading liability. Likewise, if the reorganization entails a forbearance agreement and a coupon or some other payment is not made under the terms of the debt documentation, giving rise to a failure-to-pay credit event triggering settlement of the CDS contract, the Rule would enable the SEC to consider such an event to be a purchase or sale and claim that the holders who promoted this outcome with the company engaged in fraudulent activity. This would be particularly damaging for this market considering that recent amendments to the CDS contract make these types of outcomes and behaviors entirely legitimate, in particular because they essentially enable stressed and distressed companies to achieve much-needed debt reorganization and strengthen their balance sheet. The safe harbors provided by the SEC in the Rule do not appear to be broad enough or specific enough to cover these and other situations,^[11] thereby creating the risk that market participants would either no longer engage with companies when they hold both cash and derivative positions (to the detriment of those companies) or no longer use credit derivatives for fear of potential liability (also to the detriment of borrowers and lenders, which would no longer have a ready market in which they could transfer credit risk).

Whether the Rule Exceeds the SEC's Authority

However, the Rule is vulnerable to attack because the SEC may have exceeded its authority under Dodd-Frank in its attempt to regulate transactions that are arguably not purchases or sales of securities. Dodd-Frank Section 9(j) empowers the SEC to “prescribe means reasonably designed to prevent” persons from “effect[ing] any transaction in, or ... induc[ing] or attempt[ing] to induce the purchase or sale of, any [SBS], in connection with which such person engages in any fraudulent, deceptive, or manipulative act or practice, or engages in any transaction, practice, or course of business which operates as a fraud or deceit upon any person.”^[12] A “purchase” or “sale” includes “the execution, termination, assignment, exchange, transfer, or extinguishment of rights or obligations” of SBS.^[13] Thus, the SEC is empowered to promulgate rules aimed at preventing fraud in connection with those types of SBS transactions.

The Rule appears to go further, reaching the “exercise [of] any right, or any action related to the performance of any obligation, under any security-based swap, including in connection with any payments, deliveries, rights, or obligations or alterations of any rights thereunder.”^[14] In the context of a CDS, the counterparties have “rights” and “obligations” under the terms of the swap not easily described as execution, termination, assignment, exchange, transfer, conveyance, or the extinguishing of rights or obligations — for example, various types of periodic payments under the swap contract. Indeed, the proposal cites “a margin payment that represents only part of what one counterparty owes the other” as an example of a transaction that would be covered by the Rule.^[15]

The SEC offers three justifications for its regulatory authority, though each raises questions:

Broadly defining “purchase” and “sale.” The SEC contends that the definitions of “purchase” and “sale” encompass “partial executions, terminations, assignments, exchanges, transfers, or extinguishments of rights and obligations” of SBS — that is, “actions that have an impact on some, but not all, rights and obligations, such as a margin payment that represents only part of what one counterparty owes the other.”^[16] Arguably, however, defining “purchase” and “sale” to include actions that merely “have an impact” on certain rights and obligations exceeds the SEC’s statutory authority to regulate purchases or sales of securities, i.e., transactions involving the execution, termination, assignment, exchange, transfer, conveyance, or extinguishing of rights or obligations. Courts have struck down similar efforts to regulate subjects outside an agency’s statutory authority.^[17]

The SEC attempts to allay concerns over the Rule reaching even routine payments or deliveries, by contending that it is “not taking the position that every payment or delivery made during the course of a security-based swap transaction is itself a purchase or sale of a security-based swap.” Rather, “fraudulent or manipulative conduct would be in connection with the purchase or sale of a security-based swap if it either alters any material terms of the security-based swap ... or has a material impact on any payment or delivery under the security-based swap.”^[18] In doing so, the SEC is arguably asserting that payment and delivery under an SBS becomes a purchase or sale of an SBS if there is fraudulent or manipulative conduct and there is a “material” impact on the terms of the SBS. If that is what the Commission means, it is a vulnerable position — whether a transaction is fraudulent or the terms of the SBS are materially impacted are separate questions from whether a transaction is a purchase or sale. As a practical matter, the SEC will not necessarily know before investigating whether fraud or a material alteration/impact is present, so market participants may face a putative tax in the form of attorneys’ fees from an investigation even when it comes to routine payments or deliveries.

Prophylactic rulemaking. The SEC contends that the Rule is authorized under its prophylactic rulemaking authority, that is, its power to “prohibit[] actions that directly impact a counterparty’s rights and obligations under a security-based swap — when such actions are in connection with specified fraudulent, manipulative, or deceptive conduct.”^[19] Federal agencies do possess prophylactic authority to create “bright-line” rules as to conduct related to subject matters they are authorized to regulate when passing such a rule would be more efficient than trying to detect wrongdoing in individual cases.^[20] However, agencies cannot use this power to exceed the regulatory authority granted by statute.^[21] Arguably, the Rule expands what transactions the SEC is regulating, rather than conduct related to transactions the SEC is authorized to regulate.

“Effecting any transaction” in SBS. Finally, the SEC points to statutory authority under Dodd-Frank that prohibits “effect[ing] any transaction” in any SBS in connection with fraud, deceit, and manipulation, and contends that this language, which it has historically interpreted broadly, encompasses the activity the Rule regulates.^[22] But courts have not interpreted similar language as broadly as the SEC does here.^[23]

Conclusion

Ultimately, the breadth and reach of Proposed Rule 240.9j-1 raises both practical concerns for participants in SBS markets that could chill legitimate business practices and legal questions as to the true scope of the SEC’s rulemaking authority. It seems likely that market participants will renew their criticisms of the Rule first expressed in 2010.

^[1] _{Release No. 34-93784 (Dec. 15, 2021), at 1, available at https://www.sec.gov/rules/proposed/2021/34-93784.pdf (“Proposal”).}

^[2] _{Release No. 34-63236 (Nov. 8, 2010), at 29, available at https://www.sec.gov/rules/proposed/2010/34-63236.pdf.}

^[3] _{Proposal at 26-27, 36.}

^[4] _{Proposed Rule 240.9j-1(a).}

^[5] _Id.

^[6] _{Proposal at 29-30.}

^[7] _{Proposal at 34-36.}

^[8] _{Proposed Rule 240.9j-1(b).}

^[9] _{Proposal at 14-16. For example, a CDS buyer may work with a reference entity to “create an artificial, technical, or temporary failure-to-pay credit event in order to trigger a payment,” or a CDS seller may “orphan” a CDS by “offering financing to restructure a reference entity.” Id.}

^[10] _{Id. at 15-16.}

^[11] _{Both safe harbor provisions concern transactions made while one party to an SBS is in possession of material nonpublic information. The first protects a person’s actions “in accordance with binding contractual rights and obligations under a security-based swap” if the parties entered into the swap or amended its terms before the person “came into possession of such material non-public information” and the swap itself does not violate the Rule. Proposed Rule 240.9j-1(f)(1). The second protects “swap transactions effected by a person pursuant to a bilateral ... or ... multilateral portfolio compression exercise,” as defined by statute, so long as the transactions are “consistent with all of the terms” of the bilateral or multilateral compression exercise and “[a]ll such terms were agreed to by all participants of” the exercise before it commenced. Proposed Rule 240.9j-1(f)(2).}

^[12] _{15 U.S.C. § 78i(j).}

^[13] _{See 15 U.S.C. § 78c(a)(13). (14).}

^[14] _{Proposed Rule 240.9j-1(b).}

^[15] _{Proposal at 38.}

^[16] _{Proposal at 38 (emphasis added).}

^[17] _{See, e.g., Truck Trailer Mfrs. Ass’n, Inc. v. E.P.A., 17 F.4th 1198 (D.C. Cir. 2021) (EPA regulations governing trailer portion of tractor-trailer trucks exceeded statutory authority to regulate “motor vehicles” because trailers did not fit the definition of a motor vehicle); Am. Fed’n of Gov’t Emps., AFL-CIO, Local 3669 v. Shinseki, 709 F.3d 29 (D.C. Cir. 2013) (agency decision impermissibly expanded definition of “collective bargaining rights” to include all labor rights).}

^[18] _{Proposal at 39.}

^[19] _{Proposal at 40.}

^[20] _{See, e.g., Biloxi Reg’l Med. Ctr. v. Bowen, 835 F.2d 345, 350 (D.C. Cir. 1987) (rule capping Medicare reimbursement for related parties “is prophylactic in the sense that it involves a judgment that the probability of abuse in transactions between related organizations is significant enough that it is more efficient to prevent the opportunity for abuse from arising than it is to try to detect actual incidents of abuse”).}

^[21] _{See, e.g., Ala. Ass’n of Realtors v. U.S. Dep’t of Health & Human Servs., 539 F. Supp. 3d 29 (D.D.C. 2021) (agency lacked authority to implement eviction moratorium using the power to “make and enforce ... necessary” regulations to combat the spread of disease where the statute specified more modest measures like inspection, fumigation and pest extermination).}

^[22] _{Proposal at 41.}

^[23] _{In the securities laws and court decisions interpreting them, “effecting a transaction” commonly refers to brokers and dealers transacting in securities as an agent instead of a principal. See, e.g., 15 U.S.C. § 78o(a)(1) (prohibiting brokers and dealers from “effect[ing] any transactions in” securities without registering under the Exchange Act); Clemente Global Growth Fund, Inc. v. Pickens, 705 F. Supp. 958, 962 (S.D.N.Y. 1989) (statute prohibited “an affiliated person of a registered investment company from effecting any transaction in which such registered company is a joint participant at the expense of the registered company”). As applied to the Rule, that principle suggests that “effecting” a transaction has something to do with an agency relationship, rather than bestowing authority beyond the regulation of a purchase or sale of a security.}