After nearly 13 years since its original proposal, the U.S. Securities and Exchange Commission (SEC) has adopted Rule 9j-1, a set of anti-fraud and anti-market manipulation prohibitions specifically designed for policing misconduct in security-based swap markets.[1]
Because of its broad drafting, study of future SEC guidance and court holdings will be necessary to understand the precise strictures of the new rule. Monitoring the evolution of Rule 9j-1 will be especially critical to dealers and end-users of loan-based total return swaps (“LTRS”) and credit default swaps (“CDS”), as these products must navigate thorny legal issues posed by both public securities regulations and private loan market conventions.
What is already clear, however, is that with Rule 9j-1, the SEC has forged a robust toolkit for prosecuting misconduct among security-based swap transactions – transactions whose very nature, in the SEC’s view, provides “opportunities and incentives for misconduct”.[2] With potentially more assertive SEC oversight of derivatives on the horizon, now is the time for market participants to both evaluate internal policies and practices for efficacy and build an evidentiary record of attempting to ensure good faith, institutional compliance with SEC requirements.
Below, we summarize the scope and principal prohibitions of Rule 9j-1 and discuss potential market implications and compliance concerns in more detail. The rule becomes effective August 29, 2023.
Overview
When the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in 2010, misconduct in connection with executing, terminating or assigning security-based swaps automatically became prohibited under long-established anti-fraud and anti-manipulation rules of the Securities Act of 1933 and the Exchange Act (including Rule 10b-5 thereunder). By adopting Rule 9j-1, however, the SEC has expanded its prosecutorial ambit over security-based swaps in several respects. In particular, Rule 9j-1:
- expands SEC oversight authority to include activities that occur during the term of a security-based swap transaction, rather than solely trade execution and trade unwinding;
- expands prohibitions against fraud to include negligent misconduct as well as attempted fraud in the context of security-based swap transactions; and
- creates a new prohibition against the manipulation or attempted manipulation of prices, valuations, payments and/or deliveries in connection with security-based swap transactions.
Market participants familiar with earlier SEC drafts of Rule 9j-1 will find that the essence of the final version remains the same, with modest accommodations added to address industry concerns. The final version potentially narrows the types of market activities that are subject to scrutiny, and it expressly includes two affirmative defenses from charges of fraudulent misconduct. The Adopting Release also reiterates that anti-manipulation prohibitions are not intended to threaten loan market activities taken within the “ordinary course of a typical lender-borrower relationship”. These updates and the accompanying guidance may demonstrate some SEC intention to tighten Rule 9j-1’s scope as compared to previous, proposed versions of the rule. Nevertheless, many questions remain as to how the regulator and federal courts will, in practice, interpret the broad prohibitions and narrow defenses of Rule 9j-1 going forward.
In-Scope Interim Activities
Of perhaps greatest consequence to security-based swap market participants generally, Rule 9j-1 regulates certain activities that occur between entering into and unwinding a transaction. On its face, the rule proscribes both fraudulent and manipulative misconduct “in connection with” any person “effect[ing] … or attempt[ing] to effect any transaction in” a security-based swap, which are both turns of phrase that the SEC interprets broadly. In its Adopting Release, the SEC notes that final Rule 9j-1(a) prohibits misconduct related to the exercise of rights or performance of obligations – including ongoing payments and deliveries – under a security-based swap if that misconduct occurs in connection with a broad range of activities beyond the actual consummation of purchases or sales. For example, misappropriation of customer margin would be in-scope, according to the SEC, as could some types of “sales, booking and cash and collateral management activities”.[3]
Anti-Fraud Rules: Restated and Expanded
Rule 9j-1 generally proscribes fraudulent activities in connection with effecting transactions in security-based swaps and any other in-scope activity. These fraudulent activities expressly include employing or attempting to employ any scheme to defraud or manipulate, making or attempting to make material misstatements or omitting material facts, obtaining value by any material misstatement or omission of material facts or attempting to do so and engaging in acts that operate or would operate as a fraud or deceit or attempting to do so. In many respects, Rule 9j-1’s anti-fraud rules parallel those under preexisting law – particularly Rule 10b-5 of the Exchange Act, which prohibits making false statements or not disclosing material nonpublic information (“MNPI”) in securities trading.
However, compared to antecedent anti-fraud rules, new Rule 9j-1 broadens the scope of the SEC’s anti-fraud policing authority in key respects:
- Liability for Negligence. In the SEC’s view, liability for fraudulent activity does not require a finding of “scienter” (i.e., that a person’s misconduct was intentional or recklessly conducted) in certain instances under Rule 9j-1. Rather, merely negligent conduct may be considered unlawful.
- Attempt. Rule 9j-1 expressly prohibits attempts to intentionally deal in falsehoods, omit MNPI or engage in certain other deceptive misconduct.
Affirmative Defenses to Fraud Charges
The final version of Rule 9j-1 provides two affirmative defenses to fraud allegations, notwithstanding that a person may have been aware of MNPI at times coinciding with in-scope secured-based swap activities:
- Contractual rights and obligations. The first defense is available to a person who shows that such actions were taken in accordance with “binding contractual rights and obligations” under a security-based swap, so long as the person also demonstrates that the security-based swap was executed before the person became aware of the MNPI in question, in good faith and not for evading Rule 9j-1 enforcement.
Although certain interim-trade activities will no doubt benefit from this defense, the extent of its protections is unclear. At a minimum, the defense appears to shield activities that can be shown to be entirely non-volitional. The Adopting Release, for instance, cites the act of delivering margin as protected under the defense. But the release also states that if a delivering party “fraudulently” reduces its margin delivery amount, the defense would not apply.[4] Accordingly, it is unclear to what extent the defense is available when a party acts in accordance with binding contractual rights when those rights permit the exercise of discretion.
- Information barriers. The second defense is available to a business entity that shows that the individual making the relevant investment decision on behalf of the entity was not aware of the MNPI in question and the entity had implemented reasonable policies and procedures to ensure that its personnel would not violate Rule 9j-1’s anti-fraud rules.
New Anti-Manipulation Prohibition
In addition to the anti-fraud rules above, Rule 9j-1 prohibits any person, in connection with effecting or attempting to effect any transaction in any security-based swap, from manipulating or attempting to manipulate the price or valuation of any security-based swap, or any payment or delivery related to any security-based swap. A showing of scienter is required for manipulation prosecution, but there are no express affirmative defenses set forth in the rule.
During its public comment phase, the anti-manipulation rule met open consternation among loan and derivatives industry groups due the fact that LTRS and CDS prices and valuations are inextricably tied to lender decisions in the cash markets. The anti-manipulation rule seemingly cuts a path for SEC scrutiny of loan underwriting, servicing and syndication activities by credit institutions that also use CDS to hedge against borrower credit risk. In its Adopting Release, the SEC appeared to try assuage loan market concerns, stating, for instance, that the rule generally is intended to deter actions that appear to be designed “almost exclusively” to harm a swap counterparty.[5]
Nevertheless, there are no bright-line tests for identifying activities whose influence on LTRS or CDS market prices constitutes unlawful manipulation. Rather, culpability is subject to “facts and circumstances” analyses. The SEC also rejected requests to include a safe harbor for bona fide hedging activities of lenders.
Market Implications
Significant uncertainty as yet exists regarding Rule 9j-1’s actual impact on the market. We can, however, glean a few initial implications and posit some high-level recommendations for CDS and LTRS market participants:
- Post-trade date compliance. For now, the demarcation between in-scope and out-of-scope security-based swap activities subject to Rule 9j-1 scrutiny remains ill-defined. Pending further regulatory or judicial guidance, market participants should watch for instances during the life cycle of a security-based swap when one party (whether as principal or as calculation or valuation agent) may exercise discretionary rights with potentially outsized economic effects on the counterparty. Marking to market transactions that are highly bespoke or linked to illiquid reference assets is a standout example. Exercising termination clauses, unilaterally increasing independent amount collateral requirements and calculating reference asset prices without reliable third-party quotes all might be other examples, in certain contexts.
Where such discretion exists, extra care may be warranted. To mitigate liability for fraud, market participants should consider whether any intra-trade information asymmetries put their counterparties at a material disadvantage. If so, then thought should be given as to disclosures that could help level the field. In addition, because Rule 9j-1 prohibits manipulation of valuations, payments and deliveries related to security-based swaps, a review of contract provisions and real-world desk operations may be warranted to identify trade mechanics that could yield dubious outcomes. For instance, especially opaque or convoluted calculation methodologies could be deemed manipulative, particularly in the absence of informed counterparty consent.
Ultimately, following Rule 9j-1’s adoption, participants will want to ensure that any security-based swap mechanics that could result in dramatic margin calls or forfeitures are transparent, equitable and justifiable on reasonable economic or risk mitigation grounds.
- “Opportunistic” CDS strategies targeted. CDS transactions that game market behavior or reap payouts on contractual technicalities without promoting any obvious social good clearly are a target of Rule 9j-1’s anti-manipulation prohibition. In its Adopting Release, the SEC cites as potentially wrongful activity the “orphaning” of a CDS to affect its market price and a protection seller offering financing to a borrower to merely delay a payout on a CDS tied to the borrower’s debts until after expiration of the protection seller’s CDS.
SEC guidance suggests the agency may view manipulative behavior in the CDS market as a more intractable problem than industry groups themselves.[6]This may preview a period of amplified regulatory scrutiny ahead. As a result, funds employing especially novel CDS strategies should be prepared to justify a trade’s market utility going forward. A trade which could be framed as yielding inequitable losses to counterparties on the basis of mere technicalities, for instance, may face Rule 9j-1 risk. On the other hand, being able to articulate that a trade provides hedging benefits or supports market liquidity could help mitigate that risk.
- Maintaining effective information barriers. The SEC’s recognition of effective information barriers as a valid defense to fraud claims should insulate public-side actors from fraud allegations at least at the time that trade decisions are made. However, dealers may wish to evaluate their systems for marking trades and making other day-to-day calculations and determinations to ensure that MNPI is not directly or indirectly accessed for such purposes, which could jeopardize the defense.
- Consider potential vicarious liability. Application of a negligence standard to Rule 9j-1’s anti-fraud prohibitions lowers a key threshold for successful SEC prosecutions. With that in mind, dealers may wish to analyze the legal question of whether a dealer could be vicariously liable for facilitating an end-user’s fraudulent trading activities. Though likely small, the risk probably is not zero under especially bad fact patterns. Dealers may, therefore, wish to consider their market-facing hedging strategies and evaluate their policies and procedures for vetting a client’s trading activities and responding to concerns that a client may be trading on MNPI.
- Document compliance efforts. When assessing policies, procedures and existing trading arrangements, market participants should generate a thorough record of efforts to update their internal compliance protocols. This is a “best practice” generally, but it is especially true given the questions surrounding Rule 9j-1’s rollout. Traditionally in its investigations, the SEC will show substantially greater patience in correcting errant trading behavior if the target can demonstrate that it attempted in good faith to comply with evolving regulatory requirements.
Conclusion
Rule 9j-1’s adoption and accompanying remarks from the SEC suggest there is both regulatory will and several new ways for policing misconduct in the security-based swaps markets. Accordingly, Rule 9j-1 should not be disregarded as just a technical rehash of anti-fraud and anti-manipulation prohibitions for the derivatives market. Rather, the rule represents a genuine expansion of SEC prosecutorial jurisdiction over many aspects of security-based swap trading – most notably, in the case of intra-trade activities.
Though we do not foresee Rule 9j-1 upending existing market practices, its adoption does mark an occasion for dealers and end-users to revisit their policies and procedures to consider appropriate means for avoiding all forms of proscribed misconduct under the rule. Much remains uncertain about how the SEC will interpret and exercise its authority under Rule 9j-1 going forward. But self-examinations of compliance procedures – if conducted thoughtfully and thoroughly documented – should remain a useful prophylactic against especially punitive enforcement measures.
For further information, please contact:
Richard J. Lee, Partner, Crowell & Moring
rlee@crowell.com
[1]For the adopting release of Rule 9j-1 (“Rule 9j-1”) under the Securities Exchange Act of 1934 (the “Exchange Act”), see Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition against Undue Influence over Chief Compliance Officers, Exchange Act Release No. 97656 (June 7, 2023), 88 Fed. Reg. 42546 (June 30, 2023) (the “Adopting Release”).
[2]Adopting Release, 88 Fed. Reg. at 42550.
[3]For the SEC’s discussion of the scope of activities covered by Rule 9j-1’s principal anti-fraud and anti-manipulation provisions, see the Adopting Release, 88 Fed. Reg. at 42553-55.
[4]Adopting Release, 88 FR 88 Fed. Reg. at 42566.
[5]Adopting Release, 88 Fed. Reg. at 42561.
[6]Although the SEC has acknowledged industry initiatives to curb opportunistic strategies, the agency appears to view these efforts as lacking sufficient breadth to adequately reduce manipulative market activity. See Adopting Release, 88 Fed. Reg. at 42562.
