Monday, January 10, 2011

SEC Proposed Antifraud Rule for Security-Based Swaps Exceeds Dodd-Frank’s Authorization Says Hedge Fund Association

SEC proposed Rule 9j-1 to prevent fraud and manipulation in the trading and exercise of security-based swaps exceeds the authority granted the Commission under Section 763(g) of the Dodd-Frank Act, said a global hedge fund association, and go beyond Congress’s delegated authority in extending the prohibitions of Rule 10b-5 to ongoing obligations between the execution and extinguishment of a security-based swap contract which do not fall within the statutory definitions of purchase and sale. In a letter to the SEC, the Managed Funds Association also asked the SEC to clarify that the redefined statutory terms of “purchase” and “sale” will not include the post-execution performance of security-based swap contracts in accordance with their pre-negotiated terms.

The group also requested the Commission to confirm that the affirmative defenses under Rule 10b5-1(c) are applicable to security-based swaps. Further, the MFA suggested that a scienter requirement should be imposed for all violations of proposed Rule 9j-1 to prevent it from sweeping too broadly and unintentionally prohibiting the legitimate performance of rights and obligations.

Section 763(g) prohibits fraud and manipulation in inducing the purchase or sale of any security-based swap. The Dodd-Frank Act also amended the definition of “purchase or sale” in the Securities Act and Exchange Act to include, in the context of security-based swaps:
execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishment of rights or obligations under, a security-based swap

In clarifying the terms “purchase” and “sale” in the security-based swap context, noted the MFA, Congress chose specifically not to include ongoing obligations, which are dictated by the contract between the two parties underlying the security-based swap and which bear no relation to execution, termination, assignment, exchange and transfer or extinguishment of rights. Examples of such ongoing obligations include a variety of periodic or other types of payments under the terms of the security-based swap as well as many forms of collateral or margin payments. Such obligations imposed under the parties’ security-based swap contract exist during the life of a security-based swap.

In the MFA’s view, the SEC proposal ignores the plain limitation of Dodd-Frank to the extent it includes the exercise of any right or performance of any obligation under a security-based swap by appearing to extend the prohibitions of Rule 10b-5 beyond just the execution, termination, assignment, exchange and transfer or extinguishment of rights. Congress’s deliberate use of the words “purchase or sale” in Section 763(g) of the Dodd-Frank Act reaffirms the well-established principle in securities law that the Commission’s antifraud authority is limited to the purchase or sale of securities

Rights or obligations, following the execution of the security-based swap transaction and prior to the extinguishment of the security-based swap, are determined at the outset of the entry into the transaction and are memorialized in the negotiated contract underlying the security-based swap transaction, explained the MFA. The performance of interim obligations such as periodic payments of interest or dividends do not alter the risks assumed, nor do they change the parties’ obligations and, therefore, do not constitute “purchases” or “sales.”

According to the MFA, the proposed rule purports to regulate interim obligations during the life of a security-based contract, which bear no relation to the execution, termination, assignment, exchange, transfer or extinguishment of rights. Congress unambiguously granted the Commission authority only with respect to purchases or sales. The MFA raised the specter that, when faced with a challenge to an SEC enforcement action, courts may be reluctant to enforce Rule 9j-1.

The MFA urged the Commission to exercise its discretion to confirm that the extinguishment of a security-based swap would not result from a party’s exercise of its pre-negotiated contractual termination rights, or a party’s performance of its pre-negotiated contractual obligations, under a security-based swap, and exclude from Rule 9j-1 the exercise of pre-negotiated contractual termination rights under a security-based swap and the performance of pre-negotiated contractual duties under a security-based swap, so long as the entry into that security-based swap was not itself a violation of Rule 9j-1. The MFA believes that the failure by the Commission to provide such a confirmation and exclusion would threaten the efficient operation of the security-based swap markets.

While recognizing that the physical settlement of a security-based swap may constitute a transfer of the ownership of the underlying security and hence would be a purchase or a sale subject to Rule 9j-1, the MFA posited that the cash settlement of a security-based swap does not constitute such a transfer. The MFA said that extinguishment in the context of the purchase and sale definition should be interpreted to refer to a destruction or cancellation of the relevant rights and obligations under a security-based swap. Delivery of a credit event notice or exercise of other pre-negotiated early termination rights under a credit default swap would not result in a transfer of rights or obligations, emphasized the MFA, rather such an exercise would result in the performance and satisfaction of the terms of the swap. The MFA suggested that if the “purchase” and “sale” definitions were intended to reach simple performance the statutory language would have been more explicit to that effect.

The terms of the Commission’s rule referring specifically to an exercise of rights or performance of obligations is a ``grave concern’’ to the hedge fund industry. With respect to performance of obligations, the MFA believes it would be inappropriate for the contractually obligated party to face a situation in which it must choose to either violate Rule 9j-1 or its contract. With respect to exercise of rights that were created in a manner consistent with Rule 9j-1, it is exceedingly difficult, if not impossible, to be able to predict the likelihood of coming into possession of material inside information during the life of a security-based swap.

The price of a credit default swap is contingent on the ability of parties to receive agreed upon floating payments upon the occurrence of predetermined credit events. It is the basis on which parties are able to assume differing risk positions, and if parties are unable to rely on the certainty of being able to receive such floating payments upon a credit event or terminate on the occurrence of pre-negotiated events, they would find it debilitating to determine whether to enter into a transaction. The MFA fears that such an interpretation by the Commission would risk grinding substantial CDS markets, as well as other security-based swap markets, to a complete halt. Thus, the MFA urged the SEC to define the terms “purchase” and “sale” narrowly and exclude performance of security-based swap contracts, in accordance with agreed-upon terms, from the purview of Rule 9j-1.

The MFA also urged the Commission to clarify that the affirmative defenses under Rule 10b5-1(c) are available in the context of a security-based swap. Under Rule 10b5-1(c), the Commission has established affirmative defenses that a person’s purchase or sale is not on the basis of material inside information if persons can establish that they have no influence or discretion over the purchase or sale or the manner in which it takes place.

The MFA asked that this principle be equally applied to security-based swap transactions where certain calculations are part of the performance of a swap contract or lead to the execution, termination, assignment, exchange and transfer or extinguishment of rights, and the parties to the contract do not retain any discretion or influence over such terms.

Additionally, MFA asks the Commission to clarify that good-faith modifications of an existing contract underlying the security-based swap, executed when the party is not aware of inside information, will not be prohibited by the proposed rule. This is consistent with the Commission’s position that a person acting in good-faith may modify a prior contract before becoming aware of material inside information.

Finally, a scienter requirement for the proposed regulation is seen as appropriate given the high penalties associated with a violation of the Commission’s rules. The MFA believes that Congress, in granting the SEC authority in Section 763(g), did not intend to regulate negligent practices or inadvertent mistakes but, rather, to punish and deter intentional or knowing manipulative and deceptive conduct. Additionally, imposing only a negligence standard under the rule could give counterparties to a security-based swap grounds to withhold their performance of contractually agreed terms.