Friday, April 01, 2011

Hedge Fund Industry Says SEC’s Proposed Antifraud Rule for Security-Based Swaps Would Suppress Legitimate Trading

While supporting the SEC’s proposed antifraud rule for the security-based swaps market to comply with Section 763(g) of Dodd-Frank, the hedge fund industry feared that the proposal could disrupt major segments of the OTC derivatives markets and unduly interfere with legitimate market activity. The proposed rule is intended to prevent fraud, manipulation, and deception in the security-based swaps markets. In a letter to the SEC, the Managed Funds Association said that proposed Rule 9j-1 is too vague, sweeps too broadly, and would suppress legitimate trading activity.

The MFA emphasized that much is at stake with proposed Rule 9j-1. If not done properly to proscribe true misconduct without interfering with legitimate market activity, the consequences could be enormously harmful and costly for the securities markets and investors. The challenge of drafting an antifraud rule for the security-based swap market is to have it address valid concerns of potential misconduct and provide additional benefits beyond the Commission’s current antifraud prohibitions. Proposed Rule 9j-1 does not achieve those goals, said the MFA. It employs broad and expansive language reaching beyond purchases and sales to capture performance of security-based swaps.

Moreover, the proposed rule would interject great uncertainty and unpredictability into the security-based swaps markets and reduce the willingness of law-abiding firms to trade. The regulation, as proposed, would deter a significant volume of legitimate market participation. Investors would reduce their use of swaps, and credit markets would be less liquid and possibly freeze, depriving the securities markets of the substantial benefits provided by swaps.

But the MFA allowed that it is possible for the Commission to adopt an antifraud rule that proscribes truly fraudulent behavior while avoiding these pitfalls. An antifraud regulation for the security-based swaps markets tailored to the characteristics and specific needs of these markets could benefit the markets by applying the definitions of “purchase” and “sale” of a security-based swap more in line with the statutory definitions and the practice in the swaps markets. Thus, the MFA urged the SEC to change Rule 9j-1 to clarify the meaning of purchases and sales in the context of security-based swaps.


Swaps are not simply bought and sold over the counter or on an exchange like most securities, noted the MFA. Rather, they are bilateral contracts and, as such, trade through novations, unwinds, and assignments. Viewed in that light, each word in the definitions of “purchase or sale” serves a purpose. For example, execution in the context of a security-based swap is the equivalent of a “purchase” of the swap by both parties to the agreement. Execution means the entry into a security-based swap agreement by the counterparties that specifies the terms of the swap. Unlike a traditional securities transaction, there are, in effect, two buyers rather than one buyer and one seller

Termination in the context of a security-based swap is the equivalent of a “sale” of the swap. In the MFA’s view, this provision refers to a new agreement by the parties to the security-based swap to end or otherwise eliminate exposure under the existing swap agreement before its scheduled maturity or in a manner not contemplated by the original swap agreement.

The MFA noted that Section 763(g) of Dodd-Frank is aimed at preventing fraudulent, deceptive, or manipulative acts in connection with the entry into a securities-based swap, the novation or assignment of a securities-based swap; and the unwind of a securities-based swap. These actions are all the equivalent of a purchase or sale and are appropriately subject to antifraud regulation. Over time, actual practices in the market may demonstrate that an antifraud rule need not apply when these actions do not cause a party to change its economic exposure.

Security-based swaps also terminate or settle in a variety of other circumstances contemplated by the terms of the contract itself. These types of terminations or settlements are not the equivalent of a purchase or sale and thus should not be subject to regulation pursuant to a Rule 9j-1. An easiest example of this type of termination is the expiration of a securities-based swap at maturity. The expiration of a swap is clearly not a purchase or sale within the meaning of the Dodd-Frank Act, said the MFA, since the definition of purchase and sale only covers terminations that occur prior to a swap’s scheduled maturity date. Similarly, the settlement or termination of a swap as a result of an event specified in the swap agreement does not result in the extinguishment of rights or obligations under the swap or otherwise constitute a “purchase or sale.”

In each of these instances, the settlement and termination of the swap triggered by the relevant event results in the full satisfaction of the parties’ rights and obligations in a manner contemplated by the swap agreement from the very beginning of the transaction. Moreover, in each of these instances, it would be highly disruptive to the swap markets and, particularly in the case of a counterparty default, could pose systemic risk if Rule 9j- 1 or uncertainty about its application prohibited a party to a security-based swap from terminating or settling the transaction.

Similarly, if a party to a credit default swap came into possession of material non-public information after the execution of a credit default swap, proposed Rule 9j-1 would prohibit the party from delivering securities or making relevant payments to settle the swap, notwithstanding that the existing swap agreement specified the performance of such obligations. As a result, the party would be forced to breach the agreement with its counterparty

Proposed Rule 9j-1 would create similar difficulties for a party to a swap that faces a counterparty default. The concern here is with the creditworthiness of the other party to the swap agreement and not with a credit event related to the underlying reference entity or obligation. If the party came into possession of inside information about the reference entity after the execution of the swap and its counterparty then defaulted, proposed Rule 9j-1 would not permit the party to obtain an early termination of the swap, even though swap agreements generally state that a party may terminate when a counterparty defaults.

Prohibiting a party from terminating its swap positions on a counterparty default would not advance any policy against fraud or market manipulation, said the MFA. The party would be terminating because of an event explicitly described in the swap agreement. In addition, such a prohibition would run contrary to other strong policies, repeatedly recognized by Congress, in promoting the efficient functioning of the swaps and derivatives markets.

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