Friday, July 08, 2011

Securities Industry Urges SEC to Narrowly Tailor Proposed Swap Anti-Manipulation Rule and Provide Safe Harbor

The securities industry believes that a proposed SEC anti-manipulation rule dealing with manipulation in security-based swap transactions should be tailored as narrowly as possible to prevent actual manipulation without raising costs for market participants and impeding legitimate market activities. The Commission proposed Rule 9j-1 under Section 763(g) of the Dodd-Frank Act, which expands the anti-manipulation provisions of Section 9 of the Exchange Act and authorizes the Commission to adopt rules to prevent fraud, manipulation and deception in connection with security-based swaps.

In a letter to the SEC, SIFMA said that proposed Rule 9j-1 would impose unworkable disclosure obligations to pre-negotiated security-based swap transaction that would impede the ability of market participants to continue to honor contractual terms and would create market uncertainty as to the performance of those contracts. In addition, the enforcement exposure that results from a negligence standard governing the wide range of ordinary course activities that may relate to a swap transaction would deter many parties from entering into such transactions, increase the cost of financial risk management and have other distorting effects on the market.

SIFMA fears that the proposed regulation is overly broad and does not accurately reflect relevant differences between security-based swaps and securities. Unlike a security, for which a purchase or sale is a one-time transaction that ends upon settlement, security-based swap transactions are ongoing contracts that involve rights and obligations throughout the life of the swap.

Moreover, the proposed Rule 9j-1 would expose security-based swaps market participants to inappropriate enforcement liability. SIFMA urged the Commission to craft a safe harbor under Rule 9j-1 analogous to Exchange Act Rule 10b5-1 for counterparties that obtain inside information after agreeing to the terms of a security-based swap. A rule to prevent manipulative conduct should apply exclusively to actions that involve a purchase or sale of a security-based swap, reasoned SIFMA, such as for the unwinding, assignment or novation of security-based swaps, not the pre-determined non-volitional acts that occur during the span of the swap contract.

SIFMA believes that the proposal would inappropriately expose counterparties to liability in connection with standard events that take place during the lifecycle of a swap transaction. In particular, security-based swap transactions involve a number of contractual rights and obligations that occur automatically, such as regular reset or settlement. As it relates to these rights, acquisition of material inside information makes no difference to exercise of the right or obligation and, as a result, manipulation concerns simply do not apply to what SIFMA called non-volitional actions, rights or obligations. Applying the rule to actions unrelated to swap investment decisions and actions that occur pursuant to pre-agreed contractual terms would be the equivalent of concluding that an issuer making interest payments on a bond (or a bond holder accepting such payments) violated Rule 10b-5 because it was in possession of material nonpublic information.

SIFMA urged the SEC to allow and even encourage counterparties to fulfill these non-volitional contractual obligations entered into before obtaining inside information regardless of whether that counterparty subsequently obtains material inside information. Enforcement authority should instead focus on cases where manipulation can occur when in possession of inside information, namely, any purchase or sale of security-based swap rights, which can be achieved either through entering into new a new security-based swap transaction or unwinding existing ones.