June 29, 2023 - In early June the SEC adopted Rule 9j-1 (the “Final Rule”), an anti-fraud and anti-manipulation provision focused on security-based swaps reproposed in December 2021 (the 9j-1 rule was initially proposed in 2010).  The Final Rule targets security-based swap and related transactions including transactions that are ubiquitous in the loan market. Previously, we summarized our concerns with proposed 9j-1 and, in May 2022, submitted a comment letter to the SEC expressing those concerns.  While the Final Rule adopted several modifications to the proposed rule reflecting comments received from stakeholders (including the LSTA), as we explain below, it remains problematic and could significantly disrupt the security-based swaps market.  For a deeper and more comprehensive take on the Final Rule, please see Sullivan & Cromwell’s recently published memo.

What does the Final Rule say? The Final Rule prohibits a wide range of acts, omissions, and fraudulent inducements in connection with security-based swaps, including fraud in connection with the execution, early termination, assignment, or similar transfer of, or extinguishing of any rights or obligations under, a security-based swap.  The Final Rule also prohibits the manipulation or attempted manipulation of the price or valuation of a security-based swap.  The Final Rule does add two affirmative defenses to liability which are based on affirmative defenses described in Rule 10b5-1(c) of the Exchange Act.  The first covers actions taken in connection with contractual obligations under a security-based swap that was in existence before a person became aware of MNPI, and the second confirms the general effectiveness of information barriers.

A lack of clarity around “Manufactured Credit Events” and “Opportunistic Strategies”.  In its proposed rule the SEC focused on manufactured credit events and opportunistic strategies in the CDS market that involve CDS market participants taking actions to “avoid, trigger, delay, accelerate, decrease, and/or increase payouts on CDS.”  These include colluding to create a technical credit event, restructuring credit facilities to “orphan” the CDS, or taking actions to increase the supply of deliverable obligations to increase the likelihood of a credit event.  In the Final Rule, the SEC declined to provide clarity on when a strategy would be considered manipulative and, instead indicated that it would apply a “facts and circumstances” analysis.  This lack of clarity is particularly challenging in the context of loans, where waivers and amendments are common.

The Final Rule Goes Far Beyond Purchases and Sales of Security-Based Swaps.  In contrast to the anti-fraud rules that apply to securities, the anti-fraud provisions of the Final Rule also attach to misconduct that occurs in connection with (a) effecting, or attempting to effect, a transaction in security-based swaps, or (ii) inducing, or attempting to induce, the purchase or sale of any security-based swap (including, in whole or in part, executing, terminating (prior to its maturity date), assigning, exchanging or a similar transfer or conveyance of, or extinguishing of any rights or obligations, under a security-based swap).Implications.  As noted in the Sullivan & Cromwell memo, while the Final Rule draws on the existing language of the anti-fraud rules that pertain to securities, “its scope extends beyond that of analogous rules in potentially significant ways.  The prohibitions apply not just to activity around the entry into a security-based swap transaction (the “purchase” or “sale”), or the novation or termination of a security-based swap, but also to actions taken in connection with obligations or rights under a security-based swap.”  They note too that “while the affirmative defenses are similar to those provided under Rule 10b5-1(c), they are not identical.”  Instead, they are narrower and provide less flexibility than the affirmative defenses available in Rule 10b5.  Finally, they note that the SEC declined to adopt safe-harbors or affirmative defenses in connection with, the anti-manipulation provision provided in Rule 9j-1(a)(6) despite commenters’ concerns that the provision could disrupt important aspects of the security-based swap market, including certain hedging and restructuring activities.  The Final Rule will become effective 60 days after it is published in the Federal Register.

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