Investment Management Alert
November 2010
Authors:
Susan I. Gault-Brown
susan.gaultbrown@klgates.com
+1.202.778.9083
Anthony R.G. Nolan
anthony.nolan@klgates.com
+1.212.536.4843
Robert A. Wittie
robert.wittie@klgates.com
+1.202.778.9066
K&L Gates includes lawyers practicing out
of 36 offices located in North America,
Europe, Asia and the Middle East, and
represents numerous GLOBAL 500,
FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies, entrepreneurs,
capital market participants and public
sector entities. For more information,
visit www.klgates.com.
SEC Proposes Anti-Fraud and
Anti-Manipulation Rule for Security-Based
Swaps under Section 763(g) of the
Dodd-Frank Act
On November 3, 2010, the Securities and Exchange Commission (the “SEC”)
published for comment a proposed rule intended to implement anti-fraud and antimanipulation provisions regarding security-based swaps pursuant to Section 763(g)
of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “DoddFrank Act”).1
Proposed Rule 9j-1 under the Securities Exchange Act of 1934 (the “Exchange Act”)
would make it unlawful for any person to directly or indirectly engage in fraud,
manipulation or deception in connection with the offer, purchase or sale of any
security-based swap, as well as “the exercise of any right or performance of any
obligation under” a security-based swap. The proposed rule is intended to make
clear that the fraud and manipulation protections of the federal securities laws apply
not only to offers, purchases and sales of security-based swaps but also explicitly to
“the cash flows, payments, deliveries, and other ongoing obligations and rights that
are specific to security-based swaps.” 2
Comments are due on or before December 23, 2010.
Background
Section 761(a) of the Dodd-Frank Act expanded the definition of “security” under
the Securities Act of 1933 (the “Securities Act”) and under the Exchange Act to
include “security-based swaps,”3 and, therefore, such swaps automatically became
subject to the general anti-fraud and anti-manipulation provisions of the federal
securities laws contained in Exchange Act Section 10(b) and Rule 10b-5 thereunder
and Securities Act Section 17(a). Prior to passage of the Dodd-Frank Act, such antifraud and anti-manipulation provisions generally prohibited misconduct in
connection with the offer, purchase or sale of a security.
1
Prohibition Against Fraud, Manipulation, and Deception in Connection With Security-Based Swaps,
75 Fed. Reg. 68561 (Release No. 34-63236) (November 8, 2010) (the “Proposing Release”).
2
Proposing Release, 75 Fed. Reg. at 68651.
3
Section 761(a) of the Dodd-Frank Act adds new Section 3(a)(68) of the Exchange Act to define a
“security-based swap” as any agreement, contract, or transaction that is a swap, as defined in
Section 1(a) of the Commodity Exchange Act, that is based on a narrow-based security index, or a
single security or loan, or any interest therein or on the value thereof, or the occurrence or nonoccurrence of an event relating to a single issuer of a security or the issuers of securities in a narrowbased security index, provided that such event directly affects the financial statements, financial
condition, or financial obligations of the issuer.
Investment Management Alert
However - unlike for most securities - the potential
for fraudulent or manipulative activity in connection
with a security-based swap can occur not only in
connection with an offer, purchase, or sale, but
throughout the life of the security-based swap. As
noted by the SEC in the Proposing Release, this is
because “[m]ost security-based swaps are
characterized by ongoing payments or deliveries
between the parties throughout the life of the
security-based swap.”4 The payments and deliveries
are typically linked to payment, price movements
and/or events of default on one or more underlying
securities. The SEC has expressed its concern that
the parties to a security-based swap may
consequently have incentives and opportunity to
engage in misconduct in connection with the
security-based swap (including in the “reference
underlying” of the security-based swap) to trigger,
avoid, or affect the value of such ongoing payments
or deliveries.5
Application to Proposed Rule 9j-1 to
Ongoing Payments and Deliveries
Congress appears to have attempted to address the
differences between most securities and securitybased swaps relating to the risk of fraud and
manipulation in the Dodd-Frank Act’s amendments
to Exchange Act Sections 3 and 9. The Dodd-Frank
Act expands the Section 3(a)(13) definition of
“purchase” and the Section 3(a)(14) definition of
“sale” to include, with respect to security-based
swaps, “the execution, termination (prior to its
scheduled maturity date), assignment, exchange, or
similar transfer or conveyance of, or extinguishing
of rights or obligations under, a security-based swap,
as the context may require.”6 Along with these
broadened definitions of “purchase” and “sale,” the
Dodd-Frank Act also expanded the anti-fraud and
anti-manipulation provisions of Exchange Act
Section 9 - in new Section 9(j) - to explicitly apply
to the “purchase or sale of” any security-based
swap.7
Despite these additions, the SEC’s proposed rule is
intended to make it clear that the anti-fraud and
anti-manipulation provisions of the Securities Act
and the Exchange Act apply to offers, purchases and
sales of security-based swaps as well as to ongoing
payments and deliveries under a security-based
swap. In the Proposing Release, the SEC states its
belief that its proposed rule, by explicitly addressing
misconduct during the entire life of a security-based
swap, offers a “measured and reasonable means” to
prevent fraud, manipulation, and deception in
connection with security-based swaps.
The Proposing Release indicates that the
misconduct covered by Proposed Rule 9j-1 will
include misconduct that affects the market value of
a security-based swap for purposes of posting
collateral or making ongoing payments or deliveries
under a security-based swap. The SEC
contemplates that such misconduct will include
false or misleading statements made in order to
avoid having to make a large payment, post
additional collateral or perform another obligation
under the security-based swap.
Prohibited Misconduct
The provisions of Proposed Rule 9j-1 that detail the
misconduct that is prohibited under the rule are
similar to existing prohibited misconduct provisions
under Exchange Act Rule 10b-5 and Securities Act
Section 17(a), but are drafted to reach a broader
range of misconduct.
As detailed in the SEC’s rule release, Proposed Rule
9j-1 would make it unlawful (in connection with
offers, purchases, sales, and ongoing payments and
deliveries with respect to security-based swaps) to
do the following:
“(a) To employ any device, scheme, or
artifice to defraud or manipulate.”
Proposed Rule 9j-1(a) mirrors the texts of
Exchange Act Rule 10b-5(a) and Securities
4
Proposing Release, 75 Fed. Reg. at 68561.
Proposing Release, 75 Fed. Reg. at 68562.
6
See Dodd-Frank Act Section 761(a)(3) and (a)(4).
7
See Dodd-Frank Act Section 763(g). New Exchange Act
Section 9(j) makes it unlawful for any person, directly or
indirectly, by the use of any means or instrumentality of
interstate commerce or of the mails, or of any facility of any
5
national securities exchange, to effect any transaction in, or to
induce or attempt to induce the purchase or sale of, any
security-based swap, in connection with which such person
engages in any fraudulent, deceptive, or manipulative act or
practice, makes any fictitious quotation, or engages in any
transaction, practice, or course of business which operates as
a fraud or deceit upon any person.
November 2010
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Investment Management Alert
Act Section 17(a)(1) - and, like them, would
require scienter to establish a violation.
But, in addition, paragraph (a) explicitly
adds the word “manipulation.” The word
“manipulation” is absent from the text of
Exchange Act Rule10b-5(a), but courts have
interpreted the Rule to also prohibit
manipulation. The SEC’s proposal
explicitly imports the interpretive inclusion
of “manipulation” into the proposed rule.
“(b) To knowingly or recklessly make any
untrue statement of a material fact, or to
knowingly or recklessly omit to state a
material fact necessary in order to make the
statements made, in the light of the
circumstances under which they were made,
not misleading.” Proposed Rule 9j-1(b)
mirrors Exchange Act Rule 10b-5(b), but,
by adding the words “knowingly” and
“recklessly,” makes explicit that scienter
would be required for a violation under
paragraph (b), which, as noted by the SEC
in its release, does not “represent a
departure from the past interpretation or
scope of Rule 10b-5(b).”8
“(c) To obtain money or property by means
of any untrue statement of a material fact or
any omission to state a material fact
necessary in order to make the statements
made, in light of the circumstances under
which they were made, not misleading.”
Proposed Rule 9j-1(c) - like paragraph (b)
of the proposed rule - deals with material
misstatements and omissions. But, unlike
paragraph (b) of the proposed rule,
paragraph (c) mirrors the text of Securities
Act Section 17(a)(2), and like Section
17(a)(2) would not require scienter to
establish a violation. Therefore, paragraph
(c) would extend farther than paragraph (b)
to reach misconduct that is at least
negligent.
“(d) To engage in any act, practice, or
course of business which operates or would
operate as a fraud or deceit upon any
person.” Proposed Rule 9j-1(d) mirrors the
prohibited conduct described in Securities
Act Section 17(a)(3), and like that section,
would not require scienter to establish a
violation.
Furthermore, the Proposing Release makes clear
that the conduct that would be prohibited by the
proposed rule is intended to extend not only to
fraud, manipulation, and deception involving a
security-based swap itself, but also to fraud,
manipulation, or deception in connection with a
securities-based swap agreement that involves the
“reference underlying” (for example, the referenced
security or referenced securities index) on which the
swap is based.
Conclusion
The SEC is seeking comment on Proposed
Exchange Act Rule 9j-1, which would implement
the SEC’s new anti-fraud and anti-manipulation
authority for security-based swaps by providing the
SEC with a new basis to impose liability for
prohibited misconduct on such instruments in
addition to its previously existing authority with
respect to securities generally.
It is noteworthy that the SEC has issued this
proposed rule during the same period that the
Commodity Futures Trading Commission (the
“CFTC”) is seeking comment on its separate and
distinct anti-manipulation rules for swaps, which
includes swaps that reference broad-based security
indices.9 The final form of both rules will be
important to all swap users, whether they deal in
swaps regulated by the CFTC or security-based
swaps regulated by the SEC, particularly to the
extent either agency ultimately relies on precedent
of the other agency in interpreting the application of
its own rule. For a discussion of the CFTC’s
proposed anti-manipulation rules, please see our
Alert entitled “ CFTC Proposes New Reporting
Regime for Swaps on Certain Physical
Commodities Pursuant to New Dodd-Frank
Provisions.”
9
8
Proposing Release, 75 Fed. Reg. at 68563.
Prohibition of Market Manipulation, 75 Fed. Reg. 67657
(November 3, 2010).
November 2010
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Investment Management Alert
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participants and public sector entities. For more information, visit www.klgates.com.
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©2010 K&L Gates LLP. All Rights Reserved.
November 2010
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