The seemingly intuitive application of long-standing securities anti-fraud and anti-manipulation rules to the complex world of over-the-counter derivatives, particularly where derivative products intersect with the loan market, will affect trading practices and compliance rules at all institutions trading these instruments, according to Richards Kibbe & Orbe partners Julia Lu and Eva Marie Carney…
Before The Dodd-Frank Wall Street Reform and Consumer Protection Act, loan credit default swaps (LCDS) and loan total return swaps (LTRS) were outside the ambit of each of the Commodity Exchange Act (CEA), the Securities Act of 1933, and the Securities Exchange Act of 1934 and the rules and regulations promulgated thereunder.
These derivatives products also were beyond the jurisdiction of the Commodity Futures Trading Commission and the Securities and Exchange Commission. The product design, trading and compliance frameworks for LCDS and LTRS were informed by this categorisation. When Dodd-Frank takes effect, the enhanced anti-fraud and anti-manipulation regimes applicable to the loan derivatives products will test these frameworks.
Under Dodd-Frank, over-the-counter derivatives transactions are categorised as ‘swaps’, ‘security-based swaps’ or ‘mixed swaps’. Swaps are subject to the provisions of the CEA and the jurisdiction of the CFTC, while security-based swaps are designated ‘securities’ within the meaning of the Securities Act and the Securities Exchange Act, and are subject to those federal securities laws and the jurisdiction of the SEC. Mixed swaps are subject to the jurisdiction of both regulatory agencies.
When Dodd-Frank takes effect, single-name LCDS and LTRS will be security-based swaps, and therefore securities, and become subject to the plenary jurisdiction of the SEC. Index LCDS products will be swaps subject to the CFTC’s jurisdiction and a regulatory regime that differs from the SEC’s.
Anti-fraud and anti-manipulation regulations
Dodd-Frank went beyond these definitional changes and inserted in the CEA and the Securities Exchange Act robust anti-fraud and anti-manipulation provisions in respect of swaps and security-based swaps respectively. It further directed the two agencies to promulgate implementing rules.
Section 753 of Dodd-Frank amends Section 6(c) of the CEA to give the CFTC enhanced anti-manipulation and anti-deception authority with respect to swaps. The CFTC has responded with new Part 180. Modelled after Section 10(b) of, and Rule 10b-5 under the Securities Exchange Act, proposed § 180.1 prohibits, among other conduct, making or attempting to make “any untrue or misleading statement of a material fact or to omit to state a material fact necessary in order to make the statement made not untrue or misleading”. Notably, the “attempt” language that is part of Section 753 and that the CFTC carried over into its implementing rule is not found in either Section 10(b) or Rule 10b-5, but is common to other statutory provisions of the CEA.
Security-based swaps likewise were made subject to enhanced Securities Exchange Act anti-fraud and anti-manipulation provisions. Section 763(g) of the Dodd-Frank Act adds a new sub-paragraph (j) to Section 9 of the Securities Exchange Act aimed specifically at security-based swaps. The SEC has proposed Rule 9j-1 in response, which would apply to offers, purchase and sales of security-based swaps, just as the general anti-fraud and anti-manipulation provisions apply to all securities, but would also expressly apply to the cash flows, payments, deliveries and other ongoing obligations and rights that are specific to security-based swaps.
There are appreciable differences between the rules proposed by the two regulatory agencies. It is difficult to determine whether, as currently proposed, the anti-fraud and anti-manipulation provisions applicable to security-based swaps are more or less robust than those applicable to swaps.
On one hand, the CFTC-proposed § 180.1 expressly addresses “attempted” deception and manipulation, while attempted misconduct is not expressly addressed in Section 10(b) or Rule 10b-5 or proposed Rule 9j-1. Nonetheless, new Section 9(j) of the Securities Exchange Act, under which Rule 9j-1 is promulgated, does expressly reference conduct that induces or attempts to induce the purchase or sale of any security-based swap, in connection with which a fraudulent, deceptive, or manipulative act or practice is undertaken.
On the other hand, the SEC-proposed Rule 9j-1 expressly seeks to regulate conduct subsequent to the offer, purchase or sale of a security-based swap. Conduct in connection with the exercise of any right and the performance of any obligation under a security-based swap, and conduct that avoids such exercise or performance would also be covered. As such, proposed Rule 9j-1 could be implicated after the relevant transaction has occurred and throughout the life of a security-based swap.
By contrast, the CFTC-proposed § 180.1 applies to conduct “in connection with any swap”. This broad language may reach the same conduct as would SEC-proposed Rule 9j-1, since § 180.1 has no stated limitations – in other words, it is not limited to conduct in connection with an offer, purchase or sale of any swap.
While Congress borrowed much of Section 753’s language from Section 10(b) of the Securities Exchange Act (which includes the express limiter “in connection with the purchase or sale of a security”), Congress did not import those limiters into Section 753 and neither did the CFTC when proposing its § 180.1. Nonetheless, while it appears that § 180.1, if read literally, would reach conduct subsequent to the offer, purchase or sale of a swap, that reach is not explicitly stated.
In addition, the SEC-proposed Rule 9j-1 has multiple parts, certain of which can be violated only by an actor with scienter (knowing or reckless conduct) and others of which call for a less culpable state of mind (at least negligence). The CFTC-proposed § 180.1, in contrast, makes unlawful only intentional or reckless misconduct. As a result, it appears that less culpable conduct in connection with security-based swap activity would result in liability but that same level of misconduct in connection with a swap would not.
The differing regulatory schemes applicable to LCDS and LTRS will result in very practical consequences to market participants that trade these derivatives products.
“Disclose or abstain”
For each of LCDS, LTRS and their index and basket products, anti-fraud and anti-manipulation provisions at least as stringent and expansive as Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder now apply. A derivatives trader in possession of material non-public information is obligated to disclose that information or abstain from trading.
Since the reference obligations are loans, not securities, the loan derivatives products were designed around the information disclosure regime of the loan market, a regime that relies on a “big boy” or contractual disclaimer of liability framework described in the best practices and trading advisories published by the Loan Syndications and Trading Association.
Under Dodd-Frank, reliance on the “big boy” or contractual disclaimer framework may no longer be a viable option for addressing potential information disparities between trading parties pre-trade. This presents a significant issue in the loan derivatives market, which does not have the type of infrastructure permitting and regulating information flow between the borrower and the market participants on which the securities markets are premised.
The “disclose or abstain” requirement embodied in Section 10(b) and Rule 10b-5 jurisprudence is difficult to apply in the context of ongoing exercise of rights and performance of obligations during the life of a security-based swap.
Arguably, a counterparty does not “use” material non-public information if mere possession of the information does not cause an act or decision that differs from an act or decision that would have occurred without the information. On the other hand, can a counterparty in possession of material non-public information sit in silence while the other party acts without the benefit of such information? Would it matter whether the knowing party has previously made a statement, even though unrelated to the exercise of rights or performance of obligations, which would be untrue or misleading without a refreshed statement? These questions were not addressed in the proposed rulemaking.
Adding to the uncertainty, it is not easy to determine what information should be characterised as material non-public information, particularly in the context of an LCDS or LTRS transaction and the exercise of related rights and performance of obligations. The SEC and the federal courts have deemed information material when (1) there is a “substantial likelihood” that a “reasonable investor” would consider the information important in making an investment decision; (2) public disclosure of the information would be “viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available”; or (3) public disclosure of the information would be “reasonably certain to have a substantial effect on the market price of the security”. As this general guidance suggests, the determination of materiality is always a fact-specific inquiry.
The existing materiality tests are hard to apply to the exercise of rights or performance of obligations under a swap. For example, since there is no investment decision to be made during the life of the swap, in connection with what must the “reasonable investor” consider the information important?
Materiality is even more difficult to assess in connection with index products. Information that is material to a single loan, or to a single-name LCDS based on that loan, may not be “material” to the index affected single-name LCDS represents a small component of the whole. A tranched or other correlation product such as an “Nth to default” swap poses its own analytic challenges, because whether or not information about a single loan is material to the swap often turns on the terms of the swap and is to be considered in light of the historical and expected defaults, as well as their correlation, relevant to the swap.
The seemingly intuitive application of long-standing securities rules to the complex world of over-the-counter derivatives, particularly where the derivative products intersect with the loan market, will affect trading practices and compliance rules at all institutions that trade these instruments.
Given the negative impact of even a claim that one engaged in deception or manipulation, participants in the derivatives markets will need to consider with care the impact of these new regimes, and exercise abundant caution in redesigning trading platforms and structuring transactions for LCDS, LTRS and the related index and baskets.
Julia Lu and Eva Marie Carney are partners in Richards Kibbe & Orbe’s New York and Washington, DC offices respectively. This article was first published in Derivatives Week.
