Prohibition Against Fraud, Manipulation, or Deception in Connection With Security-Based Swaps; Prohibition Against Undue Influence Over Chief Compliance Officers, 42546-42585 [2023-12592]

Download as PDF 42546 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34–97656; File No. S7–32–10] RIN 3235–AK77 Prohibition Against Fraud, Manipulation, or Deception in Connection With Security-Based Swaps; Prohibition Against Undue Influence Over Chief Compliance Officers Securities and Exchange Commission. ACTION: Final rule. AGENCY: The Securities and Exchange Commission (‘‘SEC’’ or ‘‘Commission’’) is adopting a final rule, under the Securities Exchange Act of 1934 (‘‘Exchange Act’’), that is designed to prevent fraud, manipulation, and deception in connection with effecting any transaction in, or attempting to effect any transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. The rule takes into account the features fundamental to a security-based swap and the broad definitions of purchase and sale under the Exchange Act as they relate to security-based swaps. In addition, the Commission is adopting a final rule, under the Exchange Act, that makes it unlawful for any officer, director, supervised person, or employee of a security-based swap dealer (‘‘SBSD’’) or major security-based swap participant (‘‘MSBSP’’) (each SBSD and each MSBSP also referred to as an ‘‘SBS Entity’’ and together referred to as ‘‘SBS Entities’’), or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the SBS Entity’s chief compliance officer (‘‘CCO’’) in the performance of their duties under the Federal securities laws or the rules and regulations thereunder. DATES: Effective date: August 29, 2023. FOR FURTHER INFORMATION CONTACT: Pamela Carmody, Special Counsel, Rajal B. Patel, Senior Special Counsel, or Carol M. McGee, Associate Director, at (202) 551–5870, Office of Derivatives Policy, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–8010. SUPPLEMENTARY INFORMATION: First, the Commission is adopting 17 CFR 240.9j– 1 (‘‘Rule 9j–1’’) under the Exchange Act, which is a new rule designed to prevent fraud, manipulation, and deception in ddrumheller on DSK120RN23PROD with RULES2 SUMMARY: VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 connection with effecting transactions in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. The Commission is also adopting 17 CFR 240.15fh–4(c) (‘‘Rule 15fh–4(c)’’) under the Exchange Act, which is a new rule making it unlawful for any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the SBS Entity’s CCO in the performance of their duties under the Federal securities laws or the rules and regulations thereunder. I. Introduction A. Background B. Overview of Security-Based Swaps 1. Security-Based Swaps Generally 2. Security-Based Swap Market Developments C. Overview of the Final Rules 1. Rule 9j–1 2. Rule 15fh–4(c) II. Rule 9j–1: Prohibition Against Fraud, Manipulation, and Deception in Connection With Security-Based Swaps A. Misconduct ‘‘In Connection With’’ ‘‘Purchases,’’ ‘‘Sales,’’ or ‘‘Effecting Transactions’’ 1. Proposed Approach 2. Commission Action a. In Connection With b. Purchases or Sales c. Effecting Transactions B. Fraudulent, Manipulative, or Deceptive Conduct 1. Proposed Approach 2. Commission Action a. Scienter and Negligence Standards b. Attempted Conduct C. Prohibition on Price Manipulation 1. Proposed Approach 2. Commission Action D. Liability Under Rules 9j–1(b) and (c) 1. Proposed Approach 2. Commission Action a. Rule 9j–1(b) b. Rule 9j–1(c) E. Safe Harbors and Affirmative Defenses 1. Proposed Approach 2. Commission Action a. Affirmative Defense: Binding Contractual Obligations b. Affirmative Defense: Policies and Procedures c. Proposed Safe Harbor: Compression d. Other Requested Safe Harbors and Affirmative Defenses III. Rule 15fh–4(c): Preventing Undue Influence Over Chief Compliance Officers; Policies and Procedures Regarding Compliance With Rule 9j–1 and Rule 15fh–4(c) A. Proposed Approach B. Commission Action IV. Paperwork Reduction Act V. Economic Analysis A. Introduction B. Broad Economic Considerations C. Baseline PO 00000 Frm 00002 Fmt 4701 Sfmt 4700 1. Existing Regulatory Frameworks 2. Security-Based Swap Data, Market Participants, Dealing Structures, and Levels of Security-Based Swap Trading Activity D. Benefits and Costs of Rule 9j–1 1. Benefits 2. Costs E. Benefits and Costs of Rule 15fh–4(c) 1. Benefits 2. Costs F. Effects on Efficiency, Competition, and Capital Formation 1. Competition 2. Efficiency 3. Capital Formation G. Reasonable Alternatives 1. Narrow the Scope of Rule 9j–1 2. Safe Harbors a. Safe Harbor for Hedging Exposure Arising Out of Lending Activities b. Safe Harbors for Lender Disclosure, Centralized Market Activities, and Legitimate Restructurings c. Safe Harbor for Publicly Executed Strategies d. Elimination of All Safe Harbors and Affirmative Defenses 3. Implementing a More Prescriptive Approach in Rule 9j–1 4. Separate Rules for CDS and Equity Security-Based Swaps 5. Exclude Underlying Securities 6. Limit Activities Prohibited Under Rule 15fh–4(c) VI. Regulatory Flexibility Act Certification VII. Other Matters Statutory Authority I. Introduction A. Background Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘Dodd-Frank Act’’) 1 provided the Commission with primary responsibility for regulating security-based swaps. A person who satisfies the definitions of ‘‘security-based swap dealer’’ or ‘‘major security-based swap participant’’ is required to register with the Commission in such capacity and is therefore subject to the Commission’s regime regarding, among other things, internal supervision requirements and the requirement to designate an individual to serve as the CCO.2 In addition to other requirements, the CCO must take reasonable steps to ensure that the SBS Entity establishes, maintains, and reviews written policies 1 Wall Street Transparency and Accountability Act of 2010, Public Law 111–203, sections 761–774, 124 Stat. 1376, 1754–1802 (2010). Unless otherwise indicated, references to ‘‘Title VII’’ in this release are to subtitle B of title VII of the Dodd-Frank Act. 2 See, e.g., 17 CFR 240.3a71–1 (Definition of ‘‘security-based swap dealer’’); 17 CFR 240.3a71–2 (De minimis exception for SBSD registration); 17 CFR 240.3a67–1 (Definition of ‘‘major securitybased swap participant’’); 17 CFR 240.15Fb2–1 (Registration of SBSDs and MSBSPs); 17 CFR 240.15Fh–3 (Business conduct requirements for SBSDs and MSBSPs). E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 and procedures reasonably designed to achieve compliance with the Exchange Act and the rules and regulations thereunder relating to its business as an SBS Entity.3 The Dodd-Frank Act also amended the Exchange Act in a number of important ways to prohibit fraud, manipulation, and deception in connection with security-based swaps. In particular, section 763(g) of the DoddFrank Act expanded the antimanipulation provisions of section 9 of the Exchange Act to encompass purchases or sales of security-based swaps and requires the Commission to adopt rules to prevent fraud, manipulation, and deception in connection with security-based swaps.4 Specifically, paragraph (j) of section 9 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 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.’’ 5 It also provides that the Commission ‘‘shall . . . by rules and regulations define, and prescribe means reasonably designed to prevent, such transactions, acts, practices, and courses of business as are fraudulent, deceptive, or manipulative, and such quotations as are fictitious.’’ 6 Additionally, section 761 of the DoddFrank Act modified several definitions in both the Exchange Act and the Securities Act of 1933 (‘‘Securities Act’’) to account for security-based swaps.7 For example, the Dodd-Frank Act amended the definition of ‘‘security’’ in section 3(a)(10) of the Exchange Act 8 and section 2(a)(1) of the Securities Act 9 to include security-based swaps. As a result, security-based swaps, because they are securities, are subject to the general antifraud and anti3 See 17 CFR 240.15Fk–1; Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants, Exchange Act Release No. 77617 (Apr. 14, 2016), 81 FR 29960 (May 13, 2016) (‘‘Business Conduct Standards Adopting Release’’). 4 See 15 U.S.C. 78i(j). 5 See id. Note that section 9 of the Exchange Act erroneously contains two subsection (j)s. 6 See id. 7 Section 3(a)(68) of the Exchange Act defines ‘‘security-based swap.’’ 15 U.S.C. 78c(a)(68). 8 15 U.S.C. 78c(a)(10). 9 15 U.S.C. 77b(a)(1). VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 manipulation provisions of the Federal securities laws, including sections 9(a) and 10(b) of the Exchange Act, and 17 CFR 240.10b–5 (‘‘Rule 10b–5’’) thereunder,10 and section 17(a) of the Securities Act.11 Moreover, the Dodd-Frank Act amended the definitions of ‘‘purchase’’ and ‘‘sale’’ in section 2(a)(18) of the Securities Act,12 the definitions of ‘‘buy’’ and ‘‘purchase’’ in section 3(a)(13) of the Exchange Act,13 and ‘‘sale’’ and ‘‘sell’’ in section 3(a)(14) of the Exchange Act,14 in the context of security-based swaps, to include 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. As a result of those changes, misconduct in connection with these actions is also prohibited under sections 9 and 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act. On December 15, 2021, the Commission re-proposed antifraud and anti-manipulation rules,15 as required by section 9(j) of the Exchange Act. The re-proposal followed the Commission’s adoption of much of its Title VII rulemaking related to security-based swaps,16 as well as developments in the 10 15 U.S.C. 78j(b). U.S.C. 77q(a). 12 15 U.S.C. 77b(a)(18). 13 15 U.S.C. 78c(a)(13). 14 15 U.S.C. 78c(a)(14). 15 See Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition against Undue Influence over Chief Compliance Officers; Position Reporting of Large Security-Based Swap Positions, Exchange Act Release No. 93784 (Dec. 15, 2021), 87 FR 6652 (Feb. 4, 2022) (‘‘2021 Proposing Release’’). See also Prohibition Against Fraud, Manipulation, and Deception in Connection with Security-Based Swaps, Exchange Act Release No. 63236 (Nov. 3, 2010), 75 FR 68560 (Nov. 8, 2010) (‘‘2010 Rule 9j– 1 Proposing Release’’). For purposes of this release, we will refer to the version of Rule 9j–1 that the Commission proposed in the 2010 Rule 9j–1 Proposing Release as the ‘‘2010 Proposed Rule.’’ We will refer to re-proposed Rule 9j–1 as ‘‘proposed rule’’ or ‘‘re-proposed Rule 9j–1’’and to final Rule 9j–1 as ‘‘Rule 9j–1,’’ ‘‘final rule,’’ or ‘‘final Rule 9j– 1.’’ 16 As more fully described in the 2021 Proposing Release, the Commission has now completed a majority of its rulemaking under Title VII, SBS Entities are required to register with the Commission (as of June 7, 2023, there are 50 conditionally registered security-based swap dealers), and all persons are required to report their security-based swap transactions to security-based swap data repositories. See 2021 Proposing Release, 87 FR at 6653 nn.2–4 and accompanying text. Further, since 2010, regulators overseeing the world’s primary over-the-counter (‘‘OTC’’) derivatives markets have made significant progress implementing reforms for OTC derivatives and the Commodity Futures Trading Commission (‘‘CFTC’’) has largely completed its Title VII rulemakings 11 15 PO 00000 Frm 00003 Fmt 4701 Sfmt 4700 42547 security-based swap market, including manufactured credit events or other opportunistic strategies in the credit default swap (‘‘CDS’’) market, as discussed in section I.B below.17 In addition, in recognition of the fact that CCOs of SBS Entities play an important role in preventing fraud and manipulation by SBS Entities and their personnel, the Commission proposed an additional measure under section 15F(h) of the Exchange Act 18 to protect CCOs in the furtherance of those duties.19 The Commission is adopting Rule 9j–1 with modifications in response to commenters,20 and adopting Rule 15fh– 4(c) as proposed.21 In developing this rulemaking we have consulted and related to swaps, including the adoption of antifraud and anti-manipulation rules. See 2021 Proposing Release, 87 FR at 6654–55, 6654 n.19. 17 See infra section I.B.2, describing in more detail manufactured credit events and other opportunistic strategies in the CDS market. See also 2021 Proposing Release, 87 FR at 6654–55. Additionally, in section II.C.2, infra, the Commission addresses concerns raised by commenters with regard to the application of Rule 9j–1 to legitimate credit activity or other activity in connection with security-based swap transactions, some of which may fit the descriptions of the manufactured credit events and other opportunistic strategies described in the 2021 Proposing Release. 18 See 15 U.S.C. 78o–10(h). 19 See 2021 Proposing Release, 87 FR at 6664–65. To be clear, the ultimate responsibility for compliance by the SBS Entity with the Federal securities laws, including the requirement to have adequate compliance systems and to avoid violations generally, rests with the SBS Entity itself. 20 The comment letters are available at https:// www.sec.gov/comments/s7-32-10/s73210.shtml. The Commission also received comments on topics outside the scope of the proposal that are not addressed in this release. See, e.g., Comment from Anonymous, dated Feb. 6, 2022, available at https:// www.sec.gov/comments/s7-32-10/s73210-20114041266299.htm (discussing dark pools); Comment from Anonymous, dated Dec. 16, 2021, available at https://www.sec.gov/comments/s7-32-10/s7321020109790-264127.htm (discussing securities lending). 21 As described in greater detail below, the Commission is making several changes to proposed Rule 9j–1 and adopting Rule 15fh–4(c) as proposed. First, the Commission is revising paragraph (a) to more closely track the language of section 9(j) of the Exchange Act with regard to the conduct subject to the prohibitions of final Rule 9j–1(a), moving the prohibitions on attempted conduct from paragraphs (a)(3) and (a)(4) to a new paragraph (a)(5), and clarifying that the Commission believes scienter is the proper standard to apply to violations of paragraph (a)(5). See infra sections II.A and II.B. In addition, the Commission is moving paragraph (b) of proposed Rule 9j–1 to a new paragraph (a)(6) to rely on the scope of conduct subject to the prohibitions of paragraph (a). See infra section II.C. Finally, the Commission is adopting two affirmative defenses to violations of Rule 9j–1, one for actions taken in connection with binding rights and obligations under security-based swap documentation and one for appropriate policies and procedures to ensure compliance with Rule 9j–1 such as restrictions on access to material nonpublic information. See infra sections II.E.2.a and II.E.2.b. The Commission is not adopting the proposed safe harbor for portfolio compression exercises. See infra section II.E.2.c. E:\FR\FM\30JNR2.SGM 30JNR2 42548 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations coordinated with the CFTC and the prudential regulators in accordance with section 712(a)(2) of the Dodd-Frank Act.22 Nothing in Rule 9j–1 alters the application of sections 9(a) and 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act, including to misconduct that is in connection with the exercise of any right or performance of any obligation under the security-based swap. The Commission also proposed for comment a new Rule 10B–1,23 which would require any person with a security-based swap position that exceeds a certain threshold to promptly file with the Commission a schedule disclosing certain information related to its security-based swap positions. The Commission is not finalizing Rule 10B– 1 in this release as it continues to consider comments received in connection with proposed Rule 10B–1. B. Overview of Security-Based Swaps ddrumheller on DSK120RN23PROD with RULES2 1. Security-Based Swaps Generally Although the definition of securitybased swap is detailed and comprehensive,24 at its most basic level, a security-based swap is an agreement, contract, or transaction in which two parties agree to the exchange of payments or cash flows based upon the value of other assets or upon the occurrence or non-occurrence of some event, including, for example, a change in a stock price or the occurrence of some type of credit event.25 The 22 In addition, in accordance with section 752 of the Dodd-Frank Act, the Commission has consulted and coordinated with foreign regulatory authorities through Commission staff participation in numerous bilateral and multilateral discussions with foreign regulatory authorities addressing the regulation of OTC derivatives markets. 23 See 2021 Proposing Release, 87 FR at 6667–76. 24 See 15 U.S.C. 78c(a)(68) (defining ‘‘securitybased swap’’). See also Further Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and ‘‘SecurityBased Swap Agreement’’; Mixed Swaps; SecurityBased Swap Agreement Recordkeeping, Exchange Act Release No. 67453 (July 18, 2012), 77 FR 48208, 48211 (Aug. 13, 2012) (‘‘Product Definitions Release’’) (further defining certain terms related to the definition of ‘‘security-based swap’’). 25 See generally section 3(a)(68) of the Exchange Act, which defines 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 instruments, financial condition, or financial obligations of the issuer. 15 U.S.C. 78c(a)(68). See also 2010 Rule 9j–1 Proposing Release, 75 FR at 68561 (generally discussing the definition of ‘‘security-based swap’’). This section also discusses examples of security-based swaps and the exchange of payments or deliveries, or the purchase or sale or other payments upon the VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 exchange of these payments or deliveries, including purchases or sales upon certain events, is a fundamental aspect or feature of a security-based swap.26 Moreover, this feature of security-based swaps is in contrast to secondary market transactions involving equity or debt securities where the completion of a purchase or sale transaction terminates the mutual obligations of the parties. Security-based swap counterparties, who are considered the issuers of the securitybased swaps, continue to have obligations to one another throughout the life of the instrument, which can extend for years if not decades.27 Parties may enter into a securitybased swap for a multitude of reasons, but often, the parties to the contract seek to gain exposure to an asset without owning it or to manage or transfer risks in their asset and liability portfolios (e.g., credit or equity risks). Typical participants in the security-based swap market include, among others, lenders transferring credit risk,28 insurance companies managing asset and liability risk specific to the insurance industry,29 activists or hedge funds obtaining exposure to the price movement and dividend payments of a stock without the costs and burdens of stock ownership,30 and financial institutions that engage in market-making and occurrence of a specific event, between the parties during the life of a security-based swap. 26 The definition of security-based swap requires that the instrument first meet the definition of swap in section 1a(47) of the Commodity Exchange Act. See 15 U.S.C. 78c(a)(68); supra note 25. That definition provides, inter alia, that a swap is an agreement, contract, or transaction that provides for any purchase, sale, payment, or delivery upon the occurrence or nonoccurrence of certain events or that provides on an executory basis for an exchange on a fixed or contingent basis, of one or more payments that meet certain conditions. See 7 U.S.C. 1a(47)(ii) and (iii). 27 See Further Definition of ‘‘Swap Dealer,’’ ‘‘Security-Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ ‘‘Major Security-Based Swap Participant’’ and ‘‘Eligible Contract Participant,’’ Exchange Act Release No. 66868 (Apr. 27, 2012), 77 FR 30596, 30616–17 (May 23, 2012) (‘‘In contrast to a secondary market transaction involving equity or debt securities, in which the completion of a purchase or sale transaction can be expected to terminate the mutual obligations of the parties to the transaction, the parties to a security-based swap often will have an ongoing obligation to exchange cash flows over the life of the agreement.’’). 28 See, e.g., Letter from Elliot Ganz, Loan Syndications and Trading Association (‘‘LSTA’’), dated Mar. 17, 2022 (‘‘LSTA Letter’’), at 2–3. 29 See Letter from Michael Lovendusky, American Council of Life Insurers (‘‘ACLI’’), dated Mar. 21, 2022 (‘‘ACLI Letter’’). 30 See Letter from Richard B. Zabel, Elliott Investment Management L.P., dated Mar. 21, 2022 (addressing concerns related to proposed Rule 10B– 1 but also describing the security-based swap activity of activists and hedge funds). PO 00000 Frm 00004 Fmt 4701 Sfmt 4700 dealing in security-based swaps.31 The terms of the contract between the counterparties determine the specific rights and obligations of the parties throughout the life of the security-based swap, including, for example, the amount and timing of periodic payments due under the instrument, the maturity of the instrument, and terms of settlement. Counterparties to a securitybased swap typically use a standardized agreement published by ISDA, first in 1992 and updated in 2002, which is the most widely used contract setting forth the terms of security-based swap transactions (the ‘‘ISDA Master Agreement’’). Unlike other types of securities where settlement occurs when the buyer receives the security purchased and the seller receives cash equaling the value of the security sold, for security-based swaps, a final net payment is paid by one party to the other at a future point in time to which the parties have contractually agreed.32 Two common examples of securitybased swaps—credit default swaps (‘‘CDS’’) and total return swaps (‘‘TRS’’)—are described in more detail below.33 Generally, a CDS is a contract in which a party (the ‘‘protection buyer’’), such as a lender, agrees to make periodic payments (the ‘‘premium’’) over an agreed upon time period to another party (the ‘‘protection seller’’) in exchange for a payment from the protection seller in the event of default by an issuer (or group of issuers) of securities (the ‘‘reference entity’’).34 The 31 See Letter from Bridget Polichene, Institute of International Bankers (‘‘IIB’’), Scott O’Malia, International Swaps and Derivatives Association (‘‘ISDA’’), and Kenneth E. Bensten, Jr., Securities Industry and Financial Markets Association (‘‘SIFMA’’), dated Mar. 21, 2022 (‘‘IIB–ISDA– SIFMA Letter’’). 32 See, e.g., Shortening the Securities Transaction Settlement Cycle, Exchange Act Release No. 96939 (Feb. 15, 2023), 88 FR 13872, 13878 (Mar. 6, 2023) (‘‘T+1 Adopting Release’’) (citing letter from Thomas Price, Managing Director, and Lindsey Weber Keljo, Head—Asset Management Group, Securities Industry and Financial Markets Association re: File No. S7–05–22 (Apr. 13, 2022), at 11). 33 The definition of security-based swap in the Exchange Act and the rules thereunder is broad. See supra notes 25–26 and related discussion. The application of the rules we adopt in this document is not limited to CDS and TRS or to transactions between particular types of counterparties. 34 A CDS generally falls within the second prong of the definition of a swap under section 1(a) of the Commodity Exchange Act as a contract ‘‘that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.’’ See 7 U.S.C. 1a(47)(a)(ii). If the CDS falls within any of the prongs of the definition of security-based swap in Exchange Act section 3(a)(68)(A)(ii), the E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 CDS contract states whether the CDS is settled physically or in cash in the event of default by the reference entity. Generally, the protection buyer is using the CDS to manage risk and the protection seller is using the CDS to take on risk in return for a premium. A cashsettled CDS contract relying on ISDA documentation is subject to determinations by a committee with respect to whether a defined default event (a ‘‘credit event’’) has occurred and, if so, to hold an auction to determine the settlement price of the CDS. The auction process includes the determination and publication of a list of deliverable obligations that a CDS protection buyer can deliver to the CDS protection seller after the auction settlement. A CDS protection buyer can deliver any of the obligations on the list, with delivery of the cheapest deliverable obligation maximizing recovery.35 This feature of CDS contracts is an aspect of some of the manufactured or opportunistic strategies discussed in section I.B.2. In contrast, a TRS may obligate one of the parties (i.e., the total return payer) to transfer the total economic performance (e.g., income from interest and fees, gains or losses from market movements, and credit losses) of a reference asset (e.g., a debt or equity CDS would be a security-based swap. See Product Definitions Release, 77 FR at 48267, and the broader discussion of CDS therein. 35 See 2021 Proposing Release, 87 FR at 6655 n.23. As described in the 2021 Proposing Release, in order to cash settle any CDS contract that relies on the ISDA standard documentation, a Credit Derivatives Determinations Committee (‘‘DC’’) must make a determination that a credit event occurred and vote to hold an auction to determine the settlement price of the CDS. A DC is generally composed of nine or ten dealers and five buy-side members. Once a DC determines that a credit event has occurred and that an auction should be held, the DC Secretary publishes auction terms, which include a list of obligations that a CDS protection buyer can deliver to the CDS protection seller after the auction settlement (each a ‘‘deliverable obligation’’). Each auction consists of two parts: (1) the first part of the auction, which involves submission of physical settlement requests by participating dealers, aims at determining the initial market mid-point, the net open interests, and adjustment amounts; and (2) the second part of the auction consists of calculating the final settlement price. As noted, protection buyers are incentivized to deliver into the auction the cheapest deliverable obligation, as it maximizes their recovery; as a result, the value of this ‘‘cheapest to deliver’’ deliverable obligation drives the final settlement price. See Markit and Creditex Credit Event Auction Primer, 1 (Feb. 2010), available at https:// www.creditfixings.com/information/affiliations/ fixings/auctions/docs/credit_event_auction_ primer.pdf. See also Credit Suisse, A Guide to Credit Events and Auctions, 5 (Jan. 11, 2012), available at https://doc.researchandanalytics.csfb.com/docView?language= ENG&source=emfromsendlink&format= PDF&document_id=803733390&serialid= FWHCx3yCrSE3FoEvAbEKa6fRKhqLoKs0j L1gR5W2Dfs%3D. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 security) (the ‘‘reference underlying’’), in exchange for a specified or fixed or floating cash flow (including payments for any principal losses on the reference asset) from the other party (i.e., the total return receiver).36 If the TRS is negotiated over-the-counter, the terms of the TRS can be individually negotiated and could include one payment at the expiration of the TRS or might include a series of payments on periodic interim settlement dates over the tenor of the TRS. For TRS with periodic interim settlement dates counterparties could agree to reset the price of the reference underlying on the periodic interim settlement date based on current market prices of the reference underlying (‘‘reference price’’). Accordingly, throughout the life of a TRS, depending on the terms of the TRS, the reference price that determines that payment on periodic interim settlement dates might be reset based on current market prices of the reference underlying. 2. Security-Based Swap Market Developments In 2010, following the 2008 financial crisis, Congress enacted the Dodd-Frank Act ‘‘to promote the financial stability of the United States by improving accountability and transparency in the financial system.’’ 37 Title VII of the Dodd-Frank Act addressed significant issues and risks in the swap and security-based swap markets, which had experienced dramatic growth leading up to the 2008 financial crisis and were shown to be capable of affecting significant sectors of the U.S. economy.38 In testimony before Congress introducing the first draft of the Dodd-Frank Act, Treasury Secretary Timothy Geithner highlighted the risks posed by an unregulated OTC derivatives market, which had been operating without the ‘‘basic protections and oversight’’ existing in the rest of the financial systems, including a ‘‘limited ability to police fraud and 36 See 2010 Rule 9j–1 Proposing Release, 75 FR at 68562. See also infra section V.B, discussing broad economic considerations of security-based swaps and specifically TRS. 37 Dodd-Frank Act, Public Law 111–203, Preamble. See also Business Conduct Standards Adopting Release, 81 FR at 29961. 38 Business Conduct Standards Adopting Release, 81 FR at 29961. See also Cross-Border SecurityBased Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Exchange Act Release No. 69490 (May 1, 2013), 78 FR 30967, 30980 (May 23, 2013) (‘‘Cross-Border Release’’) (discussing the spillover and contagion effects arising from security-based swap transactions in the context of American International Group, Inc., and its subsidiary AIG Financial Products Corp.). PO 00000 Frm 00005 Fmt 4701 Sfmt 4700 42549 manipulation.’’ 39 In his written testimony, Secretary Geithner listed four broad objectives of the proposed reforms which were eventually enacted as Title VII of the Dodd-Frank Act: (1) preventing activities in the OTC derivatives markets from posing risk to the stability of the financial system; (2) promoting efficiency and transparency of the OTC derivatives markets; (3) preventing market manipulation, fraud, and other abuses; and (4) protecting consumers and investors by ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.40 Secretary Geithner also stressed that the CFTC and the SEC should be provided with strong authority for civil enforcement and regulation of fraud, market manipulation, and other abuses in the OTC derivative markets.41 The authority enacted in Title VII of the Dodd-Frank Act includes, but is not limited to, Exchange Act section 9(j). Ensuring that the Commission has the necessary tools to police the security-based swap markets is a key component to ensure that Title VII’s reforms are not undermined. The security-based swap market remains large. Based on information reported pursuant to 17 CFR 242.900 to 242.909 (‘‘Regulation SBSR’’), as of November 25, 2022, the gross notional amount outstanding in the securitybased swap market is approximately $8.5 trillion across the credit, equity, and interest rate asset classes.42 The credit security-based swap asset class is large, with a gross notional amount of approximately $4.7 trillion, of which single-name CDS (including corporate and sovereign) account for the largest category at $4.3 trillion.43 Additionally, as indicated by data submitted pursuant to Regulation SBSR, the size of the equity security-based swap market is also significant—with approximately $3.6 trillion of equity security-based swaps outstanding as of November 25, 2022.44 In general, the ongoing payments of a security-based swap depend, in part, on 39 Senate Hearing on Over the Counter Derivatives Reform and Addressing Systemic Risks, S. Hrg. 1111–803 (Dec. 2, 2009), available at https:// www.govinfo.gov/content/pkg/CHRG111shrg62722/pdf/CHRG-111shrg62722.pdf. 40 Id. (including testimony noting that enacted reforms will result in ‘‘very consequential changes’’ to OTC derivatives markets). 41 Id. 42 See Report on Security-Based Swaps, Mar. 20, 2023, available at https://www.sec.gov/files/reportsecurity-based-swaps-032023.pdf (‘‘SBS Report’’). For further discussion of the Regulation SBSR data, see infra section V.C.2. 43 See id. 44 See id. E:\FR\FM\30JNR2.SGM 30JNR2 42550 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations its gross notional amount outstanding.45 The particular aspects and characteristics of security-based swaps (described above in section I.B.1) provide opportunities and incentives for misconduct. In general, parties to a security-based swap may engage in misconduct in connection with the security-based swap (including in the reference underlying of such securitybased swap) to trigger, avoid, or affect the value of ongoing payments or deliveries. For instance, a party faced with significant risk exposure may engage or attempt to engage in manipulative or deceptive conduct that increases or decreases the value of payments or cash flow under a securitybased swap relative to the value of the reference underlying, including the price or value of a deliverable obligation under a security-based swap. Moreover, fraud and manipulation in connection with a security-based swap can affect not just a direct counterparty, but also counterparties to that counterparty. For example, if fraud or manipulation leads to a large change in variation margin, the defrauded counterparty could default on its obligations to its other counterparties. In addition, other counterparties to the same securitybased swaps could be affected by fraud or manipulation that affects the reference underlying assets, as could investors in those underlying assets. Given the global and interconnected nature of the security-based swap markets, it is critical that the Commission has appropriate tools to fight fraud and manipulation in these markets.46 Recent developments in the security-based swap market highlight these concerns. For example, in the 2021 Proposing Release, the Commission discussed certain manufactured or other opportunistic CDS strategies that had been reported by academics and the press: 47 • A CDS buyer working with a reference entity to create an artificial, technical, or temporary failure-to-pay ddrumheller on DSK120RN23PROD with RULES2 45 See, e.g., Bloomberg L.P. v. Commodity Futures Trading Com’n, 949 F. Supp. 2d 91, 96 (D.D.C. 2013) (stating that a swap ‘‘is a contract that typically involves an exchange of one or more payments based on the underlying value of a notional amount of one or more commodities, or other financial or economic interest . . . .’’ (emphasis added)). 46 See Application of ‘‘Security-Based Swap Dealer’’ and ‘‘Major Security-Based Swap Participant’’ Definitions to Cross-Border SecurityBased Swap Activities, Exchange Act Release No. 72472 (June 25, 2014), 79 FR 47278, 47283 (Aug. 12, 2014) (discussing the global nature and interconnectedness of the security-based swap market and the potential for risk transmission). 47 2021 Proposing Release, 87 FR at 6655. See also supra note 35 and related discussion regarding the operation of CDS auctions. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 credit event in order to trigger a payment on a CDS to the buyer (and to the detriment of the CDS seller).48 • Alone or in combination with the above or other strategies, causing the reference entity to issue a below-market debt instrument in order to artificially increase the auction settlement price for the CDS (i.e., by creating a new ‘‘cheapest to deliver’’ deliverable obligation).49 • CDS buyers endeavoring to influence the timing of a credit event in order to ensure a payment (upon the triggering of the CDS) before expiration of a CDS, or a CDS seller taking similar actions to avoid the obligation to pay by ensuring a credit event occurs after the expiration of the CDS, or taking actions to limit or expand the number and/or kind of deliverable obligations in order to impact the recovery rate.50 • CDS sellers offering financing to restructure a reference entity in such a way that ‘‘orphans’’ the CDS— eliminating or reducing the likelihood of a credit event by moving the debts off the balance sheets of the reference entity and onto the balance sheets of a subsidiary or an affiliate that is not referenced by the CDS.51 • Taking actions, including as part of a larger restructuring, to increase (or decrease) the supply of deliverable obligations by, for example, adding (or removing) a co-borrower to existing debt of a reference entity, thereby increasing (or decreasing) the likelihood of a credit event and the cost of CDS.52 The 2021 Proposing Release also discussed the fact that in 2019, the former SEC Chairman issued a joint public statement with the principals of the CFTC and the U.K. Financial Conduct Authority at the time stating that the ‘‘continued pursuit of various opportunistic strategies in the credit derivatives markets . . . may adversely affect the integrity, confidence and reputation of the credit derivatives 48 See Henry T.C. Hu, Corporate Distress, Credit Default Swaps, and Defaults: Information and Traditional, Contingent, and Empty Creditors, 13 Brook. J. Corp. Fin. & Com. L. 5–32, at 26–27 (Nov. 2018), available at https://papers.ssrn.com/sol3/ papers.cfm?abstract_id=3302816. 49 See Statement on Manufactured Credit Events by CFTC Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight (Apr. 24, 2018), available at https:// www.cftc.gov/PressRoom/SpeechesTestimony/ divisionsstatement042418. 50 See Hu, supra note 48 at 22–26. 51 See Gina-Gail S. Fletcher, Engineered Credit Default Swaps: Innovative or Manipulative?, 94 N.Y.U. L. Rev. 1073, 1101 (2019). 52 See Fletcher, supra note 51 at 1098. See also CFTC Talks Podcast, Credit Derivatives, (Jul. 10, 2019), available at https://www.cftc.gov/Exit/ index.htm?https://youtu.be/Qqo9KR6JXaM?. PO 00000 Frm 00006 Fmt 4701 Sfmt 4700 markets, as well as markets more generally.’’ 53 Taking into consideration all of the above, Rule 9j–1 will be an important additional tool to augment the Commission’s oversight of the securitybased swap markets including, but not limited to, the markets for CDS and TRS. B. Overview of the Final Rules 1. Rule 9j–1 As described in detail below, final Rule 9j–1 includes prohibitions on categories of misconduct prohibited by section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act, when effecting any transaction in, or attempting to effect any transaction in, any security-based swap, or when purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, any security basedswap).54 The final rule also includes a provision prohibiting the manipulation or attempted manipulation of the price or valuation of any security-based swap, including any payment or delivery related thereto. This provision has been moved to paragraph (a)(6) of Rule 9j–1 (from paragraph (b) as proposed) to clarify that these provisions apply to conduct that is undertaken in connection with directly or indirectly effecting, or attempting to effect, any transaction in any security-based swap, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap.55 Further, final Rule 9j–1 provides that: (1) a person with material nonpublic information about a security cannot avoid liability under the securities laws by communicating about or making purchases or sales in the security-based swap (as opposed to communicating about or purchasing or selling the underlying security); and (2) a person cannot avoid liability under section 9(j) or Rule 9j–1 in connection with a fraudulent scheme involving a securitybased swap by instead making purchases or sales in the underlying 53 See Joint Statement on Opportunistic Strategies in the Credit Derivatives Market (June 24, 2019), available at https://www.sec.gov/news/pressrelease/2019-106 (‘‘2019 Joint Statement’’); 2021 Proposing Release, 87 FR at 6655. 54 See Rules 9j–1(a), (a)(1) through (a)(5), and (d). 55 See Rule 9j–1(a)(6). E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations security (as opposed to purchases or sales in the security-based swap).56 In addition, final Rule 9j–1 includes two affirmative defenses from the liability under paragraphs (a)(1) through (5) of Rule 9j–1: (1) where the action otherwise prohibited by Rule 9j–1 was taken pursuant to binding rights and obligations in written security-based swap documentation so long as the security-based swap was entered into, or the amendment was made, before the person became aware of the material nonpublic information, and in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 9j–1; and (2) with respect to entities, if the entity demonstrates that the individual at the entity making the investment decision was not aware of material nonpublic information and the entity had implemented reasonable policies and procedures to prevent violations of Rules 9j–1(a)(1) through(5).57 2. Rule 15fh–4(c) The Commission also is adopting a rule aimed at protecting the independence and objectivity of an SBS Entity’s CCO by preventing the personnel of an SBS Entity from taking actions to coerce, mislead, or otherwise interfere with the CCO. The Commission recognizes that SBS Entities dominate the security-based swap market and also recognizes the important role that CCOs of SBS Entities play in ensuring compliance by SBS Entities and their personnel with the Federal securities laws. As a result, the Commission is adopting Rule 15fh–4©, which makes it unlawful for any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the SBS Entity’s CCO in the performance of their duties under the Federal securities laws or the rules and regulations thereunder.58 56 See Rules 9j–1(b) and (c). Rule 9j–1(e). 58 The Commission also amends the CFR designation of Rule 15Fh–4 in order to ensure the regulatory text conforms more consistently with section 2.13 of the Document Drafting Handbook. See Office of the Federal Register, Document Drafting Handbook (Aug. 2018 Edition, Revision 1.4, dated Jan. 7, 2022), available at https:// www.archives.gov/files/federal-register/write/ handbook/ddh.pdf. In particular, the Commission amends the CFR section designation for 17 CFR 240.15Fh–4 (Rule 15Fh–4) to replace the uppercase letter with the corresponding lowercase letter, such that the rule is redesignated as 17 CFR 240.15fh– 4 (Rule 15fh–4). ddrumheller on DSK120RN23PROD with RULES2 57 See VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 II. Rule 9j–1: Prohibition Against Fraud, Manipulation, and Deception in Connection With Security-Based Swaps Final Rule 9j–1 will aid the Commission in its pursuit of actions that directly target misconduct that reaches security-based swaps. The rule takes into account the features of a security-based swap and the broad definitions of ‘‘purchase’’ and ‘‘sale’’ in the Securities Act,59 and of ‘‘buy,’’ ‘‘purchase,’’ ‘‘sale,’’ and ‘‘sell’’ in the Exchange Act,60 to include the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a securitybased swap, as the context may require. Final Rule 9j–1 applies to fraudulent, deceptive, or manipulative misconduct related to the exercise of any right or performance of any obligation under a security-based swap if such misconduct occurs in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, a security-based swap.61 For example, to the extent that such misconduct results in the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security-based swap, as the context may require, Rule 9j–1 would apply. In adopting Rule 9j– 1, the Commission continues to recognize the regulatory and market developments that supported the proposal of an antifraud and antimanipulation provision.62 In general, fraudulent, deceptive, or manipulative conduct, such as providing false or incomplete information to a counterparty to secure better terms or pricing or to alter the performance of ongoing rights and obligations, has the potential to harm counterparties to all forms of securitybased swaps, including CDS, equity security-based swaps, and non-CDS debt security-based swaps. Manipulation of the reference underlying security can affect the pricing of an equity or debt security-based swap, as well as the ongoing payments and obligations that are based on the value of that reference security. Further, in some cases, particularly in instances involving security-based swap transactions that 59 15 U.S.C. 77b(a)(18). U.S.C. 78c(a)(13) and (14). 61 See supra section I.B.1 for a discussion regarding ongoing payments and deliveries that are typical for a security-based swap. 62 See supra section I.B.2. 60 15 PO 00000 Frm 00007 Fmt 4701 Sfmt 4700 42551 are effected over the internet, there is a potential for trading software to distort pricing and payouts on security-based swaps.63 Finally, to the extent a CDSrelated opportunistic strategy alters the operations of a reference entity, shareholders in reference underlying entities and counterparties to any security-based swap based on that reference entity could be impacted; the potential harm is not limited to CDS holders or to the counterparties of bad actors. A. Misconduct ‘‘In Connection With’’ ‘‘Purchases,’’ ‘‘Sales,’’ or ‘‘Effecting Transactions’’ 1. Proposed Approach As proposed, Rule 9j–1 would have prohibited the same categories of misconduct addressed by section 10(b) of the Exchange Act,64 and Rule 10b–5 thereunder,65 as well as section 17(a) of the Securities Act.66 The proposed rule imposed liability for misconduct related to any ongoing payments and deliveries that are typical of security-based swaps and which occur throughout the life of the security-based swap.67 Specifically, proposed Rule 9j–1(a) would have made it unlawful for any person, directly or indirectly, to purchase or sell, or attempt to induce the purchase or sale of, any security-based swap; to effect any transaction in, or attempt to effect any transaction in, any security-based swap; to take any action to exercise any right, or any action related to performance of any obligation, under any security-based swap, including in connection with any payments, deliveries, rights, or obligations or alterations of any rights thereunder; or to terminate (other than on its scheduled maturity date) or settle any security-based swap, in connection with which such person: (1) employs or attempts to employ any device, scheme, 63 See, e.g., SEC Investor Alert: Binary Options Fraud, available at https://www.investor.gov/ protect-your-investments/fraud/types-fraud/binaryoptions-fraud (‘‘SEC Binary Options Fraud Alert’’) (stating that the SEC has received numerous complaints alleging that certain ‘‘internet-based binary options trading platforms manipulate the trading software to distort binary options prices and payouts’’). The SEC Binary Options Fraud Alert represents the views of the staff of the Office Investor Education and Advocacy. It is not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved its content. The SEC Binary Options Fraud Alert, like all staff statements, has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person. Depending on the facts and circumstances, binary options based on securities may be securitybased swaps. 64 15 U.S.C. 78j(b). 65 17 CFR 240.10b–5. 66 15 U.S.C. 77q(a). 67 See 2021 Proposing Release, 87 FR at 6661–62. E:\FR\FM\30JNR2.SGM 30JNR2 42552 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations or artifice to defraud or manipulate; (2) makes or attempts to make any untrue statement of a material fact, or to 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; (3) obtains or attempts 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; or (4) engages or attempts to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.68 Additionally, proposed Rule 9j–1(e) provided that the terms ‘‘purchase’’ and ‘‘sale’’ would have the same meaning as set forth in sections 3(a)(13) and (14) of the Exchange Act.69 ddrumheller on DSK120RN23PROD with RULES2 2. Commission Action The Commission is adopting final Rule 9j–1(a), but has revised the rule to more closely follow the language used in the definitions of ‘‘purchase’’ and ‘‘sale,’’ and ‘‘buy’’ and ‘‘sell’’ in the Exchange Act, as amended by the DoddFrank Act, and to respond to commenter concerns.70 Specifically, the rule makes it unlawful for any person, directly or indirectly, to effect any transaction in, or attempt to effect any transaction in, any security-based swap, or to purchase or sell, or induce or attempt to induce the purchase or sale of, any securitybased swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security basedswap, as the context may require), in connection with which such person engages in the activities specified in Rules 9j–1(a)(1) through (6).71 Final Rule 9j–1(a) prohibits fraudulent, deceptive, or manipulative misconduct related to the payments, deliveries, rights, or obligations under a securitybased swap if that misconduct occurs in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, a security-based swap.72 Further, the Commission is adopting Rule 9j–1(e) as 68 See 2021 Proposing Release, 87 FR at 6703. 15 U.S.C. 78c(a)(13) and (14). 70 See 15 U.S.C. 78c(a)(13) and (14). 71 See supra sections II.B and II.C. 72 See final Rule 9j–1(a). 69 See VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 proposed but now renumbered as final Rule 9j–1(d). Several commenters supported the application of Rule 9j–1(a) to the exercise of rights and performance of obligations under a security-based swap.73 One commenter recognized that the proposed rule ‘‘appropriately recognizes that [security-based swaps] have unique characteristics in the form of ‘ongoing payments or deliveries between the parties throughout the life of the security-based swap pursuant to their rights and obligations,’ ’’ which creates additional opportunities for fraud and manipulation, as compared to other types of securities, therefore warranting ‘‘their own unique anti-fraud rule.’’ 74 Two commenters argued that the Commission exceeded its statutory authority by applying proposed Rule 9j– 1(a) ‘‘to every interim performance obligation’’ and every exercise of a right under a security-based swap.75 One commenter asserted that ‘‘[h]ad Congress intended’’ for Exchange Act section 9(j) to cover ‘‘actions related to the ongoing performance of obligations under a security-based swap agreement, it would have expressly done so in the Dodd-Frank Act or subsequent legislation, particularly given that it amended the definitions of ‘purchase’ and ‘sale’ to reflect security-based swaps.’’ 76 The commenter stated that ‘‘[i]n so doing, Congress made a determination to limit the covered actions to ‘execution,’ ‘termination,’ ‘exchange,’ or ‘extinguishing’ of rights or obligations under a security-based swap.’’ 77 The commenter also stated that ‘‘[t]here is also no precedent or support for the Commission to adopt a broad interpretation of the phrase ‘to effect any transaction in’ . . . as a basis for including interim performance obligations within the scope of proposed Rule 9j–1, as this has not been the traditional and longstanding 73 See Letter from Andrew Park, Americans for Financial Reform Education Fund (‘‘AFRED’’), dated Mar. 21, 2022 (‘‘AFRED Letter’’); Letter from Stephen W. Hall and Jason Grimes, Better Markets, Inc., dated Mar. 21, 2022 (‘‘Better Markets Letter’’); Letter from Gina-Gail S. Fletcher, Duke University School of Law, dated Mar. 21, 2022 (‘‘Fletcher Letter’’). 74 Better Markets Letter at 9. Another commenter also noted the ‘‘unique risks and long duration, with a potentially complex stream of payments and obligations’’ of security-based swaps in their support of the scope of the proposed rule. Fletcher Letter at 2. 75 Letter from Jennifer W. Han, Managed Funds Association (‘‘MFA’’), dated Mar. 21, 2022 (‘‘MFA Letter’’), at 4. See id. at 3–8; IIB–ISDA–SIFMA Letter at 6–8. 76 MFA Letter at 5. See IIB–ISDA–SIFMA Letter at 6. 77 MFA Letter at 5. PO 00000 Frm 00008 Fmt 4701 Sfmt 4700 understanding of that statutory phrase.’’ 78 Another commenter asserted that the Commission could not use its prophylactic authority under section 9(j) as a means to ‘‘extend Proposed Rule 9j– 1(a) beyond’’ what the commenter stated was ‘‘any natural reading of the terms ‘purchase’ or ‘sale.’ ’’ 79 The same two commenters also raised practical concerns about applying Rule 9j–1(a) to every exercise of a right or performance of an obligation under a security-based swap. One commenter stated that ‘‘if the proposed antifraud rule can be applied to any action or omission ‘related to performance of any obligation,’ market participants will undoubtedly seek to limit the scope of their transactions, and the terms of such transactions, in order to mitigate their exposure to liability under the rule’’ and some market participants would ‘‘terminate their involvement in the security-based swap market entirely.’’ 80 The commenter asserted that this result would ‘‘reduce liquidity in securitybased swap markets and, by restricting hedging opportunities, have a material adverse effect on the availability and cost of capital for issuers.’’ 81 The other commenter asserted that ‘‘Proposed Rule 9j–1(a)’s application to nonvolitional conduct under [a securitybased swap] would not be appropriate because it would cast uncertainty on a wide range of bona fide conduct necessary to the operation of the capital markets’’ and ‘‘risks chilling legitimate market conduct as market participants try to determine whether conduct unrelated to an affirmative investment decision could be judged after the fact to be prohibited.’’ 82 The Commission has carefully considered the comments and, as discussed below in sections II.A.2.a through II.A.2.c, is revising Rule 9j–1 to specify that it applies to misconduct that occurs in connection with effecting any transaction in, or attempting to effect any transaction in, any securitybased swap, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security basedswap). The language in final Rule 9j– 1(a) is based on section 9(j) of the 78 Id. at 7. 79 IIB–ISDA–SIFMA Letter at 8. Letter at 7–8 (emphasis in original). 81 MFA Letter at 8. 82 IIB–ISDA–SIFMA Letter at 8–9. 80 MFA E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 Exchange Act and the definitions of ‘‘purchase’’ and ‘‘sale,’’ and ‘‘buy’’ and ‘‘sell,’’ which were amended by the Dodd-Frank Act to take into account the unique characteristics of security-based swaps.83 The final rule text also is revised to make it unlawful to ‘‘induce . . . the purchase or sale’’ of any security-based swap, in addition to ‘‘purchase or sell,’’ and ‘‘attempt to induce the purchase or sale of,’’ any security-based swap. This addition is made to track the statutory language of section 9(j) of the Exchange Act.84 In addition to the changes to Rule 9j–1(a), in response to commenters’ practical concerns, as discussed in section II.E.2, the Commission is adopting affirmative defenses. Depending on the facts and circumstances of a particular situation, as discussed in sections II.A.2.a through II.A.2.c below, final Rule 9j–1 may reach misconduct that affects the payments and deliveries that typically occur throughout the life of a security-based swap, if that misconduct occurs in connection with effecting or attempting to effect any transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. Consistent with the operation of other antifraud provisions in the securities laws, whether that connection exists will be determined on a case-by-case basis.85 Sections II.A.2.a through II.A.2.c below discuss the scope of ‘‘in connection with,’’ ‘‘purchases or sales,’’ 83 The Dodd-Frank Act amended the definitions of ‘‘purchase’’ and ‘‘sale’’ in section 2(a)(18) of the Securities Act, 15 U.S.C. 77b(a)(18), the definitions of ‘‘buy’’ and ‘‘purchase’’ in section 3(a)(13) of the Exchange Act, 15 U.S.C. 78c(a)(13), and ‘‘sale’’ and ‘‘sell’’ in section 3(a)(14) of the Exchange Act, 15 U.S.C. 78c(a)(14), in the context of security-based swaps, to include ‘‘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.’’ Final Rule 9j–1(d) makes clear that ‘‘[f]or purposes of this section, the terms ‘purchase’ and ‘sale’ shall have the same meanings as set forth in Sections 3(a)(13) (15 U.S.C. 78c(a)(13)) and 3(a)(14) (15 U.S.C. 78c(a)(14)) of the Act.’’ 84 See 15 U.S.C. 78i(j). 85 One commenter asserted that the Commission’s rulemaking authority under section 9(j) is limited to ‘‘identify[ing] specific transactions, acts, practices and courses of business’’ that are fraudulent, deceptive, or manipulative. IIB–ISDA– SIFMA Letter at 8. The text of section 9(j), which authorizes the Commission to ‘‘define, and prescribe means reasonably designed to prevent, such transactions, acts, practices, and courses of business as are fraudulent, deceptive, or manipulative,’’ does not require the Commission to identify ‘‘specific transactions, acts, practices and courses of business.’’ Because security-based swaps are complex, and related strategies are constantly evolving, new opportunities for misconduct likewise constantly arise. Rule 9j–1 must be flexible to enable the Commission to prevent such misconduct. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 and ‘‘effecting transactions’’ in the context of final Rule 9j–1(a). a. In Connection With Final Rule 9j–1 prohibits misconduct ‘‘in connection with’’ effecting any transaction in, or attempting to effect any transaction in, any security-based swap, or when purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. Even if taking an action related to payments and deliveries under any security-based swap would not itself constitute a purchase or sale, or effecting a transaction, conduct that affects payments and deliveries may occur ‘‘in connection with’’ purchases or sales, or effecting a transaction. The Supreme Court has ‘‘espoused a broad interpretation’’ of ‘‘in connection with,’’ 86 holding that the phrase ‘‘should be ‘construed not technically and restrictively, but flexibly to effectuate its remedial purposes.’ ’’ 87 Accordingly, the Court has held that ‘‘it is enough that the fraud alleged ‘coincide’ with a securities transaction.’’ 88 As one commenter who was critical of the breadth of proposed Rule 9j–1(a) acknowledged, ‘‘much of the illegitimate conduct described in the [proposing] release’’—and in section I.B.2, supra—‘‘involves a purchase or sale of securities.’’ 89 Moreover, the Supreme Court has held that the requirement that ‘‘deception occur ‘in connection with the purchase or sale of any security’’’ does not require ‘‘deception of an identifiable purchaser or seller’’ because ‘‘[t]he Exchange Act was enacted in part ‘to insure the maintenance of fair and honest markets’’’ generally.90 The ‘‘in connection with’’ requirement accordingly can be satisfied ‘‘even though the person or entity defrauded is 86 Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 85 (2006). 87 SEC v. Zandford, 535 U.S. 813, 819 (2002) (citations omitted). 88 Dabit, 547 U.S. at 85 (citation omitted). See Superintendent of Ins. of State of N.Y. v. Bankers Life & Cas. Co., 404 U.S. 6, 12 (1971) (‘‘deceptive practices touching [a] sale’’ are actionable); Chadbourne & Parke LLP v. Troice, 571 U.S. 377, 387 (2014) (fraud occurred ‘‘in connection with’’ a purchase or sale if it was ‘‘material to and ‘coincided with’ third-party securities transactions’’ (quoting Dabit, 547 U.S. at 85)). 89 IIB–ISDA–SIFMA Letter at 9. As an example, the commenter stated, ‘‘the credit event under a credit default swap . . . typically settles through an auction process that involves purchases and sales of securities [and] many of the transactions with reference entities identified by the Commission are securities transactions.’’ Id. As discussed below, see infra section II.A.2.c, settlement also is part of effecting a securities transaction. See 15 U.S.C. 78bb(e)(3)(C). 90 United States v. O’Hagan, 521 U.S. 642, 657– 58 (1997) (quoting 15 U.S.C. 78b). PO 00000 Frm 00009 Fmt 4701 Sfmt 4700 42553 not the other party to the trade’’—or here, the counterparty to the relevant security-based swap.91 For that reason, misconduct that affects the payments and deliveries under one security-based swap could be prohibited by final Rule 9j–1 if that misconduct occurs in connection with effecting or attempting to effect transactions or purchasing or selling or attempting to induce the purchase or sale of any security-based swap, and not just the security-based swap that was the subject of the misconduct. b. Purchases or Sales Not only is ‘‘in connection with’’ construed broadly, Congress also has broadly defined what constitutes a ‘‘purchase’’ and ‘‘sale.’’ Generally, purchases and sales of securities include ‘‘contracts to buy, purchase or otherwise acquire’’ or ‘‘contracts to sell or otherwise dispose of’’ the security, respectively.92 For security-based swaps, as part of the provisions of the Dodd Frank Act that gave the Commission new authority over that market, Congress added that purchases and sales also include ‘‘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.’’ 93 Final Rule 9j– 1(a) accordingly prohibits fraudulent, deceptive, or manipulative conduct that affects ongoing payments and deliveries under a security-based swap if that misconduct occurs in connection with any activity that falls within those broad definitions.94 91 Id. at 656. U.S.C. 78c(a)(13) and 78c(a)(14). 93 15 U.S.C. 77b(a)(18), 78c(a)(13), and 78c(a)(14). 94 One commenter expressed concern that the term ‘‘terminate (other than on its scheduled maturity date)’’ in proposed Rule 9j–1(a) was ‘‘simultaneously too broad and too narrow.’’ Fletcher Letter at 2. The commenter stated that the term ‘‘would appear to exempt terminations at maturity from the scope of the rule’’ even if ‘‘an opportunistic scheme could be executed in line with the scheduled maturity date,’’ while applying to ‘‘contractually permitted terminations’’ prior to maturity that are ‘‘not conducted to intentionally distort the swap transaction.’’ Id. Consistent with Exchange Act sections 3(a)(13) and (14), the Commission has revised final Rule 9j–1(a) to state that a purchase or sale of a security-based swap includes, but is not limited to, a ‘‘termination (prior to its scheduled maturity date) . . . of . . . a security-based swap,’’ and includes any ‘‘similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security-based swap, as the context may require.’’ Depending on the context, the termination of a security-based swap on the scheduled maturity date could constitute such a ‘‘similar transfer or conveyance’’ or ‘‘extinguish[ment] of any rights or obligations.’’ And while a contractually permitted termination of 92 15 E:\FR\FM\30JNR2.SGM Continued 30JNR2 42554 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 Those definitions are not limited to executions, terminations, assignments, exchanges, or similar transfer or conveyance of, or extinguishing of all the rights or obligations under, a security-based swap. Therefore, the Commission also has revised final Rule 9j–1(a) to add the words ‘‘including but not limited to, in whole or in part’’ before listing the activities enumerated in Exchange Act sections 3(a)(13) and (14).95 In addition, the final rule includes the word ‘‘any’’ before ‘‘rights or obligations.’’ These modifications clarify that, for purposes of the antifraud and anti-manipulation provisions of paragraph (a), the definitions of purchase and sale encompass, among other things, partial executions, terminations, assignments, exchanges, transfers or conveyances of, or extinguishing of any rights or obligations under, a security-based swap, as the context may require.96 The Commission stated in the 2021 Proposing Release that the Exchange Act’s definitions of purchase and sale in the context of security-based swaps ‘‘incorporate actions that have an impact on some, but not all, rights and obligations’’ under a security-based swap, including ‘‘partial executions, terminations, assignments, exchanges, transfers, or extinguishments of rights or obligations.’’ 97 Commenters did not disagree.98 It also is reasonable to include partial executions, terminations, assignments, exchanges, or similar transfers or conveyances of, or extinguishing of rights or obligations under, a securitybased swap within the scope of the rule because those actions could result in amendments to the material terms of the security-based swap and, therefore, result in a new security-based swap a security-based swap prior to maturity constitutes a purchase or sale under the terms of both section 3(a) and Rule 9j–1(a), Rule 9j–1(a) prohibits only fraudulent, deceptive, or manipulative conduct in connection with a termination. 95 The phrase ‘‘but not limited to’’ reflects the fact that Exchange Act sections 3(a)(13) and (14) do not limit the definition of purchase or sale to the enumerated activities, contrary to the assertion of one commenter. See MFA Letter at 5; supra notes 76 and 77, and related discussion. 96 See Rule 9j–1(a) (‘‘to purchase or sell, or induce or attempt to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security based-swap, as the context may require’’). 97 2021 Proposing Release, 87 FR at 6661. 98 See, e.g., IIB–ISDA–SIFMA Letter at 7 (‘‘We concur with this reading, insofar as it would extend Proposed Rule 9j–1(a) to an affirmative action relating to an investment decision and affecting a material term of [a security-based swap], for example a partial termination or assignment.’’). VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 (that is, a ‘‘purchase’’ or ‘‘sale’’).99 Security-based swaps take many different forms and are used for many different purposes, but often are used to hedge risks. Even a partial change in any of the rights and obligations underlying the security-based swap— particularly those related to ongoing payments and deliveries—could affect the alignment of that hedge with the attendant risk and, under a facts and circumstances analysis, could constitute a purchase or sale of a security-based swap. A different approach—one that only prohibited misconduct in connection with the extinguishment of all of the rights and obligations under a security-based swap—would leave market participants vulnerable to the risks that the security-based swap was entered into to address (as well as decrease the alignment of any hedge entered into to address the risk of the security-based swap itself). These revisions to the text of final Rule 9j–1 also ensure that market participants cannot evade liability under Rule 9j–1 by, for example, structuring fraudulent, deceptive, or manipulative conduct so that some portion of a counterparty’s rights and obligations under a securitybased swap remain in place. Relatedly, the Commission reiterates that ‘‘[i]f the material terms of a’’ security-based swap ‘‘are amended or modified during its life based on an exercise of discretion and not through predetermined criteria or a predetermined self-executing formula,’’ then ‘‘the amended or modified’’ security-based swap is a ‘‘new’’ security-based swap.100 For example, 99 See infra note 100, and related discussion of amendments of material terms. 100 Product Definitions Release, 77 FR at 48286; see 17 CFR 230.145(a) Preliminary Note (‘‘Changing the nature and terms of an investor’s relationship to the issuer may represent the offer or sale of a new security for value.’’); 2021 Proposing Release, 87 FR at 6661. Similarly, courts have found that if an amendment or modification to the terms of a security results in ‘‘ ‘a significant change in the nature of the investment or risk’ ’’ related to that security, a new security results. Department of Economic Development v. Arthur Anderson & Co. (U.S.A.), 924 F. Supp. 449, 478 (S.D.N.Y. 1996) (citation omitted). See also, e.g., Ingenito v. Bermac Corp., 376 F. Supp. 1154, 1181 (S.D.N.Y. 1974) (considering claims of Section 10(b) and finding that ‘‘a purchase or a sale arises when the nature and terms of an investor’s involvement in a business enterprise are substantially altered by the creation of new rights or obligations’’); Louis Loss, et al., Securities Regulation § 3.A.2 (2023) (citing to N. Natural Gas Co., 14 SEC 506, 509 (1943) (noting that ‘‘for example, a change in interest or dividend rate or a liquidation preference or underlying security, or a change in the identity of the issuer, would seem clearly to result in a new security’’)). Changes are more likely to be considered ‘‘significant’’ if they are adverse to the security holders affected. See, e.g., SEC v. Associated Gas & Electric Co., 99 F.2d 795, 797–98 (2nd Cir. 1938) (holding that under the Public Utility Holding PO 00000 Frm 00010 Fmt 4701 Sfmt 4700 contrary to one commenter’s assertion,101 amendments to terms regarding ongoing rights and obligations under a security-based swap, including those related to ongoing payments and deliveries, could result in a new transaction.102 When an amendment or modification constitutes a purchase or sale of a security-based swap, Rule 9j– 1(a) prohibits any fraudulent, deceptive, or manipulative conduct that occurs in connection with it. Two commenters agreed that ‘‘Rule 9j–1 should be applicable . . . if the parties to a security-based swap transaction make changes to material terms that result in the creation of a new transaction.’’ 103 But these commenters disagreed with the Commission’s assertion in the 2021 Proposing Release that such a modification or amendment—and thus a purchase or sale—occurs when a party engages in conduct that ‘‘has a material impact on any payment or delivery under the security-based swap, such that it would not be consistent with what a reasonable person would have expected to pay, deliver, or receive absent such conduct.’’ 104 Under final Rule 9j–1(a), whether a purchase or sale of a securitybased swap has occurred will depend on the facts and circumstances and therefore the operation of the rule, as revised, is not dependent on the language in the 2021 Proposing Release Company Act of 1935, the extension of the maturity date of a debt security increased the risk to the holder and therefore constituted the sale of a new security). See also Rathborne v. Rathborne, 683 F.2d 914, 920 (5th Cir. 1982) (‘‘In determining whether a party to a securities transaction is a ‘purchaser’ or ‘seller,’ we must ask whether the transaction has wrought a fundamental change in the nature of the plaintiff’s investment . . . . [T]he core issue is whether the transaction has transformed the plaintiff into the functional equivalent of a purchaser or seller—has the plaintiff been forced to exchange his stock for shares representing a participation in a substantially different enterprise? We must focus upon the economic reality of the transaction, and determine whether the transaction has ‘transformed’ the plaintiff’s interests ‘in any real sense.’ ’’ (citations omitted)); Keys v. Wolfe, 709 F.2d 413, 417 (5th Cir. 1983) (holding that ‘‘the determination of whether’’ there has been ‘‘a significant change in the nature of the investment or in the investment risks . . . hinges on the economic reality of the transaction rather than on formal changes in the rights and obligations of the parties’’). 101 MFA Letter at 6. 102 See Loss, supra note 100 (noting that ‘‘a change in interest or dividend rate’’—which is an ongoing right or obligation—‘‘would seem clearly to result in a new security’’). 103 MFA Letter at 4. See IIB–ISDA–SIFMA Letter at 7 (‘‘[M]arket participants have arranged their affairs to treat such an exercise of discretion to amend a material term of [a security-based swap] as tantamount to the ‘purchase’ or ‘sale’ of [a securitybased swap], including for anti-fraud purposes.’’). 104 2021 Proposing Release, 87 FR at 6661. See IIB–ISDA–SIFMA Letter at 7–8; MFA Letter at 4. E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations quoted by the commenters.105 Applying a facts and circumstances analysis, if conduct that affects ongoing payments or deliveries results in the extinguishment of a right or obligation under a security-based swap, such as the right to such a payment or delivery, or otherwise results in a new transaction, then a purchase or sale will have occurred, and any related fraudulent, deceptive, or manipulative misconduct will fall within Rule 9j–1’s prohibitions. ddrumheller on DSK120RN23PROD with RULES2 c. Effecting Transactions Exchange Act section 9(j), and accordingly final Rule 9j–1(a), also is not limited to prohibitions on fraud, manipulation, or deception in connection with the purchase or sale of a security-based swap, but also encompasses misconduct in connection with effecting a transaction in any security-based swap. While the term ‘‘transaction’’ ‘‘is not defined in the Act, its broad meaning in everyday usage’’ and ‘‘the context in which it is used in the various sections of the Act’’ demonstrate that ‘‘it has a broader meaning than purchases or sales.’’ 106 The Commission accordingly has construed the term ‘‘to effect any transaction in’’ a security, variations of which appear in numerous provisions of the securities laws, to include activity such as placing bids or orders, and clearance and settlement of a securities transaction.107 The Commission also has 105 See supra note 96. The language ‘‘as the context may require,’’ which is included in Rule 9j– 1, comes from the definitions of purchase and sale in Exchange Act sections 3(a)(13) and 3(a)(14), and recognizes the need to consider the facts of a particular situation to determine whether a purchase or sale has occurred. 106 In re Kidder Peabody & Co., 18 S.E.C. 559, 1945 WL 332559, at *8 (Apr. 2, 1945) (interpreting Exchange Act section 9(a)(2) and finding that Congress intended to extend its ‘‘prohibition against manipulation . . . beyond the actual consummation of purchases or sales,’’ to include ‘‘affecting the market artificially by raising or depressing security prices, or creating actual or apparent activity, whether or not accomplished by actual purchases or sales’’). See SEC v. Lek Sec. Corp., 276 F. Supp. 3d 49, 62 (S.D.N.Y. 2017) (‘‘Courts have held that a ‘series of transactions’ includes not only completed purchases or sales but also bids and orders to purchase or sell securities.’’). 107 Kidder Peabody, 1945 WL 332559, at *8. See 15 U.S.C. 78bb (identifying ‘‘clearance, settlement, and custody’’ as ‘‘functions incidental’’ to ‘‘effect[ing] securities transactions’’). Settlement of security-based swaps occurs over time in accordance with contractually agreed upon terms (in contrast to other securities such as debt or equity, where settlement occurs when the parties exchange securities for cash equal to the full value of the securities sold). See T+1 Adopting Release, 88 FR at 13878, 13883 (quoting SIFMA who noted that, that for security-based swaps, settlement occurs when a ‘‘final net payment is paid by one party to the other at a future point in time to which the parties have contractually agreed’’ (citation omitted)). See also supra note 32. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 stated that ‘‘key aspects of the overall process of effecting security-based swap transactions’’ include ‘‘sales, booking and cash and collateral management activities.’’ 108 Final Rule 9j–1(a) therefore prohibits fraudulent, manipulative, or deceptive conduct related to the exercise of rights or performance of obligations— including ongoing payments and deliveries—under a security-based swap if that misconduct occurs in connection with a broad range of activities ‘‘beyond the actual consummation of purchases or sales.’’ 109 For example, as discussed in section II.C below, a manipulation of the ongoing payments and deliveries under a security-based swap could be used to ‘‘affect[ ] the market artificially by raising or depressing securities prices,’’ and that conduct would be connected to effecting transactions in security-based swaps.110 Similarly, as one commenter noted, a ‘‘misappropriation of customer margin’’ 108 Registration Process for Security-Based Swap Dealers and Major Security-Based Swap Participants, Exchange Act Release No. 75611 (Aug. 5, 2015), 80 FR 48964, 48976 n.99 (Aug. 14, 2015) (‘‘SBSD/MSBSP Registration Process Release’’). In the SBSD/MSBSP Registration Process Release, in the context of determining who has to register as a security-based swap dealer, the Commission identified some activities that would fall within the definition of ‘‘involved in effecting security-based swap transactions’’—for example, pricing securitybased swap positions and managing collateral. The identification of these activities as part of ‘‘the overall process of effecting’’ a transaction’’ also serves to demonstrate that not all activities in that process take place prior to the execution of the security-based swap. See MFA Letter at 7 (asserting ‘‘[i]nterpretations of ‘effect[ing] a transaction,’ . . . have been limited to the process leading to the purchase or sale of a security’’ (emphasis added)). In addition, as the Commission has previously explained in the context of broker-dealers, ‘‘effecting’’ transactions in securities has been construed broadly to encompass a wide range of activities, including: (1) transmission of an order for execution, order execution, clearance and settlement, and arranging for the performance of any such function, see 17 CFR 240.11a2–2(T); 2014 Temp Rule 11a2–2(T); and (2) screening potential transaction participants for creditworthiness, soliciting securities transactions, routing or matching orders or facilitating the execution of a transaction, handling customer funds and securities, and preparing and sending transaction confirmations, Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, Exchange Act Release No. 44291 (May 11, 2001), 66 FR 27760, 27772–73 (May 18, 2001)). Critically, several of these activities are not limited to pre-trade actions (e.g., clearance, settlement, and handling counterparty funds). 109 Kidder Peabody, 1945 WL 332559, at *8. See 15 U.S.C. 78bb (identifying ‘‘clearance, settlement, and custody’’ as ‘‘functions incidental’’ to ‘‘effect[ing] securities transactions’’). 110 Id. For example, a platform that effects transactions in security-based swaps, such as binary options or other event contracts, could fraudulently extinguish a holder’s right to payment. Such conduct could also affect the market price for similar binary options or event contracts. PO 00000 Frm 00011 Fmt 4701 Sfmt 4700 42555 would be connected to effecting a security-based swap transaction.111 In addition, the Commission is extending the application of final Rule 9j–1(a) to fraudulent, deceptive, or manipulative misconduct that occurs in connection with an ‘‘attempt’’ to effect a transaction in any security-based swap. This application is consistent with section 9(j)’s prohibition of fraud, deception, and manipulation in connection with an ‘‘attempt to induce the purchase or sale of’’ any securitybased swap and is supported by case law that recognizes that fraudulent, deceptive, or manipulative conduct need not be successful to violate the securities laws.112 It is also a ‘‘means reasonably designed to prevent’’ misconduct that results in completed transactions, which the statute explicitly prohibits.113 B. Fraudulent, Manipulative, or Deceptive Conduct 1. Proposed Approach Proposed Rules 9j–1(a)(1) through (4), describing the prohibited fraudulent, manipulative, or deceptive conduct, was structured to include the antifraud and anti-manipulation provisions—in section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act—that apply to all securities (including securitybased swaps), and the additional antifraud and anti-manipulative authority specific to security-based swaps provided to the Commission in section 9(j) of the Exchange Act. Specifically, the proposed rule would have prohibited: (1) employing or attempting to employ any device, scheme, or artifice to defraud or manipulate; (2) making or attempting to make any untrue statement of a material fact, or omitting to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were 111 IIB–ISDA–SIFMA Letter at 9. e.g., Koch v. SEC, 793 F.3d 147, 153–54 (D.C. Cir. 2015) (‘‘[I]ntent—not success—is all that must accompany manipulative conduct to prove a violation of the Exchange Act and its implementing regulations.’’ (citation omitted)); Kuehnert v. Texstar Corp., 412 F.2d 700, 704 (5th Cir. 1969) (‘‘[W]e are not convinced of any difference in substance between a successful fraud and an attempt. The statutory phrase ‘any manipulative or deceptive device,’ 15 U.S.C. 78j(b), seems broad enough to encompass conduct irrespective of its outcome.’’); Lek, 276 F. Supp. at 60 (S.D.N.Y. 2017) (‘‘manipulative conduct need [not] be successful in order to violate the securities laws’’); SEC v. Martino, 255 F. Supp. 2d 268, 287 (S.D.N.Y. 2003) (‘‘an attempted manipulation is as actionable as a successful one’’). See also Lorenzo v. SEC, 139 S. Ct. 1094, 1104 (2019) (‘‘The Commission . . . need not show reliance in its enforcement actions.’’). 113 15 U.S.C. 78i(j). 112 See, E:\FR\FM\30JNR2.SGM 30JNR2 42556 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations made, not misleading; (3) obtaining or attempting 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; or (4) engaging or attempting to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.114 Proposed Rules 9j–1(a)(1) and (2), consistent with section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a)(1) of the Securities Act, would have required scienter. In contrast, proposed Rules 9j– 1(a)(3) and (4) would not have required scienter and would have extended to conduct that is at least negligent, consistent with sections 17(a)(2) and (3) of the Securities Act. 2. Commission Action After considering the comments, the Commission is revising proposed Rule 9j–1(a) as discussed below in sections II.B.2.a and II.B.2.b.115 Final Rule 9j–1(a)(1) is being adopted as proposed, and will prohibit employing or attempting to employ any device, scheme, or artifice to defraud or manipulate. Although most of that language is derived from section 10(b) of the Exchange Act,116 Rule 10b–5 thereunder,117 and section 17(a)(1) of the Securities Act,118 the inclusion of 114 2021 Proposing Release, 87 FR at 6658–60. Rule 9j–1(a)(6), which is a revision of proposed Rule 9j–1(b), is discussed in section II.C below. 116 Section 10(b) of the Exchange Act provides that ‘‘[i]t shall be unlawful for any person, directly or indirectly . . . (b) to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.’’ 15 U.S.C. 78j(b). 117 Rule 10b–5 under the Exchange Act provides that ‘‘[i]t shall be unlawful for any person, directly or indirectly . . . (a) to employ any device, scheme, or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they are made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.’’ 17 CFR 240.10b– 5. 118 Section 17(a) of the Securities Act provides that ‘‘[i]t shall be unlawful for any person in the offer or sale of securities . . . directly or indirectly—(1) to employ any device, scheme, or artifice to defraud, or (2) 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 are made, not misleading, or (3) to engage in any ddrumheller on DSK120RN23PROD with RULES2 115 Final VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 ‘‘manipulate’’ also comes from the text of section 9(j)). Final Rule 9j–1(a)(2), which is based on section 9(j) and Rule 10b–5, will prohibit making or attempting to make any untrue statement of a material fact, or omitting 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 paragraphs (a)(3) and (4) are revised to separate attempted conduct into a new paragraph (a)(5) (to which a scienter standard is applicable, as discussed in section II.B.2.b below). Paragraph (a)(3) will prohibit obtaining 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. Paragraph (a)(4) will prohibit engaging in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. Paragraphs (a)(3) and (4) are based on sections 17(a)(2) and (3) of the Securities Act, as well as Exchange Act section 9(j), which similarly prohibits ‘‘engag[ing] in any transaction, practice, or course of business which operates as a fraud or deceit upon any person.’’ 119 Paragraph (a)(5) will prohibit attempting 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 or attempts to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. As discussed in section II.B.2.b below, the prohibition on attempted conduct in paragraphs (a)(1), (a)(2), and (a)(5) is premised on the text of section 9(j), including the Commission’s prophylactic authority to ‘‘prescribe means reasonably designed to prevent, such transactions, acts, practices, and courses of business as are fraudulent, deceptive, or manipulative, and such quotations as are fictitious.’’ The provisions described above generally prohibit a range of fraudulent, manipulative, and deceptive conduct in the security-based swap market.120 Case law related to section 10(b) of the Exchange Act, Rule 10b–5 thereunder, transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.’’ 15 U.S.C. 77q(a). 119 See supra notes 5 and 118. 120 See 2021 Proposing Release, 87 FR at 6659. PO 00000 Frm 00012 Fmt 4701 Sfmt 4700 and section 17(a) of the Securities Act provides guidance as to what conduct violates section 9(j) of the Exchange Act and Rule 9j–1 thereunder. a. Scienter and Negligence Standards Findings of misconduct under final Rules 9j–1(a)(1) and (2) require scienter while final Rules 9j–1(a)(3) and (4) do not require scienter and extend to conduct that is at least negligent.121 While both Rules 9j–1(a)(2) and (3) prohibit material misstatements and omissions,122 they address different levels of culpability.123 Specifically, Rule 9j–1(a)(2) will apply when there is evidence of scienter (e.g., when a party to a security-based swap knowingly or recklessly makes a false statement even though the party may not receive any money or property as a result). In contrast, Rule 9j–1(a)(3) extends to conduct that is at least negligent (e.g., when a party to a security-based swap knows or reasonably should know that a statement was false or misleading and directly or indirectly obtains money or property by means of such statement). Several commenters argued for a scienter standard, rather than the proposed negligence standard, with respect to paragraphs (3) and (4) of Rule 9j–1(a).124 Specifically, one commenter 121 In addition, findings of misconduct under paragraphs (a)(5) and (a)(6) will require scienter. See infra section II.B.2.b (paragraph (a)(5)) and section II.C.2 (paragraph (a)(6)). 122 Consistent with section 10(b) of the Exchange Act, such misstatements and omissions must be material to be actionable. ‘‘The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor . . . there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.’’ TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 445, 449 (1976). See also Basic v. Levinson, 485 U.S. 224, 233 (1988). 123 In addition to differences in the standard, there are additional deviations between Rules 9j– 1(a)(2) and (3), notwithstanding the significant overlap in the rule text. For example, while paragraph (a)(2), like Rule 10b–5(b), makes it unlawful to make any untrue statement of a material fact, paragraph (a)(3), like section 17(a)(2) of the Securities Act does not use the word ‘‘make.’’ Based on that difference courts have contrasted the application of Rule 10b–5(b) from the application of section 17(a)(2) of the Securities Act as it relates to determining who is the maker of a material misstatement. See, e.g., SEC v. Big Apple Consulting USA, Inc., 783 F.3d 786, 797 (11th Cir. 2015) (‘‘[W]e . . . agree with the Securities and Exchange Commission’s recent opinion, which held ‘Janus’s limitation on primary liability under Rule 10b–5(b) does not apply to claims arising under Section 17(a)(2).’ ’’); SEC v. Tambone, 597 F.3d 436, 444 (1st Cir. 2010) (en banc) (contrasting the language of Rule 10b–5(b) with ‘‘the expansive language of section 17(a)(2),’’ which covers ‘‘the ‘use’ of an untrue statement of material fact (regardless of who created or composed the statement)’’). 124 See IIB–ISDA–SIFMA Letter at 13 (arguing against applying a negligence standard for E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 argued that applying a negligence standard ‘‘is inconsistent with the concept of fraud’’ and that ‘‘mere human error—which often occurs from the high volume of the [security-based swaps] business/frequent settlement activities—could result in liability.’’ 125 Another commenter stated that, at a minimum, ‘‘any liability for interim actions taken during the term of the security-based swap should be subject to a scienter standard.’’ 126 In addition, other commenters believed that a negligence based standard would be ‘‘disruptive to’’ or ‘‘chill’’ the securitybased swap market 127 and interfere with the legitimate actions taken by lenders engaged in security-based swap transactions.128 Although the Commission has considered the concerns raised by these commenters, it is adopting Rules 9j– attempted conduct); LSTA Letter, at 5–7; MFA Letter at 12; Letter from John R. Williams, Milbank LLP, dated Mar. 22, 2022 (‘‘Milbank Letter’’), at 5. The European Banking Federation (‘‘EBF’’) supports the arguments in the IIB–ISDA–SIFMA Letter regarding proposed Rule 9j–1. See Letter from EBF, dated Apr. 1, 2022, at 1. As proposed, paragraphs (3) and (4) of Rule 9j–1(a) would have prohibited actions related to security-based swaps in which a person obtains or attempts 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, or in which a person engages or attempts to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person. 125 See Milbank Letter at 5. 126 MFA Letter at 12–13 (arguing that liability under Rule 9j–1(a)(3) and (4) should be subject to scienter because security-based swap transactions are between ‘‘sophisticated counterparties dealing directly with each other on negotiated terms’’ rather than ‘‘impersonal transactions’’ where there is a stronger argument for imposing liability under section 17(a) without scienter because it is harder to form a specific intent absent a relationship between the purchaser and the seller). Actions by the Commission demonstrate that security-based swap transactions are not always between sophisticated counterparties with ongoing relationships. See, e.g., In the Matter of Plutus Financial Inc. d/b/a Abra and Plutus Technologies Philippines Corp., Exchange Act Release No. 89296 (July 13, 2020) (offering security-based swaps to retail investors via a phone application); In the Matter of Forcerank LLC, Exchange Act Release No. 79093 (Oct. 13, 2016) (illegally offering complex security-based swaps to retail investors). See also SEC Binary Options Fraud Alert, supra note 63 (alerting investors of fraudulent binary options internet-based trading platforms). 127 See, e.g., MFA Letter at 12; Milbank Letter at 5. See also ACLI Letter at 6 (arguing that ‘‘a negligence standard . . . could impact detrimentally other market participants that are involved in private credit markets and originations’’). 128 See LSTA Letter at 5–6 (supporting a scienter standard to ‘‘address the concern that a lender could be subject to negligence claims as a result of the often-fluid nature of security-based swap or loan transactions that may be subject to private negotiations, restructuring, or amendment at any given time’’). VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 1(a)(1) through (4) using the same standards as proposed, with the exception of the attempted misconduct addressed in paragraph (a)(5), as discussed below. Each of these four provisions is based on an existing statutory and regulatory provision that is supported by a large body of case law. Final Rules 9j–1(a)(1) and (2), consistent with section 10(b) of the Exchange Act, and Rule 10b–5 thereunder,129 and section 17(a)(1) of the Securities Act,130 require scienter. In contrast, final Rules 9j–1(a)(3) and (4) do not require scienter and extend to conduct that is at least negligent, consistent with sections 17(a)(2) and (3) of the Securities Act.131 129 To state a claim under section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, the Commission must establish that the misstatements or omissions were made with scienter. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). The Supreme Court has defined scienter as ‘‘a mental state embracing intent to deceive, manipulate or defraud.’’ Id. Recklessness will generally satisfy the scienter requirement. See, e.g., Sunstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). See also Greebel v. FTP Software, Inc., 194 F.3d 185, 198 (1st Cir. 1999); SEC v. Environmental, Inc., 155 F.3d 107, 111 (2d Cir. 1998). 130 Establishing violations of Securities Act section 17(a)(1) requires a showing of scienter. See, e.g., Aaron v. SEC, 446 U.S. 680, 701–02 (1980). Scienter is the ‘‘mental state embracing intent to deceive, manipulate or defraud.’’ Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). See also section 206(1) of the Investment Advisers Act of 1940 (‘‘Advisers Act’’), which makes it unlawful for an investment adviser to employ any device, scheme, or artifice to defraud any client or prospective client. 15 U.S.C. 80b–6(1). Claims arising under section 206(1) of the Advisers Act require scienter. See, e.g., Robare Grp. LTD v. SEC, 922 F.3d 468, 472 (D.C. Cir. 2019); SEC v. Moran, 922 F. Supp. 867, 896 (S.D.N.Y. 1996); Carroll v. Bear, Stearns & Co., 416 F. Supp. 998, 1001 (S.D.N.Y. 1976). 131 Actions pursuant to sections 17(a)(2) and 17(a)(3) of the Securities Act do not require a showing of scienter. See, e.g., Aaron, 446 U.S. at 701–02. In Aaron, the Supreme Court sought to determine whether scienter was required in a Commission injunctive proceeding pursuant to the antifraud provisions of section 10(b) of the Exchange Act and section 17(a) of the Securities Act. The Court examined the language of both sections and determined that scienter was required under section 10(b) because the words ‘‘manipulative,’’ ‘‘device,’’ and ‘‘contrivance,’’ which are used in the statute, evidenced a Congressional intent to proscribe only knowing or intentional misconduct. Similarly, the Court concluded that subsection (1) of section 17(a) required proof of scienter because Congress used such words as ‘‘device,’’ ‘‘scheme,’’ and ‘‘artifice to defraud.’’ Aaron, 446 U.S. at 696. In contrast, the Court concluded that the absence of such words under subsections (2) and (3) of section 17(a) demonstrated that no scienter was required. Section 17(a)(2) prohibits any person from obtaining money or property ‘‘by means of any untrue statement of a material fact or omission to state a material fact,’’ which the Court found to be ‘‘devoid of any suggestion whatsoever of a scienter requirement.’’ Aaron, 446 U.S. at 696. Similarly, the Court found, in construing section 17(a)(3), under which it is unlawful for any person ‘‘to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit,’’ that PO 00000 Frm 00013 Fmt 4701 Sfmt 4700 42557 Although, as noted above, certain commenters argued that a negligence standard would be inconsistent with a fraud rule,132 the Supreme Court has determined that a negligence standard applies to the fraud rule upon which the provisions in Rules 9j–1(a)(3) and (4) are based—Securities Act sections 17(a)(2) and (3).133 In Aaron v. SEC, the Supreme Court stated that violations of these provisions could be satisfied by a finding of a mental state lower than scienter.134 Specifically, the Court determined that the ‘‘language of [section] 17 (a)(2), which prohibits any person from obtaining money or property ‘by means of any untrue statement of a material fact or any omission to state a material fact,’ is devoid of any suggestion whatsoever of a scienter requirement’’ 135 and ‘‘the language of [section] 17 (a)(3), under which it is unlawful for any person ‘to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit,’ (emphasis added) quite plainly focuses upon the effect of particular conduct on members of the investing public, rather scienter was not required because it ‘‘quite plainly focuses upon the effect of particular conduct on members of the investing public, rather than upon the culpability of the person responsible.’’ Aaron, 446 U.S. at 697. 132 See MFA Letter at 12 (arguing that a negligence standard could extend liability ‘‘to conduct that is merely negligent or inadvertent, without requiring any intent by the party to mislead or defraud’’); Milbank Letter at 5 (arguing in addition that the negligence standard is inconsistent with the concept of fraud which requires intent or recklessness and that human error could result in liability). Courts have found, for example, that the negligence standard in 17(a) requires a defendant to act in the manner that a reasonably prudent person in its position would have acted under the circumstances. SEC v. Shanahan, 646 F.3d 536, 545–46 (8th Cir. 2011). 133 Moreover, these provisions are consistent with the antifraud and anti-manipulation authority that the Commission had under the Commodity Futures Modernization Act over security-based swap agreements as then defined in section 206B of the Gramm-Leach-Bliley Act. Commodity Futures Modernization Act of 2000, Public Law 106–554, section 1(a)(5), 114 Stat. 2763 (Dec. 21, 2000) (codified at 15 U.S.C. 78j(b)). Prior to the passage of the Dodd-Frank Act, section 206B of the GrammLeach-Bliley Act defined a ‘‘security-based swap agreement’’ as a ‘‘swap agreement . . . of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein.’’ Gramm-LeachBliley Act, Public Law 106–102 section 206B, 113 Stat 1338 (Nov. 12, 1999) (set out as a note under 15 U.S.C. 78(c). Given that many security-based swaps would have been security-based swap agreements before the passage of the Dodd-Frank Act, it is contrary to the purposes of the Dodd-Frank Act to create a scienter standard under Rule 9j–1 for actions that would have been covered by a negligence standard under section 17(a) of the Securities Act pre-Dodd-Frank. 134 See Aaron, 446 U.S. at 696–97 (discussing the standard under sections 17(a)(2) and (3) of the Securities Act). 135 Id. at 696. E:\FR\FM\30JNR2.SGM 30JNR2 42558 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations than upon the culpability of the person responsible.’’ 136 It would be incongruous to provide different standards in Rules 9j–1(a)(3) and (4), which use language identical to the language in sections 17(a)(2) and (3) of the Securities Act that was interpreted by the Supreme Court. In addition, the Commission disagrees with commenters who argued that scienter must apply because of the ongoing and ‘‘fluid nature’’ of securitybased swap transactions.137 The Commission agrees, as stated previously, that a fundamental aspect of a security-based swap is the ongoing payments or deliveries between the parties through the life of the securitybased swap. That characteristic creates additional opportunities for misconduct after the parties enter into the securitybased swap contract and during the term of the security-based swap.138 The Commission disagrees, however, that the nature of security-based swaps—and the additional opportunities for harm— warrants applying a scienter standard rather than following the precedent applicable to sections 17(a)(2) and (3) of the Securities Act. Following the Court’s ruling in Aaron v. SEC, Rules 9j–1(a)(3) and (4) focus on the ‘‘effect’’ of the particular misconduct, and therefore, a negligence standard is appropriate. Similarly, the Commission does not agree with the commenters who suggested that the sophistication of, or the extent of the relationship between, counterparties to a security-based swap negates the need to prohibit certain misconduct, such as the acquisition of money or property by means of an untrue statement or acts that operate as a fraud, absent a showing of scienter, as provided in Rules 9j–1(a)(3) and (4).139 Although the courts and Commission have, for example, recognized that certain investors, based on qualities ddrumheller on DSK120RN23PROD with RULES2 136 Id. at 696–97. 137 See, e.g., LSTA Letter at 6 (arguing that a scienter standard would address concerns that a lender would be subject to negligence claims as a result of the ‘‘fluid nature’’ of security-based swap or loan transactions that may be subject to private negotiations, restructuring, or amendment at any given time); MFA Letter at 12–13 (arguing that sections 17(a)(2) and (3) of the Securities Act apply only to purchases or sales of securities and not to the performance of interim obligations, and also to impersonal transactions with no relationship between parties, all of which suit a negligence standard as compared to security-based swap transactions). Commenters were also concerned that a negligence standard would chill or be disruptive to the market. See MFA Letter at 13. 138 See supra section I.B. 139 See, e.g., MFA Letter at 13 (arguing that the sophistication of and personal relationships of counterparties to security-based swap transactions supported a scienter standard). VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 such as wealth or asset size,140 do not always need the same disclosure and similar investor protections as retail investors because they can ‘‘fend for themselves,’’ 141 the Commission and courts have also stated that sophisticated investors are entitled to protections of the general antifraud or anti-manipulation provisions of the Federal securities laws.142 Nothing in section 9(j) suggests that it should only apply to a limited subset of market participants. To the extent that there is overlap between Rules 9j–1(a)(3) and (4) and sections 17(a)(2) and (3) of the Securities Act, introducing a different standard would be counter to the position the Supreme Court took with regard to identical language used in section 17(a) of the Securities Act.143 A different standard could also potentially undermine the effectiveness of both provisions in certain circumstances, such as when the case law applicable to one provision contradicts the other in a way that cannot be rationalized by the differences in the underlying instruments. Commenters also argued that the negligence standard of Rules 9j–1(a)(3) and (4) would chill or disrupt the security-based swap market and would capture actions, including errors, taken in connection with normal and legitimate business activity due to the nature of security-based swap transactions.144 However, as discussed, 140 See 17 CFR 230.500 et seq. (‘‘Reg D’’) (providing an exemption from registration under section 5 of the Securities Act for securities offered or sold by an issuer to accredited investors). See also 17 CFR 230.501(a) (defining accredited investors to include, among other things, organizations with assets in access of $5,000,000 and natural persons with a net worth in excess of $1,000,000). 141 See, e.g., SEC v. Ralston Purina Co., 346 U.S. 119 (1953) (indicating that the application of the nonpublic offering exemption under Securities Act section 4(a)(2) (at the time, section 4(1)) depended on whether the offerees were able to fend for themselves and had access to the same kind of information that would be disclosed in registration). The Court noted that such persons, by virtue of their knowledge, would not need to rely on the protections afforded by registration. 142 See Brian A. Schmidt et al., Exchange Act Release No. 45330 (Jan. 24, 2002) (citing Adena Exploration Inc. v. Sylvan, 860 F.2d 1242, 1251 (5th Cir. 1988) (citing Nor-Tex Agencies Inc. v. Jones, 482 F.2d 1093 (5th Cir. 1973)); Stier v. Smith, 473 F.2d 1205, 1207 (5th Cir. 1973) (sophisticated investors, like all others, are entitled to the truth); Jay Houston Meadows, 52 SEC. 778, 785 (1996), aff’d, 119 F.3d 1219 (5th Cir. 1997) (rejecting arguments that the antifraud provisions do not apply to customers who are experienced or sophisticated). 143 The same is true with respect to Rules 9j– 1(a)(1) and (2) and section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, which the Supreme Court also addressed in Aaron. 144 See MFA Letter at 12 (addressing the sophistication of and personal relationships of PO 00000 Frm 00014 Fmt 4701 Sfmt 4700 courts have recognized that sections 17(a)(2) and (3) of the Securities Act, on which Rules 9j–1(a)(3) and (4) are based, focus on the person’s conduct and the effect of that conduct, rather than the ‘‘culpability of the persons responsible.’’ 145 Like Securities Act sections 17(a)(2) and (3), final Rules 9j– 1(a)(3) and (4) will not capture normal and legitimate business activity. Courts have found, for example, that the negligence standard requires that to be deemed in violation of these provisions, a defendant must act in a manner contrary to the manner in which a reasonably prudent person in the defendant’s position would have acted under the circumstances.146 Accordingly, a violation of Rules 9j– 1(a)(3) and (4) would require more than a mere mistake.147 b. Attempted Conduct Finally, as proposed, the Rule 9j–1(a) prohibitions would have extended to the attempted fraudulent, manipulative or deceptive conduct described in paragraphs (a)(1) through (4) of the rule. The Commission largely adopts Rule 9j– 1(a) as proposed as it relates to attempted conduct, except to address the mental state applicable to attempted conduct by placing the attempted conduct described in paragraphs (3) and (4) of proposed Rule 9j–1 into a standalone paragraph (5) in the final rule.148 The inclusion of attempted conduct in Rules 9j–1(a)(1), (2), and (5) is premised on the text of section 9(j). First, the statute expressly prohibits ‘‘engag[ing] in any fraudulent, deceptive, or manipulative act or practice, mak[ing] any fictitious quotation, or engag[ing] in any transaction, practice, or course of business which operates as a fraud or deceit upon any person’’ in an ‘‘attempt to induce the purchase or sale of, any security-based swap.’’ 149 Moreover, as counterparties to security-based swap transactions as compared to the ‘‘impersonal transactions’’ underlying other types of security transactions); Milbank Letter at 5 (asserting that in light of the pace of activity involved in security-based swap transactions ‘‘mere human error’’ could lead to liability). 145 Aaron, 446 U.S. at 696–97. 146 SEC v. Shanahan, 646 F.3d 536, 545–46 (8th Cir. 2011). 147 In addition, the affirmative defenses in Rule 9j–1(e) address some of the concerns commenters have with regard to disruption to the security-based swap and loan markets. See infra section II.E. 148 See Rules 9j–1(a)(1) through (5). In addition, final Rule 9j–1(a) has been revised to include the prohibitions on manipulation and attempted manipulation proposed in Rule 9j–1(b) in a new paragraph (a)(6) with some revision. See infra section II.C. The CFTC’s antifraud and antimanipulation rule regarding swaps similarly prohibits attempted conduct. 17 CFR 180.1. 149 15 U.S.C. 78i(j). E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations discussed above, courts have determined that an act, practice, transaction, or course of business can be fraudulent, deceptive, or manipulative, or operate as a fraud or deceit—and thus violate antifraud provisions of the securities laws—regardless of whether it succeeds in its aims.150 Second, section 9(j) authorizes the Commission to ‘‘prescribe means reasonably designed to prevent’’ the fraudulent, deceptive, or manipulative conduct that the statute expressly prohibits. The Supreme Court has held that this language allows the Commission to ‘‘prohibit acts not themselves fraudulent . . . if the prohibition is ‘reasonably designed to prevent . . . acts and practices [that] are fraudulent.’ ’’ 151 The Commission is exercising that authority in Rules 9j– 1(a)(1), (2), and (5) to prohibit attempts to engage in fraudulent, deceptive, or manipulative acts, practices, transactions, or courses of business. The prohibition applies where a person, with scienter, takes a step in furtherance of a fraudulent, deceptive, or manipulative act, practice, transaction, or course of business but for some reason—including ‘‘pure fortuity’’ 152— that act, practice, transaction, or course of business is not completed. For example, and without limitation, the prohibition would apply where a supervisor, with scienter, directs a subordinate to make a fraudulent material misstatement or omission, but the subordinate refuses to do so. Rule 9j–1(a)’s prohibition on such attempted misconduct recognizes that fraud, deception, and manipulation in the security-based swaps market can involve complex strategies implemented over multiple stages, as discussed above in section I.B.2. The prohibition is consistent with other provisions of the securities laws that recognize the importance of Commission intervention before the completion of a fraudulent, deceptive, or manipulative act, practice, transaction, or course of business. The Commission has the authority to seek an injunction whenever ‘‘any person is engaged or is about to engage in acts or practices constituting a violation of’’ the Exchange Act or Securities Act.153 Rule ddrumheller on DSK120RN23PROD with RULES2 150 See supra note 112. 151 O’Hagan, 521 U.S. at 673 (quoting a similar provision in Exchange Act section 14(e), 15 U.S.C. 78n(e)). See also id. at 672–73 (‘‘A prophylactic measure, because its mission is to prevent, typically encompasses more than the core activity prohibited.’’). 152 Kuehnert, 412 F.2d at 704. 153 15 U.S.C. 78u(d) (emphasis added) (Exchange Act); 15 U.S.C. 77t(b) (Securities Act). See, e.g., Kuehnert, 412 F.2d at 704 (‘‘The Commission may act . . . to enjoin a potential fraud or prosecute a VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 9j–1(a)’s prohibition of attempts provides the Commission with an additional tool to prevent such misconduct before any harm comes to the security-based swap market or market participants. One commenter argued against applying the negligence standard applicable to the misconduct prohibited by Rules 9j–1(a)(3) and (4) to attempts to engage in that misconduct because it ‘‘may capture conduct that is not itself fraudulent or manipulative’’ but rather ‘‘legitimate business activities’’ and would have a ‘‘chilling effect on the market for security-based swaps.’’ 154 Another commenter noted that sections 17(a)(2) and (3) of the Securities Act do not prohibit ‘‘attempts’’ and that ‘‘the Commission should either eliminate the reference to attempts in Rules 9j–1(a)(3) and (4)’’ or clarify the standard required for liability for attempted conduct prohibited under those paragraphs of Rule 9j–1.155 Similarly, one commenter believed that including attempts within the scope of conduct covered by Rule 9j–1 was broader than the scope of conduct covered by section 17(a) of the Securities Act and warranted the application of an intent standard.156 Although, as discussed above, the Commission disagrees with assertions that a different standard would capture legitimate business decisions,157 we nevertheless agree that scienter is the proper standard for attempts at conduct that would violate paragraphs (a)(3) or (a)(4) of final Rule 9j–1.158 Therefore, while final Rule 9j–1 retains the nonscienter-based standard for the underlying conduct described in paragraphs (a)(3) and (4), the Commission is revising the final rule in order to separate the attempted conduct from paragraphs (a)(3) and (4) of proposed Rule 9j–1 into a new fraud that failed, without proof of actual loss to any victim.’’). 154 LSTA Letter at 7. 155 See IIB–ISDA–SIFMA Letter at 13 (arguing that ‘‘[p]arties cannot be held to a standard of strict liability with regards to fluid discussions in the course of negotiating complex transactions—not to mention the potential for good faith mistakes to arise in connection with ongoing payment and delivery obligations’’). 156 See MFA Letter at 12. See also IIB–ISDA– SIFMA Letter at 13 (arguing for a different standard for attempted conduct). 157 See supra notes 144–147 and accompanying text. 158 In other contexts, courts have recognized that a scienter standard may be appropriate for attempts even when it is not required for the violation attempted. See, e.g., United States v. Cote, 504 F.3d 682, 687 (7th Cir. 2007). See also United States v. Gracidas-Ulibarry, 231 F.3d 1188, 1192 (9th Cir. 2000) (recognizing ‘‘the doctrine that the crime of attempt requires a showing of specific intent even if the crime attempted does not’’ (internal quotation marks omitted)). PO 00000 Frm 00015 Fmt 4701 Sfmt 4700 42559 paragraph (a)(5). Scienter is the standard that will apply to Rule 9j–1(a)(5). B. Prohibition on Price Manipulation 1. Proposed Approach Partly in response to manufactured credit events and other opportunistic CDS strategies observed over the last decade,159 paragraph (b) of proposed Rule 9j–1 was designed to address price manipulation and attempted price manipulation, similar to 17 CFR 180.2 (‘‘CFTC Rule 180.2’’).160 Paragraph (b) of proposed Rule 9j–1 would have made it unlawful for any person to, directly or indirectly, manipulate or attempt to manipulate the price or valuation of any security-based swap, or any payment or delivery related thereto. Proposed Rule 9j–1(b) was designed to capture misconduct such as situations in which a payment under the security-based swap is intentionally or recklessly distorted for the benefit of one of the security-based swap counterparties or situations in which a person intentionally or recklessly causes or avoids the purchase or sale of a security-based swap for the benefit of one counterparty. The proposed rule was not designed to capture affirmative actions taken in the ordinary course of a security-based swap transaction or the reference underlying security.161 In this regard, the 2021 Proposing Release stated that a determination as to whether manipulation or attempted manipulation under Rule 9j–1(b) occurred would largely depend on the facts and circumstances of each particular situation. However, as a general matter the Commission would expect to use its authority to bring an enforcement action under Rule 9j–1(b) when a party took action for the purposes of avoiding or causing, or increasing or decreasing, a payment under a security-based swap in a manner that would not have occurred but for such actions, or when an action appeared to be designed almost exclusively to harm a counterparty.162 The Commission specifically stated in the 2021 Proposing Release that its intent was not to discourage lenders and prospective lenders from discussing or 159 See supra section I.B.2. See also 2021 Proposing Release, 87 FR at 6654–55 (discussing the manufactured credit events and other opportunistic strategies in the CDS market identified by the Commission that ‘‘may adversely affect the integrity, confidence, and reputation of the credit derivatives markets) (quoting the 2019 Joint Statement). To be clear, Rule 9j–1, including Rule 9j–1(b), applies to all security-based swaps and is not limited to CDS. 160 See 17 CFR 180.2. 161 See 2021 Proposing Release, 87 FR at 6663. 162 Id. E:\FR\FM\30JNR2.SGM 30JNR2 42560 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations providing financing or other forms of relief to reference entities to avoid defaulting on their debt. 2. Commission Action The Commission is adopting a price manipulation rule as proposed in Rule 9j–1(b), but as a new paragraph (6) to Rule 9j–1(a). Consistent with the revisions to Rule 9j–1(a) discussed above in section II.A, the placement of the price manipulation rule in a new paragraph to Rule 9j–1(a), rather than in standalone paragraph 9j–1(b) as proposed, clarifies that the prohibited manipulative conduct must occur in connection with effecting, or attempting to effect a transaction in any securitybased swap or in connection with purchasing or selling, or inducing or attempting to induce the purchase or sale, of any security-based swap.163 We discuss this change in more detail below. The Commission received multiple comment letters specifically addressing paragraph (b) of proposed Rule 9j–1. One commenter was supportive of proposed Rule 9j–1(b) and the application of a ‘‘facts and circumstances’’ analysis to determine whether conduct in connection with a security-based swap is manipulative.164 Another commenter supported the Commission’s addition of paragraph (b) to ‘‘better protect the fairness of markets, and better enable appropriate enforcement to police abuses in the swaps markets.’’ 165 However, most of the comments addressing paragraph (b) of proposed Rule 9j–1 argued against the new provision or asked for added clarity.166 One commenter argued that the Commission’s guidance with regard to the standard to be applied to determine liability under the proposed rule was insufficient and that it was unclear how courts would apply the standard absent a ‘‘deceptive intent’’ requirement.167 163 See Rule 9j–1(a)(6). Fletcher Letter at 2 (stating that a facts and circumstances ‘‘approach avoids bright-line rules that potentially create opportunities to engage in manipulative behavior within the letter but not the spirit of the law, and provides the staff of the Commission with the flexibility it needs to evaluate transactions in an ever-evolving marketplace’’). 165 AFRED Letter at 4–5 (stating specifically that Rule 9j–1 would enable the Commission ‘‘to crack down on fraudulent conduct in the [CDS] market that unnecessarily triggers a counterparty to post collateral related to a default for the CDS buyers’ benefit’’). 166 See Milbank Letter at 2–5; MFA Letter at 17– 18; LSTA Letter at 6; IIB–ISDA–SIFMA Letter at 13– 15. 167 Milbank Letter at 3 (citing case law in which ‘‘anti-manipulation provisions of existing securities laws are generally interpreted . . . to prohibit conduct that is intended to deceive investors by ddrumheller on DSK120RN23PROD with RULES2 164 See VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 The Commission has carefully considered the comments. The Commission is adopting final Rule 9j– 1(a)(6) to prohibit manipulation and attempted manipulation of the price or valuation of any security-based swap, including any payment or delivery related thereto, in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. The Commission will apply a scienter standard—which includes intentional or reckless misconduct—to determine whether conduct is in violation of final Rule 9j–1(a)(6).168 Many of the commenters critical of proposed Rule 9j–1(b) believed that it was too broad and would lack clarity in application, thereby leading to a chilling effect on the security-based swap market and the credit market.169 Several commenters focused on the ‘‘facts and circumstances analysis’’ described by the Commission in proposing Rule 9j– 1(b) for determining whether a violation of the rule has occurred. In general, these commenters believed that the facts and circumstances test was not an adequate standard to determine when manipulation or attempted manipulation prohibited by proposed Rule 9j–1(b) occurred. One commenter pointed to the standard articulated by the CFTC in the enforcement of CFTC Rule 180.2 to argue for a clearer standard regarding manipulative conduct.170 When adopting CFTC Rule 180.2, the CFTC reiterated that it would be guided by a four-part test for manipulation that it had developed in case law under sections 6(c) 171 and 9(a)(2) 172 of the Commodity Exchange Act to determine whether to apply CFTC Rule 180.2. Under this four-part test, to bring action, the CFTC would consider ‘‘(1) [t]hat the accused had the ability to influence market prices; (2) that the accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; (3) that artificial prices existed; and (4) that the accused caused the artificial prices.’’ 173 Another commenter pointed to the amended definition of ‘‘Failure to Pay’’ in the ISDA Credit Derivatives Definition as an example of the type of guidance the commenter believed would be helpful to market participants in determining what actions may be construed as misconduct or manipulation.174 Similarly, one commenter believed that proposed Rule 9j–1(b) included a ‘‘manipulation standard that is new to securities markets’’ and requested further guidance or definition to avoid ‘‘the chilling effect that a poorlyunderstood standard could have on legitimate conduct.’’ 175 In the commenter’s view, ‘‘the Commission should articulate as precisely as possible (a) what potential conduct or activity is targeted, (b) which market participants would be harmed by it, and (c) why it is that the existing market infrastructure (whether the existing anti- artificially affecting market activity or prices, with deceptive intent being an essential element for conduct to be considered ‘manipulative’’’). 168 Courts have found that use of the term ‘‘manipulative’’ in the statute would evidence a Congressional intent to proscribe only knowing or intentional misconduct and that, accordingly, the Commission must establish that the misconduct was made with scienter. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). The Supreme Court has defined scienter as ‘‘a mental state embracing intent to deceive, manipulate or defraud.’’ Id. In addition, scienter may also be established by a finding of recklessness. See, e.g., Sunstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). 169 See, e.g., Milbank Letter at 2 (arguing that the provision is overbroad and ambiguous and that the Commission should provide ‘‘additional clarity as to the standard that would apply to claims brought under proposed Rule 9j–1(b)’’); MFA Letter at 17– 18 (positing that the scope of the provision is overly broad and that ‘‘market participants will reduce their lending activity as well as their security-based swap and securities market activity, or avoid certain markets altogether’’); LSTA Letter at 6 (finding that the provision introduces additional uncertainty for lenders). 170 See MFA Letter at 18 (‘‘The CFTC’s antimanipulation rules applicable to swap transactions, which are similar and analogous to security-based swaps in many respects, set out a much clearer standard regarding manipulative conduct.’’). CFTC Rule 180.2 addresses price manipulation and provides that ‘‘[i]t shall be unlawful for any person, directly or indirectly, to manipulate or attempt to manipulate the price of any swap, or of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity.’’ Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices and Prohibition on Price Manipulation, 76 FR 41398, 41707 (July 14, 2011) (‘‘CFTC Rule 180.2 Adopting Release’’). 171 7 U.S.C. 6c. 172 7 U.S.C. 13(a)(2). 173 See CFTC Rule 180.2 Adopting Release, 76 FR at 41407. In addition, a violation of CFTC Rule 180.2 requires a showing of ‘‘specific intent.’’ Id. (‘‘[The CFTC] reaffirms the requirement under final Rule 180.2 that a person must act with the requisite specific intent. In other words, recklessness will not suffice under final Rule 180.2 as it will under final Rule 180.1.’’). In contrast, for purposes of liability under Rule 9j–1, scienter includes recklessness as established by a long line of case law. See supra note 129. 174 Letter from Jennifer Han, Managed Funds Association, dated July 8, 2022 (‘‘July 2022 MFA Letter’’), at 5–7. In 2019, ISDA introduced amendments to its Credit Derivatives Definitions designed to address certain issues related to manufactured credit events, which ISDA termed ‘‘narrowly tailored credit events’’ (‘‘ISDA Amendments’’). See 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definition (July 15, 2019), available at https://www.isda.org/a/KDqME/Final-NTCESupplement.pdf. 175 IIB–ISDA–SIFMA Letter at 13. PO 00000 Frm 00016 Fmt 4701 Sfmt 4700 E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 fraud rules or the provisions of the relevant contracts) does not already provide sufficient protection.’’ 176 A significant concern for the commenter was whether market participants would be able to determine that their actions were manipulative and in violation of proposed Rule 9j–1(b). Absent a clear standard, they argued that market participants may determine to reduce their activity, which would have broad negative impacts on liquidity in the security-based swap market and broader economy.177 Finally, the commenter requested that the Commission provide guidance with regard to the types of conduct or activities that would violate proposed Rule 9j–1(b) and those that would not violate proposed Rule 9j–1(b) under any implemented ‘‘facts and circumstances’’ test.178 A separate commenter requested that the Commission ‘‘tailor’’ proposed Rule 9j– 1(b) so that it includes a specific description of what constitutes manipulative conduct.179 The Commission is revising the price manipulation provision, originally proposed as Rule 9j–1(b) and adopted as final Rule 9j–1(a)(6), in response to the comments above. Consistent with the revisions to final Rule 9j–1(a) discussed above in section II.A, Rule 9j–1(a)(6) will apply to conduct undertaken in connection with effecting or attempting to effect a transaction in any securitybased swap, and to purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security based-swap).180 As the Supreme Court has stated, ‘‘fraudulent manipulation of [securities] prices . . . unquestionably qualifies as a fraud ‘in connection with the purchase or sale’ of securities.’’ 181 Rule 9j–1(a)(6) also prohibits the manipulation (or attempted manipulation) of the valuation of any security-based swap, or any payment or 176 Id. at 14 (stating that care should be taken to correctly analyze the potential impact of new manipulation standards such as that in Rule 9j– 1(b)). 177 Id. at 13–14. 178 Id. at 16. 179 See MFA July 2022 Letter at 10. The commenter also believed that the Commission should re-propose Rule 9j–1(b) for public comment to allow market participants ‘‘to adequately assess the potential impact of [proposed Rule 9j–1(b)] on the security-based swap markets and . . . on the broader market for corporate debt.’’ Id. 180 See supra section II.A. 181 Dabit, 547 U.S. at 89. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 delivery related thereto, to the extent such misconduct is in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap.182 A determination as to whether a person has violated final Rule 9j–1(a)(6) will depend on the facts and circumstances of each particular situation. The assessment of facts and circumstances is an objective evaluation that considers all relevant information surrounding the alleged misconduct, including both quantitative and qualitative factors, to determine whether prohibited manipulation is present. A ‘‘facts and circumstances’’ analysis will provide the Commission with the flexibility it needs to address an evolving security-based swap market, including the ever-changing CDS market, and potential misconduct in those markets. Bright line rules or tests, on the other hand, may artificially exclude manipulative and attempted manipulative conduct and could create a roadmap for market participants to avoid liability for manipulative actions. A substantial body of case law regarding manipulative behavior exists with regard to other antifraud and antimanipulation provisions in the Securities Act and Exchange Act to which the Commission will look to assess whether a violation of Rule 9j– 1(a)(6) has occurred.183 In addition, the Commission reiterates that case law requires a showing of scienter to bring an action for manipulation or attempted manipulation and that it will apply a scienter standard to determine whether conduct is in violation of Rule 9j– 1(a)(6). Also, as noted, commenters encouraged the Commission to explicitly recognize certain market activities as legitimate.184 The Commission declines to carve out from the application of Rule 9j–1(a)(6) 182 The Commission has the authority to prohibit attempted manipulation based on section 9(j)’s application to ‘‘attempt[s] to induce the purchase or sale of’’ any security-based swap, as well as case law establishing that manipulative conduct need not be successful to violate the securities laws. See supra note 112. 183 See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976); Markowski v. SEC, 274 F.3d 525 (D.C. Cir. 2001); United States v. Mulheren, 938 F.2d 364 (2d Cir. 1991); SEC v. Malenfant, 784 F. Supp. 141, 144 (S.D.N.Y. 1992); SEC v. Markusen, 2016 U.S. Dist. LEXIS 55419 (D. Minn. Apr. 25, 2016); Sharette v. Credit Suisse Intern, 127 F. Supp. 3d 60 (S.D.N.Y. 2015); ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2d Cir. 2007); Wilson v. Merrill Lynch & Co., 671 F.3d 120 (2d Cir. 2011); SEC v. Schiffer, 1998 U.S. Dist. LEXIS 8579 (S.D.N.Y. June 10, 1998). 184 See IIB–ISDA–SIFMA Letter at 15–23. PO 00000 Frm 00017 Fmt 4701 Sfmt 4700 42561 categories of market activities based on hypothetical fact patterns as requested by commenters. Liability under Rule 9j– 1(a)(6) will depend upon an analysis of all relevant information. A different approach could artificially exclude manipulative conduct, particularly given the complex fact patterns generally at issue in many securitybased swap transactions. As discussed in the 2021 Proposing Release, Rule 9j– 1(a)(6) applies to actions taken outside the ordinary course of a typical lenderborrower relationship, such as an action taken for the purposes of avoiding or causing, or increasing or decreasing, a payment under a security-based swap in a manner that would not have occurred but for such actions, or when an action appears to be designed almost exclusively to harm counterparties, and is not intended to discourage lenders from discussing or providing financing or relief to avoid default.185 Moreover, the fact that the Commission will apply a scienter standard for liability under Rule 9j–1(a)(6) should lessen concerns regarding any ‘‘chilling effects’’ of the new rule.186 Further, as discussed in section II.E.2, the affirmative defenses of final Rule 9j–1(e) do not apply to the anti-manipulation provision in Rule 9j– 1(a)(6) because paragraph (a)(6) does not apply to affirmative actions taken in the ordinary course of a security-based swap transaction or the reference underlying security while aware of material nonpublic information. To be clear, Rule 9j–1(a)(6) will require that security-based swap market participants take care that their legitimate market activities remain within the scope of the typical lender-borrower relationship and do not cross the line into prohibited manipulation. However, the use of a facts and circumstances analysis, along with the use of a scienter standard, to identify manipulative conduct addresses commenters concerns that legitimate market activities would be captured by the prohibitions of Rule 9j– 1(a)(6) or otherwise chilled. However, to further address commenter concerns, the Commission reiterates that Rule 9j–1(a)(6) prohibits, among other things, a situation where a person (or group of persons) intentionally or recklessly causes or 185 See 2021 Proposing Release, 87 FR at 6663. As discussed above, the text of revised Rule 9j–1(a) also specifies that such actions must occur in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. 186 See Letter from Som-lok Leung, International Association of Credit Portfolio Managers (‘‘IACPM’’), dated Mar. 21, 2022 (‘‘IACPM Letter’’), at 4; MFA Letter at 8–10; LSTA Letter at 5, 7–10; IIB–ISDA–SIFMA Letter at 13–22. E:\FR\FM\30JNR2.SGM 30JNR2 42562 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 avoids the purchase or sale of a securitybased swap for the benefit of a counterparty, or to harm a counterparty, to a security-based swap. This may include, for example, orphaning a CDS,187 avoiding termination of a CDS for a period of time, or causing the termination of a CDS. But a person simply profiting from a CDS position after a company’s bankruptcy, which such person could have prevented by participating in a financing to the company, without more, is not in and of itself improper conduct for purposes of Rule 9j–1(a)(6). The Commission also recognizes that reference entities often rely on financing and other forms of relief to avoid defaulting on their debt. We understand that CDS transactions are an important means by which debt holders hedge their underlying debt instruments, and that the absence of such hedging opportunities could impact prospective investors’ willingness and ability to invest in that underlying market. The final rule is not intended to discourage lenders and prospective lenders from discussing or providing such financing or relief, even when those persons also hold CDS positions. Rather, the Commission is adopting Rule 9j–1(a)(6) to account for actions taken outside the ordinary course of a typical lenderborrower relationship (or a prospective lender-borrower relationship). Although, as discussed, any such determination would need to be based on the facts and circumstances of a particular situation, as a general matter an action that appears to be designed almost exclusively to harm one or more CDS counterparties would likely fall within the prohibition in Rule 9j– 1(a)(6). Security-based swap market participants should and can take care that their legitimate market activities remain within the scope of the typical lender-borrower relationship and do not cross the line into prohibited manipulation. Using a ‘‘facts and circumstances’’ analysis to identify conduct that is prohibited by Rule 9j– 1(a)(6), the Commission will consider all relevant facts in any attempt to determine whether prohibited manipulation or attempted manipulation has occurred. Further, the Commission will apply a scienter 187 ‘‘Orphaning’’ a CDS refers to a situation where the debt of a reference entity is eliminated or reduced for the purposes of moving the price of CDS. The end result of such activity is that CDS buyers continue to pay (and CDS sellers continue to receive) premiums on CDS that will never default. Similarly, a CDS protection seller could offer financing to the company to avoid a credit event and subsequent CDS payout, with the financing timed so that the company’s bankruptcy is merely delayed until after the CDS expires. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 standard, which will work to eliminate legitimate conduct from the scope of Rule 9j–1(a)(6). As discussed above, the adoption of a ‘‘facts and circumstances’’ analysis is appropriate given the complex fact patterns in many securitybased swap transactions. Proposed Rule 9j–1(b) was intended to address, among other things, a number of the manufactured credit events or other opportunistic strategies in the CDS market observed over the last decade.188 In re-proposing Rule 9j–1, the Commission provided specific examples of manufactured or other opportunistic CDS strategies that had been reported by academics and the press.189 Commenters raised concerns both that industry efforts, such as the ISDA Amendments and anti-net short provisions, have successfully addressed opportunistic strategies such as those described in the 2021 Proposing Release,190 and that the description of the manufactured credit events or opportunistic strategies identified by the Commission were ‘‘overly-broad and capture legitimate market activities.’’ 191 One commenter asked the Commission to ‘‘refine the descriptions of’’ manufactured credit events or opportunistic strategies that they believe are too broad and have been addressed by industry efforts.192 With regard to industry efforts, the anti-net short provisions and ISDA Amendments are narrowly focused and have limited ability to reduce fraudulent and manipulative activity in the securitybased swap market. The ISDA Amendments do not address all of the concerns identified in the 2019 Joint Statement, including, but not limited to, addressing opportunistic strategies that do not involve narrowly tailored credit events.193 Anti-net short provisions are limited to syndicated bank loans and would not apply to fraudulent activity in the security-based swap market that does not involve such loans. Thus, even if these industry efforts were successful in reducing fraudulent activity, their impact likely would be limited by their narrow scope. In response to requests to refine the descriptions of manufactured credit events in the 2021 Proposing Release, the Commission agrees that 188 See 2021 Proposing Release, 87 FR at 6663. 189 See supra section I.B.2. See also 2021 Proposing Release, 87 FR at 6654–55 (describing in more detail examples of manufactured credit events and other opportunistic strategies in the CDS market reported by academics and the press). 190 See IIB–ISDA–SIFMA Letter at 19–20; LSTA Letter at 4; MFA July 2022 Letter at 4–10; Milbank Letter at 6. 191 IIB–ISDA–SIFMA Letter at 20–23. 192 See IIB–ISDA–SIFMA Letter at 19. 193 See 2021 Proposing Release, 87 FR at 6655 n.31. PO 00000 Frm 00018 Fmt 4701 Sfmt 4700 there may be circumstances in which the types of conduct described may not be the result of manipulation or attempted manipulation; however, the facts and circumstances analysis and scienter standard sufficiently tailor final Rule 9j–1(a)(6) to properly capture manipulative conduct. Therefore, the Commission declines to revise the descriptions. One commenter requested that the ‘‘valuation’’ prong of proposed Rule 9j– 1(b) be removed because ‘‘a prohibition on manipulation of the ‘valuation’ of an asset does not exist in any U.S. regulatory context and would require a new body of case law to be formed to determine how any such new prohibition should be interpreted.’’ 194 The commenter argued that case law focuses on divergences between price and value and that ‘‘no analogy can be drawn in cases where it is the change in value that is prohibited.’’ 195 The Commission declines to remove the manipulation of a security-based swap’s valuation from the scope of Rule 9j– 1(a)(6) because the pricing and valuation of security-based swaps are intrinsically connected. For example, although CDS pricing can be complex, ‘‘[t]he basic idea of CDS pricing is that the present value of all the CDS premium payments should equal to the present value of the expected payoff from the CDS for the [net present value] to be 0 for both parties of the contract (resulting in each party being equally well off).’’ 196 In other words, a CDS typically is priced to allow the protection seller to recover its potential cash outflows upon a credit event and termination of the CDS, or its ‘‘expected loss.’’ The protection seller will determine the value of the expected loss based on several factors, including the likelihood of default and cost of capital. The value of the expected loss drives the price of the CDS and the payout upon termination of the CDS. Similarly, the price of a TRS typically is the difference between the present value of both ‘‘legs’’ of the transaction’s cash flows. Therefore, actions to manipulate price will affect valuation and vice versa. Additionally, market participants 194 Milbank Letter at 3 (citing to Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 476 (1977), to argue that ‘‘ ‘[m]anipulation’ is ‘virtually a term of art when used in connection with securities markets’ . . . The term refers generally to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity’’). 195 Milbank Letter at 3. 196 Yuan Wen and Jacob Kinsella, Credit Default Swap—Pricing Theory, Real Data Analysis and Classroom Applications Using Bloomberg Terminal, available at https://data.bloomberglp.com/bat/sites/ 3/2016/10/WhitePaper_Wen.pdf. E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations may rely on models to price or value the swap.197 This suggests that ‘‘valuation’’ of a security-based swap has a role in the market and should be included in the anti-manipulation provisions of Rule 9j–1(a)(6). Further, by prohibiting the manipulation of a security-based swap’s valuation, Rule 9j–1(a)(6) will help to prevent manipulation of payments and deliveries under a security-based swap ‘‘from distorting the price and market for such securitybased swaps, as well as for the reference underlying, and improperly interfering with the independent and proper functioning of the markets.’’ 198 Rule 9j–1(a)(6) prohibits manipulation in connection with effecting or attempting to effect a transaction in, any security-based swap, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap, which may include intentionally or recklessly distorting payments related to a security-based swap to benefit, or harm, one of the security-based swap counterparties, or actions that serve little to no economic purpose other than to artificially influence the composition of the deliverable obligations in a CDS auction and affect the security-based swap’s valuation and price. To remove the valuation prong from final Rule 9j– 1(a)(6) would create a gap in the prohibition against the manipulation or attempted manipulation of prices in the security-based swap market. D. Liability Under Rules 9j–1(b) and (c) ddrumheller on DSK120RN23PROD with RULES2 1. Proposed Approach The Commission included paragraphs (c) and (d) of re-proposed Rule 9j–1 to make it clear that market participants could not avoid liability under the rule by effecting a fraudulent scheme through the purchase or sale of an underlying security, rather than the purchase or sale of the security-based swap on which it is based, and vice versa. The first of those two provisions would have provided that a person could not escape liability for trading based on possession of material nonpublic information about a security 197 The Commission has previously recognized that market participants may rely on models for pricing and valuation of security-based swaps. See, e.g., Business Conduct Standards Adopting Release, 81 FR at 29988 (in the context of daily marks, stating that ‘‘even if the mark is calculated based on internal models or such indices, its provision by the SBS Entity will further the goal of providing helpful transparency into the SBS Entity’s pricing and valuation of the security-based swap by providing a helpful reference point that the SBS Entity’s counterparty can take into account when evaluating the pricing and valuation of the SBS.’’). 198 2010 Rule 9j–1 Proposing Release, 75 FR at 68565–66. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 by purchasing or selling a securitybased swap based on that security (as opposed to trading in the security itself). The second provision would have provided that a person could not escape liability under section 9(j) or Rule 9j–1 by purchasing or selling the underlying security (as opposed to purchasing or selling a security-based swap that is based on that security). 2. Commission Action One commenter specifically addressed these provisions and was supportive, noting that the antifraud and anti-manipulation provisions in proposed Rules 9j–1(a) and (b) would be enhanced by the addition of proposed Rules 9j–1(c) and (d).199 In contrast, one commenter questioned the Commission’s authority to extend the prohibitions of Rule 9j–1 to the purchase and sale of underlying securities.200 After considering these comments, the Commission adopts Rules 9j–1(c) and (d) largely as proposed but renumbered as final Rules 9j–1(b) and (c), respectively. a. Rule 9j–1(b) The Commission is adopting Rule 9j– 1(b), as proposed in paragraph (c). Final Rule 9j–1(b) provides that wherever communicating, or purchasing or selling a security (other than a security-based swap) while in possession of, material nonpublic information would violate, or result in liability to any purchaser or seller of the security under either the Exchange Act or the Securities Act, or any rule or regulation thereunder, such conduct in connection with a purchase or sale of a security-based swap with respect to such security or with respect to a group or index of securities including such security shall also violate, and result in comparable liability to any purchaser or seller of that security under such provision, rule, or regulation.201 Although generally a situation where a person uses material nonpublic information about a security in connection with the purchase or sale of a security-based swap would be subject to the existing antifraud authority under the Federal securities laws, particularly section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, market participants also would benefit from a clarified interpretation of that statutory provision in this rulemaking.202 This is 199 See Better Markets Letter at 9. MFA Letter at 8–9. 201 Final Rule 9j–1(b) includes non-substantive corrections to punctuation. 202 Pursuant to section 20(d) of the Exchange Act, a person with material nonpublic information about a security cannot avoid liability under the securities 200 See PO 00000 Frm 00019 Fmt 4701 Sfmt 4700 42563 particularly true given that the issuer of a security-based swap (i.e., each counterparty to the transaction) is different from the issuer of the underlying security (i.e., the reference entity). Accordingly, the Commission is now adopting Rule 9j–1(b) to provide that a person making a purchase or sale of a security-based swap while in possession of material nonpublic information with respect to the security underlying such security-based swap is subject to liability. b. Rule 9j–1(c) The Commission also is adopting Rule 9j–1(c) largely as it was proposed as paragraph (d), with a clarifying edit as discussed below.203 Final Rule 9j–1(c) will address a situation similar to the one described above. Specifically, it provides that wherever taking any of the actions set forth in Rule 9j–1(a) involving a security-based swap would violate, or result in liability under section 9(j) of the Exchange Act or Rule 9j–1(a), such conduct, when taken by a counterparty to such security-based swap (or any affiliate of, or a person acting in concert with, such securitybased swap counterparty in furtherance of such prohibited activity), in connection with a purchase or sale of a security, loan, or group or index of securities on which such security-based swap is based shall also violate, and shall be deemed a violation of, section 9(j) or Rule 9j–1(a). The adopted rule text is modified from the 2021 Proposing Release to now include a reference to ‘‘loan.’’ The addition clarifies the scope of underlying products that apply, and is consistent with the underlying products included in the definition of ‘‘security-based laws by making purchases or sales in a swap on a broad-based index containing the security (e.g., the S&P 500), which would be a security-based swap agreement, whereas the statute is silent as to the permissibility of trading on such material nonpublic information by making purchases or sales of a security-based swap (e.g., a swap on the security itself). The Commission does not construe that silence as an intent to exclude security-based swaps from the scope of section 20(d) and the Commission has the authority under section 9(j) to prescribe means reasonably designed to prevent fraud, manipulation, or deceit with respect to security-based swap transactions. In addition, Section 9(j) makes it unlawful for any person to directly or indirectly take the actions described in that section. 203 In addition, final Rule 9j–1(c) includes nonsubstantive corrections to punctuation and two non-substantive revisions: (1) the word ‘‘whenever’’ at the start of the paragraph has been replaced with the word ‘‘wherever’’ to be consistent with the language in paragraph (b); and (2) the references to ‘‘paragraphs (a) or (b)’’ of Rule 9j–1 have been replaced with just a reference to ‘‘paragraph (a)’’ to reflect the placement of paragraph (b) of proposed Rule 9j–1 into a new paragraph (a)(6) of final Rule 9j–1. E:\FR\FM\30JNR2.SGM 30JNR2 ddrumheller on DSK120RN23PROD with RULES2 42564 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations swap’’ in section 3(a)(68)(A) of the Exchange Act.204 This provision prevents a person from escaping liability under section 9(j) or Rule 9j–1(a) with respect to a securitybased swap by limiting all of its actions to purchases or sales of the security, loan, or narrow-based security index underlying that security-based swap. For example, if a person with an existing total return swap on equity securities issued by XYZ Corporation subsequently engages in a number of wash trades to artificially inflate the price of the equity securities in order to benefit from the manipulated price by way of their existing security-based swap position, such person would be liable for violations of Exchange Act section 9(j) and Rule 9j–1 regardless of the fact the manipulation was conducted through purchases or sales of the equity securities. In response to the commenter who questioned the Commission’s authority to extend the prohibitions of Rule 9j–1 to the purchase or sale of underlying securities,205 the Commission clarifies that final Rule 9j–1(c) does not create a separate category of prohibited activity absent a connection to security-based swaps. Rather, this provision is reasonably designed to prevent fraud, manipulation, or deceit with respect to security-based swaps where that misconduct is accomplished through transactions in the underlying security, loan, or group or index of securities. This provision is necessary because security-based swaps by their nature are tied intrinsically to activity in the markets for other securities. Moreover, this provision does not impose liability on a person for violations of section 9(j) of the Exchange Act and Rule 9j–1 based solely on the impact of that person’s purchases or sales on the equity, debt, or loan markets. The rule states that the person engaged in prohibited activities in the equity, debt, or loan markets must be a counterparty to a security-based swap that references such equity or debt securities or loan, or be an affiliate of, or a person acting in concert with, such security-based swap counterparty in furtherance of such prohibited activity. Accordingly, the Commission would analyze whether transactions in the underlying equity or debt securities or loan have been used as the mechanism to violate section 9(j) and Rule 9j–1. The Commission would also analyze the same transactions to determine whether they independently violate other antifraud and anti-manipulation 204 See 15 U.S.C. 78c(68)(A). Letter at 9. 205 MFA VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 provisions of the securities laws— including sections 9 and 10(b) of the Exchange Act, and Rule 10b–5 thereunder, as well as section 17(a) of the Securities Act. E. Safe Harbors and Affirmative Defenses 1. Proposed Approach In response to operational concerns raised by commenters with regard to the 2010 Proposed Rule, the Commission proposed two limited safe harbors from re-proposed Rule 9j–1(a) to address situations when a counterparty to a security-based swap was required to take certain actions while in possession of material nonpublic information.206 First, proposed Rule 9j–1(f)(1), would have allowed a person to take action in accordance with binding contractual rights and obligations under a securitybased swap (as reflected in the written security-based swap documentation governing such transaction or any amendment thereto), so long as the person could demonstrate that: (1) the security-based swap was entered into, or the amendment was made, before the person became aware of such material nonpublic information; and (2) the entry into, and the terms of, the securitybased swap were themselves not a violation of any provision of proposed Rule 9j–1(a).207 Second, recognizing the important operational benefits and market efficiencies related to security-based swap portfolio compression, proposed Rule 9j–1(f)(2) would have provided a safe harbor for transactions effected in connection with certain types of bilateral or multilateral portfolio compression exercises.208 This proposed safe harbor would have provided that a person would not be liable under re-proposed Rule 9j–1(a) solely for reason of being aware of material nonpublic information for ‘‘security-based swap transactions effected by a person pursuant to a bilateral portfolio compression exercise (as defined in § 240.15Fi–1(a)) or a multilateral portfolio compression exercise (as defined in § 240.15Fi–1(j)) so long as: (i) any such transactions are consistent with all of the terms of a bilateral portfolio compression exercise or multilateral portfolio compression exercise, including as it relates to, without limitation, the transactions to be included in the exercise, the risk tolerances of the persons participating in the exercise, and the methodology 206 See 2021 Proposing Release, 87 FR at 6662, 6662 n.87. 207 Id. at 6662. 208 See id. at 6662–63. PO 00000 Frm 00020 Fmt 4701 Sfmt 4700 used in the exercise; and (ii) all such terms were agreed to by all participants of the bilateral portfolio compression exercise or multilateral portfolio compression exercise prior to the commencement of the applicable exercise.’’ 209 2. Commission Action As discussed above, in response to operational concerns raised in response to the 2010 Proposed Rule, the Commission included two limited safe harbors from re-proposed Rule 9j– 1(a).210 After further consideration and as described in more detail below, the Commission is not adopting either proposed safe harbor. Instead, the Commission is adopting two affirmative defenses from Rules 9j–1(a)(1) through (a)(5). One affirmative defense is for actions taken in connection with the binding contractual rights and obligations under a security-based swap (similar to the proposed safe harbor). The other affirmative defense takes account of reasonable policies and procedures that ensure that individuals making investment decisions are not engaging in prohibited conduct in final Rules 9j–1(a)(1) through (a)(5). These affirmative defenses, while not identical to the affirmative defenses under Rule 10b5–1, are similar in that they apply to situations in which a person can demonstrate that material nonpublic information did not factor into their investment decision. Consistent with the analogous provisions of Rule 10b5–1, final Rule 9j–1 does not provide for an affirmative defense for violations of the antimanipulation provision in Rule 9j– 1(a)(6). Paragraph (a)(6) of Rule 9j–1 does not apply to actions that the affirmative defenses address: those taken in the ordinary course of a security-based swap transaction (including actions related to the reference underlying security) while aware of material nonpublic information.211 Several commenters urged the Commission to make the affirmative defenses under Rule 10b5–1 available under Rule 9j–1, to address situations in which a counterparty comes into possession of material nonpublic information during the life of a securitybased swap.212 Rule 10b5–1 applies to 209 Re-proposed Rule 9j–1(f)(2); 2021 Proposing Release, 87 FR at 6662. 210 See 2021 Proposing Release, 87 FR at 6660– 62. 211 Final Rule 9j–1(a)(6) is discussed in section II.C above. 212 See ACLI Letter at 2, 5; IIB–ISDA–SIFMA Letter at 4–5, 10; MFA Letter at 13–16; LSTA Letter at 9; Letter from Lindsey Weber Kiljo and William E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 insider trading cases under section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and includes affirmative defenses for: (1) purchases or sales pursuant to a binding contract, an instruction to another person to execute the trade for the instructing person’s account, or a written trading plan under certain conditions; 213 and (2) transactions by an entity if the individual making the investment decision on behalf of the entity was not aware of the material nonpublic information and the entity had implemented reasonable policies and procedures to ensure that the individuals making investment decisions would not violate insider trading laws.214 Several commenters noted that most security-based swap market participants are global financial firms that have spent considerable resources to meet the requirements of current Rule 10b5– 1(c)(2), by separating their organizations so that individuals on the public side can engage in dealing and marketmaking activity, while individuals on the private side are allowed to possess material nonpublic information.215 One commenter stated that the current policies and procedures restrict access to material nonpublic information by those individuals who engage in security-based swap transactions for hedging or other purposes.216 Since neither of the Rule 10b5–1 defenses explicitly applied to proposed Rule 9j– 1 for security-based swaps, one commenter noted the ‘‘confusion and regulatory uncertainty’’ that would be created with the omission of a Rule 10b5–1(c)(2)-type defense from Rule 9j– 1 (because identical conduct in the context of a security-based swap transaction could implicate both Rule 10b–5 and Rule 9j–1, but the affirmative defense would only be available under Rule 10b–5).217 In addition, certain commenters expressed concern with the operational impacts of Rule 9j–1(a) on the capital and loan markets. One commenter argued that the application of proposed Rule 9j–1 to the ongoing, ‘‘nonvolitional’’ rights and obligations that occur throughout the life of a securitybased swap could ‘‘cast uncertainty on C. Thum, Asset Management Group of SIFMA (‘‘SIFMA AMG’’), dated Mar. 21, 2022 (‘‘SIFMA AMG Letter’’), at 11–12. 213 See 17 CFR 240.10b5–1(c)(1) (‘‘Rule 10b5– 1(c)(1)’’). 214 See 17 CFR 240.10b5–1(c)(2) (‘‘Rule 10b5– 1(c)(2)’’). 215 See IACPM Letter at 4; IIB–ISDA–SIFMA Letter at 5; MFA Letter at 13–14. 216 See LSTA Letter at 9. 217 IIB–ISDA–SIFMA Letter at 5. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 a wide range of bona fide conduct necessary to the operation of the capital markets.’’ 218 The commenter urged the Commission to ‘‘provide an affirmative defense for actions taken by a person in accordance with binding contractual rights and obligations under [a securitybased swap] . . . or to fulfill a regulatory obligation in connection with [a security-based swap] . . . if the person did not act intentionally or recklessly in connection with such action and . . . complied in good faith with written policies and procedures reasonably designed to meet the obligation.’’ 219 The commenter was concerned that the negligence standard applicable to re-proposed Rules 9j– 1(a)(3) and (4), in particular, could lead to potential fraud liability for good faith, non-volitional conduct.220 Another commenter addressed operational concerns related to the credit markets and argued that the proposed rule would ‘‘create considerable uncertainty with respect to the legitimate business decisions of lenders and impair the [security-based swap] market and loan market.’’ 221 The commenter explained that if the rule were to apply to any activity that potentially affects the stream of payments, deliveries or other ongoing obligations or rights between parties to a security-based swap, ‘‘each party will have to implement controls and mechanisms to track decisions made in connection with each payment, delivery, obligation or right as well as to track changes in its positions in the security-based swap and reference underlying.’’ 222 The Commission agrees with commenters that an affirmative defense similar to those available under Rule 10b5–1 (when the investment decision is not based on material nonpublic information) is important given the similarity in the antifraud provisions. The Commission also agrees that the 218 Id. at 8–10. at 10–11, 11 n.18 (referencing a safe harbor adopted by the CFTC in connection with nonscienter fraud and manipulative prohibitions as part of its swap dealer business conduct standards). 220 Id. at 9. The commenter stated that it did not have the same concerns about proposed Rule 9j– 1(b) (now Rule 9j–1(a)(6)), because the scienter standard applicable to that provision is ‘‘sufficient to distinguish illegitimate conduct from merely negligent acts that affect payment or delivery obligations.’’ 221 LSTA Letter at 3–10. 222 Id. The LSTA supported the principles underlying section 9(j) but did not see the need for a new rule in light of existing antifraud rules and further believed that the existing antifraud rules would address several of the manufactured credit events described in the 2021 Proposing Release and that the adoption of anti-net short provisions would address other concerns. Id. at 3–4. The Commission believes that the affirmative defense provided by new Rule 9j–1(e)(2) will address these concerns. 219 Id. PO 00000 Frm 00021 Fmt 4701 Sfmt 4700 42565 affirmative defenses would address concerns regarding market disruption. As a result, the Commission is adopting two affirmative defenses similar in concept to the affirmative defenses in Rule 10b5–1(c).223 However, the Commission is adapting the affirmative defenses for the specific context of Rule 9j–1. In particular, the Commission is not adopting an affirmative defense that is as broad as the affirmative defenses in Rule 10b5–1(c)(1). Rather, as discussed below, the Commission is limiting the relevant Rule 9j–1 affirmative defense to actions taken pursuant to binding contractual rights under the documentation governing a securitybased swap. The Rule 10b5–1(c)(1) affirmative defenses relate to advance planning of purchases or sales pursuant to a binding contract, an instruction to another person to execute the trade for the instructing person’s account, or a written trading plan under certain conditions.224 Those Rule 10b5–1(c)(1) affirmative defenses were created to ‘‘provide appropriate flexibility to those who would like to plan securities transactions in advance, at a time when they are not aware of material nonpublic information, and then carry out those pre-planned transactions at a later time, even if they later become aware of material nonpublic information.’’ 225 That flexibility is warranted in the context of corporate insiders and others who periodically come into possession of material nonpublic information but may want to schedule orderly trading of securities of an issuer on a liquid public market. It is not appropriate in the context of security-based swaps, which are typically bespoke, created and 223 Much of the development of insider trading law has resulted from court cases. The Supreme Court has stated that ‘‘[u]nder the ‘traditional’ or ‘classical theory’ of insider trading liability, [section] 10(b) and Rule 10b–5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information.’’ O’Hagan, 521 U.S. at 651–52 (emphasis added). See also Selective Disclosure and Insider Trading, Exchange Act Release No. 43154 (Aug. 15, 2000), 65 FR 51716, 51727 (Aug. 24, 2000) (discussing the awareness standard required for insider trading liability and adopting the definition of ‘‘on the basis’’ of material nonpublic information in Rule 10b5–1(b)). In this regard, any of the actions set forth in Rule 9j–1(a) with regard to a security-based swap are ‘‘on the basis of’’ material nonpublic information about that security-based swap, the issuer of that securitybased swap, or the security underlying that security-based swap, if the person taking the action was aware of the material nonpublic information when the person took the action. 224 See Rule 10b5–1(c)(1). 225 See Insider Trading Arrangements and Related Disclosures, Exchange Act Release No. 96492 (Dec. 14, 2022), 87 FR 80362, 80363 (Dec. 29, 2022) (‘‘Rule 10b5–1 Amendments’’). E:\FR\FM\30JNR2.SGM 30JNR2 42566 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 issued by the counterparties, and thinly traded. Accordingly, the Commission is adopting two affirmative defenses to liability under paragraphs (a)(1) through (a)(5) of final Rule 9j–1. a. Affirmative Defense: Binding Contractual Obligations First, the Commission is adopting an affirmative defense that maintains the substance of the safe harbor provision in re-proposed Rule 9j–1(f)(1), which would have applied to actions taken pursuant to binding rights and obligations in written documentation governing a security-based swap that was entered into prior to the person coming into possession of material nonpublic information. As adopted, the provision in Rule 9j–1(e)(1) (renumbered from proposed paragraph (f)) is an affirmative defense, rather than a safe harbor, to be consistent with the structure of current Rule 10b5–1(c)(1). The affirmative defense in final Rule 9j– 1(e)(1) provides that actions that would otherwise violate the prohibitions of Rule 9j–1(a)(1) through (5) are not a violation ‘‘solely for reason of being aware of material nonpublic information’’ if such actions are ‘‘taken by a person in accordance with binding contractual rights and obligations under a security-based swap (as reflected in the written security-based swap documentation governing such transaction or any amendment thereto).’’ 226 Under this affirmative defense, consistent with Rule 10b5– 1(c)(1), a market participant may take action when aware of material nonpublic information but may avoid liability: ‘‘so long as the person demonstrates that: (i) [t]he securitybased swap was entered into, or the amendment was made, before the person became aware of such material nonpublic information, and (ii) [t]he security-based swap was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of [Rule 9j–1].’’ 227 Framing this relief as an affirmative defense rather than as a safe harbor, and restricting its use to circumstances in which the security-based swap was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of the rule, is consistent with Rule 10b5–1(c)(1) treatment of the defense. As discussed above, multiple commenters requested the Commission adopt affirmative defenses based on the Rule 10b5–1(c) defenses.228 Rule 10b5– 226 See final Rule 9j–1(e)(1). final Rule 9j–1(e)(1). 228 See supra note 212. 227 See VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 1(c)(1) provides an affirmative defense from Rule 10b–5 liability in circumstances where it is apparent that the trading was not made on the basis of material nonpublic information because ‘‘the trade was made pursuant to a binding contract, an instruction to another person to execute the trade for the instructing person’s account, or a written plan for the trading of securities . . . adopted at a time that the person was not aware of material nonpublic information.’’ 229 Similarly, Rule 9j– 1(e)(1) provides an affirmative defense from Rule 9j–1(a) liability when an action is taken not on basis of material nonpublic information, but pursuant to binding contractual rights and obligations reflected in the written documentation governing a securitybased swap. If the security-based swap was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of the rule, the new Rule 9j–1(e)(1) affirmative defense will allow counterparties to take actions that are required by, and in accordance with, the written agreements governing the security-based swap (i.e., actions in the normal course of the security-based swap transaction) even when aware of material nonpublic information. For example, the Rule 9j–1(e)(1) affirmative defense would apply to making a standardized coupon payment or delivering collateral to a counterparty (and would also permit the counterparty to receive the coupon payment or collateral), while such person is aware of material nonpublic information, so long as both actions are required by the terms of the transaction and documented in writing. In contrast, the affirmative defense would not apply if a counterparty took some action to fraudulently increase (in the case of the receiving counterparty) or decrease (in the case of the delivering counterparty) the amount of such payment or collateral transfer. Rule 9j–1(e) provides an affirmative defense when a person’s conduct would violate Rule 9j–1(a)(1) through (5) ‘‘solely’’ because he or she is ‘‘aware of material nonpublic information.’’ But actions to fraudulently increase or decrease 229 See Rule 10b5–1 Amendments, 87 FR 80362, 80363 (adopting revisions to the Rule 10b5–1(c)(1) affirmative defense to apply a cooling-off period on persons other than the issuer of securities subject to a plan, impose a certification requirement on directors and officers of those issuers, limit the ability of persons other than the issuer to use multiple-overlapping Rule 10b5–1 plans, limit the use of single-trade plans by persons other than the issuer to one such single-trade plan in any 12month period, and add a condition that all persons entering into a Rule 10b5–1 plan must act in good faith with respect to that plan). PO 00000 Frm 00022 Fmt 4701 Sfmt 4700 payments or collateral transfer—when taken in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap—would violate Rule 9j–1(a) regardless of the possession of material nonpublic information. A person relying on the affirmative defense in adopted final Rule 9j–1(e)(1) must demonstrate that they entered into the security-based swap, or amendment, before becoming ‘‘aware of’’ the material nonpublic information rather than before they ‘‘came into possession’’ of the information, as required in reproposed Rule 9j–1.230 The change in the rule text to an awareness standard, rather than a possession standard, brings the Rule 9j–1(e)(1) affirmative defense in line with the Commission’s intent, as described in the 2021 Proposing Release preamble.231 The change also makes Rule 9j–1(e)(1) consistent with Rule 10b5–1(c)(1), which requires that the person entered into a binding contract before becoming ‘‘aware of’’ the material nonpublic information.232 b. Affirmative Defense: Policies and Procedures Second, Rule 9j–1(e)(2) provides a defense from liability under Rules 9j– 1(a)(1) through (5) for actions taken by a person, other than a natural person, who demonstrates that: (1) the individual making the investment decision on behalf of the person was not aware of the material nonpublic information; and (2) the person had implemented reasonable policies and procedures, taking into consideration the nature of the person’s business, to ensure that individuals making investment decisions would not be in violation of Rule 9j–1(a)(1) through (5).233 These policies and procedures may include those that restrict an individual from effecting a transaction in, or purchasing or selling, any security, including any security-based swap, as to which the individual possesses material nonpublic information, or those that prevent individuals from becoming aware of such information.234 Rule 9j–1(e)(2) is modeled on Rule 10b5–1(c)(2) and addresses concerns raised by commenters that the proposed rule would have a chilling effect on the markets. Rule 9j–1(e)(2) recognizes that 230 See 2021 Proposing Release, 87 FR at 6703. 2021 Proposing Release, 87 FR at 6662. 232 See 17 CFR 240.10b5–1(c)(1)(i)(A). 233 Final Rule 9j–1(e)(2). 234 See final Rule 9j–1(e)(2)(ii). 231 See E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations many market participants, such as lenders and life insurance companies, employ compliance programs which include, among other things, information barriers that prevent access to material nonpublic information by their employees who engage in securitybased swap transactions for hedging or other purposes. ddrumheller on DSK120RN23PROD with RULES2 c. Proposed Safe Harbor: Compression Because the Commission is adopting final Rule 9j–1(e)(2), the Commission is not adopting proposed Rule 9j–1(f)(2), which would have provided a safe harbor for transactions made in connection with certain portfolio compression exercises. The proposed safe harbor would have conflicted with Rules 10b–5 and 10b5–1 by providing the same action with protection from liability under Rule 9j–1, but not Rule 10b–5. In proposing the portfolio compression safe harbor, the Commission recognized the benefits provided by portfolio compression along with the ‘‘largely administrative nature of the portfolio compression process.’’ 235 To be clear, the Commission continues to support portfolio compression and its benefits.236 Providing the safe harbor as proposed, however, would have sanctioned the use of material nonpublic information under Rule 9j–1, even though that use would have been prohibited by Rule 10b–5. Adopting Rule 9j–1(e)(2) instead will avoid confusion that could have resulted by treating the same conduct differently under Rules 10b–5 and 9j–1. In addition, the Rule 9j–1(e)(2) will provide security-based swap market participants the flexibility needed to engage in bilateral and multilateral portfolio compression exercises. The affirmative defense should be consistent with the manner in which Rules 10b–5 and 10b5–1(c)(2) currently apply to compression exercises and eliminates concerns that compression exercises may be more than merely administrative 235 2021 Proposing Release, 87 FR at 6662–63 (describing the operational benefits and efficiencies resulting from portfolio compression). 236 As the Commission recognized when it adopted portfolio compression requirements for SBS Entities, there are times when entering into compression exercises would not be appropriate. See Risk Mitigation Techniques for Uncleared Security-Based Swaps, Exchange Act Release No. 87762 (Dec. 18, 2019), 85 FR 6359, at 6370 (Feb. 4, 2020) (‘‘Risk Mitigation Adopting Release’’). As a result, 17 CFR 240.15Fi–4 provides that the policies and procedures required under the rule will need to provide that portfolio compression exercises occur ‘‘when appropriate.’’ It would not be appropriate to enter into compression exercises when doing so would be on the basis of material nonpublic information in violation of Commission rules, including Rule 10b–5 or final Rule 9j–1. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 and could be made on the basis of material nonpublic information. d. Other Requested Safe Harbors and Affirmative Defenses Certain commenters were supportive of the proposed safe harbors 237 but also believed that the safe harbors were too narrow and urged the adoption of additional Rule 9j–1 safe harbors for legitimate restructuring transactions, hedging activity related to lending, transactions with counterparty disclosure regarding status as a lender and access to material nonpublic information from the borrower, multilateral amendment exercises (including ISDA protocols) or bilateral equivalents, participation in determinations committee, or for publicly executed strategies.238 One commenter raised concerns that the proposed safe harbor only addresses situations where a lender, aware of material nonpublic information, exercises rights or takes actions with respect to security-based swaps, but not if the lender exercises rights or remedies under a credit, loan, or similar agreement, while aware of material nonpublic information.239 The Commission declines to adopt additional safe harbors. The affirmative defenses the Commission is adopting provide consistency with Rule 10b5–1. Additionally, they will address concerns expressed by market participants advocating for additional safe harbors by permitting persons to enter into certain types of activity, pursuant to the requirements of the affirmative defenses, while also addressing concerns about fraud and manipulation for the entire securitybased swap market. In response to the proposed safe harbors, one commenter urged for the elimination of all safe harbors from proposed Rule 9j–1(a) liability because the Commission had ‘‘not demonstrated that a safe harbor from the prohibition on fraud and manipulation is necessary or appropriate.’’ 240 This same 237 Only one commenter specifically addressed the compression safe harbor of re-proposed Rule 9j– 1(f)(2). See IIB–ISDA–SIFMA Letter at 11. The commenter noted that ‘‘the important operational benefits and efficiencies for market participants’’ supporting the safe harbor for portfolio compression exercises would also support a safe harbor for ‘‘other centralized market activities’’ including multilateral amendment exercises (such as an ISDA protocol) and the use of determinations committees. Id. 238 See Fletcher Letter at 4; IACPM Letter at 4; MFA Letter at 10–12; LSTA Letter at 8–9; IIB– ISDA–SIFMA Letter at 11–12. 239 See LSTA Letter at 8–9. 240 Better Markets Letter at 9. This commenter stated that it ‘‘[d]oes not appear there is any need for a safe harbor such as the one proposed by the PO 00000 Frm 00023 Fmt 4701 Sfmt 4700 42567 commenter also argued for compliance with Rule 9j–1(a) rather than for the adoption of safe harbors that it believed would encourage unlawful behavior.241 Another commenter argued that the proposed safe harbors were overly broad and protective of actions that are inherently fraudulent.242 However, as discussed above, the Commission agrees with commenters that an affirmative defense similar to those available under Rule 10b5–1 (when the investment decision is not based on material nonpublic information) is important given the similarity in the antifraud provisions. The Commission also agrees that the affirmative defenses would address concerns regarding market disruption while also addressing concerns about fraud and manipulation in the security-based swap market. Therefore, the Commission is adopting the affirmative defenses as discussed above. In addition to the request for the inclusion of additional safe harbors and affirmative defenses, commenters also addressed the scope of Rule 9j–1 as it applies to different types of securitybased swap instruments. One commenter argued for carving out sovereign debt from the scope of Rule 9j–1 due to the unlikelihood that holders of security-based swaps on sovereign debt would be able to manufacture credit events or otherwise engage in opportunistic trading, especially life insurers which are prohibited by state law from entering into speculative or abusive trading.243 While security-based swaps related to sovereign debt may present fewer opportunities for manufactured credit events or opportunistic strategies, by regulated and non-regulated market participants alike, such instruments are not without risk of fraudulent and manipulative conduct and should SEC, because it is not clear how a prohibition on fraud and manipulation could possibly apply to the performance of completely non-volitional, contractual requirements, of a contract that was entered into without fraudulent, deceptive, or manipulative intent.’’ Id. at 10. See also WebForm Comments from Anonymous Penguin, dated Oct. 7, 2022 (‘‘Anonymous Penguin Comments’’), at 1 (arguing for no affirmative defense from liability); WebForm Comments from J.T., dated Nov. 15, 2022 (‘‘J.T. Comments’’), at 1 (arguing for no safe harbor for binding contractual rights and obligations under a security-based swap). 241 Better Markets Letter at 12 (pointing to experience with Rule 10b5–1 and citing studies and Wall Street Journal reporting). 242 See WebForm Comments from Michael, dated Jan. 3, 2023 (‘‘Michael Comments’’), at 1. 243 See ACLI at 3, 13–14 (arguing that sovereign debt should be excluded from the scope of both final Rule 9j–1 and final Rule 10B–1). E:\FR\FM\30JNR2.SGM 30JNR2 42568 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations remain within the scope of Rule 9j–1.244 One commenter supported adopting different rules for CDS as opposed to other security-based swaps due to ‘‘the structure and nature of CDS instruments,’’ which the commenter believes make CDS more susceptible to opportunistic strategies.245 However, non-CDS security-based swaps are also susceptible to fraud and manipulation and, therefore, the Commission makes no change to the scope of Rule 9j–1 to treat CDS differently from other security-based swaps. Additionally, Rule 9j–1 is tailored appropriately to address fraud and manipulation for the entire security-based swap market. III. Rule 15fh–4(c): Preventing Undue Influence Over Chief Compliance Officers; Policies and Procedures Regarding Compliance With Rule 9j–1 and Rule 15fh–4(c) A. Proposed Approach The Commission also proposed a rule aimed at protecting the independence and objectivity of an SBS Entity’s CCO by preventing the personnel of an SBS Entity from taking actions to coerce, mislead, or otherwise interfere with the CCO. Specifically, proposed Rule 15Fh– 4(c) (‘‘proposed Rule 15Fh–4(c)’’) would have made it unlawful for any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the SBS Entity’s CCO in the performance of their duties under the Federal securities laws or the rules and regulations thereunder. ddrumheller on DSK120RN23PROD with RULES2 B. Commission Action After review of the comments, the Commission is adopting Rule 15fh–4(c) as proposed. The final rule will protect the independence and objectivity of an SBS Entity’s CCO by preventing the 244 As of Nov. 25, 2022, sovereign CDS have the second highest gross notional amount outstanding among credit security-based swaps. See infra section V.C.2, Table 1. The Commission further observes that the share of CDS written on sovereign debt has risen from less than four percent of the total notional amounts outstanding in the global CDS market in 2007 to 14 percent at the end of 2020. For single-name CDS during that same period, the share of the sovereign sector grew from six percent to close to one-third. See Antulio N. Bomfim, ‘‘Credit Default Swaps,’’ Finance and Economics Discussion Series 2022–023 at 4, Washington: Board of Governors of the Federal Reserve System (2022), available at https://doi.org/ 10.17016/FEDS.2022.023. See also Ben St. Clair, ‘‘Pimco Loses $400m on Failed Russia CDS Bets,’’ Risk.Net (June 20, 2022) (describing the effects on CDS of Russia’s failure to pay additional interest due on its sovereign bonds in Apr. 2022). 245 See Fletcher Letter at 4. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 personnel of an SBS Entity from taking actions to coerce, mislead, or otherwise interfere with the CCO. The Commission agrees with the two commenters who supported the adoption of Rule 15fh–4(c) to further protect SBS Entities’ CCOs from undue influence.246 Recognizing the CCO’s critical function, one commenter believed the new rule would serve as an important deterrent to improper interference with the CCO’s duties.247 A second commenter supported the rule because it would reinforce existing CCO independence requirements and duties essential to effective risk management programs of SBS Entities.248 One commenter suggested that the proposed rule was unnecessary because the existing requirements of 17 CFR 240.15Fk–1 (‘‘Rule 15Fk–1’’) are sufficient to address the risks of undue influence on a CCO.249 This commenter suggested that because the CCO is required to report directly to the board of directors or senior officer of the SBS Entity, and the CCO’s compensation and removal requires approval of a majority of the SBS Entity’s board of directors, attempts by others to influence the CCO inappropriately should be unavailing.250 The Commission disagrees. When the Commission previously considered whether to adopt a similar requirement, it concluded that requiring a majority of the board to compensate and remove the CCO was sufficient to establish CCO independence.251 However, in light of the rules finalized subsequent to the CCO rules, including Rule 9j–1 (which is being adopted in this release) and the risk mitigation requirements for SBS Entities,252 a rule expressly prohibiting 246 See Better Markets Letter at 14; Letter from Patrick T. Campbell, New York City Bar Association, dated Mar. 21, 2022 (‘‘NYC Bar Letter’’). 247 See Better Markets Letter at 14. 248 See NYC Bar Letter at 2–5. 249 See Letter from Stephanie Webster, IIB, Chris Young, ISDA, and Kyle Brandon, SIFMA, dated Mar. 21, 2022 (‘‘IIB–ISDA–SIFMA CCO Letter’’), at 3. 250 Id. 251 The Commission considered and rejected a prohibition on attempts by officers, directors, or employees to coerce, mislead, or otherwise mislead the CCO when it adopted business conduct standards for SBS Entities in 2016. See Business Conduct Standards Adopting Release, 81 FR at 30054–55. That rulemaking included, among other things, a rule to require an SBS Entity to designate a CCO and impose certain duties and responsibilities on that CCO, as well as antifraud provisions for SBS Entities. See 17 CFR 240.15Fk– 1; 240.15Fh–4(a). 252 Risk mitigation rules are designed to further effective risk management by requiring the existence of sound documentation, periodic reconciliation of portfolios, rigorously tested valuation methodologies, and sound collateralization practices. See Risk Mitigation Adopting Release, 85 FR at 6390–91. PO 00000 Frm 00024 Fmt 4701 Sfmt 4700 interference with the performance of a CCO’s duties is appropriate to: (1) deter any undue influence even if not directly related to compensation or the threat of removal of the CCO; and (2) help ensure the independence and effectiveness of the CCO function.253 In connection with Rule 9j–1, as well as other rules for which the CCO is responsible, undue influence could arise from many actors (and many actions), and not merely from those actors with the power to set compensation or with hiring and firing authority over the CCO.254 Moreover, existing 17 CFR 240.15Fh– 3(h) (‘‘Rule 15Fh–3(h)’’) requires an SBS Entity to establish and maintain a system to supervise its business and the activities of its associated persons, which must be reasonably designed to prevent violations of the provisions of applicable Federal securities laws and the rules and regulations thereunder.255 In addition, existing Rule 15Fk–1 requires an SBS Entity to designate a CCO, who must comply with certain duties. Such duties include ‘‘[t]ak[ing] reasonable steps to ensure that the [SBS Entity] establishes, maintains and reviews written policies and procedures reasonably designed to achieve compliance with the [Exchange Act] and the rules and regulations thereunder relating to its business as [an SBS Entity].’’ 256 Failure to establish, maintain, and review written policies and procedures reasonably designed to 253 As the Commission explained when adopting similar rules prohibiting persons from unduly influencing auditors pursuant to section 303(a) of the Sarbanes Oxley Act of 2002 (‘‘Sarbanes-Oxley Act), activities by persons acting ‘‘under the direction’’ of officers and directors of the issuer ‘‘currently may constitute violations of the antifraud or other provisions of the securities laws or aiding or abetting or causing an issuer’s violations of the securities laws.’’ Improper Influence on Conduct of Audits, Exchange Act Release No. 47890 (May 20, 2003), 68 FR 31820, 31821 (May 28, 2003) (internal citations omitted). Nevertheless, like the rule implementing section 303(a) of the SarbanesOxley Act, Rule 15fh–4(c) would provide the Commission with an additional means of addressing efforts by persons acting under the direction of an officer or director to thwart the responsibilities of the CCO. See also Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003), 68 FR 74714, 74721–22 (Dec. 24, 2003). 254 For example, an employee at an SBS Entity planning an opportunistic strategy could attempt to mislead the CCO by submitting false documentation to the CCO in order to avoid disclosing the buildup of a large position that might require public reporting and thwart the plans of the employee. 255 See 17 CFR 240.15Fh–3(h). 256 See 17 CFR 240.15Fk–1. Additionally, in its application for registration, an SBS Entity is required to include a senior officer’s certification that the SBS Entity has developed and implemented written policies and procedures reasonably designed to prevent violation of Federal securities laws and the rules thereunder. See 17 CFR 240.15Fb2–1(b). E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 achieve compliance with the Exchange Act and the rules and regulations thereunder (including Rules 9j–1 and 15fh–4(c)) may result in violations by the SBS Entity of Rule 15Fh–3(h), as well as Rule 15Fk–1.257 Rule 15fh–4(c) protects investors and promotes the fairness of the markets by supporting the ability of CCOs to meet their important obligations to foster compliance without undue influence, which should ultimately support the integrity of SBS Entities and the markets. One commenter argued that the scope of proposed Rule 15Fh–4(c) was ‘‘unclear and could lead to confusion and uncertainty in the market as to which activities are prohibited.’’ 258 This commenter went on to suggest that, if the Commission did adopt Rule 15fh– 4(c), the final rule should clarify which activities are prohibited by including materiality and intent standards that would limit the prohibited interference to knowingly making untrue statements or omitting material facts.259 The commenter believed that ambiguities could have a chilling effect on communications between the CCO and personnel of the SBS Entity.260 After considering the comments, the Commission declines to revise Rule 15fh–4(c) and adopts the rule as proposed. Rule 15fh–4(c) protects the independence and objectivity of an SBS Entity’s CCO by prohibiting undue influence by other personnel. The concerns regarding the rule having a chilling effect on communications are misplaced since the rule prohibits actions to coerce, manipulate, mislead, or fraudulently influence CCOs—not good faith disagreements or legitimate discussions. However, such influence could take many forms and is not limited to material misstatements or omissions. As noted, the Commission has adopted the majority of its Title VII rules related to security-based swaps,261 including rules relating to trading relationship documentation, dispute resolution, portfolio reconciliation, or portfolio compression (‘‘Risk Mitigation 257 The SBS Entity could also face liability under 17 CFR 240.15Fb2–1(b) and (h) under such circumstances. 258 IIB–ISDA–SIFMA CCO Letter at 1. 259 See id. at 2 (stating that the rule is unclear and could lead to confusion and uncertainty in the market as to which activities are prohibited and that the rule does not provide any materiality or intent standards, which could allow for immaterial or inadvertent actions or statements to result in liability). 260 Id. IIB–ISDA–SIFMA was concerned that questions could arise as to whether good faith disagreements or legitimate discussions ‘‘involve[d] ‘interference’ with or ‘undue influence’ over a CCO.’’ Id. 261 See supra note 16. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 Rules’’). As the Commission explained when adopting the Risk Mitigation Rules, those rules were designed to further effective risk management by requiring the existence of sound documentation, periodic reconciliation of portfolios, rigorously tested valuation methodologies, and sound collateralization practices.262 Attempts by officers, directors, or employees to hide transactions, submit false valuations, or manipulate or fraudulently influence the CCO in the performance of their duties related to the Risk Mitigation Rules would undermine the SBS Entity’s risk management and could pose risk to the market. Therefore, the Commission is adopting a rule that is broad enough to apply to these actions and any others that may undermine the independence and responsibilities of the CCO. A commenter also argued for more clarity with regard to the intent and conduct required to be liable under Rule 15fh–4(c).263 The Commission declines to make any revisions to the proposed rule in response to this comment. Specifically, the acts to ‘‘coerce, manipulate, mislead, or fraudulently influence’’ that would be prohibited by Rule 15fh–4(c) imply compelling the CCO to act in a certain way through pressure, threats, trickery, intimidation, misrepresentation, or some other form of purposeful action not limited to untrue statements or omissions of material facts, and therefore, further clarity is not necessary.264 As noted, one of the purposes of Title VII securitybased swap legislation is promoting the integrity of the security-based swap market. Such a purpose would not be served by imposing a scienter or materiality requirement on Rule 15fh– 4(c) violations. Further, the Commission believes that the rule will encourage directors, officers, supervised persons, or employees of SBS Entities to exercise reasonable attention and care in their dealings with CCOs. One commenter suggested expanding the scope of the rule to actions taken to coerce, manipulate, mislead, or fraudulently influence all officers and other decision-makers, and not limit the rule to actions taken with respect to the SBS Entity’s CCO.265 However, 262 See Risk Mitigation Adopting Release, 85 FR at 6390–91. 263 See IIB–ISDA–SIFMA CCO Letter at 2. 264 The Commission came to a similar conclusion when adopting similar rules prohibiting persons from unduly influencing auditors pursuant to section 303(a) of the Sarbanes Oxley Act of 2002 (‘‘Sarbanes-Oxley Act). See Improper Influence on Conduct of Audits, Exchange Act Release No. 47890 (May 20, 2003), 68 FR 31820, 31823 (May 28, 2003). 265 Michael Comments at 1. PO 00000 Frm 00025 Fmt 4701 Sfmt 4700 42569 activities taken by persons under the direction of officers and directors of an issuer may already constitute violations of the securities laws.266 This additional rule is appropriate given the key role that the CCO plays in an SBS Entity’s compliance with the security-based swap related regulations, such as the risk mitigation requirements for SBS Entities. Furthermore, it provides an additional means of addressing efforts by persons acting under the direction of an officer or director to thwart the responsibilities of the CCO. IV. Paperwork Reduction Act The Paperwork Reduction Act of 1995 (‘‘PRA’’) 267 imposes certain requirements on Federal agencies in connection with the conducting or sponsoring of any ‘‘collection of information.’’ 268 Neither Rule 9j–1 nor Rule 15fh–4(c) contain a collection of information requirement within the meaning of the PRA. Specifically, Rule 9j–1 contains prohibitions designed to prevent fraud, manipulation, and deception in connection with effecting transactions in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. Rule 15fh–4(c) generally makes it unlawful for certain specified persons to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence an SBS Entity’s CCO in the performance of their duties under the Federal securities laws or the rules and regulations thereunder. Neither of those rules require a person to establish, maintain, and enforce written policies and procedures reasonably designed to ensure compliance with the applicable rule. However, to the extent that a person is already subject to a similar policies and procedures requirement, any updates to those policies and procedures would likely be captured by an existing collection of information. For example, as previously explained, Rule 15Fh–3(h) requires an SBS Entity to establish and maintain a system to supervise its business and the activities of its associated persons and that system must be reasonably designed to prevent violations of the provisions of applicable Federal securities laws and the rules and regulations thereunder. In the PRA analysis when that rule was adopted, the Commission estimated that each SBS Entity would spend 60 hours per year to update each of the policies and procedures required by Rule 15Fh– 266 See supra note 252. U.S.C. 3501 et seq. 268 See 44 U.S.C. 3502(3). 267 44 E:\FR\FM\30JNR2.SGM 30JNR2 42570 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations 3.269 Both Rule 9j–1 and Rule 15fh–4(c) are intended solely to identify actions that an SBS Entity is not permitted to take, and as such do not make substantive modifications to any existing collection of information or impose new information collection requirements within the meaning of the PRA. Accordingly, we are not revising any burden and cost estimates in connection with these amendments. V. Economic Analysis ddrumheller on DSK120RN23PROD with RULES2 A. Introduction The Commission is mindful of the economic effects, including the costs and benefits, of Rule 9j–1 and Rule 15fh–4(c). Section 3(f) of the Exchange Act 270 directs the Commission, when engaging in rulemaking where it is required to consider or determine whether an action is necessary or appropriate in the public interest, to consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. In addition, section 23(a)(2) of the Exchange Act 271 requires the Commission, when making rules under the Exchange Act, to consider the impact that the rules would have on competition, and prohibits the Commission from adopting any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. The analysis below addresses the likely economic effects of Rule 9j–1 and Rule 15fh–4(c), including the anticipated benefits and costs of the rules and their likely effects on efficiency, competition, and capital formation. Many of the benefits and costs discussed below are difficult to quantify. For example, the Commission cannot quantify the impact of litigation and litigation risk on counterparties and underlying entities or the overall impact on the credibility and reputation of the security-based swap market. The extent of some of these impacts will depend, in part, on events difficult to predict that might affect security-based swaps, such as changes in counterparty or reference underlying entity behavior. Reputational and credibility effects also are difficult to measure. Therefore, while the Commission attempted to quantify economic effects where possible, much of the discussion of the anticipated economic effects below is qualitative and descriptive in nature. 269 See Business Conduct Standards Adopting Release, 81 FR at 30094. 270 15 U.S.C. 78c(f). 271 15 U.S.C. 78w(a)(2). VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 The Commission received a number of comments related to various aspects of the economic analysis of re-proposed Rule 9j–1 and proposed Rule 15Fh–4(c). The Commission has considered and responded to these comments in the sections that follow. B. Broad Economic Considerations This section discusses certain aspects of the security-based swap market that may raise concerns or may be associated with concerns that would be addressed by final Rule 9j–1. The discussion is illustrative and is not intended to exhaust all types of conduct that may implicate final Rule 9j–1. Opportunistic Strategies Opportunistic strategies often involve CDS buyers or sellers taking steps, either with or without the participation of the underlying entity, to avoid, trigger, delay, accelerate, decrease, and/ or increase payouts on CDS.272 When market participants employ one of these strategies, they intend to obtain gains from the positions they hold that go beyond those corresponding to the initial profit and loss expectation (the initial payoff function) at trade execution. This additional gain would be obtained to the direct detriment of a counterparty that is unaware of that additional loss potential.273 One commenter pointed out that while CDS have many privately and socially valuable uses, such instruments could lend themselves to abuses such as opportunistic strategies.274 To the extent that market participants anticipate opportunistic strategies, the CDS spread or price becomes a reflection of the likelihood of an opportunistic strategy being announced (or, if already announced, of succeeding) and decouples from the credit fundamentals of the reference entity.275 This effect reduces the utility of the CDS market as a venue to offload or take on the credit risk of a company because prices no longer reflect credit risk; bona fide hedgers or speculators in this market would be more likely to exit, 272 See supra note 35 and accompanying text for a discussion of the settlement process that determines payout on a CDS contract that relies on the ISDA standard documentation. 273 The market participant’s gain from the transaction is inversely proportional to the gain of the counterparty, so the larger the market participant’s position (and gain), the larger the counterparty’s loss. 274 Letter from Henry T.C. Hu, dated Mar. 21, 2022, at 6. 275 Two commenters noted that opportunistic strategies impede price efficiency in the CDS market, particularly the CDS of distressed issuers because such strategies can be more profitable when implemented on distressed issuers. See AFRED Letter at 4–5; Fletcher Letter at 3. PO 00000 Frm 00026 Fmt 4701 Sfmt 4700 as they cannot readily ‘‘trade’’ the credit of a company.276 In addition to their adverse impact on price efficiency, opportunistic strategies may impair the liquidity of the CDS markets. The fact that a counterparty might manufacture or delay a credit event in the future can deter others from entering into such contracts. If fewer parties enter into CDS contracts, the overall value of CDS as a risk-transferring instrument for the market will be reduced.277 Two commenters suggested that lenders may demand a higher rate of return (cost of debt) on new debt issuances by a reference entity that was involved in a manufactured credit event to compensate for the risk that such manufactured events may recur in the future.278 C. Baseline 1. Existing Regulatory Frameworks As discussed in section I.A, because security-based swaps are included in the Exchange Act’s definition of ‘‘security,’’ participants in the securitybased swap market are currently subject to the general antifraud and antimanipulation provisions of the Federal securities laws, including sections 9(a) and 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act. In particular, Rule 10b5–1 provides that a person trades ‘‘on the basis of’’ material nonpublic information when the person purchases or sells securities while aware of the information. However, the rule also sets forth several affirmative defenses to permit persons to trade in certain circumstances where it is clear that the information was not a factor in the decision to trade.279 Several commenters pointed out that most security-based market participants have organized their business activities and implemented policies and procedures to allow them to rely on the affirmative defense provided by Rule 10b5–1(c)(2) from liability under Rule 10b–5.280 276 See Gina-Gail S. Fletcher, Engineered Credit Default Swaps: Innovative or Manipulative?, 94 N.Y.U. L. Rev. 1073 (2019) (explaining that ‘‘engineered’’ or ‘‘manufactured’’ transactions distort the information reflected in CDS spreads, to the point where the default risk expressed in CDS spreads is no longer connected to the financial condition of the underlying entity). 277 See Fletcher Letter at 3. 278 See AFRED Letter at 4; Fletcher Letter at 3. 279 See Selective Disclosure and Insider Trading, Exchange Act Release No. 43154 (Aug. 15, 2000), 65 FR 51716 (Aug. 24, 2000). 280 See IACPM Letter at 4; IIB–ISDA–SIFMA Letter at 4–5; MFA Letter at 13; SIFMA AMG Letter at 11. See also supra section II.E.2. EBF supports the arguments in the IIB–ISDA–SIFMA Letter regarding proposed Rule 9j–1. See Letter from EBF at 1; supra note 124. E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations In addition, the Dodd-Frank Act expanded the anti-manipulation provisions of section 9 of the Exchange Act to encompass security-based swap transactions and required the Commission to adopt rules to prevent fraud, manipulation, and deception in connection with security-based swaps.281 The Commission has now finalized a majority of its Title VII rules related to SBS Entities, including rules that allow such persons to manage the market, counterparty, operational, and legal risks associated with their security-based swap business. These include the Risk Mitigation Rules; 282 rules relating to capital, margin, and segregation requirements for SBSDs, MSBSPs, and broker-dealers; 283 and rules relating to recordkeeping and reporting requirements for SBSDs, MSBSPs, and broker-dealers.284 These rules are discussed in the 2021 Proposing Release.285 As discussed earlier, the CFTC has largely completed its Title VII rulemakings related to swaps, including the adoption of antifraud and anti-manipulation rules.286 Finally, Rule 15Fk–1 requires an SBS Entity to designate a CCO and imposes certain duties and responsibilities on that CCO.287 Additionally, the rule requires that a majority of the board approve the compensation and removal of the CCO.288 Rule 15Fh–4(a) makes it unlawful for an SBS Entity to: (1) employ any device, scheme, or artifice to defraud any special entity or prospective customer who is a special entity; (2) engage in any transaction, practice, or course of business that operates as a fraud or deceit on any special entity or prospective customer who is a special entity; or (3) engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative.289 Further, existing Rule 15Fh–3(h) requires an SBS Entity to establish and maintain a system to supervise its business and the activities of its associated persons; the system 281 See supra note 4 and accompanying text. supra section III.B and note 262. 283 See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital and Segregation Requirements for Broker-Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84 FR 43872 (Aug. 22, 2019). 284 See Recordkeeping and Reporting Requirements for Security-Based Swap Dealers, Major Security-Based Swap Participants, and Broker-Dealers, Exchange Act Release No. 87005 (Sep. 19, 2019), 84 FR 68550 (Dec. 16, 2019). 285 See 2021 Proposing Release, 87 FR at 6681– 82. 286 See supra note 16. 287 See 17 CFR 240.15Fk–1(a) through (c). 288 See 17 CFR 240.15Fk–1(d). 289 See 17 CFR 240.15Fh–4(a). ddrumheller on DSK120RN23PROD with RULES2 282 See VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 must be reasonably designed to prevent violations of the provisions of applicable Federal securities laws and the rules and regulations thereunder.290 2. Security-Based Swap Data, Market Participants, Dealing Structures, and Levels of Security-Based Swap Trading Activity As of January 4, 2023, there were 50 entities registered with the Commission as SBSDs, and no entities registered as MSBSPs.291 Market participants such as SBSDs and MSBSPs were required to report security-based swap transactions to registered security-based swap data repositories (‘‘SBSDRs’’) pursuant to Regulation SBSR beginning on November 8, 2021. The Commission uses information reported pursuant to Regulation SBSR to two registered SBSDRs—Depository Trust & Clearing Corporation Data Repository (‘‘DDR’’) and the ICE Trade Vault (‘‘ITV’’)—to describe the baseline.292 Table 1 shows that U.S. security-based swap market activity is split across three asset classes: credit, equity, and interest rate. Based on information reported to DDR, as of November 25, 2022, there were approximately 523,000, 3.4 million, and 5,700 active security-based swaps in the credit, equity, and interest rate asset classes, respectively. The gross notional amounts outstanding in the credit, equity, and interest rate asset classes were respectively, approximately $2.8, $3.6, and $0.18 trillion.293 Based on 290 See 17 CFR 240.15Fh–3(h). List of Registered Security-Based Swap Dealers and Major Security-Based Swap Participants, available at https://www.sec.gov/files/ list_of_sbsds_msbsps_1_4_2023locked_final.xlsx (providing the list of registered SBSDs and MSBSPs that was updated as of Jan. 4, 2023). 292 DDR operates as a registered SBSDR for security-based swap transactions in the credit, equity, and interest rate derivatives asset classes. ITV operates as a registered SBSDR for securitybased swap transactions in the credit derivatives asset class. See Security-Based Swap Data Repositories; DTCC Data Repository (U.S.) LLC; Order Approving Application for Registration as a Security-Based Swap Data Repository, Exchange Act Release No. 91798 (May 7, 2021), 86 FR 26115 (May 12, 2021); Security-Based Swap Data Repositories; ICE Trade Vault, LLC; Order Approving Application for Registration as a Security-Based Swap Data Repository, Exchange Act Release No. 92189 (June 16, 2021), 86 FR 32703 (June 22, 2021). The statistics presented herein are based on the SBS Report. See supra note 42. 293 Active security-based swaps are those that have been neither terminated nor reached their scheduled maturity and are therefore open positions as of Nov. 25, 2022. Gross notional amount outstanding represents the total outstanding notional value of active, market-facing securitybased swaps on Nov. 25, 2022. Security-based swaps are considered to be ‘‘market-facing’’ when they are executed at arms-length between third parties. While a reporting party is only required to report a transaction to one SBSDR—either DDR or 291 See PO 00000 Frm 00027 Fmt 4701 Sfmt 4700 42571 information reported to ITV, as of November 25, 2022, there were approximately 155,000 active credit security-based swaps with gross notional amount outstanding of approximately $1.9 trillion. Table 1 also shows that U.S. securitybased swap market participants trade a variety of security-based swaps in each of the three asset classes. Based on information reported to DDR, as of November 25, 2022, active credit security-based swaps fall into five product types. Single-name corporate CDS constitute the largest product type, with approximately 364,000 active CDS and $1.6 trillion gross notional amount outstanding. The second largest active credit security-based swaps product type consists of single-name sovereign CDS, with approximately 94,000 active CDS and $0.9 trillion gross notional amount outstanding. For active equity security-based swaps, equity portfolio swaps constitute the largest product type, with approximately 2.3 million active equity portfolio swaps and $1.7 trillion gross notional amount outstanding. The second largest active equity security-based swaps product type consists of equity swaps, with approximately 492,000 active equity swaps and $1.2 trillion gross notional amount outstanding. Equity portfolio swaps and equity swaps can be further divided into sub-products that include, among other things, equity TRS.294 In the interest rate asset class, exotics constitute the largest product type, with approximately $0.1 trillion gross notional amount and 4,400 active exotic swaps outstanding. Based on information reported to ITV, as of November 25, 2022, active credit security-based swaps fall into two ITV—some uncleared security-based swaps in DDR also appear in ITV. This overlap is very limited in scope. As of Nov. 25, 2022, there were 605 active credit security-based swaps in ITV that were reported as uncleared (0.4% of the 154,903 active credit security-based swaps in ITV). The 605 active credit security-based swaps had a gross notional outstanding of $4.73 billion (0.3% of the approximately $1,900 billion gross notional outstanding of all active credit security-based swaps in ITV). These statistics provide an upper bound of the overlap between ITV and DDR and indicate that the overlap is very limited in scope. See SBS Report at 4 and 10. 294 An equity swap references a single underlier while an equity portfolio swap involves a portfolio wrapper under which multiple swaps can be traded with operational efficiency. See Central Clearing in the Equity Derivatives Market: An ISDA Study, ISDA.org (June 2014) at 10, available at https:// www.isda.org/a/6PDDE/central-clearing-in-the-eqdmarket-final.pdf. See ISDA, ISDA Taxonomy 2.0— Finalized, ISDA.org (Sep. 4, 2019), available at https://www.isda.org/a/o1MTE/ISDA-Taxonomy_ EQ-CR-FX-IR_v2.0__3-_September_2019-FINAL.xls (indicating that equity portfolio swaps and equity swaps can be further divided into sub-products that include, among other things, equity TRS). E:\FR\FM\30JNR2.SGM 30JNR2 42572 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations product types. Single-name corporate CDS constitute the largest product type, with approximately 135,000 active CDS and $1.3 trillion gross notional amount outstanding. The second largest active credit security-based swaps product type consists of single-name sovereign CDS, with approximately 20,000 active CDS and $0.5 trillion gross notional amount outstanding. TABLE 1—GROSS NOTIONAL AMOUNT AND ACTIVE SECURITY-BASED SWAPS OUTSTANDING ON NOV. 25, 2022, CATEGORIZED BY ASSET CLASS AND PRODUCT CLASSIFICATION a Gross notional amount outstanding (millions of USD) Active security-based swap count SBSDR Asset class Product type DDR ............... Credit ........................................................ Index ......................................................... Single-Name: Corporate ........................... Single-Name: Sovereign .......................... TRS b ........................................................ Other c ....................................................... 44,407 1,556,315 900,072 156,849 122,970 2,992 364,465 93,807 49,867 12,081 Total .......................................................... Portfolio Swap .......................................... Swap ......................................................... Contract For Difference ............................ Option ....................................................... Forward .................................................... Other d ...................................................... 2,780,613 1,688,672 1,183,279 398,952 6,915 5,663 330,136 523,212 2,266,706 491,508 642,965 1,281 1,393 41,115 Total .......................................................... Exotic ........................................................ Forward .................................................... Other e ...................................................... 3,613,617 153,306 23,818 868 3,444,968 4,419 1,164 122 Total .......................................................... Single-Name: Corporate ........................... Single-Name: Sovereign .......................... 177,992 1,348,002 544,414 5,705 134,741 20,162 Total .......................................................... 1,892,416 154,903 Equity ........................................................ Interest Rate ............................................. ITV ................. Credit ........................................................ a For ddrumheller on DSK120RN23PROD with RULES2 cleared security-based swaps in DDR, this table incorporates only one of the two security-based swaps that result from the clearing process. For ITV, this table incorporates all of the cleared security-based swaps. b As a general matter, TRS include non-CDS debt-based security swaps, equity-based security swaps, and mixed swaps. Counterparties in the TRS market use the contracts to obtain exposure, usually leveraged, to the total economic performance of a security or index and benefit from not having to own the security itself. Market participants, such as mutual funds, hedge funds, and endowments, use TRS to obtain exposure in markets where they would face difficulties purchasing or selling the underlying security (e.g., a market participant may find it difficult to buy a foreign company’s security or locate a security to sell short) while taking advantage of the capital efficiencies of not holding the security in their inventories. See also supra section I.B.1, which discusses the ongoing payment stream of TRS, among other things. c Includes the following products reported to SBSDRs: exotic, index tranche, swaptions, and other single-name (e.g., asset-backed, loan, and municipal security-based swaps). d ‘‘Other’’ is a category in the DDR Equity Product ID field. All Product ID categories are listed in the table. e Includes the following products reported to SBSDRs: inflation, debt option, and cross-currency. Table 2 shows that both SBS Entities and non-SBS Entities participate in all three asset classes in the U.S. securitybased swap market. Based on information reported to DDR, as of November 25, 2022, SBS Entities and non-SBS Entities had, respectively, entered into approximately 813,000 and 234,000 active credit security-based swaps.295 The gross notional amounts outstanding of the active credit securitybased swaps held by SBS Entities and non-SBS Entities were, respectively, approximately $4.4 and $1.2 trillion. In the equity asset class, SBS Entities and non-SBS Entities had, respectively, entered into approximately 4.0 million and 2.9 million active equity securitybased swaps. The gross notional amounts outstanding of the active equity security-based swaps held by SBS Entities and non-SBS Entities were, respectively, approximately $4.5 and $2.7 trillion. In the interest rate asset class, SBS Entities and non-SBS Entities had, respectively, entered into approximately 6,200 and 5,200 active interest rate security-based swaps. The gross notional amounts outstanding of the active interest rate security-based swaps held by SBS Entities and nonSBS Entities were, respectively, approximately $0.2 and $0.1 trillion. Based on information reported to ITV, as of November 25, 2022, SBS Entities and non-SBS Entities had, respectively, entered into approximately 123,000 and 33,000 active credit security-based swaps. The gross notional amounts outstanding of the active credit securitybased swaps held by SBS Entities and non-SBS Entities were, respectively, approximately $1.6 and $0.3 trillion. 295 For cleared security-based swaps where at least one counterparty is an SBS Entity, Table 2 reflects the security-based swaps entered into by each of the original counterparties, but does not include the positions of the clearing organizations themselves. For uncleared security-based swaps, Table 2 reflects the security-based swaps entered into by each of the original counterparties. See SBS Report at 5. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 PO 00000 Frm 00028 Fmt 4701 Sfmt 4700 E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations 42573 TABLE 2—GROSS NOTIONAL AMOUNT AND ACTIVE SECURITY-BASED SWAPS OUTSTANDING ON NOV. 25, 2022, CATEGORIZED BY ASSET CLASS AND REGISTRANT TYPE a Gross notional amount outstanding (millions of USD) SBSDR Asset class Registrant type DDR ............... Credit ........................................................ Total .......................................................... SBS Entities ............................................. Other ......................................................... Total .......................................................... SBS Entities ............................................. Other ......................................................... Total .......................................................... SBS Entities ............................................. Other ......................................................... Total .......................................................... SBS Entities ............................................. Other ......................................................... Equity ........................................................ Interest Rate ............................................. ITV ................. Credit ........................................................ 5,561,226 4,403,130 1,158,096 7,227,234 4,490,592 2,736,642 355,984 210,663 145,321 1,897,249 1,632,251 264,998 Active security-based swap count 1,046,424 812,647 233,777 6,889,936 4,013,393 2,876,543 11,410 6,214 5,196 155,578 122,831 32,747 a For cleared security-based swaps where at least one counterparty is an SBS Entity, Table 2 reflects the security-based swaps entered into by each of the original counterparties, but does not include the positions of the clearing organizations themselves. For uncleared security-based swaps, Table 2 reflects the security-based swaps entered into by each of the original counterparties. ddrumheller on DSK120RN23PROD with RULES2 In addition to information reported to registered SBSDRs, the Commission also uses data from the DTCC Derivatives Repository Limited Trade Information Warehouse (‘‘DTCC–TIW’’) to describe the baseline. DTCC–TIW provides data regarding the activity of market participants in the single-name CDS market during the period from 2006 to the end of 2021.296 The Commission acknowledges that limitations in the data constrain the extent to which it is possible to quantitatively characterize the security-based swap market.297 Based on an analysis of DTCC–TIW data, staff concluded that there are 2,326 transacting agents that engaged directly in trading between November 2006 and December 2021 with 15,721 accounts.298 296 DTCC–TIW provides weekly positions and monthly transaction files on a voluntary basis for single-name and index-based CDS. These data cover all positions and transactions where one of the counterparties is a U.S. entity or the reference entity is a U.S. entity, with status as a U.S. entity determined by DTCC–TIW. In DTCC–TIW, the Commission observes end of week CDS positions for all U.S. entities, foreign counterparties to a U.S. entity, or foreign counterparties trading a CDS referencing a U.S. underlying entity. The DTCC– TIW data have limitations. The data do not address two foreign counterparties with CDS referencing foreign underlying entities. In addition, the DTCC– TIW data do not provide any intra-weekly CDS position information, nor any information on the underlying security holdings of reference entities. Further, DTCC–TIW is a voluntary database where market participants on a voluntary basis submit transactions and end of week holdings. 297 The Commission also relies on qualitative information regarding market structure and evolving market practices provided by commenters and the knowledge and expertise of Commission staff. 298 These 2,326 entities, which are presented in more detail in Table 3, below, include all DTCC– TIW-defined ‘‘firms’’ shown in DTCC–TIW as transaction counterparties that report at least one transaction to DTCC–TIW as of Dec. 2021. The staff in the Division of Economic and Risk Analysis classified these firms by machine-matching names VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 Data from the DTCC–TIW show that activity in the single-name CDS market is concentrated among a relatively small number of entities, predominantly registered SBSDs.299 The top two SBSDs (when accounts are sorted by number of counterparties) each transacted with over a thousand counterparty accounts, consisting of both other SBSDs and nonSBSDs. The next 13 percent of SBSDs each transacted with 500 to 1,000 counterparty accounts; the following 21 percent of SBSDs each transacted with to known third-party databases and by manual classification. See, e.g., Security-Based Swap Transactions Connected with a Non-U.S. Person’s Dealing Activity That Are Arranged, Negotiated, or Executed By Personnel Located in a U.S. Branch or Office or in a U.S. Branch or Office of an Agent; Security-Based Swap Dealer De Minimis Exception, Exchange Act Release No. 77104 (Feb. 10, 2016), 81 FR 8598, 8602 n.43 (Feb. 19, 2016). Manual classification was based in part on searches of the EDGAR and Bloomberg databases, the SEC’s Investment Adviser Public Disclosure database, and a firm’s public website or the public website of the account represented by a firm. As mentioned above, data on CDS market participants come from DTCC– TIW. Principal holders of CDS risk exposure are represented by ‘‘accounts’’ in the DTCC–TIW. ‘‘Accounts’’ as defined in the DTCC–TIW context are not equivalent to ‘‘accounts’’ in the definition of ‘‘U.S. person’’ provided by Exchange Act Rule 3a71–3(a)(4)(i)(C). 17 CFR 3a71–3(a)(4)(i)(C). One entity or legal person (known as ‘‘transacting agent’’ in the terminology of DTCC–TIW) may have multiple accounts. For example, a bank that is a transacting agent may have one DTCC–TIW account for its U.S. headquarters and one DTCC–TIW account for one of its foreign branches. 299 Dealers are generally persons engaged in the business of buying and selling securities for their own account, through a broker or otherwise. 15 U.S.C. 78c(a)(5). SBSDs are generally defined as persons who hold themselves out as dealers in security-based swaps; make markets in securitybased swaps; regularly enter into security-based swaps as an ordinary course of business for their own account; or engage in any activity causing them to be commonly known in the trade as a dealer or market maker in security-based swaps. 17 CFR 240.3a71–1. PO 00000 Frm 00029 Fmt 4701 Sfmt 4700 100 to 500 counterparty accounts; and 62 percent of SBSDs each transacted security-based swaps with fewer than 100 counterparty accounts in 2021. The median number of counterparty accounts across SBSDs is 16 (the mean is approximately 191). SBSDintermediated transactions reached a gross notional amount of approximately $1.5 trillion, approximately 66 percent of which was intermediated by the top five SBSD accounts. The median nondealer counterparty transacted with only one SBSD account (with an average of approximately 1.9 SBSD accounts) in 2021. Non-dealer single-name CDS market participants include, but are not limited to, investment companies, pension funds, private funds, sovereign entities, and industrial companies. We observe that most non-dealer market participants of single-name CDS do not engage directly in the trading of security-based swaps, but trade through banks, investment advisers or funds, or other types of firms, which we refer to as transacting agents, consistent with DTCC–TIW terminology.300 As shown in Table 3, close to 79 percent of transacting agents are identified as investment advisers or funds.301 Although investment advisers and funds are the vast majority of transacting 300 Transacting agents participate directly in the security-based swap market, without relying on an intermediary, on behalf of their principals, investment companies, pension funds, private funds, sovereign entities, and industrial companies. For example, a university endowment may hold a position in a security-based swap that is established by an investment adviser that transacts on the endowment’s behalf. In this case, the university endowment is a principal that uses the investment adviser as its transacting agent. 301 DTCC-defined ‘‘firms’’ shown in DTCC–TIW, which we refer to here as ‘‘transacting agents.’’ E:\FR\FM\30JNR2.SGM 30JNR2 42574 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations agents, the transactions they executed account for only about 15 percent of all single-name CDS trading activity reported to the DTCC–TIW, measured by the number of transaction sides.302 The vast majority of transactions, approximately 82 percent, measured by number of transaction-sides were executed by ISDA-recognized dealers. TABLE 3—THE NUMBER OF TRANSACTING AGENTS BY COUNTERPARTY TYPE AND THE FRACTION OF TOTAL TRADING ACTIVITY, FROM NOV. 2006 THROUGH DEC. 2021, REPRESENTED BY EACH COUNTERPARTY TYPE Transacting agents Number Percent Transaction share (%) Investment Advisers/Funds a ....................................................................................................... Banks (excluding G16) b .............................................................................................................. Pension Funds ............................................................................................................................. Insurance Companies .................................................................................................................. ISDA-Recognized Dealers c ......................................................................................................... Other ............................................................................................................................................ 1,858 278 30 49 17 130 78.7 11.8 1.3 2.1 0.7 5.5 14.6 3.3 0.1 0.2 81.6 0.2 Total ...................................................................................................................................... 2,362 100.0 100 a Investment Adviser/Funds—For purposes of this table, these entities have the following characteristics: clients are predominantly individuals, institutions, and investment companies that take public and institutional money. Some also manage pooled investment vehicles (e.g., hedge funds), private equity and venture capital. b Banks (excluding G16)—The primary characteristic is the entity is trading for its own account and not just on behalf of its clients. This includes depository institutions, swap dealers (market makers), and classically-defined investment banks. c ISDA recognized dealer—Market makers (dealers) identified by ISDA as belonging to the G14 or G16 dealer group during the period. See, e.g., 2010 ISDA Operations Benchmarking Survey (2010), available at https://www.isda.org/a/5eiDE/isda-operations-survey-2010.pdf. ddrumheller on DSK120RN23PROD with RULES2 Figure 1 describes the percentage of global, notional transaction volume in North American corporate single-name CDS reported to the DTCC–TIW from January 2011 through December 2021, separated by whether transactions are between two ISDA-recognized dealers (interdealer transactions) or whether a transaction has at least one non-dealer counterparty. Figure 1 also depicts the notional trading volume of all North American corporate single-name CDS. As Figure 1 shows, all types of exposures have declined approximately proportionally since 2011. BILLING CODE 8011–01–P 302 Each transaction has two transaction sides, i.e., two transaction counterparties. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 PO 00000 Frm 00030 Fmt 4701 Sfmt 4700 E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations D. Benefits and Costs of Rule 9j–1 ddrumheller on DSK120RN23PROD with RULES2 1. Benefits Rule 9j–1 would decrease fraudulent activity and litigation costs, and could decrease compliance costs. In addition, Rule 9j–1 may indirectly increase price efficiency and decrease capital costs of underlying entities. The Commission discusses each of these individual benefits in more detail below. Rule 9j–1 would reduce the risk of fraud in the security-based swap market, including the risk of opportunistic trading strategies to the extent that such strategies occur in connection with effecting or attempting to effect any transaction in any security-based swap, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security basedswap). The additional specificity offered by Rule 9j–1 may enhance Commission oversight of the security-based swap market, which may ultimately benefit market participants through reducing the risk of fraud. Any reduction in the risk of fraud as a result of Rule 9j–1 would be limited to the extent that the fraudulent, manipulative, and deceptive conduct by security-based swap market participants is currently subject to the general antifraud and anti-manipulation provisions of the Federal securities laws, including but not limited to sections 9(a) and 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act. To the extent that Rule 9j–1 reduces the risk of fraud, the rule could encourage PO 00000 Frm 00031 Fmt 4701 Sfmt 4700 participation in the security-based market, which may result in increased competition.303 More security-based swap entities would be willing to supply (issue) and/or demand (buy) security-based swaps, with increased confidence that their counterparties would have limited abilities to impact the market through fraudulent conduct. Rule 9j–1 may provide additional precision and specificity regarding the application of existing antifraud and anti-manipulation laws to misconduct in the security-based swap market, which could prompt some market participants to devote greater resources to ensure that they are compliant with their obligations under antifraud and anti-manipulation laws, which could also decrease the risk of fraud in the security-based swap market. Because of this decreased risk of fraud, market participants may have fewer disputes 303 See E:\FR\FM\30JNR2.SGM 2019 Joint Statement, supra note 53. 30JNR2 ER30JN23.049</GPH> BILLING CODE 8011–01–C 42575 ddrumheller on DSK120RN23PROD with RULES2 42576 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations with their counterparties regarding security-based swap contracts, which in turn, could lower litigation costs for security-based swap participants and underlying entities. Lower litigation costs could contribute to reducing the cost of CDS and, to the extent that the cost of CDS is reduced, lower costs of borrowing to the underlying entity. Rule 9j–1 may also decrease compliance costs for some market participants who may, as a result of the additional specificity of the rule, need to spend fewer resources determining appropriate compliance under section 9(j). Decreased risk of fraud in the security-based swap market may also lead to increased price efficiency, as more trading could lead to a greater exchange of market expectations from buyers and sellers transacting in the market. Further, by providing specificity, Rule 9j–1 would help prevent prohibited conduct from distorting the market and artificially increasing or decreasing security-based swap prices, which also would help to ensure more efficient pricing. Increased price efficiency would consequently lead to greater security-based swap market efficiency, as security-based swap prices would provide greater confidence that their prices more likely reflect fundamental values and risk in more liquid markets. For example, the prices of single-name CDS contracts would more likely reflect the fundamental credit risk of the underlying entity, as opposed to counterparty credit risk, or the probability that fraudulent activity prohibited by Rule 9j–1 is being perpetrated in connection with the CDS contracts.304 Increased participation and price efficiency in the security-based swap market as a result of Rule 9j–1 could encourage lenders to make greater use of security-based swaps for hedging their loans, which in turn could increase lending activity and capital formation.305 In addition, improvements in the security-based swap market as a result of Rule 9j–1 may in turn have a positive impact on capital formation and the cost of capital for the underlying entities. The market participation increases in security-based swaps may enhance liquidity in the underlying market and related swap indices, and, in general, lower the cost of capital for entities 304 See generally Fletcher Letter at 3 (discussing the effects of engineered CDS transactions). 305 See generally LSTA Letter at 2 (stating that security-based swaps ‘‘play an important in risk management and hedging in the loan markets . . . [and] facilitate lending activity by transferring some or all of the risks associated with lending . . . .’’). VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 referenced by security-based swaps.306 If single-name CDS prices are more reflective of the fundamental credit risk of the underlying entity, as a second order effect, participants in the market for the underlying security would be better informed about the underlying security’s attributes through the CDS price signal, likely increasing their willingness to re-enter or engage in the underlying security’s market. Specifically, the underlying security market uses the derivative market to assess its quality, as the derivative market in some circumstances is forward looking, liquid, and more informative than the underlying market.307 Greater activity in the underlying security market due to increased price efficiency and greater availability to hedge these securities in the security-based swap market could lead to lower capital costs and increase capital formation for the underlying entities. To the extent that increased capital formation for the underlying entities is associated with the issuance of a greater variety of securities, investors could benefit because they will have a larger set of investment opportunities with which to meet their investment goals. Comments Received In the 2021 Proposing Release, the Commission solicited feedback on, among other things, the benefits of the proposed rules, including re-proposed Rule 9j–1.308 One commenter strongly agreed with the Commission’s discussion regarding the beneficial effects of greater participation in the security-based swap markets on liquidity in the underlying market and related swap indices, and the cost of capital for security-based swap referenced entities. The commenter also strongly agreed with the Commission’s discussion regarding the value of the derivative market to the underlying security market for assessing the security market’s quality.309 Three commenters believed that reproposed Rule 9j–1’s anticipated benefit of reduced fraudulent and manipulative 306 See Martin Oehmke & Adam Zawadowski, Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets, 28 Rev. of Fin. Stud. 3303–3337 (2015) and Ilhyock Shim & Haibin Zhu, The Impact of CDS trading on the Bond Market: Evidence from Asia, 40 J. of Banking & Finance 460–475 (2014). 307 See Haibin Zhu, An Empirical Comparison of Credit Spreads Between the Bond Market and the Credit Default Swap Market, 29 J. of Fin. Serv. Rsch. 211–235 (2006) and Jongsub Lee, et al., When do CDS Spreads Lead? Rating Events, Private Entities, and Firm-Specific Information Flows, 130 J. of Fin. Econ. 556–578 (2018). 308 2021 Proposing Release, 87 FR at 6701–02. 309 Milbank Letter at 10, n.17. PO 00000 Frm 00032 Fmt 4701 Sfmt 4700 activity in the security-based swap market would not materialize.310 Three commenters stated that the adoption of the ISDA Amendments has reduced the use of opportunistic strategies, such as manufactured credit events,311 while two of these commenters stated that the use of anti-net short provisions in the syndicated bank loan market has also had this effect.312 One commenter observed that opportunistic strategies have been, on the whole, extremely infrequent and doubted that re-proposed Rule 9j–1 will result in any market-wide benefit from addressing these strategies or significantly reduce manipulative activity in the security-based swap markets.313 One commenter provided CDS pricing data (in the form of the difference between the CDS spread and underlying cash bond implied credit spread (‘‘CDS-cash basis’’) and interpreted those data to suggest that CDS protection buyers perceived the risk of certain opportunistic strategies to be low. The commenter then reasoned that because CDS protection buyers perceived the risk of such strategies to be low, re-proposed Rule 9j–1 would not generate the anticipated benefit of reducing fraudulent activity in the security-based swap market as well as encouraging market participation.314 The Commission has considered feedback from the commenters who argued that the proposed rule would not have the benefit of reducing fraudulent and manipulative activity in the security-based swap market. The provisions in Rule 9j–1 are designed generally to prohibit a range of fraudulent, manipulative, and deceptive conduct in the security-based swap market. The rule is not solely intended to address opportunistic strategies in the CDS market.315 Further, anti-net short 310 See LSTA Letter at 4; July 2022 MFA Letter at 4–10; Milbank Letter at 8–9. 311 Id. 312 See LSTA Letter at 4; July 2022 MFA Letter at 4–10. 313 Milbank Letter at 9. 314 July 2022 MFA Letter at 2–4. The commenter referred to opportunistic strategies undertaken by CDS sellers to affect the likelihood of a credit event and the cost of CDS through actions such as changing the supply of deliverable obligations and offering financing to restructure a reference entity. See 2021 Proposing Release, 87 FR at 6655. 315 As discussed earlier in this section, Rule 9j– 1 would, among other things, reduce the risk of opportunistic trading strategies to the extent that such strategies occur in connection with effecting or attempting to effect any transaction in any security-based swap, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security based-swap). E:\FR\FM\30JNR2.SGM 30JNR2 ddrumheller on DSK120RN23PROD with RULES2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations provisions and ISDA Amendments are narrowly focused and have limited ability to reduce fraudulent and manipulative activity in the securitybased swap market. As discussed in the 2021 Proposing Release, the ISDA Amendments would not address all of the concerns identified in the 2019 Joint Statement, including but not limited to addressing opportunistic strategies that do not involve narrowly tailored credit events.316 Anti-net short provisions are limited to syndicated bank loans and would not apply to fraudulent activity in the security-based swap market that does not involve such loans. Thus, even if these industry efforts were successful in reducing fraudulent activity, their impact likely would be limited by their narrow scope. In response to the comment that opportunistic strategies have been, on the whole, extremely infrequent so that re-proposed Rule 9j–1 will not result in any market-wide benefit, the Commission reiterates that the provisions in Rule 9j–1 are designed generally to prohibit a range of fraudulent, manipulative, and deceptive conduct in the security-based swap market. The rule is not solely intended to address opportunistic strategies in the CDS market.317 Thus, even if opportunistic strategies were no longer implemented, final Rule 9j–1 would benefit the security-based swap market by prohibiting all other types of fraudulent, manipulative, and deceptive conduct in the market. That said, this benefit likely would be limited to the extent that the fraudulent, manipulative, and deceptive conduct by securitybased swap market participants is currently subject to the general antifraud and anti-manipulation provisions of the Federal securities laws, including but not limited to sections 9(a) and 10(b) of the Exchange Act, and Rule 10b–5 thereunder, and section 17(a) of the Securities Act. The Commission is not persuaded that the CDS-cash basis data provided by one of the commenters necessarily indicate that CDS protection buyers perceived the risk of certain opportunistic strategies to be low.318 Apart from such perceived risk, the academic literature suggests a number of factors that affect the CDS-cash basis such as funding cost, counterparty risk, collateral quality, and the CDS reference entity’s financial characteristics.319 316 See 2021 Proposing Release, 87 FR at 6655 n.31; supra note 52. 317 See supra note 315. 318 See July 2022 MFA Letter at 2–4. 319 See, e.g., Jennie Bai & Pierre Collin-Dufresne, The CDS-Bond Basis, 48 Fin. Mgmt., 417–439 VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 Without accounting for the influence of these other factors, it is not clear if the CDS-cash basis reflects that CDS protection buyers perceive the risk of certain opportunistic strategies to be low. Even if the CDS-cash basis data reflect CDS protection buyers’ perceived risk of certain opportunistic strategies, the data’s limited scope provides no information on the perceived risk of other types of fraudulent and manipulative activity in the securitybased swap market. Accordingly, the commenters have not offered convincing evidence that Rule 9j–1 will be without benefits. The Commission continues to believe that Rule 9j–1, by addressing the security-based swap market more broadly, would reduce fraudulent and manipulative activity in this market. One commenter asserted that proposed Rule 9j–1(b) (adopted as Rule 9j–1(a)(6)) would introduce substantial uncertainty in the application of the antifraud and anti-manipulation provisions of the Federal securities laws, and therefore questioned whether the benefits of ‘‘additional precision and specificity’’ that the Commission identified would materialize.320 Final Rule 9j–1(a)(6)’s scienter requirements, the practical utility of the rule’s objective facts-and-circumstances requirement, and the applicability of familiar case law help mitigate any uncertainty that market participants may have regarding the application of the final rule. 2. Costs Some security-based swap market participants may incur costs associated with taking actions to update existing compliance systems for compliance with Rule 9j–1. The Commission estimates that security-based swap market participants may incur one-time aggregate costs ranging between $1,225,360 and $2,450,720 to update their existing compliance systems.321 (2019) and Amrut Nashikkar, et al., Liquidity and Arbitrage in the Market for Credit Risk, 46 J. of Fin. Quantitative Analysis 627–656 (2011). 320 See Milbank Letter at 5, 9. 321 The Commission estimates that a securitybased swap market participant that updates its existing compliance system likely will do so by having a compliance attorney make a one-time update to its policies and procedures. Costs per entity = 1 hour × $424/hour national hourly rate for a compliance attorney = $424. The per-hour figure for a compliance attorney is from SIFMA’s Management and Professional Earnings in the Securities Industry—2013, as modified by Commission staff to adjust for inflation (through Dec. 2022) and to account for an 1,800-hour workyear, and multiplied by 5.35 to account for bonuses, firm size, employee benefits, and overhead. Based on an analysis of information reported pursuant to Regulation SBSR to DDR and ITV, the Commission PO 00000 Frm 00033 Fmt 4701 Sfmt 4700 42577 These additional costs could be limited to the extent that many of these practices and systems are already in place to ensure compliance with section 9(j) of the Exchange Act and the other general antifraud and anti-manipulation statutory and regulatory provisions. In addition, the rule could discourage some legitimate market activities, including some hedging activity, because of concerns that such activities might be viewed as rule violations. As a result, compliance costs related to evaluating whether or not certain activities are permissible may increase for some market participants. Market participants might incur costs associated with the affirmative defenses in Rule 9j–1(e). However, such costs likely would be very limited. As a general matter, the affirmative defenses in Rule 9j–1(e) are voluntary and do not impose requirements on market participants. Market participants choose to incur costs related to the affirmative defenses if they anticipate the associated benefits to exceed the associated costs. Market participants for whom the anticipated benefits of the affirmative defenses do not exceed the associated costs likely would not incur those costs. However, market participants that choose not to rely on the affirmative defenses may incur other costs (e.g., additional cost of counsel or other experts to evaluate whether actions taken without relying on the affirmative defenses are compliant with the Exchange Act and Commission regulations, and a potential increase in legal liability risk). estimates that there are 11,559 security-based swap market participants (including SBS Entities) as of Nov. 25, 2022. There is uncertainty as to how many security-based swap market participants will choose to update their existing compliance systems to comply with Rule 9j–1. A lower bound estimate is 25% × 11,559 = 2,889.75, or approximately 2,890 security-based swap market participants. An upper bound estimate is 50% × 11,559 = 5,779.50 or approximately 5,780 security-based swap market participants. The lower bound estimate of one-time aggregate costs = 2,890 × $424 = $1,225,360. The upper bound estimate of one-time aggregate costs = 5,780 × $424 = $2,450,720. There is also uncertainty regarding the specific changes that security-based swap market participants may make to their existing compliance systems to comply with Rule 9j–1. Two commenters believed that re-proposed Rule 9j–1 would require market participants to incur costs to design and implement extensive compliance programs and reconcile the scope of the new rule with existing practices. See LSTA Letter at 9–10; IACPM Letter at 4. However, these commenters did not provide quantified estimates of such costs. To the extent that security-based market participants choose to comply with final Rule 9j– 1 in the manner described by these commenters, the costs of complying with the final rule could be higher than the Commission’s estimate. To the extent that market participants incur compliance costs as a result of Rule 9j–1, these costs represent a reasonable trade-off in light of the benefits discussed in section V.D.1. See also discussion later in this section. E:\FR\FM\30JNR2.SGM 30JNR2 42578 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 Market participants that seek to rely on the affirmative defense in paragraph (e)(1) of Rule 9j–1 likely would do so by creating and retaining the written security-based swap documentation governing such transaction or any amendment thereto. As discussed in the 2021 Proposing Release, such documentation is already created and retained as a result of SBS Entities’ compliance with existing 17 CFR 240.15Fi–5 and the Commission’s recordkeeping requirements in 17 CFR 240.17a–4 or 17 CFR 240.18a–6, as applicable.322 Thus, the costs that may be incurred by those market participants that wish to rely on the affirmative defense likely would be very limited, if any. Market participants that seek to rely on the affirmative defense in paragraph (e)(2) of Rule 9j–1 would be required to comply with the specific provisions of that paragraph, including implementing reasonable policies and procedures to prevent insider trading. For most market participants to whom this affirmative defense would be relevant, the costs associated with policies and procedures likely would be very limited. As discussed above, most security-based swap market participants have spent considerable resources to avail themselves of the affirmative defense of Rule 10b5–1(c)(2).323 Because the affirmative defense of Rule 9j–1(e)(2) is modeled on that of Rule 10b5–1(c)(2), most security-based swap market participants likely would employ their existing policies and procedures to avail themselves of the affirmative defenses of both Rules 10b5–1(c)(2) and 9j–1(e)(2). Comments Received One commenter believed that the proposed rules would help to reduce costs for all investors by removing fraud and manipulation from the securitybased swap market and the market for underlying securities.324 However, several commenters were concerned that re-proposed Rule 9j–1 would significantly increase compliance costs for security-based swap market participants in various ways. One commenter believed that reproposed Rule 9j–1 would require market participants to incur costs to design and implement extensive compliance programs to adhere to the rule’s broad prohibitions; and that such costs are only marginally alleviated by the narrow proposed safe harbors, since ensuring that each activity falls within 322 See 2021 Proposing Release 87 FR at 6662 a designated safe harbor presents resource challenges of its own. The commenter stated that such compliance costs would be unreasonably burdensome to lenders and would have a significant, negative impact on the loan markets. The commenter also stated that, absent an affirmative defense similar to Rule 10b5–1(c)(2), market participants may have to incur cost and effort to identify all securitybased swaps and related reference underlying entities held by the organization and to track and coordinate all activity that could affect the purchase, sale, payments, deliveries, and other ongoing obligations or rights with respect to the security-based swaps and the related reference underlying entities.325 Another commenter stated that re-proposed Rule 9j–1 would entail further significant costs and challenges because market participants would need to reconcile the scope of the new rule with existing practices.326 The Commission has considered the above comments in finalizing Rule 9j– 1. As discussed above and in the 2021 Proposing Release, some security-based swap market participants may incur costs associated with taking actions to update existing compliance systems for compliance with Rule 9j–1. These additional costs could be limited to the extent that many of these practices and systems are already in place to ensure compliance with section 9(j) and the other general antifraud and antimanipulation statutory and regulatory provisions. To the extent that market participants incur compliance costs as a result of Rule 9j–1, these costs represent a reasonable trade-off in light of the benefits discussed in section V.D.1. With respect to the identification, tracking, and coordination activities that might be necessary absent an information barrier safe harbor, final Rule 9j–1(e)(2) provides an affirmative defense modeled on the affirmative defense in Rule 10b5–1(c)(2). Final Rule 9j–1(e)(2) will help mitigate the cost and effort that market participants may incur to identify, track, and coordinate activities involving security-based swaps and related reference underlying entities held by the organization. Several commenters were concerned that re-proposed Rule 9j–1’s liability standards are vague and that such vagueness would foster significant uncertainty among security-based swap market participants, resulting in reduced market participation, liquidity, capital formation, and investor n.88. 323 See supra sections II.E.2 and V.C.1. Comments at 1. 324 Michael VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 325 LSTA Letter at 9–10. Letter at 4. 326 IACPM PO 00000 Frm 00034 Fmt 4701 Sfmt 4700 choice.327 In response to these concerns, the Commission clarifies the liability standards of Rule 9j–1 in section II of this release. Specifically, the liability standards in the rule follow the wellsettled standards in section 10(b) of the Exchange Act, and Rule 10b–5 thereunder, section 17(a) of the Securities Act, and applicable case law. The Commission also explains why a non-scienter-based standard is appropriate for paragraphs (a)(3) and (a)(4) of final Rule 9j–1 and is consistent with sections 17(a)(2) and (3) of the Securities Act, on which they are based. Where commenters noted a discrepancy in the Commission’s proposed rule and the legal standard for certain attempted offenses, the Commission revised the rule to conform to the legal standard in new Rule 9j– 1(a)(5). These revisions should address any uncertainty that security-based swap market participants may have regarding the rule’s liability standards. In addition, the Commission is adopting Rule 9j–1(e), which includes two affirmative defenses for violations of the provisions in paragraphs (a)(1) through (a)(5) of Rule 9j–1.328 The final rule conforms the affirmative defenses in Rule 9j–1(e) to those in existing Rule 10b5–1(c). The revisions regarding the liability standards of Rule 9j–1 coupled with the affirmative defenses of Rule 9j– 1(e) should mitigate any potential adverse effects on market participation, liquidity, capital formation, and investor choice. Moreover, by reducing the risk of fraudulent and manipulative activity in the security-based swap market, Rule 9j–1 would increase market participation, liquidity, capital formation, and investor choice thereby further mitigating the potential adverse effects that commenters identified.329 One commenter was concerned that the inclusion of interim actions in the performance of contractual obligations within the scope of re-proposed Rule 9j– 1 will discourage market participants from transacting in security-based swaps, reduce liquidity in the securitybased swap markets, increase the cost of capital, and reduce the availability of capital.330 The Commission does not believe the final rule will adversely affect market participation, liquidity, cost of capital, and availability of capital in the manner described by the commenter. Final Rule 9j–1 applies to fraudulent, deceptive, or manipulative 327 See IACPM Letter at 4–5; IIB–ISDA–SIFMA Letter at 1–3, 5, 13–14; LSTA Letter at 3, 5, 7; Milbank Letter at 1–5, 7, 9–10; July 2022 MFA Letter at 1, 6, 7. 328 See final Rule 9j–1(e). 329 See supra section V.D.1. 330 MFA Letter at 2, 8–9. E:\FR\FM\30JNR2.SGM 30JNR2 ddrumheller on DSK120RN23PROD with RULES2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations misconduct related to the exercise of any right or performance of any obligation under a security-based swap if such misconduct occurs in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, a security-based swap. Moreover, the rule addresses actions taken outside the ordinary course of a typical lender-borrower relationship (or a prospective lenderborrower relationship). Accordingly, by reducing the risk of fraudulent and manipulative activity in the securitybased swap market, Rule 9j–1 will increase liquidity in the markets for security-based swaps and underlying cash instruments, and lower capital costs and increase capital formation for reference underlying entities.331 Some commenters were concerned that the Commission’s choice of a negligence standard for re-proposed Rules 9j–1(a)(3) and (4), coupled with the omission of Rule 10b5–1(c)(2) affirmative defenses, would discourage market participants from entering into security-based swaps and would, as a result, reduce liquidity in security-based swap markets, exacerbate risks for market participants, and increase issuers’ cost of capital. These commenters were concerned that lenders may also reduce their lending activities, which would reduce financing to private companies.332 In response to comments received on the 2021 Proposing Release, paragraphs (a)(3) and (a)(4) of new Rule 9j–1 describe conduct for which a nonscienter based standard would apply, while paragraph (a)(5) of new Rule 9j– 1 describes attempts of that conduct for which scienter is the proper standard. In addition, Rule 9j–1(e)(2) provides for an affirmative defense that is modeled on the affirmative defense in Rule 10b5– 1(c)(2). These changes from re-proposed Rule 9j–1 should address the commenters’ concerns and mitigate any potential adverse effects on liquidity, risks, cost of capital, and financing to private companies. Some commenters stated that proposed Rule 9j–1(b) would create uncertainty and implicate a wide range of innocuous and ordinary course activities that are essential to markets in both security-based swaps and underlying cash instruments. The commenters stated that this would materially increase compliance costs for security-based swap market participants, reduce participation in 331 See 332 See supra section V.D.1. ACLI Letter at 5–6; MFA Letter at 2, 13– 16. VerDate Sep<11>2014 security-based swap and securities markets, reduce lending activity and capital formation, and raise issuers’ cost of capital.333 As discussed above, final Rule 9j–1(a)(6), as revised from proposed Rule 9j–1(b), will apply to conduct undertaken in connection with effecting or attempting to effect a transaction in any security-based swap, and to purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap (including but not limited to, in whole or in part, the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of any rights or obligations under, a security basedswap). Rule 9j–1(a)(6) also prohibits the manipulation (or attempted manipulation) of the valuation of any security-based swap, or any payment or delivery related thereto, to the extent such misconduct is in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap. The final rule strikes an appropriate balance between preventing manipulation and attempted manipulation in the security-based swap market and addressing commenters’ concern. A narrowing in the scope of final Rule 9j–1(a)(6) would create a gap in the prohibition against manipulation and attempted manipulation in the security-based swap market and reduce the benefits of the rule. A determination as to whether a person has violated final Rule 9j–1(a)(6) will depend on the facts and circumstances of each particular situation. Further, a scienter standard will be used to determine whether conduct is in violation of the rule. With respect to the loan market, final Rule 9j– 1(a)(6) applies to actions taken outside the ordinary course of a typical lenderborrower relationship, such as an action taken for the purposes of avoiding or causing, or increasing or decreasing, a payment under a security-based swap in a manner that would not have occurred but for such actions, or when an action appears to be designed almost exclusively to harm counterparties, and is not intended to discourage lenders from discussing or providing financing or relief to avoid default. To be clear, Rule 9j–1(a)(6) will require that security-based swap market participants take care that their legitimate market activities remain within the scope of the 333 See 22:10 Jun 29, 2023 Jkt 259001 PO 00000 typical lender-borrower relationship and do not cross the line into prohibited manipulation. The foregoing discussion should help address concerns related to uncertainty that the rule may create and the proposed rule’s scope. However, to the extent that market participants continue to have such concerns, final Rule 9j–1(a)(6) could increase compliance costs, reduce market participation, reduce lending activity and capital formation, and raise issuers’ cost of capital. That said, by reducing the risk of fraudulent and manipulative activity in the securitybased swap market, Rule 9j–1 would increase market participation, increase lending activity and capital formation, and lower issuers’ cost of capital thereby mitigating the potential adverse effects that commenters identified. Further, to the degree that Rule 9j–1 provides additional precision and specificity regarding the application of existing antifraud and antimanipulation laws to misconduct in the security-based swap market, some market participants may need to spend fewer resources determining appropriate compliance under section 9(j) of the Exchange Act and reduce their compliance costs.334 E. Benefits and Costs of Rule 15fh–4(c) 1. Benefits Rule 15fh–4(c) makes it unlawful for any officer, director, supervised person, or employee of an SBS Entity, or any person acting under such person’s direction, to take, directly or indirectly, any action to coerce, mislead, or otherwise interfere with the SBS Entity’s CCO. This prohibition would support the ability of the CCO to meet the CCO’s important obligations to foster compliance in its role of overseeing compliance within the SBS Entity. Rule 15fh–4(c) will make it more likely that a CCO is able to more efficiently and effectively execute the CCO’s responsibilities to foster compliance, including for example, by ensuring that the SBS Entity maintains and reviews written policies and procedures reasonably designed to achieve compliance with the rules and regulations relating to the business of the SBS Entity. Ultimately, these effects will likely also reduce the risk of fraud, market manipulation, or other fraudulent activities in the securitybased swap market, providing additional protection for both counterparties in the security-based swap transaction and the underlying entity. MFA Letter at 16–19; Milbank Letter at 9– 334 See 10. Frm 00035 Fmt 4701 Sfmt 4700 42579 E:\FR\FM\30JNR2.SGM supra section V.D.1. 30JNR2 42580 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations Rule 15fh–4(c) will encourage officers, directors, supervised persons, and employees of SBS Entities to exercise reasonable attention and care in their dealings with CCOs, as discussed in section III.B. To the extent that such exercise of reasonable attention and care increases the quantity and quality of information exchanged between CCOs, officers, directors, supervised persons, and employees of SBS Entities, CCOs may more efficiently and effectively foster compliance in SBS Entities. Any resulting improvement in compliance in turn could reduce the risk of fraud, market manipulation, or other fraudulent activities in the securitybased swap market. More broadly, improved communication between CCOs, officers, directors, supervised persons, and employees of SBS Entities also could facilitate decision making within the SBS Entities. Rule 15fh–4(c) would likely have minor indirect positive impacts on competition, price efficiency, and capital formation, as discussed in section V.F. Comments Received Two commenters believed that proposed Rule 15Fh–4(c) would deter the types of actions that prevent CCOs from performing their duties and that deterring such actions would in turn help protect the CCOs’ independence and objectivity in the fulfillment of their duties.335 The Commission agrees with the commenters that Rule 15fh–4(c)’s benefit could derive in part from deterring actions that are prohibited by the rule. ddrumheller on DSK120RN23PROD with RULES2 2. Costs Rule 15fh–4(c)’s prohibition on taking actions to coerce, mislead, or otherwise interfere with the SBS Entity’s CCO, may create additional costs for SBS Entities. For example, to the extent that any current practices of an SBS Entity include activities that are explicitly prohibited under Rule 15fh–4(c), applicable policies and procedures will need to be updated. In addition, it is possible that the rule could cause officers, directors, supervised persons, or employees of an SBS Entity to be overly cautious when consulting with a CCO. The Commission does not, however, believe that any such effects will be significant, given the specificity of the rule’s prohibition on certain interferences with the SBS Entity’s CCO. 335 See Better Markets Letter at 14; NYC Bar Letter at 4–5. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 Comments Received One commenter was concerned that the scope of the proposed rule is unclear and could lead to confusion and uncertainty as to what communications between the CCO and the officers, directors, supervised persons, and employees of the SBS Entity might violate the rule. The commenter states that such confusion and uncertainty could have a chilling effect on dialog about compliance, budget, and resource matters, which, by implication, could impede decision making within the SBS Entity.336 In response to this comment, the Commission has clarified the scope of final Rule 15fh–4(c) in section III.B. Further, the Commission clarified that the acts to ‘‘coerce, manipulate, mislead or fraudulently influence’’ that would be prohibited by Rule 15fh–4(c) imply compelling the CCO to act in a certain way through pressure, threats, trickery, intimidation, misrepresentation, or some other form of purposeful action not limited to untrue statements or omissions of material facts. As discussed in section V.E.1, to the extent that the rule encourages officers, directors, supervised persons, and employees of SBS Entities to exercise reasonable attention and care in their dealings with CCOs, communication and decision making could improve within the SBS Entities and mitigate any potential adverse impact on decision making suggested by the commenter. F. Effects on Efficiency, Competition, and Capital Formation The final rules would likely affect capital formation, competition, and efficiency in various ways, as discussed below. 1. Competition As discussed earlier, by reducing the risk of fraud, Rule 9j–1 could encourage participation in the market, which may result in increased competition in the security-based swap market.337 Rule 15fh–4(c) would likely have a minor indirect positive impact on competition in the security-based swap market. Because Rule 15fh–4(c) would support the ability of the CCO to oversee compliance with the Federal securities laws within the SBS Entity and likely reduce the risk of fraud, security-based swaps would more likely reflect the fundamental credit risk of the underlying entity. This in turn could encourage greater participation in the security-based swap market and therefore, increase competition among the market participants. By decreasing the risk of fraud and preventing price manipulation in the security-based swap market, Rule 9j–1 may increase price efficiency. This would consequently lead to greater security-based swap market efficiency, as security-based swap prices would provide greater confidence that their prices more likely reflect fundamental values and risk in more liquid markets.338 Rule 15fh–4(c) would likely have a minor indirect positive impact on price efficiency. To the extent that the rule increases participation in the securitybased swap market as discussed in section V.F.1, price efficiency may increase because increased trading by market participants could incorporate more information into security-based swap prices. 3. Capital Formation Final Rule 9j–1 likely would have a positive impact on capital formation. As discussed earlier, greater activity in the underlying security market due to increased price efficiency and greater availability to hedge these securities in the security-based swap market could lead to lower capital costs and increase capital formation for the underlying entities. Increased participation and price efficiency in the security-based swap market as a result of Rule 9j–1 could encourage lenders to make greater use of security-based swaps for hedging their loans, which in turn could increase lending activity and capital formation.339 To the extent that the rule lowers litigation costs and compliance costs for market participants and underlying entities, these market participants and entities could in turn use the resources that are freed up to invest in projects. As discussed in section V.D.2, a number of commenters were concerned that re-proposed Rule 9j–1’s compliance costs, scope, and liability standards would reduce capital formation (including financing to private companies) and increase the cost of capital, among other potential effects. As discussed in that section, compliance costs could be limited by existing practices and systems that are in place to comply with section 9(j) and the other antifraud and antimanipulation provisions; that the rule’s use of clear, consistent, and familiar liability standards reduces uncertainty; and that the rule’s beneficial effects on capital formation and the cost of capital 336 IIB–ISDA–SIFMA 338 Id. 337 See 339 Id. PO 00000 CCO Letter at 1–2. supra section V.D.1. 2. Efficiency Frm 00036 Fmt 4701 Sfmt 4700 E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations would mitigate any potential adverse effects that commenters identified. Rule 15fh–4(c) would likely have a minor indirect positive impact on capital formation. To the extent that the rule increases price efficiency and competition in the security-based swap market, as discussed in sections V.F.1 and V.F.2, capital formation could, as a result, further indirectly increase, as greater price efficiency and competition among market participants could lead to a decrease in security-based swaps prices, and in turn, lower costs of borrowing (as a result of lowering the cost of CDS). G. Reasonable Alternatives The Commission considered a number of alternatives when finalizing Rules 9j–1 and 15fh–4(c). ddrumheller on DSK120RN23PROD with RULES2 1. Narrow the Scope of Rule 9j–1 Commenters recommended narrowing the scope of re-proposed Rule 9j–1 in various ways: (1) exclude valuation, payment, and delivery from the scope of proposed Rule 9j–1(b); 340 (2) exclude certain credit market conduct from the scope of proposed Rule 9j–1(b); 341 and (3) exclude security-based swaps referencing sovereign debt from the scope of re-proposed Rule 9j–1.342 The Commission has considered these alternatives but determined that the adopted approach is preferable to them. With respect to the exclusion of valuation, payment, and delivery from the scope of proposed Rule 9j–1(b), the Commission declines to adopt this alternative. The Commission is concerned that the alternative would create a gap in the prohibition against the manipulation and attempted manipulation of prices in the securitybased swap market and reduce the benefits of final Rule 9j–1(a)(6), as revised from proposed Rule 9j–1(b). The exclusion of valuation, payment, and delivery from the scope of final Rule 9j– 1(a)(6) could increase the occurrence of manipulation and attempted manipulation of security-based swap prices in connection with such activities. With respect to the exclusion of certain credit market conduct, the Commission believes it cannot specify all possible types of misconduct that may prevail in the future. Hence, provisions designed to exclude certain legitimate credit market conduct could unintentionally apply to activities that final Rule 9j–1(a)(6), as revised from 340 Milbank Letter at 5. IACPM Letter at 4; IIB–ISDA–SIFMA Letter at 18–19; Milbank Letter at 4–5. 342 ACLI Letter at 3, 13–14. 341 See VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 proposed Rule 9j–1(b), is designed to prohibit, reducing the benefits of the rule. Further, an exclusion of certain credit market conduct would need to be balanced against the risk that market participants undertake transactions for which their counterparties should have the protections of final Rule 9j–1(a)(6). In addition, as discussed in section II.C.2, the fact that the Commission intends to apply a scienter standard in connection with final Rule 9j–1(a)(6), and that the rule does not impose liability for actions taken in the ordinary course of a typical lender-borrower relationship (or a prospective lenderborrower relationship), should help mitigate concerns regarding any ‘‘chilling effects’’ of the rule. With respect to the exclusion of sovereign debt security-based swaps, as a general matter, the Commission does not see a compelling reason to treat security-based swaps referencing sovereign underliers differently than security-based swaps referencing other underliers. As discussed in section II.E.2.d, while security-based swaps related to sovereign debt may have lesser opportunity for manufactured credit events or opportunistic strategies by regulated and non-regulated market participants alike, such instruments are not without risk of fraudulent and manipulative conduct and should remain within the scope of Rule 9j–1.343 Further, the Commission is concerned that the alternative would create a gap in the prohibition against fraudulent and manipulative activity in the security-based swap market. Even if, as the commenter asserted, manufactured credit events related to a country’s sovereign debt are unlikely, other types of fraudulent and manipulative activities could be perpetrated in connection with sovereign debt security-based swaps.344 The alternative would not prohibit these activities and could increase their occurrence. In light of the above, the adopted approach is preferable to this alternative. 2. Safe Harbors Commenters suggested that the Commission add various safe harbors to Rule 9j–1. The Commission discusses these alternatives below. a. Safe Harbor for Hedging Exposure Arising Out of Lending Activities One commenter urged the Commission to consider creating a safe 343 See supra note 244 and related discussion. ACLI Letter at 13 (stating that it seems unlikely that any holders of security-based swaps on sovereign debt would possess the leverage necessary to manufacture credit events related to a country’s sovereign debt). 344 See PO 00000 Frm 00037 Fmt 4701 Sfmt 4700 42581 harbor to re-proposed Rule 9j–1 for entering into security-based swap transactions for purposes of hedging some or all exposure arising out of lending activities with a reference entity or the syndication of such lending activities.345 Such a safe harbor could minimize the effects of the rule on riskreducing hedging activity, which is one of the central purposes of CDS contracts and which provides important benefits to the lending market. Identifying legitimate, risk-reducing hedging activity—undertaken with the intent of covering potential losses in a position— and distinguishing such activity from other types of speculative transactions would likely be difficult. Hence, even a safe harbor designed to apply solely to legitimate hedging transactions could unintentionally apply to activities that Rule 9j–1 is designed to prohibit, reducing the benefits of the rule. Further, such a safe harbor would need to be balanced against the risk that market participants undertake transactions for which their counterparties should have the protections of Rule 9j–1, including in circumstances involving potentially opportunistic trading strategies. In light of the above, the adopted approach is preferable to this alternative. b. Safe Harbors for Lender Disclosure, Centralized Market Activities, and Legitimate Restructurings One commenter urged the Commission to consider allowing the lender to avoid liability under reproposed Rule 9j–1 by disclosing to the counterparty that it is a lender to the borrower and may have material nonpublic information from the borrower.346 Another commenter urged the Commission to provide safe harbors for certain centralized market activities: (1) multilateral amendment exercises (including ISDA protocols) or bilateral equivalents; and (2) participation in determination committees in accordance with the determination committees’ rules and any applicable codes of conduct.347 A third commenter suggested that the Commission provide a safe harbor or exception for legitimate restructurings to avoid limiting the supply of funds to issuers during a restructuring.348 The affirmative defenses in Rule 9j–1(e) will serve the same purpose as these alternatives by permitting persons to enter into certain types of activity, pursuant to the requirements of the affirmative 345 LSTA Letter at 8. at 9. 347 IIB–ISDA–SIFMA Letter at 11–12. 348 Fletcher Letter at 4. 346 Id. E:\FR\FM\30JNR2.SGM 30JNR2 42582 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations defenses, while also addressing concerns about fraud and manipulation for the entire security-based swap market. With respect to the suggested safe harbor for legitimate restructurings, identifying legitimate restructurings and distinguishing such activities from other types of speculative transactions would likely be difficult. Hence, even a safe harbor designed to apply solely to legitimate restructurings could unintentionally apply to activities that Rule 9j–1 is designed to prohibit, reducing the benefits of the rule. Further, such a safe harbor would need to be balanced against the risk that market participants undertake transactions for which their counterparties should have the protections of Rule 9j–1, including in circumstances involving potentially opportunistic trading strategies. Accordingly, the adopted approach is preferable to these alternatives. ddrumheller on DSK120RN23PROD with RULES2 c. Safe Harbor for Publicly Executed Strategies One commenter requested a safe harbor from liability under proposed Rule 9j–1(b) for publicly executed strategies, where multiple parties or an independent body (such as a court or regulator) are involved. The commenter distinguished publicly executed strategies from privately executed strategies, such as a single market participant entering into an agreement with a reference entity. The commenter argued that publicly executed strategies are more difficult for a single participant to manipulate than privately executed strategies because publicly executed strategies are driven by the incentives of a broader group of participants than privately executed strategies.349 The Commission declines to adopt this alternative. While publicly executed strategies may be difficult for a single participant to manipulate as the commenter argued, it is not clear that such strategies would remain difficult to manipulate when a group of market participants are acting in concert to manipulate such strategies. The Commission is concerned that providing a safe harbor for publicly executed strategies would encourage manipulative activity involving a coalition of market participants. That said, the Commission appreciates that there are legitimate publicly executed strategies that are not involved in manipulative activity. In section II.C.2, the Commission discusses at length the application of final Rule 9j–1(a)(6) and believes the discussion should alleviate 349 IIB–ISDA–SIFMA VerDate Sep<11>2014 Letter at 17. 22:10 Jun 29, 2023 Jkt 259001 concerns that legitimate publicly executed strategies may violate the rule. d. Elimination of All Safe Harbors and Affirmative Defenses Four commenters urged for the elimination of all safe harbors and affirmative defenses from proposed Rule 9j–1(a) liability.350 The adopted approach, which among other things, provides two affirmative defenses in final Rule 9j–1(e), is preferable to the alternative. As discussed in section V.D.2, the two affirmative defenses will help mitigate various adverse effects (e.g., reduced market participation) that certain commenters believed may arise as a result of Rule 9j–1. Final Rule 9j– 1(e)(2) will help mitigate the cost and effort that market participants may incur to identify, track, and coordinate activities involving security-based swaps and related reference underlying entities held by the organization. At the same time, the costs that market participants may incur in connection with these affirmative defenses likely would be very limited.351 3. Implementing a More Prescriptive Approach in Rule 9j–1 One commenter urged the Commission to consider the alternative approach of identifying and prohibiting within Rule 9j–1 specific types of events (for example, market behavior around certain events and fact patterns) and opportunistic trading behavior that have been observed. According to the commenter, this alternative approach could provide even more certainty and precision with respect to the particular types of activities that are prohibited in the security-based swap market. The commenter believed that the greater certainty of outcome with respect to Rule 9j–1 would benefit lenders when they need to exercise rights or remedies under a loan or credit agreement.352 However, this approach could lead to greater uncertainty with respect to circumstances not explicitly contemplated in the rule, which could increase litigation costs for market participants involved in such transactions. This approach may also decrease the integrity of the market for security-based swaps, and in addition, could cause market participants to bear greater compliance costs in connection with the evaluation of circumstances not explicitly contemplated in the rule. As a result, the more prescriptive alternative approach would have 350 Better Markets Letter at 2, 9–12; Anonymous Penguin Comments at 1; J.T. Comments at 1; Michael Comments at 1. 351 See supra section V.D.2. 352 LSTA Letter at 7. PO 00000 Frm 00038 Fmt 4701 Sfmt 4700 limited benefits and greater costs as compared to the adopted approach in the market for security-based swaps, as well as the market for the reference underlying of such security-based swaps. The Commission acknowledges the commenter’s concern that not adopting the more prescriptive alternative approach could prevent lenders or security-based swap participants from exercising legitimate rights and remedies and impose costs that would be greater than those discussed in the 2021 Proposing Release in connection with re-proposed Rule 9j–1.353 Final Rule 9j–1 would enable lenders or security-based swap participants to exercise legitimate rights and remedies, thereby addressing the commenter’s concern. In particular, paragraphs (a)(3) and (a)(4) of final Rule 9j–1 describe conduct for which a non-scienter based standard would apply, while paragraph (a)(5) of final Rule 9j–1 describes attempted aspects of that conduct for which scienter is the proper standard. In addition, final Rule 9j–1(e) provides for affirmative defenses similar to the affirmative defenses in Rule 10b5–1(c). The clarification regarding the liability standards of Rule 9j–1 coupled with the affirmative defenses of Rule 9j–1(e) should mitigate any potential adverse effects on market participation, liquidity, capital formation, and investor choice. Moreover, by reducing the risk of fraudulent and manipulative activity in the security-based swap market, Rule 9j–1 would increase market participation, liquidity, capital formation, and investor choice thereby further mitigating the potential adverse effects that commenters identified. 4. Separate Rules for CDS and Equity Security-Based Swaps One commenter asserted that opportunistic strategies work best with CDS and that equity SBS are less susceptible to such strategies. The commenter suggested that the Commission propose separate rules for each type of instrument.354 The Commission has considered the commenter’s suggested alternative, but believes that the adopted approach is preferable to the alternative. The aim of Rule 9j–1 is to address fraud and manipulation in the security-based swap market and is not limited to addressing fraud and manipulation in connection with certain opportunistic strategies that historically have been implemented with CDS. As discussed in section II, fraudulent and manipulative 353 Id. 354 Fletcher E:\FR\FM\30JNR2.SGM Letter at 4. 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations conduct has the potential to harm counterparties to all forms of securitybased swaps, including CDS, equity security-based swaps, and non-CDS debt security-based swaps. Rule 9j–1 is appropriately tailored to address fraud and manipulation for the entire security-based swap market. As such the Commission does not see the need to adopt separate rules for CDS and equity security-based swaps. ddrumheller on DSK120RN23PROD with RULES2 5. Exclude Underlying Securities One commenter urged the Commission to modify re-proposed Rule 9j–1 by providing that its prohibitions do not extend to the purchase or sale of underlying securities.355 The Commission declines to adopt this alternative. Because security-based swaps by their nature are tied intrinsically to activity in other securities markets, persons that intend to perpetrate fraudulent or manipulative activity with respect to a security-based swap may choose to do so by purchasing or selling the underlying security. The alternative would create a gap in the prohibition against fraudulent and manipulative activity in connection with security-based swaps and increase the risk of such activity to the detriment of investors. In contrast, final Rule 9j– 1(c) is designed so that a person cannot escape liability under section 9(j) of the Exchange Act or Rule 9j–1(a) with respect to a security-based swap by limiting all of its actions to purchases or sales of the security or narrow-based security index underlying that securitybased swap. 6. Limit Activities Prohibited Under Rule 15fh–4(c) One commenter suggested that final Rule 15fh–4(c) should limit the prohibited interference to knowingly making untrue statements or omitting material facts.356 As discussed in section III.B, Rule 15fh–4(c) protects the independence and objectivity of an SBS Entity’s CCO by prohibiting undue influence by other personnel. Such influence could take many forms and is not limited to material misstatements or omissions. The Commission is concerned that limiting prohibited activities to material misstatements and omissions, as suggested by the commenter, would fail to adequately protect the CCO from undue influence and consequently reduce the rule’s benefit. As discussed in section V.E.1, by encouraging officers, directors, supervised persons, and employees of SBS Entities to exercise reasonable attention and care in their dealings with CCOs, final Rule 15fh–4(c) would foster compliance in SBS Entities, reduce the risk of fraudulent and manipulative conduct, and facilitate decision making in SBS Entities. The suggested alternative, by its limited nature, may be less likely to encourage such exercise of reasonable attention and care in dealings with CCOs. Accordingly, the adopted approach is preferable to the alternative. its audited financial statements were prepared pursuant to 17 CFR 240.17a– 5(d) under the Exchange Act,363 or, if not required to file such statements, a broker-dealer with total capital (net worth plus subordinated liabilities) of less than $500,000 on the last business day of the preceding fiscal year (or in the time that it has been in business, if shorter); and is not affiliated with any person (other than a natural person) that is not a small business or small organization.364 VI. Regulatory Flexibility Act Based on available information about Certification the security-based swap market, the The Regulatory Flexibility Act market, while broad in scope, is largely (‘‘RFA’’) 357 requires Federal agencies, in dominated by entities such as those that promulgating rules, to consider the will be covered by the SBSD and impact of those rules on small entities. MSBSP definitions. Based on feedback Section 603(a) of the Administrative from industry participants about the Procedure Act,358 as amended by the security-based swap market, the RFA, generally requires the Commission Commission continues to believe that: to undertake a regulatory flexibility (1) the types of entities that are and will analysis of all proposed rules, or continue to register with the proposed rule amendments, to Commission as SBSDs (i.e., because determine the impact of such they engage in more than a de minimis rulemaking on ‘‘small entities.’’ 359 amount of dealing activity involving Section 605(b) of the RFA states that security-based swaps)—which generally this requirement shall not apply to any would be large financial institutions— proposed rule or proposed rule would not be ‘‘small entities’’ for amendment which, if adopted, would purposes of the RFA; and (2) the types not have a significant economic impact of entities that may have security-based on a substantial number of small swap positions above the level required entities.360 The Commission certified in to register as MSBSPs would not be the 2021 Proposing Release that new ‘‘small entities’’ for purposes of the Rules 9j–1 and 15fh–4(c) would not RFA. have a significant economic impact on Although Rule 15fh–4(c) applies only any ‘‘small entity’’ for purposes of the to SBS Entities, Rule 9j–1 is not on its RFA.361 The Commission received no face limited to SBS Entities. However, comments on its certification. while it is possible that other parties For purposes of Commission may engage in security-based swap rulemaking in connection with the RFA, transactions, the Commission does not a small entity includes: (1) when used believe that any such entities would be with reference to an ‘‘issuer’’ or a ‘‘small entities’’ as defined in Exchange ‘‘person,’’ other than an investment Act Rule 0–10.365 Feedback from company, an ‘‘issuer’’ or ‘‘person’’ that, industry participants about the securityon the last day of its most recent fiscal based swap market indicates that only year, had total assets of $5 million or persons or entities with assets less; 362 or (2) a broker-dealer with total significantly in excess of $5 million (or capital (net worth plus subordinated with annual receipts significantly in liabilities) of less than $500,000 on the excess of $7 million) participate in the date in the prior fiscal year as of which security-based swap market. With respect to Rule 9j–1, even to the extent 357 5 U.S.C. 601 et seq. that a small number of transactions did 358 5 U.S.C. 603(a). have a counterparty that was defined as 359 Although section 601(b) of the RFA defines a ‘‘small entity’’ under Rule 0–10, the the term ‘‘small entity,’’ the statute permits agencies to formulate their own definitions. The Commission Commission believes it unlikely that the has adopted definitions for the term ‘‘small entity’’ rule would have a significant economic for the purposes of Commission rulemaking in impact on such entities, as the rule accordance with the RFA. Those definitions, as prohibits fraudulent and manipulative relevant to this rulemaking, are set forth in 17 CFR acts, activities which are in most cases 240.0–10 (‘‘Rule 0–10’’) under the Exchange Act. See Final Definitions of ‘‘Small Business’’ and already prohibited. ‘‘Small Organization’’ for Purposes of the For the foregoing reasons, the Regulatory Flexibility Act, Exchange Act Release Commission certifies that Rules 9j–1 No. 18452 (Jan. 28, 1982), 47 FR 5215 (Feb. 4, 1982) and 15fh–4(c) will not have a significant (File No. S7–879). 360 See 361 See 355 MFA Letter at 2, 8–9. 356 ISDA–IIB–SIFMA CCO Letter at 2. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 42583 5 U.S.C. 605(b). 2021 Proposing Release, 87 FR at 6702– 362 See PO 00000 363 17 CFR 240.17a–5(d). 17 CFR 240.0–10(c). 365 See 17 CFR 240.0–10(a). 364 See 03. 17 CFR 240.0–10(a). Frm 00039 Fmt 4701 Sfmt 4700 E:\FR\FM\30JNR2.SGM 30JNR2 42584 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations economic impact on a substantial number of small entities for purposes of the RFA. ddrumheller on DSK120RN23PROD with RULES2 VII. Other Matters Pursuant to the Congressional Review Act,366 the Office of Information and Regulatory Affairs has designated these rules as not a ‘‘major rule,’’ as defined by 5 U.S.C. 804(2). If any of the provisions of these final rules, or the application thereof to any person or circumstance, is held to be invalid, such invalidity shall not affect other provisions or application of such provisions to other persons or circumstances that can be given effect without the invalid provision or application. §§ 240.10a–1 and 240.10a–2 [Amended] 2. Move reserved §§ 240.10a–1 and 240.10a–2 from undesignated center heading ‘‘Hypothecation of Customers’ Securities’’ to undesignated center heading ‘‘Manipulative and Deceptive Devices and Contrivances’’ in numerical order. ■ 3. Add § 240.9j–1 under the undesignated center heading ‘‘Manipulative and Deceptive Devices and Contrivances’’ to read as follows: ■ § 240.9j–1 Prohibition against fraud, manipulation, or deception in connection with security-based swaps. (a) It shall be unlawful for any person, directly or indirectly, to effect any transaction in, or attempt to effect any transaction in, any security-based swap, Statutory Authority or to purchase or sell, or induce or The Commission is adopting the new attempt to induce the purchase or sale rules and rule amendment contained in of, any security-based swap (including this release under the authority set forth but not limited to, in whole or in part, in the Exchange Act, 15 U.S.C. 78a et the execution, termination (prior to its seq., as amended, and, particularly scheduled maturity date), assignment, sections 2, 3(b), 9(i), 9(j), 10, 15, 15F, exchange, or similar transfer or and 23(a) thereof (15 U.S.C. 78b, 78c(b), conveyance of, or extinguishing of any 78i(i), 78i(j), 78j, 78o, 78o–10, and rights or obligations under, a security 78w(a)). based-swap, as the context may require), in connection with which such person: List of Subjects in 17 CFR Part 240 (1) Employs or attempts to employ Administrative practice and any device, scheme, or artifice to procedure, Brokers, Confidential defraud or manipulate; business information, Fraud, Reporting (2) Makes or attempts to make any and recordkeeping requirements, untrue statement of a material fact, or Securities, Swaps. omits to state a material fact necessary Text of the Final Rule in order to make the statements made, in the light of the circumstances under For the reasons set forth in the preamble, title 17, chapter II of the Code which they were made, not misleading; (3) Obtains money or property by of Federal Regulations is amended as means of any untrue statement of a follows: material fact or any omission to state a material fact necessary in order to make PART 240—GENERAL RULES AND the statements made, in light of the REGULATIONS, SECURITIES circumstances under which they were EXCHANGE ACT OF 1934 made, not misleading; ■ 1. The general authority citation for (4) Engages in any act, practice, or part 240 continues to read, and the course of business which operates or sectional authority for § 240.15fh–1 is would operate as a fraud or deceit upon revised to read, as follows: any person; (5) Attempts to obtain money or Authority: 15 U.S.C. 77c, 77d, 77g, 77j, property by means of any untrue 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c–3, 78c–5, 78d, 78e, 78f, statement of a material fact or any 78g, 78i, 78j, 78j–1, 78j–4, 78k, 78k–1, 78l, omission to state a material fact 78m, 78n, 78n–1, 78o, 78o–4, 78o–10, 78p, necessary in order to make the 78q, 78q–1, 78s, 78u–5, 78w, 78x, 78dd, 78ll, statements made, in light of the 78mm, 80a–20, 80a–23, 80a–29, 80a–37, 80b– 3, 80b–4, 80b–11, and 7201 et seq., and 8302; circumstances under which they were made, not misleading, or attempts to 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; Pub. L. 111–203, 939A, 124 Stat. engage in any act, practice, or course of business which operates or would 1376 (2010); and Pub. L. 112–106, sec. 503 and 602, 126 Stat. 326 (2012), unless operate as a fraud or deceit upon any otherwise noted. person; or (6) Manipulates or attempts to Sections 240.15fh–1 through 240.15Fh–6 manipulate the price or valuation of any and 240.15Fk–1 are also issued under sec. 943, Pub. L. 111–203, 124 Stat. 1376. security-based swap, or any payment or delivery related thereto. * * * * * (b) Wherever communicating, or 366 5 U.S.C. 801 et seq. purchasing or selling a security (other VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 PO 00000 Frm 00040 Fmt 4701 Sfmt 4700 than a security-based swap) while in possession of material nonpublic information would violate, or result in liability to any purchaser or seller of the security under, either the Act or the Securities Act of 1933, or any rule or regulation thereunder, such conduct in connection with a purchase or sale of a security-based swap with respect to such security or with respect to a group or index of securities including such security shall also violate, and result in comparable liability to any purchaser or seller of that security under, such provision, rule, or regulation. (c) Wherever taking any of the actions set forth in paragraph (a) of this section involving a security-based swap would violate, or result in liability under, Section 9(j) of the Act or this section, such conduct, when taken by a counterparty to such security-based swap (or any affiliate of, or a person acting in concert with, such securitybased swap counterparty in furtherance of such prohibited activity), in connection with a purchase or sale of a security, loan, or group or index of securities on which such security-based swap is based, shall also violate, and shall be deemed a violation of, section 9(j) of the Act or paragraph (a) of this section. (d) For purposes of this section, the terms ‘‘purchase’’ and ‘‘sale’’ shall have the same meanings as set forth in Sections 3(a)(13) (15 U.S.C. 78c(a)(13)) and 3(a)(14) (15 U.S.C. 78c(a)(14)) of the Act. (e) A person shall not be liable under paragraphs (a)(1) through (a)(5) of this section solely for being aware of material nonpublic information while taking the following actions: (1) Actions taken by a person in accordance with binding contractual rights and obligations under a securitybased swap (as reflected in the written documentation governing such securitybased swap or any amendment thereto) so long as the person demonstrates that: (i) The security-based swap was entered into, or the amendment was made, before the person became aware of such material nonpublic information, and (ii) The security-based swap was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of this section. (2) Actions taken by a person other than a natural person if the person demonstrates that: (i) The individual making the investment decision on behalf of the person taking the action was not aware of the material nonpublic information, and E:\FR\FM\30JNR2.SGM 30JNR2 Federal Register / Vol. 88, No. 125 / Friday, June 30, 2023 / Rules and Regulations ddrumheller on DSK120RN23PROD with RULES2 (ii) The person had implemented reasonable policies and procedures, taking into consideration the nature of the person’s business, to ensure that individuals making investment decisions would not be in violation of paragraphs (a)(1) through (a)(5) of this section. These policies and procedures may include those that restrict effecting a transaction in, or purchasing or selling, any security, including any security-based swap, as to which the person has material nonpublic information, or those that prevent such individuals from becoming aware of such information. VerDate Sep<11>2014 22:10 Jun 29, 2023 Jkt 259001 4. Redesignate § 240.15Fh–4 as § 240.15fh–4 and amend newly redesignated § 240.15fh–4 by: ■ a. Revising the section heading; and ■ b. Adding paragraph (c). The revisions read as follows: ■ § 240.15fh–4 (Rule 15fh–4) Antifraud provisions for security-based swap dealers and major security-based swap participants; special requirements for security-based swap dealers acting as advisors to special entities. * * * * * (c) No undue influence over chief compliance officer. It shall be unlawful for any officer, director, supervised person, or employee of a security-based swap dealer or major security-based PO 00000 Frm 00041 Fmt 4701 Sfmt 9990 42585 swap participant, or any person acting under such person’s direction, to directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the securitybased swap dealer’s or major securitybased swap participant’s chief compliance officer in the performance of their duties under the Federal securities laws or the rules and regulations thereunder. By the Commission. Dated: June 7, 2023. Vanessa A. Countryman, Secretary. [FR Doc. 2023–12592 Filed 6–29–23; 8:45 am] BILLING CODE 8011–01–P E:\FR\FM\30JNR2.SGM 30JNR2

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 88, Number 125 (Friday, June 30, 2023)]
[Rules and Regulations]
[Pages 42546-42585]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-12592]

[[Page 42545]]

Vol. 88

Friday,

No. 125

June 30, 2023

Part III

Securities and Exchange Commission

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17 CFR Part 240

Prohibition Against Fraud, Manipulation, or Deception in Connection
With Security-Based Swaps; Prohibition Against Undue Influence Over
Chief Compliance Officers; Final Rule

Federal Register / Vol. 88 , No. 125 / Friday, June 30, 2023 / Rules
and Regulations

[[Page 42546]]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-97656; File No. S7-32-10]
RIN 3235-AK77

Prohibition Against Fraud, Manipulation, or Deception in
Connection With Security-Based Swaps; Prohibition Against Undue
Influence Over Chief Compliance Officers

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``SEC'' or
``Commission'') is adopting a final rule, under the Securities Exchange
Act of 1934 (``Exchange Act''), that is designed to prevent fraud,
manipulation, and deception in connection with effecting any
transaction in, or attempting to effect any transaction in, or
purchasing or selling, or inducing or attempting to induce the purchase
or sale of, any security-based swap. The rule takes into account the
features fundamental to a security-based swap and the broad definitions
of purchase and sale under the Exchange Act as they relate to security-
based swaps. In addition, the Commission is adopting a final rule,
under the Exchange Act, that makes it unlawful for any officer,
director, supervised person, or employee of a security-based swap
dealer (``SBSD'') or major security-based swap participant (``MSBSP'')
(each SBSD and each MSBSP also referred to as an ``SBS Entity'' and
together referred to as ``SBS Entities''), or any person acting under
such person's direction, to directly or indirectly take any action to
coerce, manipulate, mislead, or fraudulently influence the SBS Entity's
chief compliance officer (``CCO'') in the performance of their duties
under the Federal securities laws or the rules and regulations
thereunder.

DATES: Effective date: August 29, 2023.

FOR FURTHER INFORMATION CONTACT: Pamela Carmody, Special Counsel, Rajal
B. Patel, Senior Special Counsel, or Carol M. McGee, Associate
Director, at (202) 551-5870, Office of Derivatives Policy, Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549-8010.

SUPPLEMENTARY INFORMATION: First, the Commission is adopting 17 CFR
240.9j-1 (``Rule 9j-1'') under the Exchange Act, which is a new rule
designed to prevent fraud, manipulation, and deception in connection
with effecting transactions in, or purchasing or selling, or inducing
or attempting to induce the purchase or sale of, any security-based
swap. The Commission is also adopting 17 CFR 240.15fh-4(c) (``Rule
15fh-4(c)'') under the Exchange Act, which is a new rule making it
unlawful for any officer, director, supervised person, or employee of
an SBS Entity, or any person acting under such person's direction, to
directly or indirectly take any action to coerce, manipulate, mislead,
or fraudulently influence the SBS Entity's CCO in the performance of
their duties under the Federal securities laws or the rules and
regulations thereunder.

I. Introduction
A. Background
B. Overview of Security-Based Swaps
1. Security-Based Swaps Generally
2. Security-Based Swap Market Developments
C. Overview of the Final Rules
1. Rule 9j-1
2. Rule 15fh-4(c)
II. Rule 9j-1: Prohibition Against Fraud, Manipulation, and
Deception in Connection With Security-Based Swaps
A. Misconduct ``In Connection With'' ``Purchases,'' ``Sales,''
or ``Effecting Transactions''
1. Proposed Approach
2. Commission Action
a. In Connection With
b. Purchases or Sales
c. Effecting Transactions
B. Fraudulent, Manipulative, or Deceptive Conduct
1. Proposed Approach
2. Commission Action
a. Scienter and Negligence Standards
b. Attempted Conduct
C. Prohibition on Price Manipulation
1. Proposed Approach
2. Commission Action
D. Liability Under Rules 9j-1(b) and (c)
1. Proposed Approach
2. Commission Action
a. Rule 9j-1(b)
b. Rule 9j-1(c)
E. Safe Harbors and Affirmative Defenses
1. Proposed Approach
2. Commission Action
a. Affirmative Defense: Binding Contractual Obligations
b. Affirmative Defense: Policies and Procedures
c. Proposed Safe Harbor: Compression
d. Other Requested Safe Harbors and Affirmative Defenses
III. Rule 15fh-4(c): Preventing Undue Influence Over Chief
Compliance Officers; Policies and Procedures Regarding Compliance
With Rule 9j-1 and Rule 15fh-4(c)
A. Proposed Approach
B. Commission Action
IV. Paperwork Reduction Act
V. Economic Analysis
A. Introduction
B. Broad Economic Considerations
C. Baseline
1. Existing Regulatory Frameworks
2. Security-Based Swap Data, Market Participants, Dealing
Structures, and Levels of Security-Based Swap Trading Activity
D. Benefits and Costs of Rule 9j-1
1. Benefits
2. Costs
E. Benefits and Costs of Rule 15fh-4(c)
1. Benefits
2. Costs
F. Effects on Efficiency, Competition, and Capital Formation
1. Competition
2. Efficiency
3. Capital Formation
G. Reasonable Alternatives
1. Narrow the Scope of Rule 9j-1
2. Safe Harbors
a. Safe Harbor for Hedging Exposure Arising Out of Lending
Activities
b. Safe Harbors for Lender Disclosure, Centralized Market
Activities, and Legitimate Restructurings
c. Safe Harbor for Publicly Executed Strategies
d. Elimination of All Safe Harbors and Affirmative Defenses
3. Implementing a More Prescriptive Approach in Rule 9j-1
4. Separate Rules for CDS and Equity Security-Based Swaps
5. Exclude Underlying Securities
6. Limit Activities Prohibited Under Rule 15fh-4(c)
VI. Regulatory Flexibility Act Certification
VII. Other Matters
Statutory Authority

I. Introduction

A. Background

Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act'') \1\ provided the Commission with
primary responsibility for regulating security-based swaps. A person
who satisfies the definitions of ``security-based swap dealer'' or
``major security-based swap participant'' is required to register with
the Commission in such capacity and is therefore subject to the
Commission's regime regarding, among other things, internal supervision
requirements and the requirement to designate an individual to serve as
the CCO.\2\ In addition to other requirements, the CCO must take
reasonable steps to ensure that the SBS Entity establishes, maintains,
and reviews written policies

[[Page 42547]]

and procedures reasonably designed to achieve compliance with the
Exchange Act and the rules and regulations thereunder relating to its
business as an SBS Entity.\3\
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\1\ Wall Street Transparency and Accountability Act of 2010,
Public Law 111-203, sections 761-774, 124 Stat. 1376, 1754-1802
(2010). Unless otherwise indicated, references to ``Title VII'' in
this release are to subtitle B of title VII of the Dodd-Frank Act.
\2\ See, e.g., 17 CFR 240.3a71-1 (Definition of ``security-based
swap dealer''); 17 CFR 240.3a71-2 (De minimis exception for SBSD
registration); 17 CFR 240.3a67-1 (Definition of ``major security-
based swap participant''); 17 CFR 240.15Fb2-1 (Registration of SBSDs
and MSBSPs); 17 CFR 240.15Fh-3 (Business conduct requirements for
SBSDs and MSBSPs).
\3\ See 17 CFR 240.15Fk-1; Business Conduct Standards for
Security-Based Swap Dealers and Major Security-Based Swap
Participants, Exchange Act Release No. 77617 (Apr. 14, 2016), 81 FR
29960 (May 13, 2016) (``Business Conduct Standards Adopting
Release'').
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The Dodd-Frank Act also amended the Exchange Act in a number of
important ways to prohibit fraud, manipulation, and deception in
connection with security-based swaps. In particular, section 763(g) of
the Dodd-Frank Act expanded the anti-manipulation provisions of section
9 of the Exchange Act to encompass purchases or sales of security-based
swaps and requires the Commission to adopt rules to prevent fraud,
manipulation, and deception in connection with security-based swaps.\4\
Specifically, paragraph (j) of section 9 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 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.'' \5\ It also provides that the Commission ``shall . . . by
rules and regulations define, and prescribe means reasonably designed
to prevent, such transactions, acts, practices, and courses of business
as are fraudulent, deceptive, or manipulative, and such quotations as
are fictitious.'' \6\
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\4\ See 15 U.S.C. 78i(j).
\5\ See id. Note that section 9 of the Exchange Act erroneously
contains two subsection (j)s.
\6\ See id.
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Additionally, section 761 of the Dodd-Frank Act modified several
definitions in both the Exchange Act and the Securities Act of 1933
(``Securities Act'') to account for security-based swaps.\7\ For
example, the Dodd-Frank Act amended the definition of ``security'' in
section 3(a)(10) of the Exchange Act \8\ and section 2(a)(1) of the
Securities Act \9\ to include security-based swaps. As a result,
security-based swaps, because they are securities, are subject to the
general antifraud and anti-manipulation provisions of the Federal
securities laws, including sections 9(a) and 10(b) of the Exchange Act,
and 17 CFR 240.10b-5 (``Rule 10b-5'') thereunder,\10\ and section 17(a)
of the Securities Act.\11\
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\7\ Section 3(a)(68) of the Exchange Act defines ``security-
based swap.'' 15 U.S.C. 78c(a)(68).
\8\ 15 U.S.C. 78c(a)(10).
\9\ 15 U.S.C. 77b(a)(1).
\10\ 15 U.S.C. 78j(b).
\11\ 15 U.S.C. 77q(a).
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Moreover, the Dodd-Frank Act amended the definitions of
``purchase'' and ``sale'' in section 2(a)(18) of the Securities
Act,\12\ the definitions of ``buy'' and ``purchase'' in section
3(a)(13) of the Exchange Act,\13\ and ``sale'' and ``sell'' in section
3(a)(14) of the Exchange Act,\14\ in the context of security-based
swaps, to include 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. As a result of those changes,
misconduct in connection with these actions is also prohibited under
sections 9 and 10(b) of the Exchange Act, and Rule 10b-5 thereunder,
and section 17(a) of the Securities Act.
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\12\ 15 U.S.C. 77b(a)(18).
\13\ 15 U.S.C. 78c(a)(13).
\14\ 15 U.S.C. 78c(a)(14).
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On December 15, 2021, the Commission re-proposed antifraud and
anti-manipulation rules,\15\ as required by section 9(j) of the
Exchange Act. The re-proposal followed the Commission's adoption of
much of its Title VII rulemaking related to security-based swaps,\16\
as well as developments in the security-based swap market, including
manufactured credit events or other opportunistic strategies in the
credit default swap (``CDS'') market, as discussed in section I.B
below.\17\ In addition, in recognition of the fact that CCOs of SBS
Entities play an important role in preventing fraud and manipulation by
SBS Entities and their personnel, the Commission proposed an additional
measure under section 15F(h) of the Exchange Act \18\ to protect CCOs
in the furtherance of those duties.\19\ The Commission is adopting Rule
9j-1 with modifications in response to commenters,\20\ and adopting
Rule 15fh-4(c) as proposed.\21\ In developing this rulemaking we have
consulted and

[[Page 42548]]

coordinated with the CFTC and the prudential regulators in accordance
with section 712(a)(2) of the Dodd-Frank Act.\22\ Nothing in Rule 9j-1
alters the application of sections 9(a) and 10(b) of the Exchange Act,
and Rule 10b-5 thereunder, and section 17(a) of the Securities Act,
including to misconduct that is in connection with the exercise of any
right or performance of any obligation under the security-based swap.
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\15\ See Prohibition Against Fraud, Manipulation, or Deception
in Connection with Security-Based Swaps; Prohibition against Undue
Influence over Chief Compliance Officers; Position Reporting of
Large Security-Based Swap Positions, Exchange Act Release No. 93784
(Dec. 15, 2021), 87 FR 6652 (Feb. 4, 2022) (``2021 Proposing
Release''). See also Prohibition Against Fraud, Manipulation, and
Deception in Connection with Security-Based Swaps, Exchange Act
Release No. 63236 (Nov. 3, 2010), 75 FR 68560 (Nov. 8, 2010) (``2010
Rule 9j-1 Proposing Release''). For purposes of this release, we
will refer to the version of Rule 9j-1 that the Commission proposed
in the 2010 Rule 9j-1 Proposing Release as the ``2010 Proposed
Rule.'' We will refer to re-proposed Rule 9j-1 as ``proposed rule''
or ``re-proposed Rule 9j-1''and to final Rule 9j-1 as ``Rule 9j-1,''
``final rule,'' or ``final Rule 9j-1.''
\16\ As more fully described in the 2021 Proposing Release, the
Commission has now completed a majority of its rulemaking under
Title VII, SBS Entities are required to register with the Commission
(as of June 7, 2023, there are 50 conditionally registered security-
based swap dealers), and all persons are required to report their
security-based swap transactions to security-based swap data
repositories. See 2021 Proposing Release, 87 FR at 6653 nn.2-4 and
accompanying text. Further, since 2010, regulators overseeing the
world's primary over-the-counter (``OTC'') derivatives markets have
made significant progress implementing reforms for OTC derivatives
and the Commodity Futures Trading Commission (``CFTC'') has largely
completed its Title VII rulemakings related to swaps, including the
adoption of antifraud and anti-manipulation rules. See 2021
Proposing Release, 87 FR at 6654-55, 6654 n.19.
\17\ See infra section I.B.2, describing in more detail
manufactured credit events and other opportunistic strategies in the
CDS market. See also 2021 Proposing Release, 87 FR at 6654-55.
Additionally, in section II.C.2, infra, the Commission addresses
concerns raised by commenters with regard to the application of Rule
9j-1 to legitimate credit activity or other activity in connection
with security-based swap transactions, some of which may fit the
descriptions of the manufactured credit events and other
opportunistic strategies described in the 2021 Proposing Release.
\18\ See 15 U.S.C. 78o-10(h).
\19\ See 2021 Proposing Release, 87 FR at 6664-65. To be clear,
the ultimate responsibility for compliance by the SBS Entity with
the Federal securities laws, including the requirement to have
adequate compliance systems and to avoid violations generally, rests
with the SBS Entity itself.
\20\ The comment letters are available at https://www.sec.gov/comments/s7-32-10/s73210.shtml. The Commission also received
comments on topics outside the scope of the proposal that are not
addressed in this release. See, e.g., Comment from Anonymous, dated
Feb. 6, 2022, available at https://www.sec.gov/comments/s7-32-10/s73210-20114041-266299.htm (discussing dark pools); Comment from
Anonymous, dated Dec. 16, 2021, available at https://www.sec.gov/comments/s7-32-10/s73210-20109790-264127.htm (discussing securities
lending).
\21\ As described in greater detail below, the Commission is
making several changes to proposed Rule 9j-1 and adopting Rule 15fh-
4(c) as proposed. First, the Commission is revising paragraph (a) to
more closely track the language of section 9(j) of the Exchange Act
with regard to the conduct subject to the prohibitions of final Rule
9j-1(a), moving the prohibitions on attempted conduct from
paragraphs (a)(3) and (a)(4) to a new paragraph (a)(5), and
clarifying that the Commission believes scienter is the proper
standard to apply to violations of paragraph (a)(5). See infra
sections II.A and II.B. In addition, the Commission is moving
paragraph (b) of proposed Rule 9j-1 to a new paragraph (a)(6) to
rely on the scope of conduct subject to the prohibitions of
paragraph (a). See infra section II.C. Finally, the Commission is
adopting two affirmative defenses to violations of Rule 9j-1, one
for actions taken in connection with binding rights and obligations
under security-based swap documentation and one for appropriate
policies and procedures to ensure compliance with Rule 9j-1 such as
restrictions on access to material nonpublic information. See infra
sections II.E.2.a and II.E.2.b. The Commission is not adopting the
proposed safe harbor for portfolio compression exercises. See infra
section II.E.2.c.
\22\ In addition, in accordance with section 752 of the Dodd-
Frank Act, the Commission has consulted and coordinated with foreign
regulatory authorities through Commission staff participation in
numerous bilateral and multilateral discussions with foreign
regulatory authorities addressing the regulation of OTC derivatives
markets.
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The Commission also proposed for comment a new Rule 10B-1,\23\
which would require any person with a security-based swap position that
exceeds a certain threshold to promptly file with the Commission a
schedule disclosing certain information related to its security-based
swap positions. The Commission is not finalizing Rule 10B-1 in this
release as it continues to consider comments received in connection
with proposed Rule 10B-1.
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\23\ See 2021 Proposing Release, 87 FR at 6667-76.
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B. Overview of Security-Based Swaps

1. Security-Based Swaps Generally
Although the definition of security-based swap is detailed and
comprehensive,\24\ at its most basic level, a security-based swap is an
agreement, contract, or transaction in which two parties agree to the
exchange of payments or cash flows based upon the value of other assets
or upon the occurrence or non-occurrence of some event, including, for
example, a change in a stock price or the occurrence of some type of
credit event.\25\ The exchange of these payments or deliveries,
including purchases or sales upon certain events, is a fundamental
aspect or feature of a security-based swap.\26\ Moreover, this feature
of security-based swaps is in contrast to secondary market transactions
involving equity or debt securities where the completion of a purchase
or sale transaction terminates the mutual obligations of the parties.
Security-based swap counterparties, who are considered the issuers of
the security-based swaps, continue to have obligations to one another
throughout the life of the instrument, which can extend for years if
not decades.\27\
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\24\ See 15 U.S.C. 78c(a)(68) (defining ``security-based
swap''). See also Further Definition of ``Swap,'' ``Security-Based
Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;
Security-Based Swap Agreement Recordkeeping, Exchange Act Release
No. 67453 (July 18, 2012), 77 FR 48208, 48211 (Aug. 13, 2012)
(``Product Definitions Release'') (further defining certain terms
related to the definition of ``security-based swap'').
\25\ See generally section 3(a)(68) of the Exchange Act, which
defines 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 non-occurrence of an event
relating to a single issuer of a security or the issuers of
securities in a narrow-based security index, provided that such
event directly affects the financial instruments, financial
condition, or financial obligations of the issuer. 15 U.S.C.
78c(a)(68). See also 2010 Rule 9j-1 Proposing Release, 75 FR at
68561 (generally discussing the definition of ``security-based
swap''). This section also discusses examples of security-based
swaps and the exchange of payments or deliveries, or the purchase or
sale or other payments upon the occurrence of a specific event,
between the parties during the life of a security-based swap.
\26\ The definition of security-based swap requires that the
instrument first meet the definition of swap in section 1a(47) of
the Commodity Exchange Act. See 15 U.S.C. 78c(a)(68); supra note 25.
That definition provides, inter alia, that a swap is an agreement,
contract, or transaction that provides for any purchase, sale,
payment, or delivery upon the occurrence or nonoccurrence of certain
events or that provides on an executory basis for an exchange on a
fixed or contingent basis, of one or more payments that meet certain
conditions. See 7 U.S.C. 1a(47)(ii) and (iii).
\27\ See Further Definition of ``Swap Dealer,'' ``Security-Based
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant'' and ``Eligible Contract Participant,'' Exchange
Act Release No. 66868 (Apr. 27, 2012), 77 FR 30596, 30616-17 (May
23, 2012) (``In contrast to a secondary market transaction involving
equity or debt securities, in which the completion of a purchase or
sale transaction can be expected to terminate the mutual obligations
of the parties to the transaction, the parties to a security-based
swap often will have an ongoing obligation to exchange cash flows
over the life of the agreement.'').
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Parties may enter into a security-based swap for a multitude of
reasons, but often, the parties to the contract seek to gain exposure
to an asset without owning it or to manage or transfer risks in their
asset and liability portfolios (e.g., credit or equity risks). Typical
participants in the security-based swap market include, among others,
lenders transferring credit risk,\28\ insurance companies managing
asset and liability risk specific to the insurance industry,\29\
activists or hedge funds obtaining exposure to the price movement and
dividend payments of a stock without the costs and burdens of stock
ownership,\30\ and financial institutions that engage in market-making
and dealing in security-based swaps.\31\ The terms of the contract
between the counterparties determine the specific rights and
obligations of the parties throughout the life of the security-based
swap, including, for example, the amount and timing of periodic
payments due under the instrument, the maturity of the instrument, and
terms of settlement. Counterparties to a security-based swap typically
use a standardized agreement published by ISDA, first in 1992 and
updated in 2002, which is the most widely used contract setting forth
the terms of security-based swap transactions (the ``ISDA Master
Agreement''). Unlike other types of securities where settlement occurs
when the buyer receives the security purchased and the seller receives
cash equaling the value of the security sold, for security-based swaps,
a final net payment is paid by one party to the other at a future point
in time to which the parties have contractually agreed.\32\
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\28\ See, e.g., Letter from Elliot Ganz, Loan Syndications and
Trading Association (``LSTA''), dated Mar. 17, 2022 (``LSTA
Letter''), at 2-3.
\29\ See Letter from Michael Lovendusky, American Council of
Life Insurers (``ACLI''), dated Mar. 21, 2022 (``ACLI Letter'').
\30\ See Letter from Richard B. Zabel, Elliott Investment
Management L.P., dated Mar. 21, 2022 (addressing concerns related to
proposed Rule 10B-1 but also describing the security-based swap
activity of activists and hedge funds).
\31\ See Letter from Bridget Polichene, Institute of
International Bankers (``IIB''), Scott O'Malia, International Swaps
and Derivatives Association (``ISDA''), and Kenneth E. Bensten, Jr.,
Securities Industry and Financial Markets Association (``SIFMA''),
dated Mar. 21, 2022 (``IIB-ISDA-SIFMA Letter'').
\32\ See, e.g., Shortening the Securities Transaction Settlement
Cycle, Exchange Act Release No. 96939 (Feb. 15, 2023), 88 FR 13872,
13878 (Mar. 6, 2023) (``T+1 Adopting Release'') (citing letter from
Thomas Price, Managing Director, and Lindsey Weber Keljo, Head--
Asset Management Group, Securities Industry and Financial Markets
Association re: File No. S7-05-22 (Apr. 13, 2022), at 11).
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Two common examples of security-based swaps--credit default swaps
(``CDS'') and total return swaps (``TRS'')--are described in more
detail below.\33\
---------------------------------------------------------------------------

\33\ The definition of security-based swap in the Exchange Act
and the rules thereunder is broad. See supra notes 25-26 and related
discussion. The application of the rules we adopt in this document
is not limited to CDS and TRS or to transactions between particular
types of counterparties.
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Generally, a CDS is a contract in which a party (the ``protection
buyer''), such as a lender, agrees to make periodic payments (the
``premium'') over an agreed upon time period to another party (the
``protection seller'') in exchange for a payment from the protection
seller in the event of default by an issuer (or group of issuers) of
securities (the ``reference entity'').\34\ The

[[Page 42549]]

CDS contract states whether the CDS is settled physically or in cash in
the event of default by the reference entity. Generally, the protection
buyer is using the CDS to manage risk and the protection seller is
using the CDS to take on risk in return for a premium. A cash-settled
CDS contract relying on ISDA documentation is subject to determinations
by a committee with respect to whether a defined default event (a
``credit event'') has occurred and, if so, to hold an auction to
determine the settlement price of the CDS. The auction process includes
the determination and publication of a list of deliverable obligations
that a CDS protection buyer can deliver to the CDS protection seller
after the auction settlement. A CDS protection buyer can deliver any of
the obligations on the list, with delivery of the cheapest deliverable
obligation maximizing recovery.\35\ This feature of CDS contracts is an
aspect of some of the manufactured or opportunistic strategies
discussed in section I.B.2.
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\34\ A CDS generally falls within the second prong of the
definition of a swap under section 1(a) of the Commodity Exchange
Act as a contract ``that provides for any purchase, sale, payment,
or delivery (other than a dividend on an equity security) that is
dependent on the occurrence, nonoccurrence, or the extent of the
occurrence of an event or contingency associated with a potential
financial, economic, or commercial consequence.'' See 7 U.S.C.
1a(47)(a)(ii). If the CDS falls within any of the prongs of the
definition of security-based swap in Exchange Act section
3(a)(68)(A)(ii), the CDS would be a security-based swap. See Product
Definitions Release, 77 FR at 48267, and the broader discussion of
CDS therein.
\35\ See 2021 Proposing Release, 87 FR at 6655 n.23. As
described in the 2021 Proposing Release, in order to cash settle any
CDS contract that relies on the ISDA standard documentation, a
Credit Derivatives Determinations Committee (``DC'') must make a
determination that a credit event occurred and vote to hold an
auction to determine the settlement price of the CDS. A DC is
generally composed of nine or ten dealers and five buy-side members.
Once a DC determines that a credit event has occurred and that an
auction should be held, the DC Secretary publishes auction terms,
which include a list of obligations that a CDS protection buyer can
deliver to the CDS protection seller after the auction settlement
(each a ``deliverable obligation''). Each auction consists of two
parts: (1) the first part of the auction, which involves submission
of physical settlement requests by participating dealers, aims at
determining the initial market mid-point, the net open interests,
and adjustment amounts; and (2) the second part of the auction
consists of calculating the final settlement price. As noted,
protection buyers are incentivized to deliver into the auction the
cheapest deliverable obligation, as it maximizes their recovery; as
a result, the value of this ``cheapest to deliver'' deliverable
obligation drives the final settlement price. See Markit and
Creditex Credit Event Auction Primer, 1 (Feb. 2010), available at
https://www.creditfixings.com/information/affiliations/fixings/auctions/docs/credit_event_auction_primer.pdf. See also Credit
Suisse, A Guide to Credit Events and Auctions, 5 (Jan. 11, 2012),
available at https://doc.research-andanalytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=803733390&serialid=FWHCx3yCrSE3FoEvAbEKa6fRKhqLoKs0jL1gR5W2Dfs%3D.
---------------------------------------------------------------------------

In contrast, a TRS may obligate one of the parties (i.e., the total
return payer) to transfer the total economic performance (e.g., income
from interest and fees, gains or losses from market movements, and
credit losses) of a reference asset (e.g., a debt or equity security)
(the ``reference underlying''), in exchange for a specified or fixed or
floating cash flow (including payments for any principal losses on the
reference asset) from the other party (i.e., the total return
receiver).\36\ If the TRS is negotiated over-the-counter, the terms of
the TRS can be individually negotiated and could include one payment at
the expiration of the TRS or might include a series of payments on
periodic interim settlement dates over the tenor of the TRS. For TRS
with periodic interim settlement dates counterparties could agree to
reset the price of the reference underlying on the periodic interim
settlement date based on current market prices of the reference
underlying (``reference price''). Accordingly, throughout the life of a
TRS, depending on the terms of the TRS, the reference price that
determines that payment on periodic interim settlement dates might be
reset based on current market prices of the reference underlying.
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\36\ See 2010 Rule 9j-1 Proposing Release, 75 FR at 68562. See
also infra section V.B, discussing broad economic considerations of
security-based swaps and specifically TRS.
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2. Security-Based Swap Market Developments
In 2010, following the 2008 financial crisis, Congress enacted the
Dodd-Frank Act ``to promote the financial stability of the United
States by improving accountability and transparency in the financial
system.'' \37\ Title VII of the Dodd-Frank Act addressed significant
issues and risks in the swap and security-based swap markets, which had
experienced dramatic growth leading up to the 2008 financial crisis and
were shown to be capable of affecting significant sectors of the U.S.
economy.\38\ In testimony before Congress introducing the first draft
of the Dodd-Frank Act, Treasury Secretary Timothy Geithner highlighted
the risks posed by an unregulated OTC derivatives market, which had
been operating without the ``basic protections and oversight'' existing
in the rest of the financial systems, including a ``limited ability to
police fraud and manipulation.'' \39\ In his written testimony,
Secretary Geithner listed four broad objectives of the proposed reforms
which were eventually enacted as Title VII of the Dodd-Frank Act: (1)
preventing activities in the OTC derivatives markets from posing risk
to the stability of the financial system; (2) promoting efficiency and
transparency of the OTC derivatives markets; (3) preventing market
manipulation, fraud, and other abuses; and (4) protecting consumers and
investors by ensuring that OTC derivatives are not marketed
inappropriately to unsophisticated parties.\40\ Secretary Geithner also
stressed that the CFTC and the SEC should be provided with strong
authority for civil enforcement and regulation of fraud, market
manipulation, and other abuses in the OTC derivative markets.\41\ The
authority enacted in Title VII of the Dodd-Frank Act includes, but is
not limited to, Exchange Act section 9(j). Ensuring that the Commission
has the necessary tools to police the security-based swap markets is a
key component to ensure that Title VII's reforms are not undermined.
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\37\ Dodd-Frank Act, Public Law 111-203, Preamble. See also
Business Conduct Standards Adopting Release, 81 FR at 29961.
\38\ Business Conduct Standards Adopting Release, 81 FR at
29961. See also Cross-Border Security-Based Swap Activities; Re-
Proposal of Regulation SBSR and Certain Rules and Forms Relating to
the Registration of Security-Based Swap Dealers and Major Security-
Based Swap Participants, Exchange Act Release No. 69490 (May 1,
2013), 78 FR 30967, 30980 (May 23, 2013) (``Cross-Border Release'')
(discussing the spillover and contagion effects arising from
security-based swap transactions in the context of American
International Group, Inc., and its subsidiary AIG Financial Products
Corp.).
\39\ Senate Hearing on Over the Counter Derivatives Reform and
Addressing Systemic Risks, S. Hrg. 1111-803 (Dec. 2, 2009),
available at https://www.govinfo.gov/content/pkg/CHRG-111shrg62722/pdf/CHRG-111shrg62722.pdf.
\40\ Id. (including testimony noting that enacted reforms will
result in ``very consequential changes'' to OTC derivatives
markets).
\41\ Id.
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The security-based swap market remains large. Based on information
reported pursuant to 17 CFR 242.900 to 242.909 (``Regulation SBSR''),
as of November 25, 2022, the gross notional amount outstanding in the
security-based swap market is approximately $8.5 trillion across the
credit, equity, and interest rate asset classes.\42\ The credit
security-based swap asset class is large, with a gross notional amount
of approximately $4.7 trillion, of which single-name CDS (including
corporate and sovereign) account for the largest category at $4.3
trillion.\43\ Additionally, as indicated by data submitted pursuant to
Regulation SBSR, the size of the equity security-based swap market is
also significant--with approximately $3.6 trillion of equity security-
based swaps outstanding as of November 25, 2022.\44\
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\42\ See Report on Security-Based Swaps, Mar. 20, 2023,
available at https://www.sec.gov/files/report-security-based-swaps-032023.pdf (``SBS Report''). For further discussion of the
Regulation SBSR data, see infra section V.C.2.
\43\ See id.
\44\ See id.
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In general, the ongoing payments of a security-based swap depend,
in part, on

[[Page 42550]]

its gross notional amount outstanding.\45\ The particular aspects and
characteristics of security-based swaps (described above in section
I.B.1) provide opportunities and incentives for misconduct. In general,
parties to a security-based swap may engage in misconduct in connection
with the security-based swap (including in the reference underlying of
such security-based swap) to trigger, avoid, or affect the value of
ongoing payments or deliveries. For instance, a party faced with
significant risk exposure may engage or attempt to engage in
manipulative or deceptive conduct that increases or decreases the value
of payments or cash flow under a security-based swap relative to the
value of the reference underlying, including the price or value of a
deliverable obligation under a security-based swap. Moreover, fraud and
manipulation in connection with a security-based swap can affect not
just a direct counterparty, but also counterparties to that
counterparty. For example, if fraud or manipulation leads to a large
change in variation margin, the defrauded counterparty could default on
its obligations to its other counterparties. In addition, other
counterparties to the same security-based swaps could be affected by
fraud or manipulation that affects the reference underlying assets, as
could investors in those underlying assets. Given the global and
interconnected nature of the security-based swap markets, it is
critical that the Commission has appropriate tools to fight fraud and
manipulation in these markets.\46\ Recent developments in the security-
based swap market highlight these concerns. For example, in the 2021
Proposing Release, the Commission discussed certain manufactured or
other opportunistic CDS strategies that had been reported by academics
and the press: \47\
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\45\ See, e.g., Bloomberg L.P. v. Commodity Futures Trading
Com'n, 949 F. Supp. 2d 91, 96 (D.D.C. 2013) (stating that a swap
``is a contract that typically involves an exchange of one or more
payments based on the underlying value of a notional amount of one
or more commodities, or other financial or economic interest . . .
.'' (emphasis added)).
\46\ See Application of ``Security-Based Swap Dealer'' and
``Major Security-Based Swap Participant'' Definitions to Cross-
Border Security-Based Swap Activities, Exchange Act Release No.
72472 (June 25, 2014), 79 FR 47278, 47283 (Aug. 12, 2014)
(discussing the global nature and interconnectedness of the
security-based swap market and the potential for risk transmission).
\47\ 2021 Proposing Release, 87 FR at 6655. See also supra note
35 and related discussion regarding the operation of CDS auctions.
---------------------------------------------------------------------------

A CDS buyer working with a reference entity to create an
artificial, technical, or temporary failure-to-pay credit event in
order to trigger a payment on a CDS to the buyer (and to the detriment
of the CDS seller).\48\
---------------------------------------------------------------------------

\48\ See Henry T.C. Hu, Corporate Distress, Credit Default
Swaps, and Defaults: Information and Traditional, Contingent, and
Empty Creditors, 13 Brook. J. Corp. Fin. & Com. L. 5-32, at 26-27
(Nov. 2018), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3302816.
---------------------------------------------------------------------------

Alone or in combination with the above or other
strategies, causing the reference entity to issue a below-market debt
instrument in order to artificially increase the auction settlement
price for the CDS (i.e., by creating a new ``cheapest to deliver''
deliverable obligation).\49\
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\49\ See Statement on Manufactured Credit Events by CFTC
Divisions of Clearing and Risk, Market Oversight, and Swap Dealer
and Intermediary Oversight (Apr. 24, 2018), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/divisionsstatement042418.
---------------------------------------------------------------------------

CDS buyers endeavoring to influence the timing of a credit
event in order to ensure a payment (upon the triggering of the CDS)
before expiration of a CDS, or a CDS seller taking similar actions to
avoid the obligation to pay by ensuring a credit event occurs after the
expiration of the CDS, or taking actions to limit or expand the number
and/or kind of deliverable obligations in order to impact the recovery
rate.\50\
---------------------------------------------------------------------------

\50\ See Hu, supra note 48 at 22-26.
---------------------------------------------------------------------------

CDS sellers offering financing to restructure a reference
entity in such a way that ``orphans'' the CDS--eliminating or reducing
the likelihood of a credit event by moving the debts off the balance
sheets of the reference entity and onto the balance sheets of a
subsidiary or an affiliate that is not referenced by the CDS.\51\
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\51\ See Gina-Gail S. Fletcher, Engineered Credit Default Swaps:
Innovative or Manipulative?, 94 N.Y.U. L. Rev. 1073, 1101 (2019).
---------------------------------------------------------------------------

Taking actions, including as part of a larger
restructuring, to increase (or decrease) the supply of deliverable
obligations by, for example, adding (or removing) a co-borrower to
existing debt of a reference entity, thereby increasing (or decreasing)
the likelihood of a credit event and the cost of CDS.\52\
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\52\ See Fletcher, supra note 51 at 1098. See also CFTC Talks
Podcast, Credit Derivatives, (Jul. 10, 2019), available at https://www.cftc.gov/Exit/index.htm?https://youtu.be/Qqo9KR6JXaM?.
---------------------------------------------------------------------------

The 2021 Proposing Release also discussed the fact that in 2019,
the former SEC Chairman issued a joint public statement with the
principals of the CFTC and the U.K. Financial Conduct Authority at the
time stating that the ``continued pursuit of various opportunistic
strategies in the credit derivatives markets . . . may adversely affect
the integrity, confidence and reputation of the credit derivatives
markets, as well as markets more generally.'' \53\
---------------------------------------------------------------------------

\53\ See Joint Statement on Opportunistic Strategies in the
Credit Derivatives Market (June 24, 2019), available at https://www.sec.gov/news/press-release/2019-106 (``2019 Joint Statement'');
2021 Proposing Release, 87 FR at 6655.
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Taking into consideration all of the above, Rule 9j-1 will be an
important additional tool to augment the Commission's oversight of the
security-based swap markets including, but not limited to, the markets
for CDS and TRS.

B. Overview of the Final Rules

1. Rule 9j-1
As described in detail below, final Rule 9j-1 includes prohibitions
on categories of misconduct prohibited by section 10(b) of the Exchange
Act, and Rule 10b-5 thereunder, and section 17(a) of the Securities
Act, when effecting any transaction in, or attempting to effect any
transaction in, any security-based swap, or when purchasing or selling,
or inducing or attempting to induce the purchase or sale of, any
security-based swap (including but not limited to, in whole or in part,
the execution, termination (prior to its scheduled maturity date),
assignment, exchange, or similar transfer or conveyance of, or
extinguishing of any rights or obligations under, any security based-
swap).\54\ The final rule also includes a provision prohibiting the
manipulation or attempted manipulation of the price or valuation of any
security-based swap, including any payment or delivery related thereto.
This provision has been moved to paragraph (a)(6) of Rule 9j-1 (from
paragraph (b) as proposed) to clarify that these provisions apply to
conduct that is undertaken in connection with directly or indirectly
effecting, or attempting to effect, any transaction in any security-
based swap, or purchasing or selling, or inducing or attempting to
induce the purchase or sale of, any security-based swap.\55\ Further,
final Rule 9j-1 provides that: (1) a person with material nonpublic
information about a security cannot avoid liability under the
securities laws by communicating about or making purchases or sales in
the security-based swap (as opposed to communicating about or
purchasing or selling the underlying security); and (2) a person cannot
avoid liability under section 9(j) or Rule 9j-1 in connection with a
fraudulent scheme involving a security-based swap by instead making
purchases or sales in the underlying

[[Page 42551]]

security (as opposed to purchases or sales in the security-based
swap).\56\ In addition, final Rule 9j-1 includes two affirmative
defenses from the liability under paragraphs (a)(1) through (5) of Rule
9j-1: (1) where the action otherwise prohibited by Rule 9j-1 was taken
pursuant to binding rights and obligations in written security-based
swap documentation so long as the security-based swap was entered into,
or the amendment was made, before the person became aware of the
material nonpublic information, and in good faith and not as part of a
plan or scheme to evade the prohibitions of Rule 9j-1; and (2) with
respect to entities, if the entity demonstrates that the individual at
the entity making the investment decision was not aware of material
nonpublic information and the entity had implemented reasonable
policies and procedures to prevent violations of Rules 9j-1(a)(1)
through(5).\57\
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\54\ See Rules 9j-1(a), (a)(1) through (a)(5), and (d).
\55\ See Rule 9j-1(a)(6).
\56\ See Rules 9j-1(b) and (c).
\57\ See Rule 9j-1(e).
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2. Rule 15fh-4(c)
The Commission also is adopting a rule aimed at protecting the
independence and objectivity of an SBS Entity's CCO by preventing the
personnel of an SBS Entity from taking actions to coerce, mislead, or
otherwise interfere with the CCO. The Commission recognizes that SBS
Entities dominate the security-based swap market and also recognizes
the important role that CCOs of SBS Entities play in ensuring
compliance by SBS Entities and their personnel with the Federal
securities laws. As a result, the Commission is adopting Rule 15fh-
4(copyright), which makes it unlawful for any officer, director,
supervised person, or employee of an SBS Entity, or any person acting
under such person's direction, to directly or indirectly take any
action to coerce, manipulate, mislead, or fraudulently influence the
SBS Entity's CCO in the performance of their duties under the Federal
securities laws or the rules and regulations thereunder.\58\
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\58\ The Commission also amends the CFR designation of Rule
15Fh-4 in order to ensure the regulatory text conforms more
consistently with section 2.13 of the Document Drafting Handbook.
See Office of the Federal Register, Document Drafting Handbook (Aug.
2018 Edition, Revision 1.4, dated Jan. 7, 2022), available at
https://www.archives.gov/files/federal-register/write/handbook/ddh.pdf. In particular, the Commission amends the CFR section
designation for 17 CFR 240.15Fh-4 (Rule 15Fh-4) to replace the
uppercase letter with the corresponding lowercase letter, such that
the rule is redesignated as 17 CFR 240.15fh-4 (Rule 15fh-4).
---------------------------------------------------------------------------

II. Rule 9j-1: Prohibition Against Fraud, Manipulation, and Deception
in Connection With Security-Based Swaps

Final Rule 9j-1 will aid the Commission in its pursuit of actions
that directly target misconduct that reaches security-based swaps. The
rule takes into account the features of a security-based swap and the
broad definitions of ``purchase'' and ``sale'' in the Securities
Act,\59\ and of ``buy,'' ``purchase,'' ``sale,'' and ``sell'' in the
Exchange Act,\60\ to include the execution, termination (prior to its
scheduled maturity date), assignment, exchange, or similar transfer or
conveyance of, or extinguishing of any rights or obligations under, a
security-based swap, as the context may require. Final Rule 9j-1
applies to fraudulent, deceptive, or manipulative misconduct related to
the exercise of any right or performance of any obligation under a
security-based swap if such misconduct occurs in connection with
effecting or attempting to effect a transaction in, or purchasing or
selling, or inducing or attempting to induce the purchase or sale of, a
security-based swap.\61\ For example, to the extent that such
misconduct results in the execution, termination (prior to its
scheduled maturity date), assignment, exchange, or similar transfer or
conveyance of, or extinguishing of any rights or obligations under, a
security-based swap, as the context may require, Rule 9j-1 would apply.
In adopting Rule 9j-1, the Commission continues to recognize the
regulatory and market developments that supported the proposal of an
antifraud and anti-manipulation provision.\62\
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\59\ 15 U.S.C. 77b(a)(18).
\60\ 15 U.S.C. 78c(a)(13) and (14).
\61\ See supra section I.B.1 for a discussion regarding ongoing
payments and deliveries that are typical for a security-based swap.
\62\ See supra section I.B.2.
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In general, fraudulent, deceptive, or manipulative conduct, such as
providing false or incomplete information to a counterparty to secure
better terms or pricing or to alter the performance of ongoing rights
and obligations, has the potential to harm counterparties to all forms
of security-based swaps, including CDS, equity security-based swaps,
and non-CDS debt security-based swaps. Manipulation of the reference
underlying security can affect the pricing of an equity or debt
security-based swap, as well as the ongoing payments and obligations
that are based on the value of that reference security. Further, in
some cases, particularly in instances involving security-based swap
transactions that are effected over the internet, there is a potential
for trading software to distort pricing and payouts on security-based
swaps.\63\ Finally, to the extent a CDS-related opportunistic strategy
alters the operations of a reference entity, shareholders in reference
underlying entities and counterparties to any security-based swap based
on that reference entity could be impacted; the potential harm is not
limited to CDS holders or to the counterparties of bad actors.
---------------------------------------------------------------------------

\63\ See, e.g., SEC Investor Alert: Binary Options Fraud,
available at https://www.investor.gov/protect-your-investments/fraud/types-fraud/binary-options-fraud (``SEC Binary Options Fraud
Alert'') (stating that the SEC has received numerous complaints
alleging that certain ``internet-based binary options trading
platforms manipulate the trading software to distort binary options
prices and payouts''). The SEC Binary Options Fraud Alert represents
the views of the staff of the Office Investor Education and
Advocacy. It is not a rule, regulation, or statement of the
Commission. The Commission has neither approved nor disapproved its
content. The SEC Binary Options Fraud Alert, like all staff
statements, has no legal force or effect: it does not alter or amend
applicable law, and it creates no new or additional obligations for
any person. Depending on the facts and circumstances, binary options
based on securities may be security-based swaps.
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A. Misconduct ``In Connection With'' ``Purchases,'' ``Sales,'' or
``Effecting Transactions''

1. Proposed Approach
As proposed, Rule 9j-1 would have prohibited the same categories of
misconduct addressed by section 10(b) of the Exchange Act,\64\ and Rule
10b-5 thereunder,\65\ as well as section 17(a) of the Securities
Act.\66\ The proposed rule imposed liability for misconduct related to
any ongoing payments and deliveries that are typical of security-based
swaps and which occur throughout the life of the security-based
swap.\67\ Specifically, proposed Rule 9j-1(a) would have made it
unlawful for any person, directly or indirectly, to purchase or sell,
or attempt to induce the purchase or sale of, any security-based swap;
to effect any transaction in, or attempt to effect any transaction in,
any security-based swap; to take any action to exercise any right, or
any action related to performance of any obligation, under any
security-based swap, including in connection with any payments,
deliveries, rights, or obligations or alterations of any rights
thereunder; or to terminate (other than on its scheduled maturity date)
or settle any security-based swap, in connection with which such
person: (1) employs or attempts to employ any device, scheme,

[[Page 42552]]

or artifice to defraud or manipulate; (2) makes or attempts to make any
untrue statement of a material fact, or to 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; (3)
obtains or attempts 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; or (4)
engages or attempts to engage in any act, practice, or course of
business which operates or would operate as a fraud or deceit upon any
person.\68\ Additionally, proposed Rule 9j-1(e) provided that the terms
``purchase'' and ``sale'' would have the same meaning as set forth in
sections 3(a)(13) and (14) of the Exchange Act.\69\
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\64\ 15 U.S.C. 78j(b).
\65\ 17 CFR 240.10b-5.
\66\ 15 U.S.C. 77q(a).
\67\ See 2021 Proposing Release, 87 FR at 6661-62.
\68\ See 2021 Proposing Release, 87 FR at 6703.
\69\ See 15 U.S.C. 78c(a)(13) and (14).
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2. Commission Action
The Commission is adopting final Rule 9j-1(a), but has revised the
rule to more closely follow the language used in the definitions of
``purchase'' and ``sale,'' and ``buy'' and ``sell'' in the Exchange
Act, as amended by the Dodd-Frank Act, and to respond to commenter
concerns.\70\ Specifically, the rule makes it unlawful for any person,
directly or indirectly, to effect any transaction in, or attempt to
effect any transaction in, any security-based swap, or to purchase or
sell, or induce or attempt to induce the purchase or sale of, any
security-based swap (including but not limited to, in whole or in part,
the execution, termination (prior to its scheduled maturity date),
assignment, exchange, or similar transfer or conveyance of, or
extinguishing of any rights or obligations under, a security based-
swap, as the context may require), in connection with which such person
engages in the activities specified in Rules 9j-1(a)(1) through
(6).\71\ Final Rule 9j-1(a) prohibits fraudulent, deceptive, or
manipulative misconduct related to the payments, deliveries, rights, or
obligations under a security-based swap if that misconduct occurs in
connection with effecting or attempting to effect a transaction in, or
purchasing or selling, or inducing or attempting to induce the purchase
or sale of, a security-based swap.\72\ Further, the Commission is
adopting Rule 9j-1(e) as proposed but now renumbered as final Rule 9j-
1(d).
---------------------------------------------------------------------------

\70\ See 15 U.S.C. 78c(a)(13) and (14).
\71\ See supra sections II.B and II.C.
\72\ See final Rule 9j-1(a).
---------------------------------------------------------------------------

Several commenters supported the application of Rule 9j-1(a) to the
exercise of rights and performance of obligations under a security-
based swap.\73\ One commenter recognized that the proposed rule
``appropriately recognizes that [security-based swaps] have unique
characteristics in the form of `ongoing payments or deliveries between
the parties throughout the life of the security-based swap pursuant to
their rights and obligations,' '' which creates additional
opportunities for fraud and manipulation, as compared to other types of
securities, therefore warranting ``their own unique anti-fraud rule.''
\74\
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\73\ See Letter from Andrew Park, Americans for Financial Reform
Education Fund (``AFRED''), dated Mar. 21, 2022 (``AFRED Letter'');
Letter from Stephen W. Hall and Jason Grimes, Better Markets, Inc.,
dated Mar. 21, 2022 (``Better Markets Letter''); Letter from Gina-
Gail S. Fletcher, Duke University School of Law, dated Mar. 21, 2022
(``Fletcher Letter'').
\74\ Better Markets Letter at 9. Another commenter also noted
the ``unique risks and long duration, with a potentially complex
stream of payments and obligations'' of security-based swaps in
their support of the scope of the proposed rule. Fletcher Letter at
2.
---------------------------------------------------------------------------

Two commenters argued that the Commission exceeded its statutory
authority by applying proposed Rule 9j-1(a) ``to every interim
performance obligation'' and every exercise of a right under a
security-based swap.\75\ One commenter asserted that ``[h]ad Congress
intended'' for Exchange Act section 9(j) to cover ``actions related to
the ongoing performance of obligations under a security-based swap
agreement, it would have expressly done so in the Dodd-Frank Act or
subsequent legislation, particularly given that it amended the
definitions of `purchase' and `sale' to reflect security-based swaps.''
\76\ The commenter stated that ``[i]n so doing, Congress made a
determination to limit the covered actions to `execution,'
`termination,' `exchange,' or `extinguishing' of rights or obligations
under a security-based swap.'' \77\ The commenter also stated that
``[t]here is also no precedent or support for the Commission to adopt a
broad interpretation of the phrase `to effect any transaction in' . . .
as a basis for including interim performance obligations within the
scope of proposed Rule 9j-1, as this has not been the traditional and
longstanding understanding of that statutory phrase.'' \78\ Another
commenter asserted that the Commission could not use its prophylactic
authority under section 9(j) as a means to ``extend Proposed Rule 9j-
1(a) beyond'' what the commenter stated was ``any natural reading of
the terms `purchase' or `sale.' '' \79\
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\75\ Letter from Jennifer W. Han, Managed Funds Association
(``MFA''), dated Mar. 21, 2022 (``MFA Letter''), at 4. See id. at 3-
8; IIB-ISDA-SIFMA Letter at 6-8.
\76\ MFA Letter at 5. See IIB-ISDA-SIFMA Letter at 6.
\77\ MFA Letter at 5.
\78\ Id. at 7.
\79\ IIB-ISDA-SIFMA Letter at 8.
---------------------------------------------------------------------------

The same two commenters also raised practical concerns about
applying Rule 9j-1(a) to every exercise of a right or performance of an
obligation under a security-based swap. One commenter stated that ``if
the proposed antifraud rule can be applied to any action or omission
`related to performance of any obligation,' market participants will
undoubtedly seek to limit the scope of their transactions, and the
terms of such transactions, in order to mitigate their exposure to
liability under the rule'' and some market participants would
``terminate their involvement in the security-based swap market
entirely.'' \80\ The commenter asserted that this result would ``reduce
liquidity in security-based swap markets and, by restricting hedging
opportunities, have a material adverse effect on the availability and
cost of capital for issuers.'' \81\ The other commenter asserted that
``Proposed Rule 9j-1(a)'s application to non-volitional conduct under
[a security-based swap] would not be appropriate because it would cast
uncertainty on a wide range of bona fide conduct necessary to the
operation of the capital markets'' and ``risks chilling legitimate
market conduct as market participants try to determine whether conduct
unrelated to an affirmative investment decision could be judged after
the fact to be prohibited.'' \82\
---------------------------------------------------------------------------

\80\ MFA Letter at 7-8 (emphasis in original).
\81\ MFA Letter at 8.
\82\ IIB-ISDA-SIFMA Letter at 8-9.
---------------------------------------------------------------------------

The Commission has carefully considered the comments and, as
discussed below in sections II.A.2.a through II.A.2.c, is revising Rule
9j-1 to specify that it applies to misconduct that occurs in connection
with effecting any transaction in, or attempting to effect any
transaction in, any security-based swap, or purchasing or selling, or
inducing or attempting to induce the purchase or sale of, any security-
based swap (including but not limited to, in whole or in part, the
execution, termination (prior to its scheduled maturity date),
assignment, exchange, or similar transfer or conveyance of, or
extinguishing of any rights or obligations under, a security based-
swap). The language in final Rule 9j-1(a) is based on section 9(j) of
the

[[Page 42553]]

Exchange Act and the definitions of ``purchase'' and ``sale,'' and
``buy'' and ``sell,'' which were amended by the Dodd-Frank Act to take
into account the unique characteristics of security-based swaps.\83\
The final rule text also is revised to make it unlawful to ``induce . .
. the purchase or sale'' of any security-based swap, in addition to
``purchase or sell,'' and ``attempt to induce the purchase or sale
of,'' any security-based swap. This addition is made to track the
statutory language of section 9(j) of the Exchange Act.\84\ In addition
to the changes to Rule 9j-1(a), in response to commenters' practical
concerns, as discussed in section II.E.2, the Commission is adopting
affirmative defenses.
---------------------------------------------------------------------------

\83\ The Dodd-Frank Act amended the definitions of ``purchase''
and ``sale'' in section 2(a)(18) of the Securities Act, 15 U.S.C.
77b(a)(18), the definitions of ``buy'' and ``purchase'' in section
3(a)(13) of the Exchange Act, 15 U.S.C. 78c(a)(13), and ``sale'' and
``sell'' in section 3(a)(14) of the Exchange Act, 15 U.S.C.
78c(a)(14), in the context of security-based swaps, to include ``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.'' Final Rule 9j-1(d) makes clear that
``[f]or purposes of this section, the terms `purchase' and `sale'
shall have the same meanings as set forth in Sections 3(a)(13) (15
U.S.C. 78c(a)(13)) and 3(a)(14) (15 U.S.C. 78c(a)(14)) of the Act.''
\84\ See 15 U.S.C. 78i(j).
---------------------------------------------------------------------------

Depending on the facts and circumstances of a particular situation,
as discussed in sections II.A.2.a through II.A.2.c below, final Rule
9j-1 may reach misconduct that affects the payments and deliveries that
typically occur throughout the life of a security-based swap, if that
misconduct occurs in connection with effecting or attempting to effect
any transaction in, or purchasing or selling, or inducing or attempting
to induce the purchase or sale of, any security-based swap. Consistent
with the operation of other antifraud provisions in the securities
laws, whether that connection exists will be determined on a case-by-
case basis.\85\ Sections II.A.2.a through II.A.2.c below discuss the
scope of ``in connection with,'' ``purchases or sales,'' and
``effecting transactions'' in the context of final Rule 9j-1(a).
---------------------------------------------------------------------------

\85\ One commenter asserted that the Commission's rulemaking
authority under section 9(j) is limited to ``identify[ing] specific
transactions, acts, practices and courses of business'' that are
fraudulent, deceptive, or manipulative. IIB-ISDA-SIFMA Letter at 8.
The text of section 9(j), which authorizes the Commission to
``define, and prescribe means reasonably designed to prevent, such
transactions, acts, practices, and courses of business as are
fraudulent, deceptive, or manipulative,'' does not require the
Commission to identify ``specific transactions, acts, practices and
courses of business.'' Because security-based swaps are complex, and
related strategies are constantly evolving, new opportunities for
misconduct likewise constantly arise. Rule 9j-1 must be flexible to
enable the Commission to prevent such misconduct.
---------------------------------------------------------------------------

a. In Connection With
Final Rule 9j-1 prohibits misconduct ``in connection with''
effecting any transaction in, or attempting to effect any transaction
in, any security-based swap, or when purchasing or selling, or inducing
or attempting to induce the purchase or sale of, any security-based
swap. Even if taking an action related to payments and deliveries under
any security-based swap would not itself constitute a purchase or sale,
or effecting a transaction, conduct that affects payments and
deliveries may occur ``in connection with'' purchases or sales, or
effecting a transaction. The Supreme Court has ``espoused a broad
interpretation'' of ``in connection with,'' \86\ holding that the
phrase ``should be `construed not technically and restrictively, but
flexibly to effectuate its remedial purposes.' '' \87\ Accordingly, the
Court has held that ``it is enough that the fraud alleged `coincide'
with a securities transaction.'' \88\ As one commenter who was critical
of the breadth of proposed Rule 9j-1(a) acknowledged, ``much of the
illegitimate conduct described in the [proposing] release''--and in
section I.B.2, supra--``involves a purchase or sale of securities.''
\89\
---------------------------------------------------------------------------

\86\ Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547
U.S. 71, 85 (2006).
\87\ SEC v. Zandford, 535 U.S. 813, 819 (2002) (citations
omitted).
\88\ Dabit, 547 U.S. at 85 (citation omitted). See
Superintendent of Ins. of State of N.Y. v. Bankers Life & Cas. Co.,
404 U.S. 6, 12 (1971) (``deceptive practices touching [a] sale'' are
actionable); Chadbourne & Parke LLP v. Troice, 571 U.S. 377, 387
(2014) (fraud occurred ``in connection with'' a purchase or sale if
it was ``material to and `coincided with' third-party securities
transactions'' (quoting Dabit, 547 U.S. at 85)).
\89\ IIB-ISDA-SIFMA Letter at 9. As an example, the commenter
stated, ``the credit event under a credit default swap . . .
typically settles through an auction process that involves purchases
and sales of securities [and] many of the transactions with
reference entities identified by the Commission are securities
transactions.'' Id. As discussed below, see infra section II.A.2.c,
settlement also is part of effecting a securities transaction. See
15 U.S.C. 78bb(e)(3)(C).
---------------------------------------------------------------------------

Moreover, the Supreme Court has held that the requirement that
``deception occur `in connection with the purchase or sale of any
security''' does not require ``deception of an identifiable purchaser
or seller'' because ``[t]he Exchange Act was enacted in part `to insure
the maintenance of fair and honest markets''' generally.\90\ The ``in
connection with'' requirement accordingly can be satisfied ``even
though the person or entity defrauded is not the other party to the
trade''--or here, the counterparty to the relevant security-based
swap.\91\ For that reason, misconduct that affects the payments and
deliveries under one security-based swap could be prohibited by final
Rule 9j-1 if that misconduct occurs in connection with effecting or
attempting to effect transactions or purchasing or selling or
attempting to induce the purchase or sale of any security-based swap,
and not just the security-based swap that was the subject of the
misconduct.
---------------------------------------------------------------------------

\90\ United States v. O'Hagan, 521 U.S. 642, 657-58 (1997)
(quoting 15 U.S.C. 78b).
\91\ Id. at 656.
---------------------------------------------------------------------------

b. Purchases or Sales
Not only is ``in connection with'' construed broadly, Congress also
has broadly defined what constitutes a ``purchase'' and ``sale.''
Generally, purchases and sales of securities include ``contracts to
buy, purchase or otherwise acquire'' or ``contracts to sell or
otherwise dispose of'' the security, respectively.\92\ For security-
based swaps, as part of the provisions of the Dodd Frank Act that gave
the Commission new authority over that market, Congress added that
purchases and sales also include ``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.'' \93\ Final Rule 9j-
1(a) accordingly prohibits fraudulent, deceptive, or manipulative
conduct that affects ongoing payments and deliveries under a security-
based swap if that misconduct occurs in connection with any activity
that falls within those broad definitions.\94\
---------------------------------------------------------------------------

\92\ 15 U.S.C. 78c(a)(13) and 78c(a)(14).
\93\ 15 U.S.C. 77b(a)(18), 78c(a)(13), and 78c(a)(14).
\94\ One commenter expressed concern that the term ``terminate
(other than on its scheduled maturity date)'' in proposed Rule 9j-
1(a) was ``simultaneously too broad and too narrow.'' Fletcher
Letter at 2. The commenter stated that the term ``would appear to
exempt terminations at maturity from the scope of the rule'' even if
``an opportunistic scheme could be executed in line with the
scheduled maturity date,'' while applying to ``contractually
permitted terminations'' prior to maturity that are ``not conducted
to intentionally distort the swap transaction.'' Id. Consistent with
Exchange Act sections 3(a)(13) and (14), the Commission has revised
final Rule 9j-1(a) to state that a purchase or sale of a security-
based swap includes, but is not limited to, a ``termination (prior
to its scheduled maturity date) . . . of . . . a security-based
swap,'' and includes any ``similar transfer or conveyance of, or
extinguishing of any rights or obligations under, a security-based
swap, as the context may require.'' Depending on the context, the
termination of a security-based swap on the scheduled maturity date
could constitute such a ``similar transfer or conveyance'' or
``extinguish[ment] of any rights or obligations.'' And while a
contractually permitted termination of a security-based swap prior
to maturity constitutes a purchase or sale under the terms of both
section 3(a) and Rule 9j-1(a), Rule 9j-1(a) prohibits only
fraudulent, deceptive, or manipulative conduct in connection with a
termination.

---------------------------------------------------------------------------

[[Page 42554]]

Those definitions are not limited to executions, terminations,
assignments, exchanges, or similar transfer or conveyance of, or
extinguishing of all the rights or obligations under, a security-based
swap. Therefore, the Commission also has revised final Rule 9j-1(a) to
add the words ``including but not limited to, in whole or in part''
before listing the activities enumerated in Exchange Act sections
3(a)(13) and (14).\95\ In addition, the final rule includes the word
``any'' before ``rights or obligations.'' These modifications clarify
that, for purposes of the antifraud and anti-manipulation provisions of
paragraph (a), the definitions of purchase and sale encompass, among
other things, partial executions, terminations, assignments, exchanges,
transfers or conveyances of, or extinguishing of any rights or
obligations under, a security-based swap, as the context may
require.\96\ The Commission stated in the 2021 Proposing Release that
the Exchange Act's definitions of purchase and sale in the context of
security-based swaps ``incorporate actions that have an impact on some,
but not all, rights and obligations'' under a security-based swap,
including ``partial executions, terminations, assignments, exchanges,
transfers, or extinguishments of rights or obligations.'' \97\
Commenters did not disagree.\98\
---------------------------------------------------------------------------

\95\ The phrase ``but not limited to'' reflects the fact that
Exchange Act sections 3(a)(13) and (14) do not limit the definition
of purchase or sale to the enumerated activities, contrary to the
assertion of one commenter. See MFA Letter at 5; supra notes 76 and
77, and related discussion.
\96\ See Rule 9j-1(a) (``to purchase or sell, or induce or
attempt to induce the purchase or sale of, any security-based swap
(including but not limited to, in whole or in part, the execution,
termination (prior to its scheduled maturity date), assignment,
exchange, or similar transfer or conveyance of, or extinguishing of
any rights or obligations under, a security based-swap, as the
context may require'').
\97\ 2021 Proposing Release, 87 FR at 6661.
\98\ See, e.g., IIB-ISDA-SIFMA Letter at 7 (``We concur with
this reading, insofar as it would extend Proposed Rule 9j-1(a) to an
affirmative action relating to an investment decision and affecting
a material term of [a security-based swap], for example a partial
termination or assignment.'').
---------------------------------------------------------------------------

It also is reasonable to include partial executions, terminations,
assignments, exchanges, or similar transfers or conveyances of, or
extinguishing of rights or obligations under, a security-based swap
within the scope of the rule because those actions could result in
amendments to the material terms of the security-based swap and,
therefore, result in a new security-based swap (that is, a ``purchase''
or ``sale'').\99\ Security-based swaps take many different forms and
are used for many different purposes, but often are used to hedge
risks. Even a partial change in any of the rights and obligations
underlying the security-based swap--particularly those related to
ongoing payments and deliveries--could affect the alignment of that
hedge with the attendant risk and, under a facts and circumstances
analysis, could constitute a purchase or sale of a security-based swap.
A different approach--one that only prohibited misconduct in connection
with the extinguishment of all of the rights and obligations under a
security-based swap--would leave market participants vulnerable to the
risks that the security-based swap was entered into to address (as well
as decrease the alignment of any hedge entered into to address the risk
of the security-based swap itself). These revisions to the text of
final Rule 9j-1 also ensure that market participants cannot evade
liability under Rule 9j-1 by, for example, structuring fraudulent,
deceptive, or manipulative conduct so that some portion of a
counterparty's rights and obligations under a security-based swap
remain in place.
---------------------------------------------------------------------------

\99\ See infra note 100, and related discussion of amendments of
material terms.
---------------------------------------------------------------------------

Relatedly, the Commission reiterates that ``[i]f the material terms
of a'' security-based swap ``are amended or modified during its life
based on an exercise of discretion and not through predetermined
criteria or a predetermined self-executing formula,'' then ``the
amended or modified'' security-based swap is a ``new'' security-based
swap.\100\ For example, contrary to one commenter's assertion,\101\
amendments to terms regarding ongoing rights and obligations under a
security-based swap, including those related to ongoing payments and
deliveries, could result in a new transaction.\102\ When an amendment
or modification constitutes a purchase or sale of a security-based
swap, Rule 9j-1(a) prohibits any fraudulent, deceptive, or manipulative
conduct that occurs in connection with it.
---------------------------------------------------------------------------

\100\ Product Definitions Release, 77 FR at 48286; see 17 CFR
230.145(a) Preliminary Note (``Changing the nature and terms of an
investor's relationship to the issuer may represent the offer or
sale of a new security for value.''); 2021 Proposing Release, 87 FR
at 6661. Similarly, courts have found that if an amendment or
modification to the terms of a security results in `` `a significant
change in the nature of the investment or risk' '' related to that
security, a new security results. Department of Economic Development
v. Arthur Anderson & Co. (U.S.A.), 924 F. Supp. 449, 478 (S.D.N.Y.
1996) (citation omitted). See also, e.g., Ingenito v. Bermac Corp.,
376 F. Supp. 1154, 1181 (S.D.N.Y. 1974) (considering claims of
Section 10(b) and finding that ``a purchase or a sale arises when
the nature and terms of an investor's involvement in a business
enterprise are substantially altered by the creation of new rights
or obligations''); Louis Loss, et al., Securities Regulation Sec.
3.A.2 (2023) (citing to N. Natural Gas Co., 14 SEC 506, 509 (1943)
(noting that ``for example, a change in interest or dividend rate or
a liquidation preference or underlying security, or a change in the
identity of the issuer, would seem clearly to result in a new
security'')). Changes are more likely to be considered
``significant'' if they are adverse to the security holders
affected. See, e.g., SEC v. Associated Gas & Electric Co., 99 F.2d
795, 797-98 (2nd Cir. 1938) (holding that under the Public Utility
Holding Company Act of 1935, the extension of the maturity date of a
debt security increased the risk to the holder and therefore
constituted the sale of a new security). See also Rathborne v.
Rathborne, 683 F.2d 914, 920 (5th Cir. 1982) (``In determining
whether a party to a securities transaction is a `purchaser' or
`seller,' we must ask whether the transaction has wrought a
fundamental change in the nature of the plaintiff's investment . . .
. [T]he core issue is whether the transaction has transformed the
plaintiff into the functional equivalent of a purchaser or seller--
has the plaintiff been forced to exchange his stock for shares
representing a participation in a substantially different
enterprise? We must focus upon the economic reality of the
transaction, and determine whether the transaction has `transformed'
the plaintiff's interests `in any real sense.' '' (citations
omitted)); Keys v. Wolfe, 709 F.2d 413, 417 (5th Cir. 1983) (holding
that ``the determination of whether'' there has been ``a significant
change in the nature of the investment or in the investment risks .
. . hinges on the economic reality of the transaction rather than on
formal changes in the rights and obligations of the parties'').
\101\ MFA Letter at 6.
\102\ See Loss, supra note 100 (noting that ``a change in
interest or dividend rate''--which is an ongoing right or
obligation--``would seem clearly to result in a new security'').
---------------------------------------------------------------------------

Two commenters agreed that ``Rule 9j-1 should be applicable . . .
if the parties to a security-based swap transaction make changes to
material terms that result in the creation of a new transaction.''
\103\ But these commenters disagreed with the Commission's assertion in
the 2021 Proposing Release that such a modification or amendment--and
thus a purchase or sale--occurs when a party engages in conduct that
``has a material impact on any payment or delivery under the security-
based swap, such that it would not be consistent with what a reasonable
person would have expected to pay, deliver, or receive absent such
conduct.'' \104\ Under final Rule 9j-1(a), whether a purchase or sale
of a security-based swap has occurred will depend on the facts and
circumstances and therefore the operation of the rule, as revised, is
not dependent on the language in the 2021 Proposing Release

[[Page 42555]]

quoted by the commenters.\105\ Applying a facts and circumstances
analysis, if conduct that affects ongoing payments or deliveries
results in the extinguishment of a right or obligation under a
security-based swap, such as the right to such a payment or delivery,
or otherwise results in a new transaction, then a purchase or sale will
have occurred, and any related fraudulent, deceptive, or manipulative
misconduct will fall within Rule 9j-1's prohibitions.
---------------------------------------------------------------------------

\103\ MFA Letter at 4. See IIB-ISDA-SIFMA Letter at 7
(``[M]arket participants have arranged their affairs to treat such
an exercise of discretion to amend a material term of [a security-
based swap] as tantamount to the `purchase' or `sale' of [a
security-based swap], including for anti-fraud purposes.'').
\104\ 2021 Proposing Release, 87 FR at 6661. See IIB-ISDA-SIFMA
Letter at 7-8; MFA Letter at 4.
\105\ See supra note 96. The language ``as the context may
require,'' which is included in Rule 9j-1, comes from the
definitions of purchase and sale in Exchange Act sections 3(a)(13)
and 3(a)(14), and recognizes the need to consider the facts of a
particular situation to determine whether a purchase or sale has
occurred.
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c. Effecting Transactions
Exchange Act section 9(j), and accordingly final Rule 9j-1(a), also
is not limited to prohibitions on fraud, manipulation, or deception in
connection with the purchase or sale of a security-based swap, but also
encompasses misconduct in connection with effecting a transaction in
any security-based swap. While the term ``transaction'' ``is not
defined in the Act, its broad meaning in everyday usage'' and ``the
context in which it is used in the various sections of the Act''
demonstrate that ``it has a broader meaning than purchases or sales.''
\106\ The Commission accordingly has construed the term ``to effect any
transaction in'' a security, variations of which appear in numerous
provisions of the securities laws, to include activity such as placing
bids or orders, and clearance and settlement of a securities
transaction.\107\ The Commission also has stated that ``key aspects of
the overall process of effecting security-based swap transactions''
include ``sales, booking and cash and collateral management
activities.'' \108\
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\106\ In re Kidder Peabody & Co., 18 S.E.C. 559, 1945 WL 332559,
at *8 (Apr. 2, 1945) (interpreting Exchange Act section 9(a)(2) and
finding that Congress intended to extend its ``prohibition against
manipulation . . . beyond the actual consummation of purchases or
sales,'' to include ``affecting the market artificially by raising
or depressing security prices, or creating actual or apparent
activity, whether or not accomplished by actual purchases or
sales''). See SEC v. Lek Sec. Corp., 276 F. Supp. 3d 49, 62
(S.D.N.Y. 2017) (``Courts have held that a `series of transactions'
includes not only completed purchases or sales but also bids and
orders to purchase or sell securities.'').
\107\ Kidder Peabody, 1945 WL 332559, at *8. See 15 U.S.C. 78bb
(identifying ``clearance, settlement, and custody'' as ``functions
incidental'' to ``effect[ing] securities transactions''). Settlement
of security-based swaps occurs over time in accordance with
contractually agreed upon terms (in contrast to other securities
such as debt or equity, where settlement occurs when the parties
exchange securities for cash equal to the full value of the
securities sold). See T+1 Adopting Release, 88 FR at 13878, 13883
(quoting SIFMA who noted that, that for security-based swaps,
settlement occurs when a ``final net payment is paid by one party to
the other at a future point in time to which the parties have
contractually agreed'' (citation omitted)). See also supra note 32.
\108\ Registration Process for Security-Based Swap Dealers and
Major Security-Based Swap Participants, Exchange Act Release No.
75611 (Aug. 5, 2015), 80 FR 48964, 48976 n.99 (Aug. 14, 2015)
(``SBSD/MSBSP Registration Process Release''). In the SBSD/MSBSP
Registration Process Release, in the context of determining who has
to register as a security-based swap dealer, the Commission
identified some activities that would fall within the definition of
``involved in effecting security-based swap transactions''--for
example, pricing security-based swap positions and managing
collateral. The identification of these activities as part of ``the
overall process of effecting'' a transaction'' also serves to
demonstrate that not all activities in that process take place prior
to the execution of the security-based swap. See MFA Letter at 7
(asserting ``[i]nterpretations of `effect[ing] a transaction,' . . .
have been limited to the process leading to the purchase or sale of
a security'' (emphasis added)). In addition, as the Commission has
previously explained in the context of broker-dealers, ``effecting''
transactions in securities has been construed broadly to encompass a
wide range of activities, including: (1) transmission of an order
for execution, order execution, clearance and settlement, and
arranging for the performance of any such function, see 17 CFR
240.11a2-2(T); 2014 Temp Rule 11a2-2(T); and (2) screening potential
transaction participants for creditworthiness, soliciting securities
transactions, routing or matching orders or facilitating the
execution of a transaction, handling customer funds and securities,
and preparing and sending transaction confirmations, Definition of
Terms in and Specific Exemptions for Banks, Savings Associations,
and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the
Securities Exchange Act of 1934, Exchange Act Release No. 44291 (May
11, 2001), 66 FR 27760, 27772-73 (May 18, 2001)). Critically,
several of these activities are not limited to pre-trade actions
(e.g., clearance, settlement, and handling counterparty funds).
---------------------------------------------------------------------------

Final Rule 9j-1(a) therefore prohibits fraudulent, manipulative, or
deceptive conduct related to the exercise of rights or performance of
obligations--including ongoing payments and deliveries--under a
security-based swap if that misconduct occurs in connection with a
broad range of activities ``beyond the actual consummation of purchases
or sales.'' \109\ For example, as discussed in section II.C below, a
manipulation of the ongoing payments and deliveries under a security-
based swap could be used to ``affect[ ] the market artificially by
raising or depressing securities prices,'' and that conduct would be
connected to effecting transactions in security-based swaps.\110\
Similarly, as one commenter noted, a ``misappropriation of customer
margin'' would be connected to effecting a security-based swap
transaction.\111\
---------------------------------------------------------------------------

\109\ Kidder Peabody, 1945 WL 332559, at *8. See 15 U.S.C. 78bb
(identifying ``clearance, settlement, and custody'' as ``functions
incidental'' to ``effect[ing] securities transactions'').
\110\ Id. For example, a platform that effects transactions in
security-based swaps, such as binary options or other event
contracts, could fraudulently extinguish a holder's right to
payment. Such conduct could also affect the market price for similar
binary options or event contracts.
\111\ IIB-ISDA-SIFMA Letter at 9.
---------------------------------------------------------------------------

In addition, the Commission is extending the application of final
Rule 9j-1(a) to fraudulent, deceptive, or manipulative misconduct that
occurs in connection with an ``attempt'' to effect a transaction in any
security-based swap. This application is consistent with section 9(j)'s
prohibition of fraud, deception, and manipulation in connection with an
``attempt to induce the purchase or sale of'' any security-based swap
and is supported by case law that recognizes that fraudulent,
deceptive, or manipulative conduct need not be successful to violate
the securities laws.\112\ It is also a ``means reasonably designed to
prevent'' misconduct that results in completed transactions, which the
statute explicitly prohibits.\113\
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\112\ See, e.g., Koch v. SEC, 793 F.3d 147, 153-54 (D.C. Cir.
2015) (``[I]ntent--not success--is all that must accompany
manipulative conduct to prove a violation of the Exchange Act and
its implementing regulations.'' (citation omitted)); Kuehnert v.
Texstar Corp., 412 F.2d 700, 704 (5th Cir. 1969) (``[W]e are not
convinced of any difference in substance between a successful fraud
and an attempt. The statutory phrase `any manipulative or deceptive
device,' 15 U.S.C. 78j(b), seems broad enough to encompass conduct
irrespective of its outcome.''); Lek, 276 F. Supp. at 60 (S.D.N.Y.
2017) (``manipulative conduct need [not] be successful in order to
violate the securities laws''); SEC v. Martino, 255 F. Supp. 2d 268,
287 (S.D.N.Y. 2003) (``an attempted manipulation is as actionable as
a successful one''). See also Lorenzo v. SEC, 139 S. Ct. 1094, 1104
(2019) (``The Commission . . . need not show reliance in its
enforcement actions.'').
\113\ 15 U.S.C. 78i(j).
---------------------------------------------------------------------------

B. Fraudulent, Manipulative, or Deceptive Conduct

1. Proposed Approach
Proposed Rules 9j-1(a)(1) through (4), describing the prohibited
fraudulent, manipulative, or deceptive conduct, was structured to
include the antifraud and anti-manipulation provisions--in section
10(b) of the Exchange Act, and Rule 10b-5 thereunder, and section 17(a)
of the Securities Act--that apply to all securities (including
security-based swaps), and the additional antifraud and anti-
manipulative authority specific to security-based swaps provided to the
Commission in section 9(j) of the Exchange Act. Specifically, the
proposed rule would have prohibited: (1) employing or attempting to
employ any device, scheme, or artifice to defraud or manipulate; (2)
making or attempting to make any untrue statement of a material fact,
or omitting to state a material fact necessary in order to make the
statements made, in the light of the circumstances under which they
were

[[Page 42556]]

made, not misleading; (3) obtaining or attempting 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; or (4) engaging or attempting to engage in any
act, practice, or course of business which operates or would operate as
a fraud or deceit upon any person.\114\
---------------------------------------------------------------------------

\114\ 2021 Proposing Release, 87 FR at 6658-60.
---------------------------------------------------------------------------

Proposed Rules 9j-1(a)(1) and (2), consistent with section 10(b) of
the Exchange Act, and Rule 10b-5 thereunder, and section 17(a)(1) of
the Securities Act, would have required scienter. In contrast, proposed
Rules 9j-1(a)(3) and (4) would not have required scienter and would
have extended to conduct that is at least negligent, consistent with
sections 17(a)(2) and (3) of the Securities Act.
2. Commission Action
After considering the comments, the Commission is revising proposed
Rule 9j-1(a) as discussed below in sections II.B.2.a and II.B.2.b.\115\
---------------------------------------------------------------------------

\115\ Final Rule 9j-1(a)(6), which is a revision of proposed
Rule 9j-1(b), is discussed in section II.C below.
---------------------------------------------------------------------------

Final Rule 9j-1(a)(1) is being adopted as proposed, and will
prohibit employing or attempting to employ any device, scheme, or
artifice to defraud or manipulate. Although most of that language is
derived from section 10(b) of the Exchange Act,\116\ Rule 10b-5
thereunder,\117\ and section 17(a)(1) of the Securities Act,\118\ the
inclusion of ``manipulate'' also comes from the text of section 9(j)).
---------------------------------------------------------------------------

\116\ Section 10(b) of the Exchange Act provides that ``[i]t
shall be unlawful for any person, directly or indirectly . . . (b)
to use or employ, in connection with the purchase or sale of any
security . . . any manipulative or deceptive device or contrivance
in contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for
the protection of investors.'' 15 U.S.C. 78j(b).
\117\ Rule 10b-5 under the Exchange Act provides that ``[i]t
shall be unlawful for any person, directly or indirectly . . . (a)
to employ any device, scheme, or artifice to defraud, (b) to make
any untrue statement of a material fact or to omit to state a
material fact necessary in order to make the statements made, in
light of the circumstances under which they are made, not
misleading, or (c) to engage in any act, practice, or course of
business which operates or would operate as a fraud or deceit upon
any person, in connection with the purchase or sale of any
security.'' 17 CFR 240.10b-5.
\118\ Section 17(a) of the Securities Act provides that ``[i]t
shall be unlawful for any person in the offer or sale of securities
. . . directly or indirectly--(1) to employ any device, scheme, or
artifice to defraud, or (2) 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 are made, not
misleading, or (3) to engage in any transaction, practice, or course
of business which operates or would operate as a fraud or deceit
upon the purchaser.'' 15 U.S.C. 77q(a).
---------------------------------------------------------------------------

Final Rule 9j-1(a)(2), which is based on section 9(j) and Rule 10b-
5, will prohibit making or attempting to make any untrue statement of a
material fact, or omitting 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 paragraphs (a)(3) and (4) are revised to separate
attempted conduct into a new paragraph (a)(5) (to which a scienter
standard is applicable, as discussed in section II.B.2.b below).
Paragraph (a)(3) will prohibit obtaining 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.
Paragraph (a)(4) will prohibit engaging in any act, practice, or course
of business which operates or would operate as a fraud or deceit upon
any person. Paragraphs (a)(3) and (4) are based on sections 17(a)(2)
and (3) of the Securities Act, as well as Exchange Act section 9(j),
which similarly prohibits ``engag[ing] in any transaction, practice, or
course of business which operates as a fraud or deceit upon any
person.'' \119\
---------------------------------------------------------------------------

\119\ See supra notes 5 and 118.
---------------------------------------------------------------------------

Paragraph (a)(5) will prohibit attempting 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 or attempts to engage in any act, practice, or
course of business which operates or would operate as a fraud or deceit
upon any person. As discussed in section II.B.2.b below, the
prohibition on attempted conduct in paragraphs (a)(1), (a)(2), and
(a)(5) is premised on the text of section 9(j), including the
Commission's prophylactic authority to ``prescribe means reasonably
designed to prevent, such transactions, acts, practices, and courses of
business as are fraudulent, deceptive, or manipulative, and such
quotations as are fictitious.''
The provisions described above generally prohibit a range of
fraudulent, manipulative, and deceptive conduct in the security-based
swap market.\120\ Case law related to section 10(b) of the Exchange
Act, Rule 10b-5 thereunder, and section 17(a) of the Securities Act
provides guidance as to what conduct violates section 9(j) of the
Exchange Act and Rule 9j-1 thereunder.
---------------------------------------------------------------------------

\120\ See 2021 Proposing Release, 87 FR at 6659.
---------------------------------------------------------------------------

a. Scienter and Negligence Standards
Findings of misconduct under final Rules 9j-1(a)(1) and (2) require
scienter while final Rules 9j-1(a)(3) and (4) do not require scienter
and extend to conduct that is at least negligent.\121\ While both Rules
9j-1(a)(2) and (3) prohibit material misstatements and omissions,\122\
they address different levels of culpability.\123\ Specifically, Rule
9j-1(a)(2) will apply when there is evidence of scienter (e.g., when a
party to a security-based swap knowingly or recklessly makes a false
statement even though the party may not receive any money or property
as a result). In contrast, Rule 9j-1(a)(3) extends to conduct that is
at least negligent (e.g., when a party to a security-based swap knows
or reasonably should know that a statement was false or misleading and
directly or indirectly obtains money or property by means of such
statement).
---------------------------------------------------------------------------

\121\ In addition, findings of misconduct under paragraphs
(a)(5) and (a)(6) will require scienter. See infra section II.B.2.b
(paragraph (a)(5)) and section II.C.2 (paragraph (a)(6)).
\122\ Consistent with section 10(b) of the Exchange Act, such
misstatements and omissions must be material to be actionable. ``The
question of materiality, it is universally agreed, is an objective
one, involving the significance of an omitted or misrepresented fact
to a reasonable investor . . . there must be a substantial
likelihood that the disclosure of the omitted fact would have been
viewed by the reasonable investor as having significantly altered
the `total mix' of information made available.'' TSC Indus., Inc. v.
Northway, Inc., 426 U.S. 438, 445, 449 (1976). See also Basic v.
Levinson, 485 U.S. 224, 233 (1988).
\123\ In addition to differences in the standard, there are
additional deviations between Rules 9j-1(a)(2) and (3),
notwithstanding the significant overlap in the rule text. For
example, while paragraph (a)(2), like Rule 10b-5(b), makes it
unlawful to make any untrue statement of a material fact, paragraph
(a)(3), like section 17(a)(2) of the Securities Act does not use the
word ``make.'' Based on that difference courts have contrasted the
application of Rule 10b-5(b) from the application of section
17(a)(2) of the Securities Act as it relates to determining who is
the maker of a material misstatement. See, e.g., SEC v. Big Apple
Consulting USA, Inc., 783 F.3d 786, 797 (11th Cir. 2015) (``[W]e . .
. agree with the Securities and Exchange Commission's recent
opinion, which held `Janus's limitation on primary liability under
Rule 10b-5(b) does not apply to claims arising under Section
17(a)(2).' ''); SEC v. Tambone, 597 F.3d 436, 444 (1st Cir. 2010)
(en banc) (contrasting the language of Rule 10b-5(b) with ``the
expansive language of section 17(a)(2),'' which covers ``the `use'
of an untrue statement of material fact (regardless of who created
or composed the statement)'').
---------------------------------------------------------------------------

Several commenters argued for a scienter standard, rather than the
proposed negligence standard, with respect to paragraphs (3) and (4) of
Rule 9j-1(a).\124\ Specifically, one commenter

[[Page 42557]]

argued that applying a negligence standard ``is inconsistent with the
concept of fraud'' and that ``mere human error--which often occurs from
the high volume of the [security-based swaps] business/frequent
settlement activities--could result in liability.'' \125\ Another
commenter stated that, at a minimum, ``any liability for interim
actions taken during the term of the security-based swap should be
subject to a scienter standard.'' \126\ In addition, other commenters
believed that a negligence based standard would be ``disruptive to'' or
``chill'' the security-based swap market \127\ and interfere with the
legitimate actions taken by lenders engaged in security-based swap
transactions.\128\
---------------------------------------------------------------------------

\124\ See IIB-ISDA-SIFMA Letter at 13 (arguing against applying
a negligence standard for attempted conduct); LSTA Letter, at 5-7;
MFA Letter at 12; Letter from John R. Williams, Milbank LLP, dated
Mar. 22, 2022 (``Milbank Letter''), at 5. The European Banking
Federation (``EBF'') supports the arguments in the IIB-ISDA-SIFMA
Letter regarding proposed Rule 9j-1. See Letter from EBF, dated Apr.
1, 2022, at 1. As proposed, paragraphs (3) and (4) of Rule 9j-1(a)
would have prohibited actions related to security-based swaps in
which a person obtains or attempts 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, or in which a person engages or attempts to engage in
any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person.
\125\ See Milbank Letter at 5.
\126\ MFA Letter at 12-13 (arguing that liability under Rule 9j-
1(a)(3) and (4) should be subject to scienter because security-based
swap transactions are between ``sophisticated counterparties dealing
directly with each other on negotiated terms'' rather than
``impersonal transactions'' where there is a stronger argument for
imposing liability under section 17(a) without scienter because it
is harder to form a specific intent absent a relationship between
the purchaser and the seller). Actions by the Commission demonstrate
that security-based swap transactions are not always between
sophisticated counterparties with ongoing relationships. See, e.g.,
In the Matter of Plutus Financial Inc. d/b/a Abra and Plutus
Technologies Philippines Corp., Exchange Act Release No. 89296 (July
13, 2020) (offering security-based swaps to retail investors via a
phone application); In the Matter of Forcerank LLC, Exchange Act
Release No. 79093 (Oct. 13, 2016) (illegally offering complex
security-based swaps to retail investors). See also SEC Binary
Options Fraud Alert, supra note 63 (alerting investors of fraudulent
binary options internet-based trading platforms).
\127\ See, e.g., MFA Letter at 12; Milbank Letter at 5. See also
ACLI Letter at 6 (arguing that ``a negligence standard . . . could
impact detrimentally other market participants that are involved in
private credit markets and originations'').
\128\ See LSTA Letter at 5-6 (supporting a scienter standard to
``address the concern that a lender could be subject to negligence
claims as a result of the often-fluid nature of security-based swap
or loan transactions that may be subject to private negotiations,
restructuring, or amendment at any given time'').
---------------------------------------------------------------------------

Although the Commission has considered the concerns raised by these
commenters, it is adopting Rules 9j-1(a)(1) through (4) using the same
standards as proposed, with the exception of the attempted misconduct
addressed in paragraph (a)(5), as discussed below. Each of these four
provisions is based on an existing statutory and regulatory provision
that is supported by a large body of case law. Final Rules 9j-1(a)(1)
and (2), consistent with section 10(b) of the Exchange Act, and Rule
10b-5 thereunder,\129\ and section 17(a)(1) of the Securities Act,\130\
require scienter. In contrast, final Rules 9j-1(a)(3) and (4) do not
require scienter and extend to conduct that is at least negligent,
consistent with sections 17(a)(2) and (3) of the Securities Act.\131\
---------------------------------------------------------------------------

\129\ To state a claim under section 10(b) of the Exchange Act,
and Rule 10b-5 thereunder, the Commission must establish that the
misstatements or omissions were made with scienter. See, e.g., Ernst
& Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). The Supreme Court
has defined scienter as ``a mental state embracing intent to
deceive, manipulate or defraud.'' Id. Recklessness will generally
satisfy the scienter requirement. See, e.g., Sunstrand Corp. v. Sun
Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). See also
Greebel v. FTP Software, Inc., 194 F.3d 185, 198 (1st Cir. 1999);
SEC v. Environmental, Inc., 155 F.3d 107, 111 (2d Cir. 1998).
\130\ Establishing violations of Securities Act section 17(a)(1)
requires a showing of scienter. See, e.g., Aaron v. SEC, 446 U.S.
680, 701-02 (1980). Scienter is the ``mental state embracing intent
to deceive, manipulate or defraud.'' Ernst & Ernst v. Hochfelder,
425 U.S. 185, 193 (1976). See also section 206(1) of the Investment
Advisers Act of 1940 (``Advisers Act''), which makes it unlawful for
an investment adviser to employ any device, scheme, or artifice to
defraud any client or prospective client. 15 U.S.C. 80b-6(1). Claims
arising under section 206(1) of the Advisers Act require scienter.
See, e.g., Robare Grp. LTD v. SEC, 922 F.3d 468, 472 (D.C. Cir.
2019); SEC v. Moran, 922 F. Supp. 867, 896 (S.D.N.Y. 1996); Carroll
v. Bear, Stearns & Co., 416 F. Supp. 998, 1001 (S.D.N.Y. 1976).
\131\ Actions pursuant to sections 17(a)(2) and 17(a)(3) of the
Securities Act do not require a showing of scienter. See, e.g.,
Aaron, 446 U.S. at 701-02. In Aaron, the Supreme Court sought to
determine whether scienter was required in a Commission injunctive
proceeding pursuant to the antifraud provisions of section 10(b) of
the Exchange Act and section 17(a) of the Securities Act. The Court
examined the language of both sections and determined that scienter
was required under section 10(b) because the words ``manipulative,''
``device,'' and ``contrivance,'' which are used in the statute,
evidenced a Congressional intent to proscribe only knowing or
intentional misconduct. Similarly, the Court concluded that
subsection (1) of section 17(a) required proof of scienter because
Congress used such words as ``device,'' ``scheme,'' and ``artifice
to defraud.'' Aaron, 446 U.S. at 696. In contrast, the Court
concluded that the absence of such words under subsections (2) and
(3) of section 17(a) demonstrated that no scienter was required.
Section 17(a)(2) prohibits any person from obtaining money or
property ``by means of any untrue statement of a material fact or
omission to state a material fact,'' which the Court found to be
``devoid of any suggestion whatsoever of a scienter requirement.''
Aaron, 446 U.S. at 696. Similarly, the Court found, in construing
section 17(a)(3), under which it is unlawful for any person ``to
engage in any transaction, practice, or course of business which
operates or would operate as a fraud or deceit,'' that scienter was
not required because it ``quite plainly focuses upon the effect of
particular conduct on members of the investing public, rather than
upon the culpability of the person responsible.'' Aaron, 446 U.S. at
697.
---------------------------------------------------------------------------

Although, as noted above, certain commenters argued that a
negligence standard would be inconsistent with a fraud rule,\132\ the
Supreme Court has determined that a negligence standard applies to the
fraud rule upon which the provisions in Rules 9j-1(a)(3) and (4) are
based--Securities Act sections 17(a)(2) and (3).\133\ In Aaron v. SEC,
the Supreme Court stated that violations of these provisions could be
satisfied by a finding of a mental state lower than scienter.\134\
Specifically, the Court determined that the ``language of [section] 17
(a)(2), which prohibits any person from obtaining money or property `by
means of any untrue statement of a material fact or any omission to
state a material fact,' is devoid of any suggestion whatsoever of a
scienter requirement'' \135\ and ``the language of [section] 17 (a)(3),
under which it is unlawful for any person `to engage in any
transaction, practice, or course of business which operates or would
operate as a fraud or deceit,' (emphasis added) quite plainly focuses
upon the effect of particular conduct on members of the investing
public, rather

[[Page 42558]]

than upon the culpability of the person responsible.'' \136\ It would
be incongruous to provide different standards in Rules 9j-1(a)(3) and
(4), which use language identical to the language in sections 17(a)(2)
and (3) of the Securities Act that was interpreted by the Supreme
Court.
---------------------------------------------------------------------------

\132\ See MFA Letter at 12 (arguing that a negligence standard
could extend liability ``to conduct that is merely negligent or
inadvertent, without requiring any intent by the party to mislead or
defraud''); Milbank Letter at 5 (arguing in addition that the
negligence standard is inconsistent with the concept of fraud which
requires intent or recklessness and that human error could result in
liability). Courts have found, for example, that the negligence
standard in 17(a) requires a defendant to act in the manner that a
reasonably prudent person in its position would have acted under the
circumstances. SEC v. Shanahan, 646 F.3d 536, 545-46 (8th Cir.
2011).
\133\ Moreover, these provisions are consistent with the
antifraud and anti-manipulation authority that the Commission had
under the Commodity Futures Modernization Act over security-based
swap agreements as then defined in section 206B of the Gramm-Leach-
Bliley Act. Commodity Futures Modernization Act of 2000, Public Law
106-554, section 1(a)(5), 114 Stat. 2763 (Dec. 21, 2000) (codified
at 15 U.S.C. 78j(b)). Prior to the passage of the Dodd-Frank Act,
section 206B of the Gramm-Leach-Bliley Act defined a ``security-
based swap agreement'' as a ``swap agreement . . . of which a
material term is based on the price, yield, value, or volatility of
any security or any group or index of securities, or any interest
therein.'' Gramm-Leach-Bliley Act, Public Law 106-102 section 206B,
113 Stat 1338 (Nov. 12, 1999) (set out as a note under 15 U.S.C.
78(c). Given that many security-based swaps would have been
security-based swap agreements before the passage of the Dodd-Frank
Act, it is contrary to the purposes of the Dodd-Frank Act to create
a scienter standard under Rule 9j-1 for actions that would have been
covered by a negligence standard under section 17(a) of the
Securities Act pre-Dodd-Frank.
\134\ See Aaron, 446 U.S. at 696-97 (discussing the standard
under sections 17(a)(2) and (3) of the Securities Act).
\135\ Id. at 696.
\136\ Id. at 696-97.
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In addition, the Commission disagrees with commenters who argued
that scienter must apply because of the ongoing and ``fluid nature'' of
security-based swap transactions.\137\ The Commission agrees, as stated
previously, that a fundamental aspect of a security-based swap is the
ongoing payments or deliveries between the parties through the life of
the security-based swap. That characteristic creates additional
opportunities for misconduct after the parties enter into the security-
based swap contract and during the term of the security-based
swap.\138\ The Commission disagrees, however, that the nature of
security-based swaps--and the additional opportunities for harm--
warrants applying a scienter standard rather than following the
precedent applicable to sections 17(a)(2) and (3) of the Securities
Act. Following the Court's ruling in Aaron v. SEC, Rules 9j-1(a)(3) and
(4) focus on the ``effect'' of the particular misconduct, and
therefore, a negligence standard is appropriate.
---------------------------------------------------------------------------

\137\ See, e.g., LSTA Letter at 6 (arguing that a scienter
standard would address concerns that a lender would be subject to
negligence claims as a result of the ``fluid nature'' of security-
based swap or loan transactions that may be subject to private
negotiations, restructuring, or amendment at any given time); MFA
Letter at 12-13 (arguing that sections 17(a)(2) and (3) of the
Securities Act apply only to purchases or sales of securities and
not to the performance of interim obligations, and also to
impersonal transactions with no relationship between parties, all of
which suit a negligence standard as compared to security-based swap
transactions). Commenters were also concerned that a negligence
standard would chill or be disruptive to the market. See MFA Letter
at 13.
\138\ See supra section I.B.
---------------------------------------------------------------------------

Similarly, the Commission does not agree with the commenters who
suggested that the sophistication of, or the extent of the relationship
between, counterparties to a security-based swap negates the need to
prohibit certain misconduct, such as the acquisition of money or
property by means of an untrue statement or acts that operate as a
fraud, absent a showing of scienter, as provided in Rules 9j-1(a)(3)
and (4).\139\ Although the courts and Commission have, for example,
recognized that certain investors, based on qualities such as wealth or
asset size,\140\ do not always need the same disclosure and similar
investor protections as retail investors because they can ``fend for
themselves,'' \141\ the Commission and courts have also stated that
sophisticated investors are entitled to protections of the general
antifraud or anti-manipulation provisions of the Federal securities
laws.\142\ Nothing in section 9(j) suggests that it should only apply
to a limited subset of market participants.
---------------------------------------------------------------------------

\139\ See, e.g., MFA Letter at 13 (arguing that the
sophistication of and personal relationships of counterparties to
security-based swap transactions supported a scienter standard).
\140\ See 17 CFR 230.500 et seq. (``Reg D'') (providing an
exemption from registration under section 5 of the Securities Act
for securities offered or sold by an issuer to accredited
investors). See also 17 CFR 230.501(a) (defining accredited
investors to include, among other things, organizations with assets
in access of $5,000,000 and natural persons with a net worth in
excess of $1,000,000).
\141\ See, e.g., SEC v. Ralston Purina Co., 346 U.S. 119 (1953)
(indicating that the application of the nonpublic offering exemption
under Securities Act section 4(a)(2) (at the time, section 4(1))
depended on whether the offerees were able to fend for themselves
and had access to the same kind of information that would be
disclosed in registration). The Court noted that such persons, by
virtue of their knowledge, would not need to rely on the protections
afforded by registration.
\142\ See Brian A. Schmidt et al., Exchange Act Release No.
45330 (Jan. 24, 2002) (citing Adena Exploration Inc. v. Sylvan, 860
F.2d 1242, 1251 (5th Cir. 1988) (citing Nor-Tex Agencies Inc. v.
Jones, 482 F.2d 1093 (5th Cir. 1973)); Stier v. Smith, 473 F.2d
1205, 1207 (5th Cir. 1973) (sophisticated investors, like all
others, are entitled to the truth); Jay Houston Meadows, 52 SEC.
778, 785 (1996), aff'd, 119 F.3d 1219 (5th Cir. 1997) (rejecting
arguments that the antifraud provisions do not apply to customers
who are experienced or sophisticated).
---------------------------------------------------------------------------

To the extent that there is overlap between Rules 9j-1(a)(3) and
(4) and sections 17(a)(2) and (3) of the Securities Act, introducing a
different standard would be counter to the position the Supreme Court
took with regard to identical language used in section 17(a) of the
Securities Act.\143\ A different standard could also potentially
undermine the effectiveness of both provisions in certain
circumstances, such as when the case law applicable to one provision
contradicts the other in a way that cannot be rationalized by the
differences in the underlying instruments.
---------------------------------------------------------------------------

\143\ The same is true with respect to Rules 9j-1(a)(1) and (2)
and section 10(b) of the Exchange Act, and Rule 10b-5 thereunder,
which the Supreme Court also addressed in Aaron.
---------------------------------------------------------------------------

Commenters also argued that the negligence standard of Rules 9j-
1(a)(3) and (4) would chill or disrupt the security-based swap market
and would capture actions, including errors, taken in connection with
normal and legitimate business activity due to the nature of security-
based swap transactions.\144\ However, as discussed, courts have
recognized that sections 17(a)(2) and (3) of the Securities Act, on
which Rules 9j-1(a)(3) and (4) are based, focus on the person's conduct
and the effect of that conduct, rather than the ``culpability of the
persons responsible.'' \145\ Like Securities Act sections 17(a)(2) and
(3), final Rules 9j-1(a)(3) and (4) will not capture normal and
legitimate business activity. Courts have found, for example, that the
negligence standard requires that to be deemed in violation of these
provisions, a defendant must act in a manner contrary to the manner in
which a reasonably prudent person in the defendant's position would
have acted under the circumstances.\146\ Accordingly, a violation of
Rules 9j-1(a)(3) and (4) would require more than a mere mistake.\147\
---------------------------------------------------------------------------

\144\ See MFA Letter at 12 (addressing the sophistication of and
personal relationships of counterparties to security-based swap
transactions as compared to the ``impersonal transactions''
underlying other types of security transactions); Milbank Letter at
5 (asserting that in light of the pace of activity involved in
security-based swap transactions ``mere human error'' could lead to
liability).
\145\ Aaron, 446 U.S. at 696-97.
\146\ SEC v. Shanahan, 646 F.3d 536, 545-46 (8th Cir. 2011).
\147\ In addition, the affirmative defenses in Rule 9j-1(e)
address some of the concerns commenters have with regard to
disruption to the security-based swap and loan markets. See infra
section II.E.
---------------------------------------------------------------------------

b. Attempted Conduct
Finally, as proposed, the Rule 9j-1(a) prohibitions would have
extended to the attempted fraudulent, manipulative or deceptive conduct
described in paragraphs (a)(1) through (4) of the rule. The Commission
largely adopts Rule 9j-1(a) as proposed as it relates to attempted
conduct, except to address the mental state applicable to attempted
conduct by placing the attempted conduct described in paragraphs (3)
and (4) of proposed Rule 9j-1 into a standalone paragraph (5) in the
final rule.\148\
---------------------------------------------------------------------------

\148\ See Rules 9j-1(a)(1) through (5). In addition, final Rule
9j-1(a) has been revised to include the prohibitions on manipulation
and attempted manipulation proposed in Rule 9j-1(b) in a new
paragraph (a)(6) with some revision. See infra section II.C. The
CFTC's antifraud and anti-manipulation rule regarding swaps
similarly prohibits attempted conduct. 17 CFR 180.1.
---------------------------------------------------------------------------

The inclusion of attempted conduct in Rules 9j-1(a)(1), (2), and
(5) is premised on the text of section 9(j). First, the statute
expressly prohibits ``engag[ing] in any fraudulent, deceptive, or
manipulative act or practice, mak[ing] any fictitious quotation, or
engag[ing] in any transaction, practice, or course of business which
operates as a fraud or deceit upon any person'' in an ``attempt to
induce the purchase or sale of, any security-based swap.'' \149\
Moreover, as

[[Page 42559]]

discussed above, courts have determined that an act, practice,
transaction, or course of business can be fraudulent, deceptive, or
manipulative, or operate as a fraud or deceit--and thus violate
antifraud provisions of the securities laws--regardless of whether it
succeeds in its aims.\150\
---------------------------------------------------------------------------

\149\ 15 U.S.C. 78i(j).
\150\ See supra note 112.
---------------------------------------------------------------------------

Second, section 9(j) authorizes the Commission to ``prescribe means
reasonably designed to prevent'' the fraudulent, deceptive, or
manipulative conduct that the statute expressly prohibits. The Supreme
Court has held that this language allows the Commission to ``prohibit
acts not themselves fraudulent . . . if the prohibition is `reasonably
designed to prevent . . . acts and practices [that] are fraudulent.' ''
\151\ The Commission is exercising that authority in Rules 9j-1(a)(1),
(2), and (5) to prohibit attempts to engage in fraudulent, deceptive,
or manipulative acts, practices, transactions, or courses of business.
The prohibition applies where a person, with scienter, takes a step in
furtherance of a fraudulent, deceptive, or manipulative act, practice,
transaction, or course of business but for some reason--including
``pure fortuity'' \152\--that act, practice, transaction, or course of
business is not completed. For example, and without limitation, the
prohibition would apply where a supervisor, with scienter, directs a
subordinate to make a fraudulent material misstatement or omission, but
the subordinate refuses to do so.
---------------------------------------------------------------------------

\151\ O'Hagan, 521 U.S. at 673 (quoting a similar provision in
Exchange Act section 14(e), 15 U.S.C. 78n(e)). See also id. at 672-
73 (``A prophylactic measure, because its mission is to prevent,
typically encompasses more than the core activity prohibited.'').
\152\ Kuehnert, 412 F.2d at 704.
---------------------------------------------------------------------------

Rule 9j-1(a)'s prohibition on such attempted misconduct recognizes
that fraud, deception, and manipulation in the security-based swaps
market can involve complex strategies implemented over multiple stages,
as discussed above in section I.B.2. The prohibition is consistent with
other provisions of the securities laws that recognize the importance
of Commission intervention before the completion of a fraudulent,
deceptive, or manipulative act, practice, transaction, or course of
business. The Commission has the authority to seek an injunction
whenever ``any person is engaged or is about to engage in acts or
practices constituting a violation of'' the Exchange Act or Securities
Act.\153\ Rule 9j-1(a)'s prohibition of attempts provides the
Commission with an additional tool to prevent such misconduct before
any harm comes to the security-based swap market or market
participants.
---------------------------------------------------------------------------

\153\ 15 U.S.C. 78u(d) (emphasis added) (Exchange Act); 15
U.S.C. 77t(b) (Securities Act). See, e.g., Kuehnert, 412 F.2d at 704
(``The Commission may act . . . to enjoin a potential fraud or
prosecute a fraud that failed, without proof of actual loss to any
victim.'').
---------------------------------------------------------------------------

One commenter argued against applying the negligence standard
applicable to the misconduct prohibited by Rules 9j-1(a)(3) and (4) to
attempts to engage in that misconduct because it ``may capture conduct
that is not itself fraudulent or manipulative'' but rather ``legitimate
business activities'' and would have a ``chilling effect on the market
for security-based swaps.'' \154\ Another commenter noted that sections
17(a)(2) and (3) of the Securities Act do not prohibit ``attempts'' and
that ``the Commission should either eliminate the reference to attempts
in Rules 9j-1(a)(3) and (4)'' or clarify the standard required for
liability for attempted conduct prohibited under those paragraphs of
Rule 9j-1.\155\ Similarly, one commenter believed that including
attempts within the scope of conduct covered by Rule 9j-1 was broader
than the scope of conduct covered by section 17(a) of the Securities
Act and warranted the application of an intent standard.\156\
---------------------------------------------------------------------------

\154\ LSTA Letter at 7.
\155\ See IIB-ISDA-SIFMA Letter at 13 (arguing that ``[p]arties
cannot be held to a standard of strict liability with regards to
fluid discussions in the course of negotiating complex
transactions--not to mention the potential for good faith mistakes
to arise in connection with ongoing payment and delivery
obligations'').
\156\ See MFA Letter at 12. See also IIB-ISDA-SIFMA Letter at 13
(arguing for a different standard for attempted conduct).
---------------------------------------------------------------------------

Although, as discussed above, the Commission disagrees with
assertions that a different standard would capture legitimate business
decisions,\157\ we nevertheless agree that scienter is the proper
standard for attempts at conduct that would violate paragraphs (a)(3)
or (a)(4) of final Rule 9j-1.\158\ Therefore, while final Rule 9j-1
retains the non-scienter-based standard for the underlying conduct
described in paragraphs (a)(3) and (4), the Commission is revising the
final rule in order to separate the attempted conduct from paragraphs
(a)(3) and (4) of proposed Rule 9j-1 into a new paragraph (a)(5).
Scienter is the standard that will apply to Rule 9j-1(a)(5).
---------------------------------------------------------------------------

\157\ See supra notes 144-147 and accompanying text.
\158\ In other contexts, courts have recognized that a scienter
standard may be appropriate for attempts even when it is not
required for the violation attempted. See, e.g., United States v.
Cote, 504 F.3d 682, 687 (7th Cir. 2007). See also United States v.
Gracidas-Ulibarry, 231 F.3d 1188, 1192 (9th Cir. 2000) (recognizing
``the doctrine that the crime of attempt requires a showing of
specific intent even if the crime attempted does not'' (internal
quotation marks omitted)).
---------------------------------------------------------------------------

B. Prohibition on Price Manipulation

1. Proposed Approach
Partly in response to manufactured credit events and other
opportunistic CDS strategies observed over the last decade,\159\
paragraph (b) of proposed Rule 9j-1 was designed to address price
manipulation and attempted price manipulation, similar to 17 CFR 180.2
(``CFTC Rule 180.2'').\160\ Paragraph (b) of proposed Rule 9j-1 would
have made it unlawful for any person to, directly or indirectly,
manipulate or attempt to manipulate the price or valuation of any
security-based swap, or any payment or delivery related thereto.
---------------------------------------------------------------------------

\159\ See supra section I.B.2. See also 2021 Proposing Release,
87 FR at 6654-55 (discussing the manufactured credit events and
other opportunistic strategies in the CDS market identified by the
Commission that ``may adversely affect the integrity, confidence,
and reputation of the credit derivatives markets) (quoting the 2019
Joint Statement). To be clear, Rule 9j-1, including Rule 9j-1(b),
applies to all security-based swaps and is not limited to CDS.
\160\ See 17 CFR 180.2.
---------------------------------------------------------------------------

Proposed Rule 9j-1(b) was designed to capture misconduct such as
situations in which a payment under the security-based swap is
intentionally or recklessly distorted for the benefit of one of the
security-based swap counterparties or situations in which a person
intentionally or recklessly causes or avoids the purchase or sale of a
security-based swap for the benefit of one counterparty. The proposed
rule was not designed to capture affirmative actions taken in the
ordinary course of a security-based swap transaction or the reference
underlying security.\161\ In this regard, the 2021 Proposing Release
stated that a determination as to whether manipulation or attempted
manipulation under Rule 9j-1(b) occurred would largely depend on the
facts and circumstances of each particular situation. However, as a
general matter the Commission would expect to use its authority to
bring an enforcement action under Rule 9j-1(b) when a party took action
for the purposes of avoiding or causing, or increasing or decreasing, a
payment under a security-based swap in a manner that would not have
occurred but for such actions, or when an action appeared to be
designed almost exclusively to harm a counterparty.\162\ The Commission
specifically stated in the 2021 Proposing Release that its intent was
not to discourage lenders and prospective lenders from discussing or

[[Page 42560]]

providing financing or other forms of relief to reference entities to
avoid defaulting on their debt.
---------------------------------------------------------------------------

\161\ See 2021 Proposing Release, 87 FR at 6663.
\162\ Id.
---------------------------------------------------------------------------

2. Commission Action
The Commission is adopting a price manipulation rule as proposed in
Rule 9j-1(b), but as a new paragraph (6) to Rule 9j-1(a). Consistent
with the revisions to Rule 9j-1(a) discussed above in section II.A, the
placement of the price manipulation rule in a new paragraph to Rule 9j-
1(a), rather than in standalone paragraph 9j-1(b) as proposed,
clarifies that the prohibited manipulative conduct must occur in
connection with effecting, or attempting to effect a transaction in any
security-based swap or in connection with purchasing or selling, or
inducing or attempting to induce the purchase or sale, of any security-
based swap.\163\ We discuss this change in more detail below.
---------------------------------------------------------------------------

\163\ See Rule 9j-1(a)(6).
---------------------------------------------------------------------------

The Commission received multiple comment letters specifically
addressing paragraph (b) of proposed Rule 9j-1. One commenter was
supportive of proposed Rule 9j-1(b) and the application of a ``facts
and circumstances'' analysis to determine whether conduct in connection
with a security-based swap is manipulative.\164\ Another commenter
supported the Commission's addition of paragraph (b) to ``better
protect the fairness of markets, and better enable appropriate
enforcement to police abuses in the swaps markets.'' \165\
---------------------------------------------------------------------------

\164\ See Fletcher Letter at 2 (stating that a facts and
circumstances ``approach avoids bright-line rules that potentially
create opportunities to engage in manipulative behavior within the
letter but not the spirit of the law, and provides the staff of the
Commission with the flexibility it needs to evaluate transactions in
an ever-evolving marketplace'').
\165\ AFRED Letter at 4-5 (stating specifically that Rule 9j-1
would enable the Commission ``to crack down on fraudulent conduct in
the [CDS] market that unnecessarily triggers a counterparty to post
collateral related to a default for the CDS buyers' benefit'').
---------------------------------------------------------------------------

However, most of the comments addressing paragraph (b) of proposed
Rule 9j-1 argued against the new provision or asked for added
clarity.\166\ One commenter argued that the Commission's guidance with
regard to the standard to be applied to determine liability under the
proposed rule was insufficient and that it was unclear how courts would
apply the standard absent a ``deceptive intent'' requirement.\167\
---------------------------------------------------------------------------

\166\ See Milbank Letter at 2-5; MFA Letter at 17-18; LSTA
Letter at 6; IIB-ISDA-SIFMA Letter at 13-15.
\167\ Milbank Letter at 3 (citing case law in which ``anti-
manipulation provisions of existing securities laws are generally
interpreted . . . to prohibit conduct that is intended to deceive
investors by artificially affecting market activity or prices, with
deceptive intent being an essential element for conduct to be
considered `manipulative''').
---------------------------------------------------------------------------

The Commission has carefully considered the comments. The
Commission is adopting final Rule 9j-1(a)(6) to prohibit manipulation
and attempted manipulation of the price or valuation of any security-
based swap, including any payment or delivery related thereto, in
connection with effecting or attempting to effect a transaction in, or
purchasing or selling, or inducing or attempting to induce the purchase
or sale of, any security-based swap. The Commission will apply a
scienter standard--which includes intentional or reckless misconduct--
to determine whether conduct is in violation of final Rule 9j-
1(a)(6).\168\
---------------------------------------------------------------------------

\168\ Courts have found that use of the term ``manipulative'' in
the statute would evidence a Congressional intent to proscribe only
knowing or intentional misconduct and that, accordingly, the
Commission must establish that the misconduct was made with
scienter. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193
(1976). The Supreme Court has defined scienter as ``a mental state
embracing intent to deceive, manipulate or defraud.'' Id. In
addition, scienter may also be established by a finding of
recklessness. See, e.g., Sunstrand Corp. v. Sun Chemical Corp., 553
F.2d 1033, 1045 (7th Cir. 1977).
---------------------------------------------------------------------------

Many of the commenters critical of proposed Rule 9j-1(b) believed
that it was too broad and would lack clarity in application, thereby
leading to a chilling effect on the security-based swap market and the
credit market.\169\ Several commenters focused on the ``facts and
circumstances analysis'' described by the Commission in proposing Rule
9j-1(b) for determining whether a violation of the rule has occurred.
In general, these commenters believed that the facts and circumstances
test was not an adequate standard to determine when manipulation or
attempted manipulation prohibited by proposed Rule 9j-1(b) occurred.
One commenter pointed to the standard articulated by the CFTC in the
enforcement of CFTC Rule 180.2 to argue for a clearer standard
regarding manipulative conduct.\170\ When adopting CFTC Rule 180.2, the
CFTC reiterated that it would be guided by a four-part test for
manipulation that it had developed in case law under sections 6(c)
\171\ and 9(a)(2) \172\ of the Commodity Exchange Act to determine
whether to apply CFTC Rule 180.2. Under this four-part test, to bring
action, the CFTC would consider ``(1) [t]hat the accused had the
ability to influence market prices; (2) that the accused specifically
intended to create or effect a price or price trend that does not
reflect legitimate forces of supply and demand; (3) that artificial
prices existed; and (4) that the accused caused the artificial
prices.'' \173\ Another commenter pointed to the amended definition of
``Failure to Pay'' in the ISDA Credit Derivatives Definition as an
example of the type of guidance the commenter believed would be helpful
to market participants in determining what actions may be construed as
misconduct or manipulation.\174\
---------------------------------------------------------------------------

\169\ See, e.g., Milbank Letter at 2 (arguing that the provision
is overbroad and ambiguous and that the Commission should provide
``additional clarity as to the standard that would apply to claims
brought under proposed Rule 9j-1(b)''); MFA Letter at 17-18
(positing that the scope of the provision is overly broad and that
``market participants will reduce their lending activity as well as
their security-based swap and securities market activity, or avoid
certain markets altogether''); LSTA Letter at 6 (finding that the
provision introduces additional uncertainty for lenders).
\170\ See MFA Letter at 18 (``The CFTC's anti-manipulation rules
applicable to swap transactions, which are similar and analogous to
security-based swaps in many respects, set out a much clearer
standard regarding manipulative conduct.''). CFTC Rule 180.2
addresses price manipulation and provides that ``[i]t shall be
unlawful for any person, directly or indirectly, to manipulate or
attempt to manipulate the price of any swap, or of any commodity in
interstate commerce, or for future delivery on or subject to the
rules of any registered entity.'' Prohibition on the Employment, or
Attempted Employment, of Manipulative and Deceptive Devices and
Prohibition on Price Manipulation, 76 FR 41398, 41707 (July 14,
2011) (``CFTC Rule 180.2 Adopting Release'').
\171\ 7 U.S.C. 6c.
\172\ 7 U.S.C. 13(a)(2).
\173\ See CFTC Rule 180.2 Adopting Release, 76 FR at 41407. In
addition, a violation of CFTC Rule 180.2 requires a showing of
``specific intent.'' Id. (``[The CFTC] reaffirms the requirement
under final Rule 180.2 that a person must act with the requisite
specific intent. In other words, recklessness will not suffice under
final Rule 180.2 as it will under final Rule 180.1.''). In contrast,
for purposes of liability under Rule 9j-1, scienter includes
recklessness as established by a long line of case law. See supra
note 129.
\174\ Letter from Jennifer Han, Managed Funds Association, dated
July 8, 2022 (``July 2022 MFA Letter''), at 5-7. In 2019, ISDA
introduced amendments to its Credit Derivatives Definitions designed
to address certain issues related to manufactured credit events,
which ISDA termed ``narrowly tailored credit events'' (``ISDA
Amendments''). See 2019 Narrowly Tailored Credit Event Supplement to
the 2014 ISDA Credit Derivatives Definition (July 15, 2019),
available at https://www.isda.org/a/KDqME/Final-NTCE-Supplement.pdf.
---------------------------------------------------------------------------

Similarly, one commenter believed that proposed Rule 9j-1(b)
included a ``manipulation standard that is new to securities markets''
and requested further guidance or definition to avoid ``the chilling
effect that a poorly-understood standard could have on legitimate
conduct.'' \175\ In the commenter's view, ``the Commission should
articulate as precisely as possible (a) what potential conduct or
activity is targeted, (b) which market participants would be harmed by
it, and (c) why it is that the existing market infrastructure (whether
the existing anti-

[[Page 42561]]

fraud rules or the provisions of the relevant contracts) does not
already provide sufficient protection.'' \176\ A significant concern
for the commenter was whether market participants would be able to
determine that their actions were manipulative and in violation of
proposed Rule 9j-1(b). Absent a clear standard, they argued that market
participants may determine to reduce their activity, which would have
broad negative impacts on liquidity in the security-based swap market
and broader economy.\177\ Finally, the commenter requested that the
Commission provide guidance with regard to the types of conduct or
activities that would violate proposed Rule 9j-1(b) and those that
would not violate proposed Rule 9j-1(b) under any implemented ``facts
and circumstances'' test.\178\ A separate commenter requested that the
Commission ``tailor'' proposed Rule 9j-1(b) so that it includes a
specific description of what constitutes manipulative conduct.\179\
---------------------------------------------------------------------------

\175\ IIB-ISDA-SIFMA Letter at 13.
\176\ Id. at 14 (stating that care should be taken to correctly
analyze the potential impact of new manipulation standards such as
that in Rule 9j-1(b)).
\177\ Id. at 13-14.
\178\ Id. at 16.
\179\ See MFA July 2022 Letter at 10. The commenter also
believed that the Commission should re-propose Rule 9j-1(b) for
public comment to allow market participants ``to adequately assess
the potential impact of [proposed Rule 9j-1(b)] on the security-
based swap markets and . . . on the broader market for corporate
debt.'' Id.
---------------------------------------------------------------------------

The Commission is revising the price manipulation provision,
originally proposed as Rule 9j-1(b) and adopted as final Rule 9j-
1(a)(6), in response to the comments above. Consistent with the
revisions to final Rule 9j-1(a) discussed above in section II.A, Rule
9j-1(a)(6) will apply to conduct undertaken in connection with
effecting or attempting to effect a transaction in any security-based
swap, and to purchasing or selling, or inducing or attempting to induce
the purchase or sale of, any security-based swap (including but not
limited to, in whole or in part, the execution, termination (prior to
its scheduled maturity date), assignment, exchange, or similar transfer
or conveyance of, or extinguishing of any rights or obligations under,
a security based-swap).\180\ As the Supreme Court has stated,
``fraudulent manipulation of [securities] prices . . . unquestionably
qualifies as a fraud `in connection with the purchase or sale' of
securities.'' \181\ Rule 9j-1(a)(6) also prohibits the manipulation (or
attempted manipulation) of the valuation of any security-based swap, or
any payment or delivery related thereto, to the extent such misconduct
is in connection with effecting or attempting to effect a transaction
in, or purchasing or selling, or inducing or attempting to induce the
purchase or sale of, any security-based swap.\182\
---------------------------------------------------------------------------

\180\ See supra section II.A.
\181\ Dabit, 547 U.S. at 89.
\182\ The Commission has the authority to prohibit attempted
manipulation based on section 9(j)'s application to ``attempt[s] to
induce the purchase or sale of'' any security-based swap, as well as
case law establishing that manipulative conduct need not be
successful to violate the securities laws. See supra note 112.
---------------------------------------------------------------------------

A determination as to whether a person has violated final Rule 9j-
1(a)(6) will depend on the facts and circumstances of each particular
situation. The assessment of facts and circumstances is an objective
evaluation that considers all relevant information surrounding the
alleged misconduct, including both quantitative and qualitative
factors, to determine whether prohibited manipulation is present. A
``facts and circumstances'' analysis will provide the Commission with
the flexibility it needs to address an evolving security-based swap
market, including the ever-changing CDS market, and potential
misconduct in those markets. Bright line rules or tests, on the other
hand, may artificially exclude manipulative and attempted manipulative
conduct and could create a roadmap for market participants to avoid
liability for manipulative actions. A substantial body of case law
regarding manipulative behavior exists with regard to other antifraud
and anti-manipulation provisions in the Securities Act and Exchange Act
to which the Commission will look to assess whether a violation of Rule
9j-1(a)(6) has occurred.\183\ In addition, the Commission reiterates
that case law requires a showing of scienter to bring an action for
manipulation or attempted manipulation and that it will apply a
scienter standard to determine whether conduct is in violation of Rule
9j-1(a)(6).
---------------------------------------------------------------------------

\183\ See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185
(1976); Markowski v. SEC, 274 F.3d 525 (D.C. Cir. 2001); United
States v. Mulheren, 938 F.2d 364 (2d Cir. 1991); SEC v. Malenfant,
784 F. Supp. 141, 144 (S.D.N.Y. 1992); SEC v. Markusen, 2016 U.S.
Dist. LEXIS 55419 (D. Minn. Apr. 25, 2016); Sharette v. Credit
Suisse Intern, 127 F. Supp. 3d 60 (S.D.N.Y. 2015); ATSI
Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2d Cir.
2007); Wilson v. Merrill Lynch & Co., 671 F.3d 120 (2d Cir. 2011);
SEC v. Schiffer, 1998 U.S. Dist. LEXIS 8579 (S.D.N.Y. June 10,
1998).
---------------------------------------------------------------------------

Also, as noted, commenters encouraged the Commission to explicitly
recognize certain market activities as legitimate.\184\ The Commission
declines to carve out from the application of Rule 9j-1(a)(6)
categories of market activities based on hypothetical fact patterns as
requested by commenters. Liability under Rule 9j-1(a)(6) will depend
upon an analysis of all relevant information. A different approach
could artificially exclude manipulative conduct, particularly given the
complex fact patterns generally at issue in many security-based swap
transactions. As discussed in the 2021 Proposing Release, Rule 9j-
1(a)(6) applies to actions taken outside the ordinary course of a
typical lender-borrower relationship, such as an action taken for the
purposes of avoiding or causing, or increasing or decreasing, a payment
under a security-based swap in a manner that would not have occurred
but for such actions, or when an action appears to be designed almost
exclusively to harm counterparties, and is not intended to discourage
lenders from discussing or providing financing or relief to avoid
default.\185\ Moreover, the fact that the Commission will apply a
scienter standard for liability under Rule 9j-1(a)(6) should lessen
concerns regarding any ``chilling effects'' of the new rule.\186\
Further, as discussed in section II.E.2, the affirmative defenses of
final Rule 9j-1(e) do not apply to the anti-manipulation provision in
Rule 9j-1(a)(6) because paragraph (a)(6) does not apply to affirmative
actions taken in the ordinary course of a security-based swap
transaction or the reference underlying security while aware of
material nonpublic information. To be clear, Rule 9j-1(a)(6) will
require that security-based swap market participants take care that
their legitimate market activities remain within the scope of the
typical lender-borrower relationship and do not cross the line into
prohibited manipulation. However, the use of a facts and circumstances
analysis, along with the use of a scienter standard, to identify
manipulative conduct addresses commenters concerns that legitimate
market activities would be captured by the prohibitions of Rule 9j-
1(a)(6) or otherwise chilled.
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\184\ See IIB-ISDA-SIFMA Letter at 15-23.
\185\ See 2021 Proposing Release, 87 FR at 6663. As discussed
above, the text of revised Rule 9j-1(a) also specifies that such
actions must occur in connection with effecting or attempting to
effect a transaction in, or purchasing or selling, or inducing or
attempting to induce the purchase or sale of, any security-based
swap.
\186\ See Letter from Som-lok Leung, International Association
of Credit Portfolio Managers (``IACPM''), dated Mar. 21, 2022
(``IACPM Letter''), at 4; MFA Letter at 8-10; LSTA Letter at 5, 7-
10; IIB-ISDA-SIFMA Letter at 13-22.
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However, to further address commenter concerns, the Commission
reiterates that Rule 9j-1(a)(6) prohibits, among other things, a
situation where a person (or group of persons) intentionally or
recklessly causes or

[[Page 42562]]

avoids the purchase or sale of a security-based swap for the benefit of
a counterparty, or to harm a counterparty, to a security-based swap.
This may include, for example, orphaning a CDS,\187\ avoiding
termination of a CDS for a period of time, or causing the termination
of a CDS. But a person simply profiting from a CDS position after a
company's bankruptcy, which such person could have prevented by
participating in a financing to the company, without more, is not in
and of itself improper conduct for purposes of Rule 9j-1(a)(6).
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\187\ ``Orphaning'' a CDS refers to a situation where the debt
of a reference entity is eliminated or reduced for the purposes of
moving the price of CDS. The end result of such activity is that CDS
buyers continue to pay (and CDS sellers continue to receive)
premiums on CDS that will never default. Similarly, a CDS protection
seller could offer financing to the company to avoid a credit event
and subsequent CDS payout, with the financing timed so that the
company's bankruptcy is merely delayed until after the CDS expires.
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The Commission also recognizes that reference entities often rely
on financing and other forms of relief to avoid defaulting on their
debt. We understand that CDS transactions are an important means by
which debt holders hedge their underlying debt instruments, and that
the absence of such hedging opportunities could impact prospective
investors' willingness and ability to invest in that underlying market.
The final rule is not intended to discourage lenders and prospective
lenders from discussing or providing such financing or relief, even
when those persons also hold CDS positions. Rather, the Commission is
adopting Rule 9j-1(a)(6) to account for actions taken outside the
ordinary course of a typical lender-borrower relationship (or a
prospective lender-borrower relationship). Although, as discussed, any
such determination would need to be based on the facts and
circumstances of a particular situation, as a general matter an action
that appears to be designed almost exclusively to harm one or more CDS
counterparties would likely fall within the prohibition in Rule 9j-
1(a)(6). Security-based swap market participants should and can take
care that their legitimate market activities remain within the scope of
the typical lender-borrower relationship and do not cross the line into
prohibited manipulation. Using a ``facts and circumstances'' analysis
to identify conduct that is prohibited by Rule 9j-1(a)(6), the
Commission will consider all relevant facts in any attempt to determine
whether prohibited manipulation or attempted manipulation has occurred.
Further, the Commission will apply a scienter standard, which will work
to eliminate legitimate conduct from the scope of Rule 9j-1(a)(6). As
discussed above, the adoption of a ``facts and circumstances'' analysis
is appropriate given the complex fact patterns in many security-based
swap transactions.
Proposed Rule 9j-1(b) was intended to address, among other things,
a number of the manufactured credit events or other opportunistic
strategies in the CDS market observed over the last decade.\188\ In re-
proposing Rule 9j-1, the Commission provided specific examples of
manufactured or other opportunistic CDS strategies that had been
reported by academics and the press.\189\ Commenters raised concerns
both that industry efforts, such as the ISDA Amendments and anti-net
short provisions, have successfully addressed opportunistic strategies
such as those described in the 2021 Proposing Release,\190\ and that
the description of the manufactured credit events or opportunistic
strategies identified by the Commission were ``overly-broad and capture
legitimate market activities.'' \191\ One commenter asked the
Commission to ``refine the descriptions of'' manufactured credit events
or opportunistic strategies that they believe are too broad and have
been addressed by industry efforts.\192\ With regard to industry
efforts, the anti-net short provisions and ISDA Amendments are narrowly
focused and have limited ability to reduce fraudulent and manipulative
activity in the security-based swap market. The ISDA Amendments do not
address all of the concerns identified in the 2019 Joint Statement,
including, but not limited to, addressing opportunistic strategies that
do not involve narrowly tailored credit events.\193\ Anti-net short
provisions are limited to syndicated bank loans and would not apply to
fraudulent activity in the security-based swap market that does not
involve such loans. Thus, even if these industry efforts were
successful in reducing fraudulent activity, their impact likely would
be limited by their narrow scope. In response to requests to refine the
descriptions of manufactured credit events in the 2021 Proposing
Release, the Commission agrees that there may be circumstances in which
the types of conduct described may not be the result of manipulation or
attempted manipulation; however, the facts and circumstances analysis
and scienter standard sufficiently tailor final Rule 9j-1(a)(6) to
properly capture manipulative conduct. Therefore, the Commission
declines to revise the descriptions.
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\188\ See 2021 Proposing Release, 87 FR at 6663.
\189\ See supra section I.B.2. See also 2021 Proposing Release,
87 FR at 6654-55 (describing in more detail examples of manufactured
credit events and other opportunistic strategies in the CDS market
reported by academics and the press).
\190\ See IIB-ISDA-SIFMA Letter at 19-20; LSTA Letter at 4; MFA
July 2022 Letter at 4-10; Milbank Letter at 6.
\191\ IIB-ISDA-SIFMA Letter at 20-23.
\192\ See IIB-ISDA-SIFMA Letter at 19.
\193\ See 2021 Proposing Release, 87 FR at 6655 n.31.
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One commenter requested that the ``valuation'' prong of proposed
Rule 9j-1(b) be removed because ``a prohibition on manipulation of the
`valuation' of an asset does not exist in any U.S. regulatory context
and would require a new body of case law to be formed to determine how
any such new prohibition should be interpreted.'' \194\ The commenter
argued that case law focuses on divergences between price and value and
that ``no analogy can be drawn in cases where it is the change in value
that is prohibited.'' \195\ The Commission declines to remove the
manipulation of a security-based swap's valuation from the scope of
Rule 9j-1(a)(6) because the pricing and valuation of security-based
swaps are intrinsically connected. For example, although CDS pricing
can be complex, ``[t]he basic idea of CDS pricing is that the present
value of all the CDS premium payments should equal to the present value
of the expected payoff from the CDS for the [net present value] to be 0
for both parties of the contract (resulting in each party being equally
well off).'' \196\ In other words, a CDS typically is priced to allow
the protection seller to recover its potential cash outflows upon a
credit event and termination of the CDS, or its ``expected loss.'' The
protection seller will determine the value of the expected loss based
on several factors, including the likelihood of default and cost of
capital. The value of the expected loss drives the price of the CDS and
the payout upon termination of the CDS. Similarly, the price of a TRS
typically is the difference between the present value of both ``legs''
of the transaction's cash flows. Therefore, actions to manipulate price
will affect valuation and vice versa. Additionally, market participants

[[Page 42563]]

may rely on models to price or value the swap.\197\ This suggests that
``valuation'' of a security-based swap has a role in the market and
should be included in the anti-manipulation provisions of Rule 9j-
1(a)(6). Further, by prohibiting the manipulation of a security-based
swap's valuation, Rule 9j-1(a)(6) will help to prevent manipulation of
payments and deliveries under a security-based swap ``from distorting
the price and market for such security-based swaps, as well as for the
reference underlying, and improperly interfering with the independent
and proper functioning of the markets.'' \198\
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\194\ Milbank Letter at 3 (citing to Santa Fe Industries, Inc.
v. Green, 430 U.S. 462, 476 (1977), to argue that ``
`[m]anipulation' is `virtually a term of art when used in connection
with securities markets' . . . The term refers generally to
practices, such as wash sales, matched orders, or rigged prices,
that are intended to mislead investors by artificially affecting
market activity'').
\195\ Milbank Letter at 3.
\196\ Yuan Wen and Jacob Kinsella, Credit Default Swap--Pricing
Theory, Real Data Analysis and Classroom Applications Using
Bloomberg Terminal, available at https://data.bloomberglp.com/bat/sites/3/2016/10/WhitePaper_Wen.pdf.
\197\ The Commission has previously recognized that market
participants may rely on models for pricing and valuation of
security-based swaps. See, e.g., Business Conduct Standards Adopting
Release, 81 FR at 29988 (in the context of daily marks, stating that
``even if the mark is calculated based on internal models or such
indices, its provision by the SBS Entity will further the goal of
providing helpful transparency into the SBS Entity's pricing and
valuation of the security-based swap by providing a helpful
reference point that the SBS Entity's counterparty can take into
account when evaluating the pricing and valuation of the SBS.'').
\198\ 2010 Rule 9j-1 Proposing Release, 75 FR at 68565-66.
---------------------------------------------------------------------------

Rule 9j-1(a)(6) prohibits manipulation in connection with effecting
or attempting to effect a transaction in, any security-based swap, or
purchasing or selling, or inducing or attempting to induce the purchase
or sale of, any security-based swap, which may include intentionally or
recklessly distorting payments related to a security-based swap to
benefit, or harm, one of the security-based swap counterparties, or
actions that serve little to no economic purpose other than to
artificially influence the composition of the deliverable obligations
in a CDS auction and affect the security-based swap's valuation and
price. To remove the valuation prong from final Rule 9j-1(a)(6) would
create a gap in the prohibition against the manipulation or attempted
manipulation of prices in the security-based swap market.

D. Liability Under Rules 9j-1(b) and (c)

1. Proposed Approach
The Commission included paragraphs (c) and (d) of re-proposed Rule
9j-1 to make it clear that market participants could not avoid
liability under the rule by effecting a fraudulent scheme through the
purchase or sale of an underlying security, rather than the purchase or
sale of the security-based swap on which it is based, and vice versa.
The first of those two provisions would have provided that a person
could not escape liability for trading based on possession of material
nonpublic information about a security by purchasing or selling a
security-based swap based on that security (as opposed to trading in
the security itself). The second provision would have provided that a
person could not escape liability under section 9(j) or Rule 9j-1 by
purchasing or selling the underlying security (as opposed to purchasing
or selling a security-based swap that is based on that security).
2. Commission Action
One commenter specifically addressed these provisions and was
supportive, noting that the antifraud and anti-manipulation provisions
in proposed Rules 9j-1(a) and (b) would be enhanced by the addition of
proposed Rules 9j-1(c) and (d).\199\ In contrast, one commenter
questioned the Commission's authority to extend the prohibitions of
Rule 9j-1 to the purchase and sale of underlying securities.\200\ After
considering these comments, the Commission adopts Rules 9j-1(c) and (d)
largely as proposed but renumbered as final Rules 9j-1(b) and (c),
respectively.
---------------------------------------------------------------------------

\199\ See Better Markets Letter at 9.
\200\ See MFA Letter at 8-9.
---------------------------------------------------------------------------

a. Rule 9j-1(b)
The Commission is adopting Rule 9j-1(b), as proposed in paragraph
(c). Final Rule 9j-1(b) provides that wherever communicating, or
purchasing or selling a security (other than a security-based swap)
while in possession of, material nonpublic information would violate,
or result in liability to any purchaser or seller of the security under
either the Exchange Act or the Securities Act, or any rule or
regulation thereunder, such conduct in connection with a purchase or
sale of a security-based swap with respect to such security or with
respect to a group or index of securities including such security shall
also violate, and result in comparable liability to any purchaser or
seller of that security under such provision, rule, or regulation.\201\
---------------------------------------------------------------------------

\201\ Final Rule 9j-1(b) includes non-substantive corrections to
punctuation.
---------------------------------------------------------------------------

Although generally a situation where a person uses material
nonpublic information about a security in connection with the purchase
or sale of a security-based swap would be subject to the existing
antifraud authority under the Federal securities laws, particularly
section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, market
participants also would benefit from a clarified interpretation of that
statutory provision in this rulemaking.\202\ This is particularly true
given that the issuer of a security-based swap (i.e., each counterparty
to the transaction) is different from the issuer of the underlying
security (i.e., the reference entity). Accordingly, the Commission is
now adopting Rule 9j-1(b) to provide that a person making a purchase or
sale of a security-based swap while in possession of material nonpublic
information with respect to the security underlying such security-based
swap is subject to liability.
---------------------------------------------------------------------------

\202\ Pursuant to section 20(d) of the Exchange Act, a person
with material nonpublic information about a security cannot avoid
liability under the securities laws by making purchases or sales in
a swap on a broad-based index containing the security (e.g., the S&P
500), which would be a security-based swap agreement, whereas the
statute is silent as to the permissibility of trading on such
material nonpublic information by making purchases or sales of a
security-based swap (e.g., a swap on the security itself). The
Commission does not construe that silence as an intent to exclude
security-based swaps from the scope of section 20(d) and the
Commission has the authority under section 9(j) to prescribe means
reasonably designed to prevent fraud, manipulation, or deceit with
respect to security-based swap transactions. In addition, Section
9(j) makes it unlawful for any person to directly or indirectly take
the actions described in that section.
---------------------------------------------------------------------------

b. Rule 9j-1(c)
The Commission also is adopting Rule 9j-1(c) largely as it was
proposed as paragraph (d), with a clarifying edit as discussed
below.\203\ Final Rule 9j-1(c) will address a situation similar to the
one described above. Specifically, it provides that wherever taking any
of the actions set forth in Rule 9j-1(a) involving a security-based
swap would violate, or result in liability under section 9(j) of the
Exchange Act or Rule 9j-1(a), such conduct, when taken by a
counterparty to such security-based swap (or any affiliate of, or a
person acting in concert with, such security-based swap counterparty in
furtherance of such prohibited activity), in connection with a purchase
or sale of a security, loan, or group or index of securities on which
such security-based swap is based shall also violate, and shall be
deemed a violation of, section 9(j) or Rule 9j-1(a). The adopted rule
text is modified from the 2021 Proposing Release to now include a
reference to ``loan.'' The addition clarifies the scope of underlying
products that apply, and is consistent with the underlying products
included in the definition of ``security-based

[[Page 42564]]

swap'' in section 3(a)(68)(A) of the Exchange Act.\204\
---------------------------------------------------------------------------

\203\ In addition, final Rule 9j-1(c) includes non-substantive
corrections to punctuation and two non-substantive revisions: (1)
the word ``whenever'' at the start of the paragraph has been
replaced with the word ``wherever'' to be consistent with the
language in paragraph (b); and (2) the references to ``paragraphs
(a) or (b)'' of Rule 9j-1 have been replaced with just a reference
to ``paragraph (a)'' to reflect the placement of paragraph (b) of
proposed Rule 9j-1 into a new paragraph (a)(6) of final Rule 9j-1.
\204\ See 15 U.S.C. 78c(68)(A).
---------------------------------------------------------------------------

This provision prevents a person from escaping liability under
section 9(j) or Rule 9j-1(a) with respect to a security-based swap by
limiting all of its actions to purchases or sales of the security,
loan, or narrow-based security index underlying that security-based
swap. For example, if a person with an existing total return swap on
equity securities issued by XYZ Corporation subsequently engages in a
number of wash trades to artificially inflate the price of the equity
securities in order to benefit from the manipulated price by way of
their existing security-based swap position, such person would be
liable for violations of Exchange Act section 9(j) and Rule 9j-1
regardless of the fact the manipulation was conducted through purchases
or sales of the equity securities.
In response to the commenter who questioned the Commission's
authority to extend the prohibitions of Rule 9j-1 to the purchase or
sale of underlying securities,\205\ the Commission clarifies that final
Rule 9j-1(c) does not create a separate category of prohibited activity
absent a connection to security-based swaps. Rather, this provision is
reasonably designed to prevent fraud, manipulation, or deceit with
respect to security-based swaps where that misconduct is accomplished
through transactions in the underlying security, loan, or group or
index of securities. This provision is necessary because security-based
swaps by their nature are tied intrinsically to activity in the markets
for other securities.
---------------------------------------------------------------------------

\205\ MFA Letter at 9.
---------------------------------------------------------------------------

Moreover, this provision does not impose liability on a person for
violations of section 9(j) of the Exchange Act and Rule 9j-1 based
solely on the impact of that person's purchases or sales on the equity,
debt, or loan markets. The rule states that the person engaged in
prohibited activities in the equity, debt, or loan markets must be a
counterparty to a security-based swap that references such equity or
debt securities or loan, or be an affiliate of, or a person acting in
concert with, such security-based swap counterparty in furtherance of
such prohibited activity. Accordingly, the Commission would analyze
whether transactions in the underlying equity or debt securities or
loan have been used as the mechanism to violate section 9(j) and Rule
9j-1. The Commission would also analyze the same transactions to
determine whether they independently violate other antifraud and anti-
manipulation provisions of the securities laws--including sections 9
and 10(b) of the Exchange Act, and Rule 10b-5 thereunder, as well as
section 17(a) of the Securities Act.

E. Safe Harbors and Affirmative Defenses

1. Proposed Approach
In response to operational concerns raised by commenters with
regard to the 2010 Proposed Rule, the Commission proposed two limited
safe harbors from re-proposed Rule 9j-1(a) to address situations when a
counterparty to a security-based swap was required to take certain
actions while in possession of material nonpublic information.\206\
First, proposed Rule 9j-1(f)(1), would have allowed a person to take
action in accordance with binding contractual rights and obligations
under a security-based swap (as reflected in the written security-based
swap documentation governing such transaction or any amendment
thereto), so long as the person could demonstrate that: (1) the
security-based swap was entered into, or the amendment was made, before
the person became aware of such material nonpublic information; and (2)
the entry into, and the terms of, the security-based swap were
themselves not a violation of any provision of proposed Rule 9j-
1(a).\207\
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\206\ See 2021 Proposing Release, 87 FR at 6662, 6662 n.87.
\207\ Id. at 6662.
---------------------------------------------------------------------------

Second, recognizing the important operational benefits and market
efficiencies related to security-based swap portfolio compression,
proposed Rule 9j-1(f)(2) would have provided a safe harbor for
transactions effected in connection with certain types of bilateral or
multilateral portfolio compression exercises.\208\ This proposed safe
harbor would have provided that a person would not be liable under re-
proposed Rule 9j-1(a) solely for reason of being aware of material
nonpublic information for ``security-based swap transactions effected
by a person pursuant to a bilateral portfolio compression exercise (as
defined in Sec. 240.15Fi-1(a)) or a multilateral portfolio compression
exercise (as defined in Sec. 240.15Fi-1(j)) so long as: (i) any such
transactions are consistent with all of the terms of a bilateral
portfolio compression exercise or multilateral portfolio compression
exercise, including as it relates to, without limitation, the
transactions to be included in the exercise, the risk tolerances of the
persons participating in the exercise, and the methodology used in the
exercise; and (ii) all such terms were agreed to by all participants of
the bilateral portfolio compression exercise or multilateral portfolio
compression exercise prior to the commencement of the applicable
exercise.'' \209\
---------------------------------------------------------------------------

\208\ See id. at 6662-63.
\209\ Re-proposed Rule 9j-1(f)(2); 2021 Proposing Release, 87 FR
at 6662.
---------------------------------------------------------------------------

2. Commission Action
As discussed above, in response to operational concerns raised in
response to the 2010 Proposed Rule, the Commission included two limited
safe harbors from re-proposed Rule 9j-1(a).\210\ After further
consideration and as described in more detail below, the Commission is
not adopting either proposed safe harbor. Instead, the Commission is
adopting two affirmative defenses from Rules 9j-1(a)(1) through (a)(5).
One affirmative defense is for actions taken in connection with the
binding contractual rights and obligations under a security-based swap
(similar to the proposed safe harbor). The other affirmative defense
takes account of reasonable policies and procedures that ensure that
individuals making investment decisions are not engaging in prohibited
conduct in final Rules 9j-1(a)(1) through (a)(5). These affirmative
defenses, while not identical to the affirmative defenses under Rule
10b5-1, are similar in that they apply to situations in which a person
can demonstrate that material nonpublic information did not factor into
their investment decision.
---------------------------------------------------------------------------

\210\ See 2021 Proposing Release, 87 FR at 6660-62.
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Consistent with the analogous provisions of Rule 10b5-1, final Rule
9j-1 does not provide for an affirmative defense for violations of the
anti-manipulation provision in Rule 9j-1(a)(6). Paragraph (a)(6) of
Rule 9j-1 does not apply to actions that the affirmative defenses
address: those taken in the ordinary course of a security-based swap
transaction (including actions related to the reference underlying
security) while aware of material nonpublic information.\211\
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\211\ Final Rule 9j-1(a)(6) is discussed in section II.C above.
---------------------------------------------------------------------------

Several commenters urged the Commission to make the affirmative
defenses under Rule 10b5-1 available under Rule 9j-1, to address
situations in which a counterparty comes into possession of material
nonpublic information during the life of a security-based swap.\212\
Rule 10b5-1 applies to

[[Page 42565]]

insider trading cases under section 10(b) of the Exchange Act, and Rule
10b-5 thereunder, and includes affirmative defenses for: (1) purchases
or sales pursuant to a binding contract, an instruction to another
person to execute the trade for the instructing person's account, or a
written trading plan under certain conditions; \213\ and (2)
transactions by an entity if the individual making the investment
decision on behalf of the entity was not aware of the material
nonpublic information and the entity had implemented reasonable
policies and procedures to ensure that the individuals making
investment decisions would not violate insider trading laws.\214\
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\212\ See ACLI Letter at 2, 5; IIB-ISDA-SIFMA Letter at 4-5, 10;
MFA Letter at 13-16; LSTA Letter at 9; Letter from Lindsey Weber
Kiljo and William C. Thum, Asset Management Group of SIFMA (``SIFMA
AMG''), dated Mar. 21, 2022 (``SIFMA AMG Letter''), at 11-12.
\213\ See 17 CFR 240.10b5-1(c)(1) (``Rule 10b5-1(c)(1)'').
\214\ See 17 CFR 240.10b5-1(c)(2) (``Rule 10b5-1(c)(2)'').
---------------------------------------------------------------------------

Several commenters noted that most security-based swap market
participants are global financial firms that have spent considerable
resources to meet the requirements of current Rule 10b5-1(c)(2), by
separating their organizations so that individuals on the public side
can engage in dealing and market-making activity, while individuals on
the private side are allowed to possess material nonpublic
information.\215\ One commenter stated that the current policies and
procedures restrict access to material nonpublic information by those
individuals who engage in security-based swap transactions for hedging
or other purposes.\216\ Since neither of the Rule 10b5-1 defenses
explicitly applied to proposed Rule 9j-1 for security-based swaps, one
commenter noted the ``confusion and regulatory uncertainty'' that would
be created with the omission of a Rule 10b5-1(c)(2)-type defense from
Rule 9j-1 (because identical conduct in the context of a security-based
swap transaction could implicate both Rule 10b-5 and Rule 9j-1, but the
affirmative defense would only be available under Rule 10b-5).\217\
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\215\ See IACPM Letter at 4; IIB-ISDA-SIFMA Letter at 5; MFA
Letter at 13-14.
\216\ See LSTA Letter at 9.
\217\ IIB-ISDA-SIFMA Letter at 5.
---------------------------------------------------------------------------

In addition, certain commenters expressed concern with the
operational impacts of Rule 9j-1(a) on the capital and loan markets.
One commenter argued that the application of proposed Rule 9j-1 to the
ongoing, ``non-volitional'' rights and obligations that occur
throughout the life of a security-based swap could ``cast uncertainty
on a wide range of bona fide conduct necessary to the operation of the
capital markets.'' \218\ The commenter urged the Commission to
``provide an affirmative defense for actions taken by a person in
accordance with binding contractual rights and obligations under [a
security-based swap] . . . or to fulfill a regulatory obligation in
connection with [a security-based swap] . . . if the person did not act
intentionally or recklessly in connection with such action and . . .
complied in good faith with written policies and procedures reasonably
designed to meet the obligation.'' \219\ The commenter was concerned
that the negligence standard applicable to re-proposed Rules 9j-1(a)(3)
and (4), in particular, could lead to potential fraud liability for
good faith, non-volitional conduct.\220\ Another commenter addressed
operational concerns related to the credit markets and argued that the
proposed rule would ``create considerable uncertainty with respect to
the legitimate business decisions of lenders and impair the [security-
based swap] market and loan market.'' \221\ The commenter explained
that if the rule were to apply to any activity that potentially affects
the stream of payments, deliveries or other ongoing obligations or
rights between parties to a security-based swap, ``each party will have
to implement controls and mechanisms to track decisions made in
connection with each payment, delivery, obligation or right as well as
to track changes in its positions in the security-based swap and
reference underlying.'' \222\
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\218\ Id. at 8-10.
\219\ Id. at 10-11, 11 n.18 (referencing a safe harbor adopted
by the CFTC in connection with non-scienter fraud and manipulative
prohibitions as part of its swap dealer business conduct standards).
\220\ Id. at 9. The commenter stated that it did not have the
same concerns about proposed Rule 9j-1(b) (now Rule 9j-1(a)(6)),
because the scienter standard applicable to that provision is
``sufficient to distinguish illegitimate conduct from merely
negligent acts that affect payment or delivery obligations.''
\221\ LSTA Letter at 3-10.
\222\ Id. The LSTA supported the principles underlying section
9(j) but did not see the need for a new rule in light of existing
antifraud rules and further believed that the existing antifraud
rules would address several of the manufactured credit events
described in the 2021 Proposing Release and that the adoption of
anti-net short provisions would address other concerns. Id. at 3-4.
The Commission believes that the affirmative defense provided by new
Rule 9j-1(e)(2) will address these concerns.
---------------------------------------------------------------------------

The Commission agrees with commenters that an affirmative defense
similar to those available under Rule 10b5-1 (when the investment
decision is not based on material nonpublic information) is important
given the similarity in the antifraud provisions. The Commission also
agrees that the affirmative defenses would address concerns regarding
market disruption. As a result, the Commission is adopting two
affirmative defenses similar in concept to the affirmative defenses in
Rule 10b5-1(c).\223\ However, the Commission is adapting the
affirmative defenses for the specific context of Rule 9j-1. In
particular, the Commission is not adopting an affirmative defense that
is as broad as the affirmative defenses in Rule 10b5-1(c)(1). Rather,
as discussed below, the Commission is limiting the relevant Rule 9j-1
affirmative defense to actions taken pursuant to binding contractual
rights under the documentation governing a security-based swap. The
Rule 10b5-1(c)(1) affirmative defenses relate to advance planning of
purchases or sales pursuant to a binding contract, an instruction to
another person to execute the trade for the instructing person's
account, or a written trading plan under certain conditions.\224\ Those
Rule 10b5-1(c)(1) affirmative defenses were created to ``provide
appropriate flexibility to those who would like to plan securities
transactions in advance, at a time when they are not aware of material
nonpublic information, and then carry out those pre-planned
transactions at a later time, even if they later become aware of
material nonpublic information.'' \225\ That flexibility is warranted
in the context of corporate insiders and others who periodically come
into possession of material nonpublic information but may want to
schedule orderly trading of securities of an issuer on a liquid public
market. It is not appropriate in the context of security-based swaps,
which are typically bespoke, created and

[[Page 42566]]

issued by the counterparties, and thinly traded.
---------------------------------------------------------------------------

\223\ Much of the development of insider trading law has
resulted from court cases. The Supreme Court has stated that
``[u]nder the `traditional' or `classical theory' of insider trading
liability, [section] 10(b) and Rule 10b-5 are violated when a
corporate insider trades in the securities of his corporation on the
basis of material, nonpublic information.'' O'Hagan, 521 U.S. at
651-52 (emphasis added). See also Selective Disclosure and Insider
Trading, Exchange Act Release No. 43154 (Aug. 15, 2000), 65 FR
51716, 51727 (Aug. 24, 2000) (discussing the awareness standard
required for insider trading liability and adopting the definition
of ``on the basis'' of material nonpublic information in Rule 10b5-
1(b)). In this regard, any of the actions set forth in Rule 9j-1(a)
with regard to a security-based swap are ``on the basis of''
material nonpublic information about that security-based swap, the
issuer of that security-based swap, or the security underlying that
security-based swap, if the person taking the action was aware of
the material nonpublic information when the person took the action.
\224\ See Rule 10b5-1(c)(1).
\225\ See Insider Trading Arrangements and Related Disclosures,
Exchange Act Release No. 96492 (Dec. 14, 2022), 87 FR 80362, 80363
(Dec. 29, 2022) (``Rule 10b5-1 Amendments'').
---------------------------------------------------------------------------

Accordingly, the Commission is adopting two affirmative defenses to
liability under paragraphs (a)(1) through (a)(5) of final Rule 9j-1.
a. Affirmative Defense: Binding Contractual Obligations
First, the Commission is adopting an affirmative defense that
maintains the substance of the safe harbor provision in re-proposed
Rule 9j-1(f)(1), which would have applied to actions taken pursuant to
binding rights and obligations in written documentation governing a
security-based swap that was entered into prior to the person coming
into possession of material nonpublic information. As adopted, the
provision in Rule 9j-1(e)(1) (renumbered from proposed paragraph (f))
is an affirmative defense, rather than a safe harbor, to be consistent
with the structure of current Rule 10b5-1(c)(1). The affirmative
defense in final Rule 9j-1(e)(1) provides that actions that would
otherwise violate the prohibitions of Rule 9j-1(a)(1) through (5) are
not a violation ``solely for reason of being aware of material
nonpublic information'' if such actions are ``taken by a person in
accordance with binding contractual rights and obligations under a
security-based swap (as reflected in the written security-based swap
documentation governing such transaction or any amendment thereto).''
\226\ Under this affirmative defense, consistent with Rule 10b5-
1(c)(1), a market participant may take action when aware of material
nonpublic information but may avoid liability: ``so long as the person
demonstrates that: (i) [t]he security-based swap was entered into, or
the amendment was made, before the person became aware of such material
nonpublic information, and (ii) [t]he security-based swap was entered
into in good faith and not as part of a plan or scheme to evade the
prohibitions of [Rule 9j-1].'' \227\
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\226\ See final Rule 9j-1(e)(1).
\227\ See final Rule 9j-1(e)(1).
---------------------------------------------------------------------------

Framing this relief as an affirmative defense rather than as a safe
harbor, and restricting its use to circumstances in which the security-
based swap was entered into in good faith and not as part of a plan or
scheme to evade the prohibitions of the rule, is consistent with Rule
10b5-1(c)(1) treatment of the defense. As discussed above, multiple
commenters requested the Commission adopt affirmative defenses based on
the Rule 10b5-1(c) defenses.\228\ Rule 10b5-1(c)(1) provides an
affirmative defense from Rule 10b-5 liability in circumstances where it
is apparent that the trading was not made on the basis of material
nonpublic information because ``the trade was made pursuant to a
binding contract, an instruction to another person to execute the trade
for the instructing person's account, or a written plan for the trading
of securities . . . adopted at a time that the person was not aware of
material nonpublic information.'' \229\ Similarly, Rule 9j-1(e)(1)
provides an affirmative defense from Rule 9j-1(a) liability when an
action is taken not on basis of material nonpublic information, but
pursuant to binding contractual rights and obligations reflected in the
written documentation governing a security-based swap.
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\228\ See supra note 212.
\229\ See Rule 10b5-1 Amendments, 87 FR 80362, 80363 (adopting
revisions to the Rule 10b5-1(c)(1) affirmative defense to apply a
cooling-off period on persons other than the issuer of securities
subject to a plan, impose a certification requirement on directors
and officers of those issuers, limit the ability of persons other
than the issuer to use multiple-overlapping Rule 10b5-1 plans, limit
the use of single-trade plans by persons other than the issuer to
one such single-trade plan in any 12-month period, and add a
condition that all persons entering into a Rule 10b5-1 plan must act
in good faith with respect to that plan).
---------------------------------------------------------------------------

If the security-based swap was entered into in good faith and not
as part of a plan or scheme to evade the prohibitions of the rule, the
new Rule 9j-1(e)(1) affirmative defense will allow counterparties to
take actions that are required by, and in accordance with, the written
agreements governing the security-based swap (i.e., actions in the
normal course of the security-based swap transaction) even when aware
of material nonpublic information. For example, the Rule 9j-1(e)(1)
affirmative defense would apply to making a standardized coupon payment
or delivering collateral to a counterparty (and would also permit the
counterparty to receive the coupon payment or collateral), while such
person is aware of material nonpublic information, so long as both
actions are required by the terms of the transaction and documented in
writing. In contrast, the affirmative defense would not apply if a
counterparty took some action to fraudulently increase (in the case of
the receiving counterparty) or decrease (in the case of the delivering
counterparty) the amount of such payment or collateral transfer. Rule
9j-1(e) provides an affirmative defense when a person's conduct would
violate Rule 9j-1(a)(1) through (5) ``solely'' because he or she is
``aware of material nonpublic information.'' But actions to
fraudulently increase or decrease payments or collateral transfer--when
taken in connection with effecting or attempting to effect a
transaction in, or purchasing or selling, or inducing or attempting to
induce the purchase or sale of, any security-based swap--would violate
Rule 9j-1(a) regardless of the possession of material nonpublic
information.
A person relying on the affirmative defense in adopted final Rule
9j-1(e)(1) must demonstrate that they entered into the security-based
swap, or amendment, before becoming ``aware of'' the material nonpublic
information rather than before they ``came into possession'' of the
information, as required in re-proposed Rule 9j-1.\230\ The change in
the rule text to an awareness standard, rather than a possession
standard, brings the Rule 9j-1(e)(1) affirmative defense in line with
the Commission's intent, as described in the 2021 Proposing Release
preamble.\231\ The change also makes Rule 9j-1(e)(1) consistent with
Rule 10b5-1(c)(1), which requires that the person entered into a
binding contract before becoming ``aware of'' the material nonpublic
information.\232\
---------------------------------------------------------------------------

\230\ See 2021 Proposing Release, 87 FR at 6703.
\231\ See 2021 Proposing Release, 87 FR at 6662.
\232\ See 17 CFR 240.10b5-1(c)(1)(i)(A).
---------------------------------------------------------------------------

b. Affirmative Defense: Policies and Procedures
Second, Rule 9j-1(e)(2) provides a defense from liability under
Rules 9j-1(a)(1) through (5) for actions taken by a person, other than
a natural person, who demonstrates that: (1) the individual making the
investment decision on behalf of the person was not aware of the
material nonpublic information; and (2) the person had implemented
reasonable policies and procedures, taking into consideration the
nature of the person's business, to ensure that individuals making
investment decisions would not be in violation of Rule 9j-1(a)(1)
through (5).\233\ These policies and procedures may include those that
restrict an individual from effecting a transaction in, or purchasing
or selling, any security, including any security-based swap, as to
which the individual possesses material nonpublic information, or those
that prevent individuals from becoming aware of such information.\234\
Rule 9j-1(e)(2) is modeled on Rule 10b5-1(c)(2) and addresses concerns
raised by commenters that the proposed rule would have a chilling
effect on the markets. Rule 9j-1(e)(2) recognizes that

[[Page 42567]]

many market participants, such as lenders and life insurance companies,
employ compliance programs which include, among other things,
information barriers that prevent access to material nonpublic
information by their employees who engage in security-based swap
transactions for hedging or other purposes.
---------------------------------------------------------------------------

\233\ Final Rule 9j-1(e)(2).
\234\ See final Rule 9j-1(e)(2)(ii).
---------------------------------------------------------------------------

c. Proposed Safe Harbor: Compression
Because the Commission is adopting final Rule 9j-1(e)(2), the
Commission is not adopting proposed Rule 9j-1(f)(2), which would have
provided a safe harbor for transactions made in connection with certain
portfolio compression exercises. The proposed safe harbor would have
conflicted with Rules 10b-5 and 10b5-1 by providing the same action
with protection from liability under Rule 9j-1, but not Rule 10b-5. In
proposing the portfolio compression safe harbor, the Commission
recognized the benefits provided by portfolio compression along with
the ``largely administrative nature of the portfolio compression
process.'' \235\ To be clear, the Commission continues to support
portfolio compression and its benefits.\236\ Providing the safe harbor
as proposed, however, would have sanctioned the use of material
nonpublic information under Rule 9j-1, even though that use would have
been prohibited by Rule 10b-5. Adopting Rule 9j-1(e)(2) instead will
avoid confusion that could have resulted by treating the same conduct
differently under Rules 10b-5 and 9j-1. In addition, the Rule 9j-
1(e)(2) will provide security-based swap market participants the
flexibility needed to engage in bilateral and multilateral portfolio
compression exercises. The affirmative defense should be consistent
with the manner in which Rules 10b-5 and 10b5-1(c)(2) currently apply
to compression exercises and eliminates concerns that compression
exercises may be more than merely administrative and could be made on
the basis of material nonpublic information.
---------------------------------------------------------------------------

\235\ 2021 Proposing Release, 87 FR at 6662-63 (describing the
operational benefits and efficiencies resulting from portfolio
compression).
\236\ As the Commission recognized when it adopted portfolio
compression requirements for SBS Entities, there are times when
entering into compression exercises would not be appropriate. See
Risk Mitigation Techniques for Uncleared Security-Based Swaps,
Exchange Act Release No. 87762 (Dec. 18, 2019), 85 FR 6359, at 6370
(Feb. 4, 2020) (``Risk Mitigation Adopting Release''). As a result,
17 CFR 240.15Fi-4 provides that the policies and procedures required
under the rule will need to provide that portfolio compression
exercises occur ``when appropriate.'' It would not be appropriate to
enter into compression exercises when doing so would be on the basis
of material nonpublic information in violation of Commission rules,
including Rule 10b-5 or final Rule 9j-1.
---------------------------------------------------------------------------

d. Other Requested Safe Harbors and Affirmative Defenses
Certain commenters were supportive of the proposed safe harbors
\237\ but also believed that the safe harbors were too narrow and urged
the adoption of additional Rule 9j-1 safe harbors for legitimate
restructuring transactions, hedging activity related to lending,
transactions with counterparty disclosure regarding status as a lender
and access to material nonpublic information from the borrower,
multilateral amendment exercises (including ISDA protocols) or
bilateral equivalents, participation in determinations committee, or
for publicly executed strategies.\238\ One commenter raised concerns
that the proposed safe harbor only addresses situations where a lender,
aware of material nonpublic information, exercises rights or takes
actions with respect to security-based swaps, but not if the lender
exercises rights or remedies under a credit, loan, or similar
agreement, while aware of material nonpublic information.\239\ The
Commission declines to adopt additional safe harbors. The affirmative
defenses the Commission is adopting provide consistency with Rule 10b5-
1. Additionally, they will address concerns expressed by market
participants advocating for additional safe harbors by permitting
persons to enter into certain types of activity, pursuant to the
requirements of the affirmative defenses, while also addressing
concerns about fraud and manipulation for the entire security-based
swap market.
---------------------------------------------------------------------------

\237\ Only one commenter specifically addressed the compression
safe harbor of re-proposed Rule 9j-1(f)(2). See IIB-ISDA-SIFMA
Letter at 11. The commenter noted that ``the important operational
benefits and efficiencies for market participants'' supporting the
safe harbor for portfolio compression exercises would also support a
safe harbor for ``other centralized market activities'' including
multilateral amendment exercises (such as an ISDA protocol) and the
use of determinations committees. Id.
\238\ See Fletcher Letter at 4; IACPM Letter at 4; MFA Letter at
10-12; LSTA Letter at 8-9; IIB-ISDA-SIFMA Letter at 11-12.
\239\ See LSTA Letter at 8-9.
---------------------------------------------------------------------------

In response to the proposed safe harbors, one commenter urged for
the elimination of all safe harbors from proposed Rule 9j-1(a)
liability because the Commission had ``not demonstrated that a safe
harbor from the prohibition on fraud and manipulation is necessary or
appropriate.'' \240\ This same commenter also argued for compliance
with Rule 9j-1(a) rather than for the adoption of safe harbors that it
believed would encourage unlawful behavior.\241\ Another commenter
argued that the proposed safe harbors were overly broad and protective
of actions that are inherently fraudulent.\242\ However, as discussed
above, the Commission agrees with commenters that an affirmative
defense similar to those available under Rule 10b5-1 (when the
investment decision is not based on material nonpublic information) is
important given the similarity in the antifraud provisions. The
Commission also agrees that the affirmative defenses would address
concerns regarding market disruption while also addressing concerns
about fraud and manipulation in the security-based swap market.
Therefore, the Commission is adopting the affirmative defenses as
discussed above.
---------------------------------------------------------------------------

\240\ Better Markets Letter at 9. This commenter stated that it
``[d]oes not appear there is any need for a safe harbor such as the
one proposed by the SEC, because it is not clear how a prohibition
on fraud and manipulation could possibly apply to the performance of
completely non-volitional, contractual requirements, of a contract
that was entered into without fraudulent, deceptive, or manipulative
intent.'' Id. at 10. See also WebForm Comments from Anonymous
Penguin, dated Oct. 7, 2022 (``Anonymous Penguin Comments''), at 1
(arguing for no affirmative defense from liability); WebForm
Comments from J.T., dated Nov. 15, 2022 (``J.T. Comments''), at 1
(arguing for no safe harbor for binding contractual rights and
obligations under a security-based swap).
\241\ Better Markets Letter at 12 (pointing to experience with
Rule 10b5-1 and citing studies and Wall Street Journal reporting).
\242\ See WebForm Comments from Michael, dated Jan. 3, 2023
(``Michael Comments''), at 1.
---------------------------------------------------------------------------

In addition to the request for the inclusion of additional safe
harbors and affirmative defenses, commenters also addressed the scope
of Rule 9j-1 as it applies to different types of security-based swap
instruments. One commenter argued for carving out sovereign debt from
the scope of Rule 9j-1 due to the unlikelihood that holders of
security-based swaps on sovereign debt would be able to manufacture
credit events or otherwise engage in opportunistic trading, especially
life insurers which are prohibited by state law from entering into
speculative or abusive trading.\243\ While security-based swaps related
to sovereign debt may present fewer opportunities for manufactured
credit events or opportunistic strategies, by regulated and non-
regulated market participants alike, such instruments are not without
risk of fraudulent and manipulative conduct and should

[[Page 42568]]

remain within the scope of Rule 9j-1.\244\ One commenter supported
adopting different rules for CDS as opposed to other security-based
swaps due to ``the structure and nature of CDS instruments,'' which the
commenter believes make CDS more susceptible to opportunistic
strategies.\245\ However, non-CDS security-based swaps are also
susceptible to fraud and manipulation and, therefore, the Commission
makes no change to the scope of Rule 9j-1 to treat CDS differently from
other security-based swaps. Additionally, Rule 9j-1 is tailored
appropriately to address fraud and manipulation for the entire
security-based swap market.
---------------------------------------------------------------------------

\243\ See ACLI at 3, 13-14 (arguing that sovereign debt should
be excluded from the scope of both final Rule 9j-1 and final Rule
10B-1).
\244\ As of Nov. 25, 2022, sovereign CDS have the second highest
gross notional amount outstanding among credit security-based swaps.
See infra section V.C.2, Table 1. The Commission further observes
that the share of CDS written on sovereign debt has risen from less
than four percent of the total notional amounts outstanding in the
global CDS market in 2007 to 14 percent at the end of 2020. For
single-name CDS during that same period, the share of the sovereign
sector grew from six percent to close to one-third. See Antulio N.
Bomfim, ``Credit Default Swaps,'' Finance and Economics Discussion
Series 2022-023 at 4, Washington: Board of Governors of the Federal
Reserve System (2022), available at https://doi.org/10.17016/FEDS.2022.023. See also Ben St. Clair, ``Pimco Loses $400m on Failed
Russia CDS Bets,'' Risk.Net (June 20, 2022) (describing the effects
on CDS of Russia's failure to pay additional interest due on its
sovereign bonds in Apr. 2022).
\245\ See Fletcher Letter at 4.
---------------------------------------------------------------------------

III. Rule 15fh-4(c): Preventing Undue Influence Over Chief Compliance
Officers; Policies and Procedures Regarding Compliance With Rule 9j-1
and Rule 15fh-4(c)

A. Proposed Approach

The Commission also proposed a rule aimed at protecting the
independence and objectivity of an SBS Entity's CCO by preventing the
personnel of an SBS Entity from taking actions to coerce, mislead, or
otherwise interfere with the CCO. Specifically, proposed Rule 15Fh-4(c)
(``proposed Rule 15Fh-4(c)'') would have made it unlawful for any
officer, director, supervised person, or employee of an SBS Entity, or
any person acting under such person's direction, to directly or
indirectly take any action to coerce, manipulate, mislead, or
fraudulently influence the SBS Entity's CCO in the performance of their
duties under the Federal securities laws or the rules and regulations
thereunder.

B. Commission Action

After review of the comments, the Commission is adopting Rule 15fh-
4(c) as proposed. The final rule will protect the independence and
objectivity of an SBS Entity's CCO by preventing the personnel of an
SBS Entity from taking actions to coerce, mislead, or otherwise
interfere with the CCO.
The Commission agrees with the two commenters who supported the
adoption of Rule 15fh-4(c) to further protect SBS Entities' CCOs from
undue influence.\246\ Recognizing the CCO's critical function, one
commenter believed the new rule would serve as an important deterrent
to improper interference with the CCO's duties.\247\ A second commenter
supported the rule because it would reinforce existing CCO independence
requirements and duties essential to effective risk management programs
of SBS Entities.\248\
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\246\ See Better Markets Letter at 14; Letter from Patrick T.
Campbell, New York City Bar Association, dated Mar. 21, 2022 (``NYC
Bar Letter'').
\247\ See Better Markets Letter at 14.
\248\ See NYC Bar Letter at 2-5.
---------------------------------------------------------------------------

One commenter suggested that the proposed rule was unnecessary
because the existing requirements of 17 CFR 240.15Fk-1 (``Rule 15Fk-
1'') are sufficient to address the risks of undue influence on a
CCO.\249\ This commenter suggested that because the CCO is required to
report directly to the board of directors or senior officer of the SBS
Entity, and the CCO's compensation and removal requires approval of a
majority of the SBS Entity's board of directors, attempts by others to
influence the CCO inappropriately should be unavailing.\250\ The
Commission disagrees. When the Commission previously considered whether
to adopt a similar requirement, it concluded that requiring a majority
of the board to compensate and remove the CCO was sufficient to
establish CCO independence.\251\ However, in light of the rules
finalized subsequent to the CCO rules, including Rule 9j-1 (which is
being adopted in this release) and the risk mitigation requirements for
SBS Entities,\252\ a rule expressly prohibiting interference with the
performance of a CCO's duties is appropriate to: (1) deter any undue
influence even if not directly related to compensation or the threat of
removal of the CCO; and (2) help ensure the independence and
effectiveness of the CCO function.\253\ In connection with Rule 9j-1,
as well as other rules for which the CCO is responsible, undue
influence could arise from many actors (and many actions), and not
merely from those actors with the power to set compensation or with
hiring and firing authority over the CCO.\254\
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\249\ See Letter from Stephanie Webster, IIB, Chris Young, ISDA,
and Kyle Brandon, SIFMA, dated Mar. 21, 2022 (``IIB-ISDA-SIFMA CCO
Letter''), at 3.
\250\ Id.
\251\ The Commission considered and rejected a prohibition on
attempts by officers, directors, or employees to coerce, mislead, or
otherwise mislead the CCO when it adopted business conduct standards
for SBS Entities in 2016. See Business Conduct Standards Adopting
Release, 81 FR at 30054-55. That rulemaking included, among other
things, a rule to require an SBS Entity to designate a CCO and
impose certain duties and responsibilities on that CCO, as well as
antifraud provisions for SBS Entities. See 17 CFR 240.15Fk-1;
240.15Fh-4(a).
\252\ Risk mitigation rules are designed to further effective
risk management by requiring the existence of sound documentation,
periodic reconciliation of portfolios, rigorously tested valuation
methodologies, and sound collateralization practices. See Risk
Mitigation Adopting Release, 85 FR at 6390-91.
\253\ As the Commission explained when adopting similar rules
prohibiting persons from unduly influencing auditors pursuant to
section 303(a) of the Sarbanes Oxley Act of 2002 (``Sarbanes-Oxley
Act), activities by persons acting ``under the direction'' of
officers and directors of the issuer ``currently may constitute
violations of the anti-fraud or other provisions of the securities
laws or aiding or abetting or causing an issuer's violations of the
securities laws.'' Improper Influence on Conduct of Audits, Exchange
Act Release No. 47890 (May 20, 2003), 68 FR 31820, 31821 (May 28,
2003) (internal citations omitted). Nevertheless, like the rule
implementing section 303(a) of the Sarbanes-Oxley Act, Rule 15fh-
4(c) would provide the Commission with an additional means of
addressing efforts by persons acting under the direction of an
officer or director to thwart the responsibilities of the CCO. See
also Compliance Programs of Investment Companies and Investment
Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003),
68 FR 74714, 74721-22 (Dec. 24, 2003).
\254\ For example, an employee at an SBS Entity planning an
opportunistic strategy could attempt to mislead the CCO by
submitting false documentation to the CCO in order to avoid
disclosing the build-up of a large position that might require
public reporting and thwart the plans of the employee.
---------------------------------------------------------------------------

Moreover, existing 17 CFR 240.15Fh-3(h) (``Rule 15Fh-3(h)'')
requires an SBS Entity to establish and maintain a system to supervise
its business and the activities of its associated persons, which must
be reasonably designed to prevent violations of the provisions of
applicable Federal securities laws and the rules and regulations
thereunder.\255\ In addition, existing Rule 15Fk-1 requires an SBS
Entity to designate a CCO, who must comply with certain duties. Such
duties include ``[t]ak[ing] reasonable steps to ensure that the [SBS
Entity] establishes, maintains and reviews written policies and
procedures reasonably designed to achieve compliance with the [Exchange
Act] and the rules and regulations thereunder relating to its business
as [an SBS Entity].'' \256\ Failure to establish, maintain, and review
written policies and procedures reasonably designed to

[[Page 42569]]

achieve compliance with the Exchange Act and the rules and regulations
thereunder (including Rules 9j-1 and 15fh-4(c)) may result in
violations by the SBS Entity of Rule 15Fh-3(h), as well as Rule 15Fk-
1.\257\ Rule 15fh-4(c) protects investors and promotes the fairness of
the markets by supporting the ability of CCOs to meet their important
obligations to foster compliance without undue influence, which should
ultimately support the integrity of SBS Entities and the markets.
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\255\ See 17 CFR 240.15Fh-3(h).
\256\ See 17 CFR 240.15Fk-1. Additionally, in its application
for registration, an SBS Entity is required to include a senior
officer's certification that the SBS Entity has developed and
implemented written policies and procedures reasonably designed to
prevent violation of Federal securities laws and the rules
thereunder. See 17 CFR 240.15Fb2-1(b).
\257\ The SBS Entity could also face liability under 17 CFR
240.15Fb2-1(b) and (h) under such circumstances.
---------------------------------------------------------------------------

One commenter argued that the scope of proposed Rule 15Fh-4(c) was
``unclear and could lead to confusion and uncertainty in the market as
to which activities are prohibited.'' \258\ This commenter went on to
suggest that, if the Commission did adopt Rule 15fh-4(c), the final
rule should clarify which activities are prohibited by including
materiality and intent standards that would limit the prohibited
interference to knowingly making untrue statements or omitting material
facts.\259\ The commenter believed that ambiguities could have a
chilling effect on communications between the CCO and personnel of the
SBS Entity.\260\
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\258\ IIB-ISDA-SIFMA CCO Letter at 1.
\259\ See id. at 2 (stating that the rule is unclear and could
lead to confusion and uncertainty in the market as to which
activities are prohibited and that the rule does not provide any
materiality or intent standards, which could allow for immaterial or
inadvertent actions or statements to result in liability).
\260\ Id. IIB-ISDA-SIFMA was concerned that questions could
arise as to whether good faith disagreements or legitimate
discussions ``involve[d] `interference' with or `undue influence'
over a CCO.'' Id.
---------------------------------------------------------------------------

After considering the comments, the Commission declines to revise
Rule 15fh-4(c) and adopts the rule as proposed. Rule 15fh-4(c) protects
the independence and objectivity of an SBS Entity's CCO by prohibiting
undue influence by other personnel. The concerns regarding the rule
having a chilling effect on communications are misplaced since the rule
prohibits actions to coerce, manipulate, mislead, or fraudulently
influence CCOs--not good faith disagreements or legitimate discussions.
However, such influence could take many forms and is not limited to
material misstatements or omissions. As noted, the Commission has
adopted the majority of its Title VII rules related to security-based
swaps,\261\ including rules relating to trading relationship
documentation, dispute resolution, portfolio reconciliation, or
portfolio compression (``Risk Mitigation Rules''). As the Commission
explained when adopting the Risk Mitigation Rules, those rules were
designed to further effective risk management by requiring the
existence of sound documentation, periodic reconciliation of
portfolios, rigorously tested valuation methodologies, and sound
collateralization practices.\262\ Attempts by officers, directors, or
employees to hide transactions, submit false valuations, or manipulate
or fraudulently influence the CCO in the performance of their duties
related to the Risk Mitigation Rules would undermine the SBS Entity's
risk management and could pose risk to the market. Therefore, the
Commission is adopting a rule that is broad enough to apply to these
actions and any others that may undermine the independence and
responsibilities of the CCO.
---------------------------------------------------------------------------

\261\ See supra note 16.
\262\ See Risk Mitigation Adopting Release, 85 FR at 6390-91.
---------------------------------------------------------------------------

A commenter also argued for more clarity with regard to the intent
and conduct required to be liable under Rule 15fh-4(c).\263\ The
Commission declines to make any revisions to the proposed rule in
response to this comment. Specifically, the acts to ``coerce,
manipulate, mislead, or fraudulently influence'' that would be
prohibited by Rule 15fh-4(c) imply compelling the CCO to act in a
certain way through pressure, threats, trickery, intimidation,
misrepresentation, or some other form of purposeful action not limited
to untrue statements or omissions of material facts, and therefore,
further clarity is not necessary.\264\ As noted, one of the purposes of
Title VII security-based swap legislation is promoting the integrity of
the security-based swap market. Such a purpose would not be served by
imposing a scienter or materiality requirement on Rule 15fh-4(c)
violations. Further, the Commission believes that the rule will
encourage directors, officers, supervised persons, or employees of SBS
Entities to exercise reasonable attention and care in their dealings
with CCOs.
---------------------------------------------------------------------------

\263\ See IIB-ISDA-SIFMA CCO Letter at 2.
\264\ The Commission came to a similar conclusion when adopting
similar rules prohibiting persons from unduly influencing auditors
pursuant to section 303(a) of the Sarbanes Oxley Act of 2002
(``Sarbanes-Oxley Act). See Improper Influence on Conduct of Audits,
Exchange Act Release No. 47890 (May 20, 2003), 68 FR 31820, 31823
(May 28, 2003).
---------------------------------------------------------------------------

One commenter suggested expanding the scope of the rule to actions
taken to coerce, manipulate, mislead, or fraudulently influence all
officers and other decision-makers, and not limit the rule to actions
taken with respect to the SBS Entity's CCO.\265\ However, activities
taken by persons under the direction of officers and directors of an
issuer may already constitute violations of the securities laws.\266\
This additional rule is appropriate given the key role that the CCO
plays in an SBS Entity's compliance with the security-based swap
related regulations, such as the risk mitigation requirements for SBS
Entities. Furthermore, it provides an additional means of addressing
efforts by persons acting under the direction of an officer or director
to thwart the responsibilities of the CCO.
---------------------------------------------------------------------------

\265\ Michael Comments at 1.
\266\ See supra note 252.
---------------------------------------------------------------------------

IV. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (``PRA'') \267\ imposes certain
requirements on Federal agencies in connection with the conducting or
sponsoring of any ``collection of information.'' \268\ Neither Rule 9j-
1 nor Rule 15fh-4(c) contain a collection of information requirement
within the meaning of the PRA. Specifically, Rule 9j-1 contains
prohibitions designed to prevent fraud, manipulation, and deception in
connection with effecting transactions in, or purchasing or selling, or
inducing or attempting to induce the purchase or sale of, any security-
based swap. Rule 15fh-4(c) generally makes it unlawful for certain
specified persons to directly or indirectly take any action to coerce,
manipulate, mislead, or fraudulently influence an SBS Entity's CCO in
the performance of their duties under the Federal securities laws or
the rules and regulations thereunder. Neither of those rules require a
person to establish, maintain, and enforce written policies and
procedures reasonably designed to ensure compliance with the applicable
rule. However, to the extent that a person is already subject to a
similar policies and procedures requirement, any updates to those
policies and procedures would likely be captured by an existing
collection of information. For example, as previously explained, Rule
15Fh-3(h) requires an SBS Entity to establish and maintain a system to
supervise its business and the activities of its associated persons and
that system must be reasonably designed to prevent violations of the
provisions of applicable Federal securities laws and the rules and
regulations thereunder. In the PRA analysis when that rule was adopted,
the Commission estimated that each SBS Entity would spend 60 hours per
year to update each of the policies and procedures required by Rule
15Fh-

[[Page 42570]]

3.\269\ Both Rule 9j-1 and Rule 15fh-4(c) are intended solely to
identify actions that an SBS Entity is not permitted to take, and as
such do not make substantive modifications to any existing collection
of information or impose new information collection requirements within
the meaning of the PRA. Accordingly, we are not revising any burden and
cost estimates in connection with these amendments.
---------------------------------------------------------------------------

\267\ 44 U.S.C. 3501 et seq.
\268\ See 44 U.S.C. 3502(3).
\269\ See Business Conduct Standards Adopting Release, 81 FR at
30094.
---------------------------------------------------------------------------

V. Economic Analysis

A. Introduction

The Commission is mindful of the economic effects, including the
costs and benefits, of Rule 9j-1 and Rule 15fh-4(c). Section 3(f) of
the Exchange Act \270\ directs the Commission, when engaging in
rulemaking where it is required to consider or determine whether an
action is necessary or appropriate in the public interest, to consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation. In addition,
section 23(a)(2) of the Exchange Act \271\ requires the Commission,
when making rules under the Exchange Act, to consider the impact that
the rules would have on competition, and prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act.
---------------------------------------------------------------------------

\270\ 15 U.S.C. 78c(f).
\271\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

The analysis below addresses the likely economic effects of Rule
9j-1 and Rule 15fh-4(c), including the anticipated benefits and costs
of the rules and their likely effects on efficiency, competition, and
capital formation. Many of the benefits and costs discussed below are
difficult to quantify. For example, the Commission cannot quantify the
impact of litigation and litigation risk on counterparties and
underlying entities or the overall impact on the credibility and
reputation of the security-based swap market. The extent of some of
these impacts will depend, in part, on events difficult to predict that
might affect security-based swaps, such as changes in counterparty or
reference underlying entity behavior. Reputational and credibility
effects also are difficult to measure. Therefore, while the Commission
attempted to quantify economic effects where possible, much of the
discussion of the anticipated economic effects below is qualitative and
descriptive in nature.
The Commission received a number of comments related to various
aspects of the economic analysis of re-proposed Rule 9j-1 and proposed
Rule 15Fh-4(c). The Commission has considered and responded to these
comments in the sections that follow.

B. Broad Economic Considerations

This section discusses certain aspects of the security-based swap
market that may raise concerns or may be associated with concerns that
would be addressed by final Rule 9j-1. The discussion is illustrative
and is not intended to exhaust all types of conduct that may implicate
final Rule 9j-1.
Opportunistic Strategies
Opportunistic strategies often involve CDS buyers or sellers taking
steps, either with or without the participation of the underlying
entity, to avoid, trigger, delay, accelerate, decrease, and/or increase
payouts on CDS.\272\ When market participants employ one of these
strategies, they intend to obtain gains from the positions they hold
that go beyond those corresponding to the initial profit and loss
expectation (the initial payoff function) at trade execution. This
additional gain would be obtained to the direct detriment of a
counterparty that is unaware of that additional loss potential.\273\
One commenter pointed out that while CDS have many privately and
socially valuable uses, such instruments could lend themselves to
abuses such as opportunistic strategies.\274\
---------------------------------------------------------------------------

\272\ See supra note 35 and accompanying text for a discussion
of the settlement process that determines payout on a CDS contract
that relies on the ISDA standard documentation.
\273\ The market participant's gain from the transaction is
inversely proportional to the gain of the counterparty, so the
larger the market participant's position (and gain), the larger the
counterparty's loss.
\274\ Letter from Henry T.C. Hu, dated Mar. 21, 2022, at 6.
---------------------------------------------------------------------------

To the extent that market participants anticipate opportunistic
strategies, the CDS spread or price becomes a reflection of the
likelihood of an opportunistic strategy being announced (or, if already
announced, of succeeding) and decouples from the credit fundamentals of
the reference entity.\275\ This effect reduces the utility of the CDS
market as a venue to offload or take on the credit risk of a company
because prices no longer reflect credit risk; bona fide hedgers or
speculators in this market would be more likely to exit, as they cannot
readily ``trade'' the credit of a company.\276\ In addition to their
adverse impact on price efficiency, opportunistic strategies may impair
the liquidity of the CDS markets. The fact that a counterparty might
manufacture or delay a credit event in the future can deter others from
entering into such contracts. If fewer parties enter into CDS
contracts, the overall value of CDS as a risk-transferring instrument
for the market will be reduced.\277\ Two commenters suggested that
lenders may demand a higher rate of return (cost of debt) on new debt
issuances by a reference entity that was involved in a manufactured
credit event to compensate for the risk that such manufactured events
may recur in the future.\278\
---------------------------------------------------------------------------

\275\ Two commenters noted that opportunistic strategies impede
price efficiency in the CDS market, particularly the CDS of
distressed issuers because such strategies can be more profitable
when implemented on distressed issuers. See AFRED Letter at 4-5;
Fletcher Letter at 3.
\276\ See Gina-Gail S. Fletcher, Engineered Credit Default
Swaps: Innovative or Manipulative?, 94 N.Y.U. L. Rev. 1073 (2019)
(explaining that ``engineered'' or ``manufactured'' transactions
distort the information reflected in CDS spreads, to the point where
the default risk expressed in CDS spreads is no longer connected to
the financial condition of the underlying entity).
\277\ See Fletcher Letter at 3.
\278\ See AFRED Letter at 4; Fletcher Letter at 3.
---------------------------------------------------------------------------

C. Baseline

1. Existing Regulatory Frameworks
As discussed in section I.A, because security-based swaps are
included in the Exchange Act's definition of ``security,'' participants
in the security-based swap market are currently subject to the general
antifraud and anti-manipulation provisions of the Federal securities
laws, including sections 9(a) and 10(b) of the Exchange Act, and Rule
10b-5 thereunder, and section 17(a) of the Securities Act. In
particular, Rule 10b5-1 provides that a person trades ``on the basis
of'' material nonpublic information when the person purchases or sells
securities while aware of the information. However, the rule also sets
forth several affirmative defenses to permit persons to trade in
certain circumstances where it is clear that the information was not a
factor in the decision to trade.\279\ Several commenters pointed out
that most security-based market participants have organized their
business activities and implemented policies and procedures to allow
them to rely on the affirmative defense provided by Rule 10b5-1(c)(2)
from liability under Rule 10b-5.\280\
---------------------------------------------------------------------------

\279\ See Selective Disclosure and Insider Trading, Exchange Act
Release No. 43154 (Aug. 15, 2000), 65 FR 51716 (Aug. 24, 2000).
\280\ See IACPM Letter at 4; IIB-ISDA-SIFMA Letter at 4-5; MFA
Letter at 13; SIFMA AMG Letter at 11. See also supra section II.E.2.
EBF supports the arguments in the IIB-ISDA-SIFMA Letter regarding
proposed Rule 9j-1. See Letter from EBF at 1; supra note 124.

---------------------------------------------------------------------------

[[Page 42571]]

In addition, the Dodd-Frank Act expanded the anti-manipulation
provisions of section 9 of the Exchange Act to encompass security-based
swap transactions and required the Commission to adopt rules to prevent
fraud, manipulation, and deception in connection with security-based
swaps.\281\ The Commission has now finalized a majority of its Title
VII rules related to SBS Entities, including rules that allow such
persons to manage the market, counterparty, operational, and legal
risks associated with their security-based swap business. These include
the Risk Mitigation Rules; \282\ rules relating to capital, margin, and
segregation requirements for SBSDs, MSBSPs, and broker-dealers; \283\
and rules relating to recordkeeping and reporting requirements for
SBSDs, MSBSPs, and broker-dealers.\284\ These rules are discussed in
the 2021 Proposing Release.\285\ As discussed earlier, the CFTC has
largely completed its Title VII rulemakings related to swaps, including
the adoption of antifraud and anti-manipulation rules.\286\
---------------------------------------------------------------------------

\281\ See supra note 4 and accompanying text.
\282\ See supra section III.B and note 262.
\283\ See Capital, Margin, and Segregation Requirements for
Security-Based Swap Dealers and Major Security-Based Swap
Participants and Capital and Segregation Requirements for Broker-
Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84 FR 43872
(Aug. 22, 2019).
\284\ See Recordkeeping and Reporting Requirements for Security-
Based Swap Dealers, Major Security-Based Swap Participants, and
Broker-Dealers, Exchange Act Release No. 87005 (Sep. 19, 2019), 84
FR 68550 (Dec. 16, 2019).
\285\ See 2021 Proposing Release, 87 FR at 6681-82.
\286\ See supra note 16.
---------------------------------------------------------------------------

Finally, Rule 15Fk-1 requires an SBS Entity to designate a CCO and
imposes certain duties and responsibilities on that CCO.\287\
Additionally, the rule requires that a majority of the board approve
the compensation and removal of the CCO.\288\ Rule 15Fh-4(a) makes it
unlawful for an SBS Entity to: (1) employ any device, scheme, or
artifice to defraud any special entity or prospective customer who is a
special entity; (2) engage in any transaction, practice, or course of
business that operates as a fraud or deceit on any special entity or
prospective customer who is a special entity; or (3) engage in any act,
practice, or course of business that is fraudulent, deceptive, or
manipulative.\289\ Further, existing Rule 15Fh-3(h) requires an SBS
Entity to establish and maintain a system to supervise its business and
the activities of its associated persons; the system must be reasonably
designed to prevent violations of the provisions of applicable Federal
securities laws and the rules and regulations thereunder.\290\
---------------------------------------------------------------------------

\287\ See 17 CFR 240.15Fk-1(a) through (c).
\288\ See 17 CFR 240.15Fk-1(d).
\289\ See 17 CFR 240.15Fh-4(a).
\290\ See 17 CFR 240.15Fh-3(h).
---------------------------------------------------------------------------

2. Security-Based Swap Data, Market Participants, Dealing Structures,
and Levels of Security-Based Swap Trading Activity
As of January 4, 2023, there were 50 entities registered with the
Commission as SBSDs, and no entities registered as MSBSPs.\291\ Market
participants such as SBSDs and MSBSPs were required to report security-
based swap transactions to registered security-based swap data
repositories (``SBSDRs'') pursuant to Regulation SBSR beginning on
November 8, 2021.
---------------------------------------------------------------------------

\291\ See List of Registered Security-Based Swap Dealers and
Major Security-Based Swap Participants, available at https://www.sec.gov/files/list_of_sbsds_msbsps_1_4_2023locked_final.xlsx
(providing the list of registered SBSDs and MSBSPs that was updated
as of Jan. 4, 2023).
---------------------------------------------------------------------------

The Commission uses information reported pursuant to Regulation
SBSR to two registered SBSDRs--Depository Trust & Clearing Corporation
Data Repository (``DDR'') and the ICE Trade Vault (``ITV'')--to
describe the baseline.\292\ Table 1 shows that U.S. security-based swap
market activity is split across three asset classes: credit, equity,
and interest rate. Based on information reported to DDR, as of November
25, 2022, there were approximately 523,000, 3.4 million, and 5,700
active security-based swaps in the credit, equity, and interest rate
asset classes, respectively. The gross notional amounts outstanding in
the credit, equity, and interest rate asset classes were respectively,
approximately $2.8, $3.6, and $0.18 trillion.\293\ Based on information
reported to ITV, as of November 25, 2022, there were approximately
155,000 active credit security-based swaps with gross notional amount
outstanding of approximately $1.9 trillion.
---------------------------------------------------------------------------

\292\ DDR operates as a registered SBSDR for security-based swap
transactions in the credit, equity, and interest rate derivatives
asset classes. ITV operates as a registered SBSDR for security-based
swap transactions in the credit derivatives asset class. See
Security-Based Swap Data Repositories; DTCC Data Repository (U.S.)
LLC; Order Approving Application for Registration as a Security-
Based Swap Data Repository, Exchange Act Release No. 91798 (May 7,
2021), 86 FR 26115 (May 12, 2021); Security-Based Swap Data
Repositories; ICE Trade Vault, LLC; Order Approving Application for
Registration as a Security-Based Swap Data Repository, Exchange Act
Release No. 92189 (June 16, 2021), 86 FR 32703 (June 22, 2021). The
statistics presented herein are based on the SBS Report. See supra
note 42.
\293\ Active security-based swaps are those that have been
neither terminated nor reached their scheduled maturity and are
therefore open positions as of Nov. 25, 2022. Gross notional amount
outstanding represents the total outstanding notional value of
active, market-facing security-based swaps on Nov. 25, 2022.
Security-based swaps are considered to be ``market-facing'' when
they are executed at arms-length between third parties. While a
reporting party is only required to report a transaction to one
SBSDR--either DDR or ITV--some uncleared security-based swaps in DDR
also appear in ITV. This overlap is very limited in scope. As of
Nov. 25, 2022, there were 605 active credit security-based swaps in
ITV that were reported as uncleared (0.4% of the 154,903 active
credit security-based swaps in ITV). The 605 active credit security-
based swaps had a gross notional outstanding of $4.73 billion (0.3%
of the approximately $1,900 billion gross notional outstanding of
all active credit security-based swaps in ITV). These statistics
provide an upper bound of the overlap between ITV and DDR and
indicate that the overlap is very limited in scope. See SBS Report
at 4 and 10.
---------------------------------------------------------------------------

Table 1 also shows that U.S. security-based swap market
participants trade a variety of security-based swaps in each of the
three asset classes. Based on information reported to DDR, as of
November 25, 2022, active credit security-based swaps fall into five
product types. Single-name corporate CDS constitute the largest product
type, with approximately 364,000 active CDS and $1.6 trillion gross
notional amount outstanding. The second largest active credit security-
based swaps product type consists of single-name sovereign CDS, with
approximately 94,000 active CDS and $0.9 trillion gross notional amount
outstanding. For active equity security-based swaps, equity portfolio
swaps constitute the largest product type, with approximately 2.3
million active equity portfolio swaps and $1.7 trillion gross notional
amount outstanding. The second largest active equity security-based
swaps product type consists of equity swaps, with approximately 492,000
active equity swaps and $1.2 trillion gross notional amount
outstanding. Equity portfolio swaps and equity swaps can be further
divided into sub-products that include, among other things, equity
TRS.\294\ In the interest rate asset class, exotics constitute the
largest product type, with approximately $0.1 trillion gross notional
amount and 4,400 active exotic swaps outstanding. Based on information
reported to ITV, as of November 25, 2022, active credit security-based
swaps fall into two

[[Page 42572]]

product types. Single-name corporate CDS constitute the largest product
type, with approximately 135,000 active CDS and $1.3 trillion gross
notional amount outstanding. The second largest active credit security-
based swaps product type consists of single-name sovereign CDS, with
approximately 20,000 active CDS and $0.5 trillion gross notional amount
outstanding.
---------------------------------------------------------------------------

\294\ An equity swap references a single underlier while an
equity portfolio swap involves a portfolio wrapper under which
multiple swaps can be traded with operational efficiency. See
Central Clearing in the Equity Derivatives Market: An ISDA Study,
ISDA.org (June 2014) at 10, available at https://www.isda.org/a/6PDDE/central-clearing-in-the-eqd-market-final.pdf. See ISDA, ISDA
Taxonomy 2.0_Finalized, ISDA.org (Sep. 4, 2019), available at
https://www.isda.org/a/o1MTE/ISDA-Taxonomy_EQ-CR-FX-IR_v2.0__3-_September_2019-FINAL.xls (indicating that equity portfolio swaps
and equity swaps can be further divided into sub-products that
include, among other things, equity TRS).

Table 1--Gross Notional Amount and Active Security-Based Swaps Outstanding on Nov. 25, 2022, Categorized by
Asset Class and Product Classification a
----------------------------------------------------------------------------------------------------------------
Gross notional
amount Active security-
SBSDR Asset class Product type outstanding based swap count
(millions of USD)
----------------------------------------------------------------------------------------------------------------
DDR....................... Credit................ Index................. 44,407 2,992
Single-Name: Corporate 1,556,315 364,465
Single-Name: Sovereign 900,072 93,807
TRS \b\............... 156,849 49,867
Other \c\............. 122,970 12,081
-------------------------------------
Total................. 2,780,613 523,212
Equity................ Portfolio Swap........ 1,688,672 2,266,706
Swap.................. 1,183,279 491,508
Contract For 398,952 642,965
Difference.
Option................ 6,915 1,281
Forward............... 5,663 1,393
Other \d\............. 330,136 41,115
-------------------------------------
Total................. 3,613,617 3,444,968
Interest Rate......... Exotic................ 153,306 4,419
Forward............... 23,818 1,164
Other \e\............. 868 122
-------------------------------------
Total................. 177,992 5,705
ITV....................... Credit................ Single-Name: Corporate 1,348,002 134,741
Single-Name: Sovereign 544,414 20,162
-------------------------------------
Total................. 1,892,416 154,903
----------------------------------------------------------------------------------------------------------------
\a\ For cleared security-based swaps in DDR, this table incorporates only one of the two security-based swaps
that result from the clearing process. For ITV, this table incorporates all of the cleared security-based
swaps.
\b\ As a general matter, TRS include non-CDS debt-based security swaps, equity-based security swaps, and mixed
swaps. Counterparties in the TRS market use the contracts to obtain exposure, usually leveraged, to the total
economic performance of a security or index and benefit from not having to own the security itself. Market
participants, such as mutual funds, hedge funds, and endowments, use TRS to obtain exposure in markets where
they would face difficulties purchasing or selling the underlying security (e.g., a market participant may
find it difficult to buy a foreign company's security or locate a security to sell short) while taking
advantage of the capital efficiencies of not holding the security in their inventories. See also supra section
I.B.1, which discusses the ongoing payment stream of TRS, among other things.
\c\ Includes the following products reported to SBSDRs: exotic, index tranche, swaptions, and other single-name
(e.g., asset-backed, loan, and municipal security-based swaps).
\d\ ``Other'' is a category in the DDR Equity Product ID field. All Product ID categories are listed in the
table.
\e\ Includes the following products reported to SBSDRs: inflation, debt option, and cross-currency.

Table 2 shows that both SBS Entities and non-SBS Entities
participate in all three asset classes in the U.S. security-based swap
market. Based on information reported to DDR, as of November 25, 2022,
SBS Entities and non-SBS Entities had, respectively, entered into
approximately 813,000 and 234,000 active credit security-based
swaps.\295\ The gross notional amounts outstanding of the active credit
security-based swaps held by SBS Entities and non-SBS Entities were,
respectively, approximately $4.4 and $1.2 trillion. In the equity asset
class, SBS Entities and non-SBS Entities had, respectively, entered
into approximately 4.0 million and 2.9 million active equity security-
based swaps. The gross notional amounts outstanding of the active
equity security-based swaps held by SBS Entities and non-SBS Entities
were, respectively, approximately $4.5 and $2.7 trillion. In the
interest rate asset class, SBS Entities and non-SBS Entities had,
respectively, entered into approximately 6,200 and 5,200 active
interest rate security-based swaps. The gross notional amounts
outstanding of the active interest rate security-based swaps held by
SBS Entities and non-SBS Entities were, respectively, approximately
$0.2 and $0.1 trillion. Based on information reported to ITV, as of
November 25, 2022, SBS Entities and non-SBS Entities had, respectively,
entered into approximately 123,000 and 33,000 active credit security-
based swaps. The gross notional amounts outstanding of the active
credit security-based swaps held by SBS Entities and non-SBS Entities
were, respectively, approximately $1.6 and $0.3 trillion.
---------------------------------------------------------------------------

\295\ For cleared security-based swaps where at least one
counterparty is an SBS Entity, Table 2 reflects the security-based
swaps entered into by each of the original counterparties, but does
not include the positions of the clearing organizations themselves.
For uncleared security-based swaps, Table 2 reflects the security-
based swaps entered into by each of the original counterparties. See
SBS Report at 5.

[[Page 42573]]

Table 2--Gross Notional Amount and Active Security-Based Swaps Outstanding on Nov. 25, 2022, Categorized by
Asset Class and Registrant Type a
----------------------------------------------------------------------------------------------------------------
Gross notional
amount Active security-
SBSDR Asset class Registrant type outstanding based swap count
(millions of USD)
----------------------------------------------------------------------------------------------------------------
DDR....................... Credit................ Total................. 5,561,226 1,046,424
SBS Entities.......... 4,403,130 812,647
Other................. 1,158,096 233,777
Equity................ Total................. 7,227,234 6,889,936
SBS Entities.......... 4,490,592 4,013,393
Other................. 2,736,642 2,876,543
Interest Rate......... Total................. 355,984 11,410
SBS Entities.......... 210,663 6,214
Other................. 145,321 5,196
ITV....................... Credit................ Total................. 1,897,249 155,578
SBS Entities.......... 1,632,251 122,831
Other................. 264,998 32,747
----------------------------------------------------------------------------------------------------------------
\a\ For cleared security-based swaps where at least one counterparty is an SBS Entity, Table 2 reflects the
security-based swaps entered into by each of the original counterparties, but does not include the positions
of the clearing organizations themselves. For uncleared security-based swaps, Table 2 reflects the security-
based swaps entered into by each of the original counterparties.

In addition to information reported to registered SBSDRs, the
Commission also uses data from the DTCC Derivatives Repository Limited
Trade Information Warehouse (``DTCC-TIW'') to describe the baseline.
DTCC-TIW provides data regarding the activity of market participants in
the single-name CDS market during the period from 2006 to the end of
2021.\296\ The Commission acknowledges that limitations in the data
constrain the extent to which it is possible to quantitatively
characterize the security-based swap market.\297\ Based on an analysis
of DTCC-TIW data, staff concluded that there are 2,326 transacting
agents that engaged directly in trading between November 2006 and
December 2021 with 15,721 accounts.\298\
---------------------------------------------------------------------------

\296\ DTCC-TIW provides weekly positions and monthly transaction
files on a voluntary basis for single-name and index-based CDS.
These data cover all positions and transactions where one of the
counterparties is a U.S. entity or the reference entity is a U.S.
entity, with status as a U.S. entity determined by DTCC-TIW. In
DTCC-TIW, the Commission observes end of week CDS positions for all
U.S. entities, foreign counterparties to a U.S. entity, or foreign
counterparties trading a CDS referencing a U.S. underlying entity.
The DTCC-TIW data have limitations. The data do not address two
foreign counterparties with CDS referencing foreign underlying
entities. In addition, the DTCC-TIW data do not provide any intra-
weekly CDS position information, nor any information on the
underlying security holdings of reference entities. Further, DTCC-
TIW is a voluntary database where market participants on a voluntary
basis submit transactions and end of week holdings.
\297\ The Commission also relies on qualitative information
regarding market structure and evolving market practices provided by
commenters and the knowledge and expertise of Commission staff.
\298\ These 2,326 entities, which are presented in more detail
in Table 3, below, include all DTCC-TIW-defined ``firms'' shown in
DTCC-TIW as transaction counterparties that report at least one
transaction to DTCC-TIW as of Dec. 2021. The staff in the Division
of Economic and Risk Analysis classified these firms by machine-
matching names to known third-party databases and by manual
classification. See, e.g., Security-Based Swap Transactions
Connected with a Non-U.S. Person's Dealing Activity That Are
Arranged, Negotiated, or Executed By Personnel Located in a U.S.
Branch or Office or in a U.S. Branch or Office of an Agent;
Security-Based Swap Dealer De Minimis Exception, Exchange Act
Release No. 77104 (Feb. 10, 2016), 81 FR 8598, 8602 n.43 (Feb. 19,
2016). Manual classification was based in part on searches of the
EDGAR and Bloomberg databases, the SEC's Investment Adviser Public
Disclosure database, and a firm's public website or the public
website of the account represented by a firm. As mentioned above,
data on CDS market participants come from DTCC-TIW. Principal
holders of CDS risk exposure are represented by ``accounts'' in the
DTCC-TIW. ``Accounts'' as defined in the DTCC-TIW context are not
equivalent to ``accounts'' in the definition of ``U.S. person''
provided by Exchange Act Rule 3a71-3(a)(4)(i)(C). 17 CFR 3a71-
3(a)(4)(i)(C). One entity or legal person (known as ``transacting
agent'' in the terminology of DTCC-TIW) may have multiple accounts.
For example, a bank that is a transacting agent may have one DTCC-
TIW account for its U.S. headquarters and one DTCC-TIW account for
one of its foreign branches.
---------------------------------------------------------------------------

Data from the DTCC-TIW show that activity in the single-name CDS
market is concentrated among a relatively small number of entities,
predominantly registered SBSDs.\299\ The top two SBSDs (when accounts
are sorted by number of counterparties) each transacted with over a
thousand counterparty accounts, consisting of both other SBSDs and non-
SBSDs. The next 13 percent of SBSDs each transacted with 500 to 1,000
counterparty accounts; the following 21 percent of SBSDs each
transacted with 100 to 500 counterparty accounts; and 62 percent of
SBSDs each transacted security-based swaps with fewer than 100
counterparty accounts in 2021. The median number of counterparty
accounts across SBSDs is 16 (the mean is approximately 191). SBSD-
intermediated transactions reached a gross notional amount of
approximately $1.5 trillion, approximately 66 percent of which was
intermediated by the top five SBSD accounts. The median non-dealer
counterparty transacted with only one SBSD account (with an average of
approximately 1.9 SBSD accounts) in 2021.
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\299\ Dealers are generally persons engaged in the business of
buying and selling securities for their own account, through a
broker or otherwise. 15 U.S.C. 78c(a)(5). SBSDs are generally
defined as persons who hold themselves out as dealers in security-
based swaps; make markets in security-based swaps; regularly enter
into security-based swaps as an ordinary course of business for
their own account; or engage in any activity causing them to be
commonly known in the trade as a dealer or market maker in security-
based swaps. 17 CFR 240.3a71-1.
---------------------------------------------------------------------------

Non-dealer single-name CDS market participants include, but are not
limited to, investment companies, pension funds, private funds,
sovereign entities, and industrial companies. We observe that most non-
dealer market participants of single-name CDS do not engage directly in
the trading of security-based swaps, but trade through banks,
investment advisers or funds, or other types of firms, which we refer
to as transacting agents, consistent with DTCC-TIW terminology.\300\ As
shown in Table 3, close to 79 percent of transacting agents are
identified as investment advisers or funds.\301\ Although investment
advisers and funds are the vast majority of transacting

[[Page 42574]]

agents, the transactions they executed account for only about 15
percent of all single-name CDS trading activity reported to the DTCC-
TIW, measured by the number of transaction sides.\302\ The vast
majority of transactions, approximately 82 percent, measured by number
of transaction-sides were executed by ISDA-recognized dealers.
---------------------------------------------------------------------------

\300\ Transacting agents participate directly in the security-
based swap market, without relying on an intermediary, on behalf of
their principals, investment companies, pension funds, private
funds, sovereign entities, and industrial companies. For example, a
university endowment may hold a position in a security-based swap
that is established by an investment adviser that transacts on the
endowment's behalf. In this case, the university endowment is a
principal that uses the investment adviser as its transacting agent.
\301\ DTCC-defined ``firms'' shown in DTCC-TIW, which we refer
to here as ``transacting agents.''
\302\ Each transaction has two transaction sides, i.e., two
transaction counterparties.

Table 3--The Number of Transacting Agents by Counterparty Type and the Fraction of Total Trading Activity, From
Nov. 2006 Through Dec. 2021, Represented by Each Counterparty Type
----------------------------------------------------------------------------------------------------------------
Transaction
Transacting agents Number Percent share (%)
----------------------------------------------------------------------------------------------------------------
Investment Advisers/Funds \a\................................... 1,858 78.7 14.6
Banks (excluding G16) \b\....................................... 278 11.8 3.3
Pension Funds................................................... 30 1.3 0.1
Insurance Companies............................................. 49 2.1 0.2
ISDA-Recognized Dealers \c\..................................... 17 0.7 81.6
Other........................................................... 130 5.5 0.2
-----------------------------------------------
Total....................................................... 2,362 100.0 100
----------------------------------------------------------------------------------------------------------------
\a\ Investment Adviser/Funds--For purposes of this table, these entities have the following characteristics:
clients are predominantly individuals, institutions, and investment companies that take public and
institutional money. Some also manage pooled investment vehicles (e.g., hedge funds), private equity and
venture capital.
\b\ Banks (excluding G16)--The primary characteristic is the entity is trading for its own account and not just
on behalf of its clients. This includes depository institutions, swap dealers (market makers), and classically-
defined investment banks.
\c\ ISDA recognized dealer--Market makers (dealers) identified by ISDA as belonging to the G14 or G16 dealer
group during the period. See, e.g., 2010 ISDA Operations Benchmarking Survey (2010), available at https://www.isda.org/a/5eiDE/isda-operations-survey-2010.pdf.

Figure 1 describes the percentage of global, notional transaction
volume in North American corporate single-name CDS reported to the
DTCC-TIW from January 2011 through December 2021, separated by whether
transactions are between two ISDA-recognized dealers (interdealer
transactions) or whether a transaction has at least one non-dealer
counterparty. Figure 1 also depicts the notional trading volume of all
North American corporate single-name CDS. As Figure 1 shows, all types
of exposures have declined approximately proportionally since 2011.
BILLING CODE 8011-01-P

[[Page 42575]]

[GRAPHIC] [TIFF OMITTED] TR30JN23.049

BILLING CODE 8011-01-C

D. Benefits and Costs of Rule 9j-1

1. Benefits
Rule 9j-1 would decrease fraudulent activity and litigation costs,
and could decrease compliance costs. In addition, Rule 9j-1 may
indirectly increase price efficiency and decrease capital costs of
underlying entities. The Commission discusses each of these individual
benefits in more detail below.
Rule 9j-1 would reduce the risk of fraud in the security-based swap
market, including the risk of opportunistic trading strategies to the
extent that such strategies occur in connection with effecting or
attempting to effect any transaction in any security-based swap, or
purchasing or selling, or inducing or attempting to induce the purchase
or sale of, any security-based swap (including but not limited to, in
whole or in part, the execution, termination (prior to its scheduled
maturity date), assignment, exchange, or similar transfer or conveyance
of, or extinguishing of any rights or obligations under, a security
based-swap). The additional specificity offered by Rule 9j-1 may
enhance Commission oversight of the security-based swap market, which
may ultimately benefit market participants through reducing the risk of
fraud. Any reduction in the risk of fraud as a result of Rule 9j-1
would be limited to the extent that the fraudulent, manipulative, and
deceptive conduct by security-based swap market participants is
currently subject to the general antifraud and anti-manipulation
provisions of the Federal securities laws, including but not limited to
sections 9(a) and 10(b) of the Exchange Act, and Rule 10b-5 thereunder,
and section 17(a) of the Securities Act. To the extent that Rule 9j-1
reduces the risk of fraud, the rule could encourage participation in
the security-based market, which may result in increased
competition.\303\ More security-based swap entities would be willing to
supply (issue) and/or demand (buy) security-based swaps, with increased
confidence that their counterparties would have limited abilities to
impact the market through fraudulent conduct.
---------------------------------------------------------------------------

\303\ See 2019 Joint Statement, supra note 53.
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Rule 9j-1 may provide additional precision and specificity
regarding the application of existing antifraud and anti-manipulation
laws to misconduct in the security-based swap market, which could
prompt some market participants to devote greater resources to ensure
that they are compliant with their obligations under antifraud and
anti-manipulation laws, which could also decrease the risk of fraud in
the security-based swap market. Because of this decreased risk of
fraud, market participants may have fewer disputes

[[Page 42576]]

with their counterparties regarding security-based swap contracts,
which in turn, could lower litigation costs for security-based swap
participants and underlying entities. Lower litigation costs could
contribute to reducing the cost of CDS and, to the extent that the cost
of CDS is reduced, lower costs of borrowing to the underlying entity.
Rule 9j-1 may also decrease compliance costs for some market
participants who may, as a result of the additional specificity of the
rule, need to spend fewer resources determining appropriate compliance
under section 9(j).
Decreased risk of fraud in the security-based swap market may also
lead to increased price efficiency, as more trading could lead to a
greater exchange of market expectations from buyers and sellers
transacting in the market. Further, by providing specificity, Rule 9j-1
would help prevent prohibited conduct from distorting the market and
artificially increasing or decreasing security-based swap prices, which
also would help to ensure more efficient pricing. Increased price
efficiency would consequently lead to greater security-based swap
market efficiency, as security-based swap prices would provide greater
confidence that their prices more likely reflect fundamental values and
risk in more liquid markets. For example, the prices of single-name CDS
contracts would more likely reflect the fundamental credit risk of the
underlying entity, as opposed to counterparty credit risk, or the
probability that fraudulent activity prohibited by Rule 9j-1 is being
perpetrated in connection with the CDS contracts.\304\
---------------------------------------------------------------------------

\304\ See generally Fletcher Letter at 3 (discussing the effects
of engineered CDS transactions).
---------------------------------------------------------------------------

Increased participation and price efficiency in the security-based
swap market as a result of Rule 9j-1 could encourage lenders to make
greater use of security-based swaps for hedging their loans, which in
turn could increase lending activity and capital formation.\305\
---------------------------------------------------------------------------

\305\ See generally LSTA Letter at 2 (stating that security-
based swaps ``play an important in risk management and hedging in
the loan markets . . . [and] facilitate lending activity by
transferring some or all of the risks associated with lending . . .
.'').
---------------------------------------------------------------------------

In addition, improvements in the security-based swap market as a
result of Rule 9j-1 may in turn have a positive impact on capital
formation and the cost of capital for the underlying entities. The
market participation increases in security-based swaps may enhance
liquidity in the underlying market and related swap indices, and, in
general, lower the cost of capital for entities referenced by security-
based swaps.\306\ If single-name CDS prices are more reflective of the
fundamental credit risk of the underlying entity, as a second order
effect, participants in the market for the underlying security would be
better informed about the underlying security's attributes through the
CDS price signal, likely increasing their willingness to re-enter or
engage in the underlying security's market. Specifically, the
underlying security market uses the derivative market to assess its
quality, as the derivative market in some circumstances is forward
looking, liquid, and more informative than the underlying market.\307\
Greater activity in the underlying security market due to increased
price efficiency and greater availability to hedge these securities in
the security-based swap market could lead to lower capital costs and
increase capital formation for the underlying entities. To the extent
that increased capital formation for the underlying entities is
associated with the issuance of a greater variety of securities,
investors could benefit because they will have a larger set of
investment opportunities with which to meet their investment goals.
---------------------------------------------------------------------------

\306\ See Martin Oehmke & Adam Zawadowski, Synthetic or Real?
The Equilibrium Effects of Credit Default Swaps on Bond Markets, 28
Rev. of Fin. Stud. 3303-3337 (2015) and Ilhyock Shim & Haibin Zhu,
The Impact of CDS trading on the Bond Market: Evidence from Asia, 40
J. of Banking & Finance 460-475 (2014).
\307\ See Haibin Zhu, An Empirical Comparison of Credit Spreads
Between the Bond Market and the Credit Default Swap Market, 29 J. of
Fin. Serv. Rsch. 211-235 (2006) and Jongsub Lee, et al., When do CDS
Spreads Lead? Rating Events, Private Entities, and Firm-Specific
Information Flows, 130 J. of Fin. Econ. 556-578 (2018).
---------------------------------------------------------------------------

Comments Received
In the 2021 Proposing Release, the Commission solicited feedback
on, among other things, the benefits of the proposed rules, including
re-proposed Rule 9j-1.\308\ One commenter strongly agreed with the
Commission's discussion regarding the beneficial effects of greater
participation in the security-based swap markets on liquidity in the
underlying market and related swap indices, and the cost of capital for
security-based swap referenced entities. The commenter also strongly
agreed with the Commission's discussion regarding the value of the
derivative market to the underlying security market for assessing the
security market's quality.\309\
---------------------------------------------------------------------------

\308\ 2021 Proposing Release, 87 FR at 6701-02.
\309\ Milbank Letter at 10, n.17.
---------------------------------------------------------------------------

Three commenters believed that re-proposed Rule 9j-1's anticipated
benefit of reduced fraudulent and manipulative activity in the
security-based swap market would not materialize.\310\ Three commenters
stated that the adoption of the ISDA Amendments has reduced the use of
opportunistic strategies, such as manufactured credit events,\311\
while two of these commenters stated that the use of anti-net short
provisions in the syndicated bank loan market has also had this
effect.\312\ One commenter observed that opportunistic strategies have
been, on the whole, extremely infrequent and doubted that re-proposed
Rule 9j-1 will result in any market-wide benefit from addressing these
strategies or significantly reduce manipulative activity in the
security-based swap markets.\313\ One commenter provided CDS pricing
data (in the form of the difference between the CDS spread and
underlying cash bond implied credit spread (``CDS-cash basis'') and
interpreted those data to suggest that CDS protection buyers perceived
the risk of certain opportunistic strategies to be low. The commenter
then reasoned that because CDS protection buyers perceived the risk of
such strategies to be low, re-proposed Rule 9j-1 would not generate the
anticipated benefit of reducing fraudulent activity in the security-
based swap market as well as encouraging market participation.\314\
---------------------------------------------------------------------------

\310\ See LSTA Letter at 4; July 2022 MFA Letter at 4-10;
Milbank Letter at 8-9.
\311\ Id.
\312\ See LSTA Letter at 4; July 2022 MFA Letter at 4-10.
\313\ Milbank Letter at 9.
\314\ July 2022 MFA Letter at 2-4. The commenter referred to
opportunistic strategies undertaken by CDS sellers to affect the
likelihood of a credit event and the cost of CDS through actions
such as changing the supply of deliverable obligations and offering
financing to restructure a reference entity. See 2021 Proposing
Release, 87 FR at 6655.
---------------------------------------------------------------------------

The Commission has considered feedback from the commenters who
argued that the proposed rule would not have the benefit of reducing
fraudulent and manipulative activity in the security-based swap market.
The provisions in Rule 9j-1 are designed generally to prohibit a range
of fraudulent, manipulative, and deceptive conduct in the security-
based swap market. The rule is not solely intended to address
opportunistic strategies in the CDS market.\315\ Further, anti-net
short

[[Page 42577]]

provisions and ISDA Amendments are narrowly focused and have limited
ability to reduce fraudulent and manipulative activity in the security-
based swap market. As discussed in the 2021 Proposing Release, the ISDA
Amendments would not address all of the concerns identified in the 2019
Joint Statement, including but not limited to addressing opportunistic
strategies that do not involve narrowly tailored credit events.\316\
Anti-net short provisions are limited to syndicated bank loans and
would not apply to fraudulent activity in the security-based swap
market that does not involve such loans. Thus, even if these industry
efforts were successful in reducing fraudulent activity, their impact
likely would be limited by their narrow scope.
---------------------------------------------------------------------------

\315\ As discussed earlier in this section, Rule 9j-1 would,
among other things, reduce the risk of opportunistic trading
strategies to the extent that such strategies occur in connection
with effecting or attempting to effect any transaction in any
security-based swap, or purchasing or selling, or inducing or
attempting to induce the purchase or sale of, any security-based
swap (including but not limited to, in whole or in part, the
execution, termination (prior to its scheduled maturity date),
assignment, exchange, or similar transfer or conveyance of, or
extinguishing of any rights or obligations under, a security based-
swap).
\316\ See 2021 Proposing Release, 87 FR at 6655 n.31; supra note
52.
---------------------------------------------------------------------------

In response to the comment that opportunistic strategies have been,
on the whole, extremely infrequent so that re-proposed Rule 9j-1 will
not result in any market-wide benefit, the Commission reiterates that
the provisions in Rule 9j-1 are designed generally to prohibit a range
of fraudulent, manipulative, and deceptive conduct in the security-
based swap market. The rule is not solely intended to address
opportunistic strategies in the CDS market.\317\ Thus, even if
opportunistic strategies were no longer implemented, final Rule 9j-1
would benefit the security-based swap market by prohibiting all other
types of fraudulent, manipulative, and deceptive conduct in the market.
That said, this benefit likely would be limited to the extent that the
fraudulent, manipulative, and deceptive conduct by security-based swap
market participants is currently subject to the general antifraud and
anti-manipulation provisions of the Federal securities laws, including
but not limited to sections 9(a) and 10(b) of the Exchange Act, and
Rule 10b-5 thereunder, and section 17(a) of the Securities Act.
---------------------------------------------------------------------------

\317\ See supra note 315.
---------------------------------------------------------------------------

The Commission is not persuaded that the CDS-cash basis data
provided by one of the commenters necessarily indicate that CDS
protection buyers perceived the risk of certain opportunistic
strategies to be low.\318\ Apart from such perceived risk, the academic
literature suggests a number of factors that affect the CDS-cash basis
such as funding cost, counterparty risk, collateral quality, and the
CDS reference entity's financial characteristics.\319\ Without
accounting for the influence of these other factors, it is not clear if
the CDS-cash basis reflects that CDS protection buyers perceive the
risk of certain opportunistic strategies to be low. Even if the CDS-
cash basis data reflect CDS protection buyers' perceived risk of
certain opportunistic strategies, the data's limited scope provides no
information on the perceived risk of other types of fraudulent and
manipulative activity in the security-based swap market. Accordingly,
the commenters have not offered convincing evidence that Rule 9j-1 will
be without benefits. The Commission continues to believe that Rule 9j-
1, by addressing the security-based swap market more broadly, would
reduce fraudulent and manipulative activity in this market.
---------------------------------------------------------------------------

\318\ See July 2022 MFA Letter at 2-4.
\319\ See, e.g., Jennie Bai & Pierre Collin-Dufresne, The CDS-
Bond Basis, 48 Fin. Mgmt., 417-439 (2019) and Amrut Nashikkar, et
al., Liquidity and Arbitrage in the Market for Credit Risk, 46 J. of
Fin. Quantitative Analysis 627-656 (2011).
---------------------------------------------------------------------------

One commenter asserted that proposed Rule 9j-1(b) (adopted as Rule
9j-1(a)(6)) would introduce substantial uncertainty in the application
of the antifraud and anti-manipulation provisions of the Federal
securities laws, and therefore questioned whether the benefits of
``additional precision and specificity'' that the Commission identified
would materialize.\320\ Final Rule 9j-1(a)(6)'s scienter requirements,
the practical utility of the rule's objective facts-and-circumstances
requirement, and the applicability of familiar case law help mitigate
any uncertainty that market participants may have regarding the
application of the final rule.
---------------------------------------------------------------------------

\320\ See Milbank Letter at 5, 9.
---------------------------------------------------------------------------

2. Costs
Some security-based swap market participants may incur costs
associated with taking actions to update existing compliance systems
for compliance with Rule 9j-1. The Commission estimates that security-
based swap market participants may incur one-time aggregate costs
ranging between $1,225,360 and $2,450,720 to update their existing
compliance systems.\321\ These additional costs could be limited to the
extent that many of these practices and systems are already in place to
ensure compliance with section 9(j) of the Exchange Act and the other
general antifraud and anti-manipulation statutory and regulatory
provisions.
---------------------------------------------------------------------------

\321\ The Commission estimates that a security-based swap market
participant that updates its existing compliance system likely will
do so by having a compliance attorney make a one-time update to its
policies and procedures. Costs per entity = 1 hour x $424/hour
national hourly rate for a compliance attorney = $424. The per-hour
figure for a compliance attorney is from SIFMA's Management and
Professional Earnings in the Securities Industry--2013, as modified
by Commission staff to adjust for inflation (through Dec. 2022) and
to account for an 1,800-hour work-year, and multiplied by 5.35 to
account for bonuses, firm size, employee benefits, and overhead.
Based on an analysis of information reported pursuant to Regulation
SBSR to DDR and ITV, the Commission estimates that there are 11,559
security-based swap market participants (including SBS Entities) as
of Nov. 25, 2022. There is uncertainty as to how many security-based
swap market participants will choose to update their existing
compliance systems to comply with Rule 9j-1. A lower bound estimate
is 25% x 11,559 = 2,889.75, or approximately 2,890 security-based
swap market participants. An upper bound estimate is 50% x 11,559 =
5,779.50 or approximately 5,780 security-based swap market
participants. The lower bound estimate of one-time aggregate costs =
2,890 x $424 = $1,225,360. The upper bound estimate of one-time
aggregate costs = 5,780 x $424 = $2,450,720. There is also
uncertainty regarding the specific changes that security-based swap
market participants may make to their existing compliance systems to
comply with Rule 9j-1. Two commenters believed that re-proposed Rule
9j-1 would require market participants to incur costs to design and
implement extensive compliance programs and reconcile the scope of
the new rule with existing practices. See LSTA Letter at 9-10; IACPM
Letter at 4. However, these commenters did not provide quantified
estimates of such costs. To the extent that security-based market
participants choose to comply with final Rule 9j-1 in the manner
described by these commenters, the costs of complying with the final
rule could be higher than the Commission's estimate. To the extent
that market participants incur compliance costs as a result of Rule
9j-1, these costs represent a reasonable trade-off in light of the
benefits discussed in section V.D.1. See also discussion later in
this section.
---------------------------------------------------------------------------

In addition, the rule could discourage some legitimate market
activities, including some hedging activity, because of concerns that
such activities might be viewed as rule violations. As a result,
compliance costs related to evaluating whether or not certain
activities are permissible may increase for some market participants.
Market participants might incur costs associated with the
affirmative defenses in Rule 9j-1(e). However, such costs likely would
be very limited. As a general matter, the affirmative defenses in Rule
9j-1(e) are voluntary and do not impose requirements on market
participants. Market participants choose to incur costs related to the
affirmative defenses if they anticipate the associated benefits to
exceed the associated costs. Market participants for whom the
anticipated benefits of the affirmative defenses do not exceed the
associated costs likely would not incur those costs. However, market
participants that choose not to rely on the affirmative defenses may
incur other costs (e.g., additional cost of counsel or other experts to
evaluate whether actions taken without relying on the affirmative
defenses are compliant with the Exchange Act and Commission
regulations, and a potential increase in legal liability risk).

[[Page 42578]]

Market participants that seek to rely on the affirmative defense in
paragraph (e)(1) of Rule 9j-1 likely would do so by creating and
retaining the written security-based swap documentation governing such
transaction or any amendment thereto. As discussed in the 2021
Proposing Release, such documentation is already created and retained
as a result of SBS Entities' compliance with existing 17 CFR 240.15Fi-5
and the Commission's recordkeeping requirements in 17 CFR 240.17a-4 or
17 CFR 240.18a-6, as applicable.\322\ Thus, the costs that may be
incurred by those market participants that wish to rely on the
affirmative defense likely would be very limited, if any.
---------------------------------------------------------------------------

\322\ See 2021 Proposing Release 87 FR at 6662 n.88.
---------------------------------------------------------------------------

Market participants that seek to rely on the affirmative defense in
paragraph (e)(2) of Rule 9j-1 would be required to comply with the
specific provisions of that paragraph, including implementing
reasonable policies and procedures to prevent insider trading. For most
market participants to whom this affirmative defense would be relevant,
the costs associated with policies and procedures likely would be very
limited. As discussed above, most security-based swap market
participants have spent considerable resources to avail themselves of
the affirmative defense of Rule 10b5-1(c)(2).\323\ Because the
affirmative defense of Rule 9j-1(e)(2) is modeled on that of Rule 10b5-
1(c)(2), most security-based swap market participants likely would
employ their existing policies and procedures to avail themselves of
the affirmative defenses of both Rules 10b5-1(c)(2) and 9j-1(e)(2).
---------------------------------------------------------------------------

\323\ See supra sections II.E.2 and V.C.1.
---------------------------------------------------------------------------

Comments Received
One commenter believed that the proposed rules would help to reduce
costs for all investors by removing fraud and manipulation from the
security-based swap market and the market for underlying
securities.\324\ However, several commenters were concerned that re-
proposed Rule 9j-1 would significantly increase compliance costs for
security-based swap market participants in various ways.
---------------------------------------------------------------------------

\324\ Michael Comments at 1.
---------------------------------------------------------------------------

One commenter believed that re-proposed Rule 9j-1 would require
market participants to incur costs to design and implement extensive
compliance programs to adhere to the rule's broad prohibitions; and
that such costs are only marginally alleviated by the narrow proposed
safe harbors, since ensuring that each activity falls within a
designated safe harbor presents resource challenges of its own. The
commenter stated that such compliance costs would be unreasonably
burdensome to lenders and would have a significant, negative impact on
the loan markets. The commenter also stated that, absent an affirmative
defense similar to Rule 10b5-1(c)(2), market participants may have to
incur cost and effort to identify all security-based swaps and related
reference underlying entities held by the organization and to track and
coordinate all activity that could affect the purchase, sale, payments,
deliveries, and other ongoing obligations or rights with respect to the
security-based swaps and the related reference underlying
entities.\325\ Another commenter stated that re-proposed Rule 9j-1
would entail further significant costs and challenges because market
participants would need to reconcile the scope of the new rule with
existing practices.\326\
---------------------------------------------------------------------------

\325\ LSTA Letter at 9-10.
\326\ IACPM Letter at 4.
---------------------------------------------------------------------------

The Commission has considered the above comments in finalizing Rule
9j-1. As discussed above and in the 2021 Proposing Release, some
security-based swap market participants may incur costs associated with
taking actions to update existing compliance systems for compliance
with Rule 9j-1. These additional costs could be limited to the extent
that many of these practices and systems are already in place to ensure
compliance with section 9(j) and the other general antifraud and anti-
manipulation statutory and regulatory provisions. To the extent that
market participants incur compliance costs as a result of Rule 9j-1,
these costs represent a reasonable trade-off in light of the benefits
discussed in section V.D.1. With respect to the identification,
tracking, and coordination activities that might be necessary absent an
information barrier safe harbor, final Rule 9j-1(e)(2) provides an
affirmative defense modeled on the affirmative defense in Rule 10b5-
1(c)(2). Final Rule 9j-1(e)(2) will help mitigate the cost and effort
that market participants may incur to identify, track, and coordinate
activities involving security-based swaps and related reference
underlying entities held by the organization.
Several commenters were concerned that re-proposed Rule 9j-1's
liability standards are vague and that such vagueness would foster
significant uncertainty among security-based swap market participants,
resulting in reduced market participation, liquidity, capital
formation, and investor choice.\327\ In response to these concerns, the
Commission clarifies the liability standards of Rule 9j-1 in section II
of this release. Specifically, the liability standards in the rule
follow the well-settled standards in section 10(b) of the Exchange Act,
and Rule 10b-5 thereunder, section 17(a) of the Securities Act, and
applicable case law. The Commission also explains why a non-scienter-
based standard is appropriate for paragraphs (a)(3) and (a)(4) of final
Rule 9j-1 and is consistent with sections 17(a)(2) and (3) of the
Securities Act, on which they are based.
---------------------------------------------------------------------------

\327\ See IACPM Letter at 4-5; IIB-ISDA-SIFMA Letter at 1-3, 5,
13-14; LSTA Letter at 3, 5, 7; Milbank Letter at 1-5, 7, 9-10; July
2022 MFA Letter at 1, 6, 7.
---------------------------------------------------------------------------

Where commenters noted a discrepancy in the Commission's proposed
rule and the legal standard for certain attempted offenses, the
Commission revised the rule to conform to the legal standard in new
Rule 9j-1(a)(5). These revisions should address any uncertainty that
security-based swap market participants may have regarding the rule's
liability standards. In addition, the Commission is adopting Rule 9j-
1(e), which includes two affirmative defenses for violations of the
provisions in paragraphs (a)(1) through (a)(5) of Rule 9j-1.\328\ The
final rule conforms the affirmative defenses in Rule 9j-1(e) to those
in existing Rule 10b5-1(c). The revisions regarding the liability
standards of Rule 9j-1 coupled with the affirmative defenses of Rule
9j-1(e) should mitigate any potential adverse effects on market
participation, liquidity, capital formation, and investor choice.
Moreover, by reducing the risk of fraudulent and manipulative activity
in the security-based swap market, Rule 9j-1 would increase market
participation, liquidity, capital formation, and investor choice
thereby further mitigating the potential adverse effects that
commenters identified.\329\
---------------------------------------------------------------------------

\328\ See final Rule 9j-1(e).
\329\ See supra section V.D.1.
---------------------------------------------------------------------------

One commenter was concerned that the inclusion of interim actions
in the performance of contractual obligations within the scope of re-
proposed Rule 9j-1 will discourage market participants from transacting
in security-based swaps, reduce liquidity in the security-based swap
markets, increase the cost of capital, and reduce the availability of
capital.\330\ The Commission does not believe the final rule will
adversely affect market participation, liquidity, cost of capital, and
availability of capital in the manner described by the commenter. Final
Rule 9j-1 applies to fraudulent, deceptive, or manipulative

[[Page 42579]]

misconduct related to the exercise of any right or performance of any
obligation under a security-based swap if such misconduct occurs in
connection with effecting or attempting to effect a transaction in, or
purchasing or selling, or inducing or attempting to induce the purchase
or sale of, a security-based swap. Moreover, the rule addresses actions
taken outside the ordinary course of a typical lender-borrower
relationship (or a prospective lender-borrower relationship).
Accordingly, by reducing the risk of fraudulent and manipulative
activity in the security-based swap market, Rule 9j-1 will increase
liquidity in the markets for security-based swaps and underlying cash
instruments, and lower capital costs and increase capital formation for
reference underlying entities.\331\
---------------------------------------------------------------------------

\330\ MFA Letter at 2, 8-9.
\331\ See supra section V.D.1.
---------------------------------------------------------------------------

Some commenters were concerned that the Commission's choice of a
negligence standard for re-proposed Rules 9j-1(a)(3) and (4), coupled
with the omission of Rule 10b5-1(c)(2) affirmative defenses, would
discourage market participants from entering into security-based swaps
and would, as a result, reduce liquidity in security-based swap
markets, exacerbate risks for market participants, and increase
issuers' cost of capital. These commenters were concerned that lenders
may also reduce their lending activities, which would reduce financing
to private companies.\332\ In response to comments received on the 2021
Proposing Release, paragraphs (a)(3) and (a)(4) of new Rule 9j-1
describe conduct for which a non-scienter based standard would apply,
while paragraph (a)(5) of new Rule 9j-1 describes attempts of that
conduct for which scienter is the proper standard. In addition, Rule
9j-1(e)(2) provides for an affirmative defense that is modeled on the
affirmative defense in Rule 10b5-1(c)(2). These changes from re-
proposed Rule 9j-1 should address the commenters' concerns and mitigate
any potential adverse effects on liquidity, risks, cost of capital, and
financing to private companies.
---------------------------------------------------------------------------

\332\ See ACLI Letter at 5-6; MFA Letter at 2, 13-16.
---------------------------------------------------------------------------

Some commenters stated that proposed Rule 9j-1(b) would create
uncertainty and implicate a wide range of innocuous and ordinary course
activities that are essential to markets in both security-based swaps
and underlying cash instruments. The commenters stated that this would
materially increase compliance costs for security-based swap market
participants, reduce participation in security-based swap and
securities markets, reduce lending activity and capital formation, and
raise issuers' cost of capital.\333\ As discussed above, final Rule 9j-
1(a)(6), as revised from proposed Rule 9j-1(b), will apply to conduct
undertaken in connection with effecting or attempting to effect a
transaction in any security-based swap, and to purchasing or selling,
or inducing or attempting to induce the purchase or sale of, any
security-based swap (including but not limited to, in whole or in part,
the execution, termination (prior to its scheduled maturity date),
assignment, exchange, or similar transfer or conveyance of, or
extinguishing of any rights or obligations under, a security based-
swap). Rule 9j-1(a)(6) also prohibits the manipulation (or attempted
manipulation) of the valuation of any security-based swap, or any
payment or delivery related thereto, to the extent such misconduct is
in connection with effecting or attempting to effect a transaction in,
or purchasing or selling, or inducing or attempting to induce the
purchase or sale of, any security-based swap. The final rule strikes an
appropriate balance between preventing manipulation and attempted
manipulation in the security-based swap market and addressing
commenters' concern. A narrowing in the scope of final Rule 9j-1(a)(6)
would create a gap in the prohibition against manipulation and
attempted manipulation in the security-based swap market and reduce the
benefits of the rule.
---------------------------------------------------------------------------

\333\ See MFA Letter at 16-19; Milbank Letter at 9-10.
---------------------------------------------------------------------------

A determination as to whether a person has violated final Rule 9j-
1(a)(6) will depend on the facts and circumstances of each particular
situation. Further, a scienter standard will be used to determine
whether conduct is in violation of the rule. With respect to the loan
market, final Rule 9j-1(a)(6) applies to actions taken outside the
ordinary course of a typical lender-borrower relationship, such as an
action taken for the purposes of avoiding or causing, or increasing or
decreasing, a payment under a security-based swap in a manner that
would not have occurred but for such actions, or when an action appears
to be designed almost exclusively to harm counterparties, and is not
intended to discourage lenders from discussing or providing financing
or relief to avoid default. To be clear, Rule 9j-1(a)(6) will require
that security-based swap market participants take care that their
legitimate market activities remain within the scope of the typical
lender-borrower relationship and do not cross the line into prohibited
manipulation. The foregoing discussion should help address concerns
related to uncertainty that the rule may create and the proposed rule's
scope.
However, to the extent that market participants continue to have
such concerns, final Rule 9j-1(a)(6) could increase compliance costs,
reduce market participation, reduce lending activity and capital
formation, and raise issuers' cost of capital. That said, by reducing
the risk of fraudulent and manipulative activity in the security-based
swap market, Rule 9j-1 would increase market participation, increase
lending activity and capital formation, and lower issuers' cost of
capital thereby mitigating the potential adverse effects that
commenters identified. Further, to the degree that Rule 9j-1 provides
additional precision and specificity regarding the application of
existing antifraud and anti-manipulation laws to misconduct in the
security-based swap market, some market participants may need to spend
fewer resources determining appropriate compliance under section 9(j)
of the Exchange Act and reduce their compliance costs.\334\
---------------------------------------------------------------------------

\334\ See supra section V.D.1.
---------------------------------------------------------------------------

E. Benefits and Costs of Rule 15fh-4(c)

1. Benefits
Rule 15fh-4(c) makes it unlawful for any officer, director,
supervised person, or employee of an SBS Entity, or any person acting
under such person's direction, to take, directly or indirectly, any
action to coerce, mislead, or otherwise interfere with the SBS Entity's
CCO. This prohibition would support the ability of the CCO to meet the
CCO's important obligations to foster compliance in its role of
overseeing compliance within the SBS Entity. Rule 15fh-4(c) will make
it more likely that a CCO is able to more efficiently and effectively
execute the CCO's responsibilities to foster compliance, including for
example, by ensuring that the SBS Entity maintains and reviews written
policies and procedures reasonably designed to achieve compliance with
the rules and regulations relating to the business of the SBS Entity.
Ultimately, these effects will likely also reduce the risk of fraud,
market manipulation, or other fraudulent activities in the security-
based swap market, providing additional protection for both
counterparties in the security-based swap transaction and the
underlying entity.

[[Page 42580]]

Rule 15fh-4(c) will encourage officers, directors, supervised
persons, and employees of SBS Entities to exercise reasonable attention
and care in their dealings with CCOs, as discussed in section III.B. To
the extent that such exercise of reasonable attention and care
increases the quantity and quality of information exchanged between
CCOs, officers, directors, supervised persons, and employees of SBS
Entities, CCOs may more efficiently and effectively foster compliance
in SBS Entities. Any resulting improvement in compliance in turn could
reduce the risk of fraud, market manipulation, or other fraudulent
activities in the security-based swap market. More broadly, improved
communication between CCOs, officers, directors, supervised persons,
and employees of SBS Entities also could facilitate decision making
within the SBS Entities.
Rule 15fh-4(c) would likely have minor indirect positive impacts on
competition, price efficiency, and capital formation, as discussed in
section V.F.
Comments Received
Two commenters believed that proposed Rule 15Fh-4(c) would deter
the types of actions that prevent CCOs from performing their duties and
that deterring such actions would in turn help protect the CCOs'
independence and objectivity in the fulfillment of their duties.\335\
The Commission agrees with the commenters that Rule 15fh-4(c)'s benefit
could derive in part from deterring actions that are prohibited by the
rule.
---------------------------------------------------------------------------

\335\ See Better Markets Letter at 14; NYC Bar Letter at 4-5.
---------------------------------------------------------------------------

2. Costs
Rule 15fh-4(c)'s prohibition on taking actions to coerce, mislead,
or otherwise interfere with the SBS Entity's CCO, may create additional
costs for SBS Entities. For example, to the extent that any current
practices of an SBS Entity include activities that are explicitly
prohibited under Rule 15fh-4(c), applicable policies and procedures
will need to be updated. In addition, it is possible that the rule
could cause officers, directors, supervised persons, or employees of an
SBS Entity to be overly cautious when consulting with a CCO. The
Commission does not, however, believe that any such effects will be
significant, given the specificity of the rule's prohibition on certain
interferences with the SBS Entity's CCO.
Comments Received
One commenter was concerned that the scope of the proposed rule is
unclear and could lead to confusion and uncertainty as to what
communications between the CCO and the officers, directors, supervised
persons, and employees of the SBS Entity might violate the rule. The
commenter states that such confusion and uncertainty could have a
chilling effect on dialog about compliance, budget, and resource
matters, which, by implication, could impede decision making within the
SBS Entity.\336\ In response to this comment, the Commission has
clarified the scope of final Rule 15fh-4(c) in section III.B. Further,
the Commission clarified that the acts to ``coerce, manipulate, mislead
or fraudulently influence'' that would be prohibited by Rule 15fh-4(c)
imply compelling the CCO to act in a certain way through pressure,
threats, trickery, intimidation, misrepresentation, or some other form
of purposeful action not limited to untrue statements or omissions of
material facts. As discussed in section V.E.1, to the extent that the
rule encourages officers, directors, supervised persons, and employees
of SBS Entities to exercise reasonable attention and care in their
dealings with CCOs, communication and decision making could improve
within the SBS Entities and mitigate any potential adverse impact on
decision making suggested by the commenter.
---------------------------------------------------------------------------

\336\ IIB-ISDA-SIFMA CCO Letter at 1-2.
---------------------------------------------------------------------------

F. Effects on Efficiency, Competition, and Capital Formation

The final rules would likely affect capital formation, competition,
and efficiency in various ways, as discussed below.
1. Competition
As discussed earlier, by reducing the risk of fraud, Rule 9j-1
could encourage participation in the market, which may result in
increased competition in the security-based swap market.\337\
---------------------------------------------------------------------------

\337\ See supra section V.D.1.
---------------------------------------------------------------------------

Rule 15fh-4(c) would likely have a minor indirect positive impact
on competition in the security-based swap market. Because Rule 15fh-
4(c) would support the ability of the CCO to oversee compliance with
the Federal securities laws within the SBS Entity and likely reduce the
risk of fraud, security-based swaps would more likely reflect the
fundamental credit risk of the underlying entity. This in turn could
encourage greater participation in the security-based swap market and
therefore, increase competition among the market participants.
2. Efficiency
By decreasing the risk of fraud and preventing price manipulation
in the security-based swap market, Rule 9j-1 may increase price
efficiency. This would consequently lead to greater security-based swap
market efficiency, as security-based swap prices would provide greater
confidence that their prices more likely reflect fundamental values and
risk in more liquid markets.\338\
---------------------------------------------------------------------------

\338\ Id.
---------------------------------------------------------------------------

Rule 15fh-4(c) would likely have a minor indirect positive impact
on price efficiency. To the extent that the rule increases
participation in the security-based swap market as discussed in section
V.F.1, price efficiency may increase because increased trading by
market participants could incorporate more information into security-
based swap prices.
3. Capital Formation
Final Rule 9j-1 likely would have a positive impact on capital
formation. As discussed earlier, greater activity in the underlying
security market due to increased price efficiency and greater
availability to hedge these securities in the security-based swap
market could lead to lower capital costs and increase capital formation
for the underlying entities. Increased participation and price
efficiency in the security-based swap market as a result of Rule 9j-1
could encourage lenders to make greater use of security-based swaps for
hedging their loans, which in turn could increase lending activity and
capital formation.\339\ To the extent that the rule lowers litigation
costs and compliance costs for market participants and underlying
entities, these market participants and entities could in turn use the
resources that are freed up to invest in projects.
---------------------------------------------------------------------------

\339\ Id.
---------------------------------------------------------------------------

As discussed in section V.D.2, a number of commenters were
concerned that re-proposed Rule 9j-1's compliance costs, scope, and
liability standards would reduce capital formation (including financing
to private companies) and increase the cost of capital, among other
potential effects. As discussed in that section, compliance costs could
be limited by existing practices and systems that are in place to
comply with section 9(j) and the other antifraud and anti-manipulation
provisions; that the rule's use of clear, consistent, and familiar
liability standards reduces uncertainty; and that the rule's beneficial
effects on capital formation and the cost of capital

[[Page 42581]]

would mitigate any potential adverse effects that commenters
identified.
Rule 15fh-4(c) would likely have a minor indirect positive impact
on capital formation. To the extent that the rule increases price
efficiency and competition in the security-based swap market, as
discussed in sections V.F.1 and V.F.2, capital formation could, as a
result, further indirectly increase, as greater price efficiency and
competition among market participants could lead to a decrease in
security-based swaps prices, and in turn, lower costs of borrowing (as
a result of lowering the cost of CDS).

G. Reasonable Alternatives

The Commission considered a number of alternatives when finalizing
Rules 9j-1 and 15fh-4(c).
1. Narrow the Scope of Rule 9j-1
Commenters recommended narrowing the scope of re-proposed Rule 9j-1
in various ways: (1) exclude valuation, payment, and delivery from the
scope of proposed Rule 9j-1(b); \340\ (2) exclude certain credit market
conduct from the scope of proposed Rule 9j-1(b); \341\ and (3) exclude
security-based swaps referencing sovereign debt from the scope of re-
proposed Rule 9j-1.\342\
---------------------------------------------------------------------------

\340\ Milbank Letter at 5.
\341\ See IACPM Letter at 4; IIB-ISDA-SIFMA Letter at 18-19;
Milbank Letter at 4-5.
\342\ ACLI Letter at 3, 13-14.
---------------------------------------------------------------------------

The Commission has considered these alternatives but determined
that the adopted approach is preferable to them. With respect to the
exclusion of valuation, payment, and delivery from the scope of
proposed Rule 9j-1(b), the Commission declines to adopt this
alternative. The Commission is concerned that the alternative would
create a gap in the prohibition against the manipulation and attempted
manipulation of prices in the security-based swap market and reduce the
benefits of final Rule 9j-1(a)(6), as revised from proposed Rule 9j-
1(b). The exclusion of valuation, payment, and delivery from the scope
of final Rule 9j-1(a)(6) could increase the occurrence of manipulation
and attempted manipulation of security-based swap prices in connection
with such activities.
With respect to the exclusion of certain credit market conduct, the
Commission believes it cannot specify all possible types of misconduct
that may prevail in the future. Hence, provisions designed to exclude
certain legitimate credit market conduct could unintentionally apply to
activities that final Rule 9j-1(a)(6), as revised from proposed Rule
9j-1(b), is designed to prohibit, reducing the benefits of the rule.
Further, an exclusion of certain credit market conduct would need to be
balanced against the risk that market participants undertake
transactions for which their counterparties should have the protections
of final Rule 9j-1(a)(6). In addition, as discussed in section II.C.2,
the fact that the Commission intends to apply a scienter standard in
connection with final Rule 9j-1(a)(6), and that the rule does not
impose liability for actions taken in the ordinary course of a typical
lender-borrower relationship (or a prospective lender-borrower
relationship), should help mitigate concerns regarding any ``chilling
effects'' of the rule.
With respect to the exclusion of sovereign debt security-based
swaps, as a general matter, the Commission does not see a compelling
reason to treat security-based swaps referencing sovereign underliers
differently than security-based swaps referencing other underliers. As
discussed in section II.E.2.d, while security-based swaps related to
sovereign debt may have lesser opportunity for manufactured credit
events or opportunistic strategies by regulated and non-regulated
market participants alike, such instruments are not without risk of
fraudulent and manipulative conduct and should remain within the scope
of Rule 9j-1.\343\ Further, the Commission is concerned that the
alternative would create a gap in the prohibition against fraudulent
and manipulative activity in the security-based swap market. Even if,
as the commenter asserted, manufactured credit events related to a
country's sovereign debt are unlikely, other types of fraudulent and
manipulative activities could be perpetrated in connection with
sovereign debt security-based swaps.\344\ The alternative would not
prohibit these activities and could increase their occurrence. In light
of the above, the adopted approach is preferable to this alternative.
---------------------------------------------------------------------------

\343\ See supra note 244 and related discussion.
\344\ See ACLI Letter at 13 (stating that it seems unlikely that
any holders of security-based swaps on sovereign debt would possess
the leverage necessary to manufacture credit events related to a
country's sovereign debt).
---------------------------------------------------------------------------

2. Safe Harbors
Commenters suggested that the Commission add various safe harbors
to Rule 9j-1. The Commission discusses these alternatives below.
a. Safe Harbor for Hedging Exposure Arising Out of Lending Activities
One commenter urged the Commission to consider creating a safe
harbor to re-proposed Rule 9j-1 for entering into security-based swap
transactions for purposes of hedging some or all exposure arising out
of lending activities with a reference entity or the syndication of
such lending activities.\345\ Such a safe harbor could minimize the
effects of the rule on risk-reducing hedging activity, which is one of
the central purposes of CDS contracts and which provides important
benefits to the lending market. Identifying legitimate, risk-reducing
hedging activity--undertaken with the intent of covering potential
losses in a position--and distinguishing such activity from other types
of speculative transactions would likely be difficult. Hence, even a
safe harbor designed to apply solely to legitimate hedging transactions
could unintentionally apply to activities that Rule 9j-1 is designed to
prohibit, reducing the benefits of the rule. Further, such a safe
harbor would need to be balanced against the risk that market
participants undertake transactions for which their counterparties
should have the protections of Rule 9j-1, including in circumstances
involving potentially opportunistic trading strategies. In light of the
above, the adopted approach is preferable to this alternative.
---------------------------------------------------------------------------

\345\ LSTA Letter at 8.
---------------------------------------------------------------------------

b. Safe Harbors for Lender Disclosure, Centralized Market Activities,
and Legitimate Restructurings
One commenter urged the Commission to consider allowing the lender
to avoid liability under re-proposed Rule 9j-1 by disclosing to the
counterparty that it is a lender to the borrower and may have material
nonpublic information from the borrower.\346\ Another commenter urged
the Commission to provide safe harbors for certain centralized market
activities: (1) multilateral amendment exercises (including ISDA
protocols) or bilateral equivalents; and (2) participation in
determination committees in accordance with the determination
committees' rules and any applicable codes of conduct.\347\ A third
commenter suggested that the Commission provide a safe harbor or
exception for legitimate restructurings to avoid limiting the supply of
funds to issuers during a restructuring.\348\ The affirmative defenses
in Rule 9j-1(e) will serve the same purpose as these alternatives by
permitting persons to enter into certain types of activity, pursuant to
the requirements of the affirmative

[[Page 42582]]

defenses, while also addressing concerns about fraud and manipulation
for the entire security-based swap market. With respect to the
suggested safe harbor for legitimate restructurings, identifying
legitimate restructurings and distinguishing such activities from other
types of speculative transactions would likely be difficult. Hence,
even a safe harbor designed to apply solely to legitimate
restructurings could unintentionally apply to activities that Rule 9j-1
is designed to prohibit, reducing the benefits of the rule. Further,
such a safe harbor would need to be balanced against the risk that
market participants undertake transactions for which their
counterparties should have the protections of Rule 9j-1, including in
circumstances involving potentially opportunistic trading strategies.
Accordingly, the adopted approach is preferable to these alternatives.
---------------------------------------------------------------------------

\346\ Id. at 9.
\347\ IIB-ISDA-SIFMA Letter at 11-12.
\348\ Fletcher Letter at 4.
---------------------------------------------------------------------------

c. Safe Harbor for Publicly Executed Strategies
One commenter requested a safe harbor from liability under proposed
Rule 9j-1(b) for publicly executed strategies, where multiple parties
or an independent body (such as a court or regulator) are involved. The
commenter distinguished publicly executed strategies from privately
executed strategies, such as a single market participant entering into
an agreement with a reference entity. The commenter argued that
publicly executed strategies are more difficult for a single
participant to manipulate than privately executed strategies because
publicly executed strategies are driven by the incentives of a broader
group of participants than privately executed strategies.\349\ The
Commission declines to adopt this alternative. While publicly executed
strategies may be difficult for a single participant to manipulate as
the commenter argued, it is not clear that such strategies would remain
difficult to manipulate when a group of market participants are acting
in concert to manipulate such strategies. The Commission is concerned
that providing a safe harbor for publicly executed strategies would
encourage manipulative activity involving a coalition of market
participants. That said, the Commission appreciates that there are
legitimate publicly executed strategies that are not involved in
manipulative activity. In section II.C.2, the Commission discusses at
length the application of final Rule 9j-1(a)(6) and believes the
discussion should alleviate concerns that legitimate publicly executed
strategies may violate the rule.
---------------------------------------------------------------------------

\349\ IIB-ISDA-SIFMA Letter at 17.
---------------------------------------------------------------------------

d. Elimination of All Safe Harbors and Affirmative Defenses
Four commenters urged for the elimination of all safe harbors and
affirmative defenses from proposed Rule 9j-1(a) liability.\350\ The
adopted approach, which among other things, provides two affirmative
defenses in final Rule 9j-1(e), is preferable to the alternative. As
discussed in section V.D.2, the two affirmative defenses will help
mitigate various adverse effects (e.g., reduced market participation)
that certain commenters believed may arise as a result of Rule 9j-1.
Final Rule 9j-1(e)(2) will help mitigate the cost and effort that
market participants may incur to identify, track, and coordinate
activities involving security-based swaps and related reference
underlying entities held by the organization. At the same time, the
costs that market participants may incur in connection with these
affirmative defenses likely would be very limited.\351\
---------------------------------------------------------------------------

\350\ Better Markets Letter at 2, 9-12; Anonymous Penguin
Comments at 1; J.T. Comments at 1; Michael Comments at 1.
\351\ See supra section V.D.2.
---------------------------------------------------------------------------

3. Implementing a More Prescriptive Approach in Rule 9j-1
One commenter urged the Commission to consider the alternative
approach of identifying and prohibiting within Rule 9j-1 specific types
of events (for example, market behavior around certain events and fact
patterns) and opportunistic trading behavior that have been observed.
According to the commenter, this alternative approach could provide
even more certainty and precision with respect to the particular types
of activities that are prohibited in the security-based swap market.
The commenter believed that the greater certainty of outcome with
respect to Rule 9j-1 would benefit lenders when they need to exercise
rights or remedies under a loan or credit agreement.\352\ However, this
approach could lead to greater uncertainty with respect to
circumstances not explicitly contemplated in the rule, which could
increase litigation costs for market participants involved in such
transactions. This approach may also decrease the integrity of the
market for security-based swaps, and in addition, could cause market
participants to bear greater compliance costs in connection with the
evaluation of circumstances not explicitly contemplated in the rule. As
a result, the more prescriptive alternative approach would have limited
benefits and greater costs as compared to the adopted approach in the
market for security-based swaps, as well as the market for the
reference underlying of such security-based swaps.
---------------------------------------------------------------------------

\352\ LSTA Letter at 7.
---------------------------------------------------------------------------

The Commission acknowledges the commenter's concern that not
adopting the more prescriptive alternative approach could prevent
lenders or security-based swap participants from exercising legitimate
rights and remedies and impose costs that would be greater than those
discussed in the 2021 Proposing Release in connection with re-proposed
Rule 9j-1.\353\ Final Rule 9j-1 would enable lenders or security-based
swap participants to exercise legitimate rights and remedies, thereby
addressing the commenter's concern. In particular, paragraphs (a)(3)
and (a)(4) of final Rule 9j-1 describe conduct for which a non-scienter
based standard would apply, while paragraph (a)(5) of final Rule 9j-1
describes attempted aspects of that conduct for which scienter is the
proper standard. In addition, final Rule 9j-1(e) provides for
affirmative defenses similar to the affirmative defenses in Rule 10b5-
1(c). The clarification regarding the liability standards of Rule 9j-1
coupled with the affirmative defenses of Rule 9j-1(e) should mitigate
any potential adverse effects on market participation, liquidity,
capital formation, and investor choice. Moreover, by reducing the risk
of fraudulent and manipulative activity in the security-based swap
market, Rule 9j-1 would increase market participation, liquidity,
capital formation, and investor choice thereby further mitigating the
potential adverse effects that commenters identified.
---------------------------------------------------------------------------

\353\ Id.
---------------------------------------------------------------------------

4. Separate Rules for CDS and Equity Security-Based Swaps
One commenter asserted that opportunistic strategies work best with
CDS and that equity SBS are less susceptible to such strategies. The
commenter suggested that the Commission propose separate rules for each
type of instrument.\354\ The Commission has considered the commenter's
suggested alternative, but believes that the adopted approach is
preferable to the alternative. The aim of Rule 9j-1 is to address fraud
and manipulation in the security-based swap market and is not limited
to addressing fraud and manipulation in connection with certain
opportunistic strategies that historically have been implemented with
CDS. As discussed in section II, fraudulent and manipulative

[[Page 42583]]

conduct has the potential to harm counterparties to all forms of
security-based swaps, including CDS, equity security-based swaps, and
non-CDS debt security-based swaps. Rule 9j-1 is appropriately tailored
to address fraud and manipulation for the entire security-based swap
market. As such the Commission does not see the need to adopt separate
rules for CDS and equity security-based swaps.
---------------------------------------------------------------------------

\354\ Fletcher Letter at 4.
---------------------------------------------------------------------------

5. Exclude Underlying Securities
One commenter urged the Commission to modify re-proposed Rule 9j-1
by providing that its prohibitions do not extend to the purchase or
sale of underlying securities.\355\ The Commission declines to adopt
this alternative. Because security-based swaps by their nature are tied
intrinsically to activity in other securities markets, persons that
intend to perpetrate fraudulent or manipulative activity with respect
to a security-based swap may choose to do so by purchasing or selling
the underlying security. The alternative would create a gap in the
prohibition against fraudulent and manipulative activity in connection
with security-based swaps and increase the risk of such activity to the
detriment of investors. In contrast, final Rule 9j-1(c) is designed so
that a person cannot escape liability under section 9(j) of the
Exchange Act or Rule 9j-1(a) with respect to a security-based swap by
limiting all of its actions to purchases or sales of the security or
narrow-based security index underlying that security-based swap.
---------------------------------------------------------------------------

\355\ MFA Letter at 2, 8-9.
---------------------------------------------------------------------------

6. Limit Activities Prohibited Under Rule 15fh-4(c)
One commenter suggested that final Rule 15fh-4(c) should limit the
prohibited interference to knowingly making untrue statements or
omitting material facts.\356\ As discussed in section III.B, Rule 15fh-
4(c) protects the independence and objectivity of an SBS Entity's CCO
by prohibiting undue influence by other personnel. Such influence could
take many forms and is not limited to material misstatements or
omissions. The Commission is concerned that limiting prohibited
activities to material misstatements and omissions, as suggested by the
commenter, would fail to adequately protect the CCO from undue
influence and consequently reduce the rule's benefit. As discussed in
section V.E.1, by encouraging officers, directors, supervised persons,
and employees of SBS Entities to exercise reasonable attention and care
in their dealings with CCOs, final Rule 15fh-4(c) would foster
compliance in SBS Entities, reduce the risk of fraudulent and
manipulative conduct, and facilitate decision making in SBS Entities.
The suggested alternative, by its limited nature, may be less likely to
encourage such exercise of reasonable attention and care in dealings
with CCOs. Accordingly, the adopted approach is preferable to the
alternative.
---------------------------------------------------------------------------

\356\ ISDA-IIB-SIFMA CCO Letter at 2.
---------------------------------------------------------------------------

VI. Regulatory Flexibility Act Certification

The Regulatory Flexibility Act (``RFA'') \357\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) of the Administrative Procedure
Act,\358\ as amended by the RFA, generally requires the Commission to
undertake a regulatory flexibility analysis of all proposed rules, or
proposed rule amendments, to determine the impact of such rulemaking on
``small entities.'' \359\ Section 605(b) of the RFA states that this
requirement shall not apply to any proposed rule or proposed rule
amendment which, if adopted, would not have a significant economic
impact on a substantial number of small entities.\360\ The Commission
certified in the 2021 Proposing Release that new Rules 9j-1 and 15fh-
4(c) would not have a significant economic impact on any ``small
entity'' for purposes of the RFA.\361\ The Commission received no
comments on its certification.
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\357\ 5 U.S.C. 601 et seq.
\358\ 5 U.S.C. 603(a).
\359\ Although section 601(b) of the RFA defines the term
``small entity,'' the statute permits agencies to formulate their
own definitions. The Commission has adopted definitions for the term
``small entity'' for the purposes of Commission rulemaking in
accordance with the RFA. Those definitions, as relevant to this
rulemaking, are set forth in 17 CFR 240.0-10 (``Rule 0-10'') under
the Exchange Act. See Final Definitions of ``Small Business'' and
``Small Organization'' for Purposes of the Regulatory Flexibility
Act, Exchange Act Release No. 18452 (Jan. 28, 1982), 47 FR 5215
(Feb. 4, 1982) (File No. S7-879).
\360\ See 5 U.S.C. 605(b).
\361\ See 2021 Proposing Release, 87 FR at 6702-03.
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For purposes of Commission rulemaking in connection with the RFA, a
small entity includes: (1) when used with reference to an ``issuer'' or
a ``person,'' other than an investment company, an ``issuer'' or
``person'' that, on the last day of its most recent fiscal year, had
total assets of $5 million or less; \362\ or (2) a broker-dealer with
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared pursuant to 17 CFR 240.17a-5(d)
under the Exchange Act,\363\ or, if not required to file such
statements, a broker-dealer with total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last business
day of the preceding fiscal year (or in the time that it has been in
business, if shorter); and is not affiliated with any person (other
than a natural person) that is not a small business or small
organization.\364\
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\362\ See 17 CFR 240.0-10(a).
\363\ 17 CFR 240.17a-5(d).
\364\ See 17 CFR 240.0-10(c).
---------------------------------------------------------------------------

Based on available information about the security-based swap
market, the market, while broad in scope, is largely dominated by
entities such as those that will be covered by the SBSD and MSBSP
definitions. Based on feedback from industry participants about the
security-based swap market, the Commission continues to believe that:
(1) the types of entities that are and will continue to register with
the Commission as SBSDs (i.e., because they engage in more than a de
minimis amount of dealing activity involving security-based swaps)--
which generally would be large financial institutions--would not be
``small entities'' for purposes of the RFA; and (2) the types of
entities that may have security-based swap positions above the level
required to register as MSBSPs would not be ``small entities'' for
purposes of the RFA.
Although Rule 15fh-4(c) applies only to SBS Entities, Rule 9j-1 is
not on its face limited to SBS Entities. However, while it is possible
that other parties may engage in security-based swap transactions, the
Commission does not believe that any such entities would be ``small
entities'' as defined in Exchange Act Rule 0-10.\365\ Feedback from
industry participants about the security-based swap market indicates
that only persons or entities with assets significantly in excess of $5
million (or with annual receipts significantly in excess of $7 million)
participate in the security-based swap market. With respect to Rule 9j-
1, even to the extent that a small number of transactions did have a
counterparty that was defined as a ``small entity'' under Rule 0-10,
the Commission believes it unlikely that the rule would have a
significant economic impact on such entities, as the rule prohibits
fraudulent and manipulative acts, activities which are in most cases
already prohibited.
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\365\ See 17 CFR 240.0-10(a).
---------------------------------------------------------------------------

For the foregoing reasons, the Commission certifies that Rules 9j-1
and 15fh-4(c) will not have a significant

[[Page 42584]]

economic impact on a substantial number of small entities for purposes
of the RFA.

VII. Other Matters

Pursuant to the Congressional Review Act,\366\ the Office of
Information and Regulatory Affairs has designated these rules as not a
``major rule,'' as defined by 5 U.S.C. 804(2).
---------------------------------------------------------------------------

\366\ 5 U.S.C. 801 et seq.
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If any of the provisions of these final rules, or the application
thereof to any person or circumstance, is held to be invalid, such
invalidity shall not affect other provisions or application of such
provisions to other persons or circumstances that can be given effect
without the invalid provision or application.

Statutory Authority

The Commission is adopting the new rules and rule amendment
contained in this release under the authority set forth in the Exchange
Act, 15 U.S.C. 78a et seq., as amended, and, particularly sections 2,
3(b), 9(i), 9(j), 10, 15, 15F, and 23(a) thereof (15 U.S.C. 78b,
78c(b), 78i(i), 78i(j), 78j, 78o, 78o-10, and 78w(a)).

List of Subjects in 17 CFR Part 240

Administrative practice and procedure, Brokers, Confidential
business information, Fraud, Reporting and recordkeeping requirements,
Securities, Swaps.

Text of the Final Rule

For the reasons set forth in the preamble, title 17, chapter II of
the Code of Federal Regulations is amended as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934

0
1. The general authority citation for part 240 continues to read, and
the sectional authority for Sec. 240.15fh-1 is revised to read, as
follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78j-4, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o,
78o-4, 78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78dd, 78ll,
78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, and 7201
et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18
U.S.C. 1350; Pub. L. 111-203, 939A, 124 Stat. 1376 (2010); and Pub.
L. 112-106, sec. 503 and 602, 126 Stat. 326 (2012), unless otherwise
noted.

Sections 240.15fh-1 through 240.15Fh-6 and 240.15Fk-1 are also
issued under sec. 943, Pub. L. 111-203, 124 Stat. 1376.
* * * * *

Sec. Sec. 240.10a-1 and 240.10a-2 [Amended]

0
2. Move reserved Sec. Sec. 240.10a-1 and 240.10a-2 from undesignated
center heading ``Hypothecation of Customers' Securities'' to
undesignated center heading ``Manipulative and Deceptive Devices and
Contrivances'' in numerical order.

0
3. Add Sec. 240.9j-1 under the undesignated center heading
``Manipulative and Deceptive Devices and Contrivances'' to read as
follows:

Sec. 240.9j-1 Prohibition against fraud, manipulation, or deception
in connection with security-based swaps.

(a) It shall be unlawful for any person, directly or indirectly, to
effect any transaction in, or attempt to effect any transaction in, any
security-based swap, or to purchase or sell, or induce or attempt to
induce the purchase or sale of, any security-based swap (including but
not limited to, in whole or in part, the execution, termination (prior
to its scheduled maturity date), assignment, exchange, or similar
transfer or conveyance of, or extinguishing of any rights or
obligations under, a security based-swap, as the context may require),
in connection with which such person:
(1) Employs or attempts to employ any device, scheme, or artifice
to defraud or manipulate;
(2) Makes or attempts to make any untrue statement of a material
fact, or omits 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;
(3) Obtains 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;
(4) Engages in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person;
(5) Attempts 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, or attempts
to engage in any act, practice, or course of business which operates or
would operate as a fraud or deceit upon any person; or
(6) Manipulates or attempts to manipulate the price or valuation of
any security-based swap, or any payment or delivery related thereto.
(b) Wherever communicating, or purchasing or selling a security
(other than a security-based swap) while in possession of material
nonpublic information would violate, or result in liability to any
purchaser or seller of the security under, either the Act or the
Securities Act of 1933, or any rule or regulation thereunder, such
conduct in connection with a purchase or sale of a security-based swap
with respect to such security or with respect to a group or index of
securities including such security shall also violate, and result in
comparable liability to any purchaser or seller of that security under,
such provision, rule, or regulation.
(c) Wherever taking any of the actions set forth in paragraph (a)
of this section involving a security-based swap would violate, or
result in liability under, Section 9(j) of the Act or this section,
such conduct, when taken by a counterparty to such security-based swap
(or any affiliate of, or a person acting in concert with, such
security-based swap counterparty in furtherance of such prohibited
activity), in connection with a purchase or sale of a security, loan,
or group or index of securities on which such security-based swap is
based, shall also violate, and shall be deemed a violation of, section
9(j) of the Act or paragraph (a) of this section.
(d) For purposes of this section, the terms ``purchase'' and
``sale'' shall have the same meanings as set forth in Sections 3(a)(13)
(15 U.S.C. 78c(a)(13)) and 3(a)(14) (15 U.S.C. 78c(a)(14)) of the Act.
(e) A person shall not be liable under paragraphs (a)(1) through
(a)(5) of this section solely for being aware of material nonpublic
information while taking the following actions:
(1) Actions taken by a person in accordance with binding
contractual rights and obligations under a security-based swap (as
reflected in the written documentation governing such security-based
swap or any amendment thereto) so long as the person demonstrates that:
(i) The security-based swap was entered into, or the amendment was
made, before the person became aware of such material nonpublic
information, and
(ii) The security-based swap was entered into in good faith and not
as part of a plan or scheme to evade the prohibitions of this section.
(2) Actions taken by a person other than a natural person if the
person demonstrates that:
(i) The individual making the investment decision on behalf of the
person taking the action was not aware of the material nonpublic
information, and

[[Page 42585]]

(ii) The person had implemented reasonable policies and procedures,
taking into consideration the nature of the person's business, to
ensure that individuals making investment decisions would not be in
violation of paragraphs (a)(1) through (a)(5) of this section. These
policies and procedures may include those that restrict effecting a
transaction in, or purchasing or selling, any security, including any
security-based swap, as to which the person has material nonpublic
information, or those that prevent such individuals from becoming aware
of such information.

0
4. Redesignate Sec. 240.15Fh-4 as Sec. 240.15fh-4 and amend newly
redesignated Sec. 240.15fh-4 by:
0
a. Revising the section heading; and
0
b. Adding paragraph (c).
The revisions read as follows:

Sec. 240.15fh-4 (Rule 15fh-4) Antifraud provisions for security-based
swap dealers and major security-based swap participants; special
requirements for security-based swap dealers acting as advisors to
special entities.

* * * * *
(c) No undue influence over chief compliance officer. It shall be
unlawful for any officer, director, supervised person, or employee of a
security-based swap dealer or major security-based swap participant, or
any person acting under such person's direction, to directly or
indirectly take any action to coerce, manipulate, mislead, or
fraudulently influence the security-based swap dealer's or major
security-based swap participant's chief compliance officer in the
performance of their duties under the Federal securities laws or the
rules and regulations thereunder.

By the Commission.

Dated: June 7, 2023.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2023-12592 Filed 6-29-23; 8:45 am]
BILLING CODE 8011-01-P

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