SEC Proposes New Rule to Prevent Fraud in Connection with Security-Based Swaps

The Securities and Exchange Commission has voted unanimously to propose a new rule to help prevent fraud, manipulation, and deception in connection with security-based swaps.

The rule is proposed under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which generally authorizes the SEC to regulate security-based swaps. The proposal would ensure that market conduct in connection with the offer, purchase or sale of any security-based swap is subject to the same general anti-fraud provisions that apply to all securities. And it also would explicitly reach misconduct in connection with ongoing payments and deliveries under a security-based swap.

“The proposed rule would be an important means to ensure that the security-based swap market operates with integrity, and that the SEC has the ability to respond through enforcement to a range of potentially fraudulent conduct,” said SEC Chairman Mary L. Schapiro.

The SEC’s rule proposal recognizes that security-based swaps are unlike other securities because they are typically characterized by ongoing payments or deliveries between the parties throughout the life of the swap. Therefore, it’s possible that one party may engage in misconduct to trigger, avoid, or affect the value of such ongoing payments. Such fraud may occur separately from the sale, purchase, or offering.

The proposed antifraud rule would apply not only to offers, purchases and sales of security-based swaps, but also explicitly to the cash flows, payments, deliveries, and other ongoing obligations and rights that are specific to security-based swaps. The rule would make explicit the liability of persons that engage in misconduct to trigger, avoid, or affect the value of such ongoing payments or deliveries.

Background

Jurisdiction Over Security-Based Swaps:

Title VII of the Dodd-Frank Act establishes a comprehensive framework for the regulation of the over the counter swaps markets. In particular, the Act divides regulatory authority over swaps between the CFTC and SEC.

The SEC has authority over “security-based swaps,” which are broadly defined as swaps based on a single security or loan or a narrow-based group or index of securities or events relating to a single issuer or issuers of securities in a narrow-based security index.

The CFTC has primary regulatory authority over all other swaps. The CFTC and SEC share authority over “mixed swaps,” which are security-based swaps that also have a commodity component.

Preventing Fraudulent Conduct Related to Swaps:

Under federal securities laws, the SEC has long had the authority to pursue fraud in connection with the sale, purchase and offering of securities, including security-based swaps.

But, security-based swaps, unlike many other securities, are characterized by ongoing payments and deliveries that often continue to occur after the purchase and before the subsequent sale — a time during which fraud could occur by one party or the other.

One party may seek to defraud another by avoiding the payment or by triggering a delivery that it would not otherwise be entitled to receive. Such fraud, therefore, may occur separately from the sale, purchase or offering

The Dodd-Frank Act directs the SEC to adopt rules reasonably designed to prevent fraud, manipulation, and deception in connection with transactions in and inducements and attempted inducements to purchase or sell security-based swaps.

The Rule

The proposed rule (Rule 9j-1) would prohibit fraud, manipulation, and deception in connection with the offer, purchase or sale of any security-based swap — in the same way that general anti-fraud provisions apply to all securities. The rule also would explicitly reach misconduct in connection with ongoing payments and deliveries under a security-based swap.

Specifically, the proposed rule would prohibit people from employing fraudulent or manipulative devices or schemes, making untrue statements or omitting material facts, or engaging in conduct that would operate as a fraud or deceit on another person in connection with security-based swaps.

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