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CFTC and SEC Propose New Anti-Manipulation Rules for Swaps and Security-Based Swaps

Nov.09.2010

Title VII of the Dodd-Frank Act, known as the Wall Street Transparency and Accountability Act of 2010, amended the Commodity Exchange Act ("CEA") and the Securities Exchange Act of 1934 (the "Exchange Act") to create a new regulatory framework for swaps and security-based swaps.  Under these revisions, Title VII expanded and clarified authority to prohibit manipulative behavior.  To implement this authority, both the Commodity Futures Trading Commission ("CFTC") and the Securities Exchange Commission ("SEC") recently proposed new rules intended to proscribe and regulate fraud and manipulation for swaps and security-based swaps.

Swaps are derivative transactions enabling parties to exchange financial instruments or the benefits associated with those instruments.  Pursuant to financial contracts, swaps often involve parties agreeing to transfer to each other the cash flow stream, such as principal, interest or proceeds, from a commodity, an asset or an investment.  Section 721 of the Dodd-Frank Act identifies common swaps to include interest rate swaps, foreign exchange swaps and credit default swaps.  The CFTC has authority to regulate swaps in general.  The SEC regulates security-based swaps.

On October 26, 2010, the CFTC proposed two new rules pursuant to Dodd-Frank's section 753 anti-manipulation provisions.  The proposed CFTC rules reflect an effort to ensure that the financial system is regulated in ways considered to have been ignored or lacking during the financial crisis.  Most significantly, the CFTC created a catch-all anti-fraud rule patterned after Rule 10b-5 of the Exchange Act that explicitly prohibits manipulative devices, material misstatements or omissions, fraudulent business practices and misleading reports in connection with any swap or contract for sale of any commodity in interstate commerce.  The CFTC will also continue vigorously to pursue price manipulation of swaps and commodities.

On November 3, 2010, the SEC introduced a new rule governing security-based swaps, known as Rule 9j-1 under section 763(g) of the Dodd-Frank Act.  Although largely borrowing language from other securities' regulations, such as Rule 10b-5, Rule 9j-1 would provide a distinct anti-fraud regulation specific to security-based swaps.  By tailoring anti-fraud regulation to a particular type of financial instrument and its risks, Rule 9j-1 signifies even more vigorous oversight by the regulatory agencies.  The SEC has justified Rule 9j-1, however, on account of security-based swaps differing from other securities by contemplating ongoing payments during the life of the swap.  Thus, in addition to fraud associated with the purchase or sale of the swap, the rules would impose liability for fraud that occurs throughout the lifetime of the swap.

A description of the proposed CFTC and SEC rules governing swaps and security-based swaps is contained in the full alert that is linked below.  We will continue to monitor developments at the CFTC and SEC concerning any comments or revisions as these proposed rules proceed through the approval process, and we will update accordingly.

Section 753 of the Dodd-Frank Act revised section 6(c) of the CEA, enhancing the CFTC's anti-manipulation authority.  Based on this authority, on October 26, 2010, the CFTC proposed two new anti-manipulation regulations.

A. Revised CEA Section 6(c)

1. CEA § 6(c)(1)

Dodd-Frank established a new CEA§ 6(c)(1), providing for broader authority over fraud-based manipulative schemes.  It is a "catch-all" anti-fraud provision for swaps that is comparable to § 10(b) of the Exchange Act.  It reads in pertinent part:

It shall be unlawful for any person, directly or indirectly, to use or employ, or attempt to use or employ, in connection with any swap, or contract of sale of any commodity in interstate commerce, or for future delivery on or subject to the rules of any registered entity, any manipulative or deceptive device or contrivance, in contravention of such rules and regulations as the Commission shall promulgate by not later than 1 year after the date of enactment of the Dodd –Frank Act . . .

As the statute provides, the CFTC must promulgate implementing rules within one year of Dodd-Frank's enactment, which was signed into law on July 21, 2010.  .

Revised § 6(c)(1) contains three new subsections.  In section 6(c)(1)(A), the CEA defines the "Special Provisions for Manipulation by False Reporting."  It provides that

Unlawful manipulation for purposes of this paragraph shall include, but not be limited to, delivering, or causing to be delivered for transmission through the mails or interstate commerce, by any means of communication whatsoever, a false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing or acting in reckless disregard of the fact that such report is false, misleading or inaccurate.

Section 6(c)(1)(B), captioned "Effect on Other Law," qualifies that Dodd-Frank provisions, such as revised section 6(c) will not affect CEA section 9(a)(2) that proscribes manipulating the price of any commodity and knowingly transmitting false or misleading reports concerning crop or market conditions affecting the price of any commodity.  Finally, section 6(c)(1)(C), exempts "good faith mistakes" so that transmitting "false or misleading or inaccurate information to a price reporting service would not be sufficient to violate subsection (c)(1)(A)."

2. CEA § 6(c)(2)

Section 753 of Dodd-Frank also revised CEA § 6(c)'s prohibition against false reporting in new CEA § 6(c)(2).  Now, the CEA proscribes not just false statements made in registration applications or reports filed with the CFTC but any material misstatements or omissions concerning swaps made to the CFTC at all.  The provision reads:

It shall be unlawful for any person to make any false or misleading statement of a material fact to the [CFTC], including in any registration application or any report filed with the [CFTC] under this Act, or any other information relating to a swap, or a contract of sale of a commodity, in interstate commerce, or for future delivery on or subject to the rules of any registered entity, or to omit to state in any such statement any material fact that is necessary to make any statement of material fact made not misleading in any material respect, if the person knew or reasonably should have known, the statement to be false or misleading.

3. CEA § 6(c)(3)

The last revision is new CEA § 6(c)(3)'s "other manipulation" provision, which adds to section 6(c)(1)'s anti manipulation provision that "it 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 the registered entity."

B. New CFTC Anti-Manipulation Rules

While some of the provisions in the new CEA § 6(c) are self actuating and need no rulemaking, the CFTC has now proposed two new rules to execute the anti-manipulation provisions in Sections 6(c)(1) and 6(c)(3).  One rule is a new anti-fraud rule authorized under CEA § 6(c)(1) and will be comparable to Rule 10b-5 of the Exchange Act and anti-manipulation authority granted the Federal Energy Regulatory Commission and the Federal Trade Commission.  The other will simply mirror the language of CEA § 6(c)(3).

1. Proposed New Rule Under CEA § 6(c)(1)

The CFTC proposed a new Part 180 to execute a rule under CEA § 6(c)(1).  The proposed rule reads:

(1)        It shall be unlawful for any person, directly or indirectly, in connection with any swap, or contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity, to intentionally or recklessly:

(a)        use or employ, or attempt to use or employ, any manipulative device, scheme or artifice to defraud;
(b)        make, or attempt to make, any untrue or misleading statement, of a material fact or to omit to state a material fact necessary in order to make the statements made not untrue or misleading;
(c)        engage, or attempt to engage, in any act, practice or course of business, which operates or would operate as a fraud or deceit upon any person; or
(d)        deliver or cause to be delivered, or attempt to deliver or cause to be delivered, for transmission through the mails or interstate commerce, by any means of communication whatsoever, a false or misleading or inaccurate report concerning crop or market information or conditions that affect or tend to affect the price of any commodity in interstate commerce, knowing or acting in reckless disregard of the fact that such report is false, misleading or inaccurate.  Notwithstanding the foregoing, no violation of this subsection shall exist where the person mistakenly transmits, in good faith, false or misleading information to a price reporting service.

(2)        Nothing in this section shall be construed to require any person to disclose to another person nonpublic information that may be material to the market price, rate or level of the commodity transaction, except as necessary to make any statement made to the other person in or in connection with the transaction not misleading in any material respect.

(3)        Nothing in this section shall affect, or be construed to affect, the applicability of the Commodity Exchange Act section 9(a)(2).

The CFTC's proposed new rule under CEA § 6(c)(1) is principally modeled after Rule 10b-5 of the Exchange Act but intended to account for unique features of the CEA and CFTC authority.  It encompasses the following considerations:

  • While CEA § 9(a)(2) remains in effect to prohibit manipulation or attempted manipulation of "the price of any commodity," the new Section 6(c)(1) is broader and now prohibits the use or employment of "any manipulative or deceptive device or contrivance;"
  • Under CEA § 6(c)(1), there must be a showing of scienter.  Scienter means that the violator acted with intent to deceive, manipulate or defraud or with recklessness.  Negligent conduct, even gross negligence, will not be sufficient to make out a claim.  Reliance, loss causation and damages are not needed to establish an enforcement action brought by the CFTC;
  • Materiality, which is applicable to sections 1(b) and 2 of the proposed rule, will also be defined as that term is used in interpreting Rule 10b-5.  That is, materiality will be a fact-specific inquiry based on an objective test of whether the reasonable person would have considered the fact material.  Omissions are material if there a substantial likelihood that the omitted fact would have been viewed by the reasonable persona as having significantly altered the total mix of information available.
  • As with other provisions of the CEA, the proposed rule also includes an "attempt" proscription.  To show attempt, there must be proof of the requisite intent and an overt act in furtherance of that intent.

    2. Proposed New Rule Under CEA § 6(c)(3)

    The CFTC's proposed new rule under CEA § 6(c)(3) contains identical language to the statute itself.  It reads that: "it 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 the registered entity."  Under this revised rule, the CFTC will continue to interpret price manipulation and attempted price manipulation to cover every effort to influence the price of a swap, commodity or futures contract that interferes with market forces.

    The CFTC will continue to apply a four part test in analyzing price manipulation.  These include that: (1) the accused has the ability to influence market power; (2) the accused specifically intended to influence market price; (3) artificial prices existed; and (4) the accused caused the artificial prices.  Sometimes economic analysis will be required to determine whether the conduct caused the artificial price.  On other occasions, however, the illegal effect on price will be presumed from the nature of the conduct in question and other factual circumstances not requiring expert economic analysis.

II. SEC

Section 761(a)(2) of the Dodd-Frank Act amended the definition of "security" in section 3(a)(10) of the Exchange Act to include security-based swaps.  As a security, therefore, security-based swaps will be subject to anti-manipulation provisions of the federal securities laws including Rule 10b-5.  Dodd-Frank, however, went further.  It amended the Exchange Act by creating a new section 9(j) to authorize fraud liability affecting "any transaction" associated with security-based swaps.  Therefore, the SEC has proposed a separate rule effectuating section 9(j), known as Rule 9j-1, which is designed to encompass this more expansive liability.

In particular, the SEC underscored that a distinctive feature of security-based swaps is that, unlike other securities, they involve ongoing payments and deliveries.  This means that fraud can occur not only with the purchase, sale or offering of the security but throughout the lifetime of the swap.  In this context, parties to a security-based swap may engage in misconduct in connection with the swap designed to avoid or affect the value of ongoing payments or deliveries.  A party faced with significant risk exposure might, for example, attempt to engage in manipulative or deceptive conduct that increases or decreases the value of payments or cash flows under a security-based swap relative to any referenced asset underlying the swap.  Because such payments – or the avoidance of such payments – occur after the purchase of the swap but before its sale or termination, the SEC determined that a separate rule was needed to make it explicit that fraud or manipulation with respect to such payments is illegal.

A. New Exchange Act Section 9(j)

Section 763(g) of the Dodd-Frank Act created a new section 9(j) of the Exchange Act.  It makes it unlawful for:

any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or the mails, or of any facility of any national security 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.

By covering any "person," section 9(j) applies to a wide range of individuals and institutions.  Some of those include issuers, broker-dealers, security-based swap dealers, major security-based swap participants, security-based swap counterparties, and any customers, clients or other persons that use, employ or effect transactions in security-based swaps.  Section 761 of the Dodd-Frank Act defines "security-based swap dealers" as those who hold themselves out as dealers in security-based swaps, make a market in security-based swaps, regularly enter into such swaps with counterparties and engage in business activity causing the person to be commonly known in the trade as a dealer or market maker in security-based swaps.

Section 9(j) explicitly directs the SEC to create rules and regulations in order to "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."  Based on this authority, the SEC has proposed Rule 9j-1.

B. Proposed Rule 9j-1

Rule 9j-1 chiefly prohibits the same categories of misconduct as Rule 10b-5.  Specifically, the rule would make it unlawful for:

any person, directly or indirectly, in connection with the offer, purchase or sale of any security-based swap, the exercise of any right or performance of any obligation under a security-based swap, or the avoidance of such exercise or performance:

(a) to employ any device, scheme or artifice to defraud or manipulate;
(b) to knowingly or recklessly make any untrue statement of a material fact, or to knowingly or recklessly omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading;
(c) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(d) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

Paragraphs (a) and (b) of Rule 9j-1 largely track the language of Rule 10b-5, though they explicitly provide for certain elements incorporated into 10b-5 liability.  For example, Rule 9j-1 explicitly refers to "manipulative" conduct as well as to "knowingly or recklessly" made misstatements or omissions.  The SEC makes it clear, however, that these paragraphs are to be construed consistent with Rule 10b-5.  Paragraphs (c) and (d) are modeled after other provisions of the securities laws that do not require proof of scienter. 

III. Conclusion

The new CFTC and SEC rules governing swaps and security-based swaps signify vigilance at regulating financial service products, especially derivatives.  This vigilance is directed against financial fraud and manipulation beyond securities and at a more specific and heightened level for securities themselves.  We will continue to monitor development at the SEC and CFTC concerning this and other proposed regulation.

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For more information, please contact the professional(s) listed below, or your regular Crowell & Moring contact.

Daniel D. Edelman
Partner – New York
Phone: +1 212.895.4309
Email: dedelman@crowell.com