U.S. Securities and Exchange Commission Open Meeting June 7, 2023

U.S. Securities and Exchange Commission

Open Meeting

Wednesday, June 7, 2023

Topline

• Both items were approved by the Commission. Item 1 was approved by a vote of 3-2, with Chair Gensler, Commissioner Crenshaw, and Commissioner Lizarraga voting yes and Commissioners Peirce and Uyeda opposing. Item 2 was approved unanimously.

 

ITEM 1: Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition against Undue Influence over Chief Compliance Officers

The Commission will consider whether to adopt rules under the Securities Exchange Act of 1934 (“Exchange Act”) that are designed to prevent fraud, manipulation, and deception in connection with transactions in security-based swaps as well as to prevent the personnel of a security-based swap dealer or major security-based swap participant from taking actions to coerce, mislead, or otherwise interfere with such entity’s chief compliance officer.

 

Staff Discussion

Andrea Orr, Division of Trading and Markets

Orr began by discussing the staff’s recommendation for a new Exchange Act Rule 9J1 to prevent fraud, manipulation, and deception with security-based swap (SBS) transactions. She said that Rule 9J1 will prohibit this activity in the security-based swap market, including misconduct in connection with security-based swap transactions.

She also discussed the proposed rule to prohibit undue influence of the chief compliance officer (CCO) of an SBS dealer or a major security-based swap participant. Orr explained that existing Commission rules require SBS entities to designate a chief compliance officer, and this rule will protect investors and promote fairness by supporting the ability of chief compliance officers to meet their obligations to foster compliance without undue influence.

 

Pam Carmody, Division of Trading and Markets

Carmody began by explaining that Rules 9J1 and 15F-h4(c) are intended to address fraud, manipulation, and deception in the context of SBS transactions and support the ability of CCOs of security-based swap dealers or SBS entities to meet obligations to foster compliance by SBS entities. She then discussed the specifics of each rule.

Carmody said that final Rule 9J1 will prohibit the use of material non-public information and manipulation in connection with affecting any transaction or attempting to affect any transaction or purchasing/selling or attempting to induce the purchase/sale of any security-based swap. She stated that the provision will also ensure that individuals cannot evade liability for trading based on the possession of material non-public information, even if they engage in transactions involving financial derivatives such as security-based swaps instead of the underlying asset. She added that the rule includes two affirmative defenses for certain specific conduct.

Finally, on Rule 15F-h4(c), Carmody said that it will prohibit employees of SBS entities from taking any action to coerce, manipulate, or fraudulently influence the CCO and the performance of their duties under the federal securities rules and regulations.

 

Jessica Wachter, Division of Economic and Risk Analysis

Wachter explained that Rule 9J1 will reduce incidents of fraudulent activities such as opportunistic behavior, which would improve the functions of the security-based swap market and increase price efficiency. She also noted that it is possible it could discourage some legitimate activity.

Wachter also said that Rule 15F-h4(c) prohibits coercion or interference with a CCO, which is a required position under Dodd-Frank. She said that it would help foster compliance within the SBS entity.

 

Commissioner Questions and Comments

Commissioner Hester Peirce

Peirce began by stating that while she agrees with the objectives of these rules to reduce incidents of misconduct in SBS markets, the final rules leave concerns she had in the proposed stage unaddressed so she cannot support them. She added that the final rule is better than the proposed rule but argued that it is still overly broad. Peirce continued by highlighting the provision that concerns her most, which she described as an overly broad anti-manipulation provision directed at opportunistic trading strategies. She said that the final rule describes the scope in the same broad and ambiguous terms that she originally opposed.

Furthermore, Pierce said that the adopting release does attempt to provide assurance that the Commission will only use the provision to pursue action outside the ordinary course of a typical lender-borrower relationship. She noted that drawing a line in advance between manipulative conduct and actions taken in the normal course of business is difficult and subjective if not defined by their rules.

Peirce also said that the rule risks spurring inaction and thus reducing market efficiency. She said the targeted misconduct has occurred infrequently in this market, and anti-fraud rules already prohibit some of that conduct. Additionally, she argued that the Commission’s desire to maximize its own flexibility does not seem to further any regulatory objective, and instead will deter legitimate activity more than prevent truly manipulative activity.

As it relates to the second rule, Peirce said that regulation that prohibits bad things always has tradeoffs. She wondered whether the CCO rule would make employees less likely to approach the officers for input on compliance-related issues.

Peirce asked multiple questions of staff as well. First, she explained that one commenter noted that the broad language of the anti-manipulation provision coupled with the use of the facts and circumstances test could chill legitimate exercises of lenders, and she asked for any evidence that those views are groundless. Orr replied that the release is clear that the Commission would have to prove an intent to manipulate in order to bring an action.

Peirce also asked if there is any evidence of fraud and manipulation in this market that presents a risk. Wachter said that the evidence presented does not indicate that the risk of opportunistic strategies is low. She added that the rule is required by Dodd-Frank, and opportunistic/fraudulent behavior does occur.

Finally, Peirce said that the SEC is writing this rule to address events that are unseemly, perhaps illegal, but to which industry has already responded. She asked if there is still evidence of the conduct that would form the basis for the rule, or if staff is only relying on the statutory provision for justification. Wachter replied by arguing that a short time period of no recorded events does not negate the effect of those events on markets. She added that the staff also believes the industry response to be incomplete.

 

Commissioner Caroline Crenshaw

Crenshaw opened by stating that the need for increased regulatory oversight of the secure-based swap market became abundantly clear following the 2008 crisis. She noted that in the wake of the crisis, Title 7 of Dodd-Frank accorded additional regulatory authority to the SEC, including implementing the security-based swap registration and regulation framework finalized in the fall of 2022.

She also said that Rule 9J1 is an anti-fraud rule that takes into account the features fundamental to a security-based swap and the broad definitions under the relevant statutes. She added that the rule will help address opportunistic strategies in the market. Finally, Crenshaw highlighted the second rule prohibiting undue influence over the CCOs of security-based swap dealers and major participants. She said the rule is designed to safeguard the independence and objectivity of CCOs.

 

Commissioner Mark Uyeda

Uyeda opened by stating his concern that the rule does not consider the special features of various types of SBSs. He said that existing anti-fraud rules already cover SBS, so the reason for this rule is questionable. Uyeda also argued that regulations should define such transactions, acts, and practices that are deemed fraudulent, deceptive, or manipulative in the context of SBSs, but the final rule does not do that. Instead, he said it relies heavily on “facts and circumstances” which to him appears to constitute a linguistic simulation for the failure to provide sufficient specifics for the SBS market as well as appropriate guidance.

Uyeda also said that the rule should prescribe a regulation, but this rule instead largely regurgitates language from existing anti-fraud rules that already apply to these products. He stated that the adopting release should have been clear about what is covered by this rule that is not already covered by existing anti-fraud and entitlement escalation provisions, but that is hardly discussed.

Overall, the commissioner said that the rule makes it appear that the SEC has not done the hard work of studying the SBS market to see what may be specifically or uniquely required. He argued that the rule will serve to suppress otherwise healthy activity in the SBS market and does not contain any safe harbor for hedging activities arising out of lending activities, which seems ill advised.

 

Commissioner Jaime Lizarraga

Lizarraga stated that Dodd Frank required the SEC to establish a framework to oversee SBSs more effectively. He said that today the Commission is adopting a rule to prevent fraud, manipulation, and deception in these markets. Lizarraga also noted the second rule related to CCOs. He said that the integrity of the swap market relies on CCOs to perform their roles free of threats and manipulation, and that the final rule accomplishes this goal to strengthen SBS markets and fulfill the Commission’s mission to promote fair and transparent markets.

 

Chair Gary Gensler

Gensler said that as part of Dodd Frank, Congress granted the agency broad authority regarding SBSs. He noted that in the 13 years since, SBSs have continued to play an influential role in our markets, and that misconduct in this market not only harms direct counterparties, but can also affect referenced entities and their stocks, loans, and bonds, and the investors in those entities. The chair said that the rules being voted on today will enhance the SEC’s work to protect investors and the integrity of the markets.

Gensler continued by explaining that Congress mandated that the SEC put forward rules to prevent such fraudulent, deceptive, or manipulative practices in SBSs. Today’s adoption will fulfill that mandate, he said, considering the unique characteristics of these markets. He noted that the rules identify the type of misconduct prohibited, including the manipulation of the price or evaluation of an SBS. Gensler also discussed the second rule to prohibit personnel of SBS dealers from influencing their CCOs, which he said will provide that it is unlawful to coerce, mislead, or otherwise interfere with these officers.

Vote

Chairman Gensler called the role. The item was approved 3-2. Peirce and Uyeda voted no.

 

ITEM 2: Removal of References to Credit Ratings from Regulation M

The Commission will consider whether to adopt rule amendments to Regulation M under the Exchange Act that remove certain existing rule exceptions that reference credit ratings and substitute in their place new exceptions that are based on alternative standards of creditworthiness.

 

Staff Discussion

Haoxiang Zhu, Division of Trading and Markets

Zhu noted that Dodd Frank requires the SEC to remove credit ratings and provide alternate standards of creditworthiness. He said that today’s amendments would fulfill this mandate. He explained that the staff recommends that the Commission adopt these amendments to remove the existing exceptions and substitute new exceptions.

 

Laura Weber, Division of Trading and Markets

Weber explained that the recommendation includes amendments to remove existing exceptions in Rule 101 and Rule 102 of Regulation M that reference credit ratings for nonconvertible debt securities, nonconvertible preferred securities, and asset-backed securities, and to substitute them with new exceptions that are based on alternative standards of creditworthiness.

Weber said that these substitutes include exceptions for nonconvertible debt securities and nonconvertible preferred securities of issuers who meet a probability of default threshold, as well as exceptions for asset-backed securities that are offered pursuant to an effective registration statement filed on the Commission’s Form SF-3.

Finally, Weber explained that the rule includes changes to require the preservation of records for broker dealers who rely on the new exception for nonconvertible debt securities and nonconvertible preferred securities. She said record preservation could help avoid broker dealer misuse of the exceptions by relying on determinations that do not meet conditions with the exception.

 

Jessica Wachter, Division of Economic and Risk Analysis

Wachter reiterated that the Commission is considering rule amendments to remove any references to credit ratings and substitute alternative standards. She explained that Regulation M is intended to prevent potential manipulation during distribution, such as buying activity, and that this rulemaking would replace references to investment grade credit with a threshold for the probability of default for a security. She noted that this metric is consistent with the basis for the investment-grade exception and those securities with low probability of default. She concluded by stating that the amendment will benefit competition and reduce reliance on credit ratings.

 

Commissioner Questions and Comments

Commissioner Hester Peirce

Peirce stated that she is pleased that the Commission has gotten to this point of removing the final credit ratings from the rulebook. She said the staff’s recommendation appears to be a reasonable approach to implementing Congress’s mandate, and she is happy to support it.

Despite her support, Peirce mentioned that commenters suggested some simpler alternatives. She asked staff why they did not take one of these approaches. Zhu said that the objective is to find an alternative measure of credit risk/worthiness. The disclosures that commenters mentioned, however, were not intended to be measures of credit risk or worthiness, so the default measure is more appropriate. Weber added that probability of default allows for the selection of issuers whose securities traded on the basis of yield and credit rating.

 

Commissioner Caroline Crenshaw

Crenshaw said that credit rating agencies are incentivized to inflate the ratings of paying clients, to the potential detriment of investors relying on them. She said that these agencies were a focus of the post-financial crisis Dodd Frank reforms. She also noted that this rule represents the implementation of a Dodd Frank directive, and she is pleased that the Commission will be completing this aspect of the mandate.

Finally, Crenshaw said that the Commission should also undertake a rulemaking to address issuer-pay confirms, which is on the agenda, as well as considerations as to whether there are areas of credit rating oversight that could be improved.

 

Commissioner Mark Uyeda

Uyeda stated that this is the third proposal to replace Regulation M’s reference to credit ratings, and he added that this one is based on the probability of default standards. Uyeda also said that the removal of Regulation M’s reference to credit worthiness is long overdue, and he strongly supports removing all credit rating references from the agency’s rulebook.

 

Commissioner Jaime Lizarraga

Lizarraga reiterated that the SEC is replacing references to credit rating with an alternative standard and said that he supports the adoption of today’s final rules.

 

Chair Gary Gensler

Gensler said that there used to be an overreliance on credit ratings (particularly as there was an inherent conflict in the issuer-pay model). He added that in Dodd Frank, Congress said the SEC should rely on these ratings and remove any references or requirements of reliance from its rules. He said this adoption will be the sixth and final rule to remove credit ratings.

Gensler also noted that the proposal is the third time that the agency has attempted to remove these references from Regulation M (2008, 2011, and 2022). He explained that Regulation M is a 27-year-old rule that prohibits parties involved in the distribution of securities from buying or inducing others to buy securities during a restricted period, but there are some exceptions. Gensler said the amendments being considered today will modify and replace these exceptions with alternative standards of credit worthiness.

Vote

Chairman Gensler called the role. The item was approved unanimously.

 

For more information on this meeting, please click here.

For an archive of past SIFMA hearing coverage, please click here.