Just as the market was catching its breath from go-live of the SEC’s Title VII framework regulating security-based swaps, the SEC has rolled out another set of proposals aimed at the security-based swap ("SBS") marketplace.
Long story short, the SEC appears to be principally targeting two discrete issues — the alleged rise of “opportunistic” or “manipulative” credit default swap ("CDS") strategies on the one hand, and the arguably opaque market in total return swaps ("TRS") and similar instruments on the other hand.
None of this is particularly surprising. Both the CFTC (the “swaps” regulator) and the SEC (the “security-based swaps” regulator) have been grumbling about the CDS market for a while now (see, for example, the joint statement made by then-Chairmen Giancarlo and Clayton in 2019). And after Archegos Capital’s spectacular implosion, the SEC has made no secret of its concern that under existing law and regulation, single investors can accrue significant synthetic positions in public issuers without the issuers — or the market — finding out.
That said, the proposals come at a time when the derivatives market, having settled into the post-Dodd-Frank normal, is grappling with a number of issues (from LIBOR cessation to new SEC margin and capital rules for SBS to new derivatives use limitations for mutual funds and business development companies), and moving the regulatory goalposts again may well cause new growing pains. Market participants on both the buy-side and sell-side will likely want to read the proposals carefully and share their views with the SEC before anything gets fully baked.
One of the more confusing aspects of the regulatory landscape governing derivatives in the U.S. is the fact that different rulesets (and regulators!) govern different types of derivatives. As noted above, the SEC generally regulates “security-based swaps” and the CFTC generally regulates “swaps.” Although the contemporary distinction arises from Dodd-Frank, allocating jurisdiction over derivatives products has a long history at the commissions that is well beyond the scope of this post. For our purposes, it’s probably sufficient to point out that single-name CDS and TRS that reference single securities and/or single loans constitute “security-based swaps,” whereas index CDS and TRS on other underliers tend to constitute “swaps.”
CDS in the Spotlight, Again
CDS might have preferred to lay low after the 2008 financial crisis threw an unflattering spotlight on them. But the stories that played out in a number of credit events (e.g., Codere, Hovnanian, Sears, Windstream, etc.) made that all but impossible. Many commentators have applied an overly simplistic lens to these fact patterns, often failing to fully balance the pros and cons. These patterns tend to be grouped into too-basic categories — “manufactured” credit events (e.g., Codere, Hovnanian), introduction of “game-changing” deliverable obligations (e.g., Sears) and net short “activism” (i.e., creditors with access to CDS buying protection in amounts believed to be greater than their long physical position) (e.g., Windstream). There are strong arguments on both sides of the debate — the public narrative tends unfortunately to pit “good guys” against the “bad guys”.
But it’s not uniformly accepted that all these (and similar) fact patterns constitute “bad” behavior or behavior injurious to the CDS marketplace, particularly when the CDS marketplace is considered holistically with the credit market it inhabits. So in proposing a new rule to “address manufactured or other opportunistic strategies that involve fraudulent, deceptive, or manipulative activity” in the CDS space, the SEC is entering messy territory. And they’re doing so midstream, so to speak, as the market is still working through organically developed solutions — such as the 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions (the "NTCE Supplement") and the various flavors of anti-net-short-investor language floating around.
The SEC’s solution, re-proposed Rule 9j-1, targets more than just CDS, but its sights are trained on CDS. Unlike the NTCE Supplement, though, Rule 9j-1 doesn’t provide detailed factors to balance or explicitly provide wiggle room for specific circumstances. The rule makes 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.” Understanding what this means in practice requires, however, a preconceived notion of what’s “good” and what's “bad.” The SEC seems to be drawing a line at actions “designed almost exclusively to harm one or more CDS counterparties.” This leaves a lot to interpretation.
Consider restructurings, for example. It is common — particularly in the European Union — for institutional investors to use CDS to hedge out credit risk when buying debt securities. Getting these creditors to cooperate in a restructuring often hinges on ensuring that the CDS pays out per expectations. Where does that fall on the line?
While the SEC states that it “recognizes that CDS buyers and sellers regularly engage in legitimate interactions with reference entities, and often offer critical means of restructuring and funding for reference entities”, it doesn’t provide the clarity that the NTCE Supplement does, particularly with respect to restructurings. For example, the NTCE Supplement states:
…within the context of a bona fide restructuring, if the [issuer] enters into an arrangement or understanding with [creditors] that includes a failure to make a payment with the purpose of causing settlement of [a CDS] so as to increase the likelihood of success of such bona fide restructuring, and in circumstances where without such restructuring the [issuer] would be likely to enter into bankruptcy or similar proceedings, such arrangement or understanding should generally be considered to have the essential purpose of facilitating such restructuring rather than creating a benefit under [a CDS].”
Keeping a restructuring on track is different than taking a big net short position or engineering a CDS trigger to bankroll a refinancing offer to a struggling enterprise, of course. But judging even those cases requires a moral compass as to what constitutes objectionable conduct. Hopefully, the proposed rule’s ambiguities in this regard will spark another much-needed round of educated robust debate.
Revisiting Beneficial Ownership Obliquely
Although “swaps” drown out SBS in the market on a notional basis, SBS tend to be the culprits when passions flare. Aside from single-name CDS, single-name equity derivatives are a key driver of agita. This has a lot to do with the very technical disclosure regime that has developed in the space. It also has something to do with the fact that SBS reporting to data repositories has only recently come into effect, despite the statutory authority for the same being around since the advent of Title VII (recall that swaps have been regularly reported to swap data repositories for some time now).
So what’s the technicality? If you’re an activist fund and you enter into a bunch of delta-one TRS (a TRS the value of which increases or decreases roughly 1:1 with the referenced stock) on the shares of a public company, if your trade doesn’t give you any voting rights and/or doesn’t give you a right to acquire the shares, you’re not likely to be viewed as being the beneficial owner of the shares. That means that unless you separately hold other positions in the shares that would put you over the relevant reporting threshold, the TRS positions wouldn’t likely independently require disclosure to the market outside of confidential reporting to data repositories. However, if you enter into a bunch of delta-one TRS on the shares of the same company, and the trade passes along voting rights or gives you a clear right to acquire the shares, you likely do have beneficial ownership of the shares.
Why does this dichotomy matter? For one, it makes it difficult for public issuers to keep tabs on who might be accreting a position in secret. It also makes it difficult for market participants to know what other market participants are up to (and how much of a given issuer’s equity is tied up as a dealer’s hedge for a market participant’s synthetic position). So when, for example, multiple banks independently offer TRS liquidity on a given issuer’s shares to a single investment fund, those banks may well be in the dark on each others’ relationships with that fund. That can arguably lead to systemic risk in meltdown scenarios. The downward pressure on an issuer’s equity that can result when dealers dump their hedge shares is similar to the downward pressure that motivates the concerns of Regs T, U and X.
To pull back the curtains, the SEC is proposing that any market participant (not just broker-dealers, security-based swap dealers or major security-based swap participants) file a new form (Schedule 10B) on EDGAR within a business day of booking a trade that causes the market participant to exceed a specified threshold. The threshold changes based on product, but it’s relatively low.
For example, for CDS, market participants with a long notional of $150 million (calculated after backing out physical hedged positions) would likely need to file; similarly, market participants with a short notional amount of $150 million or gross notional amount of $300 million would likely need to file. For equity derivatives, a gross notional amount of the lesser of $300 million and 5% of a given class of equity securities triggers reporting.
The information proposed to be reported on Schedule 10B includes the name of the reporting person, the reporting person’s LEI, the notional amount of the applicable SBS position, information on ownership of related debt securities (including the issuer’s LEI, if any) and information on ownership of related equity securities (including the issuer’s LEI, if any).
Some might reasonably ask why not just change the approach to beneficial ownership and revisit the notion that certain synthetic positions don’t count. That would potentially help issuers better defend against activists and would also put large equity positions on the public map. But the SEC isn’t only looking to improve disclosure around equity trades. It also seems to want to use disclosure as a tool to tamp down net short debt activism.
So in some regards, the disclosure rule may be at the same time too broad and not broad enough. It might be too broad because it captures far more than the equity positions that are often the focus of Archegos-like meltdowns and that can impact the ordinary individual investor — is it necessary that investment funds disclose positions in high-yield debt that is not available to the general public? It also might be too narrow because not all equity derivatives are covered — for example, single-equity options, which are not SBS but can also be used to obtain synthetic positions in equity, and repurchase agreements, which are not SBS but can also be used to obtain leverage on debt securities.
As with Rule 9j-1, the more market participants submit feedback, the better the final result is likely to be. There may even be an argument to pump the brakes a bit insofar as the market will have to absorb two new derivatives-regimes in the coming year — the SEC’s Title VII margin and capital rules for SBS and the SEC’s new rule regulating the use of derivatives by registered investment companies and business development companies.
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