Broker Swaps Fraud Signs New Regulations
Among the many things that a broker should consider is the potential for fraud, such as misrepresentations and omissions, improper orphaning of a CDS, or the misuse of a broker’s aggregated position. In some cases, misconduct in the issuance of a CDS can lead to liability for the person who engaged in the misconduct.
Material misstatements and omissions
CFTC rules and regulations will continue to snuff out fraudulent business practices. The CFTC recently rolled out two rules under section 753 of the Dodd-Frank Act. CFTC proposals are modeled after the rules of the Exchange Act. They aim to ensure that the financial system functions as intended. The CFTC is on the lookout for fraudulent activities such as price manipulation of swaps. The CFTC will not tolerate misleading reports or misleading statements.
The CFTC has taken a hardline approach to financial regulation, and will continue to take a hardline approach to price manipulation of swaps. For example, it will seek to levy penalties against a person who engages in fraudulent activity. It will also continue to investigate and enforce rules regarding a person’s use of a CFTC-registered electronic trading system.
Improperly and intentionally orphaning a CDS
Several weeks ago, the Securities and Exchange Commission (SEC) proposed new rules for security-based swaps (SBSs). The SEC’s intention is to prevent orphaning of CDS, a situation where a CDS holder’s debt becomes unpayable. In addition, the SEC is concerned with CDS buyers influencing the timing of CDS payments to avoid paying out. In these situations, the SEC will seek enforcement action.
The SEC’s proposal includes three notional thresholds for large CDS positions. The first is $150 million. This threshold is designed to capture scenarios where a CDS seller has a large position. The second is $1 billion. The third is $1.5 billion. The notional thresholds will be adjusted based on the facts of a particular case.
The SEC’s proposed Rule 9j-1(b) is intended to prevent fraud in connection with the purchase, sale, or repurchase of security-based swaps. The rule draws on existing language in the Securities Act and aims to prevent deception and manipulation. The rule would also prohibit the use of fraudulent inducements. It would also prohibit deceit, early termination of a transaction, and manipulation of the valuation or price of a security-based swap.
Reporting of the aggregated position
Until a position has reached a certain number of contracts, the firm is not required to report the position. However, once a firm’s position exceeds that threshold, the firm will be required to report it to the LOPR system. This is done using a similar process to the one used by FINRA.
In addition to reporting the aggregated position, the firm will also be required to report the trade, the trade’s corresponding effective date, and the clearing member number of the trade. This process is called the add and delete process. The add process involves creating an account with a unique In Concert ID. The same applies to the delete process. A firm will only be able to delete a record if the effective date is the same as the record’s latest date submitted to the LOPR system.
Liability of persons that engage in misconduct to trigger, avoid, or affect the value of ongoing payments or deliveries
Whether or not a person should be held liable for misconduct to trigger, avoid, or affect the value of ongoing payments or deliveries varies based on several factors. The first factor is whether the person’s conduct is inherently fraudulent. If the person’s conduct is not inherently fraudulent, the liability will be lessened.
The second factor is whether the person’s conduct has the potential to harm a company or create an incentive to vote against a debt holder. If the person’s conduct has these potential effects, the liability will increase. This is because large CDS positions can be advantageous to a market participant or regulator, while creating a potential incentive to harm a company.
The third factor is whether the person’s conduct was the result of an act of deception. If the person’s conduct was the result of deception, the liability will be lessened. This is because acts of deception are fraudulent. The carrying value is the sum of the SAP book value plus the accrued interest. The carrying value is also reduced if a non-admitted adjustment is made.