The SEC posted a proposal this afternoon to keep its existing rules on beneficial ownership for people who buy or sell security-based swaps (Rules 13d-3 and 16a-1 under the Securities Exchange Act of 1934).

The Commission seems to be responding to concerns that if the Dodd-Frank Sections 766 and 13(o) go into effect this summer as scheduled, then problematic drafting would cancel out the rules already in place.

The SEC said its proposals “are intended to clarify” that those who buy or sell security-based swaps “will remain within the scope of these rules to the same extent as they are now.”

“This proposal is intended to preserve the status quo of existing beneficial ownership rules relating to security-based swaps and to provide certainty in the markets,” says Elizabeth Powers, partner at the law firm Dewey & LeBoeuf.  It also gives the SEC time to work on any other rules they may want to propose pursuant to Section 766, she says.

The problem seems to come down to a single word in the Dodd-Frank mandate. Section 13(o) provides that for purposes of that section and Section 16 of the Exchange Act, "a person shall be deemed to acquire beneficial ownership of an equity security based on the purchase or sale of a security-based swap, only to the extent that the Commission, by rule, determines...." Influential Wall Street law firm Wachtell Lipton, in its March 7 petition for rule-making, identified that once DFA Section 766 and Section 13(o) become effective on July 16, 2011, the use of the word "only" would, or could be interpreted to, prevent the existing Commission rules on beneficial ownership under Rule 13d-3 and Rule 16a-1 from applying to persons who purchase or sell security-based swaps, Powers says.

Since section 766 could thus be interpreted as canceling out Rule 13d-3's definitions of beneficial ownership, there could be some serious consequences in the marketplace, the Commission said in the proposal. For example, it could become possible for an investor to use a security-based swap to accumulate an influential or control position in a public company without public disclosure. In another case, a person who holds a security-based swap that confers beneficial ownership of the referenced equity securities (under 13d-3), may no longer be considered a ten percent holder subject to Section 16 of the Exchange Act. Alternatively, an insider may no longer be subject to Section 16 reporting and short-swing profit recovery through transactions in security-based swaps that confer a right to receive either the underlying equity securities or cash.

The SEC also announces a side project in the release: “While these proposals are only intended to preserve the existing application of the beneficial ownership rules as they relate to security-based swaps, our staff is engaged in a separate project to develop proposals to modernize reporting under Exchange Act Sections 13(d) and 13(g).” These sections—13(d) and 13(g)—require a person who is the beneficial owner of more than five percent of certain equity securities to disclose information relating to such beneficial ownership.

 The Commission will accept comments on the proposal through April 15, 2011.

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