SEC Aggressively Policing Swaps After Recent Loss

The Securities and Exchange Commission recently lost its first battle to enforce insider-trading laws over the vast business of credit default swaps, but compliance departments should take note: The agency still won the right to police such trading generally.

The SEC saw its case—one of the first filed under its new system of specialized, fast-acting enforcement teams—dismissed in federal district court when the judge determined that no insider trading actually occurred between the two defendants in question. But, crucially, the judge did rule that trading in credit default swaps is governed by Section 10(b) of the Securities Exchange Act, and that the SEC can at least try to bring insider-trading cases involving credit default swaps if it chooses.

Henning

That conclusion could have serious implications for hedge funds, financial institutions, and even corporations that trade in credit default swaps, a business that exploded in popularity in the 2000s and then crashed back to earth after the financial crisis. At the moment, swaps are essentially unregulated financial instruments (expect regulatory reform pending in Washington to change that soon) and enforcement has been non-existent. Peter Henning, a securities law professor at Wayne State University and a former SEC lawyer, describes the swaps trade as “a complete Wild West.”

The SEC tried to change that last year when it first filed charges against Renato Negrin, a former portfolio manager at hedge fund investment adviser Millennium Partners, and Jon-Paul Rorech, a salesman at Deutsche Bank. The SEC alleged that Rorech tipped Negrin to confidential information about changes to a bond offering by Dutch media company VNU, which was expected to inflate the price of credit default swaps on VNU bonds. Negrin then allegedly purchased swaps on VNU for one of Millennium’s hedge funds ahead of the news; the bond restructuring was announced, the price of VNU swaps soared, and Negrin sold Millennium’s holdings for a $1.2 million profit.

After a three-week bench trial in June in the Southern District of New York, however, federal judge John Koeltl ruled that the SEC failed to establish the necessary elements of its insider-trading claim against Negrin and Rorech. He concluded that the agency failed to prove that the information Rorech shared was material or confidential and said Rorech didn’t breach any duty he had to Deutsche Bank.

Referring to SEC allegations that insider information was passed between the two men during two unrecorded cell phone calls, Koeltl wrote: “While the SEC attempts to attribute nefarious content to those calls through circumstantial evidence, there is, in fact, no evidence to support this inference and ample evidence that undercuts the SEC’s theory that the defendants engaged in insider trading.”

“This case is a statement by the SEC that it is going to police this largely unregulated area.”
—Thomas Gorman,
Head of Securities Litigation Practice,
Porter Wright

There is no word on whether the SEC may appeal. An agency spokesman says the SEC is reviewing the decision.

Henning says the case shows the challenges of “trying to apply the traditional fraud analysis to a market that’s very different than the traditional stock or bond market.” Typical insider-trading cases involve stocks or bonds widely traded on public exchanges and sensitive information related to a significant transaction (a merger, for example) or corporate earnings report. But credit default swaps and other derivative instruments are quite different, Henning says.

“When you get into more exotic securities like credit default swaps, that aren’t heavily traded and where there’s a lot of contact between the players in the market, with information being exchanged … almost on a minute-by-minute basis, it’s harder to prove any insider information got passed,” he says.

Broader Implications

Koeltl’s 122-page decision does have a silver lining for the SEC: It meticulously explains why credit default swaps are governed by Section 10(b), subject to insider-trading and anti-fraud laws generally.

Rorech and Negrin’s lawyers had argued that the SEC had no jurisdiction because the credit default swaps in question weren’t securities-based swaps, and therefore were exempt from SEC oversight as stipulated in the Commodity Futures Modernization Act. Koeltl rejected that. Instead, he concluded that the material terms of the swaps hinged on the price, yield, value, or volatility of VNU’s securities—which meant the swaps were indeed securities-based instruments, subject to the antifraud provisions of Section 10(b) of the Securities Exchange Act.

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Branson on SEC Enforcement

Trekking Toward Über Regulation: Prospects for Meaningful Change at SEC Enforcement?, by Douglas M. Branson, University of Pittsburgh School of Law, was recently posted on SSRN.  Here is the abstract:

Whether used in analysis of Senator Christopher Dodd’s, the administration’s, or anyone else’s regulatory reform proposals, a phrase often heard in Washington, D.C., is über regulation. Large, or very large, (über) regulators of banks and financial institutions are thought to be necessary for at least three reasons. First, large financial institutions (Goldman Sachs, Bank of America, Citigroup) need to counterbalanced with large, all powerful regulators. Second, broad (large) grants of subject matter jurisdiction are necessary to eliminate possibilities for regulatory arbitrage which currently exist (banks, for example, may be able to chose from among the Office of Comptroller of the Currency, the Federal Reserve, or various state’s departments of banking or financial institutions as their principal regulator). Third, only an über regulator would have the overview to detect and the powers to curb unacceptable levels of systemic risk which may lurk over the horizon from time to time. This article recounts some of those arguments, also documenting the downside of über regulation, such as loss of historic camaraderie and high morale in certain smaller regulatory agencies such as the SEC.

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Goldman Sachs, SEC Said to Be In Settlement Talks

Goldman Sachs has apparently entered settlement talks with the Securities and Exchange Commission (SEC) to settle civil fraud charges the agency levied against the investment bank last month. According to a Wall Street Journal report, the talks didn’t include any specific settlement terms, such as the amount of a fine or agreements Goldman could make with the agency. What’s more, the two side remain far apart.

In April, the SEC filed a civil suit against Goldman Sachs, as well as Vice President Fabrice Tourre, over a financial product called Abacus 2007-AC1. As we reported previously, Abacus was a collateralized debt obligation linked to the performance of subprime mortgages that the SEC says was designed to lose money. Investors in Abacus were never informed that a hedge-fund firm helped to pick some of its underlying mortgage securities and was betting on the financial instrument’s decline, the SEC said.

In addition, the Justice Department is also said to be looking into Goldman Sach’s mortgage deals, raising fears of a potential criminal charges.

According to The Wall Street Journal, since the SEC charges were filed, Goldman Sach’s shares have fallen 23 percent, wiping out $20 billion in shareholder value.

While the investment bank initially took a combative stance with the SEC, the Journal said Goldman Sach’s lawyers have concluded that the company needs to make a serious effort to resolve the SEC lawsuit. Unnamed sources reported to the Journal that the firm’s Chief Financial Officer David Viniar and Vice Chairman J. Michael Evans told some large shareholders that Goldman “would be happy to settle today.”

News of the SEC-Goldman Sach’s talks came the same day as the firm held its annual shareholder meeting in Manhattan. According to the Journal, its Chief Operating Officer, Gary Cohn, declined to comment about the reported talks during the meeting, but told reporters that “something has to happen in the case.”

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Second Circuit Rejects Extending Private Rule 10b-5 Liability to Attorneys Who “Created” the Fraud

In Pacific Investment Management Co. v. Mayer Brown (2d Cir. Apr. 27, 2010)(Download MayerBrownopinion), the Second Circuit affirms the district court’s dismissal of investors’ complaint against the law firm Mayer Brown and its partner Joseph Collins for their role in the securities fraud committed by Refco Inc.  The Court holds that a secondary actor (defined as parties who are not employed by the issuer whose securities are the subject of allegations of fraud) can be held liable in private Rule 10b-5 damages actions only for false statements attributed to the secondary actor at the time of dissemination.  Absent attribution, plaintiffs cannot establish that they relied on the defendants’ own false statements, and the secondary actors’ participation in the creation of the false statements amounts to, at best, aiding and abetting securities fraud.  The Court rejects the plaintiff’s argument (supported in an SEC amicus brief) in favor of a creator standard as inconsistent with Supreme Court precedent (Central Bank, Stoneridge) and the Second Circuit’s “bright line” test adopted in Wright v. Ernst & Young (2d Cir. 1998), which held that an outside accountant could not be held liable for public statements not attributed to it.

The Court acknowledges the confusion in the Circuit created by Wright and its later decision in In re Scholastic Corp. Securities Litigation (2d Cir. 2001), where it held that a corporate officer could be liable for misrepresentations made by the corporation, even though none of the statements was specifically attributable to him.  That opinion did not cite Wright and led to confusion about whether Wright’s attribution standard was relaxed.  However, in 2007, the Second Circuit applied the attribution standard again in a case involving an outside accounting firm in Lattanzio v. Deloitte & Touche.  While emphasizing the Wright attribution standard and rejecting the creator standard, the Second Circuit does not entirely clear up the confusion.  While its definition of secondary actors to exclude the issuer’s employees would logically point to reconciling Wright/Lattanzio and Scholastic on this basis, the Court explicitly declines to do so:  “because this appeal does not involve claims against corporate insiders, we intimate no view on whether attribution is required for such claims or whether Scholastic can be meaningfully distinguished from Wright and Lattanzio.”

The Court also affirms the district court in rejecting plaintiffs’ alternative argument based on “scheme liability” because Stoneridge foreclosed this theory.  The Court does acknowledge that after Stoneridge it is “somewhat unclear” how the deceptive conduct of a secondary actor could be communicated to the public and yet remain “deceptive,” but it nevertheless finds it clear after Stoneridge that the “mere fact that the ultimate result of a secondary actor’s deceptive course of conduct is communicated to the public through a company’s financial statements is insufficient to show reliance on the secondary actor’s own deceptive conduct.”

After Stoneridge, some have argued that the Supreme Court’s opinion should not be read as foreclosing the “scheme liability” theory where the secondary actors play a role that is more closely connected to the securities or capital-raising process, such as those professionals who advise securities issuers, in contrast to the suppliers named as defendants in Stoneridge.  I always thought that argument to be wishful thinking, and at least in the Second Circuit, it will not fly.

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SEC Announces Policy of Unscheduled Adviser Visits

An SEC compliance official recently announced that OCIE is indefinitely suspending its regularly-scheduled examinations of investment advisers and instead is conducting unannounced inspections based on tips of wrong-doing.  Obviously in response to the Madoff scandal, the new policy leads industry people to worry that competitors may plot to make their lives miserable.  InvNews, SEC’s new adviser exam schedule: ‘We simply show up’

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The D.C. Circuit’s Anti-Regulation Attitude

Steven Pearlstein, of The Washington Post, has an excellent column today on the D.C. Circuit’s anti-regulation attitude as reflected in its frequent vacating of agency rules on questionable grounds.  Regulatory failure? Blame the D.C. Circuit. Other recent examples include Fin. Planning Ass’n v. SEC, 482 F.3d 481 (D.C. Cir. 2007) (vacating the SEC’s rule excluding broker-dealers that charged asset-based fees from definition of investment adviser if certain conditions met) and Amer. Equity Life Ins. Co. v. SEC, 572 F.3d 933 (D.C. Cir. 2009) (holding that SEC failed to consider adequately effect on competition of rule that state fixed indexed annuities were securities).

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Wall Street Says “Jump!” and the SEC Says “How High?”

The Wall Street Journal last Thursday published three prominently featured articles that, at first blush, seemed unrelated but together underscored why the SEC has pretty much abdicated any moral authority to represent and protect the interests of individual investors.

The first and most alarming article was the lead story about how the SEC is supporting Wall Street’s efforts to dismantle the provisions of the 2003  global settlement designed to ensure the integrity of Wall Street’s research.  The provisions, which prevent research analysts from talking to their firm’s investment bankers without a compliance officer being present, are of considerable importance to me as it was my case against Merrill Lynch alleging fraudulent research that sparked former New York Attorney General Eliot Spitzer to bring his action.  Eliminating the protection definitely isn’t in the interests of individual investors, and it is an abomination that the SEC is squandering its limited resources by getting involved in the matter.

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Interview with SEC Chair Schapiro

Charles Lane of the Washington Post has a video interview with SEC Chair Mary Schapiro, in which she discusses improvements at the agency in response to the Madoff scandal, the inadequacies of the SEC’s Consolidated Supervised Entity (CSE) Program and the downfall of Lehman Brothers, and her expectations for regulatory reform.

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SEC Obtains Freeze on Russian Defendants’ Assets in Online Intrusion Scheme

On Monday, March 15, 2010, the SEC obtained a freeze on the assets of Russian defendants allegedly responsible for a hi-tech market manipulation scheme. According to the SEC, BroCo Investments, Inc. and its president Valery Maltsev hijacked the online brokerage accounts of unwitting investors using stolen usernames and passwords and subsequently placed unauthorized trades through the compromised accounts to manipulate the markets of at least thirty-eight issuers between August 2009 and December 2009. In almost every instance, prior to intruding into these accounts, the Defendants acquired positions in their own account. Then, just minutes later, without the accountholders’ knowledge, the Defendants, and/or individuals acting in concert with them, placed scores of unauthorized buy orders at above-market prices using the compromised accounts. After these unauthorized buy orders were placed, the Defendants sold the positions held in their own account at the artificially inflated prices. In other instances, the Defendants profited by covering short positions previously established in their account while placing unauthorized sell orders through the compromised accounts at substantially lower prices. This illicit account activity artificially affected the share price and trading volume for each of the thinly-traded issuers and enabled the Defendants to sell their holdings at a substantial profit, realizing at least $255,532 in ill-gotten gains.

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SEC Adopts New Restrictions on Short Selling

Short selling is a convenient scape goat for market volatility and downward spiraling of stock prices, so it was to be expected that the SEC would adopt new restrictions on the practice, which it did at today’s open meeting.  The SEC’s new rule will place certain restrictions on short selling when a stock is experiencing significant downward price pressure and is intended to promote market stability and preserve investor confidence.  According to SEC Chair Mary Schapiro, “the rule is designed to preserve investor confidence and promote market efficiency, recognizing short selling can potentially have both a beneficial and a harmful impact on the market.  It is important for the Commission and the markets to have in place a measure that creates certainty about how trading restrictions will operate during periods of stress and volatility.”

This alternative uptick rule (Rule 201) is designed to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers to stand in the front of the line and sell their shares before any short sellers once the circuit breaker is triggered.  Rule 201 imposes restrictions on short selling only when a stock has triggered a circuit breaker by experiencing a price decline of at least 10 percent in one day. At that point, short selling would be permitted if the price of the security is above the current national best bid.

Commissioner Paredes dissented with a thoughtful statement:

My comments center around two related themes. First, the essential rationale behind the rule is that the short sale restriction, if implemented, will bolster investor confidence. This claim is rooted in conjecture and is too speculative to form a properly cognizable basis for adopting the alternative uptick rule. Indeed, a more thorough analysis indicates that the rule amendments are just as likely, if not more so, to erode investor confidence instead of boosting it. Second, there is an insubstantial empirical basis to support the Commission in adopting the rule, especially in light of the rigorous economic analysis that led the SEC to repeal the “original” uptick rule in 2007 after years of study. The Commission bears the burden to justify its rules. It has not done so in this instance.

Rule 201 includes the following features:

Short Sale-Related Circuit Breaker: The circuit breaker would be triggered for a security any day in which the price declines by 10 percent or more from the prior day’s closing price.

Duration of Price Test Restriction: Once the circuit breaker has been triggered, the alternative uptick rule would apply to short sale orders in that security for the remainder of the day as well as the following day.

Securities Covered by Price Test Restriction: The rule generally applies to all equity securities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.

Implementation: The rule requires trading centers to establish, maintain, and enforce written policies and procedures that are reasonably designed to prevent the execution or display of a prohibited short sale.

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