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.

More.

This entry was posted on Wednesday, July 14th, 2010 at 1:53 am and is filed under SEC News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.