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(The article featured
below is a selection from Federal
Securities Law Reporter, which is available to subscribers of that
publication.)
Initial CDS Insider Trading Case Survives Challenge
The first insider trading action filed by the SEC alleging
misconduct in the credit default swaps (CDS) market survived a motion for
judgment on the pleadings. The complaint, filed in the U.S. District Court for
the Southern District of New York, alleged Renato Negrin, a former portfolio
manager at hedge fund investment adviser Millennium Partners, L.P., and Jon-Paul
Rorech, a salesman at Deutsche Bank Securities Inc., engaged in insider trading
in the credit default swaps of VNU N.V., an international holding company.
According to the Commission's complaint, Mr. Rorech learned
information from Deutsche Bank investment bankers about a change to the proposed
VNU bond offering that was expected to increase the price of the CDS on VNU
bonds. Deutsche Bank was the lead underwriter for a proposed bond offering by
VNU. According to the complaint, Mr. Rorech illegally tipped Mr. Negrin about
the contemplated change to the bond structure, and Mr. Negrin then purchased
credit default swaps on VNU for a Millennium hedge fund. When news of the
restructured bond offering became public in late July 2006, the price of VNU CDS
substantially increased, and Mr. Negrin closed Millennium's VNU CDS position at
a profit of approximately $1.2 million.
The defendants argued that they could not be liable for insider
trading under Section 10(b) because the credit default swaps in this case were
not securities-based swap agreements. In addition, the court rejected arguments
by both defendants that the SEC lacked jurisdiction as a matter of law because
the credit default swaps at issue were based on foreign bonds, and by Mr. Rorech
that he had no duty to keep information about the VNU bonds confidential. The
court did not reach the merits of the Commission's charges.
As amended by the Commodity Futures Modernization Act, the
Exchange Act antifraud provisions apply to security-based swap agreements. The
definition includes swap agreements in which "a
material term is based on the price, yield, value, or volatility of any security
or any group or index of securities, or any interest therein." The
swap agreements in this case did not specifically state whether a material term
of the instruments was based on a security. However, Judge Koeltl wrote that "it
cannot be that traders can escape the ambit of Section 10(b) and Rule 10b-5 by
basing a CDS’s material term on a security, but simply omitting reference to
the security from the text of the CDS contract." He also noted that
there is a secondary market for the instruments, and concluded that there was an
issue of fact concerning whether the market price would be based on the value of
the underlying bond.
The foreign domicile of the bond issuer was not dispositive,
because the unlawful conduct, the tipping and the trading, took place in this
country. The court also found that it could not dispose of Mr. Rorech's claim
that he had no duty of confidentiality on the pleadings. The SEC alleged that he
acquired the information about the bonds through his relationship of trust and
confidence with his employer. "The question of the
scope of his duty to DBSI and whether the information he shared was in fact
confidential is a fact-based inquiry that cannot be decided in the defendant's
favor on a motion for judgment on the pleadings," concluded Judge
Koeltl. The SEC allegations supported a reasonable inference that Mr. Rorech
breached a duty of confidentiality, and his responses "do
not show that the SEC's claim is implausible on its face."
SEC v. Rorech (SD NY) will be published in a forthcoming Report.
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