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(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
SEC Charges Hedge Fund Manager in First Insider Trading Case Involving
Credit Default Swaps
The SEC has filed an enforcement action
alleging that a hedge fund manager and a Deutsche Bank Securities bond salesman
engaged in insider trading in the credit default swaps of an international
holding company, VNU, a Dutch media conglomerate. The SEC charged the hedge fund
manager and bond salesman with violations of the antifraud provisions of the
Exchange Act. The Commission has asked a federal court to order them to pay
financial penalties and disgorge ill-gotten gains, plus prejudgment interest.
The hedge fund has agreed to escrow the amount that the SEC is seeking as
ill-gotten gains pending a final judgment in the action. (SEC
v. Rorech, et al.,
SD NY, Litigation Release No. 21023).
James Clarkson, Acting Director of the SEC's New York Regional Office, noted
that, while credit default swaps may be obscure to the average individual
investor, there is nothing obscure about fraudulently trading with an unfair
advantage. Further, the SEC official emphasized that there must be a level
playing field with even the most sophisticated financial instruments. The case
was handled by the SEC Enforcement Division's Hedge Fund Working Group, which is
investigating fraud and market manipulation by hedge fund investment advisers.
The SEC also acknowledged the assistance of the U.K.'s Financial Services
Authority.
The SEC alleged that the bond salesman learned information from his firm's
investment bankers about a change to the holding company's bond offering that
was expected to increase the price of the credit default swaps on the company's
bonds. Deutsche Bank was the lead underwriter for a proposed bond offering by
the company. According to the SEC's complaint, the salesman illegally tipped the
hedge fund manager about the contemplated change to the bond structure, and the
manager then purchased credit default swaps on the company for the hedge fund.
When news of the restructured bond offering became public, the price of the
swaps substantially increased, said the SEC, and the asset manager closed the
fund's position at a profit of approximately $1.2 million.
The SEC said that the bond salesman knew that the information he was
providing to the fund manager was material, inside information in breach of the
salesman's duties to his employer. The SEC also alleged that the salesman was
aware of his employer's policies concerning the treatment of confidential
information, and knew that the information he had imparted to the asset manager
was confidential. The SEC similarly alleged that the hedge fund manager also
knew or should have known that the bond salesman provided him with information
concerning the restructuring in breach of the duties he owed to Deutsche Bank
Securities.
The SEC explained that credit default swaps are a type of credit derivative,
economically similar to default insurance for a referenced debt obligation, such
as a bond. The seller of the credit default swap agrees to pay to the buyer of
the swap a specified amount if the issuer of the bond referenced by the swap
defaults on its obligations. The buyer, in return for that protection, pays a
specified amount, or premium, to the seller each quarter, during the term of the
credit default swap contract. In the event of a default, the swap buyer tenders
defaulted bonds (or their cash equivalent) to the seller in exchange for the
full amount of the credit default swap.
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