Wednesday, April 7, 2010

Securities: First SEC Insider Trading of Default Swaps Case Goes to Trial

For the first time the Securities and Exchange Commission is bringing to trial an insider trading case based on credit default swaps. The case is taking place in the United States District Court for the Southern District of New York in Manhattan. It will be a bellwether for the handling of these types of cases by the SEC.

A "credit default swap" is exactly what the name suggests. It is a bet that a credit instrument will go into default. Typically, a credit default swap references a bond or a loan. The buyer of the credit default swap pays a premium and receives proceeds of the contract from the seller if the bond or loan goes into default. The buyer may or may not also hold the underlying obligation. However, in most cases the buyer does not hold the bonds or loan.

The SEC alleges that Jon-Paul Rorech, a bond and credit default swap salesman for Deutsche Bank Securities, provided information about a bond sale to Renato Negrin, a former Millennium Partners portfolio manager. The complaint further alleges that based on the tip, Negrin executed credit default swap transactions, which referenced the bond being offered.

The case revolves around bond offerings by the Dutch media company, VNU Group BV. In July 2006 VNU announced a $1.67 billion bond offer by its subsidiaries. Investors in the offering became concerned that the bonds could not be used to settle credit default swaps referencing them. As a result, on July 24, 2006, Deutsche Bank, the underwriter for the bond offering, announced a restructuring of the bond offer. The restructured offer was to include a 200 million euro tranche from VNU to cover the credit default swaps.

The SEC alleges that Rorech tipped Negrin about the restructuring before the announcement. Negrin bought 20 million euros of VNU subsidiary swaps. Upon the announcement of the restructuring, the price of the swaps rose. Then, Negrin sold his holdings of the swaps to realize a profit. The SEC alleges that the trading realized a gain of $1.2 million of which Negrin's personal gain was $240,000.

The case is significant because derivatives such as credit default swaps are part of the "shadow banking" system which has been essentially unregulated. A threshold issue in the trial is whether the SEC has jurisdiction in the matter. The defendants contend that credit default swaps are private contracts rather than securities and are outside the purview of the SEC. Congress has given the Commission authority to prosecute credit default swap cases where material terms of the contract relate to the price, yield, value, or volatility of a security. The Commission is arguing that the price of the credit default swap involving the VNU bonds brings the matter within its jurisdiction.

How the district court and ultimately the Second Circuit Court of Appeals rules on this issue will dictate how active an approach the SEC will be able to take in its enforcement program concerning credit default swaps. The trial is underway and the initial answer to this question should be forthcoming.

For a further discussion of the pending trial, please see BussinessWeek, "Trial Begins in First SEC Insider Default-Swap Case," April 7, 2010,

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