In a recently issued opinion following a bench trial, the US District Court for the Southern District of New York rejected the SEC's insider trading charges against a bond salesman and hedge fund manager but, in the process, delivered to the SEC a significant victory in its efforts to police derivatives markets.

SEC v. Rorech marked the SEC's first-ever insider trading case based on credit-default swaps and the first-ever decision by a court interpreting the SEC's anti-fraud jurisdiction over "securities-based swap agreements."

The court rejected the defendants' argument that the SEC had no jurisdiction over the credit default swaps because they were privately negotiated contracts, agreeing instead with the SEC that the swaps were "securities-based" and subject to the SEC's antifraud regulations because the price of the swaps reflected the price, yield, or value of the underlying bond.

Credit Default Swaps

Credit default swaps (CDS) are privately negotiated contracts that provide for the transfer of credit risk from one party to another. They are similar to insurance or other hedging instruments because they provide the buyer of the contract, who often holds the underlying credit as well, with protection against default, a credit rating downgrade, or another negative "credit event" with respect to a borrower. The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay a predetermined "notional amount" only if a negative credit event occurs. If a credit event occurs, the buyer generally must provide to the seller any of certain debt instruments that are "deliverable" pursuant to the CDS contract. An investor may also buy CDSs as non-hedged investments (naked CDS) with the expectation that they will increase in value based on the likelihood of a credit event occurring.

CDSs trade between private parties rather than on exchanges and, by themselves, are not considered securities under the federal securities laws. 15 U.S.C. § 78c-1. CDSs, like many derivative products, are often designed to be synthetic substitutes for securities in an effort to avoid securities regulations. CDSs are generally excluded from the SEC's jurisdiction, except in one respect: the SEC has antifraud enforcement jurisdiction over "securities-based swap agreements." 15 U.S.C. § 78j(b). Securities-based swap agreements are those for 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." Id.; Gramm-Leach Bliley Act of 1999, 113 Stat. 1338, 1394 (1999).

In Rorech, the SEC sought to test the limits of its antifraud jurisdiction to regulate the CDS market, which has been estimated to be in the tens of trillions of dollars - over twice the size of the US stock market.

SEC v. Rorech

The CDSs at issue in Rorech were contracts that provided protection against the credit risk of VNU N.V., a Dutch media holding company. In 2006, VNU was bought out by a group of private equity firms. The deal was announced in March but the structure of the bond issuance financing the deal was altered in July. Prior to the announcement of the restructured deal in July 2006, the SEC said Jon-Paul Rorech, a bond salesman at a large investment bank, learned about the new financing structure from bankers at his firm who were working on the deal and tipped off Renato Negrin, a former portfolio manger at a hedge fund, about the new terms. Negrin allegedly bought CDSs based on the recommendation of Rorech. In the revised offering, VNU issued bonds that were "deliverable" into the existing CDSs, which pushed up the value of the CDSs. Negrin profited in the amount of $1.2 million.

In May 2009, the SEC charged Rorech and Negrin with insider trading in the VNU CDSs. SEC v. Rorech et al., No. 09-4329 (JGK) (S.D.N.Y). The court ruled in favor of the defendants on the insider trading charges. To reach that decision, however, the court first held that the SEC had antifraud jurisdiction over the CDSs at issue.

The CDSs in Rorech were not tied to VNU bonds based on a direct or measurable formula. Rather, the CDS prices were individually negotiated between the buyer and seller and the court noted that the price was affected by many factors, including the strength of the overall economy and the market's assessment of the referenced company's credit risk. Slip op. at 90. The defendants argued that the CDSs at issue were not securities-based swaps because (1) they did not "make actual reference to the price or value" of the bonds, and (2) they did not have "a direct, or exclusive dependence" on the VNU bonds that was "spelled out in the text of [the] CDS contract." Slip op. at 90, 95.

The court rejected the defendants' jurisdiction argument and held that the CDSs were securities-based swaps because the price terms of the CDSs were fundamentally (though not expressly) based on the price, yield, and value of VNU bonds. The court's holding relied heavily on evidence that the defendants anticipated that the price of the VNU CDSs and the deliverable bonds would move in tandem and "twice discussed and calculated the target price of VNU CDSs based on the expected spread of the VNU holding company bonds" Slip op. at 96. The court said its holding was further supported by the "long-term equilibrium" between CDS prices and the price or yield of their underlying bonds and the fact that "both VNU and bond spreads contribute to price discovery of each other." Slip op. at 82-83.

Rorech and the Regulation of Derivatives

The conclusion of the court in Rorech that the VNU CDSs were securities-based swaps – despite the fact that the price of the CDSs were not tied to the price, yield, or value of the VNU bonds in a direct or measurable way – makes it more likely that courts will similarly find other swap agreements are securities-based swaps that are subject to the SEC's antifraud jurisdiction.

Having won this new jurisdictional territory, expending litigation resources to secure it, and creating a new enforcement unit to focus on structured products, the SEC is likely to police the CDS market more aggressively. Firms engaged in trading CDSs and other derivative products should take steps to prepare for increased SEC scrutiny and to implement appropriate compliance measures.

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