CDS: Insider Trading Case brought by SEC

SEC Claims New Territory With Insider Trading Case

Marisa McQuilken
The National Law Journal
June 23, 2009

John Olson, a senior securities partner at Gibson, Dunn & Crutcher, says he knows which two cases are about to become the talk of the securities bar.

One, the U.S. Securities and Exchange Commission's action against billionaire Mark Cuban, has already generated a lot of hype. But the other one -- a suit that has so far kept a low profile -- could be even more significant. It's the case brought by the SEC last month accusing a Deutsche Bank Securities bond salesman and a former Millennium Partners hedge fund manager of insider trading in credit default swaps -- the derivatives blamed for much of the economic meltdown.

The case marks the first time the SEC has gone after trading in credit default swaps. It comes as debate rages over how to regulate them and other increasingly creative and complex financial products. Last week, President Barack Obama released a new regulatory plan that calls on the SEC and the Commodity Futures Trading Commission to jointly police derivatives markets. But securities experts say the case, filed on May 5, shows that the SEC is willing to push the limits of its current enforcement ability to stake out that territory. The SEC "probably moved it forward more quickly than otherwise would've been the case to make that statement," said Olson.

By filing the matter, Securities and Exchange Commission v. Jon-Paul Rorech and Renato Negrin , in the U.S. District Court for the Southern District of New York, the SEC is asking the court, for the first time, to agree that credit default swaps are security-based, and therefore subject to the SEC's anti-fraud actions.

"They certainly have strong arguments," said University of Maryland School of Law professor Michael Greenberger, though he added, "Whether [the SEC's] argument is right or wrong is an open question, and it's a novel issue."

STAKING A CLAIM

In its complaint against Rorech and Negrin, the SEC says credit default swaps clearly meet the definition of "security-based swap agreements" established by the Gramm-Leach-Bliley Act, enacted in 1999. The statute's goal was deregulating the financial industry, but it does contain language defining security-based swap agreements, which is the key to this particular case.

The SEC's interpretation of Gramm-Leach-Bliley raises an obvious question: Given that the statute is a decade old, why is the agency just now bringing its first case under the authority?

Bruce Karpati, assistant director in the SEC's Division of Enforcement and one of three lawyers assigned to the case, says the answer is simple: "With over-the-counter derivatives, there's no audit trail. It's difficult to get information." In other words, it's harder -- and takes longer -- to establish a case involving transactions that didn't take place on the public market. Karpati also heads the SEC's hedge fund working group, which handled the investigation into Rorech and Negrin. He declined to comment on specifics of the case.

Securities lawyers say there are other reasons for the timing, too.

The SEC has been fighting to restore its reputation as a tough regulator after months of criticism over the agency's failure to avert excesses seen as leading to the financial meltdown. The SEC's new chairwoman, Mary Schapiro, and new Division of Enforcement Director Robert Khuzami have been promising a vigorous crackdown on corporate wrongdoing.

In written testimony to a Senate Banking subcommittee last month, Khuzami said a key instruction he's given to enforcement staff is "to be as strategic as possible" with the cases they bring. (The emphasis on the word "strategic" was Khuzami's own.)

And as Congress and the administration grapple with revamping the patchwork regulatory system, securities experts say a logical place for the SEC to prove itself as a worthwhile enforcer is in the shadowy area of over-the-counter derivatives. Credit default swaps -- essentially a form of insurance that transfers the risk of bond defaults from the bondholder to the seller of the swap -- have been blamed for much of the crisis.

"I'm sure the pressure on the Enforcement Division is substantial because this has been a widely discussed problem within the investment community, and the academic community," said Greenberger, who teaches about derivatives at the University of Maryland School of Law. "If they're right about this, it will be a very, very significant case."

It's already getting a strong point across. During a conference call with financial institutions clients earlier this month, Mayer Brown partner Sean Casey used the case to demonstrate the SEC's tougher stance.

Pointing out that credit default swaps don't necessarily qualify as security-based, Casey said the case "really shows that the SEC is really reaching. ... They want to show that they can be the police officers."

'OUTSIZED MESSAGE'

As of press time, a response to the SEC's complaint had not been filed, but Lawrence Iason, a name partner at Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer in New York, said his client, Negrin, is "truly innocent." Regardless of whether the SEC has authority to bring the case, Iason said, "Whatever was discussed between my client and Mr. Rorech was not confidential information."

Rorech's lawyer, Richard Strassberg, a partner in Boston-based Goodwin Procter's New York office, did not return a call seeking comment.

The case is a complicated one, and it's made more so by the fact that the derivatives are tied to a European company, which defense lawyers had previously said raised questions about the SEC's jurisdiction. The SEC claims that, through his employment at Deutsche Bank, Rorech became aware of confidential information concerning the refinancing of Dutch media company VNU N.V. that was material to the market price of credit default swaps that referenced VNU bonds. According to the complaint, Rorech allegedly passed the information to Negrin, who purchased some of the credit default swaps on behalf of a hedge fund advised by his then-employer Millennium Partners. Ultimately, the complaint alleges that Negrin made $1.2 million from the transaction.

It's a relatively modest profit, but for the SEC, the amount of the alleged fraud is apparently not the point.

To be strategic, Khuzami said in the written testimony last month, enforcement staff should not only focus on "cases involving the greatest and most immediate harm," but they should also zero in "on cases that send an outsized message of deterrence."

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