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.