On May 5, 2009, the U.S. Securities and Exchange Commission ("SEC") brought an action in the U.S. District Court for the Southern District of New York alleging the "the first insider trading enforcement action involving credit default swaps."[1]

Historically, the SEC has pursued enforcement actions focused primarily on violations of the antifraud provisions in the context of equity securities.[2] However, in the recent case of SEC v. Barclays Bank PLC,[3] the SEC brought an enforcement action for violations of the insider trading laws involving debt securities. SEC v. Rorech may represent the next step in the extension of the insider trading laws.

In its complaint, the SEC alleges that Renato Negrin, a former portfolio manager employed by hedge fund investment adviser Millennium Partners L.P. ("Millennium"), and Jon-Paul Rorech, a bond and credit default swap ("CDS") salesman at Deutsche Bank Securities Inc. ("DBSI"), engaged in insider trading in CDSs of VNU N.V. ("VNU"), a Dutch media conglomerate.[4]


CDSs are derivatives, similar to insurance in the event an issuer defaults on a debt obligation, such as a bond. Accordingly, the price of a CDS generally increases when an issuer increases its outstanding debt obligations. These instruments have recently exploded into public prominence as a result of the U.S. government's intervention in American International Group, Inc. ("AIG"), which was required partly because of the perception that a default by AIG on its CDS obligations may have wreaked havoc on the world's financial system.

Despite the size of the CDS market, estimated at $38.6 trillion traded value, CDSs are largely unregulated. Former SEC Chairman Christopher Cox has referred to the CDS market as a "regulatory hole" because under the current regulatory regimes "neither the SEC nor any regulator has authority over the CDS market."[5] In the late 1990s, the Commodities Futures Trading Commission attempted to regulate CDSs, but, in 2000, Congress passed the Commodity Futures Modernization Act, which made clear that these instruments were to remain unregulated.

The SEC lacks the general power to directly regulate CDSs because they fall outside the definition of a "security" under both the Securities Act of 1933, as amended (the "Securities Act"), and the Securities Exchange Act of 1934, as amended (the "Exchange Act"). However, the SEC's Division of Enforcement does have specific authority over "securities-based swap agreements" (as defined in section 206B of the Gramm-Leach-Bliley Act) under the antifraud provisions in Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act.[6] Thus, the SEC has jurisdiction over insider trading of CDSs linked to bonds. Although widely prevalent, CDSs linked to loans are beyond the SEC's reach.

SEC v. Rorech

The SEC brought the action in SEC v. Rorech for alleged violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. In its complaint, the SEC indicated that: "The CDSs at issue in this matter qualify as security-based swap agreements under the Gramm-Leach-Bliley Act of 2002 and are therefore subject to the antifraud provisions set forth in Section 10(b) of the Exchange Act and the rules promulgated thereunder."[7]

The complaint alleges that Rorech, by virtue of his employment at DBSI, obtained confidential information concerning the restructuring of an upcoming bond offering by VNU, which was material to the market price of the separately traded CDSs that referenced VNU bonds. The complaint goes on to allege that, notwithstanding his duty to maintain the confidentiality of this material information, Rorech "tipped Negrin to the confidential information" regarding the bond offering by VNU.[8] Thereafter, Negrin allegedly used this information to purchase €20 million of CDSs on VNU, on behalf of hedge funds advised by Millennium. Negrin later allegedly closed Millennium's CDS position in VNU for a profit of approximately $1.2 million.

Impact of SEC v. Rorech

CDSs. In light of the role CDSs have played in the current financial crisis, the SEC will likely bring additional enforcement actions relating to "securities-based swap agreements." In addition, legislators, regulators, practitioners, and academics may reexamine current legislation relating to CDSs, including "non-securities-based swap agreements." It remains to be seen whether Congress will pursue legislation relating to the direct regulation of CDSs or antifraud regulation of non-securities-based swap agreements.

Hedge Funds. Since the U.S. Court of Appeals for the District of Columbia Circuit vacated the SEC's attempt to directly regulate hedge funds in Goldstein v. SEC,[9] the SEC has increased its antifraud enforcement efforts in the hedge fund industry. The SEC reportedly has at least 50 investigations involving derivatives underway.[10] In light of the current financial crisis, increased scrutiny of transactions involving derivatives and hedge funds,[11] as well as calls for Congressional legislation authorizing direct regulation of hedge funds, are likely to continue.