The SEC’s first insider trading enforcement action involving credit default swaps is leading the way

In the aftermath of the bankruptcy filings by Lehman Brothers Holdings Inc. and certain of its subsidiaries and the ensuing market turmoil, credit default swaps ("CDS") have been cited as one of the main culprits for causing the current crisis. On September 23, 2008, former Chairman of the U.S. Securities and Exchange Commission (the "SEC") Christopher Cox testified before the Committee on Banking, Housing and Urban Affairs that the CDS market is "completely unregulated" and that "neither the SEC nor any regulator has authority over the CDS market."1 On June 17, 2009, President Obama announced that the government is "proposing a sweeping overhaul of the financial regulatory system,"2 including the "comprehensive regulation of credit default swaps and other derivatives that have threatened the entire financial system" (see inset on next page). On a parallel track, the SEC has intensified its focus on prosecuting fraud in connection with over the counter ("OTC") derivatives under its existing authority, and brought the first-ever enforcement action relating to insider trading in connection with CDS.3 This civil action comes at a pivotal time, as discussions continue on the proposed comprehensive regulatory framework for OTC derivatives and the roles that the Commodity Futures Trading Commission (the "CFTC") and the SEC will occupy in this framework. As such, this case offers an insight into the SEC's possible role and jurisdiction in the oversight of OTC derivatives.

Background on CDS

A CDS is an agreement between two parties, pursuant to which the protection buyer pays a one-time or periodic premium to the protection seller in exchange for a contingent payment of a specified amount if the entity referenced by the CDS experiences a "credit event" (usually a bankruptcy or a failure to pay its obligations). The trading prices of CDS fluctuate according to the perceived likelihood that the referenced entity will default on its obligations.

SEC v. Rorech and Negrin

The SEC brought this action based on an alleged violation of the antifraud provisions in the U.S. Securities Exchange Act of 1934, as amended (the "Exchange Act") and the regulations promulgated thereunder. In its complaint, the SEC alleges that in July 2006, Jon-Paul Rorech, a bond and CDS salesman at Deutsche Bank Securities Inc., became privy to confidential information regarding the restructuring of an upcoming bond issuance by VNU N.V. ("VNU"), a Dutch media conglomerate. VNU was taken private by a consortium of private equity companies in May 2006, and in July 2006 announced a financing structure to fund the transaction mainly through debt issuances by VNU subsidiaries. Prior to the announcement of the final structure, the financing was restructured to include the issuance of a tranche of bonds by VNU. The new financing structure resulted in new debt of VNU, which in turn resulted in increased market value for CDS covering the default on such bonds.

The complaint alleges that Rorech provided Renato Negrin, then a portfolio manager at Millennium Partners, L.P. ("Millennium"), with confidential information regarding the proposed restructuring of VNU's financing. Negrin allegedly acted on this confidential information and purchased CDS that referenced VNU prior to the announcement of the new financing structure, resulting in a profit of $1.2 million for Millennium when the bonds deal was announced and Negrin sold the VNU CDS. The complaint alleges that Rorech and Negrin violated Section 10(b)4 of the Exchange Act and Rule 10b-5 promulgated thereunder. 5 In answers to the complaint submitted by Rorech and Negrin on June 19, 2009, both denied the SEC's allegations of insider trading and challenged the SEC's authority to bring the case arguing that the SEC does not have jurisdiction over a foreign company's securities or the CDS referencing such securities.

The SEC’s Jurisdiction Over CDS

Despite the exponential growth of the CDS market over the last decade, the SEC's prior actions relating to insider trading so far have focused on equity and debt securities. This is the first time the SEC has pursued an action for insider trading relating to OTC derivatives. The SEC generally is prohibited from directly regulating swap agreements, including CDS and securities- based swap agreements, since they do not fall within the definition of a "security" under the Exchange Act or the U.S. Securities Act of 1933, as amended (the "Securities Act"). In 2000, both Acts were amended by the Commodity Futures Modernization Act of 2000 ("CFMA") to expressly prevent the SEC from requiring any registration of security-based swap agreements and to prohibit the SEC from enforcing rules or issuing orders that impose prophylactic measures against any kind of fraud with respect to security-based swap agreements.6 The CFMA defined "security-based swap agreements" in section 206B of the Gramm- Leach-Bliley Act as any "swap agreement . . . of 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 SEC's Division of Enforcement is, however, granted authority to promulgate rules that prohibit fraud, manipulation and insider trading and enforce those rules against securities-based swap agreements under the antifraud provisions in Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act. As a result, the SEC has jurisdiction over insider trading of securitiesbased swap agreements.

In its complaint, the SEC argued that it has jurisdiction to bring the case against Rorech and Negrin. The SEC noted that: "[t]he CDS at issue in this matter qualify as security-based swap agreements under the Gramm-Leach-Bliley Act . . . and are therefore subject to the antifraud provisions set forth in Section 10(b) of the Exchange Act and the rules promulgated thereunder."7

In a memorandum of law in support of his Motion for Judgment on the Pleadings filed on August 13, 2009, Rorech argues that the complaint should be dismissed as the CDS at issue does not constitute a "securities-based swap agreement".8 Pursuant to Rorech, the material terms of the CDS, such as the term, notional amount, fixed payments, settlement mechanics and triggering credit events, are not based on "the price, yield, value, or volatility of any security," as required by the statutory definition of "securitybased swap agreement." Rorech further posits that the SEC does not have jurisdiction over the VNU bonds, as these bonds were issued by a foreign issuer and trade on a foreign exchange. Without jurisdiction over the VNU bonds, Rorech concludes, the SEC also lacks jurisdiction over the CDS that references these bonds.9

Negrin, in his August 19, 2009 Motion for Judgment on the Pleadings, seconds Rorech's argument and equally takes the view that the SEC lacks jurisdiction to bring its enforcement action because the CDS did not constitute a "securitiesbased swap agreement" as defined in the Gramm- Leach-Bliley Act.10

Beyond SEC v. Rorech and Negrin

The SEC filed the complaint against Rorech and Negrin in reliance on existing jurisdiction over securities-based swap agreements. Chairman Schapiro has publicly stated that the SEC currently has more than 50 ongoing investigations involving CDS and other derivatives-related investments, which highlights the SEC's revived focus on asserting its role in the oversight of OTC derivatives. 11 The SEC has also entered into a Memorandum of Understanding with the CFTC on March 11, 2008, in order to "establish a permanent regulatory liaison and facilitate the discussion and coordination of regulatory action regarding issues of common regulatory interest."12 The SEC and the CFTC entered into the Memorandum of Understanding to ensure complete and effective regulation of OTC derivatives, as financial innovation has meant that "novel derivative products may reflect elements of both securities and commodity futures or options, and may impact the regulatory mission of each agency."13 On June 22, 2009, Chairmen Gensler14 and Schapiro15 testified before the Subcommittee on Securities, Insurance, and Investment regarding the regulatory framework for OTC derivatives. Both Chairmen agreed that the SEC should have "primary responsibility for 'securities-related' OTC derivatives," including CDS, and the CFTC should have "primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals."16 Both the House Agricultural Committee and the House Financial Services Committee reached agreement to work together on draft legislation when Congress returns from summer recess. On July 30, 2009, Congressman Peterson, Chairman of the House Agricultural Committee, and Congressman Frank, Chairman of the House Financial Services Committee, released a concept paper describing the principles for OTC derivatives legislation and procedures for resolving disputes between the SEC and the CFTC over authority over new derivatives products.17

Going forward, the SEC's jurisdiction likely will grow as President Obama's plans for the "comprehensive regulation" of OTC derivatives, as released by the U.S. Department of the Treasury, are implemented.18 This will include amending the U..S. Commodities Exchange Act of 1936, as amended (the "CEA"), and the securities laws to ensure that the CFTC and the SEC "have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives."19 The plans for reform also provide that the CFTC and the SEC should have the power "to impose recordkeeping and reporting requirements (including an audit trail) on all OTC derivatives."20 While it remains to be seen how the CEA and the securities laws will be amended to implement the President's plans and to provide both agencies with the tools to effectively protect the markets from fraud in connection with OTC derivatives, the outcome of SEC v. Rorech likely will receive much attention in determining the effectiveness of the presently existing tool set.