Court Rules Against SEC in Section 10(b) Case

One year ago the Securities and Exchange Commission made headlines when it charged two Wall Street bankers with insider trading in credit default swaps. In bringing the case—the first-ever insider-trading enforcement action involving credit default swaps—the SEC sought to stake out new ground under the decade-old Gramm-Leach-Bliley Act.

Well, it failed.

On June 24, after presiding over a three-week bench trial, Judge John Koeltl of the Southern District of New York dismissed the case and exonerated the two defendants: Jon-Paul Rorech, a salesman at Deutsche Bank Securities, and Renato Negrin, a former portfolio manager at hedge fund Millennium Partners.

Koeltl’s opinion in the Rorech case is notable on multiple fronts. Foremost, while the SEC lost the battle against Rorech and Negrin, it gained a crucial victory when the court found that it did have jurisdiction to hear the case because the derivatives at issue were “security-based swap agreements” subject to Section 10(b) of the Securities Exchange Act. That allows the SEC to bring future insider-trading cases over swaps and similar derivatives.

On the other hand, the Rorech case is also a reminder that offerings in the bond market are different than those in the stock market, and that communications in the bond offering process might not be the same “material, non-public information” that land someone in trouble when trading stocks.

SEC alleged that Rorech learned information from Deutsche Bank investment bankers about changes to a proposed bond offering from European media business VNU. Those changes were expected to increase the price of credit default swaps for VNU bonds. Deutsche Bank was the lead underwriter for a proposed bond offering by VNU. The SEC claimed that Rorech then “illegally tipped” Negrin about the contemplated change to the bond offering, and Negrin purchased swaps on VNU for a Millennium hedge fund. When news of the restructured bond offering became public in 2006, the price of VNU swaps soared. Negrin then closed Millennium’s VNU swaps position at a profit of approximately $1.2 million. The SEC charged that Rorech and Negrin engaged in insider trading, in violation of the anti-fraud provisions of Section 10(b).

Rorech and Negrin quickly denied any improper conduct, stating that they were simply doing their jobs. They also argued that swaps aren’t covered by Section 10(b), and therefore the SEC had no right to bring any case against them. That argument didn’t pass muster with the judge. He pointed to the Commodity Futures Modernization Act, passed in 2000, which amended the anti-fraud provisions in Section 10(b) to include “securities-based swap agreement[s]” as defined in Section 206(b) of the Gramm-Leach-Bliley Act. Section 206(b), in turn, defines a securities-based swap agreement as “a 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” (emphasis added).

In other words, the court’s decision turned on the meaning of the phrase “based on.” Following a lengthy analysis, the court found that the price, yield, and value of VNU bonds all were important to Negrin as he determined whether to purchase VNU swaps; and that beyond the VNU transaction, the evidence suggested that market analysts and experts considered swap prices in general to be based on the price, yield, or value of the referenced entity’s bonds. Therefore, the swaps in question in the Rorech case were “security-based swap agreements” subject to enforcement by the SEC under Section 10(b).

Now, yes, that legal ruling is critical to the SEC’s enforcement program going forward, but it was only the first hurdle that the SEC had to overcome in this particular case. Indeed, following the three-week bench trial, Judge Koeltl found that the SEC utterly failed to prove an insider-trading case against either Rorech or Negrin. In particular, Koeltl found that:

The SEC produced no evidence that Rorech either received or shared with Negrin any confidential information;

The SEC failed to prove that any of the allegedly shared information was material, as any information Rorech possessed was “completely speculative” and there was widespread discussion in the market regarding investor demand for a restructuring of the VNU bond offering; and

The SEC failed to establish any “deception” or motive in the case. The court found that Rorech disclosed to his supervisors that he was, in fact, sharing information about the potential holding company issuance with his customers, including Negrin’s hedge fund, and was never told to stop sharing such information.

In addition, the court found that Rorech believed discussing the information about VNU with prospective investors was part of his job as a salesman. “This belief comported with both the custom and practice in the industry as well as the actions of capital markets officers and other Deutsche Bank salespeople on the high-yield desk,” including his supervisor, Koelti wrote in his decision.

Participants in the derivatives markets need to take notice that the SEC will no longer “shy away from the most complicated corner of the financial industry.”

Rorech’s attorney, Richard Strassberg, believes that this last point—that Rorech’s discussions with customers about VNU bonds were standard industry practice—is a crucial part of the case. The practice of marketing high-yield bonds, Strassberg says, is fundamentally different from selling stocks. That is what the SEC misunderstood.

I won’t go into all the details here (if you want them, read Koelti’s decision), but the difference is this: In a stock purchase, purchasers have a relatively simple “buy or not buy” decision. High-yield offerings, however, are far more interactive. Strassberg emphasizes that issuers of high-yield bonds will go to the marketplace, indicate that they are considering a particular offering, and ask for feedback. Potential purchasers will then often suggest changes to the offering (known as a “reverse inquiry”) that would make it more attractive. This type of negotiation and ongoing conversation is natural and commonplace in the fixed-income market, Strassberg says, and the court’s ruling in the Rorech case will hopefully make that point clear.

In Strassberg’s opinion, if the SEC wants to change existing practices about marketing high-yield bond deals, issuing new regulations would be the proper way to achieve this. Using an enforcement action to send a message instead, he says, was a “great injustice” in the Rorech case. He also believes that the case shows hedge funds that while the justice system did ultimately work and provide the right outcome for people such as Rorech (who has been on paid leave from Deutsche Bank since mid-2009) and Negrin, they should remain aware that their actions in the derivatives area may well be singled out for scrutiny by regulators.

Regardless of the outcome of the Rorech case, recent events show that the SEC intends to continue to push hard on derivatives. In January 2010, the SEC created a new Structured and New Products unit that focuses on complex derivatives and financial products, including swaps, collateralized debt obligations (CDOs), and securitized products. This unit promptly filed the high-profile action against Goldman Sachs in April related to the disclosure provided on the sale of certain synthetic CDOs. In June, the SEC also filed an enforcement action against investment advisory firm ICP Asset Management alleging that the firm put its own interests ahead of clients, and engaged in fraudulent practices that caused four multibillion-dollar CDOs to lose tens of millions of dollars.

Participants in the derivatives markets need to take notice that, as the SEC stated when it filed its case against ICP, the agency will no longer “shy away from the most complicated corner of the financial industry.”