In a detailed, 122-page opinion (pdf), U.S. District Court Judge John G. Koeltl systematically dismantled and dismissed the SEC’s first-ever credit default swap insider trading case.  In SEC  v. Jon-Paul Rorech and Renato Negrin (pdf), the SEC alleged that Deutsche Bank bond salesman, Jon-Paul Rorech, passed material, non-public information to a Millennium Partners hedge fund manager, Renato Negrin and that Negrin profitably traded credit default swaps (“CDS”) based upon that information.  The allegedly confidential information concerned a bond offering for two subsidiaries of a Dutch media holding company VNU N.V. being underwritten by Deutsche Bank.  The SEC complaint asserted that Rorech told Negrin that Deutsche Bank would “recommend” to VNU’s sponsors that the bonds be issued at the holding company level rather than the subsidiary level and that Rorech already had a commitment from a customer to buy $100 million of the holding company bonds when released.  The SEC claimed that Negrin, once armed with this information, purchased two VNU CDS contracts which he later sold after the formal announcement of the VNU bond offering at a profit of $1.2 million.    

Rorech was heralded as a groundbreaking test of the SEC’s resolve to leave no corner of the capital markets unregulated.  Involving sophisticated market participants trading in complex credit derivatives, the SEC’s litigation release announcing the action in May 2009 led with the headline “SEC Files First Credit Default Swap Insider Trading Case.”  The implication of this “first” of its kind was supposed to act as a message:  the SEC understands Wall Street’s sophisticated products and will prosecute wrongdoing involving them.  

The massive challenge facing the SEC in Rorech was whether it had jurisdiction to sue over misconduct involving credit default swaps.  This was a highly technical question of whether the CDS contracts at issue fell within the definition of a “securities-based swap agreement” under section 206B of the Gramm-Leach-Bliley Act.  The results of that analysis would in-turn have an impact on whether the CDS at issue could fall within Section 10(b) of the Securities Exchange Act as amended by the Commodity Futures Modernization Act.

According to Judge Koeltl, the threat actually facing the SEC’s case was not its subject matter jurisdiction, the reach of securities laws, or even the complexities of credit derivatives but rather old-fashioned sufficiency of the evidence.  After a three-week bench trial, the Court found that the SEC’s complaint was deficient with respect to every required element of an insider trading case as (1) the SEC failed to show any evidence that the underlying confidential information was true, let alone that Rorech could have possibly possessed it;  (2) no evidence was presented, even assuming the purportedly confidential information to be true, that the information would have been material to investors;  (3)  the evidence presented demonstrated that the allegedly “confidential” information may not have been confidential, as there was no requirement or expectation that the information would be kept confidential by any of the parties involved;  (4)  no evidence of “deceit” or unauthorized theft of information was presented as required in insider trading actions brought pursuant to the misappropriation theory; and (5) the SEC failed to show that Rorech had the necessary intent, or scienter, to be held liable for insider trading.

The Court also noted that the SEC was unable to offer “any” evidence of Rorech’s motive for violating the securities laws since nothing was presented regarding how sales of the bonds or CDS protection would impact his compensation. 

In the end, the “controversial” issue of whether the CDS contracts were subject to the antifraud provisions of the federal securities laws was a red herring.  The Court reached the conclusion that the derivatives at issue were “securities-based” and thus well within the jurisdiction of the SEC. 

There is no word yet on whether the SEC will appeal this decision 

Allison D. Charney contributed to this post.