Insider trading has a new face. Credit default swaps, long one of the least understood and least regulated sets of financial instruments can be used for insider trading in a similar manner to stocks, but the government has never brought a case about illegally gotten CDS profits. That changed yesterday and it could be the beginning of a new wave of investigations by the SEC.

According to a civil suit filed today by the Securities Exchange Commission in the Southern District Court of New York, John-Paul Rorech, a bond salesman at Deutsche Bank Securities, and Reanto Negrin, a former portfolio manager at hedge fund investment advisor Millennium Partners L.P., were charged with insider trading in credit default swaps of VNU N.V. VNU, now Nielsen Company, is a Dutch media conglomerate that owns Nielsen Media and other media businesses. According to Scott W. Friestad, Deputy Director of the SEC’s Division of Enforcement, “This is the first insider trading enforcement action involving credit default swaps.”

According to the accompanying SEC press release, the complaint alleges that Rorech learned from his company’s investment bankers about “a change to the proposed VNU bond offering that was expected to increase the price of the CDS on VNU bonds.” According to the complaint, “Rorech illegally tipped Negrin about the contemplated change to the bond structure, and Negrin then purchased CDS on VNU for a Millennium hedge fund.” In July 2006, following public announcement of the restructured bond offering, “the price of VNU CDS substantially increased, and Negrin closed Millennium’s VNU CDS position at a profit of approximately $1.2 million.”

VNU, which changed its name to Nielsen Company in 2007, was taken private in May of 2006 by Valcon B.V., a company controlled by a private equity group consortium which consisted of some of the largest private equity funds including The Blackstone Group, L.P., The Carlyle Group, and Kohlberg Kravis Roberts & Co. L.P. Estimated at $9.7 billion, the acquisition is the largest LBO in the media industry, and second only to the acquisition of RJR Nabisco, an acquisition which also involved KKR. The acquisition was financed in part by a bond offering completed in August of 2006 for which Deutsche Bank Securities, a subsidiary of Deutsche Bank, served as lead underwriter.

In July 2006 the demand for CDS referencing VNU bonds was weak due to the limited number of bonds covered by these CDS. According to the SEC, in order to increase interest in the bond offering, underwriters, led by Deutsche Bank Securities, added a new tranche of bonds issued by VNU that would be covered by CDS which were already trading in the market. The additional tranche then increased supply of these bonds resulting in an increased demand and price of the swaps.

On July 24, 2006, it was publicly announced that VNU would issue a tranche of bonds out of the VNU holding company. Following the announcement, prices of CDS backed by VNU bonds increased substantially. As a result, “A trader who had purchased a CDS referencing VNU bonds before the announcement would have seen an increase in the market value of those CDS holdings, as the pricing for such CDSs rose after the July 24 announcement,” according to the SEC.

According to the complaint, from July 14 though July 17, Rorech and Negrin had a series of conversations regarding VNU’s issuance of the tranche covered by CDSs. Frequently switching between recorded telephone lines and unrecorded cell phones, Rorech revealed that Deutscehe Bank Securities “had $200 million worth of customer orders for and interest in that tranche.” During these conversations, Rorech “solicited and encouraged Negrin to purchase VNU CDSs based on this nonpublic information, with the understanding that the price of CDSs would increase substantially once the new tranche was announced.”

The complaint provides that “This non-public information assured Negrin that he would profit by buying CDSs that referenced VNU bonds before the public announcement of that tranche, and then selling those CDSs after VNU announced the restructuring, and the demand (and price) for those CDSs increased.”

According to the SEC, following a conversation with Rorech, on July 17 & July 18, Negrin placed two orders on behalf of a hedge fund advised by Millennium which totaled € 20 million worth of VNU CDS. The First order was placed with Deutsche Bank Securities and the other with another dealer. Following the July 24, announcement, Negrin sold the CDS for a profit of approximately $1.2 million. On the same day, Negrin thanked Rorech for his efforts.

Russel Ryan, a former SEC enforcement lawyer, believes that that the SEC has taken great care in bringing the enforcement action. Quoted in Bloomberg, Ryan said, “The SEC is clearly determined to assert its jurisdiction over trading in credit-default swaps, even though they’re not traditionally seen as publicly traded securities.” He added, “The SEC presumably put a lot of thought into this and realized the risk that it could get a bad precedent here.”
In the SEC’s accompanying press release, James Clarkson, Acting Director of the SEC’s New York Regional Office, said, “CDS may still be obscure to the average individual investor, but there is nothing obscure about fraudulently trading with an unfair advantage. Although CDS market participants tend to be experienced professionals, there must be a level playing field with even the most sophisticated financial instruments.”

According to Negrin’s Attorney, Lawrence Iason, Negrin “flatly denies the charges, and he intends to contest them.” Confident that his client will be vindicated, Iason added, “I don’t think there’s jurisdiction and I don’t think there’s insider trading here.” According to Bloomberg, he indicated that the SEC does not have jurisdiction because the Dutch bonds are not subject to the regulator’s oversight.

Rule 10b, the securities regulation that governs insider trading, instructs that insider trading applies to the trading of securities and securities-based swap agreements. Because credit default swaps are not defined as securities according to securities regulation, in order for a credit default swaps to be a security for the purposes of insider trading, it must fall under the Gramm-Leach Bliley Act’s definition of securities-based swap agreement. According to the definition, such agreements include contracts based on the occurrence of any event relating to securities. Because bonds are included in regulatory definition of security, bond-backed credit default swaps are a species of securities-bases swap agreement. Accordingly, these agreements are regulated for the purposes of insider trading regulation.

In August 2006, the Wall Street Journal published an article on the growing concern over insider trading of CDSs. The article cited to academic and financial experts who believed that insider trading in CDS was rampant. These experts noted as evidence that CDS prices moved before major market announcements, indicating that CDS investors where obtaining information before it was publicly available and trading on it. In the article, VNU’s bond issuance was listed as an example of the kind of irregular market activity that was at issue. “In Europe, some investors complained last month that the credit-default swaps of Dutch media company VNU NV had become significantly more expensive ahead of an announcement that the company’s bond issue was being restructured. A spokesman for VNU’s owners didn’t return calls.”

Whether “Dutch bonds” are considered bonds for the purposes of securities-based swap agreements may be the subject of debate. However, given the importance of this case to securities regulation and the time that the SEC has taken to build it, it is very likely that Negrin and Rorech’s attorneys have a tough case ahead of them.

Ashley C. Allen

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