SEC Brings First Insider Trading Case Regarding CDSs

For the first time, the SEC has brought an insider trading case involving the market for credit default swaps (“CDS”). In a civil complaint filed yesterday in the Southern District of New York, the SEC alleged that a CDS salesman with inside information regarding an upcoming bond offering improperly shared information about it with a portfolio manager for a hedge fund. SEC v. Rorech and Negrin, No. 09-Civ-4329 (May 5, 2009). According to the complaint, the portfolio manager used that information to trade in CDS that referenced bonds of the same issuer, and after the bond restructuring was publicly announced, the price of CDS referencing those bonds rose substantially, leading to a substantial profit.

The CDS market trades over the counter and its participants typically are sophisticated institutional players, and for those reasons, among others, it has not historically been a focus of SEC insider-trading enforcement activity, at least until now. In yesterday’s complaint, however, the SEC asserted that the CDS involved in this case qualified as security-based swap agreements under the Gramm-Leach-Bliley Act and hence are subject to the anti-fraud provisions of the federal securities laws — a proposition that has yet to be tested in court.

This broadening of the reach of SEC enforcement efforts against insider trading is consistent with signals sent in recent speeches by SEC Chairman Mary Schapiro and Division of Enforcement Director Robert Khuzami that they intend to expand and increase the Commission’s enforcement activities in this area. It is also worth pointing out that enforcement activity and private litigation regarding CDS may not be limited to insider trading actions, but may also extend to charges of market manipulation and other theories of liability. One example of a potentially manipulative use of the CDS market would be trading strategies designed to generate profits from short sales by widening CDS spreads and intentionally sending misleading signals on the company’s creditworthiness. CDS can form an effective part of a liability management or hedging strategy and the CDS market and participants in it can serve a helpful purpose in the capital formation process. However, writers and purchasers of CDS are well advised to be extremely careful in today’s volatile environment, where the distinction between appropriate market activity and improper speculation and manipulation is thin, and highly political.

This enforcement action is also a timely reminder of the critical importance of ensuring that public companies and financial institutions adopt and maintain state-of-the art antiinsider trading compliance policies and procedures, as well as implementing regular training and effective controls to prevent and detect employee misconduct. Especially in periods of market volatility and economic distress, a program of prudent vigilance is necessary and appropriate.