Tuesday, April 6, 2010

Insider trading trial could give new powers to SEC

Original posted on the Times Online by Christine Seib:

An insider trading trial could dramatically expand the powers of America's securities regulator to monitor the derivatives blamed for exacerbating the financial crisis.

The Securities and Exchange Commission will bring its first prosecution tomorrow for insider trading which involved credit default swaps (CDS). Attorneys described the prosecution as an attempt by the commission to assert its authority over CDSs at a time when Congress is discussing how to regulate the huge derivatives market.

Stanley Keller, a partner at the law firm Edwards Angell Palmer & Dodge, said: “It’s a very interesting and important case because it really covers the whole issue of the scope of the SEC’s enforcement authority.”

The commission has accused Jon-Paul Rorech, a bond and credit default swap salesman at Deutsche Bank, of giving Renato Negrin, a portfolio manager at the hedge fund manager Millennium Partners, inside information on an upcoming bond issue by VNU, the Dutch media company. They allege that the information handed Mr Negrin’s fund a €950,000 profit.

The regulator argues that in July 2006 Mr Rorech, whose employer was advising on the debt issuance, told Mr Negrin that VNU planned to issue bonds and suggested that he buy credit default swaps against the risk of a VNU default.

Credit default swaps are a type of insurance against a company defaulting on a security but are also used by investors to bet on the possibility of a default without owning the underlying securities. When a default occurs the CDS owners must deliver the security, such as a bond, to the seller in return for a payout.

At the time there was a shortage of VNU bonds that could be used by owners of VNU swaps in case a default occurred. With more bonds in the market the demand for swaps would rise. The issuance of new bonds by VNU would also increase its likelihood of default, increasing the value of the existing credit default swaps.

The commission cites a recorded telephone conversation in which Mr Rorech told Mr Negrin that the odds were “very good” that there would be a bond issuance by VNU. Mr Negrin asked Mr Rorech to give him some way to assess how likely the issuance was. The bond salesman allegedly replied: “You’re listening to my silence, right?” After their conversation Mr Negrin bought €20 million worth of VNU credit default swaps for his fund, making a €950,000 profit when the VNU bond issuance was announced.

The commission brought its case against the men last May, demanding that they give up their profits and pay a civil penalty. The regulator argues that credit default swaps qualify as securities-based swap agreements and therefore come under its jurisdiction.

Attorneys for Mr Rorech and Mr Negrin argue that the terms of credit default swaps are not based on the “price, yield, value or volatility” of a security but on a more remote event affecting the security, such as the company’s default, and are therefore not in the commission's remit.

Both men have denied any wrongdoing.

The conmmission is attempting to restore its reputation in the wake of the financial crisis and the Madoff scandal, both of which it failed to spot. It has increased its pursuit of insider trading, bringing a prosecution against 21 people allegedly involved in the Galleon Group insider trading rings.

Credit default swaps were blamed for worsening the financial crisis by magnifying the impact of defaults and making it more difficult for companies to borrow.

Congress has struggled to improve monitoring of the derivatives market, which has an estimated value of $600 trillion. The commission regulates some derivatives, such as options, and the Commodity Futures Trading Commission regulates others, such as futures. But over-the-counter instruments such as credit default swaps are unregulated.

When putting together its financial reform Bill the Senate Banking Committee failed to agree on an approach to derivatives. It instead fell back on an old proposal, strongly opposed by the financial sector, to force all derivatives trading on to an exchange.

The Washington Post reported last Friday that the Senate Agriculture Committee was drafting new derivatives rules that it wanted added to the Banking Committee’s Bill. The new rules are expected to be more favourable to the financial industry.

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