SUSPICION, SNIPPETS AND PROOF: THE RORECH INSIDER TRADING CASE

Insider trading cases are very difficult to prove. Nobody doubts this basic fact. Equally clear is the fact that there is a significant difference between “suspicious” trading and insider trading. The former may occur because of the timing of a trade if, for example, it is executed shortly before a significant corporate event is announced. FINRA regularly monitors trading in the markets and refers such trading for additional inquiry, recognizing that suspicion does not equal proof of wrongful conduct. More is needed to establish insider trading.

In SEC v. Rorech, Civil Action No. 09 Civ. 4329 (S.D.N.Y.), the Commission lost sight of these basic principles. Rorech is the first insider trading case involving credit default swaps, discussed here. The defendants are Jon-Paul Rorech, a trader in the high yield bond sales group at Deutsche Bank and Renato Negrin, a portfolio manager for Millennium Partners, L.P., a New York based hedge fund. The Commission claimed that Mr. Rorech misappropriated inside information and then furnished it to Mr. Negrin in two unrecorded cell phone calls on July 14 and 17, 2006. The information supposedly concerned amendments to a bond offering for VNU N.V., a Dutch media holding company. As a result, the complaint alleges, Mr. Negrin bought two VNU credit default swaps on behalf of Millennium on July 17 and 18, 2006. Following a July 24, 2006 announcement that VNU’s bond offering would be amended, the price of the VNU CDSs increased substantially. Millennium sold its holdings for a profit of about $1.2 million.

In a non-jury trial before Judge Koeltl, there were two critical issues. First, did the court have jurisdiction over the case in view of the Commission’s limited authority in the swaps area. Second, did Mr. Rorech misappropriate material non-public information and illegally tip Mr. Negrin in violation of Exchange Act Section 10(b). The SEC prevailed on the first issue. The agency lost on the second however, and the case was dismissed.

First, the Commission established it had properly invoked the jurisdiction of the court. When Congress passed the Commodity Futures Modernization Act of 2000, it provided that Section 10(b) would prohibit fraud, manipulation and insider trading as to “securities-based swap agreement[s] . . .” as defined in Section 206B of the Graham-Leach-Bliley Act. Under that Act, a security-based swap agreement is one “in which a material term is based on the price, value or volatility of any security or any group or index of securities . . .” Here, the CDS are a swap agreement within the meaning of the Act. Since the price of those CDS is based on the spread for the VNU bonds, trading in the instruments is covered by Section 10(b).

Second, the Commission failed to prove insider trading. The critical question here was if defendant Rorech misappropriated material non-public information about the bond offering and furnished it to Mr. Negrin in the two unrecorded cell phone conversation. Prior to and at the time of the two cell phone calls, there had been on-going discussions concerning the bond offering and if it would be amended. It was customary in the high yield bond market for salesman to discuss such matters with potential customers. The confidentiality policies of the bank did not preclude such discussions.

During its efforts to sell the bonds, Deutsche Bank, the lead underwriter for the offering by two of VNU’s subsidiaries, learned that there was demand for bonds issued by the holding company rather than the subsidiaries. This is because bonds from the subs would not be deliverable instruments under the terms of VNU CDSs then in the market. Holders of VNU CDSs and prospective purchasers preferred that the offering be modified to issue at least some bonds at the holding company level. There was discussion in the marketplace about this possibility.

The Commission claimed that in the two cell phone calls Mr. Rorech told Mr. Negrin that the offering would be modified. The calls were unrecorded. The SEC argued, however, that the illegal act could be implied from the surrounding facts. Neither defendant could remember the calls when testifying at trial. At the time of each cell phone call, the defendants had been speaking on phones that were recorded. They terminated the conversations and then spoke on the cell phones. The calls are clearly suspicious.

At trial however, there was no evidence that Deutsche Bank had actually decided to recommend that the sponsors of the bond offering issue a holding company tranche at the time of the cell phone calls. To the contrary, the record demonstrates that the decision was made until after the trades.

The only information that Mr. Rorech possessed at the time of the cell phone calls on the restructuring question was that there was wide spread demand in the market for a modification to the offering. That information was publicly known and completely speculative. Accordingly, it was not confidential non-public information. In any event, Mr. Rorech had discussed with his supervisors the fact that customers were interested in such a modification and that he was sharing that information with others. Clearly under these circumstances, there was no misappropriation of material non-public information and no illegal tipping or insider trading, the court concluded. This conclusion is fortified by the fact that the trades by Mr. Negrin’s with those he had placed earlier.

It is good to win the key legal issue as the SEC did here. It is better to win the trial, something the Commission failed to do. As the SEC struggles to re-establish its enforcement program, it is critical that the facts be carefully evaluated before writing the complaint. Comments by the court in its opinion suggest that at trial the SEC relied on snippets of evidence rather that the entire picture. That comment sounds very much like the statements made by the jurors who rejected the government’s claims against two Bear Stearns hedge fund managers discussed here. Snippets are just that, not proof when taken out of context and standing alone. Suspicion is a beginning, not an end and surely not proof at trial.

FREE ENTERPRISE FUND: DIFFERING VIEWS OF SEPARATION OF POWERS

The Public Company Accounting Oversight Board, and the Sarbanes Oxley Act under which it was created, withstood a constitutional challenge in a case which may be remembered more for its separation of powers analysis than the specific holding. Free Enterprise Fund v. PCAOB, No. 08-861 (June 28, 2010). The plaintiff petitioners claimed that the Act contravened separation of powers principles, as well as the presidential appointment power. The district court granted summary judgment in favor of the Board. The circuit court affirmed. The Supreme Court, in an opinion written by Chief Justice Roberts, reversed in part striking down a portion of the Act and remanded for further proceedings. Despite striking down part of the statute, the PCAOB remains intact.

The PCAOB was created to provide tighter regulation of the accounting profession in the wake of a series of corporate scandals. Its five members are appointed by the SEC. A member can only be terminated if the Commission finds, after notice and a hearing, that the member willfully violated a provision of the Act, abused the authority of a member or without justification failed to enforce compliance with the Act or its rules. The board has broad authority over the accounting profession.

The focus of Chief Justice Roberts’ opinion is a separation of powers analysis. The Constitution divided the powers of the federal government into three defined categories, the Legislative, Executive and Judicial, the opinion notes. Article II vests the executive Power in the President who has the obligation to “take Care that the Laws be faithfully executed.” Under long standing decisions of the Court, the President has been understood to have the authority under the Constitution to hold executive officers accountable who are retained to assist. In those decisions, the Court held that it was appropriate when creating independent agencies run by principal officers to provide that the President cannot remove those officers except for good cause shown.
The question in this case however differs from those considered in the Court’s precedents. Here, the issue is whether “the President [may] be restricted in his ability to remove a principle officer, who is in turn restricted in his ability to remove an inferior officer . . .” Slip Op. at 2. This occurs in this case because the SEC Commissioners can only be removed by the President for cause. The Board members in turn may only be removed for cause. The difference in the statutory scheme here which causes the constitutional infirmity, Chief Justice Roberts wrote, is the fact that it “withdraws from the President any decision on whether that good cause exists . . .” because of the double layer of for cause decisions. Id. at 14. Without the ability to oversee the Board, the President is no longer the judge of its conduct.

The Constitution envisions that the people will govern through their elected representatives. The President is accountable to the people. Diffusing the power of the President means that control may slip from the Executive and thus from the people. Indeed, the scheme here undercuts the authority of the President and is a blueprint for the extensive expansion of legislative power. This is contrary to Article II, the Court concluded.

The constitutional difficulty can be solved however by severing the provisions which create the infirmity. This will leave the Board removable at will by the Commission. Thus revised, the SEC is fully responsible for the actions of the Board. The Commission in turn is responsible to the President.

Justice Breyer, in a dissent joined by Justices Stevens and Sotomayor, took a different approach to the question of Presidential power in the context of the separation of powers principles. The issue in this case arises at the intersection of two general constitutional principles. One is the broad power of Congress to enact statutes “necessary and proper” in the exercise of its specifically enumerated authority. The other is the separation of powers in Articles I, II and III and the directive of Article II that the President take care that the laws are faithfully executed. This limits the power of Congress to structure the federal government.

Since the Constitution is silent on the power and authority of the President to remove officials from office, it is clear that Congress may sometimes limit that authority, Justice Breyer noted. Here, the justification for insulating the technical expertise of the board from fear of losing their jobs due to political influence is particularly strong. Where, as here, the structure is unlikely to restrict presidential power and furthers a legitimate institutional need, the Court’s precedent strongly support its constitutionality. In contrast, the rule adopted by the majority will apply to numerous inferior officers unless limited to the Board. This will, in fact, undermine the authority of the President.

In the end, what is perhaps most notable about Free Enterprise is the differing views of the authority of the President. The majority opinion by the Chief Justice seeks to preserve executive power with a President accountable to the people, precluding a dilution by Congress which might diffuse the government. The dissent however, views the provisions of the Act which were struck down as serving a valid purpose consistent with the congressional goals for creating the Board and as having has little impact on the authority of the President. In this regard, the majority’s effort to create a simple bright line test is misguided and may undermine Presidential power, according to the dissent.