Market Professionals, Insider Trading And Credit Default Swaps

The SEC brought another market crisis cases earlier this week, SEC v. Rorech, Civil Action No. 09 CV 4329 (S.D.N.Y. Filed May 5, 2009). This action is based on an insider trading claim against two market professionals for trading in credit default swaps. The trading was not for their personal accounts. Rather, it was for the benefit on one defendant’s employer.

The facts to the case, as detailed in the complaint, present a straight forward insider trading fact pattern. According to the complaint, Renato Negrin, a former portfolio manager at investment adviser Millennium Partners, L.P., and Jon-Paul Rorech, a salesman at Deutsche Bank Securities, Inc., engaged in insider trading regarding the credit default swaps of VNU N.V., a privately held Dutch media conglomerate, now known as the Nielsen Company. The company had been taken private by a group of private equity companies. The restructuring of the financing for that transaction included a bond offering which is the predicate for the case here.

According to the SEC, Mr. Rorech learned about the restructuring of the bond offering related to VNU through his employment at Deutsche Bank in July 2006. In a series of phone calls, some of which were recorded and some of which were made on cell phones, Mr. Rorech told Renato Negrin about the transaction. Mr. Negrin purchased CDSs covering the VNU bonds based on information about the restructuring when that information was non-public. At the time of these conversations, there was a limited supply of bonds covered by the CDSs. An increase in the supply of VNU bonds deliverable into the CDSs would result in more exposure and demand for the credit default swaps covering the default of the bonds. This would increase their market price, according to the complaint.

The complaint alleges that Defendant Negrin purchased about 20 million euros worth of VNU CDSs in two transactions on behalf of a hedge funds advised by Millennium. After the public announcement of the restructuring, the credit default swaps were sold for a profit of about $1.2 million.

For passing on the confidential information, the SEC claims that Mr. Rorech received a benefit because it solidified his client relationship with Mr. Negrin. He also received credit from his employer toward compensation for trades placed by his clients, including those of Mr. Negrin.

The SEC’s complaint alleges violations of Section 10b and Rule 10(b)-5. In this regard is specifies that: “The CDSs at issue in this matter qualify as security-based swap agreements under the Gramm-Leach-Bliley Act of 2002 and are therefore subject to the antifraud provisions set forth in Section 10(b) of the Exchange Act and the rules promulgated thereunder.” Under Section 206B of that Act, a security based swap agreement is one “of which a material term is based on the price, yield, value, or volatility of any security or any group of index or securities, or any interest therein.”

In its complaint, which is in litigation, the SEC seeks an injunction, disgorgement and civil penalties against Messrs. Rorech and Negrin. This is the Commission’s first insider trading case based on trading in credit default swaps.

The SEC Sues The Principals Of The Reserve Primary Fund

In SEC v. Reserve Management Company, Inc., Case No. 09 CV 4346 (S.D.N.Y. Filed May 5, 2009), the Commission brought an enforcement action the principals The Reserve Primary Fund, the first money market fund to “break the buck.” In this case, the SEC alleges fraud by the principals of a once highly regarded fund as they sacrificed the interests of their investors in an ill-fated effort to save the collapsing fund following the bankruptcy of Lehman Brothers. Previously, the Commission and the U.S. Attorney’s Office brought actions against two Bear Stearns fund managers alleged to have defrauded investors in an effort to stem withdrawals from and save two collapsing hedge funds stocked with subprime mortgages. SEC v. Cioffi, Civil Action No. 08-2457 (E.D.N.Y. June 19, 2008). Similar stories will undoubtedly unfold in the future as the SEC works through their large inventory of market crisis cases.

The Reserve Primary Fund is a series of the Reserve Fund, a Massachusetts business trust registered with the SEC under the Investment Company Act. The defendants are: Reserve Management Company (RMC), a registered investment advisor owned by defendant Bruce Bent Sr. and his family including defendant Bruce Bent II; Resrv Partners, a registered broker dealer which is the distributor for the funds managed by RMC and which is also controlled by the Bent defendants; Bruce Bent Sr., the Chairman of RMC and President, Treasurer and Trustee of the Primary Fund; and Bruce Bent II, the Vice Chairman and President of RMC and co-chief executive officer, senior vice president and assistant treasurer of the Primary Fund.

The complaint, which alleges violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Section 206 of the Investment Advisers Act, claims that the defendants failed to provide key material information to Primary Fund’s investors, board and rating agencies after the bankruptcy of Lehman Brothers on September 15. The Primary Fund was a money market fund that historically provided shareholders with a $1.00 per share NAV. At the time Lehman filed for bankruptcy, the Fund held $785 million in Lehman Debt securities. Over the previous two years the fund had taken increasingly risky positions in commercial paper issued by financial institutions including Lehman, Merrill Lynch and Washington Mutual. This strategy resulted in higher yields. At the same time, the positions carried more risk, particularly for the Fund which, unlike many money market funds, was not owned or affiliated with a large public company or commercial bank that had the resources to provide financial support in the event a portfolio security became impaired. Moodys warned the Fund about this fact in July 2008 to no avail.

In the weeks prior to Lehman’s bankruptcy, concerns were raised about the Lehman debt held by the Fund. Nevertheless, the Fund continued to hold Lehman paper.

Following Lehman’s bankruptcy filing, the Fund was overwhelmed by redemption demands. By mid-morning on September 15th, the Fund’s custodian bank suspended its overdraft privileges in the wake of massive redemption requests. Redemptions halted, as the defendants knew.

In an effort to reassure investors, the Fund’s Board of Trustees and the rating agencies, and to avoid breaking the buck, defendants made a series of false and misleading statements including claims that:

• RMC would provide whatever funds were necessary to protect the NAV;

• RMC and the Bents had sufficient capital to maintain the NAV;

• RMC was in the process of executing a credit support agreement to protect the NAV;

• RMC had submitted a request for “no-action” relief to the SEC in connection with the implementation of a credit support agreement; and

• the Fund was liquid and honoring redemption requests.

As a result of these misrepresentations, the process the board used to strike the NAV for the Fund up to 4:00 pm on September 16 was flawed. This advantaged some investors and disadvantaged others. By the end of the day, on September 16 the Fund was forced to disclose that it had broken the buck.

Approximately 20 law suits followed. The Attorney General of Massachusetts brought an action. Although the Fund adopted a liquidation process the SEC is seeking to compel distribution of the remaining assets on a pro rata basis.