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.