SEC Insider-Fraud Suit Out of Bounds, Credit-Swap Traders Say

Bond traders who allegedly used inside information to profit illegally from credit default swaps say in federal court papers that the Securities and Exchange Commission lacks authority under existing law to sue them.

Credit default swaps are financial contracts that function as insurance against default risk on various kinds of debt. CDS can be traded like securities but with little or no regulatory oversight.

Congress, in response to critics who have blamed the swaps for spreading the U.S. subprime mortgage meltdown around the globe, is currently considering several bills that would restrict their use.

Meanwhile, the SEC, itself under pressure to rein in debt speculators who use CDS as a betting tool, filed a fraud suit in May against Jon-Paul Rorech, 36, a CDS salesman with Deutsche Bank, and Renato Negrin, 45, a former hedge fund manager employed by Millennium Partners.

The SEC said in a statement that the case is the first insider-trading enforcement action involving credit default swaps.

The suit, filed in the U.S. District Court for the Southern District of New York, alleges the pair violated the Securities Exchange Act of 1934 by misappropriating confidential inside information to make a profit for a Millennium fund.

In separate dismissal motions Rorech and Negrin say the SEC has no authority to sue them because, among other things, the CDS are not "security-based" as defined in the Gramm-Leach-Bliley Act of 2002, a law that gives the agency limited jurisdiction over swap trades.

Under GLBA, a swap is security-based if it is based on the "price, yield, value or volatility" of a security.

In a memo opposing dismissal the SEC says the CDS are "classic examples" of security-based swap agreements.

According to the complaint, Rorech learned from Deutsche Bank investment bankers about a change to a proposed bond offering by VNU, a Dutch media conglomerate. The proposed change was expected to increase the price of the CDS on VNU bonds.

Deutsche Bank was lead underwriter for the offering, the suit says.

Rorech illegally tipped Negrin about the contemplated change to the bond structure, and Negrin then purchased credit default swaps on VNU for a Millennium hedge fund, according to the SEC.

When news of the restructured bond offering became public in late July 2006, the price of VNU credit default swaps substantially increased, and Negrin sold them at a profit of about $1.2 million, the complaint says.

The defendants recently filed reply memos urging the District Court to toss the case.

"The SEC wastes page after page arguing that CDS prices are determined by certain economic models that supposedly rely on the price or value of the VNU reference bond, a security," Rorech's memo says.

"This is entirely beside the point," it continues. "The price of the CDS was negotiated by the parties to the CDS agreement and, as a matter of law, was not based on the price or value of any security."

The SEC is seeking permanent injunctions barring the defendants from future violations of the federal securities laws, disgorgement of ill-gotten gains and fines.

Millennium agreed to escrow its profit from the CDS deal pending a final judgment in the case, the agency said in the statement.

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