SEC Charges Hedge Fund Manager In First Insider Trading Case Involving Credit Default Swaps

The SEC has filed an enforcement action alleging that a hedge fund manager and a Deutsche Bank Securities bond salesman engaged in insider trading in the credit default swaps of an international holding company, VNU, a Dutch media conglomerate. The SEC charged the hedge fund manager and bond salesman with violations of the antifraud provisions of the Exchange Act. The Commission has asked a federal court to order them to pay financial penalties and disgorge ill-gotten gains, plus prejudgment interest. The hedge fund has agreed to escrow the amount that the SEC is seeking as ill-gotten gains pending a final judgment in the action. (SEC v. Rorech, SD NY, Litigation Release No. 21023).

James Clarkson, Acting Director of the SEC's New York Regional Office, noted that, while credit default swaps may be obscure to the average individual investor, there is nothing obscure about fraudulently trading with an unfair advantage. Further, the SEC official emphasized that there must be a level playing field with even the most sophisticated financial instruments. The case was handled by the SEC Enforcement Division's Hedge Fund Working Group, which is investigating fraud and market manipulation by hedge fund investment advisers. The SEC also acknowledged the assistance of the U.K.'s Financial Services Authority

The SEC alleged that the bond salesman learned information from his firm’s investment bankers about a change to the holding company’s bond offering that was expected to increase the price of the credit default swaps on the company’s bonds. Deutsche Bank was the lead underwriter for a proposed bond offering by the company. According to the SEC's complaint, the salesman illegally tipped the hedge fund manager about the contemplated change to the bond structure, and the manager then purchased credit default swaps on the company for the hedge fund. When news of the restructured bond offering became public, the price of the swaps substantially increased, said the SEC, and the asset manager closed the fund’s position at a profit of approximately $1.2 million.

The SEC said that the bond salesman knew that the information he was providing to the fund manager was material, inside information in breach of the salesman’s duties to his employer. The SEC also alleged that the salesman was aware of his employer’s policies concerning the treatment of confidential information, and knew that the information he had imparted to the asset manager was confidential. The SEC similarly alleged that the hedge fund manager also knew or should have known that the bond salesman provided him with information concerning the restructuring in breach of the duties he owed to Deutsche Bank Securities.

The SEC explained that credit default swaps are a type of credit derivative, economically similar to default insurance for a referenced debt obligation, such as a bond. The seller of the credit default swap agrees to pay to the buyer of the swap a specified amount if the issuer of the bond referenced by the swap defaults on its obligations. The buyer, in return for that protection, pays a specified amount, or premium, to the seller each quarter, during the term of the credit default swap contract. In the event of a default, the swap buyer tenders defaulted bonds (or their cash equivalent) to the seller in exchange for the full amount of the credit default swap.