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New CDS Battle

by Vicky Ku
Eyes On Wall Street |

On April 7, 2010, the Securities and Exchange Commission (SEC) began presenting its case against Jon-Paul Rorech, a Deutsche Bank bond salesman and Renato Negrin, a former trader at hedge fund Millennium Partners LP, for insider trading. However, this is not a run-of-the-mill insider trading case. This case is significant because it is the first case the SEC has brought to trial involving insider trading of credit default swaps (CDS), and its outcome could help clarify whether the securities laws reach the murky world of credit default swaps.

Credit default swaps are financial instruments that serve to protect against a default by a particular bond or security. They are essentially a form of insurance against defaults on a company's debt. Unlike traditional insurance, however, the market for credit default swaps is largely unregulated. Many noted economists consider unregulated CDS trading to be one of the major contributing factors to the financial crisis.

The SEC alleges that Rorech illegally tipped off Negrin about a bond offering from Dutch media company VNU Group, which controls Nielsen Media, the television ratings service. Based on that information, Negrin bought credit default swaps that rose in value when the deal was made public, eventually earning him a $1.2 million profit.

The defense argues that because credit default swaps are not defined as securities according to securities regulations and are not traded on any exchange, they are more like private contracts between financial players. Therefore, they are not subject to SEC enforcement under the insider trading provisions of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

The SEC in turn argues that credit default swaps, even though they are not considered securities in the traditional sense, clearly meet the definition of "security-based swap agreements" established by the Gramm-Leach-Bliley Act. Therefore credit default swaps fall within the purview of the SEC.

The decision in this case could very well determine whether credit default swaps, the derivatives blamed for much of the economic meltdown, are subject to the SEC's anti-fraud actions.