Party A works for an investment bank that underwrites bonds. He learns that his bank plans to expand a customer's upcoming bond sale. Party A passes the inside information to a client, Party B.
Party B, a hedge fund adviser, uses the tip to buy an insurance contract. Party B knows that the value of the contract will rise when the bank goes public with the bond redo. Party B later sells the contract for a $1.2 million profit.
Insider trading? The Securities and Exchange Commission thinks so.
Yesterday, the SEC announced that it filed insider-trading charges against Party A and Party B. The complaint alleges that, in 2006, Jon-Paul Rorech, a salesman at Deutsche Bank Securities, tipped off Renato Negrin, who worked at Millennium Partners. Negrin bought insurance that protected against a default on the bonds. The insurance — credit default swaps (CDSs) — rose in value because the growth in the size of the bond issue increased the dollars at risk.
Blawgletter has guessed that the big surge in the CDS industry over the last several years vastly enhanced the temptation to rig the market. We went so far as to ask whether fraud inhered in the huge, opaque, and unregulated CDS business. This case illustrates the incentive that CDSs give to people willing to cut corners. See "The Cramer Solution to Market Crisis: Hoosegow for Miscreants".
Expect to see more of these kinds of cases.
But note how hard a time we'll have in uncovering the bad acts. The SEC managed to get tapes of calls between Rorech and Negrin. Just imagine the difficulty a private investor who suspected fraud would face in getting at the truth. He'd have to know lots of details even to get past a motion to dismiss under the Private Securities Litigation Reform Act of 1995. Unlike the SEC, which can issue subpoenas without filing a case, the private investor couldn't take discovery until after he beats a motion to dismiss.
On the bright side, at least the SEC's complaint confirms that the anti-fraud pieces of federal securities laws do apply to "security-based swap agreements." But, unless the SEC becomes very active in ferreting out fraudulent uses of CDS contracts, that small victory will give private investors cold comfort.