Marketing High Yield Bond Offerings and SEC’s Authority Over Credit Default Swaps at Issue
On June 25, 2010, Judge John G. Koeltl of the U.S. District Court for the Southern District of New York issued a 122-page opinion clearing defendants Jon-Paul Rorech, a high yield bond salesman from Deutsche Bank, and Renato Negrin, a former portfolio manager for Millennium Partners L.P. and one of Mr. Rorech’s hedge fund clients, of all wrongdoing in the first-ever insider trading case involving credit default swaps (“CDSs”).
The Rorech decision provided much-needed clarity for hedge funds and other market professionals who trade credit default swaps or high yield bonds. The court’s opinion was the first one to address the jurisdiction of the SEC over credit default swaps and the manner in which high yield bond deals are marketed and sold throughout the fixed income market. It has been the subject of extensive media coverage in the financial press.
Mr. Rorech was represented by a litigation team of Goodwin Procter attorneys led by Richard M. Strassberg and Roberto M. Braceras. The Rorech trial started on April 7, 2010 and lasted for more than three weeks. Testimony was presented from 21 witnesses, including experts who testified to the custom and practice in the high yield market and provided detailed analysis of credit default swaps.
Background: Allegations and Facts
On May 5, 2009, the SEC filed charges alleging that Mr. Rorech tipped Mr. Negrin as to allegedly confidential “inside” information regarding a proposed restructuring of a high yield bond offering. Mr. Negrin then allegedly traded a CDS based on this information ahead of the restructuring announcement for a profit of approximately $1.2 million. The bond deal was brought by VNU, a Dutch media company, and a group of financial sponsors, including Blackstone Group L.P., Kohlberg Kravis Roberts & Co. L.P. and Thomas H. Lee Partners. Deutsche Bank served as the lead underwriter.
Immediately after the deal was announced on July 10, 2006, the terms of the VNU bond offering were widely discussed in the market, particularly among market participants who traded CDS contracts referencing VNU (“VNU CDS”).
CDSs are bilateral contracts that provide CDS buyers with protection against the credit risk of a particular company. Here, the referenced company was VNU. CDS contracts are somewhat analogous to buying insurance on a company’s outstanding debt without being required to own any of the company’s underlying securities.
After the VNU bond offering was announced, market participants who traded VNU CDSs expressed concern that the new bonds, which were going to be issued from VNU’s operating company, would not be “deliverable” into (or covered by) their VNU CDS contracts and asked that the terms of the bond offering be changed to issue additional deliverable bonds. As is typical in primary high yield bond offerings, capital markets and sales professionals at Deutsche Bank, including Mr. Rorech, actively engaged in an open dialogue with prospective investors to find the best solution. On July 24, 2006, two weeks after the bond deal was launched, Deutsche Bank announced that some of the operating company bonds would be issued from VNU’s holding company, because holding company bonds would be deliverable into VNU CDS contracts. By making some of the bonds deliverable, Deutsche Bank and the issuer were able to increase demand for the bond offering among CDS investors.
Court Finds No Securities Violations; Conduct Was Consistent With Custom and Practice of High Yield Bond Market
On June 25, 2010, the court held that the SEC’s allegations of insider trading were without merit. It rejected every aspect of the SEC’s theory of the case, finding that the “inside” information did not exist at the time of the alleged “tip,” the information at issue was not confidential or material, Mr. Rorech never breached his duty to his employer, and there was no deception or scienter.
Notably, the court made some important findings regarding the custom and practice of the high yield bond market. Specifically, it determined that Mr. Rorech – a high yield salesman who worked on the public side of Deutsche Bank’s “Chinese Wall” – was not in possession of any confidential information, and was fully authorized to share information regarding potential changes to the bond deal with Mr. Negrin and other prospective investors. The court found that, in the high yield bond market, there is an open flow of information among prospective investors, salespeople, capital markets and the issuer. It explained that high yield deals were unlike equity deals in that “bond deals in the high yield market are not presented on a ‘take-it-or-leave-it’ basis. If investors do not like a deal, they will negotiate with the salespeople to change the price or the structure.”
Judge Koeltl rejected the SEC’s position that, while certain aspects of the bond deal may be discussed with prospective investors, sharing information regarding an underwriter’s recommendation to the issuer regarding a proposed change to the bond offering, or information regarding customers’ orders or “indications of interest” is strictly prohibited. Instead, the court found that discussing customers’ orders or indications of interest and “sharing information about potential structural changes in a bond offering – including information related to a potential recommendation related to such changes – is consistent with the custom and practice of marketing a high yield bond deal.”
The court further held that the information regarding Deutsche Bank’s recommendation to the issuer was immaterial on several grounds. The court noted that even the SEC’s own expert on the high yield market admitted that “it was publicly known – particularly to sophisticated high yield bond buyers – that, with such strong market demand for deliverable bonds, Deutsche Bank would be speaking to the sponsors and working with them to try to find a way to issue additional deliverable bonds.” The court added that this public discussion regarding investor demand for deliverable bonds rendered immaterial information regarding customers’ orders or indications of interest for deliverable bonds as well.
Accordingly, the SEC’s charges of insider trading failed as Mr. Rorech’s conduct was consistent with the custom and practice of the high yield bond market, and the information he shared with his customer was neither confidential nor material.
The Commodity Futures Modernization Act of 2000 (“CFMA”) expanded the SEC’s enforcement authority under section 10(b) to include “securities-based swap agreement[s].” Under federal law, a “securities-based swap agreement” is defined as a swap agreement “of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein.”
As is often the case when courts interpret securities laws, the Rorech court broadly construed the definition of a “security-based swap agreement” and looked beyond the text of the CDS contracts to find that at least two material terms of the CDS agreements at issue — price and settlement terms — were based on the price, yield and value of bonds. The court determined that, in calculating the price of the CDS, Mr. Negrin and other market participants looked to the spread or yield of deliverable bonds, and also the size or “value” of an upcoming issuance of deliverable bonds (defining “value” to mean the notional amount of the outstanding bonds multiplied by their price). In particular, the court found that Mr. Negrin and other markets participants expected the price of the CDS to increase upon the issuance of additional deliverable bonds from the holding company and that this issuance would increase the “value” of the holding company bonds. Since an increase in the “value” of the bonds was expected to increase the price of the CDS, the court found that the CDS was therefore based on the “value” of those bonds (i.e., “security-based”).
According to the court, the CDS agreements were also “security-based,” because, upon a credit event, section 9.9 of the 2003 International Swaps and Derivatives Association Credit Derivatives Definitions allowed the CDS seller, under limited circumstances, to settle the contract by deducting the price of the reference entity’s securities from the amount owed to the CDS buyer.
Accordingly, while the SEC still lacks full regulatory authority over credit default swaps, the Rorech court found that the SEC has enforcement authority over such derivatives. There is also pending legislation in Congress to clarify the SEC’s enforcement authority over securities-based derivatives and further expand its overall regulatory authority over such financial instruments.
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For further information about the issues discussed in this client alert, please contact Richard M. Strassberg, chair of Goodwin Procter’s White Collar Crime & Government Investigations Practice, or Roberto M. Braceras, a partner in the practice.