Eyes On Wall Street : Executive Compensation Lawyers & Attorneys : Labaton Sucharow Law Firm : Class Action Litigation, Shareholder Rights

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.

Contributed by Vicky Ku

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Last week, the SEC proposed new rules that would require issuers, instead of credit rating agencies, to vouch for the soundness of their asset-backed securities. The types of securities that would be affected by these regulations are bundles of loans that generate profits through regular payments, such as residential mortgages, student loans and commercial loans.

While current rules require that such asset-backed securities be rated “investment grade” by a nationally recognized statistical rating organization, the 667 page proposal would require asset-backed securities issuers to (1) certify that the assets will likely produce the type of return described in the prospectus; (2) keep at least a 5% stake in the asset backed securities; (3) provide investors with a way to confirm that the assets conform to the issuer’s representations and warranties; and (4) update the SEC with Exchange Act reports on an ongoing basis (as opposed to only updating the SEC with Exchange Act reports after the first year, as these issuers are currently allowed to do).

Credit rating agencies generated large fees in the years leading up to the recent financial crisis when they offered AAA ratings to catastrophically risky bundles of home loans made to unqualified buyers. These ratings failed to give investors sufficient notice of the true risk associated with many asset backed securities, a phenomenon that played a significant role in the financial sector collapse. The SEC has stated that the rule changes, which would also seek to regulate expedited “shelf offerings,” are intended to “eliminate the appearance of an imprimatur” that might result from a rating issued by a government-approved agency.

There is no question that proposed regulations' intent "to better protect investors in the securitization market" is a laudable one.  However, some might suggest that the proposed rules serve mainly to distance the government from the acts of the credit rating agencies, without addressing the conflicts of interest that give rise to flawed ratings in the first place.

Contributed by Carol Villegas

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On March 11, a court-appointed examiner released a 9-volume, 2,200-page report detailing the demise of Lehman Brothers, a Wall Street titan for more than a century. The report lays out how Lehman Brothers used misleading accounting techniques to conceal the bad mortgage holdings that led to its collapse.

Anton R. Valukas, chairman of the law firm Jenner & Block and a former prosecutor, authored the report. He found that Lehman Brothers used "materially misleading" accounting techniques to mask the perilous state of its finances. According to the report, just months before the Company imploded, Lehman Brothers executives used what amounted to financial engineering to temporarily shuffle $50 billion of assets off its books in an effort to conceal the Company's dependence on leverage, or borrowed money. Senior Lehman Brothers executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas.

"Unbeknownst to the investing public, rating agencies, government regulators, and Lehman’s board of directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption," Mr. Valukas wrote.

According to Valukas, Lehman Brothers executives engaged in what the report characterized as "actionable balance sheet manipulation," and "nonculpable errors of business judgment." While the report draws no conclusions as to whether Lehman executives violated securities laws, Mr. Valukas writes in the report that "colorable claims" could be made against some former Lehman executives and Ernst & Young, meaning that enough evidence existed that could lead to the awarding of damages in a trial. 

A large portion of the nine-volume report centers on an accounting maneuver known inside Lehman as "Repo 105." Repo 105 involved transactions that secretly moved billions of dollars off Lehman Brothers’ books at a time when the bank was under heavy scrutiny. According to Mr. Valukas, Mr. Fuld ordered Lehman executives to reduce the bank’s debt levels, and senior officials sought repeatedly to apply Repo 105 to dress up the firm’s results. Repos, short for repurchase agreements, are a standard practice on Wall Street, representing short-term loans that provide sometimes crucial financing. It appears that Lehman used especially aggressive accounting in its Repo 105 transactions: the Company seems to have structured transactions such that it sold securities at the end of the quarter, but planned to buy them back again days later. The effect of the accounting was to artificially and temporarily lower the firm’s debt levels to hit certain targets, making the firm look healthier than it really was.

Contributed by David Sack

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