As financial institutions are increasingly using credit derivatives to take customized credit positions and manage exposure, questions have been raised as to possible misuse of material nonpublic information in connection with such transactions. In response, financial institutions have recognized the need to insulate their employees who trade in credit derivatives from insider information obtained by other employees engaged in lending or other business activities. The need for firewalls and other safeguards between different sides of a financial institution, and the potential insider trading violations where such safeguards are not in place, were highlighted in the publication of the Joint Market Practices Forum's "Statement of Principles and Recommendations Regarding the Handling of Material Nonpublic Information by Credit Market Participants" in 2003 and the "Statement of Principles and Recommendations Regarding the Handling of Material Nonpublic Information by Credit Market Participants (European Supplement)" in 2005.
The need for firewalls and safeguards arises mainly in the context of financial institutions that provide multiple services where, in the absence of appropriate policies and procedures, material nonpublic information about clients obtained in the course of lending, investment banking and/or other relationships may become available to the credit derivatives department trading in credit-default swaps referencing these clients. In a market where reputation and investor confidence are crucial, prevention is the key. Regardless of the likelihood of a successful insider trading lawsuit, multi-service firms have realized the potential loss of reputation arising from the perception of insider trading could be more damaging than any potential litigation.
Part One of this Learning Curve looks at the potential legal theories of insider trading under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, the central federal legislation prohibiting insider trading; the special concerns faced by multi-service firms under the insider trading laws; and one of the safe harbors under Rule 10b-5. Part Two examines policies and practices that qualify under the safe harbor, and the use of disclaimers to reduce the risk of liability.
In a credit-default swap, the buyer pays a periodic fee to the seller, who is obligated to make a settlement payment if the specified reference entity experiences a specified credit event. Insider trading concerns may arise where the buyer has material nonpublic information the seller does not possess. In such cases, the buyer may use or be perceived to have used the nonpublic information to enter into a credit-default swap in order to get a windfall. The buyer may then be vulnerable, if appropriate firewall protections are absent, to a claim under Section 10(b) of the Exchange Act and Rule 10b-5. Rule 10b5-1 prohibits trading in the security of an issuer "on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information."
Information is material if:
* there is a "substantial likelihood that a reasonable [investor] would consider it important in [making her investment decision]",
* its disclosure would be "viewed by the reasonable investor as having significantly altered the 'total mix' of information made available;" or
* its disclosure is "reasonably certain to have a substantial effect on the market price of the security." Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).
According to the Securities and Exchange Commission, information is nonpublic if "it has not been disseminated in a manner making it available to investors generally." Trading occurs "on the basis of" material nonpublic information if the person trading was "aware of the material nonpublic information when the person made the purchase or sale," under Rule 10b5-1.
Through the enactment of the Commodity Futures Modernization Act of 2000, security-based swaps are considered securities for the purposes of the SEC's insider trading laws and rules. A security-based swap agreement is 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 thereon" (Section 206B of the Gramm-Leach-Bliley Act, as amended). In general, credit-default swaps qualify as security-based swaps where, for example, the reference obligations or deliverable obligations under the swaps are securities, although uncertainty currently exists as to whether credit-default swaps referencing loan agreements are security-based swap agreements. Credit-default swaps referencing securities are thus subject to certain provisions of the federal securities laws, including Rule 10b-5 and Rule 10b5-1. Subject to the defenses discussed below, if a buyer of credit protection is in possession of material nonpublic information about a reference entity that is also its lending client, it cannot enter into a credit-default swap with respect to that reference entity unless it first publicly discloses this information. Because disclosing this information could be a violation of the lender's duty to its client, the reference entity, the lender may be required to refrain from trading in credit-default swaps referencing the borrower.
Multi-Service Financial Institutions
The application of Rule 10b-5 to a multi-service firm is complicated by the reality that the part of the firm engaged in credit derivative trading is usually in a separate department from the part of the firm engaged in lending, investment banking and many other business activities.
Clause (b) of Rule 10b5-1 clarifies that trading on the basis of material nonpublic information requires that the person making the purchase or sale is actually "aware of the material nonpublic information when the person made the purchase or sale." Rule 10b5-1 thereby supports the conclusion that, for example, a lending department employee's possession of material nonpublic information about one of the firm's corporate borrowers should not, by itself, lead to the legal conclusion that the credit derivatives traders in that firm were also aware of this knowledge when it entered into a credit-default swap on that borrower. Therefore, in principle, the traders should be free to enter into credit-default swaps to hedge the firm's exposure to its corporate borrowers, as long as the decision to hedge was made by firm personnel without access to material nonpublic information. The SEC may disagree, however, absent the implementation of effective firewall protections. In fact, the non-exclusive affirmative defense or safe harbor provided by clause (c)(2) of Rule 10b5-1 requires both that the individual making the investment decision on behalf of the multi-service firm not be aware of the material nonpublic information and that the firm implement reasonable policies and procedures to prevent insider trading. This implies that it does not matter how many employees at the firm possess material nonpublic information about a reference entity as long as the individual making the decision to purchase a credit-default swap is unaware of such information when the investment decision is made, provided reasonable policies and procedures have been implemented. What constitutes reasonable policies and procedures is determined on a case-by-case basis.
Rule 10b5-1(c)(2) Reasonable Policies And Procedures
Rule 10b5-1(c)(2) provides a safe harbor for multi-service firms that implement reasonable policies and procedures for handling material nonpublic information but offers little guidance on what is reasonable, other than stating that "these policies and procedures may include those that restrict any purchase, sale, and causing any purchase or sale of any security as to which the person has material nonpublic information, or those that prevent such individuals from becoming aware of such information." One source of guidance as to reasonable policies and procedures is the Statement, which was published in response to industry concern that rumors of insider trading would "erode the confidence in the integrity--and thus the liquidity and efficiency--of the securities and credit derivatives market."
The Statement suggests best practices that include the use of firewalls, restricted lists, watch lists, trading reviews and "need-to-know" policies (each described in more detail in Part Two). In determining which policies and procedures to establish and implement, the goal of any multi-service firm should be to find the most cost-effective mix of policies and procedures to prevent restricted activities without unduly burdening communication between different departments and the firm's ability to take advantage of opportunities in the market. The existence of policies and procedures designed to insulate credit derivative departments from nonpublic information obtained by lending departments will also serve as evidence that will enable the firm to avail itself of the Rule 10b5-1(c)(2) safe harbor in the event that the firm is subject to a Rule 10b-5 claim in connection with its credit derivatives trading.
This week's Learning Curve was written byEileen Bannon, partner, andYoo-Kyeong Kwon, associate, atDewey Ballantinein New York.