Last week's Learning Curve discussed the legal basis for insider trading claims with respect to credit-default swaps and the safe harbor for "reasonable policies and procedures." Part Two discusses examples of such "reasonable policies and procedures" and the use of disclaimers.
Reasonable Policies and Procedures
As articulated in the "Statement of Principles and Recommendations Regarding the Handling of Material Nonpublic Information by Credit Market Participants" by the Joint Market Practices Forum, firewalls, restricted lists, watch lists, trading reviews and need-to-know policies are examples of "reasonable policies and procedures" for handling material nonpublic information.
Firewalls
A firewall--also known as an ethical screen or Chinese wall--is the term given to procedures and policies designed to prevent the improper dissemination of material nonpublic information from one division of a financial institution that provides multiple services to another. In maintaining firewalls, the Forum recommends that firms adopt procedures for identifying material nonpublic information; permitting departments in possession of material nonpublic information to exchange information with other departments without conveying material nonpublic information; controlling permitted disclosures of material that is not material nonpublic information between individuals on opposite sides of an information wall; and handling circumstances where individuals are brought "over the wall."
Restricted Lists And Watch Lists
According to the Statement a restricted list is "a list of securities or issuers as to which a firm has determined to restrict proprietary, employee and certain solicited customer transactions." Firms often place issuers on a restricted list before sensitive information is about to be made public or when they participate in underwriting a public offering of that issuer's securities. Restrictions can range from an absolute ban on trading in the restricted securities to counseling employees to trade only for investment or other long-term purposes to discourage speculative or short-term trading. Some firms restrict trading in credit-default swaps when the underlying securities or the related issuers are on the restricted list.
Because of their wide distribution, information about the restricted lists can potentially become public information and can create a signaling effect that can influence trading in the restricted securities or issuers. In addition, placing an issuer or its securities on a restricted list may put the firm at a disadvantage by restricting its ability to trade in that issuer's securities and protect itself against credit risk.
The Statement defines a watch list as "a list of securities or issuers the trading in respect of which is not prohibited but is subject to close scrutiny by the firm's compliance department." A watch list enables a firm to monitor compliance with existing policies and procedures and to detect any violations of the policies and procedures. A watch list is not distributed as widely as a restricted list and usually is available only to legal or compliance personnel. When an issuer is placed on a watch list, firms will often conduct a retroactive review of employee and firm trading, as well as trading for customers, in the issuer and/or its securities, for as far back as thirty days, followed by daily reviews of trading activity. These reviews are often supplemented by general surveillance for unusual trading, and any unusual trading is investigated and may result in corrective or disciplinary action.
Trading Reviews And Need-To-Know Policies
Many firms conduct trading reviews and/or implement so-called need-to-know policies. Trading reviews are periodic reviews of security-based transactions conducted as a monitoring function to ensure that these transactions comply with firm policies. They can be conducted on transactions involving securities or issuers who may or may not be on a restricted list or watch list. Need-to-know policies limit the dissemination of information within the firm to those who need to know this information.
Disclaimers
Another step that can be taken by firms to reduce the risk of liability in Rule 10b-5 claims is to use disclaimers. To establish standing to bring a Rule 10b-5 claim, a private plaintiff must prove that the defendant had a duty to inform the plaintiff of material nonpublic information that is alleged to have been used in connection with the purchase or sale of a security--the same restriction does not apply to government claims. Parties to credit-default swaps often include disclaimers in their swap agreements which try to eliminate the basis for finding such a duty. They do so by disclaiming reliance of any sort between the parties, for example, by representing that neither party is acting as a fiduciary or adviser, neither is relying on the other for investment advice or recommendations, and/or that both parties are capable of assessing the merits and understanding the risks of the transactions. Another common disclaimer states that neither party is obligated to disclose to the other party material nonpublic information in relation to a reference entity that may come into its possession. Courts have generally upheld written disclaimers of reliance as an effective defense against alleged oral misrepresentation or fraud. There is, however, no guarantee that courts will always uphold this defense. In a few cases, courts have disregarded disclaimers for lack of specificity, based on the facts and circumstances of the case, as described in more detail below.
In at least two recent cases, the court has found the general no-reliance disclaimers commonly found in International Swaps and Derivatives Association documentation inadequate to bar reliance and has suggested that more specific language is necessary to foreclose a duty to disclose certain information between a broker-dealer and its client. In Louis S. Caiola v. Citibank, N.A., New York (295 F.3d 312 (2nd Cir. 2002)), the Second Circuit held that general disclaimers in an ISDA Master Agreement and the related confirmations did not prevent a bank client from relying on a bank's alleged fraudulent statements. Caiola was a major client of Citibank, who engaged in extensive cash and synthetic investment through the bank. In 2000, Caiola sued Citibank for securities fraud in violation of Section 10(b) of the Exchange Act and Rule 10b-5, for allegedly misrepresenting that it would continue their synthetic trading relationship, while secretly ending its delta hedging and transforming Caiola's synthetic portfolio into a physical one. The court found that the disclaimers included in the confirmations stating that each party "is not relying on any advice, statements or recommendations (whether written or oral) of the other party," that each party is entering the transaction "as principal and not as an agent," and that Citibank "is not acting as a fiduciary or advisor" to Caiola were not specific enough to bar reliance. It stated:
"A disclaimer is generally enforceable only if it 'tracks the substance of the alleged misrepresentation' ... [and] the disclaimer provisions contained in the confirmation fall well short of tracking the particular misrepresentation alleged by Caiola.... This disclaimer is general, not specific, and says nothing about Citibank's commitment to delta hedging."
The court in Eternity Global Master Fund Limited v. Morgan Guaranty Trust Company of New York (2002 WL 31426310 (S.D.N.Y. 2002)) applied the holding in Caiola to a negligent misrepresentation claim. The plaintiff, an investment company, entered into credit swap transactions with Morgan Guaranty Trust Company of New York. In 2002, Eternity sued Morgan for breach of contract, breach of the implied duty of good faith and fair dealing, fraud, and negligent misrepresentation for alleged statements regarding the liquidity of a secondary market for credit default swaps. The court found that the no-reliance disclaimers in the ISDA Master Agreement, which included "representations that neither party is relying on any advice of the other party, that Eternity has the capacity to evaluate the transaction and has made its own decision to enter it, that Morgan is neither acting as a fiduciary or financial advisor for Eternity nor giving any representation as to the merits of any transaction; and that neither party has 'committed to unwind' any transaction," did not bar reliance. The court held that:
"Eternity's fraud claim is based on alleged representations and/or omissions made by Morgan regarding the existence and availability of a secondary market for the swaps. The disclaimers relied upon by Morgan are general, not specific, and say nothing about the existence or availability of a secondary market."
These cases indicate that the general disclaimers found in most ISDA Master Agreements may, in certain circumstances, be found to be too general to effectively bar reliance. To minimize this risk, disclaimers should be specific, unambiguous and explicitly disclaim reliance on exactly the type of representation at issue and made proximate in time to when the reliance took place.
Conclusion
Firms may be subject to insider trading claims if their lending, investment banking or other departments receive material nonpublic information about a company that is a reference entity in a credit-default swap entered into within the same time period by their credit derivatives department. Accordingly, it is important that firms have in place effective internal policies and procedures for handling this information in order to claim the benefits of the Rule 10b5-1(c) safe harbors. Disclaimers in Master Agreements for credit-default swaps are an additional precautionary measure but not a substitute for an effective firewall.
This week's Learning Curve was written by Eileen Bannon, partner, and Yoo-Kyeong Kwon, associate, at Dewey Ballantinein New York.
