Jesse Litvak is a former Jefferies bond trader who lied to his customers. Specifically, he traded residential mortgage-backed securities, and he would tell buyers of those securities inventive little stories about the prices he had paid for them. So for instance, a customer came to him and asked to buy some bonds, he described for the customer "a fictional backandforth between himself and an unnamed, nonexistent thirdparty seller," and he ended by telling the customer that he'd paid $53.00 for the bonds.1 Then he charged the customer $53.25. The customer thought that Litvak had worked hard on his behalf and gotten paid a quarter for his efforts. But really Litvak had owned the bonds all along — he'd bought them days earlier for $51.25 — and made an undisclosed profit of $2.00.2
The question is: Is this a crime? It might seem like lying to your customers would always be a crime, but that is not true at all.3 Lying to your customers is only a crime if it is fraud, and it is only fraud if the lies that you tell them are "material," and the lies are only material if there is "a substantial likelihood that a reasonable investor would find" them "important in making an investment decision." Lying to your customers about whether an investment is a Ponzi scheme is fraud. Lying to your customers about what color socks you are wearing probably isn't.4
But lying to your investors about the price you paid for bonds is genuinely interesting. Is it fraud? It sounds like fraud. But when Litvak was arrested and charged with securities fraud in 2013, his defense was that his lies were not material, because no reasonable investor would care about them in making an investment decision. There are two main arguments for that:
- The only thing that a reasonable investor should care about is the value of the securities, not the price that Litvak paid for them. If someone thinks a bond is worth more than $53.25, he should pay $53.25 for it, regardless of whether Litvak paid $53.00 or $51.25 for it. The only information that should be material to investors is information about value (is the issuer bankrupt, etc.), not information about historical prices.5
- Bond traders just lie all the time, so no one would ever believe anything a bond trader says, so obviously nothing a bond trader says can be material.
Those are both good arguments! They are also sort of … gross? The federal judge in Connecticut who was in charge of Litvak's trial refused to let Litvak's expert witness (Ram Willner, a former bond manager with a Ph.D.6 ) testify about either of them. Without that testimony, Litvak was convicted of fraud and sentenced to two years in prison; he appealed, and today the U.S. Court of Appeals for the Second Circuit threw out his conviction and sent the case back for a new trial, this time with Litvak allowed to make those arguments to his heart's content.7 I don't particularly fancy his chances of convincing a jury of either of them, based on the expert testimony of a finance Ph.D., but you never know.
The first argument — that information about what a dealer paid for bonds is not relevant to a reasonable investor who has done his own homework on value — is sort of appealing, but probably not right. Here's how the court explains it (citation omitted):
Because RMBS lack an efficient, transparent secondary market through which value can be determined objectively, traders set the value of the security, and hence the price each is willing to accept as a seller or buyer, by engaging in "rigorous valuation procedures" involving the use of certain "analytical tools and methods." Thus, firms trading RMBS rely upon sophisticated computerpricing models, often developed by professionals with appliedmathematics backgrounds, to determine the subjective "value" of the securities. Certain testimony at trial supported a conclusion that this process, and a determination of the amount an investment manager is willing to pay for a security, nearly always takes place prior to the manager approaching a dealer such as Jefferies, here represented by Litvak, to negotiate the price of that security.
With such testimony before it, a jury could reasonably have found that misrepresentations by a dealer as to the price paid for certain RMBS would be immaterial to a counterparty that relies not on a "market" price or the price at which prior trades took place, but instead on its own sophisticated valuation methods and computer model.
On this view, smart investors in residential mortgage-backed securities — and Litvak's customers were big smart investors — don't just pay whatever their dealer asks for those securities. They have their own idea of what those securities are worth. There is … math … involved. They go to the dealer already knowing what the bonds are worth, and all that matters is whether the price the dealer charges them is less than what they think the bonds are worth. As opposed to stock investors, who have an efficient market, and who therefore just conclude that a stock is worth whatever the market says it is worth.8
That view of the stock market is obviously a bit idealized — is a stock price really an objective determination of value? — but the view of the RMBS market is no less idealized. I mean, sure, you math up the value of a bond, you decide that it's worth $55, and you go to a dealer hoping to buy it for less than $55. And if the dealer tells you it's trading at $53, you think, score, I can buy it for less than it's worth. But if the dealer tells you it's trading at $20, you don't necessarily think, score, I can buy it for way less than it's worth. You might think: Perhaps my math is wrong? Perhaps the market knows something I don't? The reasonable investor, even in mortgage-backed securities, doesn't decide what price she'll pay based purely on introspection. There is a market out there, with prices, and those prices might offer a clue about value. And so lies about those prices might deceive investors about value.
Or just more practically, whatever you believe a bond is worth, and however sure you are of your beliefs, you still might have to sell it. So knowing where the market is will always be of interest to any reasonable investor.
Still, you can see the appeal of this argument. If a bond investor is doing something socially worthwhile, it is by determining for herself what bonds are worth, and trading when prices diverge from her estimates of value. A big bond-fund manager who relies on the price a dealer gives her, without having her own independent idea of the bond's value, in some sense deserves to be cheated.
Litvak's other main argument — that bond traders always lie, so no bond trader's lie could be material to a customer — is less appealing, but more convincing. Here's how Litvak's lawyers put it, as quoted by the court (emphasis added9):
Where a manager follows rigorous valuation procedures, as was the case here, consideration of, or reliance on, statements by sellside salesmen or traders concerning the value of a RMBS or the price at which the brokerdealer acquired it or could acquire it, are not relevant to that fund's determination with respect to how much to pay for a bond. In Mr. Willner's opinion, such statements from sellside sales representatives or traders are generally biased, often misleading, and unworthy of consideration in trading decisions. Accordingly, such statements from sellside sales representatives or traders are not material to a professional investment manager's decisionmaking.
Of course that is just Mr. Willner's opinion. But if it is a widely shared opinion among bond investors, then a salesman's lies about bond prices really can't be fraud, because no reasonable investor would believe them. This is the sense in which "everybody's doing it" really is a defense against fraud charges. To be fraud, lies have to be material, and if lies are so common that they are ignored, then they can't really be material.10 It is a used-car-salesman defense, if you will.
This one is pretty controversial, so I will just leave it here. I'll note that the prosecutors offered testimony from several bond investors who said that Litvak's statements were material to them, so Willner's opinion may not be shared universally. On the other hand, some of that testimony itself supported the notion that bond trading is a war of all against all, fought mainly by lying, so who knows. And other cases similar to Litvak's make it seem like lying about bond prices is not an isolated phenomenon. It remains difficult to know for sure exactly how much dishonesty is expected, and thus allowed, in the market for residential mortgage-backed securities. It's a question for experts to argue over, and for a jury to decide.
Which is really weird! You could imagine a rule. The rule might say "it is always illegal for a bond trader to lie to his customers" (even about socks?), or it might say "it is always illegal for a bond trader to lie to his customers about the price he paid for bonds," or whatever. Congress, or the Securities and Exchange Commission, would write it down, and then everyone could know about it. Or you could have a different rule, like, "lie to your customers as much as you want about bond prices, it is their problem to figure it out." Then again everyone would know about it, and traders could lie. But customers would be on their guard, and would know to check prices with multiple dealers and punish lying dealers by not trading with them.
But now an appeals court has devoted 84 pages to this questionand decided that there is no rule. Maybe lying to customers about bond prices is a crime, maybe it's not a crime, and it's up to 12 randomly selected laypeople to decide. Leaving the rules of financial markets to be determined based on after-the-fact review by non-experts chosen at random and empowered to impose prison time is a very American system. But boy is it strange.
I get the sense that the Second Circuit knows how strange it is. That's why it sent this case back for a new trial. In theory, a jury can decide whether or not Litvak's lies were a crime, but its decision made the Second Circuit uncomfortable, and it sent the case back for a different jury to consider, this time after hearing all of Litvak's arguments, even the distasteful ones.
This seems like part of a broader discomfort, which you can also see in the Second Circuit's Newman insider trading decision last year. A lot of stuff that is widely accepted in financial markets rubs outsiders the wrong way.
Sometimes hedge fund analysts talk to corporate insiders, for instance, and sometimes bond traders are less than fully forthcoming with their customers. Those practices develop over time, and are embraced by industry norms to a greater or lesser extent. And then some outsider, generally a prosecutor, discovers those practices and finds them distasteful.
