Trading in Opaque Markets: Fraud, Materiality and Compliance

This is the second segment of an occasional series regarding a group of criminal and civil securities fraud actions involving trading in opaque markets and the lessons that can be drawn them; the first segment is here.

Litvak I

Jesse Litvak was a senior trader and managing director at Jefferies & Co. He was indicted for securities fraud. U.S. v. Litvak, No. 13 cr-00019 (D. Conn. Filed Jan. 25, 2013).

The indictment contained eleven counts of securities fraud, one count of TARP fraud and four counts of making false statements. The transactions took place over about a two year period beginning in 2009. Mr. Litvak’s book of business had been declining. Essentially, the indictment alleged that Mr. Litvak lied to his clients as detailed below.

The victims, according to the indictment, included the U.S. Treasury through its Securities Public Private Investment Program or PPIP, part of the TARP bailout program. They also included other sophisticated funds and investors such as DE Shaw, Magnetar and Putnam Investments.

The securities were bonds tied to residential mortgages and home equity loans known as RMBS. Sales were effected in three ways:

· From inventory

· Order to broker or

· A bid list where sellers circulated a list of bonds for sale seeking to negotiate the terms.

Orders and bid lists transactions are “riskless,” according to the indictment. In these transactions Jefferies acts as a match-maker. Buyer placing order, on the other hand, seek best execution.

Jefferies was compensation in three ways:

· A commission;

· On an “all in” basis – the buyer does not know the purchase price so the house makes the spread which is typical for inventory trades; or

· “On top,” that is, the broker agreed to a specific amount added to the price paid; this method was typical for bid-list transactions, according to the indictment.

The markets for RMBS are generally opaque – pricing information was not readily available.

The indictment against Mr. Litvak alleged three types of fraudulent statements by the trader involving order and bid list transactions:

· For “on top” transactions with a buyer, the price paid by Jefferies was misrepresented, adding extra profit;

· For commission transactions with a seller, the price the buyer had agreed to pay to Jefferies was misrepresented, increasing the commission;

· The trader falsely claimed he was currently negotiating to acquire the bond when Jefferies in fact already owned the RMBS.

As a result of Mr. Litvak’s alleged fraudulent conduct, the firm made an extra $2 million. The case came from a whistleblower who reported the conduct to Treasury. The SEC did not bring a parallel case.

The sales transactions here not only involve sophisticated parties, the purchase and sales were complex discussions in which the parties went back and forth; they involved the trader, his supervisor and more than one person on the other side. The conversations were recorded so there was little doubt about what was said and the prices involved. Indeed, the indictment contained examples of actual conversations and the pricing.

In February 2014 Mr. Litvak went to trial. Following a fourteen day trial the jury return guilty verdicts on all counts. Jesse Litvak was sentenced to serve twenty-four months in prison, three years of supervised release and pay a $1.75 million fine. An appeal to the Second Circuit was filed.

Shapiro – the indictment

In September 2015 while Litvak was on appeal, the U.S. Attorney’s Office in Connecticut and the SEC brought parallel cases against three Nomura Securities International traders: Robert Shapiro, Managing Director; Michael Gramins, Vice President and later Executive Director of the RMBS desk; and Tyler Peters, Vice President and later Executive Director of the RMBS desk. U.S. v. Shapio, No. 15-cv-00155 (D. Conn. Filed Sept. 3, 2015); SEC v. Shapiro, Civil Action No. 15-cv-07045 (S.D.N.Y. Filed Sept. 8, 2015).

The third superseding indictment contained nine counts: one for conspiracy, two for securities fraud and six for wire fraud. The indictment centered on trading RMBS from 2009 through 2013. The counter parties were non-government institutional investors such as QVT Financial, Monarch Alternative Capital, Putnam Investment Management and Hartford Investment Management.

The alleged fraud is similar to that in the Litvak case. The alleged misrepresentation included claimed that:

· In certain order and bid list transactions when the buyer agreed to pay “on top” the price was inflated;

· In other order and bid list transactions misrepresentations were made to deflate the price;

· In sales from inventory the buyer was falsely told the security was being acquired from a third party.

The SEC complaint, which is similar to the indictment, focused on the fact that the markets were opaque so counter-parties had to rely on the representations of traders about the pricing. The traders made about $7 million in illicit profits, according to the SEC. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Section 10(b).

Before Shapiro went to trial, the Second Circuit handed down its decision in Litvak.

Next: The Second Circuit’s decision in Litvak