Trading in Opaque Markets: Fraud, Materiality and Compliance
This is the third 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 and the second is here.
Before Shapiro went to trial, the Second Circuit reversed the jury verdict in Litvak. The court’s opinion became the blueprint for the retrial of Mr. Litvak and the upcoming trial of the Shapiro defendants. The Circuit Court focused on two key issues: 1) Materiality; and 2) the exclusion by the trial judge of certain expert testimony.
First the Court addressed the question of materiality relating to the TARP fraud charges, reversing the convictions on those counts. The definition of materiality under those statutes differs from the traditional “total mix” definition of TSC Industries which centers on what may be of importance to a reasonable investor making an investment decision.
To establish a violation under the TARP counts the government was required to prove that the defendant: 1) knowingly and willfully 2) made a material false, fictitious or fraudulent statement 3) in relation to a matter within the jurisdiction of the department or agency of the U.S. and 4) with knowledge that it was false or fictitious. The key element here is the second. The definition of materiality for that element is: a statement that “has a natural tendency to influence, or be capable of influencing, the decision making body to which it was addressed. Here the decision making body was the Department of the Treasury.
Treasury was responsible for the PPIFs. It selected asset managers and wrote rules regarding how they would invest. Since the Treasury lacked expertise in trading in these markets, it cast itself as a limited partner in the PPIFs, away from the decision making process.
Viewed in this context, the Court held that Mr. Litvak’s misrepresentations could not have reasonably influenced a decision by the Treasury. The Court found that the government presented “evidence that Litvak’s misstatements may have negatively impacted the Treasury’s investments . . . and this impact would have been reflected in aggregate monthly reports submitted by PPIF managers to the Treasury, and . . . .the misstatements were the impetus for an investigation by the Treasury that eventually led to Litvak’s prosecution . . . [but] the government submitted no evidence that Litvak’s misstatements were capable of influencing a decision by the Treasury.” Therefore the counts related to the TARP program were reversed. Mr. Litvak’s materiality claims as to the other counts in the indictment were rejected.
Second, the Court held that the exclusion of the expert testimony constituted reversible error. One potential witness was Ram Willner, a business school professor and former portfolio manager. Mr. Willner’s testimony would have focused on the “rigorous valuation procedures” used by traders in the RMBS market which is opaque. Participants in that market use sophisticated procedures to evaluate the price of the securities because the markets are not efficient like the New York Stock Exchange. Accordingly, pricing is more complex and subjective.
Ultimately Mr. Willner would have concluded that in view of the procedures used by traders the “statements by sell-side salesmen or traders concerning the value of a RMBS or the price at which the broker-dealer acquired it or could acquire it, are not relevant to that fund’s determination with respect to how much to pay for a bond.”
The second potential witness was Marc Menchel, a regulatory and compliance attorney who had been general counsel of FINRA. His testimony would have focused on the relationship between a broker-dealer and counterparty. This was relevant to the question of whether Mr. Litvak was acting as an agent for the counterparty.
The Second Circuit found that the question of the relationship between the trader and the counterparty was of critical importance in this case: “Menchel was . . . prepared to testify in respect of the significance of the agent/principal distinction in the RMBS context. Litvak offered Menchel to testify that the term commission applies when a broker-dealer is acting in the capacity of agent and are virtually unheard of in the fixed-income market . . .” which includes RMBS. Mr. Menchel would also have testified that despite the compliance procedures at the firm, Mr. Litvak’s supervisors approved of his conduct. This testimony contradicts statements in the indictment about the relationship of the parties.
Mr. Litvak was retried in January 2017, after the indictment in Shapiro and the filing of the parallel SEC case but before the criminal case went to trial. The government called witnesses which included representatives of the counterparties. Those witnesses testified that the misrepresentations made by Jesse Litvak were important to them.
While Mr. Litvak’s pre-trial expert disclosures listed four witnesses, only one was called at trial – Phillip Burnaman, Managing Director and Head of Structured Products at NewStar Financial, a publicly traded finance company that specialized I structured products. Previously, Mr. Burnaman was an ING portfolio manager responsible for a $500 million portfolio of RMBS.
Mr. Burnaman’s testimony, according to the expert report, focused on several points. Those included the structure of the market and the fact that a reasonable investor in the RMBS market conducts rigorous due diligence on the prices. Investors in those distressed markets are relatively “insensitive” to the price paid because of the upside. Mr. Burnaman used charts he created to illustrate the trading models used by those trading in the market. Using those models a reasonable investor would “give little, if any, weight to statements by the trader.
Transactions in these markets are always principal to principal at arms length between sophisticated parties, according to Mr. Burnaman. In this context the dealer does not owe the counterparties best execution. The broker’s profit comes from the spread, not commissions. Finally, while firms have compliance programs “the lack of focus on ensuring truthfulness in negotiations was reflective of the general industry attitude that RMBS transactions are arms length between sophisticated parties and that any representations should be treated with a high degree of skepticism.”
The jury instructions mirrored the expert testimony, differing from the first trial, by informing the jury that “in the transactions at issue in this case, Mr. Litak was not the agent of the buyers or sellers of the RMBS . . .” The jury instructions also defined materiality, a key element of each alleged violation, in terms of the RMBS market stating that “to be material, there must be a substantial likelihood that a reasonable investor would find the misrepresentation important in making an investment decision . . . ‘a reasonable investor’ is an investor in the RMBS market.”
Only the first eleven counts (absent number 7) were submitted to the jury – the TARP and false statement counts were dropped. The jury returned a verdict of not guilty on all counts except one count of securities fraud. Mr. Litvak was sentenced to serve 24 months in prison followed by three years of supervised release. He was also ordered to pay a $2 million fine, up from the $1.75 million imposed after the first trial. Mr. Litak’s request for bail pending appeal was recently denied.
Next: The Shapiro trial