On December 8, 2015, the Second Circuit vacated the securities fraud conviction of former Jefferies & Co. trader Jesse Litvak.1 The Court also outright reversed the convictions on fraud against, and making false statements to, the government. In vacating the convictions on the securities counts, the Court held that the District Court abused its discretion in excluding two of Litvak's experts, both of whom would have testified that Litvak's misstatements were not material.
Litvak traded residential mortgage-backed securities ("RMBS") at Jefferies in the midst of the Great Recession. The indictment charged that Litvak made three types of fraudulent misstatements to counterparties: he misrepresented to purchasers Jefferies's cost to acquire the RMBS; he misrepresented to sellers the price at which Jefferies would re-sell the RMBS; and he misrepresented to purchasers that Jefferies was acting as a broker – as opposed to a principal – on the transaction.2
Some of the counterparties with which Litvak dealt were Public-Private Investment Funds, or PPIFs. PPIFs were created in the Great Recession in an effort to resuscitate the moribund RMBS market. PPIFs are capitalized, in part, by the U.S. Treasury. It was the Treasury's funding of the PPIFs that formed the basis for the charges of defrauding and making false statements to the government.
The Court reversed the convictions on these counts, finding that Litvak's misrepresentations were not material under 18 U.S.C. §§ 1001 and 1031. To be material under these statutes, a statement must be capable of influencing the decision of, in this case, the Treasury. Litvak's statements could not have influenced a decision of the Treasury, however, because the PPIFs made all of the trading decisions and the Treasury could not direct the trading.
The Court then turned to the securities fraud conviction, which is where things got interesting. Some background: Litvak's indictment caused more than a little agita among market professionals. Prior to the indictment, many assumed that, all of the players in this market being professionals rather than public customers, the back and forth that occurred over the phone was not much more than salesmen's posturing, i.e., nothing that a counterparty would or should rely on. Some believed the government had gone too far to criminalize the behavior and, after Litvak's conviction, expected the Second Circuit to hold that such statements were not material between market professionals. This view was buttressed a year ago when the Court granted Litvak's motion for release pending appeal, stating he "raised a substantial question of law or fact likely to result in . . . reversal."3
In fact, however, the Court, rather quickly, declined to hold the statements immaterial as a matter of law. The Court pointed out that the test for materiality under section 10(b) of the Securities Exchange Act is not the same as the test under the false statements laws addressed above. Under section 10(b), a statement is material where there is "'a substantial likelihood that a reasonable investor would find the . . . misrepresentation important in making an investment decision.'"4 The Court disposed of the argument by noting that materiality is a mixed question of law and fact particularly well-suited to determination by a jury. And the jury found them material.
But the Court nonetheless vacated the securities fraud conviction because the District Court abused its discretion in excluding two of Litvak's experts. And the kicker, of course, is that the thrust of both experts' testimony was that the misstatements were not material. Specifically, one expert was prepared to testify that because RMBS rarely trade, the people who trade in them rarely rely on market information to price them. Rather, market professionals routinely rely on proprietary analytic tools to determine value. Thus what a counterparty may have paid, for example, is of little interest.
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. The full context and circumstances in which RMBS are traded were undoubtedly relevant to the jury's determination of materiality.5
Not to put too fine a point on it, the Court summed-up:
[W]e cannot conclude with fair assurance that the jury would not have found differently if it were presented with information about the functioning of the specialized RMBS market and the valuation process employed by those who participate therein.6
In essence, then, the Court vacated the conviction, not because the statements were immaterial as a matter of law, but as a matter of fact.
While this disposed of the appeal, the Court went on to discuss Litvak's arguments regarding other evidentiary rulings to guide the trial court on remand. One of the rulings related, again, to materiality.
As noted above, the test for materiality is whether a reasonable investor would find the information important. The use of the term "reasonable investor" makes the test objective. A debate exists at to whether the objective test is modulated by the circumstances of the case; specifically the sophistication of the parties. That is, is the "reasonable investor" different, for example, when a retail customer buys a stock from a brokerage as opposed to when market professionals trade complex financial instruments among themselves?
The Second Circuit touched upon this issue when it noted that "district courts in this Circuit have held repeatedly in the analogous civil context that 'the sophistication of the investor is relevant to both the adequacy of the defendant's disclosure and to the extent of the investor's reliance on any alleged misrepresentations.'"7 Among the authority for this proposition was the dissent in Republic of Iraq v. ABB AG,8 which the Court characterized as "noting that, in certain circumstances, 'sophisticated buyers' may 'not necessarily need the protection of the Securities Act.'"9 In any event, the Court held that the District Court erred when it excluded expert testimony to the effect that minor price variances would not have mattered to sophisticated investors.10
Finally, Litvak wanted to adduce testimony that his managers encouraged the types of statements at issue and that other traders at Jefferies made similar statements to customers. Litvak wanted the testimony to show that he believed these statements were permitted and thus to negative the necessary element of fraudulent intent. The District Court allowed testimony regarding Litvak in particular, but precluded evidence as to other traders as not relevant under Fed. R. Ev. 401, explaining it merely was "'suggest[ing] that everybody did it and therefore it isn't illegal.'"11
The Second Circuit held, however, that in excluding the testimony the District Court exceeded its allowable discretion "under the low threshold" of rule 402.12 In support, the opinion quoted a case [slightly] older than your author:
"[S]ince good faith may be only inferentially proven, no events or actions which bear even remotely on its probability should be withdrawn from the jury unless the tangential and confusing elements interjected by such evidence clearly outweigh" its relevance . . . .13
The obvious question is, will the government re-try Litvak? The question is even broader, however, because indicting RMBS traders is something of a cottage industry in the District of Connecticut. Three former RMBS traders at Nomura Securities were charged in an indictment unsealed in September.14 Before the Litvak decision, the prosecutor in Shapiro stated that if the Second Circuit reversed Litvak, it would "impair" the prosecution in Shapiro.15
Footnotes
1 United States v. Litvak, No. 14-2902-cr (2d Cir. Dec. 8, 2015) ("Litvak"), available on the Court's website, http://www.ca2.uscourts.gov/.
2 Litvak got caught when his "misrepresentations were brought to light by his colleague's inadvertent email to a counterparty's representative . . . ." Id. at 41.
3 Order, United States v. Litvak, No. 14-2902-cr, at 1 (2d Cir. Oct. 3, 2014) (internal quotation marks omitted).
4 Litvak, slip op. at 36 (quoting United States v. Vilar, 729 F.3d 62, 89 (2d Cir. 2013), cert. denied, 134 S. Ct. 2684 (2014)).
5 Id. at 60.
6 Id. at 64.
7 Id. at 66-67 (quoting Quintel Corp. v. Citibank, N.A., 596 F. Supp. 797, 802 (S.D.N.Y. 1984).
8 768 F.3d 145, 182 (2d Cir. 2014) (Droney, J., concurring in part & dissenting in part).
9 Litvak at 66. The fact that the quote can be read to alter the meaning of the statement in the Republic of Iraq dissent, compare id. with 768 F.3d at 182, makes the Second Circuit's statement even more provocative.
10 See id. at 65-67.
11 Id. at 81 (quoting the trial transcript at 1472:18-19, reproduced in the Joint Appendix at 645).
12 Id. at 82.
13 Id. at 83 (quoting United States v. Brandt, 196 F.2d 653, 657 (2d Cir. 1952)).
14 Indictment, United States v. Shapiro, No. 3:15-cr-155 (RNC) (D. Conn. Sept. 3, 2015). See also Information, United States v. Katke, No. 3:15-cr-38 (RNC) (D. Conn. Mar. 11, 2015) (CLO trader).
15 Robert Gearty & Chris Dolmetsch, "Ex-Nomura Traders' Trial May Hinge on Outcome of Litvak's Appeal," at 1 (Oct. 7, 2015), http://www.bloomberg.com/news/articles/2015-10-07/ex-nomura-traders-trial-may-hinge-on-outcome-of-litvak-s-appeal
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