On May 3, the Second Circuit vacated on evidentiary grounds Jesse Litvak’s conviction – after a second trial – on a single count of securities fraud related to trades of residential mortgage backed securities (“RMBS”) and remanded the case to the United States District Court for the District of Connecticut.[1]  This ruling is the latest setback for the government, as the Second Circuit in 2015 had vacated Litvak’s prior conviction on ten counts of securities fraud, one count of fraud against the Troubled Asset Relief Program (“TARP”), and four counts of making false statements to the government, following his first trial.[2]

In Litvak’s second trial, the government brought ten counts of securities fraud, alleging that Litvak misrepresented the prices at which he could (or did) buy or could sell various RMBS to induce his customers to pay higher prices or accept lower prices.  A jury convicted Litvak on a single count of securities fraud, for a transaction with an investment manager in which he told the customer’s representative that he had purchased the bond for $79.67, when in fact he had purchased it for $79.50.  Evidence at trial showed that Litvak’s profits on the trade were more than double what the customer believed them to be – a difference of more than $73,000.[3]

The central question on appeal was whether statements made by Litvak regarding the prices at which he could buy or sell would have been material to a reasonable investor.  While the Second Circuit rejected Litvak’s argument that such misstatements were immaterial as a matter of law, the court vacated the conviction on the basis that the trial court should not have allowed testimony by Litvak’s customer that the customer’s representative erroneously believed Litvak was the customer’s agent.[4]  The Second Circuit held that this testimony was both irrelevant to the question of materiality of Litvak’s statements and unduly prejudicial.[5]

The Litvak saga has been closely watched as a test of the government’s theory that a broker-dealer’s inaccurate statements about his or her own prices to customers can constitute a criminally material misrepresentation.  The Second Circuit’s most recent decision confirms that such misstatements can be material, but that the inquiry is highly fact dependent.  In addition, the decision re-emphasizes that the materiality standard is objective and demonstrates the challenges inherent in relying on evidence of the effect of a misstatement on particular “victims” without connecting that effect to the reasonable investor standard.  Whether this will be the end of the road for Litvak, however, remains to be seen.

Prior Proceedings

In January 2013, Litvak, a senior trader and managing director at Jefferies & Co, was charged with eleven counts of securities fraud in violation of 15 U.S.C. §§ 78j(b), 78ff, one count of fraud against TARP in violation of 18 U.S.C. § 1031, and four counts of making false statements to government investment funds under TARP in violation of 18 U.S.C. § 1001.[6]  According to prosecutors, Litvak induced buyers to overpay for certain RMBS by misrepresenting the price at which he had purchased (or could purchase) RMBS,[7] and misrepresented the price at which he could re-sell a security to induce sellers to lower their price to him.[8]  The government also alleged that in certain transactions Litvak misrepresented to buyers that he was serving as an intermediary in a live negotiation when in fact Jefferies already owned the RMBS in its inventory.[9]

As in all securities fraud cases, a key question in the Litvak case was whether Litvak’s statements were material misrepresentations – that is, whether there was “a substantial likelihood that a reasonable investor” would find Litvak’s misrepresentations “important in making an investment decision.”[10]  In support of the government’s case, several of Litvak’s customers testified at trial that they considered Litvak’s misrepresentations meaningful and that they (or their employer) were harmed by the misstatements.  The district court did not permit Litvak to introduce countervailing evidence that his RMBS counterparties used their own rigorous valuation procedures and did not rely on statements from traders as to a security’s value.  Litvak was convicted on all counts that went to trial (one count was dismissed before trial).

On appeal, Litvak first argued his misstatements were not material.  The Second Circuit rejected this argument, explaining that whether a misrepresentation is material “is a mixed question of law and fact” and that, on the evidence presented, “a rational jury could have found that Litvak’s misrepresentations were material.”[11]  But the court then found that the excluded testimony – that RMBS buyers and sellers determine a security’s value by reference to sophisticated models and analytical tools, rather than statements from a trader – would have been relevant to the jury’s materiality determination, and vacated the jury’s verdict on that basis.[12]

The Second Trial

On remand, the government re-tried Litvak on the ten securities fraud counts.  Over Litvak’s objection, the district court allowed the government to introduce testimony that some of Litvak’s customers believed that Litvak was acting as their agent.  But the prosecution did not claim that Litvak was acting as an agent. Instead, the prosecution sought to use this evidence to show that Litvak “chose to establish a relationship of trust to lead” his customers “to think that he was trustworthy,” which the government contended was relevant to understanding whether Litvak’s misstatements were material.[13] Other evidence at trial indicated that one such customer’s legal and compliance department had advised him that broker-dealers act as their own principals, not as agents.[14]  The jury convicted Litvak of only one count – for a trade involving a customer that considered him an agent—and acquitted Litvak of the remaining counts.[15]  Litvak was sentenced to 24 months’ imprisonment, three years of supervised release, and a $2 million fine.[16]  Litvak began serving the two-year prison sentence in September 2017.

The Current Appeal

On appeal, Litvak raised two arguments.  First, as in the prior appeal, Litvak argued that his misstatements could not, as a matter of law, have been material.  The Second Circuit’s most recent decision rejected this argument in clearer terms, finding that “[t]he broker-dealer’s profit is part of the price and lies about it can be found by a jury to significantly alter the total mix of information available.”[17]

Second, Litvak argued that the government’s “agency” evidence was improper.  Because the government had not alleged that Litvak was acting as an agent for customers; it was undisputed that the transaction was at arms-length and that Litvak “owe[d] no fiduciary duties to the buyer” in the trade in question.[18]  Instead, the government argued that if victims trusted Litvak, they would be more likely to view his misstatements as material.[19]  The government persisted in this argument notwithstanding its concession that the customer in question was “confused” and “incorrect” in viewing Litvak as its agent.[20]

In siding with Litvak, the Second Circuit found that an investor’s misunderstanding of his relationship with a counterparty cannot be admitted to demonstrate the point of view of a hypothetical objective reasonable investor.  As the court put it, “it can hardly be the law that the point of view of an investor who is admitted to be wrong . . . is relevant to prove what a reasonable investor, neither confused nor incorrect, would have deemed important.”[21]  Rather, “a reasonable investor would not misperceive the role of a broker-dealer in the RMBS market.”[22]  In arguing otherwise, the government “ignore[d] the settled law that those at either end of an arms-length transaction are acting only in their own self-interest.”[23]  The decision is consistent with the longstanding rule that materiality is judged according to an objective standard – the fact that a particular investor, or particular type of investor, might have considered information to be idiosyncratically relevant to its investment decision is not sufficient to render a misrepresentation or omission material.

The Second Circuit held that the district court abused its discretion by admitting this evidence because it was not relevant.[24]  Further, the Second Circuit held that, even if it had been relevant, the evidence should have been excluded under Federal Rule of Evidence 403, because its probative value was substantially outweighed by a danger of misleading the jury.  As the Second Circuit explained, “the testimony about the supposed agency relationship had a high probability of confusing the jury by asking it to consider as relevant the perception of a counterparty representative that was entirely wrong.”[25]  The Second Circuit concluded that the error was not harmless because the improperly admitted evidence provided a “back door for the jury to apply the heightened expectations of trust that an agency relationship carries.”[26]  The Second Circuit vacated Litvak’s conviction, remanded the case to the district court, and ordered that Litvak be released pending further proceedings.[27]

*          *          *

This is now the second time the government has secured a conviction against Litvak only to have the Second Circuit vacate the conviction.  Both appellate rulings have clarified the scope of evidence bearing on materiality.  In the first appeal, the Second Circuit held that the jury should have the benefit of considering defense evidence that reasonable RMBS investors determine a security’s value using their own sophisticated models – and thus that a counterparty trader’s statements regarding price may not be material.  In its latest decision, the Second Circuit held that prosecution evidence of a counterparty’s inaccurate belief that an agency relationship existed between him and the defendant was irrelevant to materiality in an arms-length transaction and overly prejudicial to the defendant, given its propensity to confuse the jury.

Importantly, however, the Second Circuit’s decision reinforces the need for broker-dealers and other principal traders to ensure that statements made to counterparties – including statements regarding the broker-dealer’s own costs or profit margin – are not misleading.  While it cannot be controversial to say that a trader should not lie to a customer, the question of how much information must be disclosed to customers about a broker-dealer’s profit margin (a factor traditionally not disclosed) remains an uncertain area of law.  While the Second Circuit’s decision does not resolve whether or under what circumstances a broker-dealer must disclose its own costs, it does confirm that where statements are made to counterparties about a broker-dealer’s costs or profits, care should be taken to ensure they are not misleading.[28]

[1] See United States v. Litvak, — F.3d —, No. 17-1464-CR, 2018 WL 2049677 (2d Cir. May 3, 2018) (“Litvak II”).

[2] See United States v. Litvak, 808 F.3d 160 (2d Cir. 2015) (“Litvak I”).

[3] Litvak II at *5.

[4] Id. at *1.

[5] Id. at *10.

[6] See Litvak I at 166.

[7] Id.

[8] Id.

[9] Id.

[10] See United States v. Vilar, 729 F.3d 62, 89 (2d Cir. 2013).

[11] Litvak I at 175.

[12] Id. at 182.

[13] Id. at *5.

[14] Litvak II at *10.

[15] Id. at *1.

[16] Id. at *6.

[17] Id. at *8 (citing Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)).

[18] Id. at *9.

[19] Id. at *10.

[20] Id.

[21] Id.

[22] Id.

[23] Id. (citing In re Mid-Island Hosp., Inc., 276 F.3d 123, 130 (2d Cir. 2002)).

[24] Id.

[25] Id.

[26] Id.

[27] Id. at *13.

[28] This post was prepared with the assistance of Andrew Kline.