On Monday, following two reversals of convictions, the U.S. Attorney’s Office for the District of Connecticut moved to dismiss the sole securities fraud claim remaining against former Jefferies bond trader, Jesse Litvak, bringing an end to the 5 1/2-year long case against him.[1]  During the case’s winding procedural path, the Government twice secured convictions against Litvak by jury trial—on the theory that Litvak’s alleged misstatements about his own costs and profit margins for residential mortgage-backed securities (“RMBS”) trades would have been material to the decision-making of a reasonable (and often sophisticated) investor-buyer.  And twice the Second Circuit overturned the convictions on narrow and technical grounds.  Notably, even while seeking to dismiss the remaining charge, the Government maintains in its filing that the Second Circuit’s decisions left undisturbed the soundness of its legal theories—namely that a broker-dealer’s misstatements relating to his own profits to sophisticated counterparties could satisfy the materiality requirement for securities fraud as a matter of law.[2]  Thus, notwithstanding the additional hurdles presented by the Second Circuit’s decisions, the Government’s decision not to pursue yet another trial against Litvak does not signal a death knell for all similar charges in the future, particularly those that are currently pending and arose as part of the Government’s RMBS probe.  But the somewhat torturous history of the Litvak case does highlight the difficulty for the Government in establishing the materiality of alleged misstatements made to sophisticated securities professionals who undertake their own analysis of trades.  Indeed, in many of these RMBS cases, the Government faced an uphill battle from the start, evidenced by its inability to secure convictions in many of them.

Litvak, a former trader at Jefferies & Co., was criminally charged in January 2013 with several counts of securities fraud in connection with the Troubled Asset Relief Program.[3]  The Government alleged, among other things, that Litvak misrepresented to his customers the prices he paid (or would pay) for RMBS, which had the effect of inducing customers to overpay or undersell.[4]  A critical question in the case was whether Litvak’s purportedly false and misleading statements were sufficiently material to provide a basis for the securities fraud charges, or whether, as the defense maintained, buyers and sellers of RMBS did not attach particular importance to a counterparty’s statement, instead relying on their own complex pricing models that utilized objective factors.[5]

The first jury agreed with the Government, convicting Litvak of all counts.[6]  However, the Second Circuit vacated Litvak’s conviction.[7]  The Second Circuit’s first decision turned on the issue of whether Litvak’s misrepresentations were material in nature—that is, whether there was “a substantial likelihood that a reasonable investor” would find Litvak’s misrepresentations “important in making an investment decision.”[8]  While the court rejected Litvak’s argument that his statements about price could not be material as a matter of law, it agreed that the district court should have permitted the defense to present the jury with evidence that RMBS traders relied on their own valuation procedures and not a counterparty’s statements of value.[9]

The next time around, a second jury—after being educated on such valuation procedures—convicted Litvak on a single count of securities fraud.  But on May 3, 2018, the Second Circuit again vacated the conviction.  First, the court again acknowledged that Litvak’s statements could have been material to an objective reasonable investor noting 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.”[10]  However, the court found that the evidence the Government adduced to demonstrate materiality—testimony from a counterparty who believed incorrectly that Litvak acted as his agent and thus owed him a fiduciary duty—was overly prejudicial and should not have been admitted at trial.  The court found that “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.”[11]  In other words, because Litvak’s counterparty was not reasonable in his belief as to the duties Litvak owed to him, his testimony could not satisfy the securities law’s hypothetical reasonable investor standard.  Instead, the Second Circuit instructed, the Government could only meet the objective standard for materiality where it demonstrates that there is “a nexus between a particular trader’s viewpoint and that of the mainstream thinking of investors in that market.”[12]  In finding that this evidence “was evidently of great importance to the jury” and was “the only rational reason for the jury to have convicted [Litvak]” on the securities fraud count while “acquitting him on all other counts,” the Second Circuit concluded that its admission “was not harmless and requires a vacatur.”[13]

Now, the Government has moved to dismiss the action—choosing to forego a third trial, even though the two Second Circuit decisions did not undermine the general theory of the Government’s case, only taking issue with the way in which the Government attempted to prove it.  While moving to dismiss the remaining charge, the Government went out of its way to reiterate the viability of its theory—that statements and omissions by a trader concerning a firm’s costs were material misrepresentations that support a securities fraud charge—noting that “[t]wo juries have found [Litvak] guilty of securities fraud, the Court and the Second Circuit have twice found there was sufficient evidence to support those convictions, and the Second Circuit has twice validated the Government’s prosecution theory . . . .”[14]

Thus, the dismissal of its charges against Litvak should not be interpreted as an indication that the Government will never consider similar charges going forward, nor that it will drop all pending charges involving theories and allegations similar to those in Litvak.  However, the case—and the decision not to press forward with a third trial—highlights the challenges for the Government in proving materiality of alleged misstatements about pricing and profits made in arms-length transactions between sophisticated traders.  By raising the bar on what evidence could be used at trial to satisfy the materiality requirement, the Second Circuit has shown that the inquiry is highly fact-intensive and potentially difficult to prove in markets in which counterparties utilize sophisticated pricing tools, effectively inviting the Government to test additional factual theories aimed at demonstrating how a hypothetical reasonable (and sophisticated) investor might come to rely on a broker-dealer’s own statements related to his profits.

Such testing may, in fact, begin in the near future.  In another criminal case pending against former RMBS traders, U.S. v. Shapiro, the Government brought conspiracy and securities fraud charges against three ex-Nomura employees on the Litvak theory—that the traders’ own statements to sophisticated counterparties provide the basis for the charges.  These cases have been met with headwinds.

Following a trial in May of last year, a jury convicted Michael Gramins on one count of conspiracy, but acquitted Tyler Peters and failed to reach a verdict on a conspiracy count against Ross Shapiro and two substantive fraud counts against Gramins.  Following on the heels of the Second Circuit’s May 2018 decision in Litvak and citing similarities between the charges against them and those made against Litvak, Gramins and Shapiro have requested that the District Court reconsider their motions for acquittal and dismissal of the remaining charges against them, which the court previously denied.[15]

The Government opposed the defendants’ motions, distinguishing the evidence in that case from that in Litvak.[16]  In its opposition, the Government contends that the evidence of materiality—such as co-conspirators’ admissions that the misstatements resulted in over- or underpayments by their counterparties and the court’s finding that the counterparties did not explicitly testify that they (erroneously) believed the Shapiro defendants were acting as their agents (as a counterparty did in the second Litvak trial)—was far stronger there than in Litvak.[17]  The Government also argued that, unlike Litvak, to the extent counterparties incorrectly believed in the trustworthiness of the defendants’ representations, the Shapiro defendants themselves actively contributed to that belief and, therefore, the case fell within the Second Circuit’s recognition that the subjective misbeliefs of a counterparty could help satisfy materiality so long as the defendant “was the source of [the] mistaken belief . . . or took steps sufficient to cause [the belief].”[18]  The Government also emphasized that the relevant transaction took place after Gramins learned of Litvak’s indictment in 2013, creating a stronger inference of willfulness than in Litvak.[19] It remains to be seen how the Government’s case against Gramins and Shapiro will ultimately fare.

Even though the Litvak saga appears to be ending with the dismissal of criminal charges and uncertainty remains with the Government’s other related cases, given that the Second Circuit has twice ruled that statements made by broker-dealers to counterparties could be material and actionable, broker-dealers and other traders are well advised to ensure that statements made to counterparties—even statements regarding profit margins and other trade terms not typically disclosed or obviously relied upon by counterparties—be either fully accurate or go unmade.

[1] Government’s Motion to Dismiss Count Four, U.S. v. Litvak, 13 cr. 19 (JCH), Docket Entry 599.

[2] Id.

[3] U.S. v. Litvak, 899 F.3d 56, 59 (2d Cir. May 3, 2018) (“Litvak II”).

[4] Id. at 62.

[5] Id. at 59.

[6] U.S. v. Litvak, 808 F.3d 160, 165 (2d Cir. 2015) (“Litvak I”).

[7] Id.

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

[9] Litvak I at 165-166.

[10] Litvak II at 67.

[11] Id.

[12] Id. at 65.

[13] Id. at 72.

[14] Government’s Motion to Dismiss Count Four, U.S. v. Litvak, 13 cr 19 (JCH), Docket Entry 599.

[15] Memorandum in Support of Defendants’ Motion for Reconsideration, U.S. v. Shapiro and Gramins, 15 cr

155 (RNC), Docket Entry 523.

[16] Government’s Opposition to Defendants’ Motion for Reconsideration, U.S. v. Shapiro and Gramins, 15 cr

55 (RNC), Docket Entry 530.

[17] Id. at 9-12.

[18] Id. at 7, 11-15.

[19] Id. at 9.