The Impact of Compliance - Another Reversal For a Jefferies Trader

by Dorsey & Whitney LLP

The key role of compliance threads through the continuing saga of Jefferies & Co. trader Jesse Litvak as well as a series of similar cases. Mr. Litvak is one of a number of traders who were indicted by the U.S. Attorney’s Office for allegedly making misstatements to counterparties while trading residential mortgage backed securities or RMBS. Although those markets are largely opaque, the traders and counterparties are highly sophisticated, employing complex pricing models to guide their transactions. Mr. Litvak, who was initially indicted in 2013, was just freed from prison following the second reversal of his conviction by the Second Circuit Court of Appeals. U.S. v. Litvak, No. 17-1464 (2nd Cir. May 3, 2017).

Trader Litvak was initially indicted on 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. The indictment alleged that the trader lied to his clients to induce them to enter into transactions that profited him and his firm by about $2 million. U.S. v. Litvak, No. 13 cr-00019 (D. Conn. Filed Jan. 25, 2013).

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. The transactions involved complex discussions in which the parties went back and forth. Those discussions were conducted by the trader, the counterparties, their supervisor and others in many instances.

In February 2014 Mr. Litvak went to trial for the first time. The jury return guilty verdicts on all counts after a fourteen day trial. 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. Mr. Litvak remained at liberty on bond.

The Second Circuit reversed. The 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. Since the Department structured the decision making process for these transactions in a manner which shielded the decision maker from any statements made by a trader such as Mr. Litvak, the Court conclude his statements could not have been material to its decision. Each TARP count was reversed.

Second, the Court held that the exclusion of the expert testimony constituted reversible error. That testimony would have informed the jury about the “rigorous valuation procedures” used by traders in the RMBS market which is opaque and the sophisticated procedures employed to evaluate the price of the securities because the markets are not efficient. The Court concluded that excluding such testimony was reversible error.

Mr. Litvak was retried in January 2017. Only the first eleven counts (absent number 7) were submitted to the jury – the TARP and false statement counts were dropped. Prior to trial Mr. Litvak made a motion in limine to bar counterparty representatives from testifying that they believed he was acting as their agent. This assertion was in accord with a representation made by the government at oral argument before the Second Circuit – all parties agreed that in fact Mr. Litvak was not an agent of the counterparties and thus had no fiduciary duty.

Despite that admission, the district court, at the urging of the government, permitted testimony by two counterparty witnesses stating that in their view the trader was an agent. Yet the compliance department for one of the witnesses had instructed him to the contrary – that is, the trader was not an agent but a principle. During final argument the government told the jury that the agency issue was a “red herring.” Rather, the critical point of the testimony on the agency issue was “’to establish a relationship of trust to lead them [counterparties] all to think that he [the trader] was trustworthy.’” The jury instructions stated that the trader was not an agent of the counterparties.

The jury returned a verdict of not guilty on all counts except one of securities fraud. Mr. Litvak was sentenced to serve 24 months in prison followed by three years of supervised release, the same sentence he had initially received. He was also ordered to pay a $2 million fine, up from the $1.75 million imposed after the first trial. A request for bail pending appeal was denied.

The Second Circuit again reversed. In the first appeal, the Court stressed the importance of the agency relationship to the materiality issue. Testimony on the agency issue was relevant “because it might cause a jury to ‘construe [Litvak’s misstatements] as having great import to a reasonable investor if coming from the investor’s agent.’” (emphasis original).

At the retrial, however, it was undisputed that Mr. Litvak did not act as the agent of the counterparty on the transaction for which he was convicted. Nevertheless, the testimony on agency was admitted at the urging of the government which claimed that if “trust exists . . . a jury could interpret misstatements by appellant as more likely to be material.” Yet the materiality standard is an objective one based on a hypothetical, reasonable investor. “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 . . . would have deemed important. The agency issue raised by the government’s proffer of Norris’s [counterparty witness] testimony was indeed an irrevelant ‘red herring,’” the Court found. “While the individual views of a counterparty trader may usually be relevant to the nature of the market involved . . . a reasonable investor would not misperceive the role of a broker-dealer in the RMBS market.” The fact that the compliance department of the firm at which the witness was employed instructed him that the trader was not an agent but rather was acting as a principle confirms this point, the Court found.

Under the circumstances of this case, the “government’s concept of subjective trust as evidence of materiality became a back door for the jury to apply the heightened expectations of trust that an agency relationship carries. The government’s argument similarly ignores the settled law that those at either end of an arms-length transaction are acting only in their own self-interest.” Accordingly, the admission of the testimony was error and, in view of the verdict on the one count, it cannot be harmless. This is particularly true in view of the fact that on the counts where the jury returned verdicts of acquittal there either was no counterparty testimony or those parties testified that the statements of the trader were viewed with suspicion. “We conclude that the district court’s error in admitting testimony on agency was not harmless and requires a vacatur.” The judgment of conviction was reversed, Mr. Litvak ordered released on an appropriate bond, and the case remanded for further proceedings.


Litvak is one of a number of criminal cases brought by the U.S. Attorney’s Office, at times paralleled by the SEC, tied to trading in RMBS or similar securities in opaque markets as discussed here. Typically those cases centered on claims by the government that the trader made misrepresentations to the counterparties which constituted fraud. While the relationship among the traders and counterparties, as here, was critical in each instance, the role of compliance was also key.

In the second appeal by Mr. Litvak the fact that compliance confirmed the lack of an agency relationship was important to the Court’s decision. In other cases in this group (here), compliance apparently enabled the traders who believed that the department knew and tolerated the “wild west” and “anything goes” kind of tactics often used in these markets which are at the center of all the cases. This more than suggests that the real point of all these cases is not so much the statements made by traders to counterparties but the role of compliance. Better, more effective compliance could have prevented the wild west atmosphere and avoided all of the government enforcement actions – compliance should be the first line of defense for a firm and its employees, not, as here, the last.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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