On March 7, 2014 Jesse Litvak was convicted of ten counts of securities fraud on the basis of alleged misrepresentations made by Mr. Litvak in connection with the purchase and sale of residential mortgage-backed securities, in violation of 15 U.S.C. §§ 78(j) & 78ff.[1][2][3] The district court sentenced Mr. Litvak to 24 months of imprisonment and imposed a $1.75 million dollar fine. The court then denied Mr. Litvak’s motion for release pending his appeal. Subsequently, on July 2, 2014 the district court denied Litvak’s Rule 29 motion for acquittal and Rule 33 motion for a new trial. [4] The Government later submitted a Motion for Entry of Order of Restitution for $1,604,088.47. Thereafter, Mr. Litvak succeeded on his renewed motion for release. Finding that Mr. Litvak’s case raised “substantial questions of law and fact,” the Second Circuit ordered Mr. Litvak’s release pending his appeal.
This paper addresses one of the substantial questions of law arising out Mr. Litvak’s appeal. Specifically, whether a misrepresentation made during the course of negotiations must be capable of affecting the value of the underlying security transacted to be “material” under § 78j(b). In analyzing this issue, I will first discuss the uncontested facts concerning Mr. Litvak’s conduct, the districts court’s opinion denying Litvak’s Rule 29 and Rule 33 motions, and Litvak’s brief submitted for his appeal. (The Government has yet to submit). Second, I will explore the strengths and weaknesses of the positions of the respective parties. Lastly, I will suggest a new factor that courts should consider in analyzing the materiality of statements made during negotiations.
- The Conduct and Trial of Mr. Litvak.
Jesse Litvak was a former senior trader and managing director at Jeffries & Co. (“Jeffries”), a global securities firm, engaged in investment banking and broker-dealer services. At Jeffries, Mr. Litvak frequently transacted in bonds with other professionals managing investment funds. The bonds at issue in Mr. Litvak’s case were a type of residential mortgage-backed securities (“RMBS”), the market for which was partly created and subsidized by the Federal Government pursuant to the Troubled Asset Relief Program (“TARP”). Notably, firms used internal valuation methods in valuing the bonds. According to the Litvak Brief, firms used various inputs to estimate “the value of the revenue streams associated with the constituent mortgages for each bond—which allowed the firm to assess whether the bond was a good deal at a particular price.” Importantly, for all of the relevant trades, Mr. Litvak was trading as principal, solely for the Jefferies account, and dealt strictly with sophisticated investors.
Litvak concedes to some of the conduct alleged in the indictment, including misrepresenting Jefferies’ acquisition price for the bonds, obscuring what portion of the transaction price constituted execution and transaction costs, and pretending to conduct negotiations with a non-existent third-party seller during inventory trades. For example, count 3 of the indictment alleged that during one particular negotiation, Litvak asserted Jefferies’ acquisition price to be $67.66 per bond, knowing full well the true acquisition price was $67.47, and ultimately accepted an offer at $67.78. The conduct charged in count 11 was as follows: Litvak was in touch with a buyer who was offering $50.50 per bond. Litvak pretended to be in touch with a seller offering the bonds at $55.00. Litvak then pretended to negotiate the third-party down to $54.00, then $53.50— at which point Litvak explained he had to “beat [the seller]up pretty good” to get there—eventually down to $53.00. Litvak then got the buyer to agree to purchase the bonds from Jefferies at $53.25. In reality, the bonds were already held in Jefferies’ inventory.
- The District Court Decision
In the it’s opinion denying Litvak’s Rule 29 and Rule 33 motion, the district court held there was sufficient evidence to find Litvak’s misrepresentations material, because the misrepresentations “became a part of [the counterparty’s]calculations and influenced their negotiations with Litvak.” The court explained that the testimony of the “victims” at trial showed that Litvak’s “lies affected the price they paid for the underlying securities.” For example, the court cited to the testimony of one buyer who testified that Litvak’s “lies about cost and compensation harmed the funs bottom line,” because “had [the buyer]known the true acquisition price . . . and how much compensation Litvak was actually taking ‘on top,’ he would have sought to negotiate a better deal.”
The court concluded its discussion of materiality as follows:
While these victims had other powerful investment tools, and while buyer and seller in this market ordinarily lack access to the other’s price information, there was ample evidence at trial that, in misstating his acquisition price in bid list and order trades and holding himself out to be buying from a fictional seller in inventory trades, Litvak exploited the opacity of the RMBS market to his victims’ detriment and to Jeffries’ and his own advantage.
- The Litvak Brief
Litvak argues that his misrepresentations are immaterial as a matter of law because Second Circuit and common law precedent establish an “affect on the underlying security” requirement for materiality, and that such a requirement is good public policy.
For Second Circuit precedent supporting his position, Mr. Litvak relies primarily on Feinman v. Dean Witter Reynolds, Inc.[5] In Feinman, the plaintiff’s alleged that the defendant brokerage firm embedded “hidden commissions on every transaction” in the confirmation slips supplied to customers.[6] According the Feinman Plaintiffs, the commissions, generally ranging from $2.35 to $4.85, were disguised under the rubric of various transaction fees, for example, as “handling, postage and insurance,” and were designed to “circumvent rules prohibiting fixed rates and to prevent customers from negotiating the fees.” The Feinman court held the misrepresentations at issue were not material as a matter of law. The court explained that “[i]f brokerage firms are slightly inflating the cost of their transaction fees, the remedy is competition among the firms in the labeling and pricing of their services.”
Litvak also argues that established common law precedents concerning fraud support his theory of materiality. Litvak cites cases finding a seller’s statement to a sophisticated investor that he would only receive a 75 cent commission, or a misrepresentation that a bid “was as low as the work could be done” for a profit, were purely “dealer’s talk.”[7][8] Litvak also cites cases holding misrepresentations related to the lowest price one could pay for an item[9] or the probability that a seller would not get a better price elsewhere were immaterial.[10]
Lastly, Litvak argues that accepting the district court’s theory of materiality would “raise the specter of criminal liability for commonplace conduct in negotiations.” Litvak contends that under the Government’s theory, a statement by a car salesmen expressing he can’t go lower and still make a profit, or even “about a shared love of a sport’s team,” would constitute fraud, if the statement affected the other party’s negotiation calculus.
- Strength’s and Weaknesses of the Positions of the Respective Parties.
The district court was correct in it’s refusal to adopt Litvak’s “affect on the underlying security” requirement for materiality. However, because the court was imprecise in it’s language, it erroneously and unnecessarily expanded the materiality standard, leaving room for reversal. The court begins its discussion of materiality by laying down the established standard that a false statement is material when “it would have been significant to a reasonable investor in making an investment decision,” and that materiality is a “mixed question of law and fact for the jury.” Thus, the court explains, “it left [the materiality]determination, in the first instance, to the jury,” which heard Litvak’s arguments at trial and “clearly rejected them in their verdict.”
The court gets into trouble, though, when conducting its analysis, as the court’s imprecise language seems to alter the standard it just presented. Most egregiously, the court invents multiple new standards that significantly lower the bar for materiality, by dropping the requirement that the statement be “significant to the reasonable investor.” (emphasis added). For example, the district court suggests that a misrepresentation is material if the counterparty “would have sought to negotiate a better deal”; or if the defendant made the misstatement “in order to make money” and would not have made the misrepresentation “absent a potential profit”; or simply made the misrepresentation “to his victim’s detriment and to . . . his advantage.”
Further, the court twice changes the standard from objective to subjective. For example, the court emphasizes witness testimony that Litvak’s “lies mattered to them” because they paid more for the bonds than they would have otherwise, and elsewhere suggests that a “rational jury could infer materiality from the lengths which Litvak went to deceive his victims.” (emphasis added). The proper standard, however, concerns the perspective of the objective reasonable investor, not these particular investors, or the subjective perspective of the defendant. Thus, I agree with the Litvak’s contention that the district court “erred in approving that expansive theory of materiality and condoning the use of federal fraud statutes to police negotiations between sophisticated parties.”
Litvak’s arguments are strong only insofar as they as they critique the district court’s expansive theory of materiality; otherwise, Litvak’s arguments are generally meritless. At trial, Litvak argued that his misrepresentations were per se immaterial because he was (1) trading as principal, (2) with finance professionals, (3) in the opaque RMBS market, wherein firms use their own valuation methods for the bonds at issue. In his brief, Litvak argues that his misrepresentations are immaterial as a matter of law because (4) Second Circuit and (5) common law precedent establish an “affect on the underlying security” requirement for materiality, and (6) that such a requirement is good public policy.
I begin with what Litvak got right. As explained above, Litvak was right to challenge the erroneous materiality standards of the district court. Of course, he is correct that in trading as principal, he had no duty to disclose his potential profits. Litvak is also partly correct in his reliance on the fact that the counterparties were investment professionals and used internal pricing mechanisms. In virtue of these facts, there was an expectation of due diligence on the part of the counterparties, and courts are less receptive to complaints concerning prices established through arms length negotiations between sophisticated parties.[11] Litvak’s other arguments, though, are meritless.
Lets begin with Litvak’s assertion that the Second Circuit has “repeatedly recognized the fundamental principal that, to be material, a fact must be capable of affecting the value of the security transacted.” Unfortunately for Litvak, if the above were true, the Second Circuit would be in direct contradiction with the Supreme Court’s decision in S.E.C. v. Zandford.[12] In Zandford, the Court held that an allegation that a broker simply stole the money from his client’s account, some of which were the proceeds of security transactions conducted by the broker, met the “in connection” requirement of §10(b). The defendan argued that his theft had no relation to the securities markets. The Supreme Court explained “neither the SEC nor this Court has ever held that there must be a misrepresentation about the value of a particular security in order to run afoul of the Act.”[13] Rather, “[i]t is enough that the scheme to defraud and the sale of the securities coincide.”[14] The implication of Zandford is clear: if a violation of §10(b) requires a material misstatement, which it does, and §10 (b) can be violated without “the manipulation of a particular security,” as Zandford holds, then logic dictates that satisfaction of the materiality element cannot require that the statement “affect the value of the security transacted,” as Litvak contends. [15]
Further, Litvak’s reliance on Feinman, discussed above, is highly misplaced, and arguably misleading. The Litvak Brief selectively quotes language from Feinman and then adds misleading explanatory clauses. For example, Litvak quotes Feinmans’s explanation that it has only refused to find misrepresentations “not material as a matter of law” where the “misstatements . . . [lacked]the potential to cause the plaintiff financial harm”— to which Litvak then adds, “by affecting the value of the security.” The truth, however, is that Feinman does not stand for this proposition, and never even remotely discusses or implies a requirement that a misstatement must “affect the value of the security” to be material. Rather, Feinman explained that the alleged misrepresentation were not material as a matter of law because “no reasonable investor would have considered it important . . . that a transaction fee of a few dollars might exceed the broker’s actual handling charges.”[16] In other words, Feinman simply states that a few dollars is immaterial.
Contrast the few dollars at issue in Feinman, with the losses suffered in virtue of Litvak’s misrepresentations. In the Government’s Motion for Entry of Order of Restitution, the Government shows that the losses resulting from Litvak’s misrepresentation on any given trade, ranged anywhere from $892.48 to $611,710.34. The differences are obvious. A few dollars—Immaterial. Hundreds of thousands of dollars—material.
Likewise, Litvak’s reliance on various centuries old Common Law decisions ignores the entire purpose of the Securities Exchange Act. As the Zandford Court explains, “Congress’ objective in passing the Act was to insure honest securities markets and thereby promote investor confidence,” and to “substitute a philosophy of full disclosure for [the common law]philosophy of caveat emptor [as]to achieve a high standard of business ethics in the securities industry.”[17] Evidently, Congress felt that selling cars and selling securities were not the same, and rightfully so.
Lastly, Litvak’s contention that an adverse ruling would “raise the specter of criminal liability for commonplace conduct in negotiations” is well overstated, but understandable given the districts court’s expansive notion of materiality. Admittedly, as Litvak discusses, many experts agree that “mislead[ing]an opponent about one’s true settling point is the essence of negotiation.”[18] However, even assuming such experts are correct, it does not mean, under the established standard for materiality, that material falsehoods are necessary for negotiation. Litvak could always conceal or refuse to disclose his acquisition price.
- Suggestion of a Factor for Materiality.
Finally, I would like to suggest one factor that future courts may find useful in analyzing the potential materiality of a misrepresentation made during negotiations. I believe that courts should give different weight to what I term binary statements and non-binary statements. Binary statements are either true or false in all contexts, while the truth or falsity of non-binary statements are context dependent and can vary in degree. An example of a binary statement would be, “I am pregnant.” Your either are pregnant or you are not pregnant. An example of a non-binary statement would be, “ I wont earn a sufficient profit at that price.” Here, the term “profit” is vague. Are we talking net or gross? Likewise, what is a “sufficient” profit?
I suggest that the more a misrepresentation is akin to a binary statement, the more likely it is material, while the more akin a misrepresentation is to a non-binary statement, the less likely it is material. The benefit of this approach is that the more akin a misrepresentation is to a non-binary statement, the more the listener will be on notice to consider the various potential meanings of the statement, and should be expected to rely on the statement accordingly. For example, if a car salesman tells a customer that he cannot lower his price any further because “he would only earn a miniscule profit,” the buyer is on notice that a “miniscule profit” is non-binary, and thus likely immaterial, as the buyer should not have reasonably relied on such a statement. Similarly, Litvak’s binary statements that his acquisition price was X, are more likely to be material because reliance on the quote is likely more reasonable, as the price was either X or not-X.
- Conclusion.
There are many issues of law raised by Litvak’s appeal that are not discussed in this paper, some of which may require reversal. However, although the Second Circuit should admonish the district court for the imprecision in its language, it should absolutely reject Litvak’s theory that to be material under §78j(b), a misrepresentation must be able to affect the value of the security. Not only would such a requirement be contrary to established Supreme Court precedent, it would also give legal sanction to traders to lie about anything, no matter the magnitude of the lie, so long as the lie did not affect the value of the security transacted. Certainly this would unhelpful in securing the stability of our securities markets. Lastly, I actually sympathize with Mr. Litvak and disapprove of the SEC’s habit of prosecuting “test cases” without fair warning to traders. That being said, such a complaint by Litvak would be the equivalent of getting caught going 70 mph in a 15 mph school zone, and arguing that you didn’t know it was wrong because everybody is doing it.
[1] See Securities Exchange Act of 1934 §10(b)
[2] See United States v. Litvak, No. 13-CR-19 JCH, 2014 WL 2993775, at *2 (D. Conn. July 2, 2014)
[3] Litvak was also charged and convicted of one count of TARP fraud, and three counts of making false statements in a matter within the jurisdiction of the U.S. Government. Although these convictions also raise novel issues law, they are outside the scope of this paper.
[4] See Fed.R.Crim.Pro, 29 (a); 33 (a)
[5] 84 F.3d 539, 541 (2d Cir. 1996)
[6] See 17 C.F.R. § 240.10b–10 (1995) and NYSE Rule 409.
[7] Steiner v. Hughes, 44 P.2d 857, 860 (Okla. 1935)(per curiam).
[8] Worrel & Williams v. Kinnear Manufacturing Co., 49 S.E. 988, 990-91 (Va. 1905)
[9] Ripy v. Cronan, 115 S.W. 791, 793-94 (Ky. 1909)
[10] Vernon v. Keys, 104 Eng. Rep. 246, 248 (K.B. 1810)
[11] See Branham v. Material Sys. Corp., 354 F. Supp. 1048, (S.D. Fla. 1973)
[12] 535 U.S. 813 (2002)
[13] Zandford at 820.
[14] Id. at 822.
[15] Id.
[16] Feinman at 451.
[17] Zanford at 819, 821-822 (internal citations and quotations omitted)
[18] Litvak brief at 28, quoting James J. White, Machiavelli and the bar: ethical limitations on lying in negotiations, 1980 Am. B. Found. Res. J. 926, 928 (1980) (White)
