Bond Traders Can Lie to Customers Again

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(Bloomberg) -- Litvak et al.

Yesterday Jesse Litvak—the former Jefferies Group LLC mortgage-backed securities trader who was convicted of defrauding clients, got his conviction reversed, was convicted again, and went to prison—got his conviction reversed again. Good for him, though it comes about a third of the way through his two-year prison sentence, so it’s not quite as good as it would have been if he hadn’t been convicted in the first place. Or in the second place. 

Litvak, remember, was a mortgage-bond trader who would buy bonds from one customer, sell them to another customer, and lie to one or both customers about the price he was getting on the other side. In his first trial he was convicted of a bunch of counts of fraud for doing this, but in the second trial he was convicted of fraud for only a single trade. (This description is based on the appeals court’s opinion yesterday.) A customer had put out a bid-wanted-in-competition, asking banks (including Jefferies) to bid on a list of bonds that it owned. Litvak canvassed the interest in those bonds from his customers, and had one customer—Brian Norris at Invesco Ltd.—who wanted to buy a particular bond on the list.

Norris told Litvak to bid 79-24 (i.e. $79.75 per $100 principal amount) for the bonds, but that was just a suggestion; Litvak was trying to buy the bonds for his own account to resell to Norris. In fact, Litvak bid 79-16 for the bonds, and bought them at that price. But he told Norris “bid your level,” and “Norris then proposed to buy the bond from [Litvak] for 79-30, asking ‘6 ticks cool? 79-30 to me?’” Litvak agreed and sold the bonds to Norris for 79-30; Norris though he’d paid 6/32s for Litvak’s efforts, but in fact he’d paid 14/32s, a difference of over $73,000 on the actual amount of bonds they traded. 

Was this fraud? Yes, the jury decided, but it’s a little weird, because Litvak was charged with doing a lot of very similar stuff, which the jury did not find was fraud. What’s the difference? Well, one thing is that in the Invesco trade “Litvak altered an electronic chat to make it appear that he paid more for the bond than he did,” and then forwarded the altered chat to Norris. The jury might have concluded that lying to customers about bond prices is not fraud, but that altering documents to support those lies is. 

But that’s not what the appeals court’s decision is about. Instead it focuses on a different distinction: Unlike most of the other customers whom Litvak lied to, Norris testified that he trusted Litvak. Or, not quite; rather Norris “testified that he believed [Litvak] to be his agent, and that broker-dealers ‘serve as an agent in between [buyers and sellers].’” If Litvak was acting as Norris’s agent, buying bonds from the seller on Norris’s behalf, then he would have fiduciary duties to Norris that he would not have if he was just an arms’-length counterparty trying to sell Norris bonds.

Was Litvak Norris’s agent? Nope nope nope nope nope! The appeals court’s description of the role of the dealer in bond markets—in financial markets generally, really—is worth quoting extensively:

An essential feature of all of these trades, however, is that the broker-dealer acts solely in its own interest as a principal. The broker-dealer continually tracks potential buyers and sellers, their interests in particular kinds of RMBS, and their ongoing acceptable price ranges. It seeks to profit from transactions in the securities by buying low and selling high. ... The broker-dealer assumes the risk of buying the bond, and an institutional investor can refuse to purchase a bond held by the broker-dealer even when the investor caused the broker-dealer to purchase it by an expression of interest, i.e., in an order or BWIC trade. Such an investor may also have no investment purpose but may intend to resell the bond immediately, and at a higher price, to another institution it knows to be interested.

A broker-dealer is not, therefore, an agent for its counterparties in these trades and owes them no special or fiduciary duty. In a sale by a counterparty to a broker-dealer, the counterparty has no legitimate expectation that the broker-dealer will resell the bond at the price paid to the counterparty. Similarly, in a purchase, the counterparty has no legitimate expectation of purchasing a bond at the price paid by the broker-dealer. Rather, the broker-dealer and counterparty each have their own price ranges in which they will consummate their ends of the transactions. The final price is determined in an arms-length negotiation and, if agreed upon, will be somewhere in the overlap of price ranges.

But that’s not just what the appeals court thinks. Everyone thinks it. (Except Norris.) As the court says:

The lack of an agency relationship is undisputed. The district court instructed the jury that Litvak was not Invesco’s agent. Indeed, the government argued in summation that the agency issue was a “red herring” and that it had never claimed that Litvak was Invesco’s agent.

Even Invesco doesn’t think Litvak was its agent: “Indeed, Invesco’s compliance personnel had informed Norris (before the transaction) that broker-dealers were not agents of bond buyers in BWIC trades.” But Norris testified that he thought it anyway. The government argued that this showed that Norris trusted Litvak and therefore that Litvak’s lies were material to him, and that trust shows that market expectations were that bond traders won’t lie to customers. The court disagreed:

While the individual views of a counterparty trader may usually be relevant to the nature of the market involved and as to the beliefs of a reasonable investor, a reasonable investor would not misperceive the role of a broker-dealer in the RMBS market. In fact, Norris received material from Invesco’s legal and compliance department stating that, in transactions such as the one here, broker-dealers act as principals. His disagreement with that advice was unreasonable. Norris’s indisputably idiosyncratic and unreasonable viewpoint is not, therefore, probative of the views of a reasonable, objective investor in the RMBS market.

And yet. One thing that we talk a lot about around here is that, in many of their businesses, banks really do stand in an arms’-length principal relationship to their customers, but take pains to make the customers feel like they’re trusted fiduciaries. That is a good business strategy: If your customers think you’re a good guy who is looking out for their best interests, they will do more business with you, and push back less on price. As a legal strategy it runs some risks. The fact that Norris was so convinced that Litvak was his agent that his compliance officers couldn’t convince him otherwise tells you something about their relationship. 

It is hard to tell who won, here, exactly. I mean, Litvak has been in prison since September, which seems like a pretty big loss, but on the other hand now he’ll probably get out, so that's a win. I have trouble imagining that they’ll bother with a third trial. The government, in its long-running pursuit of this case, established some key points. Litvak, noted the appeals court, “principally argues that his misstatements were, as a matter of law, immaterial to a reasonable investor in the market for residential mortgage-backed securities.” The appeals court rejected that argument. Lying to customers about the price that you paid for a bond can be fraud. It’s up to a jury to decide—whether the lies were material, whether customers relied on them, etc. That is an important principle for the government to establish, and not an entirely obvious one. Establishing it will presumably accomplish most of what the government wanted to accomplish: If you’re a bond trader, you probably won’t want to risk going to prison by lying to customers about prices.

On the other hand, it does kind of seem like juries don’t think it's fraud? Litvak’s jury convicted him of only one count, and that (the court found) because they were presented with a witness who said untrue things about the dealer/customer relationship. And  yesterday, when the appeals court was reversing Litvak’s conviction, a jury was acquitting another former bond trader, David Demos, of very similar charges:

Speaking outside the courtroom, Demos called the decision “a complete vindication of everything I’ve fought for, my family has fought for and my lawyers have fought for, for the past three years. Bluffing or lying or puffing about your cost in a negotiation was never a crime, is not a crime and should never be a crime.”

I don’t exactly think that should be the lesson that bond traders take away from all of this. And it probably isn’t:

Many salespeople no longer reveal how much their banks paid for a bond they’re trying to sell customers, as a matter of firm policy. Traders say they’re more cautious about what they put in emails and chat messages that can be traced. Banks have beefed up their efforts to monitor their employees.

"People have improved their practices overall," said Elizabeth Baird, a former bond trader and a partner at law firm Morgan, Lewis and Bockius who represents broker-dealers on enforcement issues. "There are better disclosures being made."

One way to interpret the Litvak (and related) cases is that they are essentially about prospective regulation by retrospective enforcement. The norms in the mortgage-backed securities market arguably allowed for a certain amount of “bluffing or lying or puffing about your cost,” and while it might be impolite (yesterday’s opinion describes the “penalty box” for traders caught misleading customers), no one thought it was illegal.

Federal prosecutors looked into it and decided it ought to be illegal. Federal prosecutors have no real power to make it illegal: They are not securities regulators and can’t write rules saying “no lying about bond prices.” But they have plenty of power to say that it was always illegal: They can bring charges, say that it was fraud, and try to convince juries (and the Second Circuit Court of Appeals) that it is just the sort of securities fraud that has always been prohibited. If that works, then (1) people will (you’d hope) stop doing it in the future, but also (2) some of the people who did it in the past will go to prison.

On this interpretation—and I stress that it is not the only possible interpretation; a simpler one would be “it really was always illegal”—then (1) is a perfectly fine result but (2) seems a bit unfair. If prosecutors want to change norms, fine, but why should they throw anyone in prison for following the old norms back before the norms were changed? In a sense—except for the months he’s already spent in prison, and assuming they don’t put him on trial again—the outcome for Litvak gets things more or less right. Bond traders who lie about their cost are on notice that it could be fraud, but for Litvak, it wasn’t.

Insider trading and legality.

Here are a blog post and related paper from Miriam Baer of Brooklyn Law School with the excellent title “Insider Trading’s Legality Problem,” describing one reason why it’s bad that there's no actual statute defining and prohibiting insider trading:

Criminal statutes do more than prohibit wrongdoing; they also allow us to differentiate among the variations of given offenses.

Insider trading isn’t merely a civil offense. As in the case of Salman, it often triggers criminal penalties. Criminal law derives its legitimacy in part from the “legality principle,” a set of related rules that demands that criminal laws be duly enacted in advance and in terms specific enough for the average person to understand what is forbidden.

When legislatively enacted statutes conform to the legality principle, they do more than provide adequate warning of what is and is not forbidden. Under the best circumstances, they can improve criminal law’s content, precisely because they permit the legislature to think about a family of crimes holistically and differentiate similar, yet morally distinct, conduct. Through differentiation, we become better at singling out the abstract factors that make some crimes worse than others.

I agree with this completely but would add that it's not unique to insider trading. Insider trading is part of a very big mishmash of things that just count as “securities fraud.” Insider trading, the stuff Jesse Litvak did, algorithmic spoofing, faking the accounts of a public company, running a Ponzi scheme—all of these things are for the most part prohibited not by statutes about insider trading and bond-price lying and spoofing and accounting and Ponzis, but by a single vague statute about securities fraud.

One problem with that is that it is hard to know what counts as fraud, and courts are constantly making new rules about what exactly is illegal in insider trading or bond-price-puffery or whatever. But another problem is that, once something does count as fraud, it counts the same as everything else. The securities-fraud statute doesn’t differentiate one kind of insider trading from another, but it also doesn't differentiate insider trading from Ponzi scheming, or spoofing from accounting fraud. The main practical differentiation is in the sentencing guidelines, and is based on dollar amounts: You go to prison longer if your fraud (or spoofing or insider trading or whatever) involved more dollars. But it seems to me that this is rarely the most important moral distinction; a reasonable legislature might decide that Ponzi schemes are worse than insider trading, and even that a smaller Ponzi is worse than a bigger insider trade. But it doesn’t. Practically all bad stuff with securities is lumped into a single statute, and nobody bothers to figure out which things are worse than the other things. 

Sergey Aleynikov.

Yesterday did not go as well for Sergey Aleynikov as it did for Jesse Litvak and David Demos:

A New York state appeals judge upheld a conviction against former Goldman Sachs programmer Sergey Aleynikov on Thursday — likely ending a nine-year court saga over the theft of “secret sauce” trading code used by the banking giant.

The decision, written by Judge Eugene M. Fahey, strikes at the heart of Aleynikov’s argument — that he couldn’t possibly have broken larceny laws, because those laws only apply to physical things. 

I have to say that I sort of stopped following this case because it ended up turning on the dumbest possible questions. Aleynikov put some Goldman Sachs trading code on a thumb drive, walked out the door with it, and got in a lot of trouble. Reasonable questions you might ask include: Should taking the knowledge you gained from a job to a new job be treated as criminal theft? Should two different government prosecutors use the threat of prison to protect Goldman Sachs’s trading edge? Was the code in fact open-source and therefore freely available to Aleynikov?

But instead courts have spent years on the bafflingly silly question of whether Aleynikov’s taking of the code counts as “theft” because he took the code on a thumb drive. “The medium upon which an idea is stored is generally physical, whether it is represented on a computer hard drive, vinyl record, or compact disc,” said the court in upholding his conviction and, you know, sure, whatever.

Warren Buffett is worried about GAAP accounting.

We have discussed this before, but here is a story about how Berkshire Hathaway Inc. “is scheduled to report earnings Saturday morning before its annual meeting, and a new accounting rule could sink results”: Berkshire will now have to mark-to-market its unrealized gains and losses from equity investments through its income statement, meaning that income from its operating businesses may be obscured by moves in the prices of the stocks that it owns. “Gyrations of that magnitude in reported net income will swamp the truly important numbers that describe our operating performance,” said Warren Buffett in his February letter to investors, and next time you see someone—someone like Warren Buffett, even!—say that investors should focus on earnings according to U.S. generally accepted accounting principles, and that non-GAAP earnings are deceptive fantasy numbers, just keep in mind that no less a sage than Warren Buffett thinks that GAAP earnings aren’t real either.

Elsewhere here is “How to Look Like a Pro at Buffettpalooza This Weekend.” I will not be attending Berkshire Hathaway’s annual meeting, so I did not read it, but I assume there’s a bunch of stuff about ping-pong and Cherry Coke and other Buffett fandom signifiers. 

Here you go.

You might say that Shawn Carter, a/k/a Jay-Z, like most people, deals with a number of concerns in his life, and among those concerns you might count the Securities and Exchange Commission subpoena that he got yesterday. If you were so inclined. To put it like that.

Honestly, the poor guy, every problem that he ever has comes with the additional meta-problem of people constantly making the same tired joke about it. Do you think that when he stubs his toe, Beyoncé is there to be like “yup you got 99 problems and that toe is one sorry I don’t make the rules.”

Oh the subpoena is because “the SEC is investigating potential violations of the federal securities laws related to the financial reporting of New York-based Iconix Brand Group, Inc., which paid Carter more than $200 million to acquire intangible assets associated with Carter's Rocawear apparel brand,” and Carter keeps not showing up to testify about it. I don’t really blame him. He’ll probably show up at the SEC’s offices and they’ll begin “Mr. Carter, would it be accurate to say that Iconix had 99 problems and an accounting write-down of Rocawear intangible assets was one?”

Things happen.

How Morgan Stanley Got Its Mojo Back. “To say they’re highly disappointed in Theranos as a company and an investment is an understatement.” At $1 Trillion, Leveraged Loans Are Closing In on Junk Bonds. Watch Out: Junk Bonds Are Getting Junkier. Wall Street’s Big Gender Lawsuit Is 13 Years in the Making. Volkswagen Ex-CEO Martin Winterkorn Indicted in Emissions Probe. Walmart Beats Amazon in $15 Billion Flipkart Battle. How Criminals Steal $37 Billion a Year from America’s Elderly. Goldman to treble Swedish office as post-Mifid equities hub. Musk Takes Aim at Two Analysts for Pushing ‘Tesla Short Thesis.’ A Small College’s Endowment Manager Beat Harvard With Index Funds. Heat your house by mining Bitcoins. The Gambler Who Cracked the Horse-Racing Code. Even Wall Street Couldn’t Protect Toms Shoes From Retail’s Storm. Mystery pooper at N.J. high school's track turned out to be superintendent, cops say. 

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