I was initially skeptical of Jesse Litvak's defense, in which his lawyer told a jury that Litvak actually sold his clients "great bonds at great prices." Litvak, you'll recall, is the former Jefferies & Co. trader charged with fraud for an assortment of lies and dramatic re-enactments about mortgage-backed securities that he sold to clients; the gist is that he would have a bond in inventory that he bought, say, a week ago, at 50, and then tell the client an elaborate story about how he was negotiating to buy it at 60, so he could justify selling it to the client at 60.25. The "great bonds at great prices" line was a little used-car-salesman-y for my tastes, and I would have thought you'd want to stay away from that association in this trial.
But I was totally wrong, and I really like what the defense is up to these days:
Joel Wollman, a portfolio manager with QVT Financial LP, testified yesterday that he told Litvak that his firm’s limit for a bond purchase was 57 cents on the dollar because anything more than that wouldn’t provide a 10 percent yield.
Under cross-examination from John Hillebrecht, one of Litvak’s attorneys, Wollman admitted he told another broker that he’d get a 10 percent yield at 58 cents on the dollar, and that he wasn’t telling the whole truth to Litvak.
Wollman sums up the range of tactics available to him:
“By lying is certainly one of them. Although I generally consider myself a truthful person.”
And later, when asked by a prosecutor if "the price that you purchase the bond at" was "the kind of information that you shade," Wollman replied, "Would I change that, I could, I don't," because he is transparent.
Now, Wollman's tactics are pretty harmless stuff. Litvak didn't actually care what yield his customer was getting -- he cared if he could sell a bond at a price that made him money. The price that his customer wanted to pay, and the reason he wanted to pay it, are in some sense obviously irrelevant to Litvak's pricing. Litvak was a market maker in illiquid bonds; if anyone knew what they were worth, it was Litvak -- not his client, and certainly not his client's desire for a nice round 10 percent yield.
But of course, in another sense, the price that his customer wanted to pay was the only thing relevant to Litvak's pricing. Because, again, Litvak was a market maker in illiquid bonds, and he -- obviously, and rightly or wrongly -- wanted to make himself as much money as possible. If he had a client willing to pay up to 57, he was going to sell that clients bonds at 57. If he knew that the client was actually willing to pay up to 58, well, that changes everything. Particularly the price at which he would sell. Which would be 58.
Of course there's no reason that anyone should want to protect Jesse Litvak's desire to get every last dollar out of his customers. No one is going to arrest Wollman for securities fraud just because he lied to Litvak about the price he was willing to pay to buy bonds.
But it's worth being clear on why not. I think the answer is, because Litvak is not entitled to know his customer's private information -- the client's beliefs, its financial situation, etc. -- about a trade. If Wollman was willing to pay 55 or 57 or 58 or 70, or if he thought the bonds were worth 57 or 58 or 80, or even if he knew someone else who would buy them from him at 59, he had no obligation to tell Litvak that. And in fact he had no obligation not to lie about it.
Similarly, one assumes, if Litvak was willing to sell at 57 or 55 or 50, and if he thought the bonds were worth 57 or 55 or 20, that seems as irrelevant to Wollman as Wollman's private information was to Litvak. No?
Now this is not exactly a good defense of Litvak. Litvak isn't charged with misrepresenting his own reserve price, or his own views on valuation. He's charged with concocting elaborate stories about who was selling him the bonds, and when, and at what price. This is not purely Litvak's private information, it's also information about where the market was and what trades had happened. And you really shouldn't lie about facts like that. I think.
The question is ... what is the question? In the past I've said that the question is whether the stuff you're dishonest about is material: If the reasonable investor would think it's important, then you can't lie about it; if he would not, then you can. But that's not entirely right either: Knowing the maximum price that you're willing to pay is really important for your counterparty, maybe more important than knowing where the last trade was. But that doesn't mean you have to tell them, or even that you can't lie about it. Nobody expects you to be honest about how much you'd be willing to pay.
Really, as far as I can tell, the standard is sort of tautological: You're expected to be honest about the stuff you're expected to be honest about. It's very clear that you can't lie about the basic facts of the bond you're selling, whether it's defaulted, say. It's very clear that you can lie all you want about your subjective desires: You can go ahead and say "I can't pay more than 57 for this" even if you could actually afford to pay 58.
It's not entirely clear whether you're expected to be truthful about when you bought the bonds you're selling, and at what price. I mean, it's pretty clear: Not everyone thinks Litvak's actions should be illegal, but I'm not aware of a lot of people who thought they were, you know, good. The fact that his customers, who cheerfully lied to him about some things, were horrified enough by his lies to be willing to testify against him at a trial suggests that his (alleged!) lies went well beyond the expected level of lying.
But the problem for prosecutors is drawing that distinction clearly -- in Litvak's case, and also if broader investigations into similar mortgage-bond selling practices at other banks are going to go anywhere. The charges against Litvak blandly say that he lied and made money; they don't explain why the things he lied about were the sorts of things you're not allowed to lie about.
Normally that doesn't come up much! When you're at a Senate hearing and you're asked "did you lie about X?," it's not great to respond "oh, yes, but everyone knew we were lying about that, everyone lies about that." The only way to use that defense is if the people you're accused of lying to also lied to you, about the same securities, and are in the same courtroom with you. That's pretty unusual in most securities fraud cases; it's convenient for Litvak that it's true in his.
Adds additional quote from Wollman's testimony in the seventh paragraph of this article published Feb. 25.
The law is not super clear. Litvak is charged under Securities Act section 17(a) and Exchange Act section 10(b), which say you can't "employ any device, scheme, or artifice to defraud" or make "any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading" or "engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser" or use "any manipulative or deceptive device or contrivance" in the sale of a security. Materiality and intent to defraud are the key concepts here, and are subjective.
We go a different way in the text, but actually, you could easily answer "no": Perhaps Litvak, as a dealer at a bank, had higher obligations to his customers than his customers had to him. There's probably some truth to that, though not that much. Bond dealers are not fiduciaries of their customers, even if the Senate wishes they were, and Litvak is charged mostly under general securities fraud statutes that apply to anyone buying or selling securities.
In stocks or corporate bonds, you can't, because trades are more or less public. In mortgage backed securities, and lots of other corners of the world, trades are not public, so it's harder to know what lies you can get away with.
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