Last week former Jefferies trader Jesse Litvak was convicted of criminal fraud for making up some stories about the bonds he traded. One possible view of this prosecution is that it criminalized behavior that was long thought of as fine. The bond markets were never a place where arm's-length counterparties trying to make money off each other owed each other a duty of complete honesty. Being a bit hazy about your cost is just part of the business, and it's chilling to see it turned into a federal felony.
There is an alternative, less sympathetic, view, in which being hazy is okay but outright lying is not. And in particular, when Litvak was explicitly acting as an agent to get bonds for a customer for an agreed spread, lying about his actual cost seems pretty bad. The jury seems to have heard the first view, and opted for the second, and you can't really blame them, even if you think the prosecution is a bit harsh.
But what about the Securities and Exchange Commission's $25 million settlement with Litvak's employer, Jefferies LLC, for failing to supervise him?1 You might as well start with what Jefferies was supposed to do to supervise Litvak, but didn't. That's at paragraphs 9-13 of the SEC order. Basically Jefferies made two errors:
- While it had policies to review its traders' electronic communications, and sampled communications to review "both randomly and based on language-specific searches," its review did not include Bloomberg group chats, and Litvak did some of his misrepresenting on those chats.
- While it reviewed communications (other than Bloomberg chats), it "failed reasonably to implement this procedure for review of communications in a manner that would reasonably be expected to detect the misrepresentations about purchase price made by Litvak and other representatives2
on Respondent’s MBS desk."
The first thing seems sort of uncontroversial? I mean, I don't know, the rules are pretty much that you monitor electronic communication, and if your traders are mostly communicating via Bloomberg chats, then you should be monitoring those chats. (Obviously this is my opinion, I don't speak for Bloomberg LP, etc.)
The second, though, is a little weird. The thing about Litvak's misconduct is that he was not using electronic communications to brag to his buddies about how much he was ripping off the muppets, or to exchange inside information about pending mergers, or to tell racist jokes, or otherwise to do the sorts of things that raise red flags for compliance. He was using electronic communications to tell customers things like:3
all the levels I put in this room are levels he wants to sell me...I will work for whatever you want on these...
so to recap levels he is offering to me:
hvmlt 06-10 2a1a (20mm orig) @ 58-00
lxs 40mm orig at 58-8…
Now as it turns out, the seller was offering Litvak those bonds at 57-16 and 56-16, respectively, not 58-00 and 58-8, so the customer was being deceived. The question is, should Jefferies's compliance monitors have caught that? When they read this innocent-looking chat in which Litvak was just doing his job by offering his customer some prices on some illiquid bonds, should they have noticed that the prices were wrong?
The SEC thinks yes:
Respondent failed to provide direction and/or tools to supervisors to meaningfully review its representatives’ communications with customers about the price that Respondent paid for the securities. A number of Litvak’s (and the other representatives’) electronic communications with customers contained direct misstatements about the price at which Respondent purchased the RMBS that were offered. Misrepresentations such as those made by Litvak and other representatives about RMBS pricing would have been difficult for supervisors to have detected without checking at least a sample of the representatives’ communications about RMBS pricing against actual pricing information.
One question you might ask is: Does anyone do that? That is, does any bank have its compliance officers review trader chats against a list of prices? Or rather, against "actual pricing information"? And what is "actual pricing information"? Here, the relevant information seems to be where Litvak had bought the bonds -- bonds that don't trade publicly on TRACE, requiring compliance to rely on Litvak's own trade prices. The job is not to match up the prices that Litvak communicated against some simple market price at the time, but to go back and trace individual securities and see where he had bought them and when.
This seems pretty labor-intensive, and my assumption is that most banks are not rigorously monitoring all of their traders' electronic communications for pricing accuracy, though I cannot tell you for sure.4
But the SEC concludes that Jefferies "failed to implement its procedures regarding review of customer correspondence in a manner that would reasonably be expected to prevent and detect the violations by Litvak and the other representatives," and I suppose that is sort of tautologically true in that those violations occurred. I mean, Jefferies did let bad stuff happen on its watch, so, sure, failure to supervise. And now every other bank knows that what Jefferies did is "unreasonable," and will beef up efforts to review electronic communications for pricing, just as they previously beefed up efforts to review electronic communications for the word "muppet."
You'd have to say that preventing customers from being ripped off is a better use of compliance's time than preventing customers from being referred to as muppets, so I guess this is a win. But it does feel just a little bit like doing forward-looking regulation by backwards-looking punishment of behavior that used to be considered normal by everyone. That, plus the prosecutorial momentum from winning the Litvak trial can't be good news for the next batch of traders that regulators go after.
Technically the settlement is $11 million in disgorgement to customers, $4.2 million in penalties to the SEC, and a further $9.8 million in a non-prosecution agreement with federal prosecutors.
2 Let's chat about those "other representatives"! Are they going to jail? Maybe, right?
3 This is verbatim from the SEC's complaint against Litvak; I don't know if the ellipses are his or the SEC's.
4 Informal and unscientific surveying suggests:
- Traders think that compliance does not do this monitoring.
- Compliance officers are a bit cagier -- which, really, is their job; you can't deter misconduct unless you make people think you're watching -- but it's at least a lot of work to do this, so it's not, like, done with great frequency in the absence of specific suspicion.
The disconnect may be its own lesson. Don't do naughty stuff over e-mail/chat/whatever! Even if you don't think compliance is watching! I mean, don't do naughty stuff at all, but you get the idea.
To contact the writer of this article: Matt Levine at firstname.lastname@example.org.
To contact the editor responsible for this article: Tobin Harshaw at email@example.com.