The Second Circuit Court of Appeals last week reversed the conviction of a Jefferies & Company securities broker in the closely watched case of United States v. Litvak, No. 14-Cr-2902, and remanded the case for retrial. In doing so, however, the Court of Appeals rejected the broker’s broad argument that lies concerning ancillary transaction fees could never form the basis for a securities fraud claim – an argument which, if accepted, had the potential to derail other enforcement actions directed at financial sector sales and trading practices. Instead, the appeals court based its reversal on narrower evidentiary grounds, holding that the trial court erred by precluding the defense from presenting evidence bearing on lack of materiality and fraudulent intent.

The court also reaffirmed that to prove a charge of securities fraud – in contrast to mail and wire fraud – the government need not prove “intent to harm.” And it vacated the government’s charges of defrauding the government, holding that lies to asset managers to whom the U.S. Treasury delegated complete trading discretion could not have influenced a decision of the government.

Background

In 2013, the government charged Jesse Litvak (“Litvak”), a securities broker and trader at Jefferies & Company (“Jefferies”), with defrauding fourteen privately funded entities and six Public-Private Investment Funds (“PPIF”) in the course of transacting residential mortgage-backed securities (“RMBS”). The indictment, filed in the District of Connecticut, included eleven counts of securities fraud, one count of Troubled Asset Relief Program (“TARP”) fraud, and three counts of making false statements.

The government asserted at trial that Litvak lied to the asset managers in various ways in order to inflate Jefferies’ profits in connection with RMBS trades it conducted for the asset managers. According to the government, those lies included falsely representing Jefferies’ cost of acquisition of the RMBS being sold to victim counterparties, falsely claiming lower negotiated resale prices of the RMBS being purchased from the counterparties, and falsely claiming that it was acting as an intermediary between third-party sellers and the counterparties, when in fact Jefferies was selling RMBS it held in inventory. The jury convicted Litvak on fifteen counts presented to it, and the district court denied his post-trial motions for an acquittal and a new trial. After being sentenced to two years in prison, Litvak appealed his conviction to the Second Circuit.

The charges in Litvak have garnered significant attention in the sales and trading industry, in which similar practices, viewed by many as mere puffery, are perceived to be widespread. Indeed, a core objection raised by the defendant on appeal was the trial court’s ruling precluding him from introducing expert testimony to the effect that his behavior was commonplace in the industry, and blessed by his own supervisors. Moreover, the government has purportedly been awaiting a ruling inLitvak in evaluating how and when to proceed with other investigations into industry sales practices.

The Materiality Element of Securities Fraud

The most closely watched portion of the case was the defense’s assertion that Litvak’s misstatements about pricing cannot serve as the basis of a securities fraud claim because they were not “capable of affecting the value of the security being transacted.” In other words, Litvak’s lies were not material because they did not mischaracterize the value of the RMBS themselves, but instead were mere puffery relating to ancillary transaction costs.

Had the Second Circuit accepted this argument in full, it might have presented a significant new impediment to enforcement actions relating to, among other things, opaque debt markets involving over-the-counter trading, and sales practices in foreign-exchange and commodities trading. However, the Litvak court rejected that argument as inconsistent with the “longstanding principle” that securities law “should be construed not technically and restrictively, but flexibly to effectuate its remedial purposes, and to protect against fraudulent practices, which constantly vary.” The court did little to clarify the legal standard for materiality in complex financial cases, but instead placed the decision regarding whether there is “a substantial likelihood that a reasonable investor would find the . . . misrepresentation important in making an investment decision” squarely in the hands of the jury.

At the same time, however, the Litvak court found that jurors should have access to a wider range of evidence when making that decision than the district court allowed. Specifically, the Second Circuit overruled several of the district court’s trial rulings excluding evidence proffered by the defense. Thus, on retrial, the defense likely will be allowed to offer expert evidence regarding whether a reasonable asset manager would credit brokers’ statements regarding pricing of complex financial instruments, given custom and practice in the industry. Similarly, the defense will likely be permitted to offer expert evidence to show that the defendant was acting not in an agency capacity (where he might owe a concomitant duty of loyalty), but rather as a principal (owing no such duty).

The broader import of Litvak appears now to relate more to how cases will be litigated than to whether cases will be brought. The Second Circuit refused to bless the defense’s attempt to restrict the concept of materiality in the sales and trading industry, thus leaving the door open to other similar enforcement investigations of sales commission and markup practices. Nevertheless, the decision provides defense attorneys with ammunition to offer evidence, including expert testimony, relating to industry standards and practices, to rebut the government’s proof of, among other things, materiality and fraudulent intent.

The Scienter Element of Securities Fraud

The Second Circuit also rejected Litvak’s invitation to import an intent element from mail and wire fraud to securities fraud. Basing its argument on the fact that decisions interpreting the mail and wire fraud statutes are a “particularly apt source of guidance,” the defense asserted that the “intent to deceive, manipulate or defraud” element of securities fraud ought also to include a requirement to prove “contemplated harm” to the victim. Holding this position inconsistent with Second Circuit precedent, the Second Circuit reiterated that a securities fraud charge requires no such proof.

The Materiality Element of TARP Fraud and False Statements

The defense prevailed on its argument that the government failed to adduce evidence that Litvak’s misrepresentations affected an actual decision made by the Treasury Department, the only pertinent governmental entity. To be material, a statement must have “a natural tendency to influence, or be capable of influencing, the decision-making body to which it was addressed.” The defrauded PPIFs, however, were structured such that their private fund managers were given “complete discretion” over which eligible assets to buy or sell, and the Treasury had “no authority” to tell the private investment managers which RMBS to purchase or at what price to transact. Because the Treasury was incapable of making a relevant decision under these circumstances, there was no evidence of an actual decision by a governmental actor that could be influenced by the defendant’s lies, and the Second Circuit reversed the conviction. This ruling did not, however, undermine the viability of the securities and wire fraud charges against the defendant.