“Telling a lie does not make you guilty of a federal crime”

By James Kwak

That’s what Jesse Litvak’s lawyer said at the start of his trial earlier today. And technically speaking, it’s true. If you’re trying to sell a bond to a client, and during the course of the conversation you say you can bench press 250 pounds when you can only bench 150, that’s not a federal crime. But if you lie about a material aspect of the bond and the client relies on your lie in buying the bond, that’s another story.

Litvak’s case is (barely) in the news because it has a financial crisis connection; some of the buy-side clients he is alleged to have defrauded were investment funds financed by the infamous Public-Private Investment Program (PPIP) set up in 2009 using TARP money, and hence one of the counts against Litvak is TARP-related fraud. But it bears on a much more widespread, and much more important feature of over-the-counter (OTC) securities markets.

Litvak was trading mortgage-backed securities for Jefferies when the alleged behavior occurred. The key feature of OTC markets is that there is no way to look up the prices at which securities are trading, as opposed to, say, on the New York Stock Exchange. If you are a buy-side investor and you want pricing information, you depend largely on the securities dealers themselves to tell you what the current prices are.

Litvak’s thing was that he lied to his clients about the prices of other transactions that he made up. For example, first Jefferies bought an MBS at $51.25. (SEC complaint, beginning on page 20.) Litvak then approached a potential buyer and claimed that a seller was offering him that bond at $55. The buyer offered $50.50. Litvak then lied three more times about the price that his phantom seller was offering: first $54, then $53.50, then finally $53, after which the buyer agreed to pay $53.25. Who would fall for this? Well, in this case it was Magnetar, the hedge fund renowned for destroying the U.S. economy (exaggeration). The complaint has dozens of similar examples, replete with ungrammatical emails detailing fictional negotiations.

The legal issues are whether Litvak violated Section 17(a) of the Securities Act or Securities Exchange Act Rule 10b-5, for which the lie has to be material and the buyer must have been harmed by it, among other things. Litvak’s defense is the usual one: his clients were sophisticated investors who could have read the documents themselves and analyzed the value of the securities independently. This might work with a jury, but it’s just wrong as an economic matter. If you’re an investor, you know that your analysis of a bond’s expected cash flows is just one opinion. What other people think the bond is worth is also valuable data—especially if you’re thinking you might want to unload the bond to another investor. If Litvak says that one investor expects to sell for $55 and only reluctantly parted with it at $53, that’s different from the fact that the investor sold it at $51.25—more than 3 percent different.

The broader issue is that this is the way OTC markets work. Dealers match buyers and sellers, or sometimes trade out of their own inventory, and everyone knows that they make money by taking a spread on each trade. But it’s impossible, or very difficult, to tell from the outside what the spread is. So even if the majority of bond dealers are upstanding model citizens, the system depends on them being upstanding model citizens—probably not what we want in a cutthroat, aggressive, money-driven culture. But the dealers want to preserve OTC markets precisely because it lets them charge large spreads, whether through deceit or not.

But why does the buy side put up with it? Partially because they don’t realize the extent to which they are being lied to. Litvak’s clients knew that he was buying low and selling high, but they had no idea how low he was buying because he lied about it. Had they known, they would have demanded lower prices or taken their business elsewhere.

But partially because everyone in this casino is playing with other people’s money, as described at length by Zero Hedge when the SEC first filed its complaint. Bond trading is a world of mutual back-scratching in which traders, who are paid a percentage of their profits, charge inflated spreads, and clients go along with it because they are paid a percentage of assets under management—and they get kickbacks in the form of gifts and entertainment from the traders. Everyone is better off except the investors at the end of the line. Which is the big reason why OTC markets are bad for ordinary people.

6 thoughts on ““Telling a lie does not make you guilty of a federal crime”

  1. Well done linking Zero Hedge!!!

    What “ordinary people” have access to or any voice in, or control of the OTC markets or their horrific downside ramifications???!!!

    The more critical and cutting issue is the plurality of the socalled ruleoflaw and socalled justice system! Any individual in the 99% caught lying about any business transaction would be ruthlessly punished with crushing fines, asset siezures, and long prison sentences but the den of vipers and thieves of the finance oligarchs are immunized, shielded, protected and removed from accountability for criminal conduct that would send their fellow citizens in the 98% to jail. There are two wildly divergent justice systems. One ruthless and destructively punitive system for the 99%, – and another shielded and minimally prosecutable and rarely punitive system for the den of vipers and thieves in the finance oligarchs, and the predatorclass. This rank plurality of socalled justice renders the entire system moot and suspect. Effectively – there is no socalled ruleoflaw, no socalled justice system and so – no law! In a world where there are no laws – there are no laws for anyone predatorclass biiiiaaatches!!!

    Burn it all down! Reset! It’s the only hope for the 99%!!!

  2. Price in a secondary market is not a “material aspect” of any bond. If this is the meat of the SEC complaint, they have an uphill battle. This is simple bargaining, no different than negotiating an agreeable purchase price for a house.

  3. This is a terrific post. I agree 90% with the gist of it.

    I wonder now with HFT (high frequency trading) if even on the stock exchanges dealers are taking LARGE spreads now. Investors are getting f*cked on spreads regularly on exchanges now. Dealers seem to think this is their “right” as a “market maker”. But they are NOT “market makers” and their commission for the services they provide (largely crappy service) should be enough.

    There MAY have been a time when these dealers provided liquidity. They no longer do that. They trade for their own accounts (hence the need for the Volcker rule). And I dare ANYONE to give me a non banker-to-banker, non dealer-to-dealer example where dealers have provided liquidity to the market. Not anecdotal. A REAL example where dealers have provided liquidity. <b<THERE IS NONE.

  4. I agree with you James, but only to a degree. Though the law is not my forte, I am aware in contract law that if a buyer relies on a material misrepresentation, and that misrepresentation is in writing (Statute of Frauds) then indeed the seller is civilly liable. However I’m not so sure if this constitutes a criminal act.

    Let’s focus on the civil. The courts have favored industry practices when adjudicating contract law. What if the industry practice within trading is in fact sophistry: Mixing elements of truth with fiction. Trading securities without the benefit of a transparent, electronic-based system encourages traders to “paint pictures” for their counter-party. The counter-parties are not naive retirees living on social security, James. They are presumably savvy traders, trained and experienced enough to have large credit limits, which is ample evidence that they are competent. Thus these counter-parties (such as this particular buyer) know that they will be lied to about pricing, and about alleged previous trading prices and alleged offering prices. That is why experienced traders look to outside comparable prices before making the decision to buy, or whether to believe the guy on the other side of the telephone line.

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