Can Sophisticated Investors Be Defrauded? Two Cases Raise Hurdles

Posted May 15, 2018 11:14 p.m. EDT

Proving a case of fraud seems easy: find a lie and show someone lost money because of it, or at least paid more than they should have. But in the trading of mortgage securities, a lie might not mean fraud.

On May 3, the 2nd U.S. Circuit Court of Appeals in Manhattan overturned for the second time the conviction of Jesse C. Litvak, a former trader at Jefferies & Co., for misstating the price at which his firm had acquired residential mortgage-backed securities and then resold them to investors. The appeals court made it clear that Litvak had no duty to the firm’s customers, who were all sophisticated investors, to provide truthful information, so any reliance on his statements would have been misplaced.

The same day the Litvak opinion was issued, a jury in Hartford, Connecticut, returned a not-guilty verdict for David Demos, a former managing director at Cantor Fitzgerald who had been accused of lying about the price of residential mortgage-backed securities his firm sold.

The jury verdict and appeals court decision show that misstatements are not necessarily enough to prove fraud, at least when investors can figure out the value of the securities on their own.

For prosecutors, the cases may erect such a high hurdle to proving fraud involving sophisticated investors the government will be unable to police the market through the usual provisions. Caveat emptor — let the buyer beware — may well rule the trading of complex securities.

Litvak was convicted in March 2014 on charges of securities fraud. A spreadsheet he created with the actual prices at which Jefferies bought and sold the residential mortgage-backed securities was inadvertently sent to a customer, showing he had misled them about how much Jefferies had paid.

The 2nd Circuit overturned the convictions in December 2015. Although the judges rejected Litvak’s argument that misstatements to sophisticated investors about prices for the securities were never material, they did find that the trial judge had improperly excluded expert testimony from the defense about how investors valued the securities, which would have said that what Jefferies paid had little to do with negotiating the best price.

Prosecutors retried Litvak, and he was convicted on one count of securities fraud, involving a misstatement about the price Jefferies paid for residential mortgage-backed securities that resulted in an additional gain of about $73,000 for Jefferies on the $23.6 million transaction. He was sentenced to a 24-month prison term, the same sentence he received after the first trial.

The appeals court overturned the second conviction because the judge had allowed a trader to testify that he viewed Litvak as his agent, which would mean that Jefferies had a duty to present only truthful information in the transaction. But the trader was mistaken — there was no agency relationship. Even though the government did not argue that point, the case was so close that the 2nd Circuit reversed the conviction because the jurors might have been misled by the testimony.

The 2nd Circuit pointed out that residential mortgage-backed securities are marketed “to large, sophisticated financial institutions,” which use computer models to value the securities. Each side knows the types of mortgages backing the securities and can assess the future returns based on the value of the mortgages. No one is getting taken for a ride in the negotiations, so what a trader might say about the purchase price should not affect the underlying valuation, the judges said. Unlike the first appeal, this time the appeals court seemed to be saying that lies in this area did not really matter.

The 2nd Circuit found that Jeffries and its customers did not owe each other any obligation to disclose their true positions, so the buyer (or seller) should not rely on what the opposing party says about the value of the asset. As in any negotiation, when the other side says “this is my best offer,” you don’t always believe that to be true.

The decision sends a strong message to federal prosecutors that Litvak’s case should not be tried a third time. When two sides are negotiating a deal, and they have equal access to information, then what one side says — or misstates — about value may not be enough to prove fraud.

Demos also was accused of misleading investors about what his firm had paid for residential mortgage-backed securities it was selling. The jury’s decision to acquit him sent an even stronger message that those who deal in these securities have the wherewithal to protect themselves.

In most cases, jurors accept the government’s argument that a misstatement is enough to prove a fraud, but here they found there was insufficient evidence of an effect on the transaction. That does not bode well for future cases trying to hold defendants liable when sophisticated parties are involved in the transaction.

So do parties in a negotiation get a free pass on what they say, even if it is not the truth? An April 2016 decision by the federal appeals court in Chicago in U.S. v. Weimert answered that question in the affirmative. The court overturned the conviction of David Weimert for wire fraud for misleading both sides in a real estate transaction. The judges pointed out that in a negotiation the two sides “will often try to mislead the other party about the prices and terms they are willing to accept. Such deceptions are not criminal.”

The decisions have left the Justice Department’s effort to crack down on misstatements among sophisticated investors teetering.