When Does Bar­gain­ing Be­come Fraud?

▶▶Reg­u­la­tors want to crack down on bond deal­ers who don’t tell the whole truth ▶▶“We’ve iden­ti­fied bil­lions of dol­lars of po­ten­tially prob­lem­atic trades”

Bloomberg Businessweek (Asia) - - Markets/ Finance - −Matt Robin­son

On a used-car lot, a sales­man who bends the truth to close a sale isn’t break­ing the law. But a bond trader us­ing some of the same sales tricks may end up fac­ing crim­i­nal fraud charges. That’s what hap­pened to Jesse Lit­vak— and he’s putting up a fight. The for­mer Jefferies & Co. trader was found guilty in March 2014 for ly­ing to buy­ers about how much he paid for bonds he was sell­ing. That con­vic­tion was over­turned on Dec. 8. Lit­vak will be re­tried and get an­other chance to ar­gue that bond traders are ba­si­cally used-car sales­men.

The Lit­vak re­ver­sal is an­other set­back for reg­u­la­tors who have been try­ing to change be­hav­ior on Wall Street. Al­though they’ve ex­tracted tens of bil­lions of dol­lars in set­tle­ments af­ter probes into sales of mort­gage bonds and the set­ting of in­ter­est rates and other bench­marks, reg­u­la­tors have been crit­i­cized for fail­ing to pros­e­cute high-level bank ex­ec­u­tives for wrong­do­ing that led to the fi­nan­cial cri­sis that al­most sank the global econ­omy.

Ear­lier this year, Sally Yates, the agency’s No. 2 of­fi­cial, or­dered pol­icy changes to push pros­e­cu­tors to bring crim­i­nal charges against com­pany ex­ec­u­tives sus­pected of fi­nan­cial wrong­do­ing. Her memo al­most ad­mit­ted that the U.S. Depart­ment of Jus­tice had lapsed in its duty to put crim­i­nals be­hind bars. In a Septem­ber speech, Yates said: “This memo is de­signed to en­sure that all at­tor­neys across the depart­ment are con­sis­tent in our best ef­forts to hold to ac­count the in­di­vid­u­als re­spon­si­ble for il­le­gal cor­po­rate con­duct. It’s the only way to truly de­ter cor­po­rate wrong­do­ing.”

The case against Lit­vak was sup­posed to be the open­ing salvo against dis­hon­est con­duct among bond traders. The Jus­tice Depart­ment and U.S. Se­cu­ri­ties and Ex­change Com­mis­sion have built more than a dozen other cases us­ing the one against Lit­vak as a model.

The cases won’t be easy vic­to­ries for the gov­ern­ment. Ly­ing doesn’t nec­es­sar­ily vi­o­late se­cu­ri­ties law. It’s only fraud when that de­cep­tion is con­sid­ered im­por­tant to a buyer. The ques­tion be­comes: Is it im­por­tant that the buyer knew how much Lit­vak paid for bonds he later sold? “The

gov­ern­ment may not like how th­ese mar­kets work, and it may look bad from the out­side look­ing in, but it is how they do work,” says Charles Geisst, a Wall Street his­to­rian at Man­hat­tan Col­lege in New York.

Un­like the probes into mort­gage fraud, the bond-trad­ing in­ves­ti­ga­tions started by accident. Act­ing as a mid­dle­man, Lit­vak al­legedly bilked in­vestors of $2 mil­lion from 2009 through 2011 by mis­rep­re­sent­ing how much sell­ers were ask­ing for se­cu­ri­ties, or what po­ten­tial buy­ers were will­ing to pay, then keep­ing the dif­fer­ence for Jefferies. He kept a spread­sheet of the prices he paid for the bonds and in­ad­ver­tently sent it in Novem­ber 2011 to a money man­ager at Al­lianceBern­stein. The money man­ager, re­al­iz­ing he’d been lied to, re­ported Lit­vak to the U.S. gov­ern­ment.

That mishap kicked off a broader in­ves­ti­ga­tion into the mar­ket by the SEC, which found that Lit­vak was far from the only bond trader ly­ing to cus­tomers. The probes have stunned Wall Street. Traders are fear­ful that they could end up in jail for con­duct that’s wide­spread in the mar­ket. Un­like stocks, the se­cu­ri­ties Lit­vak sold don’t trade on ex­changes, so it’s hard to get re­li­able price in­for­ma­tion. With­out a record of trades to con­sult, buy­ers rely on deal­ers for price quotes and do their own cal­cu­la­tions to de­ter­mine a bond’s value.

Through­out his case, Lit­vak didn’t deny he lied to cus­tomers, but he didn’t think buy­ers would be harmed be­cause he was sell­ing the bonds at “fully dis­closed and agreed-upon fair prices” that stayed be­low the 4 per­cent profit limit that Jefferies’s poli­cies spec­i­fied. When the ap­peals court threw out his con­vic­tion, it faulted the lower court for ex­clud­ing some de­fense ev­i­dence, say­ing Lit­vak was de­nied the chance to show that his ac­tions were in keep­ing with how Wall Street does busi­ness.

Even af­ter the re­ver­sal, the U.S. gov­ern­ment is push­ing ahead with other cases. On Dec. 21 for­mer Royal Bank of Scot­land Group bond trader Adam Siegel pleaded guilty to ly­ing to buy­ers. The agree­ment comes with a big caveat: He can with­draw his plea if Lit­vak is found to have not bro­ken the law.

As the SEC sees it, just be­cause some­thing is com­mon prac­tice on Wall Street doesn’t mean it con­forms to se­cu­ri­ties laws. The agency has built its own al­go­rithms to comb through trad­ing data to look for red flags in­stead of wait­ing for com­plaints. The SEC has un­cov­ered bro­kers charg­ing buy­ers higher fees, traders hid­ing their po­si­tions, and deal­ers run­ning de­cep­tive auc­tions. “We’ve iden­ti­fied bil­lions of dol­lars of po­ten­tially prob­lem­atic trades,” says Michael Os­nato Jr., head of the reg­u­la­tor’s Com­plex Fi­nan­cial In­stru­ments unit. “We have opened promis­ing in­ves­ti­ga­tions thus far based on th­ese ef­forts and ex­pect more to fol­low soon.”

The Lit­vak rul­ing will shape how the SEC pur­sues some of th­ese vi­o­la­tions. The in­ten­sive mon­i­tor­ing of debt backed by mort­gages and other as­sets rep­re­sents a first for the agency. Be­fore the credit cri­sis, the SEC viewed the mar­ket par­tic­i­pants as so­phis­ti­cated in­vestors who didn’t need close su­per­vi­sion. That as­sump­tion came un­done when plum­met­ing prices in the debt mar­kets kicked off the cri­sis. “The gov­ern­ment’s new in­ter­est is re­flec­tive of the fact that they’ve had very lit­tle in­ter­est in this mar­ket his­tor­i­cally,” says James Cox, a pro­fes­sor at Duke Univer­sity School of Law. “They just hadn’t looked at it.” The bot­tom line The gov­ern­ment crack­down on de­cep­tive bond-trad­ing tac­tics may bog down in court be­cause they’re so com­mon.

“The gov­ern­ment may not like how th­ese mar­kets work...but it is how they do work”

Price of a 732-square-foot Hong Kong apart­ment af­ter a $322,000 dis­count

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