A Warning to Wall Street About Misleading Clients

A former trader of residential mortgage-backed securities at Jefferies & Company, Jesse Litvak, was indicted on charges of lying to investors about the prices and commissions of securities sold as part of a government program to prop up the mortgage bond market.

The charges serve as a warning to Wall Street that misleading customers - including sophisticated ones - can result in criminal action, even for a broker who did not owe a fiduciary duty to clients.

The Justice Department charged Mr. Litvak with 11 counts of securities fraud in connection with so-called R.M.B.S. transactions that were part of the financial bailout under the Troubled Asset Relief Program, or TARP. The Securities andExchange Commission filed parallel civil charges accusing him of fraud.

Among Mr. Litvak’s customers were investment advisers retained by the Treasury Department as part of the Public-Private Investment Program, in which the government put up money to buy residential mortgage-backed securities issued before the financial crisis to try to unfreeze the market. Firms involved in the transactions include AllianceBernstein, BlackRock, and Wellington Management, all leading Wall Street investment advisers that manage billions of dollars of assets.

With government fund! ing at stake, prosecutors added charges under two other federal statutes not usually seen in this type of case. Some of the transactions involved investment vehicles financed through TARP, so Mr. Litvak was charged with violating the statute that makes it a crime to defraud the United States.

He was also charged with four counts of making false statements to the Treasury Department. Although Mr. Litvak never dealt directly with that department, it had contracted with the investment advisers to act on its behalf in the residential mortgage investments.

The accusations outline a rather simple act: Mr. Litvak is charged with telling clients that the cost of the residential mortgage investments was higher or lower than what Jefferies paid for them, depending on which side of the transaction the firm was on. In other trades, he took securities from the firm’s inventory and sold them at an undisclosed markup, although he indicated Jefferie was only matching firms for the transaction.

Mr. Litvak communicated with clients by text messages and chat sessions, and his communications contain questionable comments like those often seen in other cases. In one instance, he claimed to have tried to get a better price from his boss but that “i thought i could work him over … but he is kind of being a weenie.”

“The kind of false claims made by Litvak were unfit for a used-car lot, let alone a marketplace for mortgage-backed securities,” said George S. Canellos, deputy director of enforcement at the S.E.C.

But Mr. Litvak was dealing with investment advisers managing millions of dollars of securities. So could they have been duped, as authorities claim

Unlike stocks that trade on an open market, transactions involving these securities were much more opaque. As described in the S.E.C. complaint, the market for residential mortgage-backed securities is “generally illiquid and discovering a market price for them is ! difficult! . Participants trading in the M.B.S. market must rely on informal sources, including their broker, for this information.”

Thus, according to prosecutors, Mr. Litvak’s statements about how much Jefferies paid for the securities and its profits were material to the investment advisers.

What makes this case different is that Mr. Litvak did not owe a fiduciary duty to the investment advisers he dealt with. While those firms owe a duty to put their clients’ interests first, a broker like Jefferies is only required to make suitable investment recommendations when acting as a market maker in a security.

This was the explanation offered by Lloyd C. Blankfein, chief executive of Goldman Sachs, when he was testified before a Senate subcommittee in 2010 about the firm’s sale of a synthetic derivative obligation that was the basis for an S.E.C. civil fraud suit. In response to an accusation that Goldman had improperly bet against the security it sold to a client, Mr. Blankfein responded, “In the context of market-making, that’s not a conflict.”

Mr. Litvak’s lawyer said his client “did not cheat anyone out of a dime. In fact, most of these trades turned out to be hugely profitable.” He also pointed out that the clients were all sophisticated investors, perhaps implying they should not have relied on Mr. Litvak’s word alone about the prices of the securities.

The defense can argue that the fact the market is opaque, with prices based on informal sources. And the decision whether to buy or sell a security is based on the total cost, so whether it included a higher commission or price spread than the customer was led to believe mi! ght not h! ave been material to the transaction.

But fraud does not require that the victim be gullible or lose money on the transaction. The indictment claims that outright falsehoods were made in connection with the transactions, not just the shady practices of the used-car dealer who proclaims that the vehicle was only driven to church on Sunday.

Proving a fraud charge is much easier if it can be shown that the defendant made deliberate misstatements, even if the person was only acting as a broker who did not have a duty to disclose all relevant information to the client.

The charges against Mr. Litvak should put Wall Street on notice that the government will try to police markets that require trust among the participants in the absence of transparent price information. The defense of caveat emptor, or let the buyer beware, will not necessarily protect against criminal charges for fraud.