[ by Howard Haykin with Melanie Gretchen ]

The Justice Department and the SEC leveled significant criminal and civil charges against former Jefferies trader Jesse Litvak.  If that's not bad enough, Litvak presumed "dirty deeds" involved high profile securities that were tied to the federal financial bailout under TARP - the Troubled Asset Relief Program.  That will not help him make friends with prosecutors.  However, since we know that financial professionals settle such charges and rarely admit to breaking federal laws or violating securities regulations - it's anyone's guess as to how all of this will come together.

Litvak dealt with RMBS transactions - residential mortgage-backed securities - that were part of the financial bailout under the Troubled Asset Relief Program, or TARP.  His customers included investment advisers retained by the Treasury Department as part of the Public-Private Investment Program, where the government put up money to buy RMBS's issued before the financial crisis in an effort to unfreeze the market.  Leading Wall Street investment advisers participated in the program - including AllianceBernstein, BlackRock, and Wellington Management. 

With government funding at stake, prosecutors added charges under 2 other federal statutes not usually seen in this type of case.  Litvak's presumed fraudulent transactions involved investments financed through TARP - meaning he's also been charged with the crime of defrauding the United States.

For further details on SEC charges, go to C-I's Tuesday posting in What Went Wrong:   [Jefferies Ex-Managing Director Arrested].

So, What Can We Say About the Way Litvak Operated His Trading Desk?   Based on what we know from the civil complaint: 

• Litvak dealt exclusively with sophisticated institutional customers.
• For the most part, he conducted "riskless principal" transactions with his customers.

• If a customer is looking to buy a particular security or investment, Litvak first would typically go into the market and acquire the security for his firm's inventory.  Theoretically, Litvak is obligated to then fulfill the customer's buy order, charging a price that reflects Litvak's cost on the open market plus some market up, reflecting a profit to the firm.

• Conversely, if the customer wants to sell the security or investment vehicle, Litvak would proceed to the market to try and sell that security or investment.  Upon finding a buyer, Litvak would, for the moment, short sell that investment out of the firm's inventory or proprietary account.  Litvak theoretically is then obligated to buy the investment or security from his customer basing his price on the price he received for his open market sale less a mark-down, reflecting profit to the firm.

• Litvak, according to the SEC complaint, often lied to his customers, by overstating or understating the open market price at which he executed the opening or first leg of the riskless principal transaction.  Such actions would have enabled Litvak to increase the customer's cost to buy the security, and decrease the proceeds he needed to a customer who was selling the security.  Jefferies generated higher profits at the expense of customers who either came to buy or sell.

And What Impact Might These Cases Have on Other Wall Street Traders?   According to Peter Henning, who writes the White Collar Watch column for Dealbook, the charges against Litvak send several warnings to all of Wall Street, namely:

• misleading customers - including sophisticated ones - can result in criminal action, even for a broker who did not owe a fiduciary duty to clients.

• when dealing with a customer that is participating in a government-funded program - like TARP - the customer essentially is wearing two hats - (i) as a typical Wall Street counterparty; and, (ii) as an agent of the U.S. Government.  If a trader lies to a customer when that customer essentially is serving as an arm of the U.S. Government, then that trader risks violating securities regulations as well as defrauding the United States Government.  That gets very dicey, in that the stakes are that much greater to the trader and the trader's firm.

Notwithstanding the above facts, what obligations did Litvak owe ...  his highly sophicated buyside customers, like BlackRock and AllianceBernstein?  Even when they're wearing the hat of a government agent? 

• The SEC says that given the opaque nature of the market for RMBS's or residential mortgage-backed securities, statement about how much Jefferies paid for the securities and its profits were material to the investment advisers.

• But it can be said that Litvak did not owe a fiduciary duty to his adviser clients.  Instead, by working in the role of a broker-dealer market maker, Litvak was only required to make suitable investment recommendations. 

• Goldman Sachs CEO Blankfein offered that explanation when he testified before a Senate subcommittee in 2010.  Blankfein was referring to the firm's sale of a synthetic derivative obligation that was the basis for an SEC lawsuit against Goldman. 

• Responding to the 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.”

• Yet, committing "fraud" is not dependent upon whether the victim - in this case, AllianceBernstein or BlackRock - was gullible or lost money on the transaction.  Instead, to prove that fraud was committed, prosecution needs only to show that the defendant made deliberate misstatements, without regard to the fact that Litvak was acting as a broker who had no obligation to disclose all relevant information to the customer.

Concluding Take-Away.    Given the charges leveled at Litvak, Wall Street has been sufficiently warned to expect the federal government and regulatory authorities to police the markets as tightly as ever. 

And, in the absence of transparent price information, trust among participants not only will be expected, but it will be required. 

Caveat Vendor!

For further details, go to [Dealbook, 1/30/13] .