U.S. Said to Expand Its Probe Into Possible Bond-Trader Lies

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Bond Traders: What Are U.S. Investigators Looking for?

The U.S. is expanding an investigation into deceptive sales practices by bond traders even though the first major conviction in the area could be overturned.

Aided by technology that’s allowing unprecedented scrutiny of trades, the Securities and Exchange Commission is looking beyond 10 cases it’s been developing with U.S. prosecutors to examine other instances of bankers potentially lying to clients and booking improper round-trip transactions, said two people with knowledge of the matter. Some criminal charges from the first batch of probes may come as early as next month, another person said.

Going after bond traders, and in the case of the Justice Department, trying to put some of them behind bars, represents the government’s most aggressive effort yet to root out wrongdoing in the opaque world of complex debt securities. The investigations include a focus on bonds tied to mortgages and corporate loans, markets where pricing data is scarce so bank traders have an edge in marking up assets to charge higher fees.

“These practices have been tolerated for years, but they have to make an example someplace,” said Charles Geisst, a Wall Street historian at Manhattan College in New York. Market makers have “the advantage,” he said.

Treasury Collusion

The review of how traders market debt securities to asset managers comes as the government takes a broad look at possible malfeasance tied to bonds. The Justice Department is also investigating whether traders are colluding to share information about Treasuries, a market where rules haven’t been been updated in years and oversight is split among various federal agencies.

The probes into mortgage bonds and other securitized debt have prompted banks to fire and suspend traders, some of whom might not face enforcement actions. For Wall Street, the crackdown has left firms wondering whether long-accepted tactics based on exaggeration and cajoling now have to be scrapped.

Looming over the investigations is former Jefferies Group LLC trader Jesse Litvak’s fight to overturn his 2014 conviction for misleading clients about how much he paid for bonds and other violations. In May, an appellate judge questioned the legal arguments used against Litvak, whose case has been used as a precedent in the government’s pursuit of other traders.

SEC spokesman Kevin Callahan declined to comment.

Trader Deception

Litvak’s deception allowed him to sell mortgage bonds at inflated prices, bilking customers out of $2 million, U.S. prosecutors successfully argued during his trial. Litvak’s lawyers said it didn’t matter that he misrepresented the markup as long as his sophisticated buyers -- consisting of hedge funds and money managers -- paid what they felt was an appropriate price.

In July 2014, Litvak was sentenced to two years in prison. A three-judge panel is expected to make a decision on his appeal in the coming months.

Earlier this year, SEC lawyers debated internally whether to put other investigations on the backburner until the legal uncertainty tied to Litvak’s conviction was resolved, according to a person familiar with the matter, who like the others asked not to be named because the discussions were private.

SEC Enforcement Director Andrew Ceresney told the lawyers to push forward, saying he thought the agency would ultimately prevail against Litvak, the person said.

The Litvak case broadly hinges on materiality -- whether information he withheld was important enough to influence clients’ buying decisions or the value of the bonds. The SEC’s view is that it’s material when someone lies about how much an asset is worth.

Condoned Tactics

For the SEC, which has faced lawmaker criticism that it’s failed to punish individuals over the 2008 financial crisis, the bond probes are a top priority. At a holiday party held by the agency’s New York office last year, Chair Mary Jo White chatted with enforcement attorneys about the status of the cases, said a person with knowledge of her comments.

The sweep has confounded industry veterans who say traders for years have made misleading statements about how much they paid for bonds and embellished the level of market demand. Such negotiating tactics are condoned and expected by both buyers and sellers, the traders argue.

In March, the Justice Department brought a case against another trader, Matthew Katke, who pleaded guilty to charges that he misrepresented prices of collateralized loan obligations while working at Royal Bank of Scotland Group Plc. Katke is cooperating with the government on other probes and can withdraw his plea if Litvak wins his appeal.

Helping drive the SEC’s investigations is proprietary software that’s allowing the agency to cull through reams of data and spot suspicious transactions. The technology is capable of detecting instances when a dealer buys bonds at one price and sells them for much more, signaling regulators to the trades with automated alerts, according to SEC lawyers.

Bond Parking

The agency has also used its software to track what’s known as parking, where one trader agrees to sell a bond to another firm with the assumption that it will be bought back at a higher price. Such transactions can be used to get around bank rules that restrict how long a trader can hold a bond.

While the SEC’s new tools might be stoking nervousness on Wall Street, making the cases stick still depends on judges’ interpretation of decades-old precedents.

During oral arguments for Litvak’s appeal in May, U.S. Circuit Judge Barrington D. Parker said that everyone who participates in the bond market expects a certain amount of “puffery,” a legal term that permits sellers to exaggerate a product’s qualities.

“This kind of thing goes on all the time,” Parker said.

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