Expert Testimony on Industry Practice

Litvak thus reaffirms that expert testimony regarding industry practice may be crucial in making materiality determinations in securities fraud cases.

U.S. v. Litvak

Jesse Litvak, a securities trader, was employed by Jefferies & Company (Jefferies), a global securities broker-dealer and investment banking firm. 808 F.3d at 166. In its role as broker-dealer, Jefferies served as an intermediary, buying securities from counterparties and reselling them to other counterparties represented by professional investment managers. Litvak was alleged to have made fraudulent misrepresentations to his counterparties, including misrepresenting purchase and resale prices to investors who were interested in buying or selling RMBS securities, so that Jefferies could “covertly reap excess profits.” Id. Among the questions ultimately posed to the jury was whether Litvak's misrepresentations to his victims about the acquisition costs and negotiated resale prices of the securities at issue were material. Litvak proffered expert testimony that in the RMBS sector, investors do their own “rigorous valuation” to determine the prices they are willing to pay for bonds. The expert also would have testified that investors in the RMBS industry rely on their own valuations instead of statements by sell-side bond traders, like Litvak, who are known to provide self-serving prices and valuations that are “often misleading.” Id. at 179, 181-83. The district court sustained the prosecution's objection to this proposed testimony, and excluded it. Id. at 180.

On appeal, the Second Circuit found the exclusion to be error, concluding that such expert testimony was “highly probative” because a jury could reasonably have found that price misrepresentations by a broker-dealer, such as Litvak, “would be immaterial to a counterparty that relies not on ' the price at which prior trades took place [given by the dealer], but instead on its own sophisticated valuation methods.” Id. at 182-83. The Second Circuit further pointed out that without this testimony, Litvak was left solely with “victims” of his conduct, who undoubtedly had a horse in the race, stating that his misstatements were important to them, as the only sources of potential testimony on this issue; and he would have no way to show that “the types of statements” he made “are generally not important to a reasonable investor.” Id. at 183-84. The Litvak decision thus leaves no room for doubt that expert testimony about industry convention can be used in securities fraud cases for determinations of materiality.

Second Circuit Precedent Prior to Litvak

Although the Litvak decision has garnered much attention, it is not nearly as transformative as some have suggested. In 1991, the Second Circuit held that under certain circumstances, expert testimony regarding industry practices properly was admissible, especially “in complex cases involving the securities industry, [where] expert testimony may help a jury understand unfamiliar terms and concepts.” United States v. Bilzerian, 926 F.2d 1285, 1294-95 (2d Cir. 1991).

In Bilzerian, the government alleged that the defendant was required to disclose the purchase of a large block of stock on his Schedule 13D, a form filed with the SEC and made available to the public, which “discloses that an investor has acquired beneficial ownership of five percent or more of the stock of a public company.” Id. at 1289-90, 1297. Although the defendant filed the Form 13D, he described certain stock as having been purchased with “personal funds,” without disclosing that these funds were raised from other investors with whom he had a profit-sharing and guarantee-against-loss agreement. Id . Therefore, at trial, the court allowed the government to offer expert testimony relating to “general background on federal securities regulation and the filing requirements of Schedule 13D.” Id. at 1294.

The Second Circuit held that the government's expert testimony regarding the general background of federal securities regulation and the filing requirements of Schedule 13D appropriately was limited and “d[id] not usurp the jury's function of applying the law to the facts of the case.” Id. at 1294-95. The court, however, excluded testimony from the defendant that “the phrase 'personal funds,' as generally understood in the securities industry, includes funds derived from loans of the type received by defendant,” because it “related directly to the issue of whether [defendant's] actual 13D disclosures complied with legal requirements,” and hence, “constituted an impermissible instruction on governing law.” Id. at 1295. Thus, Bilzerian allowed expert testimony regarding ordinary practices in an industry so long as it did not encompass an impermissible legal conclusion.

In the wake of Bilzerian, district courts within the Second Circuit have “regularly permit[ted] testimony similar to that which Litvak proposed [his expert] provide.” Litvak, 808 F.3d at 180, n. 25 (citations omitted). For example, in SEC v. U.S. Envtl., Inc., the SEC alleged “wash trades” occurred between a market maker and its principal. The SEC proffered expert testimony regarding the standard practices of the securities industry, setting forth that the defendants' transactions “were inconsistent with those of a lawful market maker.” The court held that the SEC's expert's testimony as to what methods of trading are “normal” was relevant, as it could “prove helpful to the trier of fact by providing him with indirect evidence of the market manipulation” (No. 94 Civ. 6608, 2002 WL 31323832, *2-3, *5 (S.D.N.Y. Oct. 16, 2002) (citation omitted)). See SEC v. U.S. Envtl., Inc., No. 94CIV.6608(PKL)(AJP), 2003 WL 21697891, at *11 (S.D.N.Y. July 21, 2003) aff'd, 114 F. App'x 426 (2d Cir. 2004) (allowing SEC to offer expert testimony by former SEC regulator as to defendant's duties as an NASD registered market maker); Highland Capital Mgmt., L.P. v. Schneider, 551 F. Supp. 2d 173 (S.D.N.Y. 2008) (expert's testimony as to securities industry's customs and practices for recordkeeping and record making could include a discussion of regulatory rules and other guidelines for private placement transactions); In re Blech Sec. Litig. , 2003 WL 1610775 at *21 (S.D.N.Y. Mar. 26, 2003) (admitting securities industry expert' testimony “as to what ordinary broker activity entails and as to the customs and practices of the industry”).

Flannery v. Securities & Exchange Commission

In a decision issued on the same day as Litvak, the U.S. Court of Appeals for the First Circuit in Flannery v. SEC., No. 15-1080, 2015 WL 8121647, at *8 (1st Cir. Dec. 8, 2015), similarly concluded that expert testimony regarding industry practice was admissible with respect to the issue of materiality. In Flannery, the SEC initially alleged that during the 2007 subprime mortgage crisis, John P. Flannery and James D. Hopkins “engaged in a course of business and made material misrepresentations and omissions that misled investors” about two managed funds known as the Limited Duration Bond Fund (LDBF). Id . at *1. “The LBDF was offered and sold only to institutional investors” and was heavily invested in asset-backed securities (“ABS”), which included residential mortgage-backed securities. Id. at *2.

The Administrative Law Judge dismissed the proceeding, prompting an appeal to the Commission, which reversed the decision. Id. at *1. An appeal to the First Circuit followed, and expert testimony of the sort presented in Litvak was admitted and played a prominent role in the court vacating the Commission's decision. Id.

One of the key pieces of evidence relied upon by the Commission in its proceeding was a presentation that one of the defendants made to a group of investors. Id. This presentation included a slide titled “Typical Portfolio Exposures and Characteristics ' Limited Duration Bond Strategy ('Typical Portfolio Slide').” Id. at *2. The slide stated that only 55% of the fund's assets were allocated to ABS, when the actual investment amount in ABS reached 80%-100%. Id. at *3. The court assumed the slide was misleading, but relied on expert testimony offered by defendant Hopkins that: 1) “[p]re-prepared documents such as presentations are not intended to present a complete picture of the fund, but rather serve as starting points, after which due diligence is performed”; 2) “a typical investor in an unregistered fund would understand that it could specifically request additional information regarding the fund”; and 3) investors could obtain information regarding the “actual percent of sector investment ' through the fact sheets and annual audited financial statements.” Id. at *8 (internal quotation marks and ellipses omitted). And, in fact, two fact sheets (one prior to and one following the presentation) actually included information that the LBDF was 100% and 81.3% invested in ABS, respectively. Id . Bolstered by this expert testimony, the court concluded that the SEC's “materiality showing was marginal.” Id. at *1.

Thus, like the Second Circuit in Litvak, the First Circuit concluded that industry “[c]ontext makes a difference” and what “a typical investor in an unregistered fund would understand” is relevant to the materiality inquiry, regardless of whether the specific investor at issue had this understanding. Id. at *8.

Admissibility of Expert Testimony Is Far from a Guarantee of Acquittal

Litvak is a fresh reminder that expert testimony regarding standard industry practice can effectively be presented to the fact-finder making the ultimate materiality determination. At any retrial, Litvak's expert will undoubtedly testify to the jury that “statements by sell-side salesmen” such as Litvak, concerning the buy or sell price for RMBS “are not relevant to [a sophisticated investor] fund's determination with respect to how much to pay for [the] bond.” 808 F.3d at 182. In essence, Litvak will be able to argue to the jury that although he lied to counterparties about pricing, those RMBS investors would not have relied on this type of statement, and so his lies were immaterial and do not support a claim of fraud.

Of course, there is no guarantee that a jury will find Litvak's evidence persuasive. In addition to expert testimony about market dynamics and mores, the jury, as they did in Litvak's first trial, will undoubtedly also hear testimony from Litvak's counterparties that his “misstatements were important to them.” Id. at 183. Thus, although the Second Circuit and other circuits have opined on this issue, there is no way of knowing how having expert testimony will play out in the dynamic arena of the jury box or how juries, in practice, will rule in individual cases.

Indeed, Litvak does not appear to have deterred the government from pursuing similar actions, and so these issues are likely to play out in many fora in the upcoming months and years. Among the upcoming cases implicating conduct similar to the conduct at issue in Litvak , are SEC v. Shapiro et al., No. 15-cv-7045-RMB-JCF, complaint filed, 2015 WL 5217924 (S.D.N.Y. Sept. 8, 2015) and United States v. Shapiro, 3:15-cr-00155 (RNC) (D. Conn.), indictment unsealed (S.D.N.Y. Sept 8, 2015), where it is alleged/charged that three RMBS traders, similar to Litvak, falsely overstated to buyers and understated to sellers the price paid for RMBS bonds in order to fraudulently induce investors to agree to a price which would generate an additional profit margin for their employer, a broker-dealer, Nomura Securities, International.

The criminal trial is scheduled for October 2016, and several pretrial motions already have been filed, including joint motions to dismiss, a motion for severance filed by the defendants, and a reciprocal discovery motion filed by the government. One can expect that these defendants will be certain to proffer expert testimony explaining why, given the industry context in which they relayed misstatements, including false pricing information, their statements were immaterial to investors purchasing or selling RMBS.

Jodi Misher Peikin ([email protected]), a member of this newsletter's Board of Editors, is a principal at Morvillo Abramowitz Grand Iason & Anello PC, New York. Rachel Agress is an associate with the firm.