Wall Street Law Blog

Game On! SEC Says Bear Stearns Subprime Hedge Fund Case Will Go Forward

In a recent post, Fortune Magazine reported that the SEC intends to press forward with a civil lawsuit against ex-Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. See tinyurl.com/3b6a7cs

By Brett Sherman; Wall Street Law Bog, The Sherman Law Firm

CHANCE TO SAVE FACE?

Federal Prosecutors Have Been Criticized For Rushing Their 2008 Indictment in a complex criminal fraud case against former Bear Stearns Hedge Fund Managers Ralph Cioffi and Matthew Tannin.

That Case Ended In Acquittal.

Lawyers for the SEC Have Taken Their Time. But Will The Civil Trial End With A Better Reult For The Government?   Maybe so.

Double Jeopardy is Not An Issue

First, the SEC lawsuit is NOT DOUBLE JEOPARDY.

Double jeopardy is all about the possibility of incareration.  Jail.  Unlike the failed 2009 criminal prosecution of Cioffi and Tannin, the SEC lawsuit cannot result in jail time for the managers of two Bear Stearns subprime hedge funds that went bankrupt in July 2007. Thus, no double jeopardy.

BACKGROUND

The only high profile criminal case about the subprime meltdown and financial crisis ended disastrously for the federal government.

Ralph Cioffi and Matthew Tannin, the now infamous managers of two Bear Stearns hedge funds that failed during the summer of 2007, were arrested and charged in with fraud-based crimes June 2008. The crux of the charges was that the two Bear executives deceived investors about the risks and performance of complex designer securities called collateralized debt obligations (and better known as CDOs).  The CDOs at issue were backed by subprime mortgages.   

Subprime mortgage defaults spiked when the housing bubble popped in 2006.  By 2007, mortgage defaults were so high that investors stopped buying subprime-backed CDOs.  As demand shrunk, the value of these securities plunged.  

 In 2009, a jury found Cioffi and Tannin not guilty of criminal fraud charges on all counts.

 

 

A CHILLING EFFECT?

Pundits have pointed to the acquittal, an embarrassment for prosectors, to help explain the complete absence of subsequent indictments against executives from Bear Stearns or other big players in the market for mortgage bonds.

"There is no doubt in my mind that the verdict in the Bear Stearns hedge fund trial has had a huge chilling effect on prosecutions," said retired judge and trial lawyer Lee Sherman.

It isn't exactly good for the careers of prosecutors to lose these kinds of high visibility cases."

 

Lee Sherman is a senior consultant to The Sherman Law Firm and a regular Wall Street Law Blog contributor.

WHY PUT CIOFFI AND TANNIN ON TRIAL AGAIN?

For many observers, the SEC's decision to press on with its case against Cioffi and Tannin is a surprise. The allegations are nearly identical to the failed Bear Stearns prosecution.

However, Mr. Sherman believes the move makes sense. 

"Remember," Sherman said, "Unlike federal prosecutors, who were bound by the Constitution's speedy trial requirement, the SEC has had years to investigate and prepare for this. Plus -- and I believe this is a major factor -- the SEC has a far easier burden of proof."

 

 

PREPONDERRANCE OF THE EVIDENCE

In 2009, federal prosecutors failed -- in the jury's view -- to prove the two former Bear Stearns executives guilty beyond a reasonable doubt. In the civil trial, SEC lawyers will try to prove civil liability rather than guilt and, therefore, the burden of proof is the preponderance of the evidence standard.

Under the preponderrence standard, jurors are typically instructed to find liability if they feel 51% sure that the evidence supports liability.  Obviously, with the preponderrence standard, the bar is set much lower than it is under the beyond a reasonable doubt required in criminal cases.

REDEMPTION?

Perhaps the biggest reason why the SEC chose to proceed against Cioffi and Tannin is to rehabilitate the Commission's severely damaged reputation.  Under the Bush administration, the SEC failed to detect and prevent fraud by Wall Street investment banks again and again and again.  The Commission has been rightly blamed for being asleep at the switch.     

Under President Obama, personnel and cosmetic changes at the SEC have been made. And there has been the predictable amount of tough talk.  Still, in terms of real change, the SEC still needs a major accomplishment before the public will believe there's a new sheriff in town.

Stay tuned... This may get interesting.

Wall Street Law Blog; A Publication of The Sherman Law Firm

*Information about SEC's decision to move forward via Fortune tinyurl.com/3b6a7cs

Cioffi Trial - the right result? (updated 11/16/09)

Absolutely. Remember, the definition of NOT GUILTY is not innocent. Not guilty means the Government failed to prove its case beyond a reasonable doubt. The American criminal justice system works best when the system protects individual rights. Proving criminal defendants guilty beyond a reasonable doubt is a very high hurdle, and rightfully so. No defendant should face the possibility of imprisonment unless a jury is convinced beyond all reasonable doubt that the defendant is guilty as charged.

In the case of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin, the jury did NOT find anyone innocent. But the jury clearly did not believe the government met its very high burden of proof. Not guilty was the only proper verdict.

**********

That said, extensive misconduct, including fraud, occurred at Bear Stearns. Of that we have no doubt (reasonable or otherwise).

UPDATE: William Cohan's November 12 Op-Ed Piece in The New York Times (reprinted here from nyt.com) really hits the nail on the head

November 12, 2009
OP-ED CONTRIBUTOR
How the Scapegoats Escaped

By WILLIAM D. COHAN
THE quick “not guilty” verdict reached Tuesday afternoon by a Brooklyn jury in the federal criminal trial of two former Bear Stearns hedge fund managers was at once surprising — for its failure to comport with the zeitgeist — but also entirely understandable, based on a close reading of the prosecution’s arguments and the evidence the judge allowed to be introduced. “There was a reasonable doubt on every charge,” one juror told The Times afterward. “We just didn’t feel that the case had been proven.”

In short, the prosecution blew it — on two counts. First, in devising the original indictment for conspiracy and securities fraud against the two defendants, Ralph Cioffi and Matthew Tannin, it relied on damning snippets of lengthy e-mail messages that when viewed in their entirety proved to be highly ambiguous. Second, the prosecution made a reductionist opening argument claiming the men were nothing more than out-and-out liars, needlessly raising the bar in terms of what it had to prove to jurors.

In that opening speech, Patrick Sinclair, the assistant United States attorney for the Eastern District of New York, tried to head off all the confusing Wall Street jargon soon to be unleashed by claiming the defendants had simply been deceitful. He accused them of lying about the size of their personal investments in the funds and in their dealings with nervous investors who were considering getting out when subprime mortgages — in which the funds had invested heavily — began to rapidly lose value in March 2007.

“They did the best thing that they could think of to keep those investors in the fund and with any luck keep their bonuses coming: they lied,” Mr. Sinclair told the jury. “They lied over and over again to lull those investors into a false sense of confidence and make them think that these failing funds continued to be a good investment when the exact opposite was true.”

Unfortunately for the government, the evidence was not nearly as clear-cut as Mr. Sinclair portrayed it to be, and his strategy to make it seem so backfired. Consider the e-mail messages the prosecution placed at the center of its case.

In the indictment, the prosecution quoted from a note Mr. Tannin sent in April 2007 from his personal Gmail account to Mr. Cioffi’s wife. The government made much of the fact that Mr. Tannin chose not to send it to Mr. Cioffi himself or from his Bear Stearns’ e-mail account, suggesting he was trying to hide something. “The subprime market looks pretty damn ugly,” Mr. Tannin wrote, adding that if a recent financial report was correct, “I think we should close the funds now .... The entire subprime market is toast.”

But the jury eventually saw the entire message, in which Mr. Tannin ruminated at length about various courses of action and seemed to be striving to make the soundest financial choice. In other words, it was just what you would hope your fund manager would be worrying about in a precarious time. In the end, he concluded he was feeling “pretty damn good” about what was happening at the funds and that “I’ve done the best possible job that I could have done.” Any wonder the jurors came away with reasonable doubt?

The prosecution’s misjudgments are doubly vexing because there was other evidence around which it might have built a stronger case. The prime example was a “talking points” memo in June 2007, sent by Bear Stearns’s senior management to its brokers for use in discussions with hedge fund investors worried about a meltdown. The episode raised pretty clear doubts about whether Mr. Cioffi and Mr. Tannin had told investors the truth.

According to the memo, one of the questions deemed likely to be asked was: “I thought the fund was diversified, and now it turns out it seems to have had a fair amount of exposure to the subprime mortgage market. What exactly was the exposure?” The answer: “60 percent.” The problem was that in all previous communications to the investors, the two fund managers had suggested that only about six percent of the funds were invested in subprime mortgages.

During the trial, a prominent former Bear Stearns broker, Shelly Bergman, testified about the damning nature of this talking points memo, which was as close to a smoking gun as prosecutors could have hoped for. Yet the prosecution never made much use of his testimony, and it did a poor job of rebutting the defense’s claims that Mr. Bergman had a conflict of interest in testifying against the two fund managers.

So where does the verdict leave us? Word is that three federal grand juries are still investigating what went wrong at Lehman Brothers in 2007, but those prosecutors may be forced to tread lightly in the wake of what happened this week. Even though the facts and circumstances of the Lehman matter are very different from the Cioffi/Tannin episode, Tuesday’s verdict may be the best news in more than a year for Richard Fuld, the former Lehman chief executive.

For now, Mr. Cioffi and Mr. Tannin remain the only bankers indicted for their professional behavior in what became one of the worst financial crises in our history. They became a symbol of greedy carelessness for a public intent on blaming someone — anyone — for Wall Street’s folly. There must be some accountability for the Bear Stearns calamity, to say nothing of the $12 trillion of taxpayer money used to prop up capitalism, right? Not so fast, this Brooklyn jury declared. “The entire market crashed,” one juror explained. “You can’t blame that on two people.”

William D. Cohan, a contributing editor at Fortune and a former Wall Street banker, is the author of “House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.” In January, he will begin a regular column on business at nytimes.com/opinion.