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

Would Bear Stearns sales have exposed "mark to market" fraud?

    Did Bear Stearns maintain a massive mortgage-related securities portfolio to avoid huge write-downs, cover fraud, or even hide insolvency?  

We'd sure like to know.

 

• After the subprime crisis began in 2007, senior managing directors at Bear Stearns reportedly urged the firm's Executive Committee to raise capital by, among other actions, selling off chunks of the firm's massive portfolio of mortgage-related products.

• Mortgage boss Tom Marano consistently fought the idea of any substantial liquidation of Bear's mortgage holdings.  

• The ever-worsening mortgage and credit crises meant that Bear Stearns could sell mortgage-related products for only a fraction of their original values.  However, there came a point in 2007 (at the latest) when Bear Stearns management knew or should have known that the market for mortgage-backed securities and related investments was dead in the water.  The housing and credit bubbles had popped.  The party was over.

• Still, according to the estimated values Bear Stearns was assigning to its mortgage holdings in 2007 and 2008, substantial liquidations from Bear's mortgage portfolio at deep discounts could have yielded billions of dollars for the firm's war chest.    

• SEC records show that Bear Stearns had significant liquidity problems by late summer, 2007.  

• In light of Bear's documented liquidity issues and falling demand / prices for MBS and CDO's, there seems to be no logical reason why Bear Stearns would keep huge amounts of the firm's capital locked inside mortgage securities were (a) consistently losing value, (b) had virtually no chance for any real, sustained recovery, and (c) would be difficult to sell quickly if Bear Stearns needed to raise cash quickly (which, of course, is precisely what happened when Bear was undone by a severe liquidity crisis in March 2008).

• Nevertheless, Tom Marano continued to argue against any substantial reduction in the firm's mortgage holdings.  

• THE QUESTION IS WHY:  Why would Marano fight liquidations of mortgage securities?  Why would CEO Jimmy Cayne allow Bear Stearns to keep the over-concentrated mortgage portfolio largely intact when that portfolio obviously was a huge albatross for the firm?  Why would Cayne's successor as CEO, Alan Schwartz, also side with Marano?  

• POSSIBLE ANSWERS (what follows is speculation. However, if there is a better explanation for Bear's inexplicable refusal to sell off chunks of its mortgage securities book, we sure would like to hear it...)  

• Maybe the reason Bear Stearns kept most of its massive mortgage portfolio after the subprime crisis began in 2007 was that the firm knew it had marked the value of its mortgage securities way too high. 

• Maybe Bear Stearns knew that the real prices the market would pay for mortgage securities were far less than the prices Bear was using to value its portfolio (which accounted for a large portion of the total assets on Bear's balance sheet). 

• Maybe Bear Stearns knew it could not sell its mortgage holdings without exposing the firm's false valuations.  

• Bear Stearns certainly knew "mark to market" accounting rules meant sales of large blocks of mortgage securities on the open market would immediately set new benchmark prices for repricing similar, hard to value securities.  

• If Bear Stearns knew that it was over-stating the value of MBS, CDO's and related products, then Bear also knew that using new benchmark market prices to revalue the balance of the firm's mortgage holdings would reveal that the portfolio was worth far less than Bear Stearns was reporting on its balance sheet.  

• If Bear Stearns knew that the value of mortgage-related assets on the firm's balance sheet was substantially lower than Bear was telling the public, then maybe Tom Marano and Bear Stearns senior management resisted any sizable liquidation of the mortgage portfolio to avoid exposing Bear's unreasonably high marks.

• Maybe it is even true that Bear Stearns senior management knew (or believed / feared) that a large sale of mortgage-related assets, and a subsequent revaluation of the balance of the portfolio using new benchmark prices, would show that Bear Stearns was actually insolvent during the second half of 2007 and early 2008.  

Whether some, all, or none of our conjecture is accurate, Wall Street Law Blog firmly believes that any explanation would cast a bad light on the business practices of Bear Stearns. As always, we welcome your thoughts, information, criticism, and wisdom.

By Brett Sherman, The Sherman Law Firm 

 

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.

Cioffi Trial Update: Jury Deliberations to Begin in Trial of Bear Stearns Hedge Fund Managers

Reprinted by Wall Street Law Blog
CIOFFI TRIAL SET TO GO TO JURY...Latest Update on Criminal Trial of Former Bear Subprime Hedge Fund Managers Ralph Cioffi and Matthew Tannin
Associated Press News Wire

 November 9, 2009

 

NEW YORK (AP) — The case of two former Bear Stearns hedge fund managers charged with lying to investors is moving into the final stages.

Deliberations were expected to begin Monday at the Brooklyn trial of Ralph Cioffi and Matthew Tannin. They've pleaded not guilty to conspiracy and fraud charges.

It was the first criminal case to hit Wall Street amid the housing market meltdown.

The eventual implosion of the defendants' hedge funds cost 300 investors about $1.6 billion.

The domino effect nearly led to the demise of Bear Stearns itself. The firm barely avoided bankruptcy in a rescue buyout by JPMorgan Chase & Co.

Bear Stearns Cioffi Trial: Introducing Mr. Tannin and his diary

ENTRIES IN ONLINE DIARY SHOW ACCUSED BEAR STEARNS HEDGE FUND MANAGER HAD SEVERE ANXIETY OVER BEAR SUBPRIME FUNDS' "BLOW-UP RISK" AT LEAST A YEAR BEFORE FUNDS COLLAPSED. 

Throughout the arrests and legal wranglings that preceded upcoming opening statements in the Bear Stearns criminal securities fraud trial, defendant Matthew Tannin has been the other guy. So far,Tannin's co-defendant, Ralph Cioffi, has been alone in the fishbowl. Thanks to recently released E-Diary entries from the summer of 1996, Tannin's second banana status may be nearing an end.

WHO IS MATTHEW TANNIN?  

Matthew Tannin is a former Bear Stearns hedge fund manager.  He is one of two Bear Stearns employees the Justice Department is prosecuting for securities fraud charges. According to prosecutors, Tannin and co-defendant Ralph Cioffi misled investors about the risks, value, and future prospects of two Bear Stearns subprime hedge funds. The two funds collapsed in the summer of 2007.  

Tannin and Cioffi ran the now bankrupt funds for Bear Stearns.  The funds were highly leveraged, relying on massive collateralized credit facilities from other financial institutions to buy CDO's and other asset-backed securities.  The CDO's were packed with subprime mortgage-backed securities.  

After the housing bubble popped, Cioffi and Tannin allegedly began a long, egregious campaign of lies - to creditors and investors - in a misguided (and illegal) effort to save their funds.  The subprime mortgage market imploded soon after the end of the housing bubble.  Escalating Subprime mortgage defaults rose sharply, decimating the value of the CDO's owned by the Bear hedge funds. The funds' creditors demanded their money back.  By July 2007, with no liquidity and a huge stockpile of nearly worthless securities, both funds collapsed.  In August the funds declared bankruptcy. 

Many observers believe the Bear Stearns subprime fund failures ignited the subprime mortgage crisis, global credit crisis and, ultimately, the worst financial crisis since the Great Depression. Tannin and Cioffi were arrested in June 2008. 

Although much of the financial world is focused on the highly anticipated trial and star defendant Ralph Cioffi, defendant Matthew Tannin has, for the most part, has avoided the glare of the spotlight.  Even on Wall Street, the name Matthew Tannin is largely an unknown entity.  In many cases, people recognize Tannin's name but fail to associate the name with the failed Bear Stearns hedge funds, with Ralph Cioffi, or with the imminent "Bear Stearns" criminal trial.  

Part of the reason Tannin has thus far lurked in the shadow of Ralph Cioffi is that Cioffi casts a long shadow.  Cioffi, who liked to collect expensive Italian sports cars, is by far the flashier of the two.  He also was Tannin's boss and the man who created Bear's subprime hedge funds in the first place.  By the peak of the housing bubble, Ralph Cioffi had a high profile on Wall Street.   Matthew Tannin was largely unknown.

When the two men were arrested, Ralph Cioffi garnered most of the headlines.  The majority of the "cuff shot" photos in newspapers, magazines and on the internet were pictures of Cioffi, not Tannin. Finally, by the time of the arrests in the summer of 2008, Cioffi was already somewhat of a pariah on Wall Street. The failed funds were Cioffi's babies.  

Columnists for The New York Times and The Wall Street Journal have stated that the implosion of Cioffi's subprime hedge funds sent Bear Stearns into a death spiral from which the investment bank never recovered.  The widely perceived connection between Bear's hedge fund fiasco and the company's failure nine months later further added to Ralph Cioffi's notoriety in Wall Street circles. 

And so, Matthew Tannin has largely escaped much of the limelight.  His E-diary just might change all of that... 

THE E-DIARY and THE MEDICATIONS   

It seems that Matthew Tannin kept an online diary that contains some interesting revelations. For example, Tannin's diary reveals that, as far back as the summer of 2006, he was very worried about the "blow up risk" of the subprime hedge funds he helped manage. 

Tannin's diary also shows that his concern about the funds was so severe that Tannin suffered from severe anxiety, insomnia and bouts of depression.  In the e-diary Tannin wrote:

"This all hit me like a ton of bricks... and the first result -- almost immediately -- was for me to lose my ability to sleep. Classic anxiety. I could not sleep. I would wake up an hour or two after going to be[d]...My mind would be focused on all of the things that I had not done and all of the things that could have gone wrong."

The diary also reveals that - roughly a year before Matthew Tannin's worst fears were realized when the Bear Stearns hedge funds collapsed - Matthew Tannin turned to medication to address his anxiety, insomnia, and depression.  His doctor prescribed Lorazepam to ease tension and help Tannin sleep.  Tannin also started taking Wellbutrin, a popular antidepressant. 

After the psychiatric medications stabilized his mood, Tannin wrote more about the pain he had suffered:

"I was incredibly stressed. It is a strange thing to be sitting here now (albeit on Wellbutrin) and reflect back about the stress. . . .Spreads are tight and credit is deteriorating. I was worried that this would all end badly..."

Tannin was, of course, right to worry.  He knew things would go wrong by mid-2006 (at the very latest).  And if Matthew Tannin saw the handwriting on the wall regarding the disastrous fate of the Bear subprime hedge funds, you can bet that MBS experts like former Bear Stearns co-President Warren Spector saw the same handwriting on the same wall. 

By Brett Sherman, The Sherman Law Firm

Bear Stearns Hedge Fund Trial Looms

The views expressed in reprinted articles do not necessarily represent the views of WSLB

Thanks Clusterstock 

Wall Street Braces For Trial Of Two Bear Stearns Hedge Fund Managers

Lawrence Delevingne|Sep. 21, 2009, 12:12 PM |

For Wall Street, it's the most important trial of the year.

Next month, ex-Bear Stearns employees Ralph Cioffi and Matthew Tannin will be in federal court, facing up to 20 years in prison for fraud and conspiracy. Cioffi could see another 20 for insider trading.

The only major criminal prosecution stemming from the financial crisis so far, it's technically about failed hedge funds that were an early harbinger of the storied firm's collapse and the broader economic downturn.

But more generally, the fine line between salesmanship and fraud will be on trial.

Crain's: Their trial promises to be a landmark event, since these were the first investment bankers indicted for alleged crimes contributing to the Wall Street cataclysm. Convictions would give the government a boost as it pursues similar cases against former officials of Lehman Brothers and American International Group.

“This case will be looked to by the defense bar and the Wall Street community as a measure of whether the government can prove allegations of fraud in the context of the financial meltdown,” says William Johnson, a former federal prosecutor in Manhattan and now a partner at Fried Frank Harris Shriver & Jacobson.

The trial has Wall Street's attention for another reason: The optimism that Messrs. Cioffi and Tannin displayed as their funds collapsed is in the DNA of every salesman.

The prosecution will point out inconsistancies between optimistic public pronouncements on the funds' performance and pessimistic internal emails. For example:

On Feb. 27, Mr. Tannin persuaded Barclays to invest $100 million by telling its bankers that the Enhanced Leverage Fund actually gained 4.3% that month, which he called the fund's “best month ever,” according to court documents. A week later, Mr. Cioffi assembled his staff and announced that the month's decline in performance meant “we have an awesome opportunity.”

Behind the scenes, however, the talk was grim.

“Matt said it's either a meltdown or the greatest buying opportunity ever,” Mr. Cioffi e-mailed a colleague on March 15. “I'm leaning more towards the former.”

The defense will counter that the messages are taken out of context or that they don't reflect Cioffi or Tannin's true thoughts or intentions (we've written about that possible exaggeration).

It seems a stretch for prosecutors to pin criminal charges on ambiguous emails. And the precedent could be dangerous. We want fund managers to have open and free exchanges in which they debate market outcomes, which are always and everywhere uncertain. Punishing managers for having doubts about strategies threatens to stymie discussion or drive it off any recordable medium.

One question that occurs to us: if Cioffi and Tannin really believed they were lying or defauding their investors, would they have emailed their doubts? This seems absurd given that emails have routinely been used to mount prosecutions and investigations since the dotcom bubble burst. In our eyes, the fact that these emails exist in some ways suggests that Cioffi and Tannin were true believers rather than cheats.