The case against ex-Bear execs
Two hedge fund managers brazenly misled investors as their funds imploded, prosecutors say.
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| Former Bear Stearns hedge fund managers Ralph Cioffi (right) and Matthew Tannin surrendered Thursday to the FBI. |
NEW YORK (Fortune) -- Ex-Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin promised investors steady returns. What they delivered, according to prosecutors, was a steady stream of lies.
Cioffi and Tannin were indicted Thursday on federal charges tied to last summer's collapse of two funds that had made outsized bets on mortgage-backed securities. Investors ended up losing $1.4 billion when the funds, which had borrowed billions of dollars to place bets on the subprime market, filed for bankruptcy protection last July.
Both men were charged in federal court in Brooklyn with conspiracy, securities fraud and wire fraud, in an alleged plot to mislead investors about the funds' health. Cioffi faces one additional count of insider trading, tied to his decision to move some of his own money out of one of the funds as its returns were souring.
Lawyers for the men said in a statement Thursday that the government is trying to make their clients scapegoats for the subprime mess, which they note has led to hundreds of billions of dollars of losses at financial firms, and management changes at numerous Wall Street firms.
"Because his funds were the first to lose might make him an easy target but doesn't mean he did anything wrong," said Cioffi lawyer Ed Little. "Indeed, Mr. Cioffi had no motive to do anything wrong. He did not and could not have profited by doing anything the government now claims he did." Susan Brune, attorney for Tannin, said her client "looks forward to his acquittal."
The indictment alleges that Cioffi's and Tannin's conduct went far beyond bad investing. It lays out a brazen conspiracy to keep investors from fleeing the fast-sinking funds.
"The first thing I thought of was Enron," says Todd Harrison, a former U.S. attorney who is now a partner with Patton Boggs.
He says the allegation that Cioffi was reducing his stake in the fast-deteriorating funds without telling investors reminds him of the case against the late Ken Lay, the former chief of Enron. He was accused of having sold his stock in the company while telling employees, investors and others that they should support Enron by holding onto their own stock.
Lay was convicted of securities and wire fraud following Enron's 2001 collapse, but the decision was vacated after he died while his case was on appeal.
Prosecutors made clear Thursday that they believe Cioffi and Tannin misled investors, but that they don't hold the men responsible for the collapse of corporate parent Bear Stearns.
Reports of trouble at the High Grade Structured Credit Strategies and High Grade Structured Credit Strategies Enhanced funds emerged in the press last June. But Cioffi and Tannin were privately concerned about the financial health of the funds as early as February 2007, when the first cracks in the mortgage markets appeared with news of big losses at subprime lenders such as HSBC (HBC)'s Household Finance and New Century Financial, the indictment says. Prosecutors in the U.S. attorney's office in Brooklyn allege the following course of events:
The funds suffered their first-ever monthly losses in February. But Cioffi was happy enough about the fund's performance in a difficult month that he celebrated with a vodka toast with his colleagues March 2.
The heady feelings didn't last, though. By the end of March, the funds' performance had deteriorated further, prompting Cioffi to tell a member of his investing team that "I'm sick to my stomach over our performance," according to the government.
By then, prosecutors say, Cioffi was warning members of his team that the funds needed to raise cash to meet margin calls, or demands by lenders that the funds post additional collateral to secure loans.
Yet even as Cioffi and Tannin were battening down the hatches for an intensifying credit storm, they were telling investors that their best times were ahead, prosecutors allege.
Tannin told investors in the fund that he saw great "buying opportunities" and was adding to his investment in the funds, the indictment states. Yet Tannin never added to his position in the funds, prosecutors say, and Cioffi actually withdrew $2 million - representing a third of his stake in the funds - in the latter half of March, a fact he didn't disclose to investors.
As time passed, the mortgage market came under even more stress and the funds' investments declined even more sharply. Cioffi and Tannin discussed potentially shutting the funds down or changing their investment strategies, prosecutors say.
It was at this point, in mid-April, that Tannin told Cioffi in an email that if Bear Stearns' extremely dour assessment of the subprime mortgage market was correct, "we should close the funds down now" because "the entire subprime market is toast," the government alleges.
Contrary to that closely held assessment, however, Cioffi and Tannin continued to tell their investors and even their bosses at Bear Stearns Asset Management that they were confident the funds were in good shape, prosecutors said. The men also insisted to investors and lenders that they weren't receiving requests from fund investors to pull their funds - so-called redemption requests.
At least two major investors in the funds and numerous smaller investors had asked to withdraw their money by early May, prosecutors allege. Yet Tannin told a lender to the funds at that time that the funds anticipated no large redemptions, the indictment states. Prosecutors paint a picture of the increasing desperation felt by Cioffi and Tannin as the funds' performance worsened each month.
In May, confronting a 19% April loss in the more leveraged Enhanced fund, Cioffi asked Bear Stearns' internal pricing committee to use higher marks for some of the funds' assets. Those values, prosecutors said, would have allowed the fund to show a loss for April of just 6.5%. But when asked by the pricing panel to document his claims, Cioffi "was unable to produce any evidence supporting his alternative pricing method," the indictment states.
The endgame soon followed. In June, prosecutors said, investors in the funds were told they couldn't redeem their investments in either fund. The next month, the funds filed for bankruptcy, leaving investors with losses prosecutors helpfully estimated at 100 cents on the dollar.
While the case of the Bear Stearns funds is headed for resolution of sorts in a courtroom, former U.S. attorney Harrison says he believes we haven't seen the last of this sort of case. He notes that prosecutors have formed a task force to investigate subprime-related fraud cases. He also points out that since Enron's demise in late 2001, increased scrutiny and improved technology have made prosecuting financial misconduct cases easier.
Some of Cioffi and Tannin's alleged conduct may have made it tempting for prosecutors to zero in on them. Take their alleged efforts to mislead investors on conference calls, for instance. Harrison says the managers' apparent indiscretion is "amazing" in light of the practice at many firms of routinely recording such calls.
He also says Cioffi's decision to move money out of the High Grade funds at a time when their performance was declining "should have been a huge red flag" at the firm. Referring to the decision by officials at Bear Stearns Asset Management to sign off on that transfer, Harrison says, "I'm curious as to what their procedures were."
It would seem we're about to find out. 
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