Payback time for Wall Street (pg. 2)

So prosecutors will keep it simple. "The kinds of things that get our attention," says Benton Campbell, the U.S. Attorney for the Eastern District of New York, in an interview, "are fundamentally very familiar: lying, cheating, and stealing."

Let's start with lying, which brings us back to those earnings conferences that executives face every three months, the handling of which gets trickier as the company's prospects get dicier.

The poster boy for criminally false upbeat statements during a crisis is Ken Lay, the founder and chairman of Enron. Lay resumed control of the company late in the game, after Skilling abruptly resigned as CEO in August 2001, less than four months before Enron's bankruptcy filing, when the company's goose was already pretty well cooked. Lay was convicted almost exclusively for his preposterous happy talk during those final days: "The balance sheet is strong." "The third quarter is looking great." "Enron stock is an incredible bargain at current prices." (Lay's convictions were overturned automatically when he died before his appeal could be heard.)"

Though a jury found that Lay crossed the line, lawyers disagree about where that line is. If you ask a class-action lawyer, he'll tell you it's not a complicated issue. "When you speak, you need to tell the whole truth," says Gerald Silk of Bernstein Litowitz Berger & Grossmann.

But if you ask a lawyer who advises corporations, you'll get a very different answer. "The reality is, you've put your finger on one of the most difficult situations that will come up in counseling executives of corporations," says one who does that for a living and insists on anonymity. "You can't lie," he says. "You're trapped between serving the best interests of shareholders and the legal requirement not to lie. You need to thread the needle." (Now you see why he wants anonymity.)"

Continuing down U.S. Attorney Campbell's list of sins, after lying we come to cheating and stealing, rubrics that comfortably embrace insider trading, another crime that's easy for jurors to understand. Though Lay wasn't charged with insider trading, prosecutors did highlight that he had been, without disclosure, selling $24 million of his Enron stock at the same time he was urging investors and employees to buy. Yes, the sales were "involuntary" in that they were required to meet margin calls, but the government does not consider such sales as fundamentally different from any others. They are still voluntary in the sense that the investor could theoretically post cash or other collateral if he really wanted to keep the stock badly enough. The SEC is, in fact, currently scrutinizing whether certain CEOs made margin-call sales of company stock without disclosing inside information, according to a person in a position to know.

In addition, once prosecutors subpoena documents and e-mails from a company, they may stumble across other easy-to-prove crimes - "pickoffs," one former prosecutor calls them. (Lay was convicted, for instance, of four felonies for having used personal bank loans, which he paid back on time, for purposes the banks hadn't anticipated - a transgression not known to have ever been prosecuted criminally before then.) An easy-to-prove standby charge is obstruction of justice, if the target is believed to have destroyed documents or lied to investigators. (Think of tech bubble inflater Frank Quattrone, Enron enabler Arthur Andersen, or ImClone stock dumper Martha Stewart. Quattrone's and Arthur Andersen's convictions were overturned on appeal, but each defendant had suffered plenty by then.)"

Finally, there is at least one criminal investigation underway that does not concern either executives' questionable statements or insider trading. Attorney general Cuomo and the Manhattan U.S. Attorney's office have publicly announced that they are working jointly on a broad inquiry into allegedly manipulative or fictitious trading in credit default swaps. Based on the documents being sought, prosecutors appear to hypothesize that short-sellers, perhaps with assistance from bank or brokerage officials, faked trades in these instruments to artificially signal to the market widespread panic over a company's condition when, in fact, such sentiments had not existed before the manipulative trading itself.

What follows is an overview of some of the companies that prosecutors are known to be looking at and some of the likely problem areas relating to each. In most cases, the questionable statements highlighted here have already become the focus of civil shareholder suits alleging fraud.

A likely template for the prosecutions to come was set last June, with the indictment of Ralph Cioffi and Matthew Tannin, the founder and portfolio manager, respectively, of two Bear Stearns hedge funds that had collapsed 12 months earlier. (Cioffi and Tannin have pleaded not guilty, and their attorneys declined to comment on the case.)"

Cioffi and Tannin lost $1.4 billion of their clients' money by making the bad business decision to invest it in a highly leveraged portfolio of instruments called CDO-squareds, which were backed in part by subprime mortgages. But losing money is not a crime. Cioffi and Tannin were charged with making false statements in the final months of the funds' demise. The indictment alleges, for instance, gaping discrepancies between the men's reassuring public statements to investors (e.g., "We're very comfortable with exactly where we are," on April 25, 2007) and their despairing private e-mails days earlier (e.g., "If we believe the [internal report is] A NYWHERE CLOSE to accurate I think we should close the funds now," on April 22, 2007)

Nevertheless, many observers of the Bear Stearns prosecution are skeptical that the charges will hold up when the e-mails are presented in context. People change their minds rapidly and radically during any crisis, as they consult others and learn additional facts. These observers are even more dubious that the funds' investors were in the dark about risk. Cioffi and Tannin ran a hedge fund, after all, meaning that their investors had to be, by law, supersophisticated.

Plaintiffs class-action lawyers claim that Bear's problems should not end there. Two months after the hedge funds collapsed, CEO James E. Cayne assured investors that "the balance sheet, capital base, and liquidity profile have never been stronger. Bear Stearns' risk exposures to high-profile sectors are moderate and well controlled." Seven months later the company sought emergency funding from the Federal Reserve and was quickly sold to J.P. Morgan Chase (JPM, Fortune 500).

Of course, as the world has seen, a lot can change in seven months, so it will be hard to prove that Cayne did not believe what he was saying. A tougher case is presented by his successor, Alan Schwartz, who was saying much the same thing as late as the morning of March 12, 2008, just 36 hours before seeking emergency funding. "Our liquidity and balance sheet are strong," Schwartz told CNBC's David Faber. "We don't see any pressure on our liquidity, let alone a liquidity crisis."

Although federal prosecutors in Brooklyn were asking some questions immediately after the company's collapse, there does not appear to be any active criminal inquiry. Counsel for Schwartz declined to comment, as did U.S. Attorney Campbell.

NEXT: Payback time for Wall Street (pg. 3)

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