Bear Stearns: a fight over the corpse

A civil suit in Atlanta may hurt the U.S. attorney's case against rogue traders Ralph Cioffi and Matthew Tannin.

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By William D. Cohan, contributor

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NEW YORK (Fortune) -- The federal criminal trial of former Bear Stearns hedge-fund managers Ralph Cioffi and Matthew Tannin, which is set to begin in Brooklyn in September, has been expected to be a kind of template for coming Wall Street prosecutions. But the model case is already getting messy.

The latest bout pits the U.S. attorney in the Eastern District of New York against FINRA, the Financial Industry Regulatory Authority. Lurking in the background of this intra-agency spat is JPMorgan Chase (JPM, Fortune 500), which acquired Bear Stearns in the spring of 2008 and took on some of Bear's liabilities as part of the deal.

Last June, the U.S Attorney's office indicted Cioffi and Tannin on charges of conspiracy, securities fraud and wire fraud. (In Cioffi's case, insider trading as well.) Before the criminal indictment was handed up, FINRA entered the mix when an aggrieved corporate investor in the hedge funds sought to get back some of the money that Cioffi and Tannin allegedly vaporized.

The investor, Racetrac Petroleum, an Atlanta-based chain of more than 525 retail gasoline convenience stores in the southeast U.S. and a longtime Bear client, lost its entire $5 million investment in the hedge funds when the two funds collapsed in the summer of 2007. (For more on the collapse of the funds, check out "The secret history of Bear Stearns collapse.")

Originally Bear offered Racetrac one-third of its money back as part of somewhat arbitrary bi-lateral settlements the firm offered investors depending on when they invested in the hedge funds. The earliest investors, like Racetrac, were offered a smaller settlement than the later investors. Unhappy with Bear's settlement offer, Racetrac sought its only legal recourse: the FINRA arbitration. The arbitration is scheduled to begin March 17, six months before the criminal trial.

Cioffi and Tannin's criminal defense teams most likely view the FINRA arbitration as manna from heaven, while JPMorgan Chase's lawyers probably view it as a major headache. The reason? In a criminal trial, prosecutors have a lot of control over discovery. But if the FINRA arbitration were to occur before the start of the criminal trial, a whole slew of Bear Stearns alumni could be deposed.

Cioffi and Tannin's criminal defense attorneys could then use this civil testimony to show that the hedge fund traders were not rogue agents but products of a corporate culture that rewarded risk-taking, not risk-management. So FINRA could potentially open up JPMorgan Chase to legal costs and litigation as more and more of Bear Stearns alumni are called to testify and more and more former Bear Stearns hedge-fund clients might be emboldened to sue JPMorgan Chase.

Facing that prospect, assistant U.S. Attorney Patrick Sinclair asked the three arbitrators in the FINRA case to delay the start of the arbitration proceeding until after the conclusion of the criminal proceeding against Cioffi and Tannin. Sinclair's legal tactic to seek a delay of the civil proceeding until the criminal proceeding has concluded is not terribly unusual, legal experts say, because "what's called an 'adverse inference' could be taken based on the testimony in the civil case," explains John C. Coffee, the Adolph A. Berle professor of law at Columbia University. "And that is why the U.S. attorney would be seeking the delay."

For instance, if Cioffi were to testify in the arbitration that he acted with the approval of his boss and his boss' boss, then JPMorgan Chase may find itself on the losing end of a bunch more arbitrations from hedge fund investors, to say nothing of how a jury in a criminal trial would react to hearing that information. Better to just let the criminal proceeding happen first, the thinking goes, than to allow the defense to obtain any of the potentially valuable testimony or documents that it would not get ordinarily.

(Barry Berke, the partner at Kramer Levin who is representing Bear Stearns Asset Management and JPMorgan Chase in the Racetrac arbitration, declined to comment, as did his client. Racetrac officials could not be reached for comment, and Patrick Sinclair refused to comment.)

Often the prosecutors of the criminal case get their way in these circumstances, but in this case, there was a twist. The arbitrators told Sinclair they would not put the case off and said they intended to proceed on the March schedule. "What's unusual here is that the arbitrators decided to go ahead with the case in March when the trial begins in September," said Coffee, who is not involved in any aspect of the matter. "That is a bit of a surprise."

It is unlikely that prosecutor Sinclair will take no for an answer. According to legal experts, his other options at this point to prevent the arbitration from starting in two weeks would be to put pressure on more senior FINRA executives to stay the arbitration or to file a motion in federal court in Atlanta asking a federal judge to stay the matter. Such a filing would, of course, make the dispute a matter of public record, which to this point it has not been. JPMorgan Chase, the defendant in the arbitration, would be expected to support the U.S. attorney's effort to stay the arbitration.

Talkback: Who's the blame for Bear Stearns's collapse?

William Cohan is the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, to be published in March, 2009 by Doubleday Books, a division of Random House, Inc.  To top of page

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