By Matthew Goldstein and David Henry
Former Bear Stearns executives Ralph Cioffi and Matthew Tannin were indicted on federal securities fraud charges on June 18, almost a year after the two giant hedge funds they managed collapsed. The much-anticipated indictment is the first set of high-profile criminal charges to emerge from the meltdown in the market for sophisticated securities backed by subprime-mortgages.
Prosecutors allege that Cioffi and Tannin misled investors and other Wall Street investment firms about the precarious condition of the hedge funds’ financial health, in a bid to save their professional reputations, jobs and personal investments. Lawyers for the two men say the charges against their clients are misguided, and they intend to fight them. “We are shocked and disappointed that the government has seen fit to fix blame on these two decent men,” said Ed Little, Cioffi’s lawyer. “We look forward to the day they will be vindicated.”
To read the indictment, click here.
Cioffi, 52, and Tannin, 46, were arrested early June 19 at their respective homes and taken to the Brooklyn federal court house for arraignment on the nine-count indictment. The Securities and Exchange Commission also filed civil fraud charges against the men. Law enforcement authorities, at a joint press conference, hailed the indictment and regulatory charges as a signal to all of Wall Street that hedge fund managers will be called to account for lies and deceptions to investors—no matter how wealthy or sophisticated. “This is not about mismanaging a hedge fund strategy,’’ said Mark Mershon, assistant director-in-charge of the Federal Bureau of Investigation’s New York office. “This is about prostituting clients’ trust.’’
Some outside legal observers said the case is by no means a slam dunk for prosecutors. “The government has criminalized conduct which should be resolved in a civil arena,’’ said defense lawyer and former prosecutor Michael Bachner. “This is at best a case of negligence not fraud.’’
The hedge fund managers’ downfall, according to the 28-page indictment, all began with a vodka toast more than a year ago. The indictment alleges that after downing the shots on March 2, 2007, Cioffi directed Tannin and two other hedge fund employees to maintain a stony silence about the funds’ “difficulties,” even with “other members of the funds’ team.” The group was celebrating after staving off a near collapse of the funds in February.
In the weeks following that toast, prosecutors allege Cioffi and Tannin engaged in a series of misrepresentations to investors and big Wall Street banks that lent billions of dollars to the once mighty Bear funds, which were one of the biggest owners of securities backed by subprime mortgages. “Rather than disclosing the true state of the funds to investors and lenders, thus allowing an orderly wind-down,” authorities allege that Cioffi and Tannin engaged in a pattern of deception and actively encouraged investors to sink new money into the ailing funds. Ironically one of the pieces of evidence authorities plan to use against the men is a private email message from Tannin to Cioffi, in which Tannin describes the fund as being “toast.’’
The indictment and SEC lawsuit describe the two men telling lie after lie. They were so persuasive that they managed to convince supposedly sophisticated investors—including wealthy individuals and financial institutions—to pump more money into the dying funds. Tannin even expressed a bit of astonishment at his ability to get investors to cough-up more money as the first signs of trouble in the mortgage market began to flare-up in the spring of 2007. “Believe it or not, I’ve been able to convince people to add more money,’’ he wrote in a March email.
But the alleged misrepresentations only delayed the inevitable. The funds collapsed in late June, wiping out $1.6 billion in investor money, prompting a fire sale of nearly $30 billion in mortgage-related securities, and sparking a global credit crunch that has led to $400 billion in bank write-downs. In an ironic twist, the credit crunch’s biggest victim was Bear itself, which was forced to sell itself to JPMorgan Chase (JPM) in March in a deal orchestrated by the Federal Reserve. Like the hedge funds, Bear too was heavily invested in exotic securities backed by failing home loans and had too little cash on hand to pay creditors and investors.
Prosecutors allege that while Cioffi and Tannin were outwardly telling investors not to worry about the problems in the broader housing market, they were saying something quite different in emails and private conversations. Privately, the two men were scared, almost panicking, that the giant hedge funds were about to fail. In an email sent by Tannin to Cioffi on April 22, he wrote “we’re in bad bad shape.” A few days later, during an investor call on April 25, Tannin and Cioffi both said the funds were doing well and would survive the mortgage crisis.
The indictment also alleges the two men concealed the fact that one of the largest investors in the hedge funds wanted out and sought to withdraw some $57 million in April. Authorities say the pair repeatedly told investors to put more money into the fund and withheld information about redemption requests. Tannin allegedly told investors on more than occasion that he was putting more of his own money into the funds, even though he never did. On May 3, Tannin told one of the hedge funds’ bank lenders he doesn’t anticipate any large redemptions.
Cioffi, meanwhile, never disclosed that on March 23, 2007, he began moving $2 million of the $6 million he had personally invested in the funds into a better performing Bear-managed hedge fund. The $2 million was transferred to the Bear Structured Risk Partner funds, which at the time was performing relatively well. Prosecutors charged Cioffi with insider trading for moving the money out of the two funds he managed and not being honest with his superiors at Bear for the reasons for the money transfer.
The pair also didn’t disclose that a Bear committee for pricing hard-to-value securities had rejected the more optimistic valuations Cioffi and his team were using in the months before the hedge funds failed. The indictment says that “when challenged by the [Bear] Pricing Committee as to the basis for using the higher values…Cioffi was unable to produce any evidence supporting his alternative pricing method.”
The indictment against Cioffi and Tannin is the result of a nearly yearlong investigation that began after the Bear funds collapse in June 2007. Sources say the investigation is continuing and additional criminal charges may follow. In the aftermath of the funds’ collapse, Bear and the hedge funds managers were hit with a wave of class-action suits and arbitrations. In the weeks before JPMorgan completed its acquisition of Bear, the investment firm settled a number of arbitration claims; in particular claims filed by some of Bear’s own wealthy retail brokerage customers.
But Bear still faces many unresolved legal claims. In taking over Bear, JPMorgan set aside several billion dollars to cover the cost of settling claims with some of the hedge funds’ investors. One unresolved claims stems from a lawsuit filed by Barclays, which sunk nearly $400 million into one of the hedge funds. Barclays was the main provider of leverage or borrowed money to that fund and the British-based banks claims it too was lied to by Cioffi and Tannin. Ross Intelisano, an attorney who represents a number of hedge fund investors, says: “These are the first criminal indictments related to the subprime debacle and it’s fitting that Cioffi and Tannin who helped trigger the crisis are the first ones indicted.”