Hold ’em or fold ’em Bear Stearns style

Former Bear Stearns hedge fund managers Ralph Cioffi and Martin Tannin were arrested yesterday at their homes in New Jersey and Manhattan, and charged by the U.S. Attorney’s office in Brooklyn with securities fraud in connection with the allegation that they lied to investors about the health and safety of their funds. The indictment alleges that even though they knew the market for securitized interests in subprime mortgages was in dire trouble, Cioffi and Tannin told investors that the funds were in good shape, excellent buying opportunities existed, and they themselves invested their own money in the funds and added to their positions. Meanwhile, the charges cite emails between the two saying the subprime market was “toast” and the funds were in deep trouble. Ostensibly, the managers failed to disclose to remaining investors that others had withdrawn significant amounts from the funds. Lawyers for both men have denounced the prosecution’s case. One of Cioffi’s lawyers, Edward Little, stated: “Because his funds were the first to lose might make him an easy target, but doesn’t mean he did anything wrong.”

The issue in this case will be the extent to which it is proper for an investment adviser to characterize risk in a positive way and encourage investment while still maintaining personal doubts about the viability of a particular market. This is not a case of premeditated fraud in which phony companies were set up and flat-out lies were told to investors. To what extent can an adviser remain upbeat in the face of a declining financial situation in the hope that things will come around or a downturn will present a real buying opportunity? The massive extent of the subprime failure was beyond anyone’s crystal ball capabilities to predict. Now, in order to give the appearance of punishing those responsible, federal prosecutors are bent on dissecting every move these beleaguered advisers made. As I told the Newark Star Ledger, this effort to clean up Dodge is misguided. CR

Subprime debut?

Kate Kelly reports in today’s Wall Street Journal that indictments appear to be near in the year-long investigation of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. It was the collapse of their funds in July 2007 that marked the beginning of the current credit crisis.

The probe by the Brooklyn U.S. Attorney’s office focuses on the management of two high-profile bond portfolios. The issue is whether Cioffi and Tannin misled investors in these portfolios by misrepresenting the status and safety of the investments, which were tied to the mortgage and credit markets. Around the same time that Cioffi told investors he was “cautiously optimistic” about the safety of the instruments, he was moving $2 million of his own money out of one of the troubled funds. Then these markets plummeted, igniting broad problems within the economy.

This case is being closely watched on Wall Street. If these indictments are obtained, they would represent the first charges against executives in connection with the subprime mortgage market meltdown. This might signal a willingness on the part of prosecutors to aggressively pursue more cases against individual executives in connection with the broad failures in mortgage-related securities.

A few months ago, Cioffi was said to be planning an aggressive defense. One potential avenue will certainly be the unexpected and massive nature of the subprime credit failure. How could anyone have predicted its breadth and power? Moreover, simply because a manager decides to move his own money, this does not make him a liar. Why can’t he be both “guardedly optimistic” as a matter of professional opinion and extraordinarily cautious with his own dough?

For more on the potential for individual prosecutions in the wake of the subprime mortgage crisis and the available defenses, there is an article in this month’s Corporate Counselor newsletter with my byline on it. I don’t claim to have a crystal ball, and I promise not to say I told you so if there is an indictment. CR

Primetime subprime.

The Wall Street Journal reported today that Ben Campbell, the United States Attorney for the Eastern District of New York in Brooklyn, has formed a task force of federal, state, and local agencies to deepen and extend the criminal division’s ongoing probe into various players in the subprime mortgage meltdown. Campbell told the Journal that the “jury is still out” on whether the sudden decline in the value of securities backed by bundles of subprime mortgage instruments is the result of criminal activity or just market forces, but the scope of this invigorated inquiry is broad. They will be looking at whether the crimes of mortgage fraud, securities fraud, insider trading, accounting fraud, and making false statements have been committed. Mortgage banks, brokers, lenders, investment banks, and hedge funds will be under the prosecutor’s microscope.

The newly formed task force had its first meeting on Friday and includes officials and agents from the FBI's financial-institutions fraud unit known as C3; the U.S. Postal Inspection Service, which investigates mail fraud; financial-crimes investigators from the U.S. Secret Service; and investigators and representatives of the New York State Banking Department, the New York City Department of Investigation, and the Federal Deposit Insurance Corportaion, a federal banking regulator.

It remains to be seen whether this inquiry – along with the many investigations being pursued by other local prosecutors and a potential central Justice Department task force –will yield numerous individual criminal prosecutions. But this ramped-up effort is certainly part of an unmistakable trend that potential targets must recognize. Individual mortgage brokers, bankers, closing attorneys, investment bankers, ratings agency executives, and anyone else involved in the subprime deal flow should take note. The inquiry is bound to intensify in the coming months. Given the losses suffered in the subprime debacle, the potential for significant criminal exposure to serious jail time is high. However, there are market-based explanations for much of what has occurred, and complex accounting and disclosure requirements may provide proof that there was a general lack of intent to defraud on the part of individuals involved.

In the comments to the Journal’s law blog post on the new task force, a reader asks, “Who will defend these companies? Most big law firms are conflicted.” Whether or that is the case, small, savvy firms like ours specialize in the representation of individuals. As the Journal blog post points out, the subprime mess has been called “the latest Full Employment Act for Lawyers.” Now we smaller firms may be seeing the “trickle-down” effect of what is becoming an increasingly larger supply side of companies and individuals in trouble. CR

What’s my task?

Attorney General Mukasey’s resistance to forming a task force to investigate the nation’s mortgage crisis is now being met with hostility even from within his own party. In a speech on the economy yesterday, presumptive Republican presidential nominee John McCain called for the DOJ to create a task force to investigate mortgage crimes.

Mukasey had expressed his reluctance to creating such a task force at a meeting with reporters on March 21, claiming it was premature. “In order to have a task force you need to identify the task,” he stated. “That is what we are doing now.”

There are currently numerous local FBI investigations into mortgage fraud, and local U.S. Attorneys have issued subpoenas to a number of investment banks regarding the packaging of loan bundles to sell to the investing public. However, while the DOJ is “figuring out whether there is a larger criminal story to be told here,” as Mukasey put it, there is no central coordination of efforts to probe what some are calling the worst national economic crisis since the Great Depression.

I appeared before Mukasey many times when he was a District Court judge here in Manhattan, and tried a complex white-collar fraud case to a jury in his courtroom. He is a smart, thoughtful, independent thinker, a no-nonsense, cut-to-the-chase kind of guy. You don’t have to be a rocket scientist to figure out what the task is here. Simply investigate the deal flow, just as you would with any systemic problem.

Central coordination by a DOJ task force would give focus to the numerous local investigations and serve to reassure the public that a dire problem is being addressed. The time for “figuring out” is over. It’s time to act now. CR

March mortgage fraud madness.

On Monday, federal prosecutors in California announced indictments of 19 people for fraud and conspiracy in connection with a phony mortgage bailout and rescue plan. Federal prosecutors claim that sales agents for the ring contacted homeowners through mailings, offering financial assistance to those near foreclosure. Agents steered them into a plan that called for owners to put an “investor” on the home’s title. The homeowner then paid “rent” to the investor in an amount smaller than the original mortgage payment. In reality, the government claims, the investor was an associate or family member of the ringleaders or someone recruited via the Internet. The confusing documentation gave the investor the right to replace the homeowner on the title. Finally, the equity was stripped from the home through a new mortgage. Prosecutors say more indictments are likely as they continue their investigation into brokers, loan officers, and banks that did business with the indicted individuals.

This new spate of indictments, involving mortgage deals in some 22 states, signals how serious the DOJ is about prosecuting the fallout from the subprime mortgage meltdown. Sharon Ormsby, chief of the FBI’s fraud section, says that in the wake of the credit crisis, straw buyers are out and foreclosure scams are in. It certainly seems to me as if the field of potential charges and individuals facing serious criminal exposure will dwarf the opening brackets of the seasonal basketball classic currently in progress. CR