The U.S. Vs. Cioffi& Tannin: A Curtain Raiser : Forbes.com

The first criminal trial stemming from the subprime mortgage crisis will begin on Oct. 12 as former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin go on trial for securities fraud in federal court in Brooklyn, N.Y. The two were indicted a year ago on charges that they lied to investors and that at least one of them participated in insider trading. Many experts argue that this ultimately led to the collapse of Bear Stearns and the near meltdown of Wall Street.

On a number of levels, this case has significant implications for future criminal prosecutions on Wall Street.

First, this represents one of the first cases involving criminal charges that could result in hedge fund managers going to jail for losing sophisticated, high-net-worth investors’ money. Typically, only civil claims seeking monetary damages are filed.

Second, this is the first criminal prosecution relating to the near Wall Street meltdown, thus making it a proxy for indictments to come. Already, reports are surfacing that the government may bring charges against Joseph Cassano, head of AIG’s Financial Products unit, as well as senior executives at Lehman Brothers.

The government’s case hinges upon its ability to prove that the defendants knew of an impending implosion of the subprime market, yet deceived investors with a different–much more positive–story. The defense will argue that the subprime meltdown was not predictable and the defendants were caught unprepared just like many others on Wall Street.

A significant piece of evidence for the prosecution is a series of e-mails between Cioffi’s Gmail account and Tannin’s wife’s e-mail account stating that “the subprime market looks pretty damn ugly … If we believe the [CDO’s report is] ANYWHERE CLOSE to accurate I think we should close the funds now. The reason for this is that if [the CDO report] is correct then the entire subprime market is toast.

The two hedge fund managers then held an investor conference call on which they spun a completely different story. Tannin reportedly told investors on the call that “we’re comfortable with exactly where we are,” and that, “it really is a matter of whether one believes that careful credit analysis makes a difference, or whether you think that this is just one big disaster. And there’s no basis for thinking this is one big disaster.”

One cannot help but recall that e-mails led to the demise of Henry Blodget, the tech analyst who produced bogus research so that his employer, Merrill Lynch, could win investment banking business. The major difference in the Bear Stearns hedge fund case is that the e-mails were sent suspiciously from e-mail addresses outside of Bear Stearns’ purview.

Another major allegation is that Cioffi withdrew $2 million of his own money out of the fund because he was privy to insider information. The timing of the alleged insider sale is very important. According to the indictment, “on April 17, 2007, Cioffi allegedly met with one of the three largest investors in the funds. The investor, named Major Investor No. 1 in the indictment, allegedly told Cioffi that it was considering redeeming its approximately $57 million investment. In response, Cioffi allegedly told the investor that he and other portfolio managers had $8 million invested in the funds, while failing to inform the investor that he had recently withdrawn $2 million of his approximately $6 million investment in one of the funds.”

Prosecutors will allege that Cioffi’s motive was that his personal financial situation had significantly deteriorated due to a failing real estate investment deal and an extremely lavish lifestyle. Reportedly Cioffi had several vintage Ferrari’s, a multimillion-dollar beach house in the Hamptons and several country club memberships.

Here again, a previously established pattern emerges. It was Dennis Kozlowski’s lifestyle that eventually led to his conviction and 25-year jail term. The defense will likely ask the judge to not allow Cioffi’s personal spending to be discussed in the case, as it could prejudice the jury against him.

One significant development is a recent filing from the U.S. attorney’s office alleging that they have “direct evidence” of Cioffi’s wrongdoing. According to The Wall Street Journal, prosecutors said Cioffi fraudulently pledged assets in the hedge fund he ran as collateral for a real estate loan from Busey Bank. Executives at Bear Stearns Asset Management, the division that housed the fund, told prosecutors they denied Cioffi’s request to pledge part of his assets for the loan because it could create a “conflict of interest with other clients in the fund.”

This is important because the government will likely assert that the deterioration of the hedge fund’s assets led Cioffi to withdraw the $2 million and not the deterioration of his personal financial situation. Cryptically, the defense has proposed there is an innocent explanation for the withdrawal and loan issues.

And finally, there is the matter of a missing notebook and tablet PC that prosecutors allege included important evidence. The judge has not decided on whether the prosecution will be allowed to discuss this issue because it’s not part of the criminal charges.

Clearly this case has many complexities. Prosecutors must prove both fraud and intent. By the same token, there is a mountain of evidence for the defense to overcome in order to create a reasonable doubt in jurors’ minds.

The stakes are extremely high. Messieurs Cioffi and Tannin face a maximum penalty of 20 years in jail. This is the first case of its kind and, as such, will set the tone for how criminal cases involving securities fraud will be tried.

Needless to say, there will be a lot of other former Masters of Wall Street paying close attention as the trial moves forward.

Jacob H. Zamansky is a principal at the firm Zamansky LLC. He is representing individual investors in claims against Bear Stearns and the firm’s High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Enhanced Leveraged Fund.