Business Failures Are Not a Crime

By Robert A. Mintz
Friday, June 26, 2008

Anyone surprised by last week's arrest of two former Bear Stearns hedge fund managers must have slept through the Enron era. If Enron, WorldCom, Tyco – and the list goes on – taught us anything, it is that whenever the investing public suffers staggering losses on Wall Street, we can expect to see someone hauled off in handcuffs. The real question is not why it happened, but where it will end.

Despite the complex nature of the subprime meltdown, the government has presented an indictment that reads very much like a garden-variety fraud. In essence, the case turns on the simple proposition that Ralph Cioffi and Matthew Tannin lied to their investors about their funds' true status and prospects. That is, the government has alleged that they were telling the outside investing public one thing, while secretly harboring a far gloomier scenario.

There is no question that at some point permissible spin crosses the line and becomes willful misrepresentation. That is really what this prosecution is all about. In making its case, the government weaves together a series of emails that paint a portrait of once high-flying fund managers scrambling to save their careers, and trying to keep their funds afloat, by knowingly misleading their investors.

The indictment quotes Mr. Cioffi emailing a Bear Stearns colleague: "I'm fearful of these markets. Matt [Tannin] said it's either a melt down or the greatest buying opportunity ever, I'm leaning more towards the former. . . ." Mr. Tannin is quoted emailing Mr. Cioffi at one point urging that the funds be closed down and telling him, "if [the CDO report] is correct then the entire subprime market is toast." Several days later, according to the indictment, Mr. Tannin told investors, "we're very comfortable with exactly where we are. . . ."

Even more damning from the prosecutors' perspective is the allegation that Mr. Cioffi pulled his own money out, without disclosing it to investors, while at the same time encouraging others to pump more money into the funds. All of these alleged misrepresentations go to the question of intent – whether the statements made by Messrs. Cioffi and Tannin to their investors were knowingly false – and form the basis of the charges of securities fraud, wire fraud and insider trading.

But this case also raises the more troubling question of whether all of Wall Street's ills can – or should – be reduced to criminal prosecutions, rather than leaving it up to appropriate financial regulators to fight it out in the civil arena. Put another way, are we attempting to criminalize conduct primarily based upon the fact that we now know that the investing decisions led to a disastrous end?

Let's put this case in some perspective. This is not Enron, where executives were charged and ultimately convicted of cooking the books. Nor is it Tyco, a case in which the CEO was convicted of using corporate assets for his own personal gain. Rather, this is part of a much larger failure that extends well beyond these two defendants and their former employer to include many of our largest financial institutions.

This indictment, like all indictments, benefits from the wisdom of 20/20 hindsight. We all know how the story ends, and it isn't pretty. But these two hedge fund managers were not alone in reaping huge profits for years from the subprime market. Nor were they alone in understanding the fundamentally risky nature of investments that relied so heavily on the misguided expectation of perpetual real estate appreciation. True, it is clear that at some point they feared, and perhaps believed, that a meltdown was imminent, but so did many others. High yields have always been associated with high risk.

Unfortunately, these two were among the first to see their funds implode and that, perhaps more than any other reason, is why they now find themselves facing the prospect of significant jail time.

Lying to the investing public is a serious breach that cannot be condoned if we are to maintain the integrity of our markets, and we will ultimately find out if that's what happened here. But it is all too tempting for the government to ride in after a colossal collapse that many should have seen coming and look for someone to blame, when clearly there's plenty of blame to go around.