The Obligation to Throw in the Towel

So, the shoe finally dropped on the two Bear Stearns executives who managed the two Bear hedge funds that imploded in mid-2007. A copy of the indictment is here.

As I read the indictment, the government is contending that Messrs. Cioffi and Tannin were required to disclose to investors immediately in February and March, 2007 that the two of them feared that the two funds might be “toast” even as Cioffi and other Bear executives were fighting market pessimism toward the funds and urging investors to maintain trust in their ultimate financial merit.

So, with their careers riding on whether the funds would survive, Cioffi and Tannin were supposed to throw in the towel and light a match to the funds by disclosing to the market their concerns about the heightened risk of a meltdown.

Stated simply, according to the Feds, about the time you think your trust-based business might be toast, it’s already too late. Inasmuch as you are required to disclose to the markets that you think the business might be toast, that disclosure will understandably prompt the market to lose trust in your business, which means that your company is kaput.

Thus, the smart thing to do is never to voice (and sure as heck don’t write any emails!) your concern to anyone regarding the downside risk of your business. That lack of communication might dampen internal company analysis regarding risk of loss, but what the hell — at least you won’t get indicted for misleading investors when your company fails.

Just another chapter in the twisted policy implications that result from regulating business through criminalizing businesspeople’s risk-taking. Larry Ribstein has typically insightful observations along the same lines, while Bess Levin muses over the Feds’ suggestion that investors didn’t know exactly what they were buying when investing in Bear’s funds.

16 thoughts on “The Obligation to Throw in the Towel

  1. Tom–I know this will drive you crazy but what the jury will decide is when does a pig becaome a hog here? If you are making more than $10 million a year at what point does an outright lie from a fiduciary become criminal? Materiality of course is a defense too. A circumstantial case to be sure, but little different from many others. Until WS restores a sense of proportion to “pigs and hogs” (or right and wrong) the idea that a hog gets slaughtered is somewhat hard to be too indignant over. Let’s see what the facts are at trial–and hope the system works–the jury will figure it out.

  2. Actually, I have no problem whatsoever with a trial in this case. It simply should be in civil one — where the true levels of responsibility for the alleged misrepresentations regarding the funds — can be allocated among defendants. Indeed, if the government’s allegations are true, there are many other executives at Bear who should “bear” some responsibility. However, allocating responsibility in a criminal trial in this type of case is akin to using a sledgehammer on a couple of patsies where a scalpel is more appropriate.

  3. With the caveat that I haven’t seen all of the government’s evidence, I think the government may have gone an indictment too far…
    Per the WSJ, while Tannin expressed doubts, he changed his tune after meeting with Cioffi. The $64 billion question: did this take place because they agreed to deceive the public (evidence of some kind that Tannin continued to express pessimism, in which case why wasn’t the existence of this evidence included in the story?) or because Tannin was convinced by Cioffi that he was overly pessimistic and, thus, wrong in his gloom and doom scenario? There’s no shortage of managers who have looked at something, thought the end was near, only to take a second look and realize that they had missed something; there’s something wrong if managers are unable to reverse a initial pessimistic outlook because of indictment if the reversal turns out in fact not to have been wise.
    As to your ‘throw in the towel’, whatever the merits of that as a indictment avoidance tactic, that wouldn’t apply until the principals were in fact convinced there was no hope. From what I’ve read, Cioffi remained optimistic, never thinking that the funds were close to ‘toast’, so why would he ever have thought about throwing in the towel and giving up on such upside potential?
    And along those lines, as to Tannin’s surprise that they were able to attract new money, that also could have a very innocent explanation: investors get more cautious in turbulent times and Tannin may just have been expressing surprise that there were still people not sitting on the investing sidelines, and not that he was able to con them, something akin to a real estate broker expressing surprise that there are still people buying houses today.
    Having said that, I have no problem with criminal charges against those who deceive the public. Civil charges aren’t sufficient for the likes of a boiler room operation, and if in fact Cioffi and Tannin were pushing investments they KNEW to be overvalued, then yes, they should face more than civil charges. What I object to is prosecution in cases where the so-called fraud is not clearly evident at the time and only materializes after a subsequent event (in this case, the collapse of the funds).

  4. Steve, I agree with much of what you say.
    What troubles me most here is that the DOJ is saying that Cioffi and Tannin’s failure to disclose Tannin’s initial reservations about the downside risk of the funds to investors is criminal fraud even though Cioffi and others disagreed with Tannin, and even Tannin apparently backed off his initial “toast” opinion for a time. Had Cioffi disclosed Tannin’s initial reservations to the market, that would have almost certainly ignited a death spiral for the trust-based funds despite any protestations that Tannin’s reservations were not shared by everyone at Bear. Thus, the lesson is don’t ever voice reservations — heck, don’t even examine — downside risk because if you have fail to disclose it, you’ve committed criminal fraud. That is simply not a coherent approach to regulating trust-based businesses.

  5. I think in all this worry about whether we’re being too hard on Cioffi and Tannin and how to make sure our pessimism or misgivings are not indictable, we’re forgetting one thing. These guys were fiduciaries and the securities laws are supposed to protect their investors. If they were withholding or falsifying information that investors in the funds should have, if their analyses was being suppressed, even by each other for self-interested purposes, then they have breached their fiduciary duties and the securities laws should have a remedy for investors for that. Is it criminal or civil? I will let the lawyers who know better the burden of proof in each case decide. But it sure looks to me like these two were looking out for only #1 during these events.

  6. “Tannin repeatedly told investors that he would add his own money to the funds, and didn’t, prosecutors said.”
    This hardly constitutes “disclosing to the market their concerns about the heightened risk of a meltdown.”

  7. But Charles, isn’t that the point? Tannin was attempting to buoy trust in the funds at a time when it was flagging. Perhaps Tannin intended to invest more of his own money in the funds when he made the statement to investors, but decided not to later as the funds continued to decline. Certainly, most investors didn’t believe what Cioffi and Tannin were saying to the market because the funds continued to erode. Are you saying that Cioffi and Tannin were under a legal duty not to attempt to save the funds?

  8. Tom –
    Tannin was under no duty to represent an intention to add his own money to the funds. The fact that he offered such a representation was material.
    Assuming prosecutors can establish the failure of Tannin to add his own money to the funds was based on his knowledge of the condition of the funds at the time he made his assertion, one could reasonably question Tannin’s motivation for representing he intended to make a personal investment in the funds yet failed to make the investment.
    Cioffi and Tannin were under a legal (fiduciary) duty to attempt to save the funds. They were under no obligation to represent they intended to make personal investments in the fund when they in fact had no such intentions. If they made untrue representations of their intent to make personal investments in the funds in an attempt to induce investors in the funds not to sell their holdings, one could reasonably expect a 10b-5 indictment.

  9. Charles, your analysis nails the problem with the criminal case on the head. Cioffi and Tannin had a legal obligation to attempt to save the funds. In a quickly changing environment, they apparently represented to investors that they intended to increase their personal investment in the funds. You say that they made those statements “when they in fact had no such intentions.” But what is the evidence of that? That Cioffi and Tannin knew that they funds were in trouble? That certainly was no secret to the market. Could Cioffi and Tannin change their minds regarding their personal investment as the funds continued to deteriorate dramatically on almost a daily basis? And if they did change their mind, is that criminal conduct?
    I have no problem with Cioffi and Tannin being held accountable in a civil lawsuit for their misconduct in the management of these funds. However, we are crossing into some very dangerous terrain when we allow the government to use its unrestrained and overwhelming prosecutorial power to regulate what amounts to desperate attempts to maintain trust in a deteriorating trust-based business.

  10. Essentially, the case rests on a determination as to whether the statements made by Cioffi and Tannin constitute “desperate attempts to maintain trust in a deteriorating trust-based business” or an “untrue statement of a material fact or failure to state a material fact necessary in order to make the statements made not misleading.”
    Any civil action would be based on the reasonableness of the investment decisions made based upon the information available at the time. The criminal prosecution would be based on whether statements were made to induce investors to buy or sell holdings in the fund.
    It will be interesting to see the evidence the prosecution has to offer. The bottom line is that the fund managers should have kept their mouths shut and allowed spokespeople to handle communications with the clients.

  11. In response to plhughes’ statement “the jury will figure it out”, I wholeheartedly disagree given the current track record of emotional juries in this time of prosecutorial misconduct run rampant. You don’t have to look far in the legal world to see juries swayed away from the facts. Just because a business doesn’t succeed doesn’t mean someone was wronged.

  12. I think one of the issues in this indictment is that the prosecutors are looking out for the interests of the investors and not looking out for the interests of justice. This is of no surprise to most people who long ago quit looking for those in the legal profession to maintain even a passing respect for fairness, equity or justice.
    While the words of Cioffi and Tannin speak for themselves, most of the discussion has centered on whether the investors were harmed by the representations offered by the indicted fund managers. In all fairness, there has been little, if any, consideration given to the representations offered by the investors and relied upon by the fund managers.
    The funds invested in high risk, low rated mortgage derivative investments. These products are unsuitable for individuals due to their minimum trade sizes, illiquidity and difficulty in properly modeling risk parameters (PSA speeds, etc). Few fixed income professionals are qualified to manage mortgage backed securities. Damned few are qualified to manage such high risk investments as these funds contained. These funds invested in instruments appropriate only for highly sophisticated investors seeking very high levels of diversification.
    It is questionable whether representations offered by fund managers communicating with clients having to have more than an average level of sophistication would be interpreted similarly by unsophisticated retail investors.
    If the investors in these funds were accredited investors, they would be expected to understand the sub-prime mortgage market dynamics and would have little reason to rely on the representations by the fund managers that essentially state “we believe we have the situation under control.” If the investors in the funds were not sophisticated investors, what the hell were they doing invested in these products to the point that any loss would be material to their financial health?
    There is still a lot to be learned, but my sneaking suspicion is that some investors were put into unsuitable investments by salesmen. The representations offered by Cioffi and Tannin probably were offered as reassurances that they believed that it was reasonable for diversified sophisticated investors with long investment horizons to maintain current weightings in the high yield mortgage derivative sector rather than that grandma was in good shape.

  13. Charles, you are correct that we need to learn more about whether Bear salesmen dumped some unsuitable investors into these funds. However, even if all of the fund investors were accredited investors, my sense is that it is not going to make any difference in regard to the criminal prosecution. Ben Campbell, the former Enron Task Force prosecutor who is heading up the prosecution team, was quoted yesterday as saying the following: “Hedge fund investors, like all investors in our national markets, are entitled to rely on those to whom they entrust their investment dollars.” That sounds to me as if he is making no distinction between representations made to sophisticated investors, on one hand, and to grandma, on the other.
    By the way, based on the indictment, Cioffi transferred between March 23 and April 1, 2007 approximately $2 million of the $6 million he had invested in one of the two problem funds to another Bear Stearns hedge fund. That transfer is the basis of the insider trading charge. Cioffi lost the $4 million balance that he had in the funds when they melted down. Other Bear Stearns executives personally lost a total of about $8 million when the funds went kaput.
    Another key issue is how Cioffi and Tannin could have misled Bear Stearns executives who almost certainly had access to same fund information that the indicted managers had. Why didn’t the Bear executives know what was going on? According to the indictment, Cioffi and Tannin “together with others” misrepresented or omitted material facts in communications with investors and lenders.
    Cioffi and Tannin worked for Bear Stearns Asset Management, but Bear Stearns Securities Corp was the funds’ prime broker and custodian. BSAM’s Pricing Committee decided the funds’ net asset value and at one point rejected Cioffi’s argument that higher values should be ascribed to the funds so as to show a smaller loss in April 2007.
    Thus, it’s clear that a large number of people at Bear Stearns were involved with the funds, which is another reason why the allocation of responsibility for the funds’ demise is better handled in a civil case.

  14. Dispense with a jury to figure it out? So what would be the alternative? First amend the Constitution. But then what? Maybe a “special tribunal” of smart people. A jury of WS bankers perhaps? Or maybe a panel of investors who lost their life savings? How do you pick a fair panel and not let it be corrupted with agendas. I do have a name for that special panel–let’s call it Gitmo North and have it in NYC. There is no perfect system but the Man upstairs, but for here and now a jury is what is-and it beats the alternatives.

  15. plhughes, all I am trying to point out is that if the government’s overzealous young attorneys looking to cash in on a lucrative private practice come after me, I don’t want my fate decided by a high school educated stop and go clerk. I believe I am embellishing the truth a bit but not much considering the makeup of some of the juries involved in Enron.

  16. All the more reason to serve–you would be amazed how many times I hear to smart, sober, busy, successful, intelligent people who make a difference shirk their duty to appear and be willing to serve on a jury. If they refuse to participate then maybe the quality of the jury goes down, and for that we have only ourselves to blame. Society is like software–GIGO–Garbage in equals garbage out. If those that have fail to serve then the whole thing corrodes and does not work. The problem is not the system, its that responsible people opt out for their own reasons. Does that guarantee justice? No, but it helps to offset the ego, selfishness, and the rest of the 7 deadlies that undermine what justice is. Woof. I think I will stop now and have some fun.

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