An Interesting Week

What a week it was for the legal system as everybody involved in the potential bid rigging scandal, the auction rate securities fiasco, and the municipal derivatives investigation all ran to their local courts to file lawsuits against every financial institution of any size.

Los Angeles sued the mono-line insurance companies (as if they need any more problems) and also sued a laundry list of financial firms ranging from Merrill, Bank of America, Wachovia, Morgan all the way down to a relatively small firm, Investment Management Advisory Group (IMAGE). Just to make sure they got everyone, LA also included "Does 1-50".

Massachusetts sued Merrill, Connecticut and Florida are investigating, Stockton Ca sued anyone they could find while New York sued UBS. The hits just keep coming.

As far as the lawsuits involving municipal bid rigging, I will again state my position that these law suits brought by the municipalities seem to be more an effort to cast themselves as a party harmed. Especially since the federal government is very close to bringing its own action. The last thing the municipalities want is to be charged with some form of complicity in the bidding procedure.

Despite the bravado of LA City Attorney Rocky Delgadillo, ["Today we're sending the message that if you cheat the city, we will come at you with everything we've got, whether you're a gang banger or a Wall Street titan"], I think most of these suits should be dismissed because the plaintiffs will have a hard time proving they were harmed.

On July 29, in a piece written by Michael B. Marois, Bloomberg stated that US "Tax rules also stipulate that profits made by selling bonds at tax-exempt rates and then investing the proceeds at higher yields must be repaid as taxes."

While the profits on investing is not really a tax, more of a confiscation because the federal government takes everything, the concept is correct. The municipalities cannot keep the profits from investing. They cannot use that money generated through their own investing activities as any other citizen for the building of schools, roads, hospitals or any other worthwhile project. They must send the money to the IRS.

The bottom line is: the plaintiffs in the bid rigging lawsuits probably got all the profits they could get. The actions by the financial community probably did not harm those who filed the complaints. But what is unknown is how much did the municipalities know about the bidding procedure they are now challenging.

Eventually, we may all know the answer to that.

Analysis of the Indictment

The indictment filed against Cioffi and Tannin appears to be a further step in the ongoing effort on the part of employees of the Department of Justice to thoroughly punish those whose businesses fail resulting in the loss of investor funds. Despite the opinions of all the "experts" on CNBC or the members of the press or any other members of the blogging community, what the government is attempting to accomplish here is not in the best interests of either the investing community, business owners or investment advisors.

A case can be made that if the government should be successful in this prosecution, the result will be a further deterioration of the financial markets...but that is for another day.

What the government is trying to do is pin the loss of  "...approximately $1.4 billion" on the two Bear Stearns hedge fund managers. However, the indictment fails to draw the necessary lines to connect the dots.

Count one of the indictment alleges violations of the securities laws, specifically 15 USC Sections 78j(b) and 78ff. It also alleges violations of 18 USC Sec. 1341 for wire fraud.

First the easy one...for there to be a violation of wire fraud, Cioffi and Tannin must "...knowingly and intentionally devise  a scheme and artifice to defraud...." Therefore there must have been a scheme. [Wire fraud requires the existence of a "scheme" in order for there to be wire fraud.]

So now the government must prove that the two actors created a "scheme or device" designed to take money from investors. In other words, the government "...must prove (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."

And what does the government offer as violations?

1. Cioffi said to a Bear Stearns broker on 3/3/2007 that the funds represented an awesome opportunity.

2. Tannin said on 3/21/2007 he was going to invest more.

3. Cioffi and Tannin on 4/25/2007 was on a conference call and did not tell everyone on the call that the market and the funds were not in good shape.

4. Tannin told a counter-party he expected no large redemptions on 5/3/2007

5. In May of 2007, Cioffi told a Bear broker he had $5.5 million invested in the funds.

 

This indictment is a sham. The government has failed to even get close to meeting its burden of alleging a crime.

It is obvious the government must go back to the drawing boards and try to produce an indictment that alleges that these two men caused the investors in the two funds to lose money. Without causation, this indictment must be dismissed.

More later....

What Cioffi and Tannin are Facing

In Cioffi and Tannin’s indictment, at paragraph 55, the government states “Eventually, investors were told that the Funds had both lost 100% of their respective values, resulting in a total investor loss of approximately $1.4 billion."

So what penalty are these two men facing? That answer is contained in the United States Sentencing Guidelines. Those guidelines contain the convoluted method of assigning points to the dollars lost and certain surrounding events. A full version of the Fraud section of the Sentencing Guidelines are here. This is a copy of the table for crimes of “Basic Economic Offenses” (Non applicable sections have been deleted):

1. THEFT, EMBEZZLEMENT, RECEIPT OF STOLEN PROPERTY, PROPERTY DESTRUCTION, AND OFFENSES INVOLVING FRAUD OR DECEIT

§2B1.1. Larceny, Embezzlement, and Other Forms of Theft; Offenses Involving Stolen Property; Property Damage or Destruction; Fraud and Deceit; Forgery; Offenses Involving Altered or Counterfeit Instruments Other than Counterfeit Bearer Obligations of the United States

(a) Base Offense Level:

…

(2) 6, otherwise.

(b) Specific Offense Characteristics

	Loss(Apply the Greatest)	Increase in Level
(A)	$5,000 or less	no increase
(B)	More than $5,000	add 2
(C)	More than $10,000	add 4
(D)	More than $30,000	add 6
(E)	More than $70,000	add 8
(F)	More than $120,000	add 10
(G)	More than $200,000	add 12
(H)	More than $400,000	add 14
(I)	More than $1,000,000	add 16
(J)	More than $2,500,000	add 18
(K)	More than $7,000,000	add 20
(L)	More than $20,000,000	add 22
(M)	More than $50,000,000	add 24
(N)	More than $100,000,000	add 26
(O)	More than $200,000,000	add 28
(P)	More than $400,000,000	add 30

(2) (Apply the greatest) If the offense—

(A) (i) involved 10 or more victims; or (ii) was committed through mass-marketing, increase by 2 levels;

(B) involved 50 or more victims, increase by 4 levels; or

(C) involved 250 or more victims, increase by 6 levels.

…

(13) (Apply the greater) If—

(A) the defendant derived more than $1,000,000 in gross receipts from one or more financial institutions as a result of the offense, increase by 2 levels; or

(B) the offense (i) substantially jeopardized the safety and soundness of a financial institution; (ii) substantially endangered the solvency or financial security of an organization that, at any time during the offense, (I) was a publicly traded company; or (II) had 1,000 or more employees; or (iii) substantially endangered the solvency or financial security of 100 or more victims, increase by 4 levels.

(C) The cumulative adjustments from application of both subsections (b)(2) and (b)(13)(B) shall not exceed 8 levels, except as provided in subdivision (D).

(D) If the resulting offense level determined under subdivision (A) or (B) is less than level 24, increase to level 24.

…

(15) If the offense involved—

(A) a violation of securities law and, at the time of the offense, the defendant was (i) an officer or a director of a publicly traded company; (ii) a registered broker or dealer, or a person associated with a broker or dealer; or (iii) an investment adviser, or a person associated with an investment adviser; or

(B) a violation of commodities law and, at the time of the offense, the defendant was (i) an officer or a director of a futures commission merchant or an introducing broker; (ii) a commodities trading advisor; or (iii) a commodity pool operator,

increase by 4 levels.

To determine the number of levels, it is just an addition problem:

Basic Offense 6

Total Loss exceeds $400 million 30

Assume less than 50 “victims” 4

Safety of institutions 4

Violation of securities laws 4

Grand Total 48

With that total of 48 levels, a judge then goes to the “Sentencing Table” to determine the sentence. The full version is here. This is an excerpt.

Offense Level	Months
19	30-37
20	33-41
21	37-46
22	41-51
23	46-57
24	51-63
25	57-71
26	63-78
27	70-87
28	78-97
29	87-108
30	97-121
31	108-135
32	121-151
33	135-168
34	151-188
35	168-210
36	188-235
37	210-262
38	235-293
39	262-327
40	292-365
41	324-405
42	360-life
43	life

The table above starts at 19 for simplicity in addition to which it is inconceivable that with the bloodlust created by the press and fostered by the government a sentence less than level 19 could be imposed. As you can see, the table only goes to a level 43 which mandates a life sentence.

These men are looking at life in prison! And they have not even been accused with causing any loss! In future posts, I will begin dissecting the indictment, not from a legal viewpoint, but from the viewpoint of one who has already gone through the process.

The Indictment

On June 18, 2008, the government filed an indictment in US District Court for the Eastern District of New York against Ralph Cioffi and Matthew Tannin, the two former hedge fund managers at Bear Stearns. This post is an attempt to put into English what the government is attempting to do.

The defendants are charged with violating:

1. 15 USC Sections 78j(b) and 78ff. The are the sections of the US Code that charge securities fraud.

2. 18 USC Section 371...Conspiracy to commit an offense

3. 18 USC Section 1343...Fraud by wire, radio or television

4. 18 USC Section 2...charging them as principals

5. 18 USC Section 981...forfeiture allegations

6. 18 USC Section 3551...If guilty, imprisonment

7. 21 USC Section 853(p)...if guilty, forfeiture of substitute property

8. 28 USC 2461(c)...the government's power to enforce forfeiture

They are the sections of the US Code that Cioffi and Tannin allegedly violated.

If you are paying attention by this point, you will have noticed that the "violations" of 2 through 8 enumerated above are all predicated upon a crime having been committed. In other words, 2 through 8 require a crime to have been committed in order for them to come into play. The only allegation of a crime is 1, an allegation of securities fraud.

In order for there to be securities fraud, a security must have been offered, purchased or sold at a price that is not market value. There is no ambiguity, no gray area, no innuendo. A security must have been offered, purchased or sold at a fraudulent price.

You can guess what the indictment is missing...that fraudulent price.

Instead, the indictment states that the total losses in the funds exceeded $1 billion. The indictment does not claim that the defendants took the money or that they profited by that amount.

If the government is successful in its prosecution, and considering the blood lust it is creating, it probably will be successful, these two men will spend the rest of their lives in prison. Plus, they and their families will be left destitute.

More later.

They did it

They actually did it. They indicted and arrested the two hedge fund managers for the Bear Stearns hedge funds, Ralph Cioffi and Matthew Tannin. For those of you interested, a copy of the indictment is available from The New York Times.

I just downloaded a copy and will be posting an analysis in the near future. However, based upon what I read so far, this is not going to be an easy case for the government. That is assuming the defendants will be allowed to defend themselves.

The only comment I will make now is this is a day that most investment advisers had been hoping would not come. What the government is saying by instituting this action is if you lose client funds you can be sent to prison even if you did not profit.

The effect is chilling.

Indict the Bastards!!

Can you imagine! Someone actually lost money in a hedge fund! And now the cry goes up to indict the money managers, have some sort of trial or better yet a plea bargain, then throw the bastards in jail.

I promised myself when I started this blog that I would not rant about the legal system. But yesterday's Wall Street Journal really got to me.

On the front page was an article about the two Bear Stearns hedge fund managers facing a possible indictment. Why? Because they had the audacity to "paint a rosy" picture of their funds. In case you missed the article, it is available from The Wall Street Journal.

Ralph Cioffi and Matthew Tannin were the managers of "two high-profile bond portfolios." According to the Journal, they could be indicted within the next week.

Having been there and faced the same problems, I have only one piece of advice. Fight this as much as you possibly can. Do not entertain a plea bargain nor be cooperative in any respect. These people are out for a trophy, and you are the target.

Accusations of painting a rosy picture of the fund are hollow at best. I guess they would have you paint a bleak picture of the outlook so the run on the bank could have started sooner with the same results.

Painting a rosy picture of an enterprise is not illegal, if you believe the picture. Unless it can be proven that you offered, purchased or sold a security at non-market prices or that your actions caused a security to be offered, purchased or sold at non-market prices, a fair and impartial judge must dismiss any indictment presented.

Good Luck.

Too little too late

Last week I was looking over the headlines at Market Watch for interesting articles about changes in municipal finance. What really looked out of place was a piece written by Alistar Barr titled  Regulators try to ease selling pressure on muni's.

The fact that this article ran on June 2, 2008 begs the question where has the National Association of Insurance Commissioners been for the last eight months!

On October 13, 2007, Penn State was trouncing Wisconsin 38 to 7. AMBAC's stock price had closed the prior day at 68.96, down from a high of 96. But anyone who was aware of the financial markets knew the monoline insurance companies were in serious trouble. You don't lose a third of your market capitalization without some sort of alarm going off.

The National Association of Insurance Commissioners did nothing.

Fast forward to January 1, 2008. AMBAC's stock price has now fallen to 26, having lost about 75% of its market value in less than a year. And Wisconsin was on the losing end in the game with Tennessee.

By now everyone knows there are major problems with municipal bond insurance companies. The market for municipal bonds is freezing. Liquidity is vanishing.

The National Association of Insurance Commissioners did nothing.

But here on June 2, 2008, we are to believe that the Association is going to save the day by assigning its own credit ratings through its Securities Valuation Office ("SVO").

Just think of how much more credible the action would have been had the Association made its announcement in October. Better yet, how about a decade ago.

I'm sure the market awaits the time when the SVO assigns a rating to a municipal issue higher than the rating given by Moody's or S&P. Maybe it's time for a little long range planning on the part of the Association.