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.

Time to cry UNCLE!!

After almost 35 years of effort by the federal government, it may be time for the municipal bond market to cry uncle and give up the “benefit” of tax-exempt status on municipal bonds. Since 1974, the federal government has been placing a stronger and more vicious stranglehold on the muni market. It appears that the government’s long quest for the holy grail of no tax-exempt bond issues may be close at hand.

Recently, the United States Supreme Court held that the state of Kentucky could tax the interest paid by another state to a Kentucky resident. According to the Court, such taxation does not run afoul of the “Commerce Clause” of the U.S. Constitution. While this decision may be seen as a victory for Kentucky, it realistically should be viewed as a substantial setback for the proponents of maintaining the tax-exempt interest on municipal bonds.The Opinion is here.

Between the chipping away at the municipal market by the government through the operation of the arbitrage regulations and the self-destruct mode the muni market has been in for the last few years, it really is just a matter of time before all municipalities lose the right to sell tax-exempt bonds.

While this may be greeted with glee from some parties, Joe Mysak, Bloomberg, the halls of Congress and the SEC, we taxpayers will wind up shouldering most of the cost.

At this time, the spread between municipal and corporate rates is about 1%. In percentage terms, municipal rates are about 81% of AAA corporate rates. With approximately $200 billion in municipal debt being issued this year, the increase in borrowing costs will be about $2 billion annually.

But rather than trying to defend and keep the tax-exempt status, the municipal market would be well served to attempt to fashion a plan whereby they give up exempt status in return for other items.

For example, the elimination of the arbitrage regulations could be first on the list to be eliminated. It has been estimated that the costs of compliance with these regulations costs the tax-exempt market approximately $600 million a year.

Next, the federal government should be willing to eliminate its own tax-exempt status on the bonds it sells. Currently, municipalities cannot tax the interest on US government bonds; imposing an effective 5% rate on the interest paid on those bonds could generate almost a billion dollars per year. And that amount is only going up as the growth in federal borrowing exceeds the growth in municipal borrowing.

Lastly, eliminating the tax-exempt status of municipal bonds would open a huge new market of investors. Pension funds, IRA’s, Keogh’s, and other tax-exempt investors would all now be attracted to municipal bonds. The increase of efficiency and tradability in the market would assist municipalities in the issuance of their bonds.