Bear Stearns, Hedge Funds, and the Criminalization of Corporate Law (Part 2)

Should the two managers at the Bear Stearns hedge funds have been indicted?

The funds were highly invested in CDOs--mortgages, in other words.  The indictment indicates that the two defendants were aware that problems in the CDO market were affecting the funds in March 2007.  But of course concerns over CDOs and subprime mortgages were already rife in the markets.  As the indictment noted, a major investor in the fund announced in April 2007 that it intended to redeem its entire $57 million investment.  Similarly, part of the allegations in the indictment are that the defendants understated the level of redemptions by other investors.  In other words, without any disclosure from the funds, the investor was presumably concerned enough about the investments in the fund to eliminate its position.  All of this suggests that the market had considerable information and concern on the investment content of the funds.

Similarly, the alleged fraud lasted, according to the indictment, only about three months, during a period of turmoil in the market and apparent turmoil within the funds.  Discussions of closing the funds only occurred in late April 2007.  In other words, had Tannin and Cioffi announced then that they were shutting down the funds, they would have done so only about a month before the funds actually closed. 

Finally, it is not clear from the indictment that investors would have saved anything had the funds shut down even sooner.  The assets in the funds were apparently illiquid and probably worthless before June.  Had the funds shut down in late April or early May, most investors would still have lost their investment.  The only real difference is that the funds would not have processed withdrawals in May and not accepted any new investments during the month. 

The indictment makes considerable hay out of the fact that Cioffi withdrew $2 million.  It makes far less out of the fact that he left in the fund $4 million, an investment presumably lost.

None of this discussion is meant to excuse the behavior of the two managers.  It sounds from the indictment as if they had serious problems internally and understated them to the market.  The broader question, however, is whether this behavior should be ciminalized.  It shouldn't, is the short answer.  Unlike Enron, this was not a fraud of massive proportions.  Unlike Enron, the funds went into bankruptcy not because of a fraudulent conspiracy but because of bad investments.  Unlike Enron, this was a short term event during a period of turmoil.  Moreover, those investors that lost funds appear sophisticated and likely aware of the problems in the subprime market.

In this case, civil penalties are enough.  The careers of Tannin and Cioffi in the securities business are essentially over.  The SEC can bankrupt them by taking away the rest of their net worth.  And, as noted, Cioffi has already lost $4 million.  Jail, however, is not the answer.  Moreover, the criminal action will not address the broader, more significant issue.  Why were these hedge funds almost entirely unsupervised by management at Bear Stearns?  While the indictment makes a great deal out of the failure of the two defendants to reveal the true state of affairs to management at Bear Stearns, this was not a subtle matter.  Bear Stearns had two hedge funds highly invested in CDOs and other debt instruments.  Yet somehow management apparently never inquired or looked into the condition of the funds, sitting back and waiting for their managers to report any problems. 

This should be a matter left to the Securities and Exchange Commission and private investors.  It should entail an examination of the behavior not only of Tannin and Cioffi but also management at Bear Stearns.  It should not be left to criminal authorities.