Comment: Steven F. Molo, Shearman & Sterling: Wrong, maybe. But is it a crime?

Comment: Steven F. Molo, Shearman & Sterling: Wrong, maybe. But is it a crime?

As the global financial crisis continues to unfold, governments will have a fundamental decision to make regarding how to address enforcement issues. There will be no shortage of those at whom fingers may be pointed. The central question will be: Should these people be prosecuted criminally, or are the regulatory process and civil litigation better suited to dealing with these issues?

America has a tradition of prosecuting business people in times of economic upheaval. In a society that accounts for 25 per cent of the world's prisoners with 5 per cent of the world's population, that might be expected. Sometimes those prosecutions are justified - the defendants are outright fraudsters who set out to steal. But, sometimes they are not justified - the defendants may have violated a technical rule or ventured into a grey area some prosecutor believes is ripe for the expansion of already broad criminal laws.

The personal consequences for the latter, even if they are vindicated, can be devastating. Just ask the employees of Arthur Andersen, the defendants in the Enron 'Nigerian Barge' case, Frank Quattrone, or alleged market timer Ted Siphol. Or consider the case of Richard Wigton, the former head of the arbitrage disk at Kidder Peabody who was charged with insider trading and marched through Kidder's trading floor in handcuffs - only to have the charges dropped.

A Time magazine story compared the arrest to a drug bust and his career was never quite the same despite his exoneration. Wigdon, like legendary trader John Mulheren and the Princeton Newport defendants, was a victim of the overzealous Wall Street prosecutions of the 1980s. Of course, you could look back as far as Samuel Insull - the poster boy for the economic fiasco of his time and the subject of what was proven to be a misguided prosecution.

An early look at how US authorities intend to deal with the situation may be seen through the decision to file criminal charges against Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. The indictment is filled with highly-charged language and colourful e-mail quotes. If the case is actually tried, however, it will be won or lost on a full airing of the evidence - not allegations - presented on the nine-count indictment's precise legal charges: conspiracy, securities fraud, insider trading and wire fraud.

The government's basic theory is that the defendants knew that the funds were certain to collapse, but concealed that from investors. Count I, the conspiracy charge, sets forth the crux of the case. It alleges Cioffi and Tannin knowingly agreed intentionally to defraud investors in the Bear Stearns High-Grade Fund and the Bear Stearns Enhanced Fund and to obtain money from them by false pretences. It then lists a short series of 'overt acts' in furtherance of the claimed conspiracy. Those acts, in essence, are:

•    On March 7, 2007, Cioffi told a Bear Stearns broker that the funds presented an 'awesome opportunity'.
•    On March 21, 2007, Tannin told a Bear Stearns broker that he was adding money to his personal investment in one of the funds.
•    On April 25, 2007, Cioffi and Tannin participated in an investor conference call in which they supposedly made material misrepresentations and omitted material facts.
•    On May 3, 2007, Tannin told a Repo counterparty that he anticipated no large redemptions.
•    In mid-May, 2007, Cioffi told a Bear Stearns broker that he had USD5.5m personally invested in the funds.

Given the nature of these charges, the defence will likely be that either the factual allegations are wrong - that which is alleged simply did not happen - or that the factual allegations are true, but the defendants acted in good faith and without any intent to defraud.

The indictment includes a variety of additional allegations that the government will claim negate any suggestion of good faith. It makes much of the fact that Cioffi allegedly transferred USD2m of his approximately USD6m investment in the Enhanced Fund to a third Bear Stearns fund, the Structured Risk Partners Fund (hardly the Pension Trust for Widows and Orphans). However, as the indictment concedes, Cioffi was about to assume responsibility for the Structured Risk Partners Fund, and in any event, he still had approximately USD4m invested in the Enhanced Fund.

Similarly, the government contends that selective email quotes - such as 'if I can't [turn the funds around] I've effectively washed a 30-year career down the drain', 'the worry for me is that the subprime losses will be worse than anything people have modeled', and 'at least, we have our health and families…we are not a 19 year old Marine in Iraq' - reveal a fraudulent intent.

However, one could also argue that they reveal honest thinking and open debate among professionals in a highly fluid situation. Anyway, would an investor really want Cioffi managing the fund if he didn't think his career depended on successfully navigating the uncharted waters of the CDO market meltdown?

Of course, the indictment does not state what else - possibly favourable to the defence - was said in what must have been thousands of e-mails generated in the relevant time period. It also does not mention the personal financial losses of the defendants, the full contents and context of the April investor call, or other disclosures made to investors.

Cioffi and Tannin played in a high-stakes arena with big boy investors who understood that outsize returns meant outsize risks. Are they criminals, or businessmen who tried unsuccessfully to manage through market forces not seen before in their lifetimes?

As you might expect, the case, at least at first blush, does not appear to be without its challenges for the defendants. The indictment raises what seem like somewhat thorny questions concerning redemption requests. And while there is no formal obstruction of justice charge, it alludes to 'missing evidence'. All of that will be sorted out at trial.

Nonetheless, the question remains: Is this what a criminal case should be made of, particularly when there is a regulatory enforcement framework in place for dealing with the complex issues it presents? The government, in its exercise of prosecutorial discretion and perhaps to make a point, has decided that it is.

The law allows the government to do that. As a result, Cioffi and Tannin were handcuffed and paraded before the cameras, unlike most defendants in less public business crime cases, and they and their families will endure the unique emotional, psychological, and financial burdens imposed by a criminal prosecution of this nature. They, too, are big boys and had to know this was a real, albeit highly remote, occupational risk. But it will be tough.

The draconian sentences faced upon conviction often cause business people to plea bargain upon the advice of 'white collar defense' lawyers who frequently are long-ago prosecutors who are persuaded too readily of the strength of the government's case and rarely go to trial. Thus, it is not too often that the government is put to its proof. Cioffi and Tannin, who are presumed innocent, have entered pleas of not guilty. So right now, it appears that the government will be required to make its case at no small expense - not with allegations in an indictment or headlines in a newspaper, but with evidence in a courtroom. And we will see if the result is consistent with both the law and with justice.

Steven F. Molo is a trial lawyer and litigation partner with Shearman & Sterling in New York. He handles business litigation and white-collar criminal matters throughout the US and is the editor and co-author of Your Witness and co-author of Corporate Internal Investigations (smolo@shearman.com)

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