Bear Stearns, Hedge Funds, and the Criminalization of Corporate Law (Part 1)

It is a tough time to be a hedge fund.  For one thing, the economy is not cooperating and solid returns are hard to come by.  For another, the term "hedge" fund has become pejorative, a term that stands for short term investors who elevate their profit making goals over all other interests.  They have been demonized by the SEC and are not well liked by at least some on the Delaware courts. 

But the news only got worse with the indictment of two portfolio managers, Ralph Cioffi and Matthew Tannin, from hedge funds operated by Bear Stearns.  The SEC filed civil charges as well.

They managed two funds, the High Grade Structured Credit Strategies Master Fund and the the High Grade Structured Credit Strategies Enhanced Master Fund, both formed under the laws of the Cayman Islands but operated out of New York.  The Enhanced Fund invested primarily in collateralized debt obligations (CDOs), instruments backed up by debt obligations, particularly mortgages. 

The indictment alleges that by March 2007 Cioffi and Tannin believed that the funds were at risk of collapse.  They covered up this "bleak state" in order to protect their compensation and reputation.  The indictment quoted internal communications indicating concerns with the funds, including some from emails.  During the same time period, Cioffi began reducing his own investment in the Enhanced Fund, pulling $2 of the $6 million out.  At the same time, the mangers were discussing their "awesome opportunities" and "great possibilities for the coming months" when discussing the funds with the public. 

By April, Tannin sent an email advising that the funds be closed.  He described the subprime market as "damn ugly" and that if their internal report on CDOs was accurate that the subprime market was "toast."  Despite the concerns, they reaffirmed to Bear Stearns management that the funds were in good shape.  They were likewise upbeat in a conference call with investors held on April 25, understating the number of anticipated redemptions. 

On June 7, the Enhanced Fund ceased redemptions; the High Grade Fund did the same on June 27.  The funds filed for bankruptcy later in the summer.  Their collapse largely heralded the beginning of the subprime crisis and raised concerns with the future of Bear Stearns, something that would contribute to the loss of confidence in the investment banking firm the following year and its acquisition by JP Morgan.

The indictment includes counts alleging disclosure violations and insider trading.  We will offer some thoughts on the indictment in the next post. 

The indictment is posted on the DU Corporate Governance web site.