Nov. 10 (Bloomberg) -- Former Bear Stearns Cos. hedge-fund managers Ralph Cioffi and Matthew Tannin were found not guilty of misleading investors who lost $1.6 billion, the first major test of a U.S. effort to obtain convictions tied to the subprime mortgage crisis and subsequent recession.

A jury of eight women and four men deliberated less than a day before reaching a verdict today. Cioffi, 53, the portfolio manager for the hedge funds, and Tannin, 48, their chief operating officer, went on trial Oct. 13 in federal court in Brooklyn, New York, on charges of conspiracy, securities and wire fraud. Each faced as many as 20 years in prison if convicted. When the verdicts were read, the two men didn’t visibly react. Their wives burst into tears.

The trial was the first stemming from a federal probe of the collapse of the subprime mortgage-market, which cost investors as much as $396 billion. The men were indicted in June 2008 in a case brought by Brooklyn U.S. Attorney Benton Campbell a year after their hedge funds failed. The acquittal may make it more difficult for the Justice Department to bring additional prosecutions for fraud related to the subprime market and the various financial instruments that were based upon it.

“Any time the government undertakes a major prosecution in a new area, the outcome certainly influences its thinking about the prosecutability of other potential defendants,” said Jacob Frenkel, a former U.S. Securities and Exchange Commission lawyer now in private practice. “Acquittals force prosecutors to rethink their theories and charges.”

Working ‘24-7’

Juror Aram Hong said e-mails sent by Cioffi and Tannin showed that the men were working “24-7” to save the funds in the months before they collapsed.

“Just because you’re the captain of a ship and it gets hit doesn’t mean you should be blamed,” said Hong, 27, a food and beverage director at the Iroquois Hotel in midtown Manhattan.

Bears Stearns collapsed less than a year after the funds failed, and was purchased by New York-based JPMorgan Chase & Co.

Serphaine Stimpson, another juror, works as an office coordinator at Brooklyn College. Stimpson, 27, said she initially entered the case thinking both men were guilty. As the trial unfolded, she said she began to have second thoughts.

“As the witnesses began to testify I had my doubts,” Stimpson said. “The defense tore the government witnesses apart.” She added that the jurors “just weren’t 100 percent convinced” by the prosecution case.

The defendants, Stimpson said, “were scapegoats for Wall Street.”

Prosecutors have said the men will face wire fraud charges in Manhattan federal court related to the collapse of the funds.

Last Week

The government last week dismissed a wire fraud charge in the Brooklyn case because the allegations in the specific count purportedly occurred in Manhattan, located in the federal court system’s Southern District of New York. Brooklyn is located in the Eastern District of New York.

An SEC lawsuit against the two men is also pending in Brooklyn federal court.

“I am grateful for the jury’s hard work in weighing all the evidence and thank them for their commitment to finding the truth,” Tannin said in a statement. Cioffi’s lawyer Dane Butswinkas said after the verdict that the defendants “appreciate the attention the jury gave the case.”

‘Jurors Have Spoken’

Brooklyn U.S. Attorney Campbell said he was disappointed with the verdict, “but the jurors have spoken.”

Cioffi and Tannin called three witnesses during the trial, including R. Glenn Hubbard, dean of Columbia University’s Graduate School of Business in New York. Hubbard testified the funds failed because lenders stopped extending credit. The investing strategies employed by Cioffi and Tannin during this period could have returned the funds to profitability of as much as $1.35 billion had they continued to operate, he told the jury.

During the trial, presided over by U.S. District Judge Frederic Block, the defense also argued that the acts and meetings alleged to be part of the conspiracy occurred in Manhattan, outside the Brooklyn prosecutor’s jurisdiction.

According to the government, Cioffi and Tannin conspired to defraud their clients by publicly touting the health of the funds, made up mostly of subprime mortgage-backed securities.

The hedge funds, which filed for bankruptcy in July 2007, were the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd. and the Bear Stearns High- Grade Structured Credit Strategies Master Fund Ltd.

Two Hedge Funds

The two hedge funds failed when prices for collateralized debt obligations linked to home loans fell amid rising late payments by borrowers with poor credit or heavy debt.

The men claimed in e-mails and conversations to be adding their own money to the funds in the months immediately prior to their collapse, according to the government. Neither man added any money to the funds, once valued at $20 billion, the U.S. alleged.

The defense argued Cioffi and Tannin were innocent of any wrongdoing and had remained honestly optimistic about the funds’ health. E-mails which the men sent were more ambiguous than the government alleged, the defense said.

Juror Jenny McCaughey, of Deer Park, on New York’s Long Island, served as the jury forewoman. She said the e-mails presented by the government as evidence cut both ways.

“They said one thing and another thing,” McCaughey said. “The government didn’t give us enough evidence to go on.”

Private Placement

Lawyers for Cioffi and Tannin said that, according to Bear Stearns private placement memos, the fund managers had no duty to disclose what they were doing with their money. The defense also said that the government failed to prove that investors had relied upon statements made by the defendants during an April 25, 2007, investor conference call. Additionally, the defense said none of the statements which Cioffi and Tannin made where they claimed to be adding money to the funds was material to these investors.

Prosecutors claimed that Cioffi moved $2 million -- one- third of his holdings in the funds -- to another Bear fund which he supervised. The U.S. alleged that he moved the money in March to a fund that was still profitable.

Insider Trading

The government argued Cioffi committed insider trading when he moved the money ahead of investors who lost money in his funds and while using material, non-public information because of his role as a fund manager.

Juror Hong said of Cioffi’s insider trading charge that “if he had taken the money and put it in his own bank account that would be one thing, but it went to a Bear fund which he was also a portfolio manager over,” she said. “I just don’t think you can blame him for that.”

Both men were charged with one count of conspiracy to commit securities fraud, two counts of wire fraud and two counts of securities fraud. Cioffi was charged with one count of insider trading.

“There is evidence here of a conspiracy which is ‘Let’s not tell anybody about the problems we’re having,” Assistant U.S. Attorney James McGovern said during the trial. “It’s also about ‘Let’s not tell the investors about the level of redemptions we’re having, because then there will be a run on the bank.’”

Failed to Meet

Defense lawyers insisted prosecutors had failed to meet their burden of proving beyond a reasonable doubt that the two intentionally lied or conspired to defraud investors.

“It was a case of standard business dealings where the views of the markets were shifting rapidly and these guys were being criminally punished for expressing views on one day and acting differently another day,” said Larry Ribstein, a professor of law at University of Illinois. “This never should’ve been the subject of a criminal prosecution.”

The SEC, in the lawsuit it filed last year, claimed Cioffi and Tannin misled investors about the funds’ deepening financial troubles and their own holdings in the investment pools. The regulator’s case, still awaiting trial, requires a lower standard of proof than a criminal conviction.

“We of course respect the criminal verdict,” SEC spokesman John Nester said. “But at this time, we expect to go forward with litigating our civil action.”

Selectively Presenting

Butswinkas, Cioffi’s lawyer, accused the government of selectively presenting the facts of the case and quoting e-mails sent by both men out of context.

“This is a case that is built on misimpressions, on e- mails pulled out of time without the presentation of the back story,” Butswinkas told jurors. He said the panel’s job in deliberations is “a heroic undertaking when public opinion about Wall Street is where it is.”

Susan Brune, a lawyer for Tannin, said the prosecution’s case was based on “hindsight and bias” and that a government attorney mischaracterized the evidence against her client.

She cited e-mails from Tannin, Cioffi and others at Bear Stearns that were positive about prospects for the funds and about buying opportunities in a down market.

“There are two very important things that are missing in this case -- proof and motive,” Brune told jurors in her closing arguments. “There is reason to believe that the funds weren’t going to tank, that’s what they believed in real time.”

During the Trial

During the trial both prosecutors and defense lawyers argued over the meaning of an April 22, 2007, e-mail that Tannin sent from his personal Gmail account to a Hotmail account in the name of Cioffi’s wife.

“The entire sub-prime market is toast,” Tannin wrote to Cioffi in the message with a subject title, “Things to Think About.”

“If AAA bonds are systematically downgraded then there is simply no way for us to make money -- ever,” Tannin wrote in the message, sent on a Sunday morning. “Caution would lead us to conclude the model is right -- and we’re in bad shape.”

Brune told jurors that Tannin had a bleak outlook when he wrote the message because he’d misunderstood a mathematical model created by a Bear Stearns analyst. She accused prosecutors of trying to “freeze-dry” the e-mail.

Prosecutors argued that Tannin’s e-mail showed the level of concern he had about the funds’ prospects.

“If you read this e-mail, ‘toast’ is not a good thing,” McGovern said.

The government also alleged Cioffi told investors there were only “a couple million” dollars in redemptions during the conference call on April 25, 2007, a week after one investor submitted a redemption for a $57 million stake in the funds.

“When people are making money, they say anything,” Hong, the juror, said. “When people are losing money they want to put the blame on somebody.”

Hong said that if she had money, she would invest it with Cioffi and Tannin.

The case is U.S. v. Cioffi, 08-CR-00415, U.S. District Court for the Eastern District of New York (Brooklyn).

To contact the reporters on this story: Patricia Hurtado in U.S. District Court for the Eastern District of New York in Brooklyn at pathurtado@bloomberg.net and; Thom Weidlich in U.S. District Court for the Eastern District of New York in Brooklyn at tweidlich@bloomberg.net.

Last Updated: November 10, 2009 21:44 EST