Oct. 12 (Bloomberg) -- Former Bear Stearns Cos. hedge fund managers Ralph Cioffi and Matthew Tannin are either responsible for triggering a $1.4 billion hedge fund implosion or are scapegoats for a government eager to affix blame for it.

Jurors selected for a trial beginning tomorrow in Brooklyn, New York, federal court must decide whether the two men misled investors about the health of two hedge funds that collapsed in 2007. The debacle was followed a year later by the failure of Bear Stearns and its purchase by JPMorgan Chase & Co., the bankruptcy of Lehman Brothers Holdings Inc., the U.S. takeover of Fannie Mae and Freddie Mac and the rescue of AIG Inc.

While both sides say Cioffi and Tannin weren’t responsible for the demise of Bear Stearns, theirs is the biggest trial stemming from a U.S. probe of banks and mortgage firms whose losses in subprime loans and related securities total at least $396 billion. The indictment of Cioffi, who managed the funds, and Tannin, a lawyer who served as chief operating officer, was the first relating to the mortgage-market’s crash.

“Wall Street and the defense bar are looking at this trial to see if the government can prove individual criminal wrongdoing with respect to the financial market meltdown,” said Edward O’Callaghan, a former federal prosecutor in Manhattan.

Both men are charged with conspiracy, securities fraud and wire fraud. They face as much as 20 years in prison if convicted of the most serious count, securities fraud. Cioffi, 53, is charged with an additional count of insider trading for withdrawing $2 million from one of the funds, using material, non-public information ahead of his investors.

Filed For Bankruptcy

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.

Lawyers for both men, who have pleaded not guilty, said the death of the funds didn’t lead to the collapse of Bear Stearns.

“Many in the press unfairly linked Bear Stearns’s demise to the failure of two of its prominent hedge funds the year before,” defense lawyers wrote in court papers filed in May. “Press reports erroneously attributed the beginning of Bear Stearns’s collapse to the bankruptcy of the funds.”

The case is being prosecuted by lawyers under Brooklyn U.S. Attorney Benton Campbell, a former member of the Justice Department’s Enron Corp. Task Force, whose office was first to bring cases in the subprime probe and win convictions.

Not Responsible

“The government does not contend these defendants are responsible for the collapse of Bear Stearns,” Campbell said in announcing the charges. “These defendants had a duty to their hedge fund investors and they breached that trust and today they are being held accountable.”

In August, Brooklyn federal prosecutors won the conviction of Eric Butler, an ex-Credit Suisse Group Inc. trader. Butler and his co-defendant, Julian Tzolov, were found guilty of fraudulently selling corporate clients more than $1 billion of auction-rate securities linked to subprime mortgages, which they claimed were backed by U.S. guaranteed student loans.

Tzolov became a government cooperator, pleaded guilty and testified against Butler, giving a Brooklyn jury an insider’s look into the alleged conspiracy. Butler said he will appeal.

Some attorneys who have been watching the Bear Stearns case note that prosecutors don’t have a cooperator like Tzolov to help the jury understand the defendants’ alleged motives or provide a co-conspirator’s view of a purported conspiracy.

Of the 532 exhibits and 38 witnesses prosecutors have said they intend to use at trial, the centerpiece of the government case may be the defendants’ own words, both in e-mails and in comments to investors on conference calls.

‘Meeting of the Minds’

“To prove a conspiracy, the government has to show an agreement with two or more people, that there was a meeting of the minds to violate the law,” said O’Callaghan, of Nixon Peabody LLP. “Generally, the government would rely on live witnesses’ testimony, from either a co-conspirator who entered into the agreement or someone who had personal knowledge.”

Relying on e-mails without having a witness to explain their context makes it more difficult for the government to prove that an agreement to violate the law in fact existed, and provides the defense an opportunity to argue otherwise, he said.

The indictment is filled with excerpts of e-mail conversations that allegedly took place between Cioffi, Tannin and others about the health of the funds. A March 15, 2007, message from Cioffi to a team economist carries the subject line “Fear.”

‘A Meltdown’

“I’m fearful of these markets,” Cioffi wrote. Tannin “said it’s either a melt down or the greatest buying opportunity ever, I’m leaning more towards the former. As we discussed it may not be a meltdown for the general economy but in our world it will be,” the indictment quotes Cioffi as writing.

“Wall Street will be hammered with lawsuits. Dealers will lose millions and the CDO business will not be the same for years,” he wrote, according to a related complaint by the U.S. Securities and Exchange Commission.

CDOs, or collateralized debt obligations, are created by packaging assets including bonds and loans and using their income to pay investors. The securities are divided into different portions of varying risk and can offer higher returns than the debt on which they are based.

An e-mail message Tannin sent to Cioffi and Ray McGarrigal, another Bear Stearns fund manager, on April 22, 2007, is also cited in the indictment, and labeled Government Exhibit 55.

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

‘Systematically Downgraded’

“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.”

Tannin told Cioffi in his e-mail, “I am as ‘fully in’ as your partner now as I always hoped I would ever be,” and suggests he come into Manhattan where they could “go to the Racquet Club and have this discussion in the sauna.”

Prosecutors say at the same time these messages were sent, both defendants were touting the funds, which were invested in securities built on subprime mortgages, and telling clients that the funds offered a buying opportunity.

Search Warrant

The government cited a newly discovered e-mail last week which they said was obtained from Google Inc. after a search warrant was delivered upon the firm in July. Tannin’s e-mails have been the subject of a recent evidence battle between prosecutors and his lawyers, who argue they were privileged, and shouldn’t be turned over to the government. The U.S. said they received a CD-ROM last week of all of Tannin’s messages in an account the company initially told them in July had been “user deleted.”

In a Nov. 23, 2006, message Tannin sent to himself, he said he was “stressed” about his work at the fund because he feared it would “blow up.”

“I became very worried very quickly,” Tannin wrote. “I was also very nervous about the state of the market and how we were going to perform,” adding that “credit is only deteriorating,” and that he “was worried that this would all end badly and that I would have to look for work.”

Cioffi is being defended by Brendan Sullivan, who most recently won reversal of a political corruption charge against former Alaska Senator Ted Stevens. Also on the defense team are Margaret Keeley and Dane Butswinkas, all of Williams & Connolly LLP. Tannin is being represented by Susan Brune and Nina Beattie of Brune & Richard LLP, both of whom declined to comment.

Defense Case

Butswinkas said the defense case will begin on the first day of jury selection, declining further comment.

Last week, the government requested the judge presiding over the trial review possible conflicts of interest Tannin’s lawyers may have in their representation. The judge has yet to respond.

The lead prosecutor is Assistant U.S. Attorney James McGovern, who in 2008 won the conviction of Bradley Stinn, former chief executive officer of Friedman’s Inc. Stinn was convicted for lying to investors about the finances of his company, once the third-largest U.S. retailer of fine jewelry.

McGovern may call Bear Stearns employees to testify at the trial. In March 2007, Cioffi urged a Bear Stearns broker to put more money in the funds, telling him it was an “awesome opportunity,” according to the indictment.

Successfully Lured

Tannin said he agreed, and later that month bragged in an e-mail that he had successfully lured more money into the funds, prosecutors alleged.

“Believe it or not -- I’ve been able to convince people to add more money,” Tannin said in an e-mail to another member of the portfolio team in March 2007, according to the indictment.

Prosecutors told U.S. District Judge Frederic Block, the trial judge, that they will also call investors or their representatives who had “one-on-one meetings” with the defendants during this time period.

Assistant U.S. Attorney Patrick Sinclair said at an Oct. 5 hearing that one witness, Jennifer Wu of Palomar Capital Advisors Ltd., questioned Cioffi on a January 2007 conference call about their investments

Wu “asks very pointed questions about the holdings of subprime investments,” Sinclair said. “She is trying to in this call dig in and learn more.”

‘Adding More Money’

Sinclair added that “she also was the recipient of some of the defendant Tannin’s e-mails in March 2007, when he specifically represented to her that he himself would be adding more money to the fund.”

Wu couldn’t be immediately reached for comment.

The government also indicted Cioffi on a separate charge of insider trading, saying he pulled $2 million of his own money, one third of the amount he’d invested in one of the funds, before March 2007, so he could commit it to another fund he set up. The withdrawal, made with material, non-public information, occurred before the funds began to fail and ahead of investors’ redemptions, prosecutors said.

Defense lawyers plan to attack the government’s use of e- mails and conference call transcripts as cherry-picked to suit its case, according to a person familiar with their strategy. The lawyers will attempt to show that Cioffi and Tannin weren’t sure the financial markets were going to collapse, and that they expressed doubts on investor conference calls, the person said.

“What bothers me about this case is I think the government is doing a lot of overreaching,” said Andrew Frisch, a former federal prosecutor in Brooklyn who is now in private practice.

‘Looking for Scapegoats’

“The public is looking for scapegoats and it’d be very easy for a jury to gloss over the details and hold these guys accountable for a much larger problem, when the real culprits were the rating-agencies. They were the facilitators, not these two guys who ran hedge funds,” the lawyer said.

Frisch, who has reviewed e-mails the government cited, said some of them must be read in their entirety. In the April 2007 e-mail exchange including the “CDO market is toast” language, Frisch notes that Tannin also discussed “guessing” about how the market will proceed.

“The sub-prime market looks pretty damn ugly,” Tannin wrote to Cioffi, according to court filings, voicing a concern that they may be “looking at major writedowns across the board.” Tannin added that if analyses “are anywhere close to accurate I think we should close the funds now.”

‘Read Many Ways’

“The e-mails can be read many ways,” Frisch said. “The kinds of discussions that Cioffi and Tannin had in those e-mails were the kinds of discussions that were happening from the White House to people’s dinner tables at the time, trying to figure out how bad the market was and if they should get out,” he said. “Some of these messages convey other meanings when read in their entirety than the excerpts cited in the indictment.”

“If these guys miscalculated they should be sued,” Frisch added, “but it’s wrong to subject them to prosecution and a possible 20-year prison sentence because they didn’t get it right.”

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 reporter on this story: Patricia Hurtado in U.S. District Court for the Eastern District of New York in Brooklyn at pathurtado@bloomberg.net.

Last Updated: October 12, 2009 11:43 EDT