Nov. 11 (Bloomberg) -- The acquittal of two Bear Stearns Cos. hedge-fund managers in a subprime-mortgage fraud case that relied heavily on e-mail evidence may make it more difficult for the government to win related cases based on similar facts.

The loss in the face of allegedly incriminating communications between Ralph Cioffi and Matthew Tannin may prompt prosecutors and regulators to be less aggressive in cases stemming from the handling of subprime investments, such as those involving Lehman Brothers Holdings Inc. or American International Group Inc., former prosecutors and defense lawyers said.

The verdict may also have impact on hedge fund cases, they said. The jury’s finding, returned in nine hours after a month- long trial, may provide prosecutors of Galleon co-founder Raj Rajaratnam and his alleged confederates with a cautionary lesson, said attorney Bradley Simon.

“It is a risky proposition to rely on such communications, because they are open to multiple interpretations,” said Simon, a former federal prosecutor now in private practice in New York.

The acquittal of the Bear Stearns managers yesterday in Brooklyn, New York, federal court on fraud and conspiracy charges also may damage a related Securities and Exchange Commission suit against the two men. Additionally, prosecutors backed off previous statements that Cioffi and Tannin may face a wire fraud charge in Manhattan federal court.

Cioffi, 53, the portfolio manager for the Bear Stearns funds, and Tannin, 48, their chief operating officer, each faced as many as 20 years in prison. The Brooklyn trial was the first stemming from a U.S. probe of the collapse of the subprime mortgage-market, which cost investors as much as $396 billion. They were indicted in 2008 in a case brought by Brooklyn U.S. Attorney Benton Campbell a year after their funds failed.

Give Pause

This “will give the government pause before they indict” in similar cases, said Todd Harrison, an ex-federal prosecutor. “For those kinds of cases that are more market driven, as the Bears Stearns was, it’ll give the government a lot of pause.”

Simon said the government took a risk by relying on electronic communications to try to convict Cioffi and Tannin of defrauding investors. Prosecutors alleged the men touted their funds while privately acknowledging their financial health was unsound. In Galleon, a prosecution that relies in large part on wiretapped conversations, “the government’s going to have to show they were illegally trading on insider information instead of doing legitimate research.”

In the Bear Stearns case, the defense argued successfully that Cioffi and Tannin were honestly optimistic about the funds’ health. E-mails which the men sent were more ambiguous than the government alleged, defense lawyers told the jury.

Wasn’t Enough

The jurors said after the verdict that the evidence presented wasn’t enough to convince them of guilt.

“Everything contradicted,” said Jenny McCaughey, the jury forewoman. “The e-mails went both ways. They say one thing one time and another thing another time. The government didn’t give us enough to go on.”

Prosecutors accused both men of misleading investors who lost $1.6 billion when the funds collapsed in 2007, calling 21 witnesses and presenting hundreds of pages of documents.

Dane 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 in his closing arguments.

Susan Brune, a lawyer for Tannin, said the case was “built on hindsight and bias.” 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 is reason to believe that the funds weren’t going to tank, that’s what they believed,” Brune told jurors.

Revealed Evidence

While communications between defendants also form the core of publicly revealed evidence in the Galleon prosecutions, the government has cited guilty pleas, informants and trading records to support that case. Rajaratnam was arrested on Oct. 16 and accused with five others of making millions of dollars by trading on inside information. He has denied wrongdoing.

Federal prosecutors this month charged another 14 people in their widening probe of insider trading related to that New York-based hedge fund. The 20 people charged so far earned at least $53 million in illicit profits, the U.S. has said.

“You have to show a personal benefit from the transactions, or a lie” to convince a jury, and the government didn’t succeed with Cioffi and Tannin, said Peter Henning, a legal ethics professor at Wayne State University Law School in Detroit and a former federal prosecutor.

‘Impending Collapse’

Robert Mintz, an ex-federal prosecutor in private practice, said the Bear Stearns jury found the “government was trying to unfairly hold these defendants responsible for predicting the impending collapse of the economy at a time when even economists uncertain as to where the world markets were headed.”

While the Bear prosecution failed, the taped evidence in the Galleon case may be seen by jurors as more incriminating than e-mails, defense lawyers said. In the Galleon case, the government’s complaint against Danielle Chiesi, a former money manager at hedge fund New Castle Partners LLC who allegedly leaked inside information to Rajaratnam, quotes her as saying that if the government found out about the information she was relaying to an unnamed co-conspirator, she would go to jail.

“I swear to you in front of god, you put me in jail if you talk,” Chiesi said in August 2008, prosecutors said.

The Bear Stearns fund managers expressed ambiguity in their e-mail conversations, according to their defense lawyers and former Bear Stearns employees who testified at the trial.

“There wasn’t enough clear and convincing evidence,” said juror Tabasam Bhatti, 31, a New York City employee.

Second Thoughts

Serphaine Stimpson, 27, another juror, said she initially entered the case thinking both men were guilty. As the trial unfolded, she said she began to have second thoughts.

“Something happened,” said Stimpson, an office coordinator at Brooklyn College. “We just weren’t 100 percent convinced.”

Larry Ribstein, a law professor at University of Illinois, said the Bear Stearns case was “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. This never should have been the subject of a criminal prosecution.”

“You’re kind of damned if you do and damned if you don’t,” Ribstein said of the Bear Stearns defendants. “If you overplay the negativity of the circumstances then you’ve got a full-fledged bank run on your hands. On the other hand, if you play it on the optimistic side, you go to jail.”

Trying to Save

Jurors said they concluded that Cioffi and Tannin were trying to save the funds after lenders stopped extending credit.

“The jury just didn’t buy the notion that they were telling lies and recognized that no one has a crystal ball,” said David Douglass, a former federal prosecutor.

E-mails at times can be unreliable evidence, according to Gerald Shargel, a criminal defense lawyer in New York who represented lawyer Marc Dreier on charges he defrauded hedge funds out of more than $400 million.

“Everybody knows that e-mail messages are not thought out,” Shargel said. “Mistakes are made, they are sent to the wrong person, they are not proofread. Jurors have experience with e-mails, and they know they can be unreliable.”

Cioffi and Tannin also face lawsuits by investors and Bank of America Corp. Last month, a federal judge in Manhattan refused to dismiss contract and fraud claims against Bear Stearns, now a unit of New York-based JPMorgan Chase & Co.

Hedge Funds

Mortgage-backed assets mostly owned by Bear Stearns hedge funds were used to back the sale of securities in a transaction structured by Bank of America, the Charlotte, North Carolina- based bank said in its 2008 complaint. Hedge fund losses hidden from Bank of America led to the funds’ collapse and caused an “enormous decline” in the assets behind the securities and the securities themselves, the bank alleged in its complaint.

Last week, federal prosecutors in Brooklyn said that Cioffi and Tannin would face a new prosecution in Manhattan federal court for wire fraud. The government last week dropped 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.

Yesterday, Campbell’s office declined to say whether the wire fraud charge, also related to the collapse of the Bear Stearns funds, would be filed.

The SEC lawsuit against Cioffi and Tannin, brought last year, alleges they misled investors about the funds’ deepening financial troubles and their own holdings.

Awaiting Trial

The regulator’s case, still awaiting trial, requires a lower standard of proof than a criminal conviction.

Even after the acquittals, Cioffi and Tannin might decide to settle the SEC’s claims because a lawsuit carries a lower burden of proof and the stakes won’t be as high, said Harrison, who worked as a federal prosecutor in Brooklyn, and is now in private practice at Patton Boggs LLP in New York.

“It certainly gives them much more leverage in the SEC case, to point to the criminal case and say ‘Look, a jury didn’t buy it there,’” said Harrison, who didn’t work on the case while a federal prosecutor.

John Nester, a spokesman for the SEC, said yesterday that, “we expect to go forward with litigating our civil action.”

The Bear Stearns 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 Funds

The two 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.

Cioffi and Tannin 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.

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.

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.

In the Bear Stearns prosecution, there were no cooperating witnesses testifying against the two men. While the government case against Galleon’s Rajaratnam began with complaints citing wiretapped conversations, more evidence -- and possible witnesses -- have been revealed since then. Five people have pleaded guilty in the Galleon case and are cooperating with investigators. The guilty pleas of Richard Choo-Beng Lee, Gautham Shankar, Roomy Khan, Steven Fortuna and Ali Far were made public last week.

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; Bob Van Voris in New York at rvanvoris@bloomberg.net; Linda Sandler in New York at lsandler@bloomberg.net.

Last Updated: November 11, 2009 00:24 EST