June 20 (Bloomberg) -- The arrests of former Bear Stearns Cos. hedge fund managers Ralph Cioffi and Matthew Tannin yesterday show how Wall Street bankers may look out for themselves while hiding bad news from customers.

Cioffi, 52, and Tannin, 46, were charged by federal prosecutors with misleading investors about two hedge funds whose collapse last year helped ignite the subprime-mortgage crisis. A companion Securities and Exchange Commission civil suit accuses Cioffi of redeeming $2 million from the funds while Tannin mocked as ``silly'' at least one investor who wanted to get out.

``No one should be surprised that people on Wall Street talk out of both sides of their mouths,'' Peter Henning, a former U.S. Justice Department prosecutor who teaches at Wayne State University Law School in Detroit, said in an interview. ``Wall Street is in sales, and no one trusts everything a salesman says.''

In the Bear Stearns case, federal prosecutors allege that Tannin, in an April 2007 e-mail to Cioffi, wrote that the ``subprime market looks pretty damn ugly'' and could be ``toast.'' The SEC said they gave monthly reports that ``consistently understated'' the funds' exposure to subprime mortgages.

If the accusations are true, ``it shows a callousness toward their own investors,'' said Theodore Sonde, a former SEC enforcement attorney now at Patton Boggs LLP in Washington. ``You have an obligation to be honest with your investors about what's going on.''

Dot-Com Era

Not dealing candidly with investors was at the heart of two cases from the dot-com era.

Merrill Lynch & Co. analyst Henry Blodget called InfoSpace Inc. a ``piece of junk'' in an e-mail in 2000 even as he told investors to buy the maker of Internet-search software, according to an SEC complaint.

Citigroup Inc. in 2002 settled accusations that analyst Jack Grubman misled investors about stocks he recommended, including Focal Communications Corp., which sought bankruptcy protection.

Blodget and Grubman were each fined and banned for life from the securities industry.

In the credit meltdown this year, at least 24 proposed class-action lawsuits have been filed since mid-March against brokerages over claims that investors in auction-rate securities were told their holdings were almost as liquid as cash.

Auction-rate investments are typically bonds with interest rates reset by bidding, usually every seven, 14, 28 or 35 days. The sales of the securities have been failing since mid-February, leaving buyers unable to dispose of holdings.

San Francisco-based Charles Schwab Corp., the largest U.S. online broker, is accused in at least eight proposed class actions of misleading investors by describing its YieldPlus bond mutual fund in prospectuses as ``marginally'' riskier than cash.

$1.3 Billion

From last July 1 through April 30, investors lost about $1.3 billion in the fund, according to Boston-based Financial Research Corp. The company believes it has ``strong defenses to the claims,'' spokesman David Weiskopf said in a June 6 e-mail.

Former New York State Attorney General Eliot Spitzer in 2003 won $1.4 billion in settlements from 10 securities firms he accused of using analysts' research to win investment-banking deals.

The Bear Stearns action ``has similarities with the research-analyst cases, where the government tried to prove analysts said one thing privately but said something different publicly,'' said Michael Missal, a former SEC lawyer now with Kirkpatrick & Lockhart Preston Gates Ellis LLP in Washington.

Downplaying Risk

The SEC alleges that Cioffi and Tannin downplayed the risk in their investments. While the funds' monthly summaries typically said about 6 percent to 8 percent of their portfolios was directly tied to subprime mortgages, an internal report in April showed that total exposure, including indirect bets on mortgage-backed securities, amounted to about 60 percent, the SEC said.

The men misled clients about the funds' performance and holdings after one of them lost money for the first time in February last year, prosecutors said. During a meeting in early March, Cioffi urged Tannin and two colleagues not to discuss difficulties with others, according to the indictment.

On March 23, Cioffi began transferring $2 million of his own money out of one fund. On April 22, Tannin sent Cioffi an e-mail suggesting they close the funds immediately if a colleague's projections for the collateralized debt obligation market were ``anywhere close'' to accurate.

`Very Comfortable'

On a conference call with fund investors three days later, Tannin said, ``We're very comfortable with exactly where we are,'' according to the indictment. Cioffi failed to mention on the call that investors planned to pull $67 million at the end of April and May, and said June 30 redemptions would amount to ``a couple million'' when $47 million was slated, the indictment said.

Cioffi and Tannin haven't entered pleas and were freed on bond.

``Mr. Cioffi had no motive to do anything wrong,'' defense lawyer Edward Little said in a statement. Tannin is innocent and is being made ``a scapegoat for a widespread market crisis,'' said his attorney, Susan Brune.

The defendants' statements to investors about the funds' liquidity are ``worrisome,'' former analyst Blodget, a founder of the Silicon Alley Insider Web site, said in a posting to his blog yesterday.

The case ``shows that one of the fundamental lessons of Enron -- that you can't mislead investors about the state of company affairs -- did not make it to the hedge funds,'' said Jacob Frenkel, a former SEC lawyer with Schulman Rogers in Rockville, Maryland. ``The problem is saying the company is doing well when that's not true.''

To contact the reporters on this story: Ian Katz in Washington at ikatz2@bloomberg.net. David Scheer in New York at dscheer@bloomberg.net.

Last Updated: June 20, 2008 00:01 EDT