S.E.C. Reaches Settlement in Bear Stearns Fraud Case

The Securities and Exchange Commission has reached a settlement with two former Bear Stearns hedge fund managers that will avert a second trial over accusations that they had misled investors as the mortgage market was crumbling.

The deal, which is subject to court approval, could be announced on Monday, said two people with direct knowledge of the matter, who requested anonymity because they were not authorized to discuss it publicly.

A trial was set to begin on Monday in Federal District Court in Brooklyn. The former Bear executives, Ralph R. Cioffi and Matthew M. Tannin, were accused of lying to investors about the health of their hedge funds, which were laden with complex securities backed by subprime mortgages.

The settlement comes just as federal authorities have publicly vowed to redouble their efforts to hold Wall Street executives responsible for questionable conduct during the housing boom.

A civil trial would have been the second trial against the former Bear executives. The Justice Department and the S.E.C. brought parallel criminal and civil charges against Mr. Cioffi and Mr. Tannin in 2008.

The criminal case was viewed as an early test of the government’s ability to win convictions tied to the subprime mortgage-related investments that banks sold during the housing boom.

When a jury acquitted both men in November 2009, the loss was seen as a major setback for the the Justice Department. The not-guilty verdict demonstrated that it would be challenging to build successful cases against Wall Street executives at the center of the financial crisis.

Battered by criticism that it had been an ineffective regulator before the financial crisis, the S.E.C. maintained that it would continue to pursue its case. But some legal specialists questioned whether it made any sense for the commission to take the lawsuit to trial.

“The government clearly had the power to do this, but the more salient question is whether this was the best use of their resources,” said Daniel L. Zelenko, a partner at Crowell & Moring and a former S.E.C. lawyer. “More than two years after a jury has already acquitted on substantially the same set of facts, it’s not clear that it was.”

Bear’s hedge funds were among the first prominent collapses related to the bursting of the housing bubble. When the mortgage market first became unglued in 2007, the two investment vehicles failed and investors lost $1.8 billion. The demise of the funds heralded the coming calamity on Wall Street.

Lawyers for Mr. Cioffi and Mr. Tannin declined to comment, as did an S.E.C. spokesman.

One crucial issue that remains unclear is whether the two men will acknowledge any misconduct. Judges and legal commentators have criticized the commission for not forcing defendants to admit any wrongdoing when settling.

In recent weeks, there has been a flurry of activity in government investigations stemming from the financial crisis. Last week, federal prosecutors in Manhattan brought criminal charges against three former Credit Suisse traders, accusing them of inflating the value of their mortgage-bond portfolios to secure higher bonuses. Two of the traders have pleaded guilty.

During his State of the Union address last month, President Obama announced the formation of a multiagency financial crimes unit to prosecute mortgage-related fraud cases.

Robert S. Khuzami, the head of enforcement for the S.E.C., has said that the commission has already issued scores of subpoenas, analyzed more than 25 million pages of documents and interviewed scores of witnesses involved in the mortgage securities market.

“These mortgage products suffered unprecedented losses, and the pain and loss that followed is known all too well,” said Mr. Khuzami, speaking about the new unit at a news conference last month. “The job of the S.E.C. and my fellow law enforcement colleagues is to hold accountable those persons, those institutions who lied, who cheated and who misled investors in the sale of these products.”

Criminal defense lawyers have expressed concern over the creation of yet another task force, as this latest one follows several others that the government has formed since the financial crisis.

“We must distinguish what is criminal from what is reckless behavior and bad business decisions and not bow to the frenzy,” said Mary Jo White, a partner at Debevoise & Plimpton and former United States attorney in Manhattan, speaking on a panel on Wednesday. “You don’t want the search for scalps to be the metric for success,” she said.

Taking Mr. Cioffi and Mr. Tannin to trial would have been risky for the S.E.C. It is highly unusual for the agency to try defendants in a civil case after a jury has acquitted them in a criminal trial.

“A loss would have called into question the government’s apparent strategy of leaning heavily on civil litigation to handle crisis-related misconduct,” said Neil M. Barofsky, a law professor at New York University and former inspector general of the Treasury Department’s bank bailout program. “And a poor trial performance could seriously have undermined the S.E.C.’s ability to achieve settlements in other cases.”

Mr. Tannin and Mr. Cioffi also had an incentive to settle, said several lawyers, because of the government’s lower burden of proof in a civil securities fraud trial. Federal prosecutors needed to prove their case “beyond a reasonable doubt,” but the S.E.C. would have needed to prove only “by a preponderance of the evidence” that the defendants knowingly defrauded their investors.

Mr. Cioffi, once a highly regarded bond salesman at Bear, embodied the emergence of esoteric mortgage investment products as a dominant producer of Wall Street profits. He developed a specialty in structured finance securities, and in 2003, the bank put him in charge of a new hedge fund that would raise money from outside investors. He brought in Mr. Tannin, another Bear executive, as his partner.

The strategy of the fund was to invest in AAA-rated securities that were backed by pools of residential mortgages.

As the housing market boomed, the fund posted strong results. Mr. Cioffi and Mr. Tannin earned millions of dollars. They then raised another fund that promised increased returns by using more borrowed money to invest. The fund with increased leverage borrowed more than $25 for every dollar invested in the fund.

When the housing market seized up in 2007, performance of the funds sank and investors headed for the exits. All the while, the government says, Mr. Cioffi and Mr. Tannin publicly expressed confidence in the funds while privately voicing doubts about the market. By July 2007, the funds imploded.

At the criminal trial, federal prosecutors tried to simplify their case for the jury. Seeking to avoid arcane topics like collateralized debt obligations, credit-default swaps and repurchase agreements, the government focused on the truthfulness of the defendants.

“They did the best thing that they could think of to keep those investors in the fund and with any luck keep their bonuses coming,” a prosecutor told the jury in his opening statement. “They lied.”

The government’s leading evidence were private e-mails that the fund managers sent to each other.

“I think we should close the funds now,” Mr. Tannin wrote from a private e-mail account. He said that if certain analysts’ reports were correct, “the entire subprime market is toast.”

Days later, Mr. Tannin said on an investor call, “we’re very comfortable with exactly where we are.”

Defense lawyers argued that the two managers were merely debating how to position their portfolio given the market’s perilous state.

After a monthlong trial, the jury found the Mr. Cioffi and Mr. Tannin not guilty after deliberating for less than a day. Jurors said at the time that the government had not proved its case.

“The entire market crashed,” one juror said. “You can’t blame that on two people.”