It Isn’t Over Till the Fat Lady Sings (Bear Hedge Fund Edition)

Did you think the Bear Stearns hedge fund drama of the summer was over? We may see a low-budget sequel.

The Financial Times reports that aggrieved shareholders of one of the failed Bear funds, High-Grade Structured Credit Strategies Enhanced Leverage (Overseas), have assumed control. US based investors get to vote on Friday (no guess as to outcome, but the success in London would seem to bode well for the US owners). The Wall Street Journal discusses in more detail the lawsuit filed by the Massachusetts securities regulator alleging improper trading and conflicts of interest, charges which apparently resemble the ones made by the London shareholders.

This gets fun because the shareholders are “seeking recovery” which is code for “out to find a basis for suing Bear.” It’s easier and cheaper for them to investigate what happened if they posses the books and records than if they have to go through the costly and often imperfect process of discovery and document requests.

Note that Bear was sloppy in how it administered the funds, which has already worked to its disadvantage. Bear had set the funds up in the Cayman Islands, and sought to have them liquidated there, and simultaneously filed in the US for protection under Chapter 15, which shields foreign companies from US creditors. The US judge denied the request and Bear is appealing.

The problem is that Bear did not take the steps to have its Caymans domicile stick. I’m no expert, but having sat in on a few presentations, minimum steps include keeping your books and records in the jurisdiction, having a local attorney and local administrators for the fund, holding annual meetings in person (how awful can it be to be required to go to the Caymans once a year?). But Bear apparently couldn’t be bothered to do that.

Similarly, according to the Massachusetts filing, Bear also couldn’t be bothered to follow its own requirements, which required that its two independent directors sign off on any trades made between Bear and the funds to assure that the funds were getting good prices. (And I hate to be cynical, but how could directors in the Caymans have verified the prices were good anyhow? This appears to have been a matter of form with almost-certain-to-be-compliant directors.)

Rest assured that sharp-eyed attorneys will be looking to turn any other procedural sloppiness to their advantage. However, note that the suit has not indicated damages, and until the shareholders or the State of Massachusetts can establish that these failings actually hurt the funds’ investors, these moves are more heat than light.

First, from the Financial Times:

Investors in London have successfully wrested control of one of the collapsed Bear Stearns hedge funds from its previous management and directors as a first step towards seeking recovery of some of their losses…

“Today’s shareholder victory is an important first step in bringing objective review and transparency to these crashed CDO funds,” said Constantine Karides, a lawyer with Reed Smith, which represents investors in the funds.

The fund’s previous management and board will be replaced by FTI Capital Advisors, forensic accountants who seek evidence of mismanagement that could be used for lawsuits.

Jacob Zamansky, a lawyer who negotiated an early settlement from Merrill Lynch in a scandal over skewed investment bank research, said the move could also assist some investors’ pursuit of arbitration.

Mr Zamansky has filed for arbitration in the US on behalf of a group of domestic investors and expects to file similar claims in London.

An element of the claim is alleged improper trading and conflicts of interest by the bank, buttressed on Wednesday by a lawsuit from the lead securities regulator for the state of Massachusetts making the same allegations.

And from the Wall Street Journal:
Massachusetts regulators accused Bear of fraud for improperly trading mortgage-backed securities with two internal hedge funds that collapsed this summer. Regulators in the office of Secretary of State William F. Galvin say Bear employees improperly made “hundreds” of principal trades for the firm’s own account with the hedge funds without notifying the funds’ independent directors in advance. Bear declined to comment….

At issue in the Massachusetts case is a federal securities law that requires financial firms making principal trades with affiliated funds to notify the fund’s investment advisers in advance of such trading. According to the Bear funds’ offering documents, the sign-off of two independent directors was required before the entities could make trades with Bear to ensure the fairest prices.

According to the administrative complaint, 47% of the principal trades conducted by the less risky of the two funds between 2003 and 2006 didn’t secure such approval. Investors lost $1.6 billion when the funds collapsed in July. Unauthorized trades between Bear’s two hedge funds and its brokerage firm abounded during the three-year period after the less-risky fund was opened in 2003, according to the complaint.

On July 19, 2006, the filing states, a Bear sales assistant sent an email to the compliance officer for the independent directors requesting approval for 88 principal trades that had occurred since January of that year. Later, realizing it had run afoul of its own rules, Bear put a moratorium on all trades between the brokerage and the fund, which extended, with some exceptions, until May or June 2007, the complaint alleges.

The current independent directors, both executives at Walkers SPV Ltd. — a fund administrator in the Cayman Islands, where both funds were incorporated — refused to respond to a subpoena with questions about potential conflicted trades, according to Mr. Galvin. In an interview, Mr. Galvin said, “This is a recurring theme in the financial-services industry — conflicts of interest — and part of the reason we got to this,” referring to the mortgage area. The complaint doesn’t say that the trades hurt the value of the funds.