How to Screw Hedge Fund Investors

♠ Posted by Emmanuel in , at 8/07/2007 05:00:00 PM
"Hedge funds" is a misnomer as these funds often place bets that go one-way; that is, they do not "hedge" in the conventional sense by guarding against possibility X through placing bets on possibility Y just in case. Case in point: the infamous failed Bear Stearns hedge funds. I have previously mentioned the role of offshore tax havens that use low tax rates to attract financial service providers to their shores. Now, Bloomberg is reporting that tax havens like the Cayman Islands have another trick up their sleeve to attract them. When push comes to shove--such as now when Bear is forced to liquidate these hedge funds--these tax havens tilt the rules in favor of the businesses that choose these places to incorporate in. That's right--investors (and creditors) may be screwed twice over by the opaqueness of hedge fund operations and by legal chicanery courtesy of the offshore economy. What else can I say? Caveat emptor: the Bear case (no, not the "pessimistic" bear case) may be yet another battleground over matters of legal jurisdiction concerning tax havens:
Bear Stearns Cos.' decision to liquidate two bankrupt hedge funds in the Cayman Islands instead of New York may limit creditors' and investors' ability to get their money back.

While most of their assets are in New York, the funds filed for bankruptcy protection July 31 in a court in the Caymans, where they are incorporated. The bank also used a 2005 bankruptcy law to ask a U.S. judge in Manhattan to block all lawsuits against the funds and protect their U.S. assets during the Caymans proceedings.

The Bear Stearns cases may establish a precedent that would let other failed hedge funds liquidate in the Caymans, where judges have a track record of favoring management. The local monetary authority estimates that three out of four hedge funds globally are incorporated in the islands.

``This is definitely going to be closely watched,'' said Evan Flaschen, a lawyer with Bracewell & Giuliani in New York, who has represented companies and creditors in international bankruptcy cases. ``Other hedge funds might do the same thing.''

The funds, which invested in securities tied to home mortgages, collapsed amid rising defaults on subprime loans, made to people with weak credit. Bear Stearns, the fifth-largest U.S. investment firm by market value, on Aug. 5 ousted Co-President Warren Spector, who headed the mortgage and fixed-income business...

Creditors and investors in the two funds are likely to get back ``a pittance on the dollar'' and will attack Bear Stearns's bankruptcy tactics in court, said Bill Brandt, president of Chicago-based Development Specialists Inc. His firm advises hedge fund Ritchie Capital Management Ltd. in the bankruptcies of its two life insurance funds in New York...

Filing the funds' bankruptcy in the Caymans ``is a nice little stunt, and it may work for a while,'' Brandt said. ``Bear Stearns is trying to put a wall between themselves and these so- called rogue funds.''

The Caymans courts make it ``difficult to take legal action there'' and are ``much less transparent than American courts,'' said Jay Westbrook, a professor at University of Texas Law School in Austin who helped author the 2005 law. The British- administered islands are ``attractive to management,'' he said.

Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd. and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd. asked for an ``orderly liquidation'' in a petition filed in Cayman Islands Grand Court, citing volatility in the subprime mortgage market.

Chapter 15 of the U.S. bankruptcy code, a new international law passed by Congress in 2005, lets U.S. bankruptcy judges assist courts in other countries with liquidations. The measure shields the company in bankruptcy and its assets in the U.S. from lawsuits and other collection attempts. Distributions to creditors are handled by the foreign court.

Creditors may argue that the main case should proceed in the U.S. To do so they must show the U.S. bankruptcy judge that the hedge funds had their ``center of main interests'' in the U.S, said Robin Phelan, of Haynes & Boone, who represented hedge fund InverWorld Inc. in its 1999 liquidation in the Caymans.

Because the two hedge funds were incorporated in the Cayman Islands, that's presumed to be the center of main interests, according to Phelan.

``That's going to be an issue,'' he said, noting that the new bankruptcy law ``hasn't really been tested.''

The Caymans ``ought to be irrelevant'' because the funds' assets are in the U.S., according to their bankruptcy filings, Westbrook said. ``If a company is basically managed out of New York, then the case should be in New York,'' he said.

``This was a properly commenced Cayman Islands proceeding, commenced in accordance with the governing provisions of the funds and with Cayman law,'' said Fred Hodara, a lawyer for the bankrupt funds with Akin Gump Strauss Hauer & Feld in New York, ``These are Caymans-formed entities.'..'

In the U.S., the Bear Stearns hedge-fund cases were assigned to Burton Lifland, the most senior bankruptcy judge in New York. Lifland scheduled a hearing for Aug. 9 on the funds' request for an order blocking legal actions against the U.S. assets.

Lifland ``is as familiar with these types of issues as anyone,'' Flaschen said. ``He focuses on the equities of the situation -- what's fair and practical.'