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Hedge funds bankruptcy alarm

Date: Thursday, August 9, 2007
Author: Tim Ridley, Cayman Islands Monetary Authority

The failure of two Cayman Islands-based hedge funds, which is estimated at US$4 billion in losses, could have severe repercussions on the offshore banking industry in the Cayman Islands, according to experts in the sector.

US financial giant Bear Stearns was forced to liquidate the two funds, Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd, after their target loan market collapsed.

There have also been comments about the speed of the collapse with one hedge fund folding in less than ten months after being created.

On 22 June, Bear Stearns pledged a collateralised loan of up to US$3.2 billion to bail out the Bear Stearns High-Grade Structured Credit Fund, while negotiating with other banks to loan money against collateral to the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.

About three weeks later Bear Stearns disclosed that theses two hedge funds had lost nearly all of their value amid a rapid decline in the market for sub-prime mortgages, made to people with low credit ratings.

On 31 July, both funds filed for bankruptcy protection with the Grand Court in the Cayman Islands. Bear Stearns also used a recent amendment to US bankruptcy code to block all lawsuits against the funds and protect the company’s assets in the USA from litigation arising from the collapse of the hedge funds.

The revision to Chapter 15 of US bankruptcy code allows the bankruptcy to be heard in what is legally described as, “the centre of main interests,” rather than the location where most of the business was actually transacted. It protects both the company and all its assets in the USA from action and leaves the distribution of recovered funds to the local court.

The move has been heavily criticised in US media reports. Several have quoted concerns that the move effectively took the case where the judicial system made it difficult to effectively recover funds. One states that actions here tend to work in favour of management.

However, one local expert challenges this. While asking not to be named, they said, “It’s not a case of bias, but of whether the assets of the hedge fund and the actions of those involved are actually within the jurisdiction of the Cayman Islands.” They also point out, in comments mirrored by most media reports, that this aspect of the US bankruptcy code has never been tested in court before.

Although attempts to file a class action in the USA on behalf of creditors appear to have failed, one 73-year-old investor, who allegedly lost US$500,000 in the high-grade structured fund, has filed a claim. The action, filed by the law firm of Zamansky & Associates, alleges, amongst other things, that Bear Stearns withheld valuable information about the funds’ declining fortunes from investors.

But it is not just the private investors who were caught up in the failing funds. In the UK, Barclays Bank is believed to have lost a substantial sum of money and, in June, Merrill Lynch moved to protect their investors by realising US$800 million of assets from the hedge funds in a move, which some analysts believe effectively forced the bankruptcy.

Despite the scale of the collapse, one source is quoted as saying investors may only recover, “a pittance on the dollar,” and local reaction has been muted.

One source within the financial industry said the problem had nothing to do with offshore hedge funds as such: “It’s the way they are being used and sold.”

“People have to exercise due diligence and find out where their money is going. The bottom line is that smaller investors can get badly hurt if a hedge fund collapses but such collapses are few, and far between,” they advise.

A call to the law firm handling the bankruptcy petition in Grand Cayman was not returned. Attempts to contact Tim Ridley, Chairman of the Cayman Islands Monetary Authority, were also unsuccessful.

In April, at the Offshore Alert conference in Miami, Mr Ridley told Reuters that Cayman’s reputation would be at risk if just one of the hedge funds registered here collapsed.

He also said the Cayman Islands would not implement tighter regulations for hedge funds despite being regularly branded a haven for tax cheats by other countries.

About 8,500 of the world’s 9,000-plus hedge funds are domiciled in the Cayman Islands.

Media speculation in the USA now seems to centre on the possibility that other hedge fund managers may be watching the Bear Stearns saga unfold to see if it effectively provides them with a “fire exit” if problems arise.