8th Circuit Rejects Hedge Funds Debt Collection Practice

Date: Wednesday, December 10, 2008
Author: Pamela A. MacLean, Law.com

The 8th U.S. Circuit Court of Appeals has become the first circuit in the country to rebuff efforts by a hedge fund to call in a debt based on an alleged technical violation of bond terms in a dispute over an $850 million note issued to United Health Group Inc.

The circuit noted that at least three other federal judges and a New York state court have come down the same way, rejecting the practice used to assert a default claim against United Health in United Health Group Inc. v. Wilmington Trust Co., No. 08-1904 (8th Cir.)

Claims similar to Wilmington Trust's have cropped up in other cases as an investment strategy derided by attorney Robert Giuffra, as a "shakedown strategy" that takes from shareholders and gives to bondholders. Giuffra of Sullivan & Cromwell in New York represented United Health in the case. "We are pleased with the 8th Circuit's decision holding that United fully complied with the terms of its indenture, the relevant federal statute and acted in good faith," he said.

A similar effort by Wilmington Trust attorneys was rejected in February by U.S. District Judge Sidney Fitzwater in the Northern District of Texas in which the trust tried to demand early payment of $250 million in notes against Affiliated Computer Services Inc.

In some instances, companies have settled the disputes by paying hedge funds, Giuffra said.

Calls to Wilmington Trust attorneys John B. Orenstein and Jeff Ross of Anthony Ostlund Baer Louwagie & Ross in Minneapolis were not returned.

The investment tactic involves looking for a publicly traded company with bonds being traded below par value, where a technical violation can be asserted such as delayed reporting of filings to the U.S. Securities and Exchange Commission (SEC). The hedge fund buys the bonds, asserts there is a technical default on the bonds and uses that to force the company to redeem the bonds at par value, creating an immediate profit for the hedge fund, according to Giuffra.

In the case of United Health, the bonds were trading at 65 cents on the dollar, or 35 cents below par in 2006 when Wilmington asserted the default claim. When United Health delayed its annual SEC filing in order to investigate related allegations of options backdating, Wilmington claimed United violated bond requirements to mail the SEC report within 15 days of its filing and called for immediate payment of the 30-year, $850 million note. Early redemption on the bonds could have provided a windfall for bondholders.

The dispute began when Wilmington filed a default notice against United in 2006, seeking to collect the outstanding balance on the 30-year notes, then trading below the full value of the loan. Wilmington and other hedge funds alleged that United violated terms of the bond by failing to mail copies of its annual report to the SEC to bondholders within 15 days.

The 8th Circuit said United had delayed filing reports to the SEC while it investigated potential options backdating claims, but "diligently forwarded to [Wilmington] copies of its required reports within 15 days of actually submitting them to the SEC."

United met all its contractual and statutory obligations, according to the court.

"What's significant about this decision is that it makes it harder for hedge funds to engage in this shakedown strategy," Giuffra said.

In the district court opinion, U.S. District Judge James Rosenbaum noted that hedge funds increased their purchase of notes by $55.8 million after filing of the default notice, a point when most investors bail out of an investment, suggesting they hoped to force early repayment on bonds they bought at a discount.

Giuffra warned that the 8th Circuit decision clarifies the importance of careful drafting of language in bond indentures. He said lawyers for issuers should use more permissive language outlined in one of two models by the American Bar Association, and not obligate companies to file by specific times.

The first instance of such a claim came in the New York state case Bank of New York v. BearingPoint Inc., 2006 WL 2670143 (New York Co., N.Y., Sup. Ct.), followed by Cyberonics Inc., v. Wells Fargo Bank, 2007 WL 1729977 (S.D. Texas 2007); Affiliated Computer v. Wilmington Trust Co., 2008 WL 373162 (N.D. Texas 2008) and Finisar Corp. v. U.S. Bank Trust, 2008 WL 3916050 (N.D. Calif. 2008).