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High-profile lawyer, and others, lining up stable of clients claiming hedge fund misled them

Investment Dealers Digest

Following the collapse this summer of two Bear Stearns hedge funds – its High Grade Structured Credit Strategies Master Fund and its High Grade Structured Credit Strategies Enhanced Leverage Master – disgruntled investors, both in the US and overseas, are teaming up to bring legal action against the Wall Street firm. Several complaints are being filed with the US Financial Industry Regulatory Authority’s arbitration tribunal alleging that Bear Stearns misled its clients in its offering documents, leading investors to believe the funds were conservative, safe investments.

A consortium of law firms are also representing investors who have lost money in the collapse of the Bear funds and will soon file a claim with the NASD Arbitration Tribunal according to Ryan Bakhtiari, a Beverly Hills based attorney.

According to the complaint, during those conference calls to investors, Bear Stearns misrepresented that its subprime exposure was limited and/or hedged and misrepresented the status and sufficiency of its liquidity to handle margin calls and market downturns, representing that it had numerous sources of liquidity, including cash, credit lines, repurchase agreement lines and other sources of liquidity such that it faced virtually no possibility of a “fire sale” liquidation. The complaint also alleges that the fund misrepresented its valuation and performance during early 2007, which were “repeatedly revised downwards as the truth emerged, eventually admitting that they were worthless.”

In July, Bear Stearns sent a letter to investors regarding the effective collapse of the two hedge funds, stating that “there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High Grade Fund.”

Zamansky is currently representing about 10 to 12 US clients and 10 UK clients, with total losses of more than $100 million. He adds that he is being approached by investors in Germany, Finland and Indonesia and will file claims on their behalf, too.

“The claim alleges misrepresentation to investors and gross negligence in the way the risk controls were in effect and monitored,” Zamansky says. “They say 11 people were monitoring the funds to make sure hedges were in place, and obviously it didn’t work and there was misrepresentation and negligence.”

He says his clients believed they would be investing in a relatively safe and conservative fund that had specialized risk management controls, with multiple layers of surveillance. “In short, the fund investors were deceived,” the complaint reads. “The fund was far riskier than represented and they were materially misled about the purported high quality nature and safety of its investments.”

The complaint further alleges that Bear Stearns never provided investors with transparent disclosure about the full extent of its subprime exposure from its investment in pooled collateralized debt obligations and asset-backed securities. “In fact, the investors were not given full disclosure until well after it was too late for them to redeem their investments and the fund was worthless,” according to the complaint.

Russell Sherman, a spokesman for Bear Stearns, says the allegations are unjustified and without merit. “We intend to defend ourselves vigorously,” he says. “The accredited, high-net-worth investors in the fund were made very aware that this was a high-risk speculative investment vehicle.” (Indeed, the offering memorandum obtained by IDD has multiple, prominent mentions of the speculative nature of the partnership and the high degree of risk involved.)

Zamansky’s complaint alleges that the fund’s exposure to subprime investments was represented to be only 7%, when it was later revealed to be greater than 50% to 60%. A copy of an October 2006 performance profile of the funds that was sent to investors and that IDD obtained states that the fund’s subprime exposure was 6.8% while, Zamansky alleges, it was later revealed to be misleading or untrue, based on his investigation.

The fund was represented to be invested in safe, high-quality investments with at least 90% invested in AAA and AA-rated securities, when in fact, there was enormous exposure to low-quality, subprime debt, the complaint alleges. According to the fund’s offering memorandum, the master fund “has targeted a portfolio rating composition of approximately 90% structured finance securities rated from AAA to AA- by Standard & Poor’s, from Aaa to Aa3 by Moody’s or to AAA to AA- by Fitch. The 10% balance of the portfolio may be rated below such ratings or unrated.”

According to a summary of the conference calls to investors included in the complaint, on a call on Jan. 18, 2007, Ralph Cioffi, the senior portfolio manager, said that “if markets were to deteriorate and spreads widen, they would absorb very well and that they [the funds] would make money with their hedges.” He further said that he “had a lot of liquidity available in both funds to take advantage of any dislocation in the market.”

On a later investor phone call, on June 11, 2007, Cioffi revised April’s performance to -1.7% to -5% and said the year-to-date gain was 6%. He said the revision was made because the firm previously had only 75% to 80% of marks in and had estimated the rest. “Cioffi’s representations during the conference calls completely downplayed the risks and exposure faced by the funds,” Zamansky says. He repeatedly reassured investors about the lack of subprime market exposure and margin calls, management’s hedging strategies for dealing with this risk, management’s ability to raise liquidity and management’s confidence that it would be unaffected by or ride out the storm. “His representations were materially false and misleading,” the complaint reads.

An industry source who spoke on condition of anonymity said that several Bear Stearns brokers are upset over what happened with the funds and might come forth, as they believe they were misled, too.

“They are interested in seeing their clients get their money back,” the source says. “Brokers don’t do due diligence, so they used what they were told and were lied to as well.”

The offering memorandum states that “While the primary focus of the Master fund will be on highly rated debt securities, up to 10% of the investment portfolio may be invested in lower rated investment grade, below investment grade or unrated securities. As the master fund’s portfolio is leveraged, such holdings may be equal to a substantial amount of the master fund’s net asset value. In fact, if the master fund employs net leverage of 10 times its net asset value, the value of such securities may equal up to 100% of investors’ capital.”

Maddox acknowledges that although the marketing material stated that the investments were not the safest ones, the material lacked disclosure of the specific risks involved. “This will not get them off the hook,” he says. “Securities and investment fraud will be alleged in the claims.”