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  • Writer's pictureKirk Hartley

WaMu Bankruptcy Judge on Possible Insider Actions in a Chapter 11

I’m shocked, just shocked, that a judge could think inside information and lack of disclosure could have tainted a chapter 11 case (sarcasm intended).

SEPTEMBER 14, 2011, 9:28 PM

Judge Says Hedge Funds May Have Used Inside InformationBy CHARLES DUHIGG and PETER LATTMAN

There have long been whispers on Wall Street that hedge funds have hijacked the bankruptcy process, using their influence as debt holders to obtain and trade on insider information about when and how a company will restructure.

A federal court ruling highlighted such concerns late Tuesday when a judge raised the possibility that four large hedge funds might have used confidential information to trade in the debt ofWashington Mutual.

The issue was raised amid the derailment of Washington Mutual’s emergence from bankruptcy protection, the final chapter in the largest bank failure in the nation’s history.

Judge Mary F. Walrath, in dismissing a proposed settlement in the federal bankruptcy court in Delaware, wrote that four hedge funds that had played a role in Washington Mutual’s restructuring might have received confidential information that could have been used to trade improperly in the bank’s debt.

The four hedge funds are Appaloosa Management, Aurelius Capital Management, Centerbridge Partners and Owl Creek Asset Management. All have denied any wrongdoing.

The Washington Mutual bankruptcy, and Judge Walrath’s ruling, have slightly thrown back the covers on the sharp-elbowed tactics used by investors in trading the stocks and bonds of companies in Chapter 11 bankruptcy protection. That market has exploded in recent years, driven by hedge funds buying up the loans of companies in bankruptcy at a steep discount in the hopes of obtaining big profits when the companies emerge from Chapter 11.

Judge Walrath’s ruling is a victory for the Washington Mutual shareholders who claimed that hedge funds had been using insider knowledge to influence proceedings and seek profits. And the ruling is a potential blow to the funds — who have long argued they acted properly — and the large law firm Fried, Frank, Harris, Shriver & Jacobson, which was representing some of the funds and is accused of passing them confidential information.

Part of Judge Walrath’s ruling focused on a dispute involving $4 billion held by JPMorgan Chase when Washington Mutual was put into bankruptcy. Early in the bankruptcy proceedings, Washington Mutual claimed ownership of those funds, and in confidential settlement talks, JPMorgan agreed to hand them over.

If the public had been aware of that agreement, the value of Washington Mutual’s bonds would probably rise, since the $4 billion could be used to pay bondholders, including hedge funds that had bought the debt.

The deal, however, was kept secret.

Lawyers representing some Washington Mutual shareholders, in a brief filed this year, claimed that lawyers from Fried, Frank, Harris, Shriver & Jacobson, which was involved in the bankruptcy negotiations, told its clients, the hedge funds, about the secret agreement. As a result, those hedge fund investors were able to buy bonds on the cheap, and then wait for their value to rise when the agreement came to light.

Judge Walrath, in her Tuesday decision, noted that certain shareholders said that Fried, Frank “was under a written confidentiality agreement barring it from sharing information with its clients, unless they were subject to confidentiality agreements of their own. Nonetheless, on July 1, 2009, Fried, Frank shared summaries of the April negotiations with both Centerbridge and Appaloosa, who were not at the time subject to a confidentiality agreement.” Centerbridge, the judge wrote, continued to trade in Washington Mutual bonds, while Appaloosa voluntarily restricted its trading activities.

The hedge funds and others have argued that though they may have had talks with Fried, Frank or others privy to confidential information, they received no “material information” that would rise to the level of insider trading.

The judge did not rule on whether the hedge funds had committed wrongdoing or whether the claims made by shareholders’ lawyers were true. Still, those accusations, she wrote, were “a colorable claim that” the hedge funds had “received material nonpublic information,” that could be resolved only through further inquiry.

But first, the judge wrote, the parties should go to mediation to resolve the dispute.

Representatives of Fried, Frank and Aurelius Capital Management declined to comment on the judge’s ruling. Owl Creek Asset Management did not return phone calls seeking its perspective. Centerbridge Partners declined to comment.

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