Hedge Funds and the Little People

By GRETCHEN MORGENSON

Published: September 2, 2007

BURTON R. LIFLAND, a United States bankruptcy judge in Lower Manhattan, said last week that he needed more time to decide whether the liquidation of two failed Bear Stearns mortgage securities funds could proceed in the Cayman Islands, where they are incorporated, or in this country, where most of their assets and many of their investors reside.

Although there is little left in the funds to divvy up among investors and creditors, how Judge Lifland rules will be closely watched. That’s because most hedge funds are domiciled in faraway places where the courts may be, ahem, less friendly to investors than they are to the managers who park billions there. If the Bear Stearns funds are liquidated in the Cayman Islands, they will be shielded from investors’ suits, and all distributions to creditors will be handled by the courts there.

Bear Stearns wants the Cayman courts to oversee the liquidations. The firm’s spokesman, Russell Sherman, said: “Because the two funds are incorporated in the Cayman Islands, the funds’ boards filed for liquidation there. The return to creditors and investors will be based on the underlying assets and liabilities of the funds not on the location of the filing.”

Judge Lifland said in court last week that he would decide the matter shortly.

Ronald L. Greene, 79, a retiree in Northern California, is one investor watching the Bear Stearns case closely. Mr. Greene lost $280,000 in the Bear Stearns High Grade Structured Credit Strategies Fund and says he will join a suit that has been filed against the firm. He contends that Bear Stearns duped him with assurances that the fund’s high-quality investments would protect holders against market and credit risks.

Hedge funds are theoretically open only to institutional investors and extremely wealthy individuals, who are deemed savvy and well heeled enough to assess and weather complex risks. But documents from Mr. Greene’s files show that Bear Stearns Asset Management allowed investments of $250,000 in its fund, considerably smaller than the typical $1 million minimum for many hedge funds.

ON July 20, 2005, he received an e-mail message from his broker at a small regional firm, with the following header: “Bear Stearns High-Grade Structured Credit Strategies Fund will accept smaller investments this month on a limited basis.” Noting that the fund was temporarily reopening on Aug. 1, 2005, the message said that for investors who “do not have $1,000,000 to invest, the fund will accept a limited number of clients this month for 500k and perhaps 250k.”

The message went on to note the fund’s stellar performance: up a cumulative 29.4 percent since its October 2003 inception, and no down months.

Mr. Greene, a former engineer, said he invested in several hedge funds in recent years, aiming to preserve his principal. Most of the funds have worked out well, he said, producing slightly better-than-market returns with little volatility. He estimated that he has $600,000 to $800,000 invested in hedge funds.

He invested in the Bear Stearns fund in October 2005, and he said the fund appealed to him because its returns of about 1 percent a month did not seem to fall into the too-good-to-be-true category.

Mr. Sherman, the Bear Stearns spokesman, said the fund’s general partner was allowed to waive the $1 million investment minimum and that any investor in the fund had to have at least $5 million in liquid, investable assets.

“Everything went fine until last June,” Mr. Greene said; that was when he learned from his broker that the funds were having difficulties. “I asked him how they could be in trouble if they were high-grade securities. He said they were bundled high grade but not really high grade. If you’re going to be dealing with a high-grade securities dealer, I didn’t understand how that was an excuse of any kind.”

Mr. Greene said officials at Bear Stearns Asset Management conducted monthly conference calls with investors, discussing the funds’ performance.

For example, according to notes taken by another investor during some of these calls, Ralph R. Cioffi, senior portfolio manager for the fund and an executive at Bear Stearns Asset Management, predicted on Jan. 18, 2007, that fund investors would benefit from a negative bet that he had recently placed on subprime mortgages. Mr. Cioffi also said the fund had plenty of cash to take advantage of market dislocations, according to the investor, and that the team of people monitoring the securities in the fund had increased to 11.

The next month, according to the investor, Mr. Cioffi told conference-call participants that the fund had little exposure to subprime mortgages. And in April, Mr. Cioffi told investors that even though returns were down, the fund had not been forced to sell securities. Acknowledging that investors had been frightened by unusually high delinquencies on loans made in 2006, Mr. Cioffi said fund investors would be safer at Bear Stearns because it did its own due diligence and did not rely solely on ratings agencies, the investor said.

In June, the wheels came off the Bear Stearns hedge funds. Mr. Greene said that as soon as he learned that his fund was in trouble, he submitted a redemption request to Bear Stearns, through his broker. “We had all kinds of trouble getting them to admit they had received it,” he said. He never got any of his money out.

In mid-July, Bear Stearns told investors that the funds, once worth $1.5 billion, had lost almost all their value. By the end of June, the firm said, the fund Mr. Greene had held was down 91 percent.

“In light of these returns, we will seek an orderly wind-down of the funds over time,” Bear Stearns told its clients in a letter. Obviously, the lawsuits over this debacle are only just beginning for Bear Stearns. One of Mr. Greene’s lawyers, Jacob H. Zamansky, said he and his co-counsel have been contacted by fund investors from around the world. All tell the same story, Mr. Zamansky said.

“We believe that Bear Stearns misrepresented the risk to investors in the hedge fund, misrepresented the extent of risk controls that were in place to cut losses and misrepresented performance on conference calls to avoid a run on the bank,” he said.

Mr. Sherman, the spokesman, said that “the allegations are unjustified and without merit.”

“The accredited, high-net-worth investors in the fund,” he added, “were made very aware that this was a high-risk speculative investment vehicle.”

Of course, it will be up to the securities arbitrators to judge whether investors in the funds were misled about their risks. But these cases may also help regulators understand the degree to which retail investors have bought into hedge funds.

Back in 2003, the Securities and Exchange Commission conducted a study on hedge funds and determined that their investors were mostly institutions. But the study also warned that the types of hedge fund investors appeared to be changing. “Although we did not observe an existing retail market for hedge funds,” the study said, “the potential for that market is clearly at hand.”

The study was right. Four years later, that potential may have become a reality.