The news only appears to be getting worse for Bear Stearns and investors in its two failed hedge funds, the High-Grade Structured Credit Strategies Enhanced Leverage Fund (the “Enhanced Fund”) and the High-Grade Structured Credit Fund (the “High-Grade Fund”).
Last May, when investors tried to get out of the funds after learning that losses far exceeded the amounts that had been reported earlier, Bear Stearns abruptly halted redemptions. In June, Bear Stearns told clients that the High-Grade fund was down 91% and the Enhanced Fund also had suffered a sharp decline. Two months later, in a July letter to investors, Bear Stearns acknowledged that “there is effectively no value left” in the Enhanced Fund and “very little value left” in the High-Grade Fund. Much to their dismay, investors learned that the two funds -- that had an estimated value of $1.5 billion at the end of 2006 -- were essentially worthless.
Industry observers blamed the demise of Bear Stearns’ once high-flying hedge funds on the subprime mortgage crisis that began last spring. The firm’s letter to investors stated that “unprecedented declines in the valuations of a number of highly rated (AA and AAA) securities,” contributed to the funds’ devastating losses. The real reason for the funds’ failure, however, appears to be their large investments in risky mortgages and the collapse of the market for collateralized debt obligations, or CDOs.
Massachusetts securities regulators are now investigating charges that Bear Stearns engaged in improper trading in the funds and in so doing caused investors to incur additional losses. The regulators are examining whether Bear Stearns traded mortgage-backed securities for its own account with the two hedge funds without first notifying the funds’ independent directors. Federal securities law requires that any investment adviser whose affiliates engage in principal trading with clients must obtain their written consent in advance. Investment companies have long recognized the importance of giving advance disclosure of principal trades so that, from the fund’s perspective, it has assurances of fair dealing. If the investigation reveals that Bear Stearns failed to give this proper disclosure and engaged in conflicted trading, the funds may be accused of breaching their fiduciary duty to investors.
Federal prosecutors and the Securities and Exchange Commission are conducting their own investigations of the Enhanced Fund and High-Grade Fund, focusing on the circumstances that led to their implosion.
The intense scrutiny the funds now face may be only the beginning of legal problems for Bear Stearns. A recent Business Week analysis (October 22, 2007) reveals that the funds were “virtually guaranteed to implode if market conditions turned south,” as they did earlier this year. The funds not only used enormous amounts of leverage, or borrowed money, they also relied on accounting practices that allowed them to base the value of securities in their portfolios on “fair value,” or estimated value, rather than the true market price. Because the value of the assets on which the funds’ returns were based was arguably questionable at best, the high returns the funds initially earned were bound to plummet as defaults on subprime mortgage loans increased.
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