Setting a bankruptcy precedent?

NEW YORK, USA (Bloomberg): Bear Stearns Cos.’ decision to liquidate two bankrupt hedge funds in the Cayman Islands instead of New York may limit creditors’ and investors’ ability to get their money back.

While most of their assets are in New York, the funds filed for bankruptcy protection July 31 in a court in the Cayman Islands, where they are incorporated. The bank also used a 2005 bankruptcy law to ask a US judge in Manhattan to block all lawsuits against the funds and protect their US assets during the Cayman proceedings.

The Bear Stearns cases may establish a precedent that would let other failed hedge funds liquidate in the Cayman Islands, where judges have a track record of favoring management. The local monetary authority estimates that three out of four hedge funds globally are incorporated in the western Caribbean islands.

“This is definitely going to be closely watched,” said Evan Flaschen, a lawyer with Bracewell & Giuliani in New York, who has represented companies and creditors in international bankruptcy cases. “Other hedge funds might do the same thing.”

The funds, which invested in securities tied to home mortgages, collapsed amid rising defaults on subprime loans, made to people with weak credit. Bear Stearns, the fifth-largest US investment firm by market value, on August 5 ousted Co-President Warren Spector, who headed the mortgage and fixed-income business.

Creditors and investors in the two funds are likely to get back “a pittance on the dollar” and will attack Bear Stearns’s bankruptcy tactics in court, said Bill Brandt, president of Chicago-based Development Specialists Inc. His firm advises hedge fund Ritchie Capital Management Ltd. in the bankruptcies of its two life insurance funds in New York.

Bear Stearns hasn’t said how much the two funds owe creditors.

Hedge funds are lightly regulated, high-risk investment pools favored by institutional investors and wealthy individuals.

Filing the funds’ bankruptcy in the Cayman Islands, a banking center, “is a nice little stunt, and it may work for a while,” Brandt said. “Bear Stearns is trying to put a wall between themselves and these so-called rogue funds.”

The Cayman courts make it “difficult to take legal action there” and are “much less transparent than American courts,” said Jay Westbrook, a professor at University of Texas Law School in Austin who helped author the 2005 law. The British-administered islands are “attractive to management,” he said.

Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd. and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund Ltd. asked for an “orderly liquidation” in a petition filed in Cayman Islands Grand Court, citing volatility in the subprime mortgage market.

Chapter 15 of the US bankruptcy code, a new international law passed by Congress in 2005, lets US bankruptcy judges assist courts in other countries with liquidations. The measure shields the company in bankruptcy and its assets in the US from lawsuits and other collection attempts. Distributions to creditors are handled by the foreign court.

Creditors may argue that the main case should proceed in the US. To do so they must show the US bankruptcy judge that the hedge funds had their “center of main interests” in the U.S, said Robin Phelan, of Haynes & Boone, who represented hedge fund InverWorld Inc. in its 1999 liquidation in the Caymans.

Because the two hedge funds were incorporated in the Cayman Islands, that’s presumed to be the center of main interests, according to Phelan.

“That’s going to be an issue,” he said, noting that the new bankruptcy law “hasn’t really been tested.”

The Caymans “ought to be irrelevant” because the funds’ assets are in the US, according to their bankruptcy filings, Westbrook said. “If a company is basically managed out of New York, then the case should be in New York,” he said.

“This was a properly commenced Cayman Islands proceeding, commenced in accordance with the governing provisions of the funds and with Cayman law,” said Fred Hodara, a lawyer for the bankrupt funds with Akin Gump Strauss Hauer & Feld in New York, “These are Caymans-formed entities.”

“Because the two funds are incorporated in the Cayman Islands, the funds’ boards filed for liquidation there,” said Russell Sherman, a Bear Stearns spokesman. “The court appointed liquidators applied to a US court to aid the liquidation because there are US assets in the funds. 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.”

In the US, the Bear Stearns hedge-fund cases were assigned to Burton Lifland, the most senior bankruptcy judge in New York. Lifland scheduled a hearing for August 9 on the funds’ request for an order blocking legal actions against the US assets.

Lifland “is as familiar with these types of issues as anyone,” Flaschen said. “He focuses on the equities of the situation — what’s fair and practical.”

At least seven proposed securities class actions were filed in federal court this month against the company and some of its executives on behalf of investors who bought stock between July 26, 2006, and July 27, 2007. Investors claim they were deceived about the value of American Home stock because company earnings statements didn’t note rising loan delinquencies.

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