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Bear Stearns Ordered to Repay Hedge Fund $125.1Million

Bloomberg News is reporting on February 15th 2007 that Bear Stearns Cos. has been ordered to return at least $125.1 million to Manhattan Investment Fund Ltd., a failed hedge fund, that now is bankruptcy proceedings. This surprising court ruling likely will prompt other Wall Street firms with prime brokerage operations to scrutinize their most lucrative trading clients even more aggressively.

Burton Lifland, the U.S. judge overseeing the bankruptcy of Manhattan Investment Fund Ltd., made the ruling at a hearing in New York today. Lifland concluded last month that Bear Stearns, one of the biggest brokers to hedge funds, was trying to cover its own potential losses and didn't investigate thoroughly after learning of possible fraud at Manhattan Investment, court filings show. Bear Stearns faced returning as much as $180 million.

``Bear Stearns failed to act diligently in a timely manner,'' Lifland said in a Jan. 9 opinion, finding that the New York-based company, the fifth-largest U.S. securities firm, learned as early as December 1998 that fund manager Michael Berger may have been deceiving investors about returns.

Today's ruling adds to the pressure on securities firms to monitor hedge funds, which pay Wall Street about $10 billion annually in fees for prime-brokerage services. Federal regulators already are probing whether the securities industry sets strict enough limits when lending to hedge funds, and the U.S. Securities and Exchange Commission has said prime brokers should be a ``window'' into their dealings.

``This is going to send shock waves through many prime brokers, because they've been very careful to limit their responsibility for their customers' actions,'' Michael Missal, a former SEC lawyer and head of the regulatory practice at Kirkpatrick & Lockhart Preston Gates Ellis LLP in Washington, said before today's hearing. ``They do not want to be seen as insurers for their clients.''

Toomre Capital Markets LLC agrees whole-heartedly that securities firms do not want to be the "deep pockets" that "insure" hedge fund investors against fraud and other illegal activities that may occur at an alternative investment vehicle. The very interesting question is how much responsibility should prime brokers have for policing the activities of their hedge fund clients, especially in a world where the larger hedge funds have multiple prime broker relationships. Your thoughts on how important a ruling this is and what responsibilities prime brokers should have are most welcome.