Bear Stearns Probed for Conflicted Trading in Failed Hedge Funds

The Wall Street Journal reports that regulators in the office of Secretary of State William F. Galvin are examining whether Bear Stearns traded mortgage-backed securities for its own account with the hedge funds without notifying the funds’ independent directors in advance, according to sources familiar with the investigation. Investigators are also attempting to determine whether the trades were priced fairly and whether troubled securities positions were offloaded onto investors in the two funds, the sources told the WSJ.

Investors lost $1.6 billion when the two mortgage-related funds, Bear Stearns High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Enhanced Leverage Fund, failed.

Federal prosecutors and the SEC are also examining the circumstances surrounding the funds’ collapse, but the Massachusetts investigation appears to be the first suggestion that potential conflicted trading at Bear Stearns is being scrutinized, the news report said. Massachusetts regulators have found “a material number of principal transactions,” between Bear Stearns and the two funds, a person familiar with the investigation told the WSJ.

The Bear Stearns funds’ offering memorandums listed types of arrangements that could lead to conflicts, including handling brokerage business for the funds, allocating positions between the funds and other entities managed by Bear Stearns, valuing the assets of the partnerships, and lending to the funds. Also, when acting for the firm’s own account, Bear Stearns traders have a primary responsibility to make money for Bear Stearns, not for the mostly investor-owned hedge funds.

The memorandums note federal securities law mandates that any investment adviser whose affiliates engage in principal trading with clients must obtain their consent in writing in advance, and Bear Stearns Asset Management, the unit that sponsored the two funds, promised in the memorandums that it would do this by obtaining the consent of the funds’ independent directors, who act on behalf of investors. The two hedge funds each had the same five directors, three of whom were affiliated with Bear Stearns.

They had posted a string of quarters with positive returns, but when the market for subprime home loans went downhill, so did many of the funds’ holdings. Prominent in the funds were pools of securities made up of bonds backed by subprime mortgages, which are extended to borrowers with poor credit.