In recent years, the benign nature of the credit cycle has made it hard for distressed debt funds to produce returns using classic routes, writes Gillian Tett in the FT on Friday. Consequently, one tactic which is increasingly fashionable is so-called “legal arbitrage” – or the business of exploiting legal loopholes to make a quick buck.
But could some of these legal arbitrageurs be about to get their come uppance? That is the question thrown up by a battle that is playing out between some hedge funds and Wachovia in North Carolina, where Wachovia is headquartered – a saga that raises questions not just in the US but in Europe too.
The issue at stake revolves around a $268m loan deal which Wachovia arranged last September on behalf of Le-Nature, an American distributor of bottled water. Shortly after Wachovia sold this loan, Le-Nature filed for bankruptcy, amid fraud allegations. Unsurprisingly, the value of these loans tumbled, and were duly scooped up by hedge funds. Then, true to current fashion, these funds indicated they were considering suing Wachovia over its due diligence on the Le-Nature loan – and these instruments started to trade at levels that seemingly priced in a future, value-creating lawsuit.
But then Wachovia struck back: it filed a suit in North Carolina to stop the hedge funds, using a state statute known as “champerty”. This concept was first introduced into North Carolina to prevent trade in personal tort claims; but Wachovia now wants to extend this to prevent hedge funds from buying loans simply to lodge lawsuits.
It is unclear what will happen next, since North Carolina judges are still debating whether they have jurisdiction, or not. It may just be that the North Carolina judges would be well advised to hold their nose, and leave the legal arbitrage game intact. The real problem lies in the difficulty of proving when an investor has bought a credit purely to lodge a lawsuit – and when they have bought a loan in good faith, and subsequently discovered reason to sue. Thus any effort to clamp down on the legal arbitrage game risks hurting bona fide investors, too (or at least, creating a new swathe of lawsuits, as lawyers argue about intent). That could potentially undermine the liquidity of the broader market in a manner that would not be beneficial for the economy at large.
And if banks do want to fight off opportunistic hedge funds, they would do better to focus on another remedy – to ensure their due diligence is always so utterly water-tight, that nobody believes there is any point in suing at all.