Bear Stearns was ordered to pay at least $125 million by a New York bankruptcy judge for failing to disclose to investors that Manhattan Investment Fund was committing hedge fund fraud and the firm was instead accepting Manhattan’s funds to cover Bear’s margin exposure. This is a huge decision.
For many years, clearing firms and prime brokers have enjoyed significant protection from the courts when one of their clients have committed securities fraud. The firms have always argued: “all we were doing was clearing trades and providing margin.” The firms forgot to add “and minting money.”
Wall Street firms earn up to $10 billion in prime brokerage revenue each year. A big portion of this is from hedge funds. All the while, firms have been primarily shielded from potential liability when a fund blows up due to hedge fund fraud. The Manhattan decision may change that. Now, when a prime broker sees red flags of potential fraud by a hedge fund it does business with, it better start doing some due diligence.
With the U.S. government recently deciding not to regulate hedge funds, it looks like the major battles over who is to blame when hedge funds blow up will take place in courts and arbitration.