Lawsuit Against UBS Spotlights
Prime Brokers
A Fallen Hedge Fund
Says Wall Street Firm
Misused Trading Data
By RANDALL SMITH
May 23, 2007; Page C1
NEW YORK -- On Wall Street, it is one of the fastest-growing, most lucrative businesses: providing a range of brokerage services to hedge funds.
A lawsuit filed this week in Manhattan state court offers a vivid description of alleged conflicts for Wall Street giants in what is known as prime brokerage.
Investors in Wood River Partners LP, a hedge fund that collapsed in 2005, have charged that UBS AG, the fund's prime broker, fraudulently earned more than $100 million by misusing knowledge of the fund's trades.
The plaintiffs, which collectively invested $79 million in Wood River, say UBS earned profits by selling borrowed shares in Wood River's biggest single stock holding, Endwave Corp., and helping other UBS clients do the same.
"UBS intends to defend itself vigorously against these allegations," a spokeswoman for UBS said in a prepared statement. She declined to elaborate. The lawsuit claimed $200 million in damages.
The lawsuit is the latest twist in the downfall of Wood River. In February, federal prosecutors in Manhattan charged the fund's founder, John Whittier, with criminal fraud for breaking a promise that no stock would be valued at more than 10% of Wood River's portfolio. Wood River, they charged, acquired as much as 80% of Endwave, a stake that exceeded the 10% portfolio limit. The stock soared and then nose-dived in 2005. Mr. Whittier pleaded not guilty, and his lawyer yesterday declined to comment.
UBS acted as clearing broker, prime broker and custodian for all of Wood River's stock trades from late 2004 to summer 2005, the lawsuit says. UBS was also a market maker, or dealer, in the stock of Endwave, a San Jose, Calif., telecom-equipment maker, the lawsuit said. The two roles were "dual and conflicting," the lawsuit said.
Prime brokerage typically includes trade processing, stock lending and making margin loans for hedge funds that want to boost their returns through borrowing or leverage.
In a similar case, a federal bankruptcy court in February ordered Bear Stearns Cos. to pay about $160 million to the estate of Manhattan Investment Fund Ltd., saying Bear failed to act on signs of fraudulent activity at the fund for which it also served as a prime broker. Bear has filed an appeal.
The civil fraud case against UBS was filed on behalf of 20 plaintiffs led by Eurycleia Partners LP, a Delaware limited partnership that invested $1 million. The plaintiff with the most invested in Wood River was a group of Cayman Islands funds led by the Edison Fund, a fund of hedge funds that purchased options on a Wood River stake valued at $49 million through BNP Paribas.
The investors charged that UBS traders used knowledge of Wood River's undisclosed outsize Endwave stake to bet against the stock with short sales of 3.5 million Endwave shares. In a short sale, an investor sells borrowed stock and aims to profit by repurchasing the shares later at a lower price.
The lawsuit charged that Wood River's acquisition of more than 5% of Endwave triggered ownership-disclosure requirements that UBS knew Wood River was ignoring, and exceeded position limits in Wood River's own offering materials supplied to investors.
Although the lawsuit cited an April 2005 conversation in which a UBS executive was aware that Wood River owned 30% of Endwave, it didn't offer any specifics in this initial filing to support the allegation that UBS prime-brokerage executives knew that Wood River hadn't filed required ownership disclosures.
Instead of ensuring disclosure of the Endwave stake by Wood River, the lawsuit said, UBS "designed a scheme to co-opt that fraud, i.e., to make improper use of its position and nonpublic information to manipulate the market for Endwave stock for its own benefit in violation of the duties that it owed Wood River and its investors," knowing the plan risked harming Wood River's investors.
The lawsuit said UBS knew ownership of Endwave was concentrated among a few groups of holders, which limited the supply of stock that could be obtained for borrowing by short sellers seeking to profit from the stock's decline.
Despite Wood River's instructions to UBS in late 2004 not to make the Endwave stock available for borrowing by short sellers, UBS instead "lent out Wood River shares of Endwave for short selling purposes," the lawsuit said. It contended that UBS believed that Mr. Whittier couldn't complain to regulators because of his own failure to disclose the Endwave stake.
When Wood River repaid all borrowings secured by its Endwave stock in May 2005, effectively blocking UBS from lending any of the stock, UBS "improperly 'leaked' to" other brokers details of Wood River's Endwave holdings.
UBS also improperly facilitated other Endwave short sales, despite a lack of access to the shares, through "naked shorting," the plaintiffs charged. In a "naked" short sale, the seller doesn't borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period
Knowing Endwave shares were hard to borrow, UBS charged as much as 50% interest -- far above the going rate of 5% to 10% -- for short sellers to borrow shares and bet on a decline, the lawsuit said, earning interest of more than $100 million.
Mr. Whittier learned that UBS had made the stock available for borrowing by short sellers when he attempted to transfer the stock to another broker, Merrill Lynch & Co., in mid-2005, the lawsuit said.
As Wood River acquired more than four million Endwave shares by the summer of 2005, the purchases helped push the market price above $55 a share in July, up from $20 in March, the lawsuit indicated.
UBS then improperly "leaked" word of Mr. Whittier's confidential plans to sell 700,000 Endwave shares, sending the stock down 10% in one day, the lawsuit said.
In late June, BNP gave notice that the Cayman Islands funds led by Edison intended to redeem their $49 million Wood River stake, and Mr. Whittier "delayed compliance" with the request, the lawsuit said. From its peak of $55.41 in July 2005, Endwave stock tumbled to a low of $12.30 by September, sending Wood River into receivership when it couldn't honor investors' redemption requests.
