As the true extent of U.S. sub-prime losses becomes known, total losses are now estimated at more than US $400 billion - many anticipate hedge funds will be resorting to litigation to try and recoup losses.  According to some estimates, hedge funds have purchased nearly 50 percent of all CDOs (collateralised debt obligations); the structures used by many underwriters to aggregate U.S. sub-prime housing loans, many of which are now worthless.

In the U.K. potential targets of hedge funds, say experts, could include those responsible for valuing CDO type products, such as CDO administrators and collateral managers.  Another target could be arrangers of CDOs although one significant obstacle will be the recent Court of Appeal judgment IFE Fund SA v Goldman Sachs International, which held that arrangers have a limited duty of care to investors when appropriate disclaimers are used.  Some have also speculated that rating agencies could be targeted for failing to downgrade CDO loans before the full extent of the losses became known.

With the recent changes to the U.K. Companies Act, hedge funds also have more scope to bring claims against banks’ directors, although the changes, introduced on 1 October, are not retrospective in effect.  The change in the law gives investors a statutory right to sue directors even where directors did not act in bad faith, negligence is sufficient.

At the same time, hedge funds themselves may increasingly be in the firing line from their own investors.  Earlier this year, two Bear Stearns’ hedge funds became the first major sub-prime casualty, when both funds collapsed with losses of US $1.6 billion.  Lawyers representing U.K. investors in one of the funds were recently successful in ousting the fund’s management.  The fund has now been placed under the control of restructuring firm FTI Capital Advisors, which will be looking for evidence of any mismanagement by the fund to launch possible lawsuits. Meanwhile, a U.S. law firm, Zamansky & Associates, has launched an arbitration claim against the Bear Stearns’ funds.  (In August, a U.S. bankruptcy judge ruled that the Bear Stearns’ funds could not be granted bankruptcy protection in the Cayman Islands, despite being domiciled in the jurisdiction, a ruling that increases its exposure to lawsuits from U.S. creditors.  The ruling has been appealed.)

Another intriguing development is the possibility of hedge funds becoming investors in third-party sub-prime lawsuits.  According to The Times, the Jersey-based hedge fund MKM Longboat Capital Advisors is planning to invest
US $100 million in European legal disputes having hired litigation funding expert Susan Dunn, a former partner at law firm
Wragge & Co.  The fund plans to invest up to £3 million per case.