Barclays Bank accused Bear Stearns on Wednesday of loading one of its hedge funds with about $500 million in troubled assets just weeks before it collapsed with another fund.
The London-based bank's allegations appear in a lawsuit filed in U.S. Court for the Southern District of New York in Manhattan. Barclays said it did not have a precise figure for damages.
Bear Stearns had not seen the lawsuit, but said any such lawsuit is unjustified and without merit.
"While we do not like to see investors or counterparties lose money, we believe this lawsuit is an attempt by Barclays to avoid taking responsibility for its own actions," Bear Stearns said in a statement.
The lawsuit provides an inside look into the collapse of two Bear Stearns-run hedge funds last summer. Barclays accuses Bear Stearns of starting a hedge fund in 2006 so it could offload the risky assets of another one of its hedge funds that was running into trouble.
The two hedge funds, run by executives at Bear Stearns Asset Management, had more than $20 billion in assets before their ultimate collapse.
Problems began when Bear Stearns' High-Grade Structured Credit Strategies Fund, which had a track record of good returns, experienced a serious liquidity shortage as early as September 2006, the complaint said.
Two Bear Stearns executives, Ralph Cioffi and Matthew Tannin, decided to form a second fund to capitalize on the High-Grade Fund's past success. Barclays says it committed $50 million in leverage to the effort, but did not know the second Enhanced Fund was being created to conceal problems with the High-Grade Fund, the complaint said.
"Bear Stearns ... used the Enhanced Fund as a place to unload excessively risky or troubled assets that could not be sold to other investors at the prices paid by the Enhanced Fund," Barclays said in its complaint.
Bear Stearns also collected fees as the arranger and manager of these securities deals, while collecting another set of fees from the Enhanced Fund, the complaint said.
The complaint also cites an email Cioffi sent to Tannin discussing how to get High-Grade Fund investors into the Enhanced Fund.
"That will take some time, but once we do that, we have an easy liquidity source, and that's Barclays," Cioffi wrote, according to the complaint.
Cioffi is no longer at the company.
In late 2006 and the early months of this year, Bear Stearns executives put a positive spin on the Enhanced Fund's performance, saying it was doing "great," Barclays said.
Meanwhile, defaults on subprime mortgages, which were used as underlying assets in the two Bear funds, were escalating throughout the United States. And by late May 2007, Tannin was worried both funds would be wiped out. He considered selling their assets to Cerberus Capital Management before a meltdown, the complaint said.
At the end of May, for example, Bear Stearns Asset Management had the Enhanced Fund buy about $500 million of the riskiest classes of securities in a deal that it managed, Barclays' complaint says.
"BSAM did so despite the fact that investment restrictions it had promised Barclays did not permit those securities to be held in the fund," the complaint added.