The end of a period of cheap money and high asset prices is invariably marked by class action lawsuits and aggressive prosecutions by District Attorneys eager to make a name for themselves through opposing powerful malefactors. In 2001, the victims were management of Enron, Tyco, Global Grossing, Dynegy and Adelphia Communications. This time around, the asset bubble has not been confined to the U.S. stock markets, but has spread worldwide and to a host of asset classes. It’s thus interesting to speculate on who will be the victims in the next downturn.

In the downturn after 2000, the principal harassers of bubble malefactors were District Attorneys, especially New York Attorney General Elliott Spitzer. This reflected a legal sloppiness in the late 1990s business culture that has been much less prevalent in the period since the 2002 Sarbanes-Oxley Act and the legion of internal lawyers and bean counters it spawned. Conversely the trial bar was only moderately active after 2000, partly because the Private Securities Litigation Reform Act of 1995 had preemptively prevented the type of lawsuits that would have been most popular after the crash of the NASDAQ bubble – stockholders suing because their IPO investments had turned sour. Further, for most of the 2000s so far, the Presidency and both houses of Congress have been controlled by Republicans, exercising a chilling effect on trial lawyer activity.

Once the current easy money bubble collapses, it’s likely to be the other way around. Malefactors will be found to have been either unregulated or careful, so DAs will have less to get hold of. On the other hand, most investor losses will not be in the tech sector, which has always been able to gain a degree of public sympathy in the United States that is unjustified either by its achievements (modest) or its ethics (dubious). Instead, the principal perceived malefactors will be hedge funds, private equity funds and emerging markets funds, all less likely to win popular sympathy. Further, from 2007 it is likely that at least one house of Congress will be in Democrat hands, and from 2009 it’s possible we will see a Democrat President, in which case the chilling effect of Republican hegemony on the trial bar will be absent.

The near-collapse last week of the Amaranth hedge fund group, whose trader, specializing in natural gas futures, had been up substantially at the end of August and down by $4 billion by mid-September – what a life! – highlights one area that is likely to give trial lawyers much joy: the hedge fund sector, with assets under management of $1.2 trillion and almost no regulation.

Hedge funds themselves are unlikely to provide the most juice for trial lawyers. Hedge fund investors sign documents with extensive protections against investor lawsuits, so absent manifest frauds (of which there will undoubtedly be some revealed) a lawsuit by hedge fund investors against management that loses money is unlikely to get far. There are no well established rules for hedge fund management (even the requirement to “hedge” is more honored in the breach than the observance) so it will be difficult for lawyers to prove that the trading-oriented hedge fund managers have behaved in an “imprudent” manner that their investors could not be expected to foresee. The one chink in the armor may be cases where the fund has already paid out enormous performance bonuses to managers, after which it then goes bankrupt possibly (to judge from the Amaranth situation) very quickly. Lawsuits may also be possible when timing issues are raised; in the Amaranth case, for example, redemptions were only possible at the end of each quarter, on giving 45 days notice, a period which for the October quarter expired the weekend before losses were revealed. Trial lawyer juice will be found, therefore, but it is likely to be limited.

More attractive targets for the trial bar are those investors in hedge funds who have a fiduciary duty to their own investors. Pension funds in particular may be vulnerable, but in general any kind of fiduciary arrangement that involves a “prudent man” rule is vulnerable in a case where the man has, judging by the results, been highly imprudent. The San Diego County Employees Retirement Association, for example, had invested $175 million of its $7 billion assets in Amaranth and was an aggressive investor in other hedge funds and “alternative investments.”

Up to the 15-20% of total assets level a “prudent” investor which had invested in hedge funds with well established track records could argue that it was simply diversifying its portfolio, even if all its “alternative” investments proved disasters. However a number of pension funds have invested much more than 20% of assets in this way, or have bought into hedge funds where there was no established track record. These pension funds will be vulnerable. In a downturn, when a group of investments has proved to be disastrous, it will appear highly imprudent to have invested a high percentage of a fund in assets whose managers were so egregiously overpaid and whose incentives were so clearly engineered towards taking on excessive risk. The trial bar will find these cases, and will sue on behalf of pensioners who have lost a large part or all of their pensions. The amounts of money involved will be huge, the pensioners who have lost money politically sympathetic and there will doubtless be some examples where the dereliction of fiduciary duty appears particularly egregious.

As with hedge funds, it is likely that the private equity fund “space” will provide fertile pickings for the trial bar. In these cases, investors themselves, and not just their beneficiaries, may have a case against poor managers, since private equity investment is generally entered into with a greater expectation of prudence than is hedge fund investment – also, fewer private equity funds are domiciled offshore, which itself may be a partial protection against suits in U.S. courts. In private equity investment there are well established “rules” which investors can reasonably be expected to follow – for example, in a corporate buyout situation, the acquired company is supposed to have sufficient cash flow to service its debt and any junk bonds, and not rely on private equity investors for any “top-up.” Inevitably, in recent months these rules have been violated – Blackstone’s $17.6 buyout offer last week for Freescale Semiconductor, for example, pays a premium price for a company without a well established product or a secure cash flow and hence, if it goes wrong, may be legally vulnerable.

As with hedge funds, fiduciaries who have invested too much of their portfolio in failed private equity funds may be legally vulnerable, although less so since private equity investment is at least a legitimate economically productive activity in which a fiduciary might reasonably be expected to engage.

The third area in which trial lawyers are likely to have a field day is that of bond investment. Naturally, bond funds that decline in value simply because of rising interest rates or which, having been marketed as moderately risky, suffer a moderate level of conventional defaults in their portfolio will not provide significant fruit for lawyers. However, there are three new features of bond investment, all of which could well go wrong in a downturn, which will provide juicy pickings for lawyers seeking to prove that money had not been managed in an appropriately prudent manner:

• First, as with junk bond funds in the 1980s, there will be funds which have invested in bonds that turn out to have a higher risk of default than expected. Some of these will be invested in corporate “junk” bonds that prove to default, possibly with malfeasance involved. Others will be in emerging market bonds, where investment has been very aggressive in the last few years and yield spreads over Treasuries have narrowed accordingly. In some cases, lawyers will reasonably be able to claim that a prudent investor would not have made the investment – in Argentina for example, which has defaulted on its international debt three times since 1980 and where new bonds have been issued at a yield only around 3% over Treasuries. Currently, Argentine bonds may look like a good deal; when investors have woken up from the current loose-money euphoria their lawyers will ask how anybody could have been so stupid as to buy them.
• Second, bond positions are often hedged with derivatives, or combined with options, and in a down market those hedges will unexpectedly fail to work. Techniques such as “Value at Risk” which purport to measure the risk of a portfolio, in fact do no such thing because they make assumptions about randomness that are untrue. Weather and die-rolls may be random; political and economic events are generally deterministic, even if unknown, and hence do not obey the calculus of probability. “Fat tails” is not a description of overfed cats, it is a real problem of the quite frequent occurrence of sharply unfavorable combinations of factors that had been thought to be almost impossible.
• Third, the slicing and dicing of bond portfolios which has taken place in the last two decades, particularly in the home mortgage area, has allowed bond investors to purchase portfolios that in normal circumstances produce above average returns, but when interest rates move sharply in one direction or another, or homebuyer behavior shifts (for example, due to a sharp downturn in the housing market) may prove to be “toxic waste” of little or no value. Investors in such portfolios will at that point sue; they will be justified in doing so.

The coming few years may be thoroughly unpleasant ones for investors and for the U.S. economy generally. They are however likely to prove highly enjoyable and lucrative for the trial lawyer profession!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)