At least until the recent economic downturn, the returns of many hedge funds were the envy of investors. There were many techniques that created these returns. A recent 8th Circuit Court of Appeals decision illustrates one of these techniques. (UnitedHealth Group Inc. v. Wilmington Trust Co. No. 08-1904 (8th Cir.)) Unfortunately for the hedge fund, the hedge fund technique was thwarted by the court.
On March 2, 2006, UnitedHealth Group issued $850 million of 5.8% senior notes due March 15, 2036. The notes were subject to an indenture (a legal document issued to lenders describing key terms of the note). Shortly thereafter, UnitedHealth Group was among the companies accused of illegal backdating of employee stock options. As a result, UnitedHealth Group delayed its filings with the Securities and Exchange Commission while it investigated the charges.
On August 25, 2006, Wilmington Trust, representing certain hedge funds owning more than 25% of the principal on the notes, sent a notice of default to UnitedHealth Group. The notice claimed that UnitedHealth Group's failure to make timely SEC filings violated the indenture. It also issued a notice of acceleration, demanding accelerated payment of the full principal amount of the notes. In a careful analysis of the indenture language, the 8th Circuit held that UnitedHealth Group had not violated the indenture and the hedge fund investors were not entitled to accelerated payment.
While the amount of money at stake is considerable, this so far seems like a garden variety commercial dispute. But an article in The National Law Journal dated December 9 provides some fascinating behind-the-scenes background from the perspective of the UnitedHealth Group, the issuer of the notes.
The hedge funds' claim against UnitedHealth Group illustrates a common investment strategy of hedge funds. The hedge fund looks for publicly traded companies with bonds being traded below par value. In the case of United- Health Group, its bonds were trading at 65 cents, or 35 cents off par value. The hedge fund then looks for a technical violation of the indenture that would force the company to redeem the bonds at par value. The result is a quick windfall profit for the hedge fund and, conversely, a loss to the shareholders. In fact, the lower court opinion noted that the hedge funds, even after filing the default notice, increased their purchase of the UnitedHealth Group notes allegedly in default by $55.8 million. This act is contrary to most investors who would liquidate an investment in notes alleged to be in default and suggests the hedge funds were optimistic they could force early repayment of the bonds and increase their windfall.
The counsel for UnitedHealth Group calls this a "shakedown strategy." Nevertheless, some companies in a similar position as UnitedHealth Group have settled with hedge funds, so the strategy has had some success.
But courts have not been so friendly to the hedge funds. The opinion by the 8th Circuit Court of Appeals is the most recent example. Courts in New York, Texas and California have also rejected similar attempts by hedge funds to put issuers of these notes in technical default. Probably other issuers will take a stronger position against these hedge fund strategies now that courts have been supporting issuers in these cases.