UPDATE 1-Hedge fund denies insider trading in WaMu case

Mon Jul 18, 2011 5:37pm EDT

* Court begins hearing insider trading allegations

* Aurelius describes how it separated talks from trading

* Insider-trading claims could torpedo bankruptcy exit (Updates to end of testimony on Monday)

By Tom Hals

WILMINGTON, Del., July 18 (Reuters) - A hedge fund accused of trading on confidential information gleaned from the Washington Mutual Inc bankruptcy went so far as to sound-proof an office to prevent the information from reaching its traders, a managing director of the fund testified.

Aurelius Capital Management LP even hired a sound engineer to test if traders could eavesdrop on confidential talks about the bankruptcy led in part by the fund, managing director Dan Gropper said in his defense in a bankruptcy court on Monday.

Washington Mutual shareholders have accused Aurelius and three other funds of using their role in helping craft the bankruptcy plan to generate huge trading profits on the securities. The company and its creditors have dismissed the allegations as a desperate attempt to torpedo the company's reorganization plan, which likely will deny any money to shareholders.

Gropper told the court that in addition to spending $150,000 to sound-proof an office, Aurelius also hired its own legal team to further assess what information could be used for trading. "The consequence is quite severe if we get it wrong," he said.

If the insider trading accusations stick, it could derail Washington Mutual's plan to exit bankruptcy and distribute $7 billion to creditors. (For details on the allegations, see [ID:N1E76D1M6]

Washington Mutual began hearings last week to obtain court approval for its reorganization, which essentially distributes cash to creditors. A small mortgage reinsurance business would be the only operation to emerge from bankruptcy.

The company has been in bankruptcy, and creditors have been awaiting repayment, since September 2008, when its savings and loan was seized by regulators in the biggest bank failure in U.S. history.

The seized bank was sold to JPMorgan Chase & Co (JPM.N) for $1.9 billion.

An attorney for shareholders began cross-examination of Gropper late on Monday and tried to get him to acknowledge that the scope of settlement talks were material and should have been disclosed to the public or kept from his firm's traders.

For example, he asked Gropper if JPMorgan's offer to turn over a disputed $4.1 billion to Washington Mutual in early 2009, even as JPMorgan filed court papers seeking to keep the money, should have been disclosed.

Gropper replied that he did not believe that was material information because he never doubted the deposit would be turned over and various parties to the talks disagreed on conditions for returning the money.

This is the company's second attempt to end its bankruptcy. In January, U.S. Bankruptcy Judge Mary Walrath in Delaware rejected their last plan, in part because an individual investor accused four hedge funds of insider trading.

Since the last plan was rejected, the official committee of shareholders has been investigating the funds, which also include Owl Creek Asset Management LP, Appaloosa Management LP and Centerbridge Partners LP.

Unlike recent high-profile government probes of hedge-fund managers and insider trading, the funds in this case do not face criminal penalties.

The judge could penalize the funds by cutting the amount of interest they can collect on their Washington Mutual debt, or she could even reject the reorganization plan if she finds it was not negotiated in good faith.

The case is In re Washington Mutual, U.S. Bankruptcy Court, District of Delaware, No. 08-12229. (Reporting by Tom Hals)

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