Hedge funds score big win bankrolling tax refund case

WILMINGTON, Del. Wed Oct 9, 2013 1:26pm EDT

WILMINGTON, Del. Oct 9 (Reuters) - A group of hedge funds looks set to win an eyewatering return after bankrolling the winning party in a court fight over a $373.8 million tax refund in the bankruptcy of Downey Financial Corp.

U.S. Bankruptcy Judge Christopher Sontchi ruled on Tuesday that the disputed tax return belonged to Downey. The Federal Deposit Insurance Corp had argued it was entitled to the refund.

For backing the right horse, four hedge funds stood to gain up to a third of the refund, which the FDIC said in court documents could amount to a return of 1,000 percent on what they spent on legal fees.

The four funds are Alden Global Capital, Davidson Kempner Capital Management, Halcyon Asset Management and Farallon Capital Management.

The tax refund resulted from losses at Downey Savings and Loan that piled up during the 2008 U.S. housing meltdown, which exposed the poor quality of the bank's exotic mortgages. Those losses were claimed against taxes paid for the preceding five years, during the housing boom, allowing parent company Downey Financial Corp to file for a tax refund.

That refund set off a legal battle between the FDIC, the receiver for Downey Savings and Loan, and the trustee overseeing the Downey Financial Corp, which filed for Chapter 7 in 2008 in the U.S. Bankruptcy Court in Wilmington, Delaware.

But as the legal battles dragged on, the trustee ran out of money.

Last year, the four investment funds, which were holders of some of the parent company's $200 million in bonds, agreed to pony up a war chest of up to $12 million to carry on the fight.

Halcyon declined to comment and the other three funds did not immediately return a request for comment.

FDIC spokesman David Barr said the agency does not comment on litigation.

In his ruling, Sontchi said the FDIC could make a claim for the amount of the refund against the parent company, although that claim would be part of the larger pool in the bankruptcy proceeding. The ruling could be appealed.

Downey Savings and Loan and its 213 branches were seized by regulators in 2008 and immediately sold to U.S. Bank, a unit of U.S. Bancorp. The FDIC estimated at the time it expected Downey's failure would cost the insurance fund $1.6 billion.

The bankruptcy case is In re: Downey Financial Corp, U.S. Bankruptcy Court for the District of Delaware, No. 08-13042; the tax refund adversary case is 10-53731.