* Court begins hearing insider-trading allegations
* Aurelius describes how it separated talks from trading
* Insider-trading claims could torpedo bankruptcy exit
By Tom Hals
WILMINGTON, Del., July 18 (Reuters) - A hedge fund accused of trading on confidential data gleaned from the Washington Mutual Inc bankruptcy went so far as to sound-proof an office to prevent inside 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 accuse 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 dismiss 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 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.
Monday’s hearings began with Gropper being questioned by his attorney about the fund’s operations and how it separated trading activity from his role at the negotiating table.
In addition to spending $150,000 sound-proofing his office, Gropper said it was agreed that Washington Mutual would decide what constituted material nonpublic information which must not be used for trading.
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, editing by Matthew Lewis)