COLUMBUS, Ohio (HedgeWorld.com)–Ohio Attorney General Jim Petro filed a lawsuit Friday [June 10] accusing investment manager MDL Capital Management Inc., its chief executive Mark D. Lay and seven other defendants of fraud, conspiracy, breach of fiduciary duty and breach of contract in connection with a hedge fund investment that went bad.

In its complaint, filed in Franklin County Common Pleas Court, Mr. Petro’s office says the US$14 billion Ohio Bureau of Workers’ Compensation lost US$215 million in a hedge fund run by MDL called the MDL Active Duration Fund. The lawsuit claims Mr. Lay and MDL lied to bureau officials about the amount of leverage the fund was using and failed to mention that although the fund was originally supposed to attract other institutional investors, the workers compensation fund was in fact the sole investor.

“As soon as we learned three days ago about the magnitude of the [Bureau of Workers' Compensation] investment losses with MDL, we immediately began preparing to file suit,” Mr. Petro said in a statement.

The lawsuit also names the Bermuda-based Active Duration Fund as a defendant, along with fund board members Steven L. Sanders, Edward Adatepe, Oskar P. Lewnowski and C. Raymond Morrison, Warwick Fiduciary Services Ltd. and Hamilton Fiduciary Services. Warwick and Hamilton are both based in Bermuda. Messrs. Lewnowski and Morrison are understood to live in Bermuda, according to the lawsuit. Messrs. Sanders and Adadepe live in Pennsylvania.

All of them are accused of fraud, conspiracy, breach of fiduciary duty, breach of contract, violations of three sections of the Ohio Securities Act, misrepresentation, unjust enrichment and aiding and abetting, according to the lawsuit.

The suit was not an unexpected reaction by Ohio officials to revelations in various state newspapers last week that the beleaguered Bureau of Workers Compensation had lost US$215 million in a hedge fund. Earlier this year, state officials had to answer for between US$10 million and US$13 million in BWC losses in connection with a rare coin investment. The coin fiasco led to the resignation of the bureau’s former administrator, James Conrad. Terry Gasper, former chief financial officer at the fund, was reportedly forced to resign last year after state officials learned of the MDL hedge fund losses.

The relationship between the Ohio Bureau of Workers’ Compensation and MDL goes back to 1998, when the bureau made an initial allocation of US$55 million to a long bond portfolio run by Mr. Lay’s firm. Good returns on that portfolio led bureau officials to allocate another US$300 million to MDL’s long-only bond fund, according to the lawsuit.

In August 2003, after coaxing from Mr. Lay, the bureau took US$100 million out of its long-only fund with MDL and allocated it to the Active Duration Fund. It was supposed to be a hedge against poor performance in the bond fund. MDL said the Active Duration Fund would invest in “U.S. Treasury notes and bonds, U.S. agency notes and bonds, and corporate and mortgage-backed fixed income securities.” Additionally, the fund would use currencies and long and short positions in publicly traded equities “to hedge against underlying credit and interest rate trends,” according to the lawsuit. Leverage was limited by a private placement memorandum to 1.5 times fund assets, or 150%.

In 2004, the bureau allocated another US$125 million to the Active Duration Fund, for a total investment of US$225 million. In August of last year, the fund’s board of directors sent a letter to the bureau notifying it of several changes, among them that Messrs. Lewnowski and Morrison had resigned from the board and been replaced by Hamilton fiduciary and Warwick fiduciary, and that a firm called Olympia Capital Ltd.–a unit of Olympia Capital International Inc., a Bermuda hedge fund services firm co-founded by Mr. Lewnowski in 1990 and for which Mr. Morrison serves as president–had been engaged as a “Representative of the Fund.”

The letter also contained a “clarification” of the fund’s leverage practices. Historically, according to the letter, securities excluding U.S. Treasuries had been leveraged up to 150%. Leverage of U.S. Treasuries, however, “has been and will continue to be significantly higher than 150%,” the letter stated. That was a departure from the original private placement memorandum, according to the lawsuit.

The letter contained a line at the end for a representative of the workers compensation bureau to sign, indicating receipt of the letter and concurrence with the revisions. In its lawsuit, Mr. Petro’s office says the letter was never signed by the bureau, and therefore the bureau never accepted the revisions.

Subsequent to receipt of the letter, Mr. Petro’s office claims in its lawsuit, bureau officials learned that actual leverage in the Active Duration Fund was 1,900%, or 19 times assets. When bureau officials demanded an explanation, Mr. Lay said the fund had employed leverage of only 9 times assets, or 900%, and he said the bureau had approved the increased leverage, according to the lawsuit.

The lawsuit also contends that MDL and the fund’s board of directors began employing greater leverage before the letter containing the revisions to the private placement memorandum was sent, and that they drafted the letter after the fund had sustained heavy losses.

On Sept. 29, the bureau announced its intention to redeem its investment. By November, when the investment was closed out, the bureau got back US$9 million out of the US$225 million it had in the fund.

The lawsuit seeks unspecified damages in excess of US$25,000, rescission of the sale and purchase of Active Duration Fund shares, reimbursement for attorneys’ fees and costs, an order preventing MDL from destroying, transferring or disposing of documents related to the case and any other damages the court might see fit to award.

MDL officials did not immediately return a call seeking comment.

CClair@HedgeWorld.com

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.