Thomas Sandell's Execution Problem

The fund told investors that certain trades weren't done right.
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Hedge fund manager Thomas Sandell is bracing for a fight with securities regulators over

allegations that his $4 billion fund broke the rules on short-selling in a bid to cash in on the havoc wrought by Hurricane Katrina.

But seven months ago, Sandell conceded to his investors that some of those disputed trades were "improperly executed."

New York-based Sandell Asset Management made the concession in an April 7 letter to investors. In that letter, Sandell first informed investors that the

Securities and Exchange Commission

was investigating a series of trades Sandell made in shares of New Orleans-based Hibernia right after Hurricane Katrina devastated the Gulf Coast region in August 2005.

For nearly a year, the SEC has been looking into charges that Sandell improperly shorted shares of Hibernia in order to profit from speculation that the storm would force

Capital One

(COF) - Get Report

to cut the price of its planned acquisition of the Gulf Coast lender -- as it later did. Regulators believe the hedge fund engaged in "naked shorting," an improper trading strategy in which a hedge fund shorts a stock without first borrowing shares from a broker, as is required under federal securities laws.

Last month the SEC formally notified Sandell that it's considering bringing a civil enforcement action against the hedge fund. In a subsequent letter to investors, sent last week, Sandell says, "We dispute several of the commission's assertions." The fund said it still hopes to resolve the matter.

Investors in the fund described the two letters to

TheStreet.com

, which first reported that the SEC was investigating a

big hedge fund over allegations of naked shorting shares. The investors say they are ready to give Sandell the benefit of the doubt, since the fund has been upfront with them about the investigation and is up 18% this year.

Still, in April, Sandell seemed much more hopeful that it would be able to avoid getting slapped by regulators. In that initial letter, it had conducted its own "in depth investigation" and "concluded that certain trades were improperly executed." But the fund added that it had since "instituted what it believes are appropriate measures to clarify trades" and was cooperating with regulators.

A spokesman for Sandell declined to comment on the inquiry. An SEC official didn't comment.

Ron Geffner, a partner with Sadis & Goldberg who represents hedge funds, says there's nothing inherently inconsistent with a fund admitting that trading errors were made while insisting that it didn't violate securities laws. He says SEC investigations often focus on areas of the law that are unsettled and not clear-cut cases of fraud.

In Sandell's defense, people familiar with the trading say the hedge fund, which had a long position in shares of Hibernia in the summer of 2005, was simply trying to protect itself from a downward revision in Capital One's initial $5.35 billion bid for Hibernia. Indeed, after Katrina struck, the purchase price was negotiated down to $5 billion.

Regulatory filings reveal that as of June 2005, Sandell owned about 1.14 million shares of Hibernia. At the time, the stake was valued at $37.9 million.

The problem for Sandell, however, was one of timing. When the hedge fund tried to short shares of Hibernia, it likely had difficulty finding a broker from whom it could borrow shares. That's because so much of the stock had been taken out circulation in anticipation of the deal with Capital One closing as intended on Sept. 1.

In mergers, shareholders of the company being acquired must "tender" their shares to their broker in order to collect on the payout. When the shares are tendered, they generally can't be lent out by brokers to short-sellers who bet against stocks.

A trader with another hedge fund said it too had been thinking about shorting shares of Hibernia after Katrina hit. But it couldn't find a broker that had shares to lend out, so it passed on the trade.

Yet sources say Sandell went ahead and shorted Hibernia anyway. The fund allegedly told brokers at several big Wall Street firms that it was borrowing shares from another brokerage and the big Wall Street firms executed the trades.

Sources say one of the firms that executed some of those trades was

Morgan Stanley

(MS) - Get Report

, one of Sandell's prime brokers.

Bear Stearns

(BSC)

is Sandell's other prime broker. Both Wall Street firms have declined to comment on the investigation.