MDL Capital fights lawsuit over $215 million loss: CEO says charges are politically motivated.

Mark D. Lay is in for the fight of his life. His company, one of the nation's largest black-owned money managers, has been rocked by a scandal involving one of its hedge funds that lost more than $200 million.

The CEO of MDL Capital Management (No. 6 on the BE ASSET MANAGERS list with $2.82 billion in assets under management) is facing a lawsuit initiated by the Ohio Bureau of Workers' Compensation (BWC), a state agency that oversees more than $21 billion in assets. The BWC, which had a significant investment in an MDL-managed fund, alleges MDL made unauthorized investment decisions that led to a $215 million loss in November 2004. According to sources, roughly $8 billion of BWC's $21 billion in assets is invested in fixed-income investments.

Although damages sought by the bureau were not specified, the lawsuit, filed June 10 in the Franklin County Court of Common Pleas, claims MDL, its founder, and six others committed fraud, breach of contract, conspiracy, unjust enrichment, and aiding and abetting. (Black Enterprise/Greenwich Street Corporate Growth fund, which is managed by Earl G. Graves Ltd., parent company of this publication, owns a stake in MDL.)

MDL's leveraging strategy is one of the main points of contention. "There are two issues. One is that they bet correctly against interest rates--that was, in my understanding, the genesis of the fund in terms of its premise," explains Jeremy Jackson, a spokesman for the BWC. "The other issue deals with leveraging and whether or not they leveraged the value of the investment beyond what was permitted by the contract."

According to court documents, MDL's contract allowed it to leverage, or borrow, up to 150% of BWC's $225 million investment in the Active Duration Fund, an offshore hedge fund based in Bermuda. As the fund manager, MDL engaged in such transactions as a means of capitalizing on shifting market conditions. However, the BWC charges that, at one point, MDL leveraged more than 1,900% of the fund's total assets.

Compounding the high leveraging, the fund manager incorrectly predicted that long-term interest rates would begin to rise from their current lows as the economy began building momentum. MDL borrowed bonds in order to sell them and pay back the lenders at a later date, a practice known as taking a short position or shorting. If interest rates rose and bond values fell (bond valuations and interest rates move in inverse directions), MDL could have replaced the borrowed bonds at a cheaper price. As a result, the fund would generate a profit. But in 2004, long-term rates dropped, and the hedge fund, like many others, lost money. Inside sources say that BWC's investment staff agreed with Lay's strategy as it related to interest rates and instructed BWC to continue its investment in the fund.

Hedge funds are private investment vehicles--open only to accredited investors--that are not regulated by the Securities and Exchange Commission. Hedge fund managers, therefore, are bound by fewer restrictions than mutual fund managers. These funds carry the chance of high returns but also the prospect of huge losses. Hedge fund managers often make risky investment decisions, such as trading options, buying on credit, or practicing arbitrage--simultaneously buying and selling the same security in different markets to take advantage of short-term price differences.

Lay wasn't the only money manager expecting long-term rates to rise. The Federal Reserve had raised short-term interest rates, believing the move would cause rates across the board to drift higher. But foreign buying of U.S. treasuries and mortgage securities sparked demand for long-term bonds and kept rates low. Muted inflation expectations and other factors also suppressed long-term rates.

Though the loss occurred in 2004, it didn't become public knowledge until the spring of 2005, when Tom Noe, a Toledo coin dealer who was in charge of a $55 million coin investment fund set up by the BWC, reported that between $10 million and $13 million of the fund's assets were missing. The subsequent investigation into BWC's investments placed a spotlight on MDL's hedge fund performance.

Lay claims the lawsuit is a case of politicking, noting that Ohio Attorney General James Petro, who brought the complaint, has gubernatorial ambitions. Similar to New York Attorney General Eliot Spitzer, Petro is campaigning as an official that will protect public dollars. Sources say Petro, a Republican, initiated the investigation of Noe, a GOP fundraiser, as a demonstration that he would not engage in partisan politics when it came to acts of financial malfeasance. Petro's office declined to comment on any aspect of the case.

According to Lay, the BWC's investment staff fully understood and approved his firm's actions. "They knew exactly what was going on, says Barry Slotnick, Lay's attorney. "They received reports at a minimum every 30 days and anyone who knows how to read a financial report can clearly see that there was leveraging going on. They were the only shareholder in the fund. So these allegations are just foolish."

The hedge fund's board issued a memorandum to the BWC on Aug. 11, 2004, according to the complaint, stating, among other matters, that leveraging "has and will continue to be significantly higher than 150%." BWC officials maintain that they did not sign the memorandum or approve MDL's increased leveraging activity.

The BWC initially invested $55 million with MDL in 1998. Lay says his firm has been one of the state's top-performing, minority fixed-income money managers "and, because of that, they gave us an additional allocation of $100 million. We continued to perform well, and they gave us another $200 million."

Court documents confirm that "because MDL Capital's performance with the Bureau's investment yielded an average annual return through September 2003 of 6.85% [mirroring the Lehman Government Credit Bond Index, the benchmark for this asset class], the Bureau subsequently provided an additional $300 million for MDL Capital to manage."

Lay says his firm continued to manage money for the BWC for nine months after the $215 million loss, which he believes lends credence to his argument that the lawsuit is a case of political finger-pointing and investor's remorse. "They came into our office and reconciled all the books," asserts Lay. "The question for us was--this happened nine months ago, why [is it a problem] all of a sudden?"

Jackson confirmed that Lay met with the BWC's investment staff. "I can't speak of what those discussions were, so as far as them being aware of his management decisions," he says. "I can say though, specifically with regards to leveraging in the hedge fund account, the bureau was not necessarily in agreement with those decisions because it never signed off on the amendments proposed by Mr. Lay to increase the leveraging and give him greater latitude to make those decisions."

In the meantime, MDL has lost several clients, including the Philadelphia pension system and the Allegheny County Pension Board. "We've lost clients and we've gotten a couple of clients," Lay maintains. "There has been a loss of assets, but going forward we feel very confident that we'll be able to rebuild."

MDL CAPITAL MANAGEMENT INC.

       ASSETS UNDER MANAGEMENT   STAFF

2000            4,432             19
2001            2,300             12
2002            3,200             18
2003            3,810             25
2004            2,821             32

* IN MILLIONS OF DOLLARS. PREPARED BY B.E. RESEARCH

Note: Table made from bar graph.