Photo: Diego M. Radzinschi/ALM

Liquidators for a pair of defunct Bear Stearns investment funds sued Reed Smith on Tuesday alleging malpractice, seeking $500 million in damages and saying the law firm muffed a financial crisis era lawsuit against the major credit rating agencies.

The two Cayman Islands-based funds—which raised and fed capital to so-called master funds at Bear Stearns that, in turn, invested heavily in shoddy residential mortgage backed securities (RMBS) and collateralized debt obligations—tapped lawyers at Reid Collins & Tsai to file suit against Reed Smith in Manhattan state court.

The complaint alleges that while representing the two feeder hedge funds, Reed Smith missed a key deadline for bringing a potentially lucrative lawsuit against Standard & Poors, Moody's and Fitch Ratings.

“Reed Smith's negligent failure to understand New York's statute of limitations cost the Bear Stearns Funds what Reed Smith identified as a billion-dollar claim against various rating agencies,” the complaint said.

The malpractice claim stems from work Reed Smith did on behalf of the feeder funds' liquidators after the financial crisis. The liquidators were appointed in 2008 by a Cayman court and previously, they sued JPMorgan Chase & Co., which acquired Bear Stearns, Deloitte & Touche and individuals who managed the master funds at Bear Stearns. That case—which settled in 2013 for an undisclosed value—argued that an inner circle at Bear Stearns and among its close advisers knew about the risks associated with the RMBS that caused the feeder funds' losses, but purchased them anyway.

Around the time that first suit settled, Reed Smith lodged a fraud lawsuit against the rating agencies on behalf of the feeder funds. But there were at least a couple of obstacles that the feeder funds had to overcome in that case, according to court records and Tuesday's complaints.

First, the securities involved were all purchased in 2006 and 2007, and the relevant statute of limitations would have been six years. Second, the feeder funds didn't have direct standing to sue the rating agencies because it was actually the master funds that did the purchasing of the suspect securities. The standing issue meant the feeder funds would have to enter into a purchase in which the master funds would assign their claims against the rating agencies to the feeder funds.

Reed Smith also attempted to work around the statute of limitations issue, arguing that a “continuing harm” doctrine would extend the time limit to sue the rating agencies. On both fronts, however, a Manhattan state court found against the feeder funds in August 2015, dismissing the rating agency lawsuit.

The feeder funds' malpractice suit alleges that Reed Smith had conducted an early analysis of a possible rating agency suit in 2011—at a point when the relevant six-year statute of limitations would not yet have run out.

The analysis ultimately concluded that the feeder funds would have to purchase claims from the master funds in order to pursue litigation against the rating agencies, and noted questions about the statute of limitations. But Reed Smith failed to inform its feeder fund clients about that analysis until 2013. By that point, the complaint said, the rating agency case was “doomed” before it began.

“This misguided approach to the legal representation led to a disastrous result when Reed Smith failed to even raise the claim against the rating agencies with its clients until after limitations had run, even though the claims had been live when Reed Smith (unbeknownst to its clients) completed its initial, internal analysis nearly two years before,” the complaint said.

Kevin Rosen of Gibson, Dunn & Crutcher, which is defending Reed Smith, rejected the malpractice complaint's allegations in a statement Wednesday. In addition to Rosen, the defense team includes Gibson Dunn lawyers Mark Kirsch, Adam Offenhartz and Nancy Hart.

While the Bear Stearns funds allege that Reed Smith looked into a possible rating agency claim in 2011, a lawsuit against the ratings houses wasn't viable at that time, according to Rosen's statement.

Outside of the feeder funds, others impacted by the financial crisis had tried to pursue claims against the rating agencies. But, as The American Lawyer reported at the time, those types of private suits failed to gain traction until 2013, after the U.S. Justice Department had sued the rating agencies and unearthed evidence that supported its claims.

Rosen's statement also points out that Reed Smith was actually instructed not to pursue cases while the feeder funds were still awaiting approval for the 2013 settlement in the case against JPMorgan Chase & Co. and individuals who managed the master funds at Bear Stearns.

“Reed Smith obtained an extraordinary litigation victory for these Cayman hedge funds in complex litigation against their investment managers. Now the hedge funds want even more, claiming Reed Smith should have concurrently sued others for the same damages,” Rosen said. “But the hedge funds couldn't bring those claims at that time and told Reed Smith not to do so. Reed Smith always acted properly; the hedge fund claims are meritless and riddled with false allegations; and we look forward to establishing all of that in court.”