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Yesterday we reported on Goldman Sachs’ lawsuit against hedge fund Paulson & Co. over the latter’s alleged fraudulent pricing of collateralized debt obligations (CDOs). Not to be outdone,  UBS AG has launched a $686 million lawsuit against Highland Capital Management LP accusing the hedge fund of duping it into restructuring an $86 million debt securities agreement, then stripping away assets and making payment to the bank impossible.

The Swiss bank’s partially redacted complaint, lodged Monday in the Supreme Court of the State of New York, County of New York, also seeks punitive damages on top of the $686 million. UBS Prime Brokerage is a subsidiary of UBS AG.

A CDO is a structured security backed by an asset, in this case mostly mortgage-backed bonds. CDOs are sold in a series of different tranches, each with its own unique risk characteristics.  The 2008 market crises was in part blamed on credit rating agencies improperly evaluating the risks of CDOs and other asset-backed securities, which tended to exacerbate risk to market participants.

According to the complaint, once Highland Capital succeeded in misleading UBS into restructuring an original debt securities transaction, the Dallas-based fund then used fraudulent conveyances to siphon assets away from its Highland Special Opportunities Holding Co. and Highland CDO Opportunity Master Fund LP affiliates, which were the UBS counterparties.

“When UBS finally terminated the restructured transaction and demanded payment … it was owed in excess of $686 million that the fund counterparties could not pay,” the suit said.

UBS noted in its complaint that there was a parallel action in the same court against several Highland Capital-controlled defendants and that a motion to consolidate the lawsuits was pending.

In a statement issued Tuesday night Highland Capital called both lawsuits baseless.

“We are dismayed UBS continues to pursue this wasteful suit despite our attempts to work cooperatively with them to resolve the matter,” Highland Capital said.

The dispute relates to collateralized loan obligation and collateralized debt obligation securities, which UBS says it agreed in spring 2007 to “warehouse” for the hedge fund. According to UBS’ lawsuit, however, by August 2007 the agreement was terminated and, as a result, Highland Capital owed the bank $86 million.

At that point, however, the hedge fund, which currently manages some $25 billion worth of assets, provided UBS with false and misleading information, causing UBS to forgo recovery in favor of a restructuring agreement, the suit says.

Given UBS’ prior dealings with Highland Capital, as well the fund’s size and market presence, UBS had no reason to think it would be duped, the suit says.

Almost immediately after the restructuring, UBS claims, the hedge fund began to move money out of the bank’s potential reach. For example, UBS claims, in May 2008 the hedge fund misappropriated some $100 million in cash it held after selling a long position, draining the resources despite its increasing obligations.

The suit seeks a judgment that the fund committed fraud and breached its duty of good faith and fair dealing. It seeks interest on top of damages.

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