Hedge Fund Bondholders Sue Aristocrat Leisure for Failure to Convert Bonds On Demand; Federal Court Limits Evidence to be Presented at Trial

In 2001, Aristocrat Leisure Limited (Aristocrat) issued $130 million of convertible bonds due in May 2006.  The bonds were purchased by a variety of financial institutions and hedge funds.  In December 2004, Aristocrat commenced a suit seeking a declaratory judgment to correct an alleged “scrivener’s error” in the exchange rate under the bonds.  After commencement of the suit, the bondholders sought to convert the bonds into shares of Aristocrat common stock.  Aristocrat refused and further litigation ensued.  The United States District Court for the Southern District of New York previously determined that an attempt by Aristocrat to call the bonds was ineffective and that Aristocrat had breached the bond indenture by failing to convert the bonds when demanded.  The court ruled that not only were the bondholders entitled to general damages equivalent to the value of Aristocrat stock on the date that conversion was demanded, but that they were also entitled to consequential damages stemming from the hedge funds’ need to cover short positions in Aristocrat stock that the funds had taken to hedge their bond purchases.  Aristocrat countered that consequential damages should be limited because the hedge funds kept open their short positions in Aristocrat stock long after Aristocrat refused to convert its bonds and thereby failed to mitigate their damages.  On September 28, 2009, the court issued a new ruling in the case.   We discuss the more recent ruling, and provide additional background on the prior ruling.  The case is of particular interest to hedge funds employing a convertible bond or convertible arbitrage strategy.

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