Corporate Britain may have shied away from fighting its battles in court, but the City's leading litigation law firms are hoping their salvation may lie in disputes involving hedge funds.

In 2006, more than $125 billion of new money went in to the hedge fund industry - three times that of the year before - and it seems clear that the business will continue its move into the mainstream of the asset management sector. But with so much money flowing in to these funds, the potential for blow-ups and fall-outs is only increasing, not least because the funds themselves are not averse to taking contentious issues before a judge.

The fight for control of ABN Amro, the Dutch bank - in which the intervention of a Dutch court to stop ABN's plan to sell its US arm LaSalle to Bank of America for $21 billion potentially scuppered a €64 billion tie-up with Barclays – showed how much influence hedge fund investors can wield when a deal is not to their liking. Similarly, negotiations over a last-ditch plan to restructure Eurotunnel's massive £6.2 billion debt burden at the end of last year were threatened by legal action from three hedge funds.

“Hedge funds have a unique ability to take positions that others would not, or could not, take," says John Hull, a litigation partner at Latham & Watkins, who worked on the Eurotunnel deal on behalf of Deutsche Bank. "The legal budget is not so much an overhead as part of the operating budget, which the funds use to increase or improve their positions, and therefore their profits.”

But while activist hedge funds have been around for some time, the prospect of skirmishes between the funds and their investors is now emerging. Jonathan Kelly, head of the finance litigation group at Simmons & Simmons and a member of The Times Law Panel, says: “The hedge funds have historically been the preserve of wealthy, personally-known investors. Over the last couple of years that has changed and they have attracted a more mainstream investor appetite. As that happens, we certainly anticipate attacks on hedge funds from the investing public.”

The prospect of an economic downturn gives further cause for concern. Tim Parkes, a litigation partner at Herbert Smith, says: “If there’s a collapse in bond prices, or in share prices, or some problem in the currency markets, that will catch a number of these funds wrong-footed. That could well be a trigger for disputes around allegations of negligence and allegations of fraud against the managers.”

In America, where the hedge funds industry is much larger and more mature, fraud and negligence claims against funds and fund managers are now also giving rise to claims against their service providers, particularly investment banks and fund administrators. The investment banks can make as much as 20 per cent of their revenues out of prime brokerage services for these funds, having developed their role as largely back-office functions into other services such as cash and stock lending, and making introductions.

Marc Gottridge is a litigation partner based in Lovells' New York office, says: “A lot of these cases in the US have revolved around the courts sorting out who can be held liable. The prime brokers are at the cutting edge. If you imagine a situation where there was no fraud, and the prime broker has benefited from what a US jury will see as massive fees, and then there was a bad investment. The key issue for the investment banks is can they be kept in the case on an aiding and abetting issue, because if they can, then they are in the soup.”

Many of the leading litigation law firms have resisted acting in disputes that put them in conflict with the investment banks, for fear of making enemies of financial institutions that dole out a lot of legal work. That stance makes it hard for the top players to position themselves as go-to advisers for hedge funds who fall out with their prime brokers.

Parkes says, “Is there going to be a parting of the ways, with a whole bunch of firms cosying up to the investment banks and prime brokers, and another group cosying up to the hedge funds? In the long term, that may be what happens.”

But with some banks also running their own hedge funds, the waters are muddied. Herbert Smith counts Man Group, the UK’s largest listed hedge fund, as a major client alongside a batch of investment banks. “At this stage, firms need to take the time to understand the market, how it works, and what it involves. You need to build some relationships and profile across the industry,” says Parkes.

When you throw regulatory scrutiny into the mix, it is clear that the funds themselves are going to be making demands on their lawyers going forward. Very few have developed large internal legal functions, but the Financial Services Authority on this side of the Atlantic and the Securities and Exchange Commission in the US have the industry in their sights.

Kelly: “There is a systemic risk issue. Where there’s the biggest risk, and what the regulator is worried about, is the participation of the hedge funds in the credit markets. It is very difficult to get a clear idea of where the risk actually lies, and regulators are worried that while a huge amount of risk is being taken by people who are paid to take risk, if they go down, who else will go down with them?”

In September last year, a US hedge fund called Amaranth collapsed with $6 billion of losses after huge, failed bets on the natural gas markets. Earlier in the year Refco, a futures broker, hit bankruptcy amid fraud allegations, but so far neither has had a major impact on the broader securities industry.

But UK law firms are squaring up for plenty of disputes across the sector in future. Gottridge says: “It’s the law of big numbers. There are so many more funds every year, so much more liquidity, so much more money in the system, and so much more leverage. The number of things that can go wrong increases, or at least the impact is increased. Even if you don’t commit a fraud, you can very easily lose billions of dollars of people’s money.”

There may be a slowdown in the London commercial courts, but litigators have their eyes firmly fixed on the next prize.

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