Nothing Can Stop This Hedge Fund Soap Opera.

Illustrations by Yohey Horishita

Illustrations by Yohey Horishita

Not even a global pandemic.

Hedge funds that play in the rough-and-tumble world of distressed debt are accustomed to using the court system to achieve their ends.

These battles often get ugly. For firms in this world — which seek to buy the equity and debt of companies that are in dire financial straits and then turn those companies around — the playbook often involves suing to recover assets, doing battle with other creditors, and taking control of the companies post-bankruptcy.

But even by the standards of exceptionally litigious investment firms, Highland Capital Management stands in a class by itself.

The Dallas-headquartered alternative-investment firm has been slugging it out in the courts since the financial crisis with investors, investment banks, and a pair of ex-employees who allege the firm fraudulently transferred assets to avoid paying out judgments that the courts ruled they are owed.

For years the biggest legal obstacle the firm faced was a 2016 lawsuit filed in Delaware Chancery Court by investors in its Highland Crusader funds, a pre-crisis hedge fund that went into liquidation in 2008. Highland had initially worked out a restructuring plan with investors in 2011, after years of heated negotiations. But those investors sued the fund five years later, alleging that the firm had improperly paid itself fees and delayed the funds’ liquidation, among other claims.


The case ultimately went to arbitration, and the panel awarded the Crusader investors — who had cleverly christened themselves the Redeemer Committee — a $189 million judgment. That judgment had to be confirmed by a court, however, before the award became final. Highland pursued settlement talks with investors ahead of that hearing, scheduled for last fall.

But on October 16, 2019, seemingly out of nowhere, Highland Capital Management LP, the entity that operated the Crusader funds, filed for Chapter 11 bankruptcy protection in U.S. Bankruptcy Court in Delaware, acknowledging that though it “disputes the underlying claims” of the Crusader investors’ lawsuit, it may not have enough liquid assets to cover the maximum potential judgment against it.

On its face the move was surprising. Highland operates several other entities on its platform — none of which is filing for bankruptcy — and manages the majority of its $10.4 billion out of these businesses, which appear to be successful. In other words, the firm is clearly a going concern, with plenty of liquidity. In its announcement of the bankruptcy, the firm said that all of its other businesses were operating as usual amid the reorganization and that it did not expect any management changes in the bankrupt entity or elsewhere across the platform.

So why take the nuclear option?

A source close to Highland says the firm took such a drastic measure because it was eager to begin the reorganization process and bring its numerous, long-running legal dramas to a close.

Highland has good reason to want to do so. At its pre-crisis peak, in 2007, the firm managed some $40 billion and was considered a powerhouse hedge fund firm and a pioneer in so-called collateralized loan obligations, securing its status as one of the most high-profile — if controversial — credit investment firms in the business. But wrenching losses in its Crusader funds, and in another credit-focused hedge fund that had invested heavily in the toxic credit instruments that took down many of its peers, led the firm to suddenly announce in 2008 that it would suspend redemptions as it attempted to liquidate the assets — spawning the legal brawl that prompted the bankruptcy filing more than a decade later.

But since 2008, Highland also has undergone a transformation, refashioning itself as a multifaceted alternative-assets manager that bears little resemblance to its pre-crisis form. Although the firm manages a fraction of what it did before the crisis, it nevertheless operates a diverse investment platform that includes a multibillion-dollar retail mutual fund business and a sizable publicly traded real estate trust.

The one relic of its pre-crisis past that has remained, however, is Highland’s reputation as a scorched-earth litigator.

Almost no one contacted by Institutional Investor would speak on the record for this story, for fear of legal reprisal. Those fears are well founded: Thousands of pages of legal documents show that Highland’s co-founder and current chief executive, James Dondero, is not afraid to wage the legal equivalent of war — and doesn’t back down when the courts don’t rule in his favor.

Various court documents related to the lawsuits show that Highland has referred to investors as “idiots” in emails, blamed what it called one ex-employee’s “erratic” and “megalomaniacal” behavior on brain damage, and accused another ex-employee of having inappropriate sexual relationships with subordinates — the latter claim determined by an arbitration panel to be a “false pretext of ‘for cause’ termination” to get out of contractual obligations related to the value of his limited partnership.

In the firm’s latest legal battle, however, Dondero appears to have ceded some ground.

He had little choice. Facing the appointment of a trustee to oversee the case — and wrest control of the process from the firm — Highland came to an agreement with the creditors’ committee and then voluntarily proposed changes to Highland Capital Management LP’s governance structure. The changes called for Dondero to be removed as an officer of the bankrupt entity and as director of its general partner — although he stayed on as an employee and portfolio manager at Highland Capital Management LP and retains his leadership roles at Highland’s other entities. The new structure also included the appointment of a board of three independent directors with no ties to Highland to run the general partner, and a clause permitting the creditors’ committee to pursue claims against Highland, Dondero, and now-retired co-founder Mark Okada in the future. Dallas Bankruptcy Court approved the new structure in mid-January of this year.

A spokesperson for Highland Capital Management LP said in an statement emailed to Institutional Investor that “Highland’s focus is on reaching a consensual reorganization with creditors, and we view that as an attainable goal. The independent directors have echoed that view, and believe Highland’s assets and investment capabilities put the firm in a strong position to reach a resolution with all creditors found to have legitimate claims against HCMLP.”

If the reorganization proceeds as planned, it will mark an end to more than a decade of costly and combative litigation, some of which one Texas judge called “astonishingly contentious.” Highland says the reorganization is on track — and so far, that appears to be the case, even as the global coronavirus pandemic has banished many non-essential workers to their home offices. (While Dallas County is under shelter-in-place orders, some bankruptcy court proceedings are being held by phone, and others that require in-person appearances have been rescheduled for May; no major Highland hearings have been affected.)

But putting its numerous disputes behind it will be easier said than done. Many of the creditors have litigation claims against the firm, and they aren’t exactly ready to make nice. Those creditors include the two ex-employees alleging fraud, as well as investment bank UBS, which just won a $1 billion judgment against two now-defunct Highland entities over another crisis-era deal that also went south.

What’s more, some of the creditors aren’t satisfied with the new governance structure. And according to a copy of the proposal seen by II, one of them has suggested an entirely new management team to take control of Highland Capital Management.

The architect of the plan is none other than one of Dondero’s most ardent foes.

Highland’s reputation as a bare-knuckle brawler in court had already been cemented well before the crisis. That reputation is largely thanks to James Dondero.

Standing at a physically imposing 6'4", Dondero is a big-game hunting enthusiast who owns a large gun collection — though people who know him say he also owns an even larger trove of books and can be socially awkward. He started in the financial markets as a bond analyst in Los Angeles. In the late 1980s he met Mark Okada, the comparatively polished son of a Presbyterian minister, and hired him as a portfolio manager at Protective Life Insurance Corp., where Dondero was running a portfolio of guaranteed investment contracts. In 1993, Dondero and Okada formed the investment advisory firm that would become Highland Capital and moved their business to Texas soon after.

The firm weathered rocky periods in the markets, including the 1998 Russian debt defaults and the early-2000s dotcom busts, and the business took off. Highland grew its assets sixfold from 2003 to 2007 as the firm established itself as the biggest nonbank player in the fast-growing world of leveraged loans.

But as the firm’s assets swelled, so did its notoriety.

“Highland was viewed very negatively by the investor community,” a senior private equity executive told Institutional Investor for a 2007 profile of the firm. “They had an attitude of sue first and ask questions later.”

However unseemly that attitude may have been to Highland’s rivals, it worked as an investment strategy. The firm racked up impressive returns, with its Crusader funds gaining 40 percent in 2006, and attracted blue-chip investors along the way. These included the California Public Employees Retirement System and the Ontario Teachers’ Pension Plan.

Investors were willing to tolerate Highland’s aggressive legal tactics — after all, the firm was fighting these battles on their behalf, and winning many of them. Still, the firm acknowledged that it needed to repair relationships and smooth its image, and was seemingly on its way to doing just that.

And then came the financial crisis.

Highland had launched the first of its star-crossed Crusader funds in 2000 with just $20 million, growing it to $3 billion by 2007. The funds had been designed to scoop up distressed loans in the then-battered health care and telecommunications sectors and work to restructure the companies.

But trouble hit in 2008 — as it did with so many hedge fund managers — when the financial crisis began, wreaking havoc on the funds and slashing returns. In October of that year, Highland told investors it would suspend redemptions from the Crusader funds — as well as from the Highland Credit Strategies fund, a separate hedge fund — and start liquidating their assets. But at the time, Highland maintained that it wished to wait to liquidate some of the assets to avoid dumping them at cut-rate prices in a fire sale.

The announcement ignited a clash among the Crusader funds’ investors. In August 2011, after several years of litigation and negotiations, Highland and most of the funds’ investors struck an agreement stipulating that Highland would sell whatever remained of the Crusader funds’ assets in the next three and a half years and that it would be entitled to a deferred fee of $47.5 million after those sales were completed.

This agreement specified that Highland would continue managing the Crusader funds. It also created the Redeemer Committee, which would have the authority to terminate Highland as the funds’ investment manager with 30 days’ notice, among other powers.

That peace would not last.

Relations between the Redeemer Committee and Highland grew strained not long after the agreement was created. Investors complained that Highland was taking too long to liquidate assets, and objected to the sale of a particular asset, arguing that the price Highland wanted to sell it for wasn’t high enough.

(Highland had been through the wringer with angry investors before. In another case, before it ultimately settled, relations became so strained that Dondero wrote to colleagues that emails from investors “establish they are idiots and that you guys have let them misunderstand the proposal,” according to the arbitration ruling.)

What’s more, when the Redeemer Committee received its audited financial statements for 2015, it discovered that Highland had taken cash out of the Crusader funds to pay itself $32.3 million in performance fees before the funds’ assets were fully liquidated. That’s when it slapped Highland Capital Management LP with the lawsuit, alleging that the fee payment violated the earlier agreement.

Highland argued that it was allowed to pay itself the fees — which it based on asset sales and distributions already paid to investors — owing to a legal technicality arising from another lawsuit. What’s more, the firm said, the process had been highly effective: The firm had already recovered $1.55 billion for Crusader’s investors, or 90 percent of the funds’ original value, by the time of the lawsuit precisely because it hadn’t sold off assets until it could do so at an attractive price.

When the case finally went to arbitration, the panel overseeing it unanimously issued three partial final awards and one final award against Highland, finding that the firm, its in-house lawyers, and Dondero had “engaged in willful misconduct, self-dealing, and secrecy, and made multiple misrepresentations to the Redeemer Committee and the Crusader Fund’s investors,” according to a November court filing in Delaware Bankruptcy Court by the Crusader creditors’ committee citing the arbitration findings. The panel also found that “Mr. Dondero was actively involved in the misconduct” and that Highland’s internal lawyers “were integral to implementing Highland’s deceitful schemes.”

Highland pursued settlement talks with investors ahead of the hearing last October to confirm the arbitration award. But those talks broke down, prompting the surprise bankruptcy filing. After further legal squabbling — and a change of venue for the bankruptcy, from Delaware to Dallas — Highland filed the motion to implement a new governance structure that took control from Dondero and created an independent board.

That agreement, approved by the court in January, appeared to be a big step toward resolving months of litigation between Highland and its creditors, “allowing all parties to refocus on a path forward for this Chapter 11 case,” Highland said.

But just as Highland was finalizing the details of the new agreement, another battle was looming on the horizon.


In its bankruptcy filing, Highland Capital Management LP listed its two largest creditors as the Redeemers, who have a $189 million claim against the firm, and a former Highland employee named Patrick Daugherty, who was once one of the firm’s most senior partners — and, later, one of its biggest adversaries.

Highland hired Daugherty in 1998 as a portfolio analyst. He spent the next 14 years at the firm, eventually building up and leading its distressed, special situations, as well as private equity practices.

Before the financial crisis, according to sources, Daugherty and his bosses had a good relationship. But that relationship blew up — in spectacular fashion.

Daugherty, having grown disillusioned with how much the Crusader funds were plunging into risky investments, had told Dondero in 2008, as he was approaching his ten-year anniversary, that he wanted to resign, according to court documents filed by Daugherty in Dallas County Court. Dondero initially accepted the resignation, but as the crisis gained steam, he asked Daugherty in April to stay on and help navigate the firm through what would turn out to be a tumultuous period. That year, Highland lost several partners and billions of dollars in assets, breached its credit facility, and began sparring with investors.

But the firm eventually stabilized, and Daugherty ended up staying until fall 2011. By then the firm had created various new funds, including one that Daugherty was supposed to manage. But he, according to court documents, was not comfortable with the terms, autonomy, or lack of investor approval associated with the fund’s structure and wanted to see an agreement in writing.

Dondero refused, snapping at Daugherty, “You will trust or you will leave,” according to the court documents. Daugherty resigned on September 28 of that year.

Then things took a strange turn.

In October 2011, according to a lawsuit, Dondero invited Daugherty for a drink at Nicola’s, an upscale Italian restaurant in a suburb of Dallas. Over scotch, Dondero confided to Daugherty that he had amassed evidence that his wife, Becky, was cheating on him and that he planned to file for divorce. Dondero subsequently told Daugherty he planned to try to get his net worth down to avoid a hefty divorce settlement per the terms of his prenuptial agreement, according to the same court documents.

Not long after, Daugherty received a subpoena from Becky Dondero’s lawyers, seeking his testimony in the couple’s highly acrimonious divorce proceedings. In April 2012 a lawyer asked Daugherty questions about how much Highland was worth. Then he asked him point-blank if Dondero had ever told him about his plans to reduce his net worth so he could avoid paying his wife $5 million that she was owed. Daugherty testified that he had. Highland filed a lawsuit against Daugherty just two weeks later.

“Mr. Dondero never hid assets and never stated that he had any plans to do so,” Highland said in a 2013 press release. “No evidence or testimony in the trial suggested anything salacious, illicit or improper on the part of Mr. Dondero. The only unusual aspect of the trial was the active participation of Mr. Daugherty, a disgruntled former Highland employee who voluntarily resigned over two years ago, and who is engaged in a contentious legal dispute with Mr. Dondero and Highland.”

“Contentious” is an understatement. In its April 2012 complaint against Daugherty, filed in Dallas County Court, Highland accused him of improperly retaining the firm’s confidential information, breaching his fiduciary duty, and making defamatory statements about the firm; it also accused Daugherty of launching into “abusive tirades” against employees, publicly calling them “fucking idiots” and using misogynistic and homophobic slurs to berate them. Furthermore, Highland claimed that Daugherty had become “increasingly unmanageable, erratic, and insubordinate” — which it blamed on an admission Daugherty had allegedly made to the firm that years earlier he’d had two strokes that “left him with dead spots in his brain” and affected his mental competence and conduct.

In a countersuit answering the claim, also filed in Dallas County, Daugherty called that assertion “a complete fabrication,” arguing that he had had a brief period of health problems that were revealed to be caused by a hole in his heart. The hole was repaired surgically, and Daugherty had had no health problems after that while working at Highland. What’s more, his health issues had occurred 11 years before the filing, he argued. Daugherty also denied the allegations that he had misused confidential information and defamed the firm.

The case went to trial in 2014 before a jury, which awarded Highland Capital $2.8 million from Daugherty for legal fees, ruling that he had breached his contract by not returning confidential information. In a press release at the time, Highland Capital declared this result “a resounding victory.” But the jury also awarded Daugherty $2.6 million plus interest for breach of good faith and fair dealing.

“We are pleased that this matter has been resolved,” Highland said in the press release.

Reader, it had not.

Daugherty filed a new complaint against Highland in Delaware Chancery Court in 2017, alleging that the firm had not paid him what he was owed. That case went to trial on October 14 of last year.

According to trial transcripts, Daugherty testified that he paid Highland its fee award in December 2016, after the firm took aggressive measures to collect on the judgment. Daugherty testified that he and his wife had moved their vehicles out of the carport attached to their house because an internal Highland lawyer had threatened to confiscate all of Daugherty’s assets in front of his wife and kids.

“There was a vein of terror going through my family. . . . We were trying to protect our assets,” Daugherty testified at the trial.

When Dondero took the stand, he tried to portray Daugherty’s actions as simply those of a disgruntled employee.

“Ten or 20 percent of all employees, when they exit the firm, end up being some form of conflict. Eighty, 90 percent of the people move on with life for a variety of reasons, but then some people never get over it and they make it the rest of their life,” he said. “So I think that’s what Pat’s doing.”

In the ensuing years, Highland won a permanent injunction against Daugherty, barring him from disclosing the firm’s confidential information. Daugherty was sentenced to a total of 38 days in jail for various violations — some of which sources characterized as brief conversations with ex-employees — but the sentence was eventually overturned on appeal.

In spite of all the rancor, Daugherty testified at the October 2019 trial that he sincerely believed when he paid the judgment in 2016 that Highland would pay its judgment to him.

“I just thought this was Dondero being Dondero, trying to extract his . . . pound of flesh and the satisfaction of seeing me squirm,” Daugherty testified, explaining why he wired the money for his judgment before Highland paid its judgment to him. “I thought they’d pay it.”

On the third day of the trial, Highland filed for Chapter 11 bankruptcy, effectively halting the case because Daugherty was no longer able to pursue the claims against Highland outside of the bankruptcy proceedings.

So on December 5, Daugherty filed a new complaint in Delaware Chancery Court, asserting he was the victim of a “classic bait-and-switch fraud” to avoid paying him the $2.6 million judgment. He also contends that he is owed millions of dollars of compensation. On April 1, despite the pandemic, Daughterty filed a claim against Highland for more than $37 million.

If the new lawsuits prove anything, it’s that Daugherty has proven to be just as willing and able to file lawsuits as his former employer. For Daugherty it’s a matter of principle.

“I want to clear my name,” he tells Institutional Investor in an interview. “And I will fight to clear my name.”

The December 5 complaint made another allegation: “Daugherty is not the only person with an uncollectable judgment against Highland or its affiliates.”

Daugherty and his lawyers were referring to UBS’s lawsuit against Highland, the Crusader investors — and one other case.

That other case involves another ex-employee of Highland named Josh Terry.

Like Daugherty, Terry had won a judgment against his former employer. Also like Daugherty, Terry accused the firm of committing fraud to avoid paying it.

Terry joined Highland in 2005. In 2011 he, Dondero, and Okada formed Acis Capital Management as a registered investment adviser to raise money for collateralized loan obligations and put Terry in charge of running it. According to court filings, he helped grow assets to $3.7 billion from zero in less than six years.

In court documents, Terry claimed a good relationship with Dondero for several years. But in June 2016 their relationship imploded. The reason? According to his court filings, Terry says it’s because he stood up to Dondero and refused to endorse a transaction that Dondero wanted Acis to make.

Dondero, according to Terry, wanted to purchase a Brazilian latex glove manufacturer using the proceeds from the sale of collateralized loan obligations that otherwise would have gone to the CLOs’ investors. Terry objected, saying the CLOs were past due to wind down and that the investors in those CLOs should be paid first. Things came to a head, and Terry was ultimately fired.

In September 2016, Highland filed a lawsuit against Terry in Dallas County Court, alleging that he had engaged in self-dealing, breached his fiduciary duty, sexually harassed an employee, and had “sexual relationships with a number of his subordinates,” according to the claim. (Terry, through a representative, declined to comment for this story.)

Terry and Daugherty had not been particularly friendly when the two worked together at Highland, and relations between them had worsened after Daugherty quit and Terry testified on Highland’s behalf at Daugherty’s trial. But on hearing of Terry’s firing, Daugherty dropped off a handwritten letter at Terry’s house.

“There are many who are taking pleasure in your demise. I am not one of them,” the letter read, according to court documents. “While I was disgusted with your misleading testimony during my trial and your false statements in the affidavit submitted to the court last summer, I do not want to see you or your family put through the same hell that was levied upon me and my family.”

Terry, like Daugherty, fired back at Highland, in a motion to compel arbitration filed that same month.

“Highland and Jim Dondero are desperate because they fear Terry will expose the fraudulent culture that Dondero increasingly promoted at Highland in recent months; a culture where Dondero attempts to pilfer Highland’s outside investors, the very investors the firm is supposed to serve,” Terry alleged in the filing in Dallas County Court. “Dondero’s motive is to harm something that Dondero does not have: a reputation for honesty and integrity that Terry earned over his career. Psychologists call that projection.”

Terry alleged that Highland fabricated the claims against him — although he admitted to one relationship with a colleague, which he contends was consensual — because the Acis partnership agreement stipulated that if he were fired for cause, Acis wouldn’t owe him millions of dollars in compensation.

The spat went to arbitration in 2017. The arbitration panel threw out claims on both sides, including Terry’s against Highland for fraudulent transfer and conveyance, and deferred some others to the courts. But ultimately, they awarded Terry nearly $8 million, and the Texas state courts confirmed the award later that year.

But during post-judgment discovery, Terry found “a number of suspicious transactions and transfers,’” according to another filing in Delaware Bankruptcy Court. To Terry these transactions appeared to have no legitimate purpose beyond stripping Acis of its assets and making it judgment-proof. According to the filing, Dallas Bankruptcy Court found in the Acis matter that “the record contained substantial evidence of both intentional and constructive fraudulent transfers” and that the testimony of all of the witnesses for Highland was unreliable. “Oftentimes,” the court said, “there seemed to be an effort to convey plausible deniability.”

Then Terry made an intriguing move: As a creditor of Acis, he filed the company into involuntary bankruptcy. Ultimately, he became a creditor of Highland Capital Management LP.

Highland’s agreement in January to change its governance kicked off a restructuring process that sources close to the firm say it hopes will resolve these long-running legal battles and allow Highland to focus on the present.

But Daugherty, as a creditor of Highland Capital Management LP, made a proposal in late January that the firm likely wasn’t expecting.

In a presentation to HCMLP’s new board, Daugherty posited that Highland Capital is “a valuable asset management platform” that, with the right management, could split its core and noncore assets, sell the latter for a profit, and distribute the cash from those sales and management fees to the firm’s creditors.

“Highland Capital can be a successful comprehensive management platform owned by its creditors,” the presentation states.

Daugherty proposed that he assume the role of CEO and chief investment officer and report directly to the board of Highland Capital Management LP, with a team of more than a dozen investment professionals reporting to him, many of whom previously worked at Highland. Daugherty suggested that he would work on-site five days a week, “with no competing businesses or distractions,” for a base salary of $500,000 and no guaranties, retention bonuses, or equity.

Daugherty and his team would work for a fraction of the cost of the “legacy” portfolio managers — Dondero and his team of current Highland partners — according to the presentation. He also proposed a number of other cost-cutting measures, including closing offices in New York, Singapore, and Buenos Aires and putting an end to “offsite employee boondoggles and lavish holiday parties.”

The presentation says: “This is an opportunity to combine financial resources (of the creditors) and intellectual creativity (of the current and former employees) to form a platform that transforms the traditional GP and LP relationship for the good of everyone.”

Highland — which has not commented on the proposal — has maintained that it is committed to moving forward. And by all outward appearances, the firm seems as if it is ready to finally cancel its long-running legal soap opera.

If it does, filing clerks in courthouses across America will be the first to know.