09/13/2011 10:21 EDT | Updated 01/12/2012 02:22 EST

Delaware judge rejects Washington Mutual reorganization plan, cites claims of insider trading

DOVER, Del. - A Delaware bankruptcy judge on Tuesday refused for the second time to approve bank holding company Washington Mutual Inc.'s reorganization plan.

The judge said WaMu's committee of equity security holders had made credible claims that that hedge funds supporting the plan engaged in insider trading of WMI securities based on information they obtained during the bankruptcy.

The hedge funds, referred to in court documents as the settlement noteholders, denied the allegations of insider trading. But Judge Mary Walrath said their conduct raises questions about how they treated settlement discussions in which they were involved.

"The court finds that the equity committee has made sufficient allegations and presented enough evidence to state a colorable claim that the settlement noteholders acted recklessly in their use of material nonpublic information," Walrath wrote in the 139-page ruling.

The judge also said she was concerned that the bankruptcy case, already three years old, could "devolve into a litigation morass," and that as the case drags on, potential recoveries for all parties dwindle.

As a result, Walrath ordered that the parties engage in mediation. She scheduled a status hearing for Oct. 7.

Washington Mutual's reorganization plan is based on the proposed settlement of lawsuits that pitted Washington Mutual, the Federal Deposit Insurance Corp. and JPMorgan Chase against one another after the FDIC seized WaMu's Seattle-based flagship bank in 2008 and sold its assets to JPMorgan for $1.9 billion in the largest bank failure in U.S. history.

Under the proposed settlement, the competing lawsuits would be dismissed and some $10 billion in disputed assets would be distributed among Washington Mutual, JPMorgan and the FDIC.

Walrath ruled in January that the proposed settlement was reasonable, but she refused to confirm WaMu's plan until certain changes were made. The judge concluded, among other things, that the protections from future legal liabilities that the plan granted to the company's directors, officers and professionals, as well as members of its creditors committee and certain third parties, were either unwarranted or too broad.

Walrath specifically noted in her January ruling that she was reluctant to approve any legal releases for the settlement noteholders in light of the insider trading allegations.