(May 27, 2011) — The $1.9 billion Houston Municipal Employees Pension System has sued hedge fund operator Highland Capital Management and JPMorgan Chase over the shut Crusader fund, which was set up to invest in distressed corporate debt.

The suit, filed earlier this week in Delaware Chancery court, alleges that Dallas-based Highland, the largest hedge fund manager in Texas with about $22 billion in assets under management, and the Crusader Fund failed to guard investors while it collapsed, freezing investor withdrawals while protecting its own hedge fund network.

Highland co-founders James Dondero and Mark Okada caused the Crusader Fund to engage in “dozens of self-interested transactions,” the Houston Municipal Employees Pension System said in the complaint obtained by Bloomberg. The pension fund claims that Crusader engaged in at least 56 deals with other Highland funds that hurt investors in the fund. The scheme, which invested $15 million in the fund, is seeking unspecified losses caused by the alleged wrongdoing.

The Crusader Fund “was harmed by virtue of being stuck with poor quality assets that it would not have had if the partnership had been managed in the best interests of the partnership and its limited partners,” lawyers for the pension plan said in the complaint filed in Delaware Chancery Court.

In response to the lawsuit from the Houston Municipal Employees Pension System, Highland issued the following response:

“In our view, this suit represents a single plaintiff’s law firm attempting to create financial leverage for one party’s benefit at the expense of all other investors and derail the investor-led mediation process that is substantially complete. In fact, this same law firm tried to derail the successful, investor-driven process that led to the recent, equitable resolution for the Highland Credit Strategies hedge fund. Similarly, we do not expect this meritless suit to impede the approval of a final plan of distribution for Crusader in the coming weeks.”