April 7 (Bloomberg) -- MBIA Inc. was sued by Third Avenue Management LLC, the New York company founded by mutual fund manager Martin Whitman, over claims the insurer’s split of its bond-insurance businesses hurts debt holders.

Three mutual funds managed by Third Avenue bought notes issued by MBIA Insurance Corp. in February 2008 based on assurances that the company was recapitalizing following losses in its structured finance insurance business, according to a Delaware Chancery Court lawsuit.

MBIA, the largest bond insurer by outstanding guarantees, said in February it was transferring $5 billion in cash and its public finance business to another entity that has no obligation to the notes, Third Avenue said in court filings. The suit contends the transfers were illegal and seeks to unwind them.

“MBIA sold us these surplus notes, and then to our surprise and distress, stripped away the principal assets as well as the only going concern operations within MBIA Insurance Corporation,” Whitman, chairman of the Third Avenue funds, said in a statement yesterday. “That’s wrong, and a big disappointment to us, especially after we went to bat for them with our pocketbooks and more.”

Debt Guarantees

MBIA, based in Armonk, New York, said in February it will split its municipal bond insurance business from the mortgage- related debt guarantees that led to the loss of its top credit ratings.

The company transferred guarantees on about $537 billion of municipal bonds to MBIA Insurance Corp. of Illinois, which it plans to rename National Public Finance Guarantee Corp.

The new unit will be separate from an existing one that guarantees complex mortgage-linked securities and other debt, which plunged in value during the U.S. housing and credit crises, prompting a 92 percent drop in the company’s shares since October 2007 and the ouster of its chief executive a year ago.

Third Avenue is MBIA’s second-largest common shareholder, with a 13.8 percent stake as of Dec. 31, according to Bloomberg data. Hedge Funds Aurelius Capital Management and Fir Tree Partners filed a similar suit in federal court in New York in March, claiming the split hurts debt holders while benefiting investors, executives and some policyholders.

“Third Avenue has been greatly harmed by this transaction,” lawyers for the funds said in the Delaware suit.

MBIA’s actions were legal and the Third Avenue’s suit is without merit, MBIA Chief Executive Jay Brown countered yesterday in an e-mailed statement.

“We appreciate Third Avenue’s past support of MBIA and regret that they felt” it necessary to sue, Brown said.

“Our transformation should not have been a surprise, however, as I have been clear to all stakeholders since I returned a year ago that our corporate objective was to separate our structured and municipal businesses,” he added.

The case is Third Avenue Trust v. MBIA Insurance Corp., 4486, Delaware Chancery Court (Wilmington).

To contact the reporter on this story: Karen Gullo in San Francisco at kgullo@bloomberg.net.

Last Updated: April 7, 2009 15:46 EDT