Two hedge fund firms with focuses in China are preparing to resolve a bitter dispute involving allegations of fraud.

San Francisco-based Primarius Capital has commenced arbitration against Jayhawk Capital Management, a firm run by University of Kansas lecturer Kent McCarthy. McCarthy formerly worked for Goldman Sachs.

Attorneys for Primarius have accused Jayhawk of violating the Investment Advisers Act and the California Unfair Business Practices Act, as well as fraud, breach of fiduciary duties and conspiracy. They allege the much larger Jayhawk lured Primarius into association and then wrongly conspired to use the Primarius funds to advance its own interests.

The dispute goes back to 2002, when McCarthy offered to become an investment adviser and research analyst for Primarius. The idea was that the small Primarius might gain credibility and attract investors through association with McCarthy. The defendants allege, however, McCarthy used Primarius to his own benefit, going so far as to pump up certain securities owned by both Jayhawk and Primarius and then liquidate Jayhawk’s holdings without disclosing it to Primarius.

Some of the charges revolve around alleged front-running against a Primarius China-focused fund. Primarius has accused McCarthy of dumping large blocks of illiquid securities held by both Jayhawk and Primarius. Under an agreement, the Primarius fund could opt to pay certain redemptions by transferring securities to a China-focused Jayhawk fund. According to Primarius, however, Jayhawk depressed prices with its own sell-off, increasing the number of shares Primarius would have to transfer to meet the redemption request.

In 2004, Primarius had about $160 million in assets under management. By early 2007, its assets had shrunk to about $75 million.

A spokesman for Jayhawk said the allegations were nothing new and the firm had no comment at this time.