A European-based investment fund and a French bank are battling it out in New York state court over complex securities created at the behest of the hedge fund Magnetar. Loreley Financing filed a suit in New York Supreme Court last Friday claiming it was the victim of fraud by Calyon, the investment banking unit of French bank Crédit Agricole. Magnetar is not a party to the litigation.

The suit alleges that Calyon allowed Magnetar to stuff two collateralized debt obligations or CDOs with poor quality bonds as part of the Illinois-based hedge fund’s strategy to bet against them. Loreley claims Calyon then “fraudulently induced” it to purchase $70.5 million of those CDOs in 2006. According to the complaint, German bank IKB, which failed because of soured investments in American mortgage securities, advised Loreley. (Read the complaint.)

From around the middle of 2006 to the middle of 2007, Magnetar helped spur the creation of at least 30 CDOs, worth about $40 billion, as part of a strategy to bet against the mortgage securities market. The fund would purchase the riskiest portion of the deals in order to enable the bank to complete the deals. The fund also frequently bet against those same deals, using sidebets. (We detailed Magnetar’s trades back in April as part of partnership with Chicago Public Radio’s This American Life and NPR’s Planet Money. The lawsuit references our article.)

The two CDOs at the center of the suit-- Orion 2006-1 and Pyxis ABS CDO 2006-1--had third-party, independent managers whose fiduciary duty was to pick the best assets for the CDO. While Loreley is not suing either of the managers, it questions Calyon’s representation that they were truly independent.

The suit also alleges that by February 2007, Calyon launched a scheme to rid itself of the CDO inventory it had on its books. It bundled these toxic assets into a new CDO, named Millstone IV, of which Loreley also bought a piece. That CDO included pieces of previous Magnetar deals.

A Calyon spokesman said the suit is “without merit.” A lawyer for Loreley declined to comment. A spokesman for Magnetar declined to comment. Magnetar has said previously it “did not select the underlying assets” of the CDOs in which it invested, its CDOs were not designed to fail, and that it had a “market neutral” strategy.