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Wednesday, June 28, 2006

Hedge Manager Teaches SEC a Lesson

Phil Goldstein, hedge-fund champion, is the unhedge-fund manager.

The head of Bulldog Investors, Mr. Goldstein single-handedly challenged the Securities and Exchange Commission's attempt to require hedge funds to register with the agency. Last week, a federal appeals court delivered him victory, overturning the SEC's attempt to impose a modicum of regulation on the exploding industry.

He stands out among hedgies not because he was raised in blue-collar Brooklyn; those bootstrap stories are fairly common in the industry. It may be that he was a New York City civil engineer for 25 years. Now 61 years old, he made the move from managing building projects to running money in 1992. These days, a city worker has less of a chance of managing others' wealth than Jeff Skilling has of ringing the opening bell of the New York Stock Exchange.

The clincher of his maverick status in the world of hedge-fund managers is that Mr. Goldstein will admit, on occasion, that there are things he doesn't do well.

"I was never a very good engineer. It wasn't until my mid-to-late forties that I decided what I wanted to do when I grew up," he explains. Even today, he says, "I'm not a valuation expert. I'm a good value investor, but not that good." He credits his partner with his small-time ($225 million) operation's best investing instincts. He calls his main investment technique -- buying closed-end funds trading at a discount to their asset value -- "investment for dummies."

But Mr. Goldstein is good at stirring up trouble. Although more than 1,200 hedge funds registered under the new rule, he detested it. So he decided to fight. No other hedge fund joined his suit. Few gave him much of a shot to prevail. The fight cost him and his partners $300,000 out of his own pocket -- not, he emphasizes, his investors' pockets.

Now the requirement is likely to fizzle away. The SEC could appeal, but it probably won't. Lawmakers might try to jump in to change the SEC's mandate. The congressional clamor begins today, with a scaremongering hearing before the Senate Judiciary Committee on hedge funds' alleged collusion with independent stock-research shops.

But my guess is that after a lot of noise, Congress won't push for registration. So, in the end, many hedge funds will deregister, though some may not -- a sort of Good Housekeeping seal of approval.You might think the ruling from the court had something about whether the hedge-fund registration was a good thing or not, but you would be wrong. It centered on a definitional conundrum: whether the investors in an adviser's hedge fund are "clients." Under securities law, any adviser with more than 15 clients has to register. Hedgies tend to run firms that manage fewer than 15 hedge funds. Agreeing with Mr. Goldstein, the court ruled that the funds are the clients, not the underlying investors.

The ruling may well be correct as a matter of law. It is obvious to anyone who isn't a lawyer that the investors actually are the clients. Even Mr. Goldstein occasionally slips and calls his investors "clients," just like every hedge-fund manager.

It is always gratifying to see a David go up against a faceless governmental bureaucracy and win. But I just can't come around to the view that hedge-fund registration is so terrible. Nor can Mr. Goldstein, as it turns out.

"If the SEC had asked just for name, rank, serial number, audit and other basic information, I probably wouldn't have filed the lawsuit," he says. But because the SEC registration form asks for everything from "your last small-pox vaccination to every dirty joke you got on email," he says, it is onerous and intrusive. The registration forms run at least 35 pages long, asking for information about things such as compliance procedures, business relationships with investment banks and stock-research companies and regulatory records.

Antiregulation forces argue the costs outweigh the benefits. It is emblematic of a greater regulatory backlash these days, most forcefully expressed in the movement against Sarbanes-Oxley.

Hedge funds get a management fee of at least 1% and 20% of the investment gains -- often more. They are richly rewarded to control other people's money. Increasingly that money comes from the pension funds of regular folk. Given the huge fees and the enormous responsibility, the price of registration and keeping some lawyers on staff simply isn't that high. Nearly half of all investment advisers registered with the SEC have five or fewer employees. If they can handle the costs and hassles, hedge funds can, too.

Opponents maintain that registration won't prevent frauds. After all, as Mr. Goldstein points out, Atlanta hedge-fund firm International Management Associates LLC had registered with the SEC before its manager allegedly ripped off a bunch of investors.

Well, of course. Nothing will prevent all fraud. It turns out the SEC detects plenty of skullduggery through routine examinations. According to Lori Richards, the SEC's examinations director, 11% of SEC enforcement actions brought last year were the result of fraud detected during such inspections.

"Fundamentally," she says, "what we're looking for in these exams are indications of fraud. We look at the account statements the adviser sends to its clients and compare them with the custodian's records to see whether they match, we look at the adviser's disclosures to its clients, and we look at the adviser's process for pricing securities."

Here is the key: "Like any cop on the beat," she adds, "the prospect of being examined by the SEC itself has a deterrent effect."

Another benefit is that a hedge-fund census would give the SEC improved perspective. Hedge funds are diverse entities, engaged in sophisticated strategies. It is clearly to the rest of the market's benefit if the chief market regulator knows generally who and what is out there to better anticipate potential problem areas and crises.

What hedge funds should realize is that registration is good for them. The industry is attacked for being secretive, under-regulated and engaged in risky behavior. The reality is much more benign, especially since most hedge funds take fewer risks than typical, long-only mutual funds. Their name derives from the fact that they hedge their bets -- often by betting on declines in stocks and indexes by selling them short -- to avoid volatility. Registration would make hedge funds loom less ominously in the public consciousness.

The SEC should have offered some carrot with its stick of registration. It still can. Let hedge funds advertise. Let them tout performance, as mutual funds do. Let them open themselves up to a wider variety of investors.

Then Congress should make them register.

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