Hedge Funds May Face State Oversight, Blumenthal Says

Date: Wednesday, June 28, 2006
Author: Robert Schmidt & Katherine Burton, Bloomberg.com

June 28 (Bloomberg) -- The U.S. government needs to step in and regulate the $1.2 trillion hedge-fund industry or states will ``join forces'' and oversee the private investment pools, the attorney general of Connecticut told senators.

``Right now hedge funds are in a regulatory void,'' the attorney general, Richard Blumenthal, said today at a Senate Judiciary Committee hearing in Washington. Federal ``inertia'' on hedge funds ``will invite state action.''

Lawmakers are heightening their scrutiny of hedge funds after the lightly regulated investment vehicles have more than doubled their assets over the past five years. A federal appeals court in Washington last week struck down U.S. Securities and Exchange Commission rules that required many hedge funds to register with the agency and submit to inspections of their books and records.

``This is a subject of enormous importance to the United States economy,'' said Senator Arlen Specter, a Pennsylvania Republican and the committee's chairman.

Specter defended his committee's decision to hold today's hearing, which drew complaints from the Senate Banking Committee. That panel oversees the SEC and generally is charged with handling financial regulation.

Senator Charles Schumer, a member of both committees, said the hearing ``raises a yellow flag of caution'' because it treads on the banking committee's turf. The judiciary panel doesn't have the financial and market expertise that the banking committee does, he said.

Turf Dispute

``It's clear this hearing will focus on a broad range of regulatory issues facing the industry,'' Schumer, a New York Democrat, said. ``Many of these issues are best addressed in the banking committee.''

Hedge funds, which cater to wealth investors and institutions, are designed to make money whether financial markets fall or rise. They can use leverage to help boost gains and they can sell short, or borrow securities and immediately sell them with the hope of buying them back at a lower price.

Blumenthal, whose state is home to many of the world's 8,000 hedge funds, said last year that he may push for state registration of the industry.

In addition to the state attorney general, the committee heard from Matthew Friedrich, an official from the Justice Department's criminal division, and Gary Aguirre, a former SEC attorney who claims his investigation of Pequot Capital Management Inc. was stymied because of political pressures.

Aguirre

Aguirre, who was fired from the SEC, said he rewrote some of his testimony after the securities regulator said he was in danger of revealing nonpublic information about an investigation.

Specter said he ``took issue'' with the SEC's contention.

``This isn't a matter of some comment about some third party, this is about the propriety of what the SEC is doing,'' Specter said.

Aguirre warned the committee that ``our capital markets face growing risk'' from hedge funds.

``The SEC fails to recognize any hedge-fund fraud or manipulation against other market participants,'' he said.

Aguirre, a plaintiff's lawyer in Southern California before working at the SEC for less than a year, claimed in a May 30 letter to the Senate Finance Committee that he investigated a hedge fund that he alleged made millions from insider trading. Profits included $18 million from General Electric Co.'s $5.25 billion acquisition of Chicago-based commercial lender Heller Financial Inc. in 2001. The SEC has declined to confirm or deny any investigation of Pequot.

Pequot

The Westport, Connecticut-based firm said in a June 23 statement that its trading has been ``entirely proper and not based on insider information.''

Today's hearing also addressed aspects of market manipulation including naked short selling.

In a short sale, a fund will borrow shares, and then sell them in the hopes of repurchasing them later at a lower price and pocketing the difference. In a naked short, the fund sells the stock before the shares are borrowed. Aguirre also said some funds are selling shares of a company to themselves at a higher- than-market price to make it appear there is demand for the stock.

In April, Electronic Trading Group LLC sued 11 Wall Street firms including Citigroup Inc. and Morgan Stanley accusing them of charging excessive fees to naked short sellers.

Biovail

In the suit, filed in U.S. District Court in Manhattan, New York-based Electronic Trading says it paid unearned fees, commissions and interest to short stocks that the investment banks never borrowed or delivered. Other firms named in the suit include Bank of America Corp. and Goldman Sachs Group Inc.

The Senate hearing is examining relationships between fund managers and research analysts. Shareholders of Biovail Corp., Canada's largest publicly traded drugmaker, in March claimed that hedge fund SAC Capital Advisors LLC orchestrated an illegal disinformation campaign to drive down its stock price.

SAC Capital ``ghost wrote'' negative and false research reports about Mississauga, Ontario-based Biovail for analysts at firms including Gradient Analytics Inc., the company's lawsuit claims. SAC Capital, based in Stamford, Connecticut, profited when Biovail's shares dropped in 2003, the complaint said.

SAC Capital and Phoenix-based Gradient have denied the allegations. Demetrios Anifantis, a former employee at Gradient when it was known as Camelback Research Alliance Inc., was a witness at today's hearing.

To contact the reporter on this story:
Robert Schmidt in Washington at  rschmidt5@bloomberg.net;
Katherine Burton in New York at  kburton@bloomberg.net