Not In My Back Yard

Living in the heart of hedge fund country, Richard Blumenthal calls hedge funds a regulatory black hole. The Connecticut attorney general pledges to take action if the SEC and Congress don’t fill the void.

Like many of his Greenwich neighbors, Connecticut Attorney General Richard Blumenthal enjoys his privacy. He lives with his wife, Cynthia, and their four teenage children on a quiet, wooded street in the midcountry section of town. Visitors must pass through metal gates before ascending a winding driveway to his 5,600-square-foot white colonial, which is modest by local standards. Every weekday he commutes about 160 miles round-trip between his home and the state capital, Hartford.

Greenwich has long been one of the U.S.’s richest communities. In recent years its wealth has grown even more conspicuous, thanks in no small part to the 200 or so hedge fund firms that call it home. And although many of Blumenthal’s neighbors and friends manage hedge funds, that hasn’t stopped the longtime consumer advocate, who arguably has been Connecticut’s most popular elected official during his 16 years as attorney general, from pushing for broader and tougher oversight of the industry — in particular, for greater disclosure and accountability. This summer Blumenthal, 60, took his campaign national when he called for increased regulation of hedge funds following the June 23 decision by the U.S. Court of Appeals for the District of Columbia Circuit to overturn the Securities and Exchange Commission’s new hedge fund registration rule.

“Hedge funds are a regulatory black hole — lacking even minimal disclosure and accountability required of mutual funds and other similar institutions,” Blumenthal testified before the Senate Judiciary Committee on June 28. A Democrat and a former Yale Law School classmate of Bill Clinton and Hillary Rodham Clinton, Blumenthal believes that Congress or the SEC must act quickly to fill the regulatory void. If not, he matter-of-factly told chairman Arlen Specter and the other judiciary committee members, states like Connecticut will be forced to implement their own regulations.

“If federal agencies abandon the field, we will join forces, as we have done before in joint legal action, or act separately to pro-actively protect our citizens,” he told the committee.

Many in the hedge fund community, both locally and nationally, believe the Connecticut attorney general is overstepping his authority. “Dick Blumenthal is the top civil law enforcement officer in Connecticut, but he is not a legislator and he is not a regulator,” says Bruce McGuire, president and founder of the Connecticut Hedge Fund Association. “It is not his job to propose regulation.”

For Blumenthal, safeguarding hedge fund investors is part and parcel of the job that the voters of Connecticut have elected him four times to do. “There are thousands of investors whose lives and life savings may be at risk,” he tells Institutional Investor. “It’s a consumer protection issue.”

Anyone who has followed Blumenthal’s career shouldn’t be surprised by his tough stance. As a kid growing up in a middle-class neighborhood in Queens, New York, during the 1950s and early ’60s, Blumenthal was always up for a challenge, whether it was competing in sports, attending private school in the Bronx or testing his father’s curfew rules. He developed an interest in public policy while attending Harvard University, where he graduated magna cum laude in 1967. Blumenthal, who was captain of the Harvard swim team and editor-in-chief of the Harvard Crimson, wrote his senior thesis on the failure of government poverty programs.

During college Blumenthal had expected to pursue a career in journalism. Following graduation and a fellowship at the University of Oxford, he got a job as personal assistant to then–Washington Post publisher Katharine Graham. He left the newspaper in 1969 when his former Harvard faculty adviser, Daniel Patrick Moynihan, called to offer him a position in the Nixon White House. Moynihan, a liberal Democrat who would go on to have a distinguished 24-year career in the U.S. Senate, had been asked to head the president’s new Urban Affairs Council; Blumenthal, then just 23, would be one of his lieutenants. The next year, after his boss announced that he would be leaving the White House to return to Harvard, Blumenthal decided to attend law school.

He stayed on the fast track. Following his graduation from Yale in 1973, he landed two prestigious clerkships, first with then–U.S. district judge Jon Newman in Connecticut and then with Supreme Court justice Harry Blackmun. In 1977, at age 31, after serving as administrative assistant to then–Connecticut senator Abraham Ribicoff, a Democrat, Blumenthal was appointed U.S. attorney for Connecticut. During his four years in the position, he was known for his aggressiveness in prosecuting drug traffickers, white-collar criminals and civil-rights violators. He was out of a job in 1981 after Democrats lost control of the White House.

Blumenthal spent the next three years in private practice at Cummings & Lockwood, a law firm in Stamford, Connecticut. During that time he married Cynthia Malkin, a Greenwich native whose father, Peter Malkin, heads a real estate investment group that owns more than 12 million square feet of office space, including the Empire State Building. Blumenthal also decided to run for public office.

He served from 1984 to 1987 in the Connecticut House of Representatives and from 1987 to 1990 in the State Senate. During most of that time, Joseph Lieberman was Connecticut’s attorney general, but the position opened up when Lieberman was elected to the U.S. Senate in 1988. Blumenthal prevailed in a hard-fought primary battle for the Democratic nomination for attorney general in 1989 and won in the general election the following year.

Those who know Blumenthal describe him as the prototypical state attorney general, an old-fashioned consumer advocate who has defended Connecticut’s citizens against everything from Big Tobacco and Microsoft Corp. to the insurance industry and drug companies. He is especially proud of his leading role in the 1998 national tobacco settlement, in which cigarette companies agreed to pay the states $206 billion over 25 years to settle a class-action lawsuit regarding their marketing to children. Connecticut’s share: $5.5 billion after adjusting for a provision that factors in the cost of inflation.

Blumenthal has also joined forces with New York State Attorney General Eliot Spitzer. In May the pair struck a deal with Hartford Financial Services Group, which agreed to pay $20 million to settle allegations that it had paid brokers kickbacks for directing pension investment business its way. Blumenthal, however, was not involved in Spitzer’s $1.5 billion Wall Street research settlement, in part because under Connecticut law he doesn’t have the power to bring criminal charges, as does the New York attorney general.

Blumenthal’s interest in hedge funds has grown along with the industry. The attorney general has seen the economic benefits that they have brought to Connecticut, especially in his hometown of Greenwich, where hedge fund firms or the companies that service them occupy more than half the available office space. In an October 2004 speech at a meeting of the Greenwich Roundtable, a local nonprofit group set up to educate investors and money managers on alternative investments, Blumenthal said that he found himself in a somewhat odd role as a consumer advocate for the rich.

“There are few victims of financial scams as eloquent and as vehement as a well-to-do businessperson,” he explains to II. “I know it may sound counterintuitive that a wealthy person should have a right to a remedy when he is the victim of a fraud or a financial crime — because, after all, they can afford to lose money, right? — but that’s not how I see it. Everybody is the same in the eyes of the law.”

At the Greenwich Roundtable meeting, Blumenthal outlined his concerns about potential hedge fund fraud and the trouble it could cause both investors and the industry. That fear was reinforced last summer with the collapse in neighboring Stamford of hedge fund firm Bayou Management, whose principals, Samuel Israel III and Daniel Marino, later admitted to defrauding investors of hundreds of millions of dollars.

Blumenthal hoped that hedge fund registration — which SEC commissioners, led by then-chairman William Donaldson, had passed by a 3-2 vote in October 2004 — would help investors avoid another Bayou. In February the SEC began to require hedge fund managers with 15 or more clients, at least $30 million in assets and investment lockups of less than two years to register with the commission under the Investment Advisers Act of 1940. Although Blumenthal was concerned that the rule didn’t go far enough, he saw it as a powerful first step toward increasing accountability. That’s why he was vexed when the court of appeals overturned it on the grounds that the SEC’s interpretation of the word “client” was arbitrary.

“Normally, for an investment adviser, each hedge fund was a single client,” explains Perrie Weiner, the Los Angeles–based international co-chair of the securities litigation practice at law firm DLA Piper Rudnick Gray Cary. “Under the way the SEC was trying to redefine ‘client,’ you look through the hedge fund to the actual number of investors. If there were 15 or more of them, and almost every hedge fund has at least 15 investors, a hedge fund had to register.” (For more on the rule and the man who challenged it, see box.)

The court of appeals has given the SEC 45 days to appeal its decision. Paul Atkins, one of the two commissioners who voted against the original rule, says such a course of action is unlikely for the SEC and its new chairman, Christopher Cox. “The grounds for an appeal are just not there,” Atkins says. “I can’t imagine the Supreme Court would take the case.” As Atkins sees it, the court of appeals ruling gives the SEC a second chance to do what it should have done in the first place: work with the Federal Reserve Board, the Treasury Department and the Commodities Futures Trading Commission to develop a plan to oversee hedge funds.

“We need to be working in concert with these agencies because then we can put together a fuller picture that is much broader than anything that we had before,” says Atkins. “Beforehand we never talked to them. We went off on our own to do this rule, and that was a real problem.”

Blumenthal is all in favor of increased collaboration, as long as it results in meaningful regulation of hedge funds. In an interview with Institutional Investor Executive Editor Michael Peltz in early July, the attorney general discussed the pressing need for greater scrutiny of hedge funds and what he plans to do if Congress and the SEC don’t quickly act to provide it.

Institutional Investor: Why are you so worried about the hedge fund business?

Blumenthal: I’ve consulted and talked to a lot of people in this industry, and everybody agrees on the retailization of hedge funds. Hedge funds now go well beyond the initial investor audience of sophisticated, wealthy individuals. They’ve expanded to include pension funds, charitable organizations and even middle-income individuals. Yet hedge funds are still treated exactly the same as they have always been.

One of the problems is that we don’t even know how many hedge funds there are or how many investors or how much in assets they have. What kind of industry is it that nobody even knows the number of investors or the assets under management?

If you are so concerned, why haven’t you done something sooner?

I delayed any sort of consideration of what either the federal government or the states should do regarding regulation so that we would know how the courts would decide on the SEC rule. My sense was that there was growing acceptance of the SEC rule as a matter of policy. Now that it has been rejected as a matter of law, hedge funds are left in a regulatory black hole, as I have said.

What was your reaction when you found out about the ruling?

I was really surprised. Obviously, I understood the legal argument that was made by the challenge, but as a matter of common sense, the very narrow definition of “client” adopted by the court seems so contrary to reality. I understand that the court raises issues of past interpretations by the SEC. Certainly, the court made a good argument for its ruling, but even the hedge fund sector regards their investors as clients. That’s what managers have told me. The ruling sort of flies in the face of the common understanding about who hedge fund managers serve. To say that they serve the funds and that the funds are their clients seems to contradict common understanding and even common sense.

Do you think hedge funds will withdraw their registrations if the court of appeals ruling stands?

Some funds will deregister, and some will simply continue because the burdens are not so great that they should withdraw from the rule framework. Some hedge funds may use registration to their advantage as a kind of good-housekeeping seal. That’s also troubling, because the rule requires very minimal disclosure. So touting it as somehow an approval by the SEC, even if the representation is made only privately, could be misleading.

Do you think registration with the SEC was sufficient oversight for hedge funds?

It certainly was a good step in the right direction. There may well have been the need to do more based on experience with the rule, which is why I was waiting to see what happened before I made any proposals.

As I said before Congress, hedge funds play an enormously important and positive role in our markets, but they have expanded tremendously in the numbers of investors, dollars invested and impact on individual corporations and on the general economy.

What would you like to see happen now?

Congress has to provide authority for the SEC. It has to eliminate any confusion about the legal basis for such a rule and specifically clarify that the SEC has authority. And then the SEC can move forward, either to repromulgate the rule or something like it.

I would be very skeptical about Congress undertaking the actual rulemaking task. It should leave that to the SEC, for all the reasons that the SEC normally does rulemaking. Nor should Congress try to require or prohibit specific practices. It should authorize the SEC and other agencies if necessary, like the Commodities Futures Trading Commission, to require transparency and accountability.

How do the states fit in?

If Congress fails to act, the states will have to fill the void and ensure confidence in the integrity of the markets and the hedge fund industry. Federal action is certainly preferable because it maximizes the uniformity of the regulatory regime, the expertise of the regulators and the resources available to enforce it. But the states will have to fill the gap if Congress fails to act. I am very skeptical that the SEC can cure these problems on its own or that an appeal to the Supreme Court would be successful.

What can you do as Connecticut attorney general?

I’m a law enforcement official. I can’t unilaterally adopt a statute, but the Connecticut legislature could adopt disclosure requirements very similar to the SEC rule, or they could go beyond it. Each state has its own securities laws, its own banking laws, its own insurance laws — certainly in this area there’s no preemption in the federal government.

Would you support a hedge fund disclosure bill at the state level that included an antifraud unit?

I don’t think that a hedge fund fraud unit has been proved necessary or effective as a remedy for lack of disclosure. What we really want is more information, not a prosecutorial unit, necessarily. If a hedge fund were required to disclose relationships with so-called research analysts, if it were required to disclose certain general features of its major staff’s background — for example, whether they had started and closed a hedge fund before — I think it would lead investors to do more due diligence on their own. It would raise the kinds of red flags that are important to investors.

I don’t think a state hedge fund fraud unit empowers investors in the way that needs to be done. It doesn’t enable them to have more information. It does make sense on the federal level. There is such a unit: the enforcement division of the SEC.

Does the SEC have the staff to oversee hedge funds?

In some ways, I think that is the most telling question. I’ve said from the very beginning that lack of resources is a real concern. As a former federal prosecutor, I can say from experience that the SEC may well need more resources.

How much do hedge funds contribute to the economy of Connecticut?

I don’t think we have any numbers on that. There is no requirement that hedge funds be registered in Connecticut, so how would we know? My guess is that they employ a fairly significant number of people. They bring revenues to the state in terms of individual incomes that are spent here. Their managers contribute in all sorts of intangible ways; some of them donate to good causes and work hard for charities. They are very good and generous citizens.

How can you avoid hedge funds leaving Connecticut if the state requires them to register?

We can address their concerns and needs. It’s not like we did a conscious campaign to attract hedge funds. They moved here without grants or loans from the state government or anyone else. They moved here because the quality of life and convenience were good, and probably also because there were lower taxes than in New York. They will more likely stay if we maintain those features of our community and state life.

How do you answer critics who say that your call for hedge fund regulation is politically motivated because you’re up for reelection in the fall?

If you’re talking strictly in political terms, hedge funds are not an issue that attracts a great deal of attention. There are no politics in the hedge fund issue. I’m doing it because I believe strongly that there is a need for some greater disclosure and accountability in this industry.

As I said during my testimony before Congress, my strong preference is that the SEC address these issues. If the SEC won’t, then Congress should. If Congress fails to act, the states will have to fill the void. Federal inaction or inertia is a powerful impetus — in fact, an open invitation — to state intervention.