State lawmakers have introduced three bills that would dramatically reverse Connecticut's longstanding hands-off approach to regulating its once-booming but now shaky hedge fund industry.
The legislation would require each hedge fund to obtain a state license, provide for an independent annual financial audit and disclose fees and significant changes in management or management strategy.
One bill would ban investments in hedge funds from individuals with less than $2.5 million in assets or institutions with less than $5 million in assets.
"We've seen some holes in the system," said state Sen. Bob Duff (D-Norwalk), chairman of the banking committee, where the bills have been raised. "The industry is aware that there needs to be additional transparency."
Connecticut is home to hundreds of hedge funds that contribute tens of millions of dollars to the state economy.
By some measures, the state is the world's No. 3 center for the sector with 9.5 percent of world hedge fund assets mainly located in Greenwich, Stamford and Westport, according to Hedgefund Intelligence, a London-based trade group.
But imposing tight restrictions on those funds could drive some of them out of the state, some observers say.
"It's a highly competitive business, so it would take very little in terms of regulation for hedge fund managers to consider doing business elsewhere," said John Brunjes, a partner with Bracewell & Giuliani in Hartford who represents many Connecticut-based hedge funds.
"It would be very easy for them to pick up and leave to New York," he said.
State lawmakers are aware of that possibility, but they also have to contend with those who say they've been too lax in monitoring an industry that has come under enormous stress.
Last year, hedge funds lost nearly $530 billion, or 27 percent of its $1.93 trillion in assets, and were also partially blamed for the financial crisis because they were major players in short selling and credit default swaps, investment tactics accused of putting intense pressure on the stock market.
The unraveling of Bernard Madoff's $50 billion Ponzi scheme has also spotlighted what many see as a general lack of transparency in the industry.
Basic information about hedge funds, including who manages them, what they do and how much they own, is not readily available to regulators. That creates deep concerns over how the industry operates and what risks it poses to the financial system.
Need For Oversight
State Rep. John Stripp (R-Weston) said lawmakers don't have a "vendetta against hedge funds," but that "there is a need to have some kind of regulation in place."
Congress is also moving to regulate the industry. One bill on Capitol Hill that has bipartisan support would require the lightly regulated pools of capital to begin filing information with the Securities and Exchange Commission.
But the state legislation goes further in several areas, including rules to promote transparency for hedge funds that hold investments from pension funds.
"If pension funds lose money because of a bad investment in hedge funds, it has a much wider and devastating effect on people," Stripp said. "That could leave people getting ready for retirement in a state of financial misery."
Despite the extensive losses in the hedge fund sector, State Treasurer Denise Nappier has been seeking permission from the treasury's Investment Council to invest up to 8 percent of Connecticut's pension fund — estimated to be $21 billion — in alternative investments, including hedge funds.
Arthur Meizner, director, investment consulting services at Hooker & Holcombe Investment Advisors in West Hartford, said fiduciaries of pension funds have a responsibility to know as much as possible about the financial entities that they invest in.
He said his firm has been hesitant to encourage clients to invest in hedge funds because of their lack of transparency.
If the proposed bills are enacted into law, Meizner said he'd be much more willing to give hedge funds a closer look.
He also acknowledges, however, that regulating hedge funds can be a double-edged sword for the state.
Fearful Of New Rules
"You have to be careful not to suck the life out of them," he said. "Hedge funds are worried about having to reveal their secret investment strategies. They fear that once they are made public, other funds may start to use them."
Duff said the proposed bills, some of which have been brought up in the past, are only a starting point for a debate and that the state needs to find an appropriate balance between regulating funds and allowing them to conceal their investment strategies.
"We don't want to make it difficult for them to do business here," he said.
Stripp added that he doesn't expect hedge funds to tell investors everything about themselves, "but they should provide information that would be practical."
Stripp also said that if the federal government passes meaningful legislation, the state would likely back away from its proposals.
"I think it would be a good thing from the state's perspective if the federal government moves ahead with their own legislation," he said.