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The man who beat the SEC

Phil Goldstein quit being an engineer for the City of New York and taught himself the art of closed-end funding investing. Since then he has made a small fortune and battled the SEC, but now the state of Massachusetts wants to quiet him down.

By Telis Demos, writer-reporter
Last Updated: June 18, 2008: 3:48 AM EDT

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'I'm a penny-ante Carl Icahn,' says Goldstein of his activist investing.
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Low-fee investing: Goldstein works out of his basement in New York's Westchester County, so he takes client meetings nearby at the Pleasantville Diner.
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The king of closed-end funds: Goldstein (right) with his partners in Bulldog Investors - Andrew Dakos (center) and Steve Samuels (left).
Getting Started in Closed-End Funds
Asset managers like BlackRock, Nuveen, and Eaton Vance all have closed-end funds. You can make money buying and selling their funds' shares, but only if you know what you're doing.
Know the lingo.
The net asset value, or NAV, is the current market price of a fund's investments. This can be higher or lower than the fund's share price. If the share price is higher, the fund is trading at a premium; if lower, at a discount.
Understand the NAV.
Not all NAVs are created equal. If the fund is invested in plain-vanilla stocks and bonds, it's easy to calculate. For example, the two biggest holdings of Eaton Vance's Tax-Managed Global Dividend Income fund are Berkshire Hathaway and Anadarko, stocks whose prices are readily available. But if the fund is investing in more esoteric stuff, like real estate or venture capital, the NAV is only the fund manger's estimate of what those assets are worth.
Check who the shareholders are.
If the fund's shareholders are big institutions, they are more likely to complain about a discount and get management to act. If the shareholders are mostly small timers, they're much less active and typically give management a longer leash.
Watch the 13Ds.
See which investors are entering and exiting a fund by checking 13D filings. If Goldstein's Bulldog discloses a position, look for him and other activists to be circling. That means management may have to act to close the gap.
Be patient.
Shareholder activism takes time. Plus, if you're willing to wait long enough, some discounts will narrow if the fund's performance improves.

(Fortune Magazine) -- Phil Goldstein became a hedge fund manager thanks to a pair of gray sweatpants. In the summer of 1992 the 47-year-old civil engineer walked into Las Vegas's Mirage hotel to meet his first potential investor. The shorts he was wearing didn't meet the dress code of Moongate, a Chinese restaurant where the two men had planned to meet. He thought the rule was arbitrary, so he went to a nearby gift shop, purchased a pair of sweatpants, changed into them, and returned to the restaurant. After the meal he changed back into his shorts and returned the pants for store credit. When Goldstein also told the prospect that he was staying off the Strip, at a $39-a-night motel, the deal was sealed. "This is a man I want managing my money," the investor told his broker that night.

To say that Goldstein is an iconoclast is an understatement. Since that fateful meeting 16 years ago he has built himself a second career as a pioneering activist investing in the backwater world of closed-end mutual funds. Today his hedge funds manage over $500 million in assets, and they have averaged more than 15% annual returns over their lifetime. At a stage in life when other retired municipal employees might be living off pensions and picking winners at the dog track, he is picking fights with negligent fund managers, lazy shareholders, the Securities and Exchange Commission, Massachusetts's top securities regulator, and soon, he hopes, the Supreme Court itself.

His biggest scuffle so far has been a successful legal challenge to an SEC rule requiring hedge funds to register. The 2006 Goldstein decision kept potentially hundreds of billions of dollars of fast-moving private capital away from the prying eyes of the government. A year later he found himself back in court. This time he had run afoul of the top securities regulator in Massachusetts, who accused Goldstein of marketing his fund to average investors - a big no-no for unregistered investment advisors. Rather than pay the fine and move on, Goldstein is fighting back. He's on a quest to convince the courts that denying hedge fund managers the opportunity to promote their services is a violation of the First Amendment.

Many civil rights lawyers have told him that he has a decent shot at a hearing in front of the Supremes. "I have thought for some time," says constitutional lawyer Floyd Abrams, "that a day would come when the courts would take a fresh look and conclude that there is a significant level of First Amendment protection that has been denied for many years in securities law. This case is a more than respectable argument."

A hearing in June to dismiss Massachusetts's complaint will determine whether the challenge moves through the state's top courts and to the U.S. Supreme Court. If successful, Goldstein would become to hedge fund managers what Miranda is to suspects being shoved into a squad car - a name that stands for a legal precedent. A decision in his favor would open the door for hedge funds to advertise on TV, in print, and on the Web - marketing their services alongside Budweiser and Xanax, and trumpeting their performance as investors. It's a bit of a long shot, but that's how Goldstein likes things. "The only thing better than winning," he says, "is being the underdog and winning."

Goldstein did not set out to become a legal landmark. He was born in Brooklyn in 1945. He enjoyed a childhood of "stickball and all that crap," as he tenderly recalls it. After the Sputnik launch turned science into a patriotic mission, he hit the books and decided to become an engineer. After college he got a job working on road construction for New York City, which mostly involved trying to figure out how to fix potholes on the Brooklyn Bridge.

Logic defying closed-end funds

He was bored with his job, so he fell into the vice of numerically gifted people: gambling. He hated games of pure chance like roulette, preferring ones where mathematical ability gave him an edge, like blackjack. In the early 1970s he seriously considered pursuing a life as a card counter. Fortunately for him, he picked up a book that outlined a better path: "How the Experts Beat the Market," by Thomas C. Noddings. Written by a former engineer, it argued that any numbers-savvy investor could exploit inefficiencies in complex securities. After a few debacles Goldstein discovered his sweet spot: the quirky, logic-defying world of closed-end funds.

Like traditional mutual funds, closed-end funds invest in stocks and bonds, typically with some sector or strategic focus. Shares are bought and sold on major exchanges, where they can trade for more or less than a fund's net asset value, or NAV, which is defined as the current market price of all the investments it holds. In other words, the stock price can be higher or lower than the per share value of the fund's investments. "They trade like ordinary stocks do," says investor Thomas Herzfeld, who began looking at closed-end funds in the 1960s. "Sellers usually come in due to general bearishness or dim prospects for a fund's sector or strategy."

Goldstein thinks these funds provide a perfect opportunity to exploit market inefficiency. After all, you know exactly what a fund should be priced at. It's not like an operating company, which has no "true" price and is valued through the dark arts of earnings analysis. He simply looks through published stock tables for discounted funds: those where the share price is below its NAV. Then, as he likes to say, "you know that six is less than seven? Now you're a brilliant closed-end fund investor."

In the early '80s when he started, some funds had a dicey reputation, thanks to shady brokers unloading a few really bad ones on unsuspecting clients. Today closed-end funds attract only a tiny cadre of investors. They are just a sliver of the mutual fund market: $245 billion in total closed-end fund assets, out of nearly $5 trillion for all mutual funds. Goldstein, with plenty of time on his hands, became a gadfly in this world - writing frequent letters to the editor of newspapers like Barron's, cold-calling other investors, and attending small conferences.

At those conferences he kept running into a former Dean Witter broker from Los Angeles, Steve Samuels, who introduced Goldstein to his clients. After Goldstein quit his job with the city, he and Samuels launched a fund in 1993, eventually adding two more partners, Andrew Dakos and Rajeev Das, and four more funds. He combined them all into Bulldog Investors, which operates out of an office in suburban New Jersey. Bulldog is by definition a hedge fund, but Goldstein bristles at the suggestion that he is a typical hedgie. After meeting John Paulson, the billionaire who shorted the mortgage-backed security crash last year, Goldstein said, "I'm pretty much qualified to be his chauffeur."

"People say I'm Don Quixote, right?" Goldstein says about his battles with regulators as he eats a late breakfast of a cheese omelet, with a fruit cup substituted for the hash browns. The setting is a diner in Pleasantville, N.Y., 45 minutes north of Manhattan. Here, among the paisley upholstered booths, Goldstein often takes meetings. His home is built on a hill nearby in the bedroom community, so his basement office opens onto a patio at the rear of his house. From this unlikely setting he has helped Bulldog's main fund generate strong returns, with a lower risk profile than the S&P 500's, he says. It so far has never had a down year; $1 million invested in the S&P would be worth $4.5 million today - but $8.9 million if it had been invested in Bulldog's main fund, says Goldstein.

His lifestyle is hardly that of a Master of the Universe. He dresses in clothes from big-box stores. His wife works as a tour guide at the nearby Rockefeller estate, and he still gambles occasionally on poker or blackjack but quits as soon as he loses $100. "He doesn't have other hobbies," says George Karpus, America's biggest closed-end fund investor, who frequently works alongside him. "Most hedge fund managers love golf or yachts. None of that for Phil."

An activist investor

He spends much of his time and money, in fact, on legal battles - those battles being a byproduct of his shift from passive to activist investor. You might imagine activism to be the purview solely of corporate raiders besieging publicly traded companies the way Carl Icahn has with Motorola (MOT, Fortune 500), or Harbinger Capital has with the New York Times Co (NYT). But Goldstein applied those tactics to the world of closed-end funds back in the mid-1990s: Buy shares trading at a discount, align the shareholders with you, vote out the current managers, and close the gap by converting the closed-end fund to an open-end one or simply liquidating its assets and taking the cash. "I'm like a penny-ante Icahn," Goldstein says with a shrug. In all, he has waged proxy fights at 30 companies since 1996 and has sat on eight boards.

So how did shareholder activism transform into legal activism? To win these fights Goldstein often explored gray areas of securities law. In 2001, after winning election to the board of a fund focused on stocks in Mexico, he brought an idea to SEC lawyers for the fund to create a new type of share that could be redeemed for the fund's net asset value. That was in 2001, and he still hasn't gotten an answer from the SEC.

That same year he tried to get the SEC to investigate for fraud the CEO of another fund he had taken control of, one focused on venture capital. Again, he's still awaiting an answer, and in the meantime he's lost the $1 million he invested. (In response to all inquiries about Goldstein, SEC spokesman John Nester said, "We can't publicly discuss investors' private communications to the commission.")

Such experiences made Goldstein, already a libertarian and Federalist Society member, even more skeptical of regulation. So when the SEC came out in 2004 with a new rule requiring all hedge fund advisors to register in an attempt to make the industry more transparent, Goldstein was outraged. "After years of activism we'd learned a thing or two about how to deal with bullies who overstep their authority," he says. He and his firm filed a lawsuit arguing that the SEC had misused its own definition of "client" to justify regulating hedge funds. People who invest in hedge funds aren't "clients" like a broker's clients, Bulldog's suit argued. They are investors, who by the SEC's own rules don't merit the same kind of protections.

If that seems like a technicality, it is: Most lawyers dismissed the argument as too esoteric to persuade a court to second-guess the SEC. Yet the D.C. appeals court panel was surprisingly sympathetic to Goldstein. The SEC did not help its case by refusing to explain why it wanted to regulate hedge funds. One of the judges, Harry Edwards, yelled at the regulators, "You can't do anything you want!" A decision in Goldstein's favor was handed down in June 2006. And the new market-friendly commissioner of the SEC, Christopher Cox, declined to appeal it. "I felt like the Miracle Mets," Goldstein says.

Goldstein's ticker-tape parade turned out to be short-lived, though. In January 2007 he returned home from his 62nd-birthday dinner to an ominous-looking fax crawling through his machine. It was from William Galvin, the secretary of the Commonwealth of Massachusetts.

It could only have been bad news. Galvin is an outspoken critic of hedge funds. He charged Bear Stearns with improper trading after its hedge fund collapsed. As it turned out, Galvin was accusing Goldstein of advertising. If you're a hedge fund manager, that's a crime. Part of the bargain for not having to file public disclosure documents or follow other investing rules is that you cannot market to the average investor, who presumably is not sophisticated enough to understand a hedge fund's risks. Galvin was accusing Bulldog of soliciting a nonaccredited investor, defined as someone with investable assets under $1 million and annual income below $200,000. The alleged victim of this solicitation claimed that after he had sent an e-mail to one of Goldstein's partners through Bulldog's Web site, he was sent a prospectus. The state fined Bulldog $25,000 and forced the firm to take down its Web site. (Galvin's office said it could not comment on any ongoing litigation.)

"It was a sting operation," Goldstein says. He believes the alleged victim was a plant sent by a Boston-based company called RMR Advisors. (Goldstein had been involved in a legal battle for control of the RMR Hospitality & Real Estate fund, in which he owned a large share.) While RMR executives would not return phone calls from Fortune, RMR president Thomas O'Brien told Investment News, "I can't tell you we put that much thought into it, but we were surprised by what [the victim] did find as a nonaccredited investor."

Marketing to average investors

Rather than pay the fine and move on, Goldstein saw an opportunity. He knew that many hedge fund managers stay awake nights worrying about the rules against marketing their funds to average investors. The Investment Company Act of 1940, which regulates nonpublic funds, does not say anything about talking to the press, much less about Web sites. But some lawyers would tell Goldstein, if he were their client, that talking to Fortune about his firm is a crime. (You, the nonaccredited reader, would be the victim.) To protect themselves, hedge funds' Web sites offer only bare-bones information to the public - no description of holdings and certainly no information about returns. "The worry is that investors will get their appetites whetted and will try to buy into hedge funds in a secondary market," says John C. Coffee, a securities law professor at Columbia University. "The Web changes everything and makes it possible to sell things and resell to the entire world."

To take on Galvin, Goldstein hired a Boston civil rights lawyer, Andrew Good, who has fought on behalf of many free-speech litigants (but is best known for defending Louise Woodward, the British au pair who was accused of shaking a baby to death). In March 2007, Bulldog filed suit against Galvin for violating Goldstein's right to free speech. The firm's basic argument is "no harm, no foul." If you didn't qualify as an investor, you couldn't invest in the fund, and so you couldn't have lost money. "No one who didn't invest ever was defrauded or lost money," Goldstein says.

The suit cites Supreme Court precedents pertaining to pharmaceutical ads. Drugmakers are allowed to advertise prescription-only drugs to everyone even though only patients with prescriptions can get them. To Goldstein, it doesn't make sense that the world can read letters written by Warren Buffett to his investors, but not those by investor Eddie Lampert, who runs a hedge fund.

If Goldstein is successful, it's unclear exactly what would change in how hedge funds sell their services. Some say not much, since hedge funds would not want the trouble of turning away yokels drawn in from ads. Others think the case could be a game changer when it comes to the way hedge funds raise capital. "You would see more advertising in every imaginable form, especially by smaller, less established, and possibly riskier firms that need more capital," says former SEC prosecutor Steven Scholes, now of law firm McDermott Will & Emery. "It would benefit them much more than the big houses."

The road to the Supreme Court is still a long one, though. The judge in the initial round of hearings on the case in a lower Massachusetts court last December largely agreed with Goldstein but referred the case to a higher court to consider whether regulators could still prevent fraud without the advertising ban. Goldstein is pressing to continue the fight, but it may not be his firm that takes the case to the highest court in the land. His partners have asked him to drop the suit if Bulldog is absolved of any wrongdoing in a hearing scheduled for this summer. So he's been busy trying to find a proxy to sue the SEC on the same grounds as he sued Massachusetts. Over the past month he has talked to several conservative think tanks and media organizations about filing their own lawsuits. He's also spoken to other hedgies, including Pershing Square's Bill Ackman and John Paulson, about funding a new organization to battle regulators. Thus far Goldstein has had no takers among his colleagues. But he did not put on sweatpants that day in Vegas to quit now. "Sure, I work out of my basement," Goldstein says of what separates him from the big boys. "But there's a lot of sunlight down there. It's really a very nice basement."  To top of page