Hedge fund fights to keep 'trade secrets'

Is forcing hedge funds to reveal which stocks they own the equivalent of making Coca-Cola spill the beans on the top secret ingredient in one of its soft drinks?

Or is the disclosure a necessary way for regulators to protect investor confidence in the markets?

That's the question the U.S. Securities and Exchange Commission will face when Phillip Goldstein, manager at Pleasantville, N.Y.-based hedge fund Full Value Partners LLC, asks for an exemption to the rule requiring him to disclose his stock holdings every quarter.

While other money managers including Warren Buffett have asked to keep their filings confidential, Mr. Goldstein will be the first to ask not to have to file his holdings at all.

"I'm not a crank. I think I'm like Toto in the Wizard of Oz, I've pulled away the curtain and said, 'There's nothing here, there's absolutely no reason for this rule,' " said Mr. Goldstein, who recently took on regulators and won the right not to register his funds with the SEC.

The disclosure rule now in his sights requires U.S. money managers with more than US$100-million in equities to disclose their holdings every three months in a filing called a 13F. One of Mr. Goldstein's funds is poised to break through that asset threshold, and he argues that being forced to reveal its contents will violate his Constitutional rights.

"Involuntary compliance ... by requiring the Applicants to publicly disclose their trade secrets, [would] constitute a 'taking' of their property without just compensation in violation of the Fifth Amendment to the Constitution," Mr. Goldstein said in a draft of the application he plans to submit to the SEC. "An exemption from the filing requirement . ..is necessary to avoid such a violation."

But the SEC, which adopted the current disclosure rules in 1975, said there are a number of reasons for them. These include increasing market transparency and public information about institutional money managers, along with the maintenance of fair and orderly markets, SEC spokesman John Nester said in an e-mail.

Mr. Goldstein, who said investors put money into his fund with the knowledge he won't disclose his holdings to them, doesn't understand what a peek into his investment portfolio every three months offers the public-at-large other than a chance to steal his ideas.

Depending on how well-protected information about his holdings is, Mr. Goldstein's argument may well have legal merit, said Talcott Franklin, an intellectual property lawyer at law firm Patton Boggs, and author of Protecting the Brand.

"If he's managed to keep this information completely secret until now, it could fit the definition of a trade secret," Mr. Franklin said. "That definition is very broad, it can involve any formula, compilation, pattern or device whose use in business gives the operator a competitive advantage."

This can include products traditionally thought of as trade secrets, including the key ingredient in Coke, McDonald's secret sauce, or the recipe for KFC's chicken. But it can be much more unusual than that. For example, even a unique method for cleaning out a horse stall could fit the description, Mr. Franklin said.

A protectable secret has to be well guarded by a company, difficult for the public to figure out, and a firm should have expended considerable resources on it, said another lawyer who asked not to be named. He agreed with Mr. Franklin's view that a money manager's holdings could fit the bill.

In Canada, the situation is different. Disclosure requirements aren't based on how much money a fund manages, but whether it is marketed and sold directly to the public (like many mutual funds) or offered only to private investors (the case for most hedge funds.)

Public funds have to disclose their top-25 stock holdings every quarter and make the information publicly available. Private funds release financials twice a year, and are allowed to mail them to investors without putting them on the Internet. The Ontario Securities Commission has previously said these disclosure rules are necessary to protect investors and promote the transparency of publicly-offered investment funds.

But some Canadian money managers argue that exceptions should be made here too.

Last year, for example, one of Canada's top money managers, Tom Stanley, closed down his publicly-sold Resolute Growth Fund. He made the decision after the OSC denied his application to keep his stock holdings private. This was despite his unitholders voting 99.58% in favour of letting him follow the disclosure rules for a private fund.

"There is no doubt in our minds that too much disclosure can severely harm the performance of some funds," Mr. Stanley said. Funds that perform well can attract copy-cat investors, which can be especially hard on a fund trying to build a position in an illiquid stock.

"With too much disclosure, competitors or arbitrageurs may be able to 'front run' the fund to the potential detriment of the fund and unitholders," he added.

But not everyone is put off by the disclosure rules. Peter Hodson, an investment strategist at Sprott Asset Management, said seeing his top 25 won't allow others to replicate his portfolio. "We don't have to declare shorts, for example, and there are no selling restrictions. You can file on March 31 and sell everything on April 1. That makes it pretty tough for someone else to follow what we're doing," he said.

Mr. Stanley, who now manages the Resolute Performance Fund as a private fund, said there's no 'cookie cutter' solution, but he believes there has to be a balance between the needs for confidentiality and disclosure. Ultimately, the decision should rest in the hands of unitholders, he said.

"In the case of the Resolute Growth Fund, unitholders clearly understood the detrimental effects that would result from too much disclosure. While their wishes were not respected, we continue to believe in shareholder democracy as the best solution to an issue such as this."

Mr. Goldstein, who said he might also consider holding a vote for his investors, plans to file his exemption request with the SEC in the next couple of weeks. Despite his recent win against the regulator regarding fund registration, he said he's not as hopeful of a second victory.

"You know, even Warren Buffett has applied for an exemption and he got turned down. He's a lot smarter than me, so I'm really not sure how much of a chance I have."

lmcleod@nationalpost.com