An S.E.C. Settlement That Seems to Favor Falcone

There is an adage that a good legal settlement is one in which no one leaves the courtroom happy. That appears to be the case if the terms of the tentative agreement between the hedge fund manager Philip A. Falcone and the Securities and Exchange Commission to resolve civil fraud charges are approved.

While each side looks to be giving up something, the terms appear to favor Mr. Falcone.

The S.E.C. sued Mr. Falcone and his hedge fund firm, Harbinger Capital Partners, in June 2012, asserting that the “charges read like the final exam in a graduate school course in how to operate a hedge fund unlawfully.”

The agency had actually filed two cases. One claims that Mr. Falcone had obtained a loan for $113 million without properly disclosing it to his investors and flouted the rules to favor certain investors in his hedge funds. The other case asserts manipulation of the price of bonds in which he had invested. Both involve charges of violating the broad antifraud provisions, asserting that Mr. Falcone intentionally or recklessly violated the securities laws.

The settlement, which was reached last week, is subject to approval by the five agency commissioners as well as Paul A. Crotty, a Federal District Court judge in Manhattan who has been presiding over the cases. It is also not yet clear whether the agreement will involve only provisions that require proof of negligence, a low threshold of intent that cannot be used by private parties in their own securities fraud claims.

According to a filing with the S.E.C., Mr. Falcone has agreed to pay $4 million out of a total civil penalty of $18 million – a rounding error for a billionaire, as a DealBook article pointed out. Like most such settlements, this one will be without an admission or denial of liability by Mr. Falcone, meaning there is no acknowledgment of wrongdoing.

Harbinger Capital will be required to “take all actions reasonably necessary to expeditiously satisfy all received redemption requests of investors.” Its hedge funds cannot raise new money or make capital calls on its investors for two years, although this was unlikely to happen anyway given the turmoil surrounding Mr. Falcone over the last few years.
The strongest remedy looks to be a two-year ban on Mr. Falcone from working as an investment adviser. Yet, even that prohibition permits him continue to work with nine investment advisers affiliated with Harbinger Capital to help them wind down operations to deal with investor redemptions.

The S.E.C.’s action also does not preclude Mr. Falcone from serving as an officer or director of a publicly traded company, positions he occupies at the Harbinger Group as its chairman and chief executive. The original complaint sought such a ban, so the settlement lets him stay at the helm of the enterprise.

In another interesting twist, the S.E.C. will not ask the court to impose an order prohibiting Mr. Falcone from future violations of the securities laws. This is commonly known as a “sin no more” injunction because it tells a defendant not to engage in any future misconduct that might transgress securities laws.

The S.E.C. asks for this type of injunction almost as a matter of routine, including in its original complaints against Mr. Falcone. For example, the settlements with Goldman Sachs and Citigroup over marketing practices for synthetic securities tied to subprime mortgages included broad prohibitions on future violations.

A “sin no more” injunction gives the S.E.C. the power to seek a civil contempt from the court that issued it if a defendant engages in misconduct in the future. But that is largely understood to be a hollow threat, at least for a public company. There are instances in which the S.E.C. has obtained multiple injunctions against the same entity over the years without ever pursuing a civil contempt.

Some courts have questioned whether a command to obey the securities laws is permissible given the breadth of the securities law. But the S.E.C. has fought efforts to cut back on these types of injunctions.

A footnote in a 2005 decision in S.E.C. v. Smyth by the United States Court of Appeals for the Eleventh Circuit declared that this type of injunction was “unenforceable” because it violated a defendant’s due process rights if a contempt proceeding were pursued. The S.E.C. filed a brief asking the court to “delete the extensive dictum” in its opinion, to no avail.

In S.E.C. v. Goble, the appellate court reiterated its position that an injunction simply parroting an antifraud provision of the securities laws may be improper. It found that a district court entering such an order “should craft terms that provide the defendant fair notice of what conduct risks contempt and clearly inform the defendant of what he is ordered to do or not do.”

So why would Mr. Falcone negotiate to keep this type of order out of the settlement, given the general perception that these injunctions are more for show than a real threat of future enforcement, and perhaps even unenforceable in a contempt proceeding?

One reason is its permanency is that Mr. Falcone would have to make complete disclosure of the injunction for the foreseeable future when he holds an executive or board position with a public company. Unlike the two-year ban on acting in any capacity with an investment adviser, an injunction would say to the world that he agreed not to engage in fraudulent conduct again, a type of back-handed admission no one wants to make.

For the S.E.C., giving up the injunction is not very costly because it is rarely used as a means to police the future conduct of defendants. The danger is that the decision not to ask the court to issue one against Mr. Falcone as part of the settlement sends a signal to other defendants that they too might be able to avoid an order to abjure future sinfulness.

The S.E.C. could move away from the broad “sin no more” approach and focus any injunctive relief on prohibiting the actual misconduct that triggered the case. Although that would be a more cumbersome approach than simply telling a defendant to obey the law, it might help avoid judicial questioning of the propriety of a settlement.