Jacob Kepler/Bloomberg News
Philip Falcone, the founder of Harbinger Capital Partners.
Hedge fund managers have long flown underneath the radar, doing pretty much as they pleased with little oversight from the Securities and Exchange Commission. Securities fraud charges filed against Philip Falcone and his firm, Harbinger Capital Partners, are a warning that funds can now expect the same scrutiny that Wall Street banks and brokerage firms receive.
This is perhaps the most prominent enforcement case focusing on how a hedge fund manager treated investors. The S.E.C. accused Mr. Falcone of hiding information from investors, an outside law firm and even his own directors.
The S.E.C. filed two separate complaints, one accusing Mr. Falcone of treating Harbinger like his own plaything by taking out a $113 million loan to cover his tax liabilities and cutting side deals with outside investors to get their votes. The second claims that he engaged in hardball tactics by engineering a “short squeeze” on the bonds of a distressed company, which the S.E.C. asserts was an illegal market manipulation intended to inflate the price of the securities.
According to the S.E.C.’s complaint, Harbinger’s regular outside counsel questioned a loan to an insider at the hedge fund, so Mr. Falcone got a second firm – called “Law Firm A” – to give its approval. In a statement responding to the charges, Mr. Falcone’s lawyer said, “This has to be the first case involving an act of supposed dishonesty in which a client simply followed the advice of his lawyer.”
Following your lawyer’s advice can be a defense to a fraud claim because it shows the person acted in good faith. To offer it, however, the client must show that all relevant information was provided to the lawyer and the advice was followed in every respect.
The S.E.C. takes aim at this defense in its complaint, putting in a caption that reads “Law Firm A’s Advice Was Based on Inaccurate and Incomplete Facts.” It also takes a shot at the outside lawyers, stating that they “never contacted Falcone, and never did any due diligence regarding the proposed transaction.”
Usually, legal advice comes with lawyer-client privilege. But by claiming that Mr. Falcone had followed the lawyer’s advice, Mr. Falcone and Harbinger would have to waive the protection for lawyer-client communications, thus exposing what the lawyers said about the loan.
The S.E.C. also claims that “procurement of legal advice was an integral element of the defendants’ scheme.” Another way around the lawyer-client privilege is the “crime-fraud exception,” which removes the protection when a client seeks the advice of a lawyer to help engage in criminal or fraudulent conduct. If Mr. Falcone consulted Law Firm A to cover up a fraud by having outside lawyers bless the loan, then those communications would lose any protection provide by the privilege.
The hedge fund investors did not learn about the loan to Mr. Falcone for approximately five months, and were then told it had been a last resort because of an unexpected tax bill he faced. The S.E.C. claims that there were alternative financing sources and that Mr. Falcone knew six months earlier that a large tax bill was looming.
The question is whether failure to disclose the loan and describing the reasons for it were material information that should have been disclosed to the investors sooner. It is not clear what impact the transaction would have had on any investment decision by Harbinger’s investors, and the hedge fund faced problems from the financial crisis that went well beyond a large loan to an insider that was eventually repaid.
The second part of the fraud claim involves how Harbinger allowed three investors to redeem their investments in the hedge fund while others were blocked from doing so.
In 2009, Mr. Falcone wanted to amend the rules to limit any redemption to 25 percent of the total investment, a significant change that would have made it harder to pull out of the hedge fund. The change required the consent of the investors. Three large banks and investment firms that represented a number of investors planned to vote against the change.
To secure their approval, the S.E.C. said, Mr. Falcone made arrangements to give them “preferential liquidity in return for an affirmative vote,” something that required approval by the directors of the hedge fund. Mr. Falcone did not disclose these side deals, which the S.E.C. said “disadvantaged” other investors seeking to redeem their shares.
Mr. Falcone appears to have treated the rules for his hedge funds as more of a nuisance than a legal obligation. And investors were certainly kept in the dark about his actions. But whether these add up to a securities law violation may be an issue because the S.E.C. will have to show that Mr. Falcone intended to defraud investors, not just mistreat them.
The second complaint deals with what the S.E.C. describes as “an illegal ‘short squeeze’ – a form of market manipulation that occurs when a trader constricts the available supply of a security with the intention of forcing settlement from short-sellers at the trader’s arbitrary and inflated prices.”
Two of Mr. Falcone’s hedge funds bought all of a series of high-yield bonds issued by MAAX Holdings, called “MAAX zips,” in response to rumors that one of Harbinger’s prime brokers was shorting the securities and urging others to do so. Once he controlled all the bonds, Mr. Falcone had them transferred to a bank so they would not be available to the short-sellers to cover their positions.
Market manipulation can be difficult to prove because it requires showing that the investor engaged in the transactions with the intent to artificially affect the price of the securities. It is not enough to show that the person wanted to make a profit on the trades – that is why everyone buys and sells securities.
What Mr. Falcone did was every investor’s dream: create a squeeze and watch the short-sellers squirm. And if a market is cornered, it is logical that the price would rise because of the scarcity of supply. But was it also market manipulation?
The S.E.C. describes the pressure put on the short-sellers from Mr. Falcone’s demands that they cover outstanding positions by paying far more than the price that Harbinger had put on the bonds in its own records. It also claims that Mr. Falcone misstated his holdings in MAAX zips and hid the fact that he was the seller in trades to cover short positions. The question is whether that evidence is enough to show that he intended to manipulate the price through artificial means rather than just throwing some sharp elbows.
The S.E.C. has brought few market manipulation cases, and most have been settled without going to trial. Mr. Falcone has vowed to fight the charges, so there is a chance the issue will be tested in court.
The S.E.C.’s aggressive position in charging Mr. Falcone and Harbinger with fraud is a warning to the rest of the hedge fund industry that the days of operating largely unnoticed are over. A few Wall Street firms may be saying, “Welcome to our world.”