If you knew nothing about Phil Falcone but what you read in the SEC’s assortment of complaints against him today, you would probably conclude that he’s kind of a dick. The loan thing, of course – Falcone borrowed $113mm from Harbinger at the same time he was preventing investors from withdrawing their money – but also a whole range of new and exciting charges announced today. Like that time he got mad at his prime broker and so bought 113% of the issue of a bond that the prime broker was short, and then called in the prime broker’s borrow to screw them (and gloated to them about it). Or the time – sorry, three times – that he shorted stock of companies that were doing equity offerings and then illegally covered his short with his allocation in those offerings.
Robert Khuzami is right about the marvelous variety and inventiveness of Harbinger’s scammy ways, but lots of people do lots of bad things on Wall Street. It’s just that usually their victims are either diffuse markets (insider trading) or widows and orphans (Ponzi schemes etc.) – it’s rare to spend so much time screwing so many big institutions. And it’s maybe even rarer for the SEC to stick up for those institutions.
Start with the thing that’s gotten the most attention so far: the loan that allowed Falcone to take $113mm out of his fund when investors were not allowed to redeem. How did no one tell him that that was a bad idea? Well:
25. In early April 2009, the idea of a loan from a Harbinger fund to pay Falcone’s personal taxes, as well as other obligations, arose during discussions between Harbinger personnel and Harbinger’s longstanding outside law firm (“Law Firm B”). At that time, a partner at Law Firm B told Harbinger in an email that “[l]ending money to principals is not part of the fund’s investment program.”
26. In addition, a Law Firm B partner told Harbinger in a separate e-mail that it would “never be comfortable with this . . . a loan . . . will never be a good idea.” Another Law Firm B partner added on the same email that a loan to a principal is “not what investors expect their money to be used for.” An in-house Harbinger lawyer forwarded this e-mail to Falcone, stating that “[Law Firm B] is unequivocally against the loan idea for a number of reasons,” and Falcone responded “ok.”
Chastened (?), he talked to a bank that offered to lend him money at market rates secured by his “two Manhattan townhouses and artwork … interest in a National Hockey League team and an estate on the Caribbean island of St. Barts.” This however did not catch his fancy, in part because he didn’t take phrases like “will never be a good idea” too literally. “One proposal that Falcone heard in September 2009, however, did interest him: taking a loan from [Harbinger's Special Situations Fund] using his SSF interest, rather than other personal assets, as collateral.” You might think investors would object to that, but that’s just because they didn’t know what a good deal it would be if it was the deal that they were told it was, which it wasn’t:
43. The Loan Agreement provided that the interest rate to be paid on the loan was “the higher of” (1) the Applicable Federal Rate, which at the time was 2.66 percent, plus 1 percent; or (2) “the Lender’s actual cost of funds as determined by the Lender in its reasonable discretion plus one percent.” At the time, SSF was paying 7 percent on an outstanding loan, which provided a measure of SSF’s cost of funds. The Defendants, however, did not use the “cost of funds” measure, and instead Falcone paid a highly favorable rate of 3.66 percent. …
57. In addition, in an email dated September 29, 2010, Falcone advised an investor representative that “we had vetted [the loan] extensively with outside counsel . . . The [loan] furthermore, was collateralized by all my holdings, essentially 14x.” Both statements were false. Law Firm A did no due diligence or vetting, and the collateral for the loan was limited to Falcone’s interest in SSF, which was less than two times coverage.
Taking $113mm in cash out of the fund made it harder to meet the redemption requests from the more than 80% of SSF investors who wanted to redeem, so he then made SSF’s gates more restrictive, which required an investor vote, which he obtained by giving some big investment sponsors preferential liquidity in undisclosed side letters, which I guess is bad but sort of meh compared to the rest of today’s charges.
Like the short squeeze in which Harbinger bought a big chunk of some bonds (called “zips”) issued by MAAX Holdings, and then found out that his prime broker was shorting those bonds:
45. Sometime during the summer of 2006, the Harbinger analyst began hearing rumors that there was aggressive short selling in the MAAX zips. The analyst’s sources on the street speculated that one of Harbinger’s prime brokers — the Wall Street firm — and its customers were shorting the MAAX zips and trying to drive their price down. The analyst informed Falcone.
46. Falcone was angered by this. He speculated that the Wall Street firm was putting its proprietary trading interest ahead of his own—that it was undercutting the value of his MAAX position and possibly borrowing his own notes to cover its short position.
The SEC talked to the prime broker and they swear they had a good reason for doing the trade unrelated to screwing/front-running Falcone, but I guess they didn’t tell him that, so he retaliated amazingly by buying 113% of the issue:
54. Harbinger was able to acquire more than the entire issue of the MAAX zips because there is no “locate” requirement when short-selling debt instruments. … Thus, “naked” short selling of bonds is legal, which can lead to “long” positions far in excess of the issue size.
Now that he owned more than all the bonds, he repaid his margin loan to the prime broker and demanded that the prime broker return the bonds that it had been borrowing for its short:
73. Sometime in the spring of 2007, Harbinger, at Falcone’s direction, paid off the debt in its margin account and demanded that the Wall Street firm return any securities it had borrowed, including MAAX zips. …
83. At some point, the conversation turned to the trading in the MAAX bonds. The senior officer asked Falcone how the Wall Street firm might satisfy its obligation to Harbinger. Falcone stated that the Wall Street firm should just keep bidding for the bonds. Falcone acknowledged that the Wall Street firm would suffer some losses doing so, but told the senior officer and the others that sometimes you are just on the wrong side of a trade.
84. In the course of this discussion, Falcone stated that he knew that the short position in the MAAX zips had created a “long” position in excess of the issue size. When the senior officer asked how he could possibly know this, Falcone stated that he was working the position himself and that he (i.e., Harbinger) had acquired approximately 190 million bonds. The senior officer and the other the Wall Street firm personnel were stunned.
Finally there’s a series of garden-variety Rule 105 violations, in which (1) a company announced that it would be selling stock, (2) Harbinger shorted shares of that company’s stock, and (3) Harbinger got allocated shares in the company’s offering that it then used to cover its short, essentially front-running the company’s stock sale and making an instant profit on its allocation. This is illegal but more important it’s a dick move: it screws the issuer and the issuer’s investment bank and if they knew you were doing it you’d never get allocated a deal again.*
These are all … I cannot emphasize enough what dick moves these are. But the giant collection of SEC lawsuits is weird, isn’t it? The Rule 105 violations are clearly illegal and frequently pursued, but they’re also not that big a deal and it’s even possible to do them accidentally (one trader shorts, another buys in the deal, etc.). Here they were sort of self-reported (“After an inquiry from the Commission, Harbinger self-reported two of the violative transactions,” which, what?), settled quickly, and led a fine of $857,950, small potatoes compared to the rest of the cases.
The borrowing from his own fund is much much worse, but it’s also the sort of thing normally dealt with by the big institutional investors in the fund suing him, not the SEC: there is a gloss of disclosure-violation in the SEC’s complaint, but the basic problem is Falcone’s violating his fiduciary duties to, and contracts with, his investors. And the MAAX short squeeze is wonderfully evil, but again, it’s the sort of thing that is usually settled by the prime broker refusing ever to deal with you again and telling all their friends to do the same. (Did you even know it was illegal? Seems cruel but fair to me.) You don’t often see the SEC rushing to the defense of a big Wall Street firm that got itself in trouble by doing too much naked short selling of Canadian bonds.
Philip A. Falcone and Harbinger Charged with Securities Fraud [SEC.gov]
* Am I bitter because I worked on one of those deals whose stock price cratered in part because of Falcone’s illegal short sales? YOU BET I AM.