Phil Falcone Is Preparing For Trial On SEC Fraud Charges By Alienating All Of His Witnesses

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Even if Wilbur doesn't testify I'm pretty sure that a trial of the SEC/Falcone case will be something to behold - if it happens, which the public posturing suggests it will. The Journalpreviews his defense today and it sounds like courtroom tensions will run high:

Mr. Falcone plans to try deflecting blame to a former Harbinger operating chief and two lawyers who advised him to borrow $113.2 million in 2009 from a Harbinger fund to pay his personal taxes even though other investors were blocked from withdrawing money, according to people familiar with his defense. ... Mr. Falcone is expected to contend that borrowing the money was the best option for his investors, since most of his assets were illiquid and because of what he believed to be a lack of financing alternatives. The loan also prevented a possible tax lien on his Harbinger assets, which could have hurt the fund, according to the people familiar with his defense.

There is some question as to who will testify to that effect, though, since all the people he's blaming don't seem to be playing along:

"Any position by Mr. Falcone that he was not aware of all facets of the loan, the underlying legal advice, or his final approval of it, is not supported by the evidence," Mr. Clark [the lawyer for Harbinger COO Peter Jenson] said. "Mr. Falcone withheld material information from my client pertinent to the loan and failed to act on other elements of my client's advice relevant to the loan." ...

[Harbinger in-house lawyer Robin] Roger's lawyer, Paul Shechtman, said she "relied on a distinguished outside lawyer for legal advice and on Harbinger's business people for the facts and gave her best independent judgment." Ms. Roger hasn't been accused of wrongdoing.

If you are extensively involved in, um, operating pretty close to the line legally speaking, a skill you will probably develop is compartmentalizing information and advice. You could for instance go to your lawyer and say "can I borrow $113mm from my fund?" and they say "I guess, if you do it on market terms," but they don't necessarily know what market terms are because they are after all lawyers. Then you go to your COO and you say "can I borrow $113mm at 3.66%?" and your COO says "are the lawyers okay with that?" and you say "yeah, see, they're copied on this email" but you elide their demand for market terms. Not saying that that's what happened here but the lawyer's "relied on ... Harbinger's business people for the facts" sure sounds like she asked someone (Falcone?) "are these terms market" and was told yes.* Lawyers will, of course, be happy to tell you if you ask that their advice is worthless unless the facts are exactly as they understand them, so the trick is not to ask.

Of course it's plausible that Falcone borrowing the money from the fund was the best option for his investors, both because otherwise he'd have to withdraw money and make things worse and maybe even because it was a good investment for the fund (he paid back the loan!) on market terms. The SEC doesn't seem to buy it, pointing out that his fund had borrowed at 7% while lending to Falcone at 3.66%. But that proves nothing - what tenors? how much had it borrowed at 7% and what was it paying for the rest of its funds? - because the SEC are lawyers too and so not cursed by knowing what market terms are.

This is to some extent a sidelight, though; Falcone's loan is tawdry and maybe-illegal-maybe-not, but I'd guess that most hedge fund managers know that this sort of thing is Frowned Upon and avoid it unless they have no choice. And once they have no choice, they're unlikely to be deterred by a few legal precedents with slightly different facts; certainly Falcone was left undeterred by pretty emphatic legal advice.

The interesting thing for the future, though perhaps less juicy now, is Falcone's maybe-market-manipulation of the MAAX zips. Recall that Falcone bought 113% of the outstanding bonds of a particular series and then demanded that his prime broker, who had borrowed the bonds from him to short them, return them to him. The only way they could do that was, of course, to buy them from him, and the pricing was shall we say not favorable to them. He was philosophical on their behalf, noting presciently that "sometimes you are just on the wrong side of a trade."

This is mean, though also funny and sort of satisfying - Falcone thought, apparently wrongly, that the prime broker had shorted the bonds to pick him off, so the motive was revenge as well as money - but I was a bit surprised to learn it was illegal. So I guess were a lot of people:

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.

Now as an aside, demanding that a counterparty pay more for your things than you value them at on your books can't be market manipulation,** since it's pretty much the foundation of markets, but you get the idea: he definitely cornered the MAAX zips market and squoze the shorts, and that is "manipulation" in some sense though not obviously in the SEC's sense of an "act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." Using someone's desperation against them, or profiting by your own foresight in buying up a suddenly desirable issue, is not unheard of in trading, though this is an extreme case. And while the SEC's complaint suggests that people at the prime broker were shocked, shocked to hear of Falcone's obviously illegal scheme the fact is that, rather than complain to the authorities about his manipulation, they kept negotiating and eventually paid him off to close out their borrow - suggesting that even Falcone's victim wasn't entirely sure that what he was doing was illegal. Getting more clarity on exactly how brutally you can screw your counterparties in a short squeeze will, I suspect, be of more lasting importance to more people than will clarifying whether Falcone's borrowing was or was not approved by his lawyers.

Falcone Sets Up Defense [WSJ]
In Case Against Philip Falcone, a Warning to Others [DealBook]

* Btw you could replace "COO" with "CEO" in my hypothetical: maybe Jenson wanted to get the loan done to please his boss, consulted lawyers, got their signoff if it was on market terms, and then elided that requirement in talking to Falcone. The incentives don't work as well though.

** Or can it? Not, in any case, when practiced by a hedge fund against a bank, though maaaaaaaaybe when practiced by a bank against a client.

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Phil Falcone Maintains 'Absolute Lawfulness' Of Lending Himself A Hundred Mill From Investor Fund

Remember, back in 2009, when Phil Falcone realized he'd forgotten to set aside enough cash to cover his taxes and came up with the idea to loan himself the money from a gated investor fund? And investors got all bent out of shape about it and the SEC did too? If the former was looking for some sort of an apology and the latter was looking for some show of groveling (in an attempt to avoid paying a fine/have a judge rule he can't come within 200 feet of a public company sorry), sorry, 'cause Phil's not sorry.