First Is the Worst: SEC Forces Hedge Fund Manager To Admit Wrongdoing Under New Policy

It’s not often that someone wishes the government investigated him earlier. But Philip Falcone, the hedge fund advisor for Harbinger Capital, may be wishing exactly that. Mr. Falcone and Harbinger Capital recently agreed to settle an SEC investigation against them for just over $18 million. As part of the settlement, however, they admitted wrongdoing. A year ago, that likely would not have been the case.

What’s changed?

The Evolution of Neither Admit Nor Deny

For years, the SEC permitted defendants to settle cases—even major ones—while allowing them to “neither admit nor deny wrongdoing.” The SEC has come under fire for this policy, most publicly last year when Judge Jed Rakoff of the Southern District of New York refused to approve the SEC’s $285 million settlement with Citigroup without an admission of wrongdoing. Other judges have followed his lead and refused to approve settlements.

When Mary Jo White became the head of the SEC, however, she told the New York Times that the SEC would seek admissions of wrongdoing “in the interest of public accountability.”

According to the article, Ms. White said that


This will help with deterrence, and it’s a matter of strengthening [the SEC’s] hand in terms of enforcement.

She has also explained that it “is always going to be a major, major tool in the arsenal.”

The co-heads of the SEC’s enforcement staff also issued a memo in June, noting that there are cases that




Though it is not yet clear how often the SEC will seek an admission of wrongdoing, Ms. White has said that it may depend on “how much harm has been done to investors [and] how egregious is the fraud.”

There are reports that the SEC is seeking such an admission of wrongdoing  in its investigation of J.P. Morgan for the bank’s multi-billion “London Whale” trading loss.

The Falcone Case

The SEC claimed that Mr. Falcone used Harbinger Capital fund assets “to pay his personal taxes, secretly favored certain customer redemption requests at the expense of other investors and conducted an improper ‘short squeeze’ of bonds issued by a Canadian manufacturer.”

The final consent judgment contains a long description of the facts to which the defendants admitted.

Specially, Mr. Falcone admitted in the settlement that he borrowed $113.2 million from the fund to pay his taxes. He did so at an interest rate lower than the fund was paying to borrow money and he also did not immediately disclose it to investors. A major law firm did review the transaction before it was consummated but, according to the SEC, was not told all the relevant facts about it to make a considered judgment. (No advice of counsel defense here.)

As a result of investment losses in 2008, the fund’s assets declined. The fund decided to raise the barriers to withdrawing assets by investors. The potential effect of the change was “to deny many investors the ability to access all of their funds at the next available redemption date.” However, Mr. Falcone and Harbinger Capital apparently made side deals with some investors, usually large “sponsors,” to allow them more access to their funds.

The three “sponsors” with whom the defendants made these side deals are not named in the consent judgment.  So, it is not clear if the SEC has or will investigate them as well.

Finally, Mr. Falcone allegedly constricted the supply of MAAX junior discount bonds (referred to in the consent judgment as “MAAX Zips”). These were distressed high yield bonds. The defendants admitted that they “retaliated” against Goldman Sachs when Goldman encouraged its customers to short the bonds. The retaliation involved buying all the MAAX Zips in the open market, transferring them to an account in Georgia so they could not be used to cover short positions and then demanding that Goldman settle its outstanding MAAX Zips transactions (knowing that this was effectively impossible). By controlling most of the market for these bonds, the defendants manipulated their price.

The penalty against Mr. Falcone and Harbinger Capital was to pay $18,020,714 in disgorgement and penalties. Mr. Falcone is barred from the securities industry for five years.

The Effect of the New Policy

Changing this policy has potentially wide-ranging effects. An admission of wrongdoing may be used against defendants in private securities litigation or in a criminal case. Forcing such an admission may slow down SEC cases and deny financial relief to the victims of wrongdoing. It may also require the SEC—gasp!—to take more cases to trial. It has recently scored a victory in the Fabrice Tourre case but, historically, the SEC has struggled at trial.

It may also change the whole dynamic of an SEC investigation. If a company or individual under investigation thinks that the worst outcome is a financial settlement without an admission, then the defendant may be more likely to cooperate (and thus save SEC resources). But, if the defendant believes that the worst outcome is a financial settlement with an admission, this changes the landscape for follow-on civil or criminal litigation.  Cooperation may be less likely.

The policy could affect how the SEC expends its resources. Perhaps it will investigate fewer minor cases and spend more time on the major ones, forcing admissions of wrongdoing.

The SEC should provide the securities industry with more specific guidance about when it will seek an admission. It should also disclose to the target its desire to seek such an admission early in the investigation, so the target can intelligently decide how much to cooperate.

From Ms. White’s comments, this is a incremental change. There’s no question that settlements in many cases will be finalized without an admission of wrongdoing. But even incremental changes can lead to a major transformation. Time will tell how often the SEC can actually extract an admission of wrongdoing and how this new policy will alter its investigative process.

This entry was posted in SEC Investigation, SEC Settlement, Securities fraud and tagged . Bookmark the permalink.

2 Responses to First Is the Worst: SEC Forces Hedge Fund Manager To Admit Wrongdoing Under New Policy

  1. Pingback: Maybe the Third Time’s a Charm: SEC Charges Oppenheimer Private Equity Fund Manager with Misleading Investors | Grand Jury Target

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