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Falcone Sued by SEC on Personal Loan, Market Manipulation

Falcone Sued by SEC
Philip Falcone, chairman and chief executive officer of Harbinger Group Inc. Photographer: Jacob Kepler/Bloomberg

Philip Falcone, the founder of hedge fund Harbinger Capital Partners LLC, was sued by the U.S. Securities and Exchange Commission, a move that could end his plan to run a Berkshire Hathaway Inc.-style holding company if the regulator wins the case.

Falcone misappropriated client assets, favored selected investors and manipulated bond prices, the SEC said today in its lawsuit, which also named Peter Jenson, the fund’s former chief operating officer.

“Today’s charges read like the final exam in a graduate course in how to operate a hedge fund unlawfully,” Robert Khuzami, the SEC’s enforcement director in Washington, said in a statement. “Clients and market participants alike were victimized as Falcone unscrupulously used fund assets to pay his personal taxes, manipulated the market for certain bonds, favored some clients at the expense of others and violated trading rules intended to prohibit manipulative short sales.”

The lawsuit is the second blow in less than two months for Falcone, 49, a former Harvard hockey center who built a $26 billion hedge fund by 2008 with a successful bet against subprime mortgages. Having suffered $23 billion in losses and withdrawals from the peak, Falcone is now fighting to keep control of his empire. LightSquared Inc., Harbinger Capital’s biggest investment, filed for bankruptcy in May.

Seeking Penalties

The SEC is seeking disgorgement of ill-gotten gains, unspecified financial penalties and a bar prohibiting Falcone from serving as an officer or director of any public company, according to a statement by the agency.

Falcone declined to comment, according to Lew Phelps, a spokesman for Harbinger.

“The notion propagated by the SEC that investors were harmed by that conduct or any other is not only irresponsible but completely unsupported by any evidence,” Matthew Dontzin, an attorney for Falcone, said in a statement, adding that all the charges will be “vigorously defended in the courthouse.”

In 2009, Falcone took a $113 million loan from his Special Situations fund to pay personal taxes, according to the SEC, while clients were barred from pulling money. Falcone took the loan when about 60 percent of the fund’s investors had unfulfilled requests to redeem. Falcone didn’t seek approval from fund investors for the loan, according to the suit.

Private Jet

While Falcone knew in April 2009 that he would have a tax bill in the tens of millions of dollars, he continued to spend money on renovations of a $49 million townhouse once owned by Penthouse publisher Bob Guccione. He also spent money on a private jet, a security detail and motion picture investments, the SEC said.

Falcone and Jenson, 46, disregarded the advice of one law firm about whether to borrow money from the fund. That company said that “lending money to principals is not part of the fund’s investment program,” according to the SEC.

The law firm was New York-based Schulte Roth & Zabel LLP, according to two people familiar with the matter. Carolyn Sargent, a spokeswoman for the firm, declined to comment.

The SEC alleged that Jenson misrepresented the facts to a second law firm, which did eventually give Harbinger an opinion letter. The inaccuracies included that the tax liability was unexpected and that Falcone had no other viable source of funding, the suit said. The SEC didn’t identify the law firm.

Goldman Treatment

Charles Clark, an attorney for Jenson, declined to comment.

Under the terms of the loan, Falcone was supposed to pay interest equal to the cost of capital for the fund. At that time, the fund was paying interest of 7 percent on an outstanding loan. Falcone paid 3.66 percent, the SEC said.

The same year that Falcone took out the loan, he let some large investors withdraw $169 million in return for their vote to approve a plan to restrict client redemptions from a different fund. Harbinger concealed these deals from the independent directors and from fund investors, the SEC said. The regulator said the investors were large banks and investment firms, declining to name them.

Among the large clients were Goldman Sachs Group Inc., which at the end of 2008 had $1 billion invested in two Harbinger funds, and Pacific Alternative Asset Management Co., a fund-of-funds based in Irvine, California, according to two people with knowledge of the deal who asked not to be named.

Michael DuVally, a spokesman for Goldman Sachs, declined to comment, as did Katrina Allen, a spokeswoman for PAAMCO.

Mimicking Buffett

In an interview in April, Falcone said he was seeking to move away from hedge funds and build a public holding company, much like Warren Buffett’s Berkshire Hathaway, that would be better suited for long-term investments.

To that end, Falcone’s funds in 2009 bought Zapata Corp., a onetime oil driller, and turned it into Harbinger Group, a holding company that can raise capital for long-term investments. Falcone plans to use Harbinger Group to finance investments in six industries, including consumer products, financial products and natural resources, according to a 2010 regulatory filing.

Harbinger Group fell 13 percent yesterday, the biggest drop since 1999, after Bloomberg News reported the SEC may sue Falcone, who is the company’s chief executive officer and chairman. Falcone would be barred from those roles if the SEC lawsuit succeeds.

The regulator also alleges that Falcone and two of his funds engaged in a short-squeeze of MAAX Holdings Inc. bonds, a transaction in which a buyer limits the supply of a security to drive up prices and cause losses for investors betting against the security.

Punishing Goldman

Falcone, who had bought a large position in the bonds in April and June of 2006, was trying to retaliate against a Wall Street firm that was betting against MAAX bonds and encouraged clients to do the same, the SEC said.

“In September 2006, Falcone directed the Harbinger-managed funds to buy every available bond in the market, often purchasing the bonds from short sellers,” the SEC said. “Ultimately, Falcone raised the funds’ stake to approximately 13 percent more than the available supply of the MAAX bonds.”

Having seized control of the supply of the bonds, Falcone demanded that the Wall Street firm settle their short sales, effectively forcing short-sellers to buy the bonds at prices Falcone set arbitrarily.

The Wall Street firm was Goldman Sachs, according to two people familiar with the matter, who asked not to be named because the information is private. DuVally at Goldman Sachs declined to comment.

Harbert Settles

Harbert Management Corp., a Birmingham, Alabama-based money-management company that originally backed Harbinger with a $25 million investment, settled a separate complaint by the SEC that it failed to take appropriate steps to address Falcone’s trade in MAAX bonds. The company agreed to pay $1 million, without admitting or denying wrongdoing.

“We believe the resolution of this legacy matter is in the best interest of our ongoing business, and are pleased to put the matter behind us,” Tripp Kyle, a spokesman for Harbert, said in an e-mailed statement. Harbert’s relationship with Harbinger was terminated in March of 2009.

In a separate administrative and cease-and-desist proceeding, the SEC found that Harbinger engaged in illegal trades in connection with the purchase of common stock in three public offerings after having sold the same securities short during a restricted period. Harbinger agreed to pay disgorgement of $857,950, prejudgment interest of $91,838, and a civil monetary penalty of $428,975, without admitting or denying the findings.

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