The Falcone Settlement: A Harbinger of Things to Come?

by BakerHostetler

On August 19, 2013, the Securities and Exchange Commission (SEC) announced that New York-based hedge fund adviser Philip A. Falcone and his advisory firm Harbinger Capital Partners -- which once boasted $26 billion under management -- agreed to a settlement in which Falcone is barred from the securities industry for at least five years, Falcone and Harbinger must pay more than $18 million and, most notably, Falcone and Harbinger admit certain wrongdoing. The agreement comes several months after Falcone apparently jumped the gun by announcing to his investors that he and SEC staff had reached a more lenient settlement, which did not require any admission of wrongdoing. The new settlement reflects a more aggressive stance recently announced by the SEC and is a sea change from its long-standing policy of allowing defendants to "neither admit nor deny" wrongdoing. The rationale for this shift was articulated by Andrew Ceresney, new co-director of the SEC's enforcement division: "Falcone and Harbinger engaged in serious misconduct that harmed investors, and their admissions leave no doubt that they violated the federal securities laws." Time will tell if the Commission's interest in obtaining admissions of wrongdoing will enhance and advance a fair and effective enforcement program.


In June 2012, the SEC filed two civil lawsuits against Falcone and Harbinger.[1] The most serious charge was that Falcone borrowed $113 million from a Harbinger fund to pay his own personal taxes at a time when his investors were prohibited from withdrawing their own money from the fund. The first complaint also alleged that Falcone allowed some large investors to pull their money from his funds in return for their vote to approve a plan to restrict client redemptions from a different fund. According to the SEC, Harbinger concealed these preferred shareholder deals from the funds' independent directors and investors. The second complaint alleged that Falcone and Harbinger, as part of Falcone's retaliation efforts against Goldman Sachs, manipulated the bond market by conducting an illegal "short squeeze" of bonds issued by a Canadian manufacturing company.


In May, the SEC reached an initial deal with Falcone and Harbinger in which the defendants would be barred from the securities industry for two years and, most notably, in which neither defendant was required to admit any wrongdoing. The deal was rejected two months later by the Commission as being too lenient. In the new settlement, the defendants specifically admit to acting "recklessly" and admit to a long list of facts, including that Falcone improperly borrowed millions of dollars to pay personal tax obligations.[2] In addition, Falcone consents to the entry of a judgment barring him from the industry for five years.[3] Hedge fund managers and investment advisers are, from this settlement, on continued alert as to the SEC's enforcement focus on the areas of self-interested transactions and failure to disclose material information to investors, as well as preferring certain investor classes over others.


The revamped settlement agreement is the first to require a defendant to admit wrongdoing since the new policy of requiring admissions in some cases was announced in June by new SEC Chairman, Mary Jo White. For the life of the SEC Enforcement Division, spanning several generations, the SEC (and other Federal administrative and regulatory agencies, such as the FDA and EPA) agreed to settlements in which the targets of investigations were allowed to settle without admitting or denying guilt, a practice that has been criticized by some judges in recent years.

For example, in 2011, U.S. District Judge Rakoff for the Southern District of New York rejected a $285 million settlement between Citigroup Inc. and the SEC.[4] Judge Rakoff derided the amount of money that Citigroup had agreed to pay, calling it "pocket change" for the bank.[5] He also found that, in settling the case without requiring the bank to admit to wrongdoing (a practice he called "hallowed by history but not by reason"), the parties deprived the public "of ever knowing the truth in a matter of obvious public importance."[6] Both parties appealed the decision to the U.S. Court of Appeals for the Second Circuit, arguing that Judge Rakoff exceeded his authority in rejecting the settlement.[7] In March 2012, the Second Circuit granted a stay of the District Court proceeding while it reviewed the appeal. The three-judge panel of the Second Circuit, writing per curiam, found that the parties made a strong showing of likelihood of success on appeal, noting that Judge Rakoff did not "appear to have given deference to the S.E.C.'s judgment."[8] The appellate court also questioned the District Court's "apparent view that the public interest is disserved by an agency settlement that does not require the defendant's admission of liability."[9] Argument was heard on the merits of the case in February of this year and the issue remains sub judice.

In the wake of such criticism, and in response to public outrage at recent financial scandals, in 2012, then-SEC Enforcement Director Robert Khuzami announced a change to the "neither admit nor deny" policy in SEC enforcement actions involving defendants who had been convicted in parallel criminal cases. In such cases, the SEC would delete the "neither admit nor deny" language from its settlement documents, and instead recite the facts and nature of the criminal conviction.[10]

Following this trend, in June of this year, Chairman White sent a letter to staffers of the enforcement division, instructing them to assess their ongoing investigations and pending actions with an eye toward whether the conducts and circumstances might require a public admission of guilt. Later that month, Ms. White told an audience at a financial conference that the SEC was "going to, in certain cases, be seeking admissions going forward. . . Public accountability in particular kinds of cases can be quite important and if we don't get them, then we litigate them." The Falcone matter was found to be one of those particular kinds of cases.


The announcement by Ms. White, a former United States Attorney, is not without critics. Some argue that requiring admissions as part of a negotiated settlement is beyond the scope of the SEC's charge, which, as a civil administrative body, is to regulate the securities markets and promote the raising of capital. Requiring admissions, the argument goes, moves beyond deterring bad behavior and instead seeks to punish offenders, which is more properly within the province of the Department of Justice. Commentators also suggest that because of collateral consequences associated with parties being required to make admissions, the new policy may actually decrease the number of enforcement actions the SEC will be able to bring, and may result in disproportionately harsh treatment to individual defendants and those firms that lack the resources needed to litigate a case to trial in order to try and prove their innocence.

An admission of wrongdoing in an SEC settlement could also make a defendant more vulnerable to liability in investor class actions, as well as proceedings by criminal prosecutors and state regulators. Not only could the admissions embolden others to file suit, such admissions may be able to be used offensively and collaterally in future litigation. Admissions may also constitute events that will render a broker-dealer statutorily disqualified under federal law.[11] Because of these types of collateral consequences, defendants may be far less likely to settle if admissions of wrongdoing are required.

Protracted litigations could have negative consequences for all parties, as well as shareholders. Such cases could drain finite resources from the SEC's overall enforcement program, thereby reducing the number of enforcement actions the SEC could actually initiate. Moreover, the original deterrent objective behind an SEC lawsuit may be weakened if a case takes so long that, by the time a trial is over and appeals exhausted, the events from which the case arose are far in the past.

It will also be interesting to see if over time, small to mid-size defendants feel particularly squeezed or compelled to admit wrongdoing due to their own resource constraints, or whether, in the exercise of its discretion, the Commission will relax its admissions policy based on the resource sizes and constraints of such defendants.


Ms. White has stated that admissions will be sought only where the conduct alleged is particularly "egregious." Yet, the discretionary nature of determining what is "egregious" may prove difficult in practice and leave too much discretion in the hands of SEC staffers. In short, although it remains too early to tell if the Falcone settlement is indeed "a Harbinger of things to come," it should be clear to all regulated entities — including public companies, investment advisers and broker-dealers everywhere — that SEC enforcement actions come with even greater risk and potential for deeper and more far-reaching exposure.

[1] SEC v. Harbinger Capital Partners LLC,12-cv-¬5028 (PAC) (S.D.N.Y. June 27, 2012); SEC v. Philip A. Falcone, et al.,12-cv-5027 (PAC) (S.D.N.Y. June 27, 2012).
[2] There are, however, no direct admissions of liability for violating any specific rules or laws, nor does the settlement prohibit the defendants from taking a different position in other lawsuits in which the SEC is not a party.
[3] Falcone is barred from associating with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent or nationally recognized statistical rating organization for at least five years. He is, however, allowed to assist with the liquidation of his hedge funds under the supervision of an independent monitor.
[4] SEC v. Citigroup Global Markets Inc., 827 F. Supp. 2d 328 (S.D.N.Y. 2011). Likewise, in 2009, Judge Rakoff rejected the proposed settlement between the SEC and Bank of America Corp., which called for an injunction against future violations and a penalty of $33 million for the bank, but also contained a proposed "neither admit nor deny" stipulation. SEC v. Bank of America Corp., 653 F. Supp. 2d 507 (S.D.N.Y. 2009).
[5] Other judges have also questioned the SEC on settlements that do not require admissions of wrongdoing. A $602 million settlement with hedge fund SAC Capital Advisors LP, in which the defendant had been charged with insider trading, was briefly held up this year after U.S. District Judge Marrero, also of the Southern District of New York, said he needed more time to consider whether to approve the agreement without an admission of wrongdoing. The SAC settlement was ultimately approved; however, Judge Marrero stated that he was "troubled" by the settlement agreement's "neither admit nor deny" provision, and expressly conditioned his judgment on the outcome in Judge Rakoff's Citigroup appeal. SEC v. CR Intrinsic Investors, LLC, No. 12 Civ 8466, 2013 WL 1614999 (S.D.N.Y. Apr. 16, 2013).
[6] Judge Rakoff also noted the disparity in the SEC's treatment of Citigroup and Goldman Sachs, which, in a similar case, paid a $550 million penalty to settle civil charges and was forced to state that its disclosures "contained incomplete information" and that it made a "mistake" in how it marketed the securities. Citigroup, 827 F. Supp.2d at 334 n. 7
[7] SEC v. Citigroup Global Markets, Inc., 673 F.3d 158 (2d Cir. 2012).
[8] Id. at 163.
[9] Id. at 165.
[10] The policy is the same in cases in which the defendant admits or acknowledges criminal conduct in non-prosecution or deferred prosecution agreements with criminal prosecutors.
[11] Broker-dealers are required to register with the SEC. Section 15(b)(4) of the Exchange Act enumerates "disqualifying events," such as certain findings of wrongdoing, under which the SEC may suspend or revoke such registration.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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