Daniel Rosenbaum for The New York TimesPhilip A. Falcone of Harbinger Capitol Partners.9:28 a.m. | Updated Both the civil and the criminal investigations of the hedge fund Harbinger Capital Partners face significant hurdles.
The United States attorney’s office in Manhattan and the Securities and Exchange Commission are examining, according to news reports, whether a $113 million loan from one of the Harbinger funds to its chief executive, Philip A. Falcone, was properly disclosed and whether the firm favored select investors by permitting them to withdraw their investments while others were required to wait for the return of their funds.
The details of the investigation are sketchy at this point, and it is difficult to discern whether any of the conduct comes within the purview of the federal securities laws.
If the S.E.C. cannot pursue a case because Harbinger and Mr. Falcone fall outside its jurisdiction, that may mean the greater risk is the potential for a criminal prosecution if investors were misled.
The loan to Mr. Falcone, if not properly or timely reported to investors in the hedge fund that lent the funds, conceivably could be the basis for a claim of fraud if a failure to timely disclose it was misleading or involved an improper benefit.
The problem in pursuing a securities fraud case against Harbinger is that the firm is neither a publicly traded company nor is it a registered investment adviser, so the typical avenues for pursuing a fraud case do not appear to be available.
An S.E.C. investigation for misleading statements or a failure to disclose information usually involves a company whose shares are publicly traded because the federal securities laws mandate certain regular disclosure to investors that can be the basis for pursuing an inquiry.
There are a number of specific provisions that can be applied to such a case, depending on the context in which the statement is made. For example, cases involving inflating revenue and overseas payments in violation of the Foreign Corrupt Practices Act will include false reporting of financial information and a failure to maintain proper books and records.
Another means for pursuing a case is under the broad antifraud provisions found in Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. For example, the enforcement action against Goldman Sachs over the sale of a collateralized debt obligation that was settled last summer with a $550 million payment involved an alleged violation of Section 17(a) related to the issuance of the security.
But these provisions require the S.E.C. to prove that the fraud occurred “in connection with” a purchase or sale of a security, which would not be the case for disclosures to Harbinger investors.
Transactions involving hedge fund investments are usually not considered to be a security, so any statements about the loan to Mr. Falcone and potential favoritism in redeeming investments would appear to fall outside the scope of the antifraud provisions.
A violation of the subscription agreement for the investment might provide a basis for a securities fraud charge, but that would depend on the terms of the contract and might not establish the purchase or sale element for a claim.
The Dodd-Frank Wall Street Reform and Consumer Protection Act mandates that domestic hedge funds managing more than $150 million in assets register with the S.E.C. as an investment adviser, which will bring these firms under the Investment Advisers Act, including its broad antifraud provision in Section 206(a) prohibiting any scheme or artifice to defraud a client. That registration requirement does not go into effect until July 2011, however. And since Harbinger was not an investment adviser at the time of the conduct under investigation, it could not be accused under that provision.
Harbinger is required to report certain information about its investment holdings to the S.E.C. as an “institutional investor,” but that disclosure obligation does not appear to be relevant to the current investigation.
In addition, neither Harbinger nor Mr. Falcone is registered with the Financial Industry Regulatory Authority, so even that avenue for pursuing a regulatory disciplinary proceeding is not available.
The S.E.C. need not establish its jurisdiction over a person or company before initiating an investigation of possible violations, but whether it can pursue an enforcement action against Harbinger or Mr. Falcone remains to be seen.
There may be narrower, more technical rules that apply to the firm that could be the basis for pursuing a civil enforcement action, but it looks as if it may be difficult to find a jurisdictional basis in the conduct identified so far to file a complaint alleging a securities fraud.
If the S.E.C. could not bring an action for jurisdictional reasons, then the more likely vehicle for pursuing the case would be under the broad federal mail and wire fraud provisions. Unlike Section 17(a) and Section 10(b) that only apply when a security is bought or sold, the federal criminal statutes only require some use of the mails – or an interstate delivery service – or an interstate wire transmission, both of which are easily proven when a financial firm’s communications with its clients are at the heart of the inquiry.
The disclosure that the Justice Department is also involved in the investigation means that if a strong enough case can be established, then, oddly enough, the easier route to pursuing it could be a criminal charge, at least insofar as the jurisdictional issue is concerned.
The higher burden of proof for a criminal proceeding, however, means that charges for mail or wire fraud would require investigators to uncover significant evidence of deception by Harbinger and Mr. Falcone to pursue a case.
Mr. Falcone told DealBook on Friday that the $113 million loan, much of which has already been repaid, was vetted by outside counsel from Sidley Austin. That means it will be harder for prosecutors to establish any type of fraudulent intent even if there were disclosure problems related to the transaction.
Favoring some investors over others sounds more like a breach of contract claim that would be pursued in a private lawsuit, but if there was a significant benefit to Harbinger then that might be the basis to build a case showing how investors were defrauded.
The investigation is at an early stage, with no word yet whether subpoenas have been issued by the S.E.C. or a federal grand jury, which often indicates a more advanced inquiry.
Depending on what is turned up, there is a reasonable chance that the conduct does not come within the S.E.C.’s jurisdiction, and bringing criminal charges would not be easy, especially against a defendant with very deep pockets.
Update: Several readers have pointed out that the S.E.C. could pursue a fraud case against Harbinger for fraud under Section 206 of the Investment Advisers Act because that provision also reaches unregistered investment advisers. A key issue would be whether the agreements with investors prohibited the loan to Mr. Falcone or were violated regarding any redemptions, and proving a violation requires the S.E.C. to show an intent to defraud.
http://dealbook.nytimes.com/2010/11/15/hurdles-ahead-in-the-harbinger-inquiry/
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