How Phil Falcone Won The Battle Against Goldman, But Lost The War (Or How Not To Manipulate Bonds)

As part of the SEC's consent order with Harbinger's Phil Falcone, we learned that in addition to the previously well-known stuff Falcone was engaging in (using the fund as his taxpaying piggybank, giving preferential gating terms to "friends and family", etc), perhaps what really scuttled the once legendary hedge fund manager is what ended up being an outright war with Goldman, when back in 2006 Harbinger tried to not only take the other side of a short bet put on by Goldman, but literally squeezed Goldman and its clients into absolutely misery with the result millions in profit to Falcone and unknown losses to Goldie. And as one knows, you never fight Goldman and win, without ultimately losing everything.

Read on, if for no other reason than to know how not to manipulate a short squeeze when Goldman (which just happens to be your prime broker) is on the other side.

The narrative from the SEC:

Early Transactions

Between April and June 2006, Falcone and the other Defendants purchased 108 million MAAX junior discount bonds (the “MAAX zips”), which constituted about 63% of the issue, for Harbinger Capital Partners Master Fund I (“Master Fund”).

During the summer of 2006, Falcone heard rumors that Goldman Sachs, & Co. (the “Financial Services Firm”), a Wall Street financial services firm that provided prime brokerage services to the Master Fund, was shorting the bonds and encouraging its customers to do the same. Prime brokers provide a special group of services to certain clients, often hedge funds, including services such as securities lending, leveraged trade execution, cash management, and margin arrangements.

Defendants’ Actions

In September and October 2006, Falcone retaliated against the Financial Services Firm [i.e. GOLDMAN] for shorting the MAAX Zips by causing the Master Fund and the newly created Harbinger Capital Partners Special Situations Fund (“Special Situations Fund”) to purchase all of the remaining outstanding MAAX zips in the open market. (The Master Fund and the Special Situations Fund are collectively referred to hereinafter as the “Harbinger funds.”)

By October 24, 2006, the Harbinger funds had purchased more than the available supply of bonds—its position stood at 174 million notes in a 170 million note issue.

Contemporaneously with these purchases, Falcone and the other Defendants arranged for the transfer of the 5027 Harbinger Defendants’ MAAX positions from its prime brokerage accounts to a custodial account in a bank in Georgia. The principal purpose and effect of this was that it prevented the bonds from being lent out or used to cover short positions.

Falcone and the other Defendants then demanded that the Financial Services Firm settle its outstanding MAAX transactions and deliver the securities it owed. Defendants did not disclose at the time that it would be virtually impossible for the Financial Services Firm to acquire any bonds to deliver, as nearly the entire supply was locked up in the Harbinger funds’ custodial account and the Harbinger funds were not offering them for sale.

Even though he had already purchased more than the available supply of bonds, Falcone and the other Defendants continued to cause the Harbinger funds to purchase the MAAX zips from apparent short sellers—taking the long side of short sales in the open market. By late January 2007, the Harbinger funds had acquired another 18 million MAAX notes, increasing their holdings to 113% of the issue. By this point, the Harbinger funds had purchased 22 million more bonds than had ever been issued. The total cost of the MAAX position was approximately $90.7 million.

Due to Falcone’s and the other Defendants’ interference with the normal interplay of supply and demand, the bonds more than doubled in price during this period.

In the spring of 2007, Falcone and the other Defendants ratcheted up the pressure on the Financial Services Firm by paying off the Harbinger funds’ margin debt to the firm and demanding the return of any securities, including the MAAX zips, which it had borrowed. In an effort to meet its obligations to the Harbinger funds, the Financial Services Firm bid daily for the bonds, but could not find any to purchase.

In May 2007, the Financial Services Firm approached the 5027 Harbinger Defendants and asked if it had any MAAX zips to sell. Defendants replied that the Harbinger funds had such bonds and that the Financial Services Firm could have them at the price of 100, or par, despite the fact that the bonds had been selling at a deep discount to par. At the time of the offer, MAAX was in a dire financial condition, and the Harbinger funds were carrying the notes on its books at a price of 65.

On July 31, 2007, Defendants sold a block of the Harbinger funds’ MAAX zips in the open market, effecting settlement from a short seller at 95—a price that resulted from the Harbinger funds’ ownership of more than 100% of the issue. The same day, Falcone directed that the price of Harbinger funds’ MAAX zip bonds be marked down from 55 so that they were carried on the funds’ books at a price of

In late September 2007, the Financial Services Firm called Falcone to try to resolve the MAAX situation. During that conversation, Falcone claimed that a price at or above par for the MAAX bonds was reasonable and tried to induce the Financial Services Firm to buy-in the outstanding MAAX short positions at a price of 105. At the end of the conversation, Falcone informed the Financial Services Firm—for the first time—of the material fact that the Harbinger funds had acquired more than the whole issue of the MAAX zips. This was the first time anyone outside of the 5027 Harbinger Defendants knew the size of the funds’ MAAX position. Several days later, the Financial Services Firm informed Falcone that the firm could make no further bids for the MAAX zips as long as the Harbinger funds’ position in the MAAX zips was larger than the number of bonds issued. The Financial Services Firm refused to pay the prices asked by the 5027 Harbinger Defendants.

On December 24, 2007, in response to the Financial Services Firm’s concerns about the size of the Harbinger funds’ position in the bonds, Falcone and the other Defendants directed the funds to sell 25 million face amount of MAAX zips for $0.01 per $100 face amount (for a total of $2,500) to an off-shore retail account at a brokerage firm through a trader at an inter-dealer broker. The trader, who had a longstanding relationship with Falcone, executed the trade using trading discretion he had over the off-shore account. The brokerage firms involved in the transaction did not report it. For the next year, the trader made no effort to sell the bonds in the open market. Thus, the 25 million in MAAX zips were effectively unavailable to cover short positions in the bonds. As a result, while the sale of the 25 million in MAAX zips allowed Defendants to argue that they had reduced the Harbinger funds’ ownership position below the total issue of MAAX zips, the sale did not diminish the impact of their ownership of MAAX zips.

At the end of the month, Falcone directed the Harbinger funds’ investment adviser to write off the MAAX position as worthless. Falcone and the other Defendants, however, continued to press the Financial Services Firm to deliver the securities it owed.

In the first week of January 2008, Falcone informed the Financial Services Firm that the Harbinger funds had sold some of the MAAX notes and that their ownership position was below the total issue size. Falcone refused to identify the party to whom the Harbinger funds had sold the 25 million notes or give the Financial Services Firm any details of the transaction. The Financial Services Firm resumed bidding for the notes, but again could find none to deliver.

On January 11, 2008, the Financial Services Firm learned of two transactions in the MAAX zips at prices in the $60 range. In order to cover outstanding short positions, the Financial Services Firm purchased one million MAAX zips in the $60 range. When the Financial Services Firm subsequently learned that it had purchased the notes from the Harbinger funds, it became concerned that the $60 price was the product of the 5027 Harbinger Defendants’ control of the position and again suspended the firm’s trading in the security.

Between March and November 2008, the 5027 Harbinger Defendants adjusted or cancelled all of its unsettled MAAX trades.

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And when the Financial Services Firm, aka Goldman, learned Falcone had taken it for the proverbial ride... well, the rest is history.

Oh, and since Harbinger owned 113% or more than the entire issue, that means Goldman was naked shorting MAAX. But we'll let that slide: last thing we want to do is bring attention to what the real crime here was...