How Harbinger admissions to SEC will impact investors’ class action

By Alison Frankel
August 20, 2013

For the last, oh, 40 years or so, white-collar defense lawyers have been telling the Securities and Exchange Commission that their corporate clients would never agree to settlements that required them to admit wrongdoing because of the collateral effect of such admissions in private class action litigation with investors. Businesses can stomach paying millions of dollars in penalties and disgorgement to the SEC, the theory goes, but their gorge rises at the prospect of paying billions in damages to class action plaintiffs because they can’t contest liability. The SEC was content for decades to leave that assertion unchallenged, permitting defendants to resolve its allegations without admitting or denying their misconduct. That all changed in June, when, as you know, SEC Chair Mary Jo White announced a new policy: In the most egregious cases, the SEC would demand an admission as a condition of settlement.

The agency’s policy change occasioned a lot of speculation about how admissions to the SEC would impact investor class actions, and how defendants and their lawyers might try to mitigate the harm. Now, however, we’ll get some actual answers. SEC lawyers obtained their first admission under the agency’s new policy on Monday, when the hedge fund Harbinger Capital and its founder Philip Falcone not only agreed to pay $18 million in fines and penalties but also agreed to admit to the SEC’s recitation of misconduct. And now securities class action lawyers in a 2-year-old case brought by investors in Harbinger feeder funds are deliberating about the best way to use those SEC admissions in their suit, in which U.S. District Judge Alison Nathan of Manhattan is considering Harbinger’s motion to dismiss.

Unfortunately for the rest of the securities bar, the Harbinger class action isn’t a perfect vehicle to test the effect of SEC admissions. For one thing, the case involves hedge fund investors, not shareholders of a public company; so, as Evan Stewart of Zuckerman Spaeder told my Reuters colleague Emily Flitter, Falcone and his Harbinger have “a different magnitude of exposure” than a publicly traded corporation. Nor does the litigation assert classic federal securities fraud claims, but rather state-law fraud, negligence and breach-of-duty causes of action. As a result, the suit raises some unusual procedural issues, including defense arguments that the class action is precluded by the Securities Litigation Uniform Standards Act, as well as a conflation of direct claims that feeder fund investors were defrauded and indirect claims that Falcone breached his fiduciary duty to Harbinger. Moreover, many of the investors’ allegations involve Harbinger’s supposed misrepresentations about its investment in the now-bankrupt wireless broadband company LightSquared. The SEC’s settlement with Falcone and Harbinger does not even mention LightSquared, so investors certainly can’t argue that the defendants have admitted liability for statements related to that investment.

All that aside, the case should provide some early clues about whether SEC admissions have dire follow-on consequences in private litigation. Investors’ counsel at Zamansky & Associates and Girard Gibbs have put forth many of the same allegations found in typical securities class actions, asserting “a pattern of misconduct, mismanagement and disregard for investor interests that ultimately resulted in billions of dollars of losses for the fund’s investors.” That misconduct, according to their opposition to Harbinger’s motion to dismiss, included Harbinger’s failure to inform investors of the conduct at the heart of the SEC’s enforcement action: that Falcone used $113 million in hedge fund assets to pay his personal taxes; that Harbinger made secret side deals with preferred investors that permitted them to redeem their money more easily; and that Falcone used Harbinger money in a “short squeeze” bond market manipulation scheme to get back at Goldman Sachs. In fact, the plaintiffs’ 15-page appendix of alleged misrepresentations by Harbinger and Falcone lists those three omissions before any supposed misstatements about the LightSquared investment.

In the SEC consent, Falcone and Harbinger admitted to all of the conduct the SEC alleged, so you can be sure the feeder fund investors will argue that the defendants have conceded liability for failing to inform investors. (Lead counsel Jake Zamansky told me he and co-counsel are discussing their options for informing Judge Nathan about the admissions in the SEC settlement and have not yet made a decision about how to proceed.) In that regard, this case could make important law on the collateral estoppel impact of SEC admissions.

We’ll also see how successfully the Harbinger defendants’ counsel in the SEC case, Matthew Dontzin of Dontzin Nagy & Flessig, insulated his clients from harm in the private litigation. The SEC consent says that admissions by Falcone and Harbinger preclude the defendants from denying their conduct in the agency’s case – but do not dictate the positions they may take “in litigation or other legal proceedings in which the Commission is not a party.” It appears from that language that the SEC agreement does not bar the Harbinger defendants from attempting to contest liability in the investor class action. The SEC consent also says that the Harbinger defendants “acted recklessly” but does not say they acted with the intent to defraud. In the private case, feeder fund investors and Harbinger defendants disagree on the appropriate standard of scienter, with plaintiffs advocating for a New York state-law standard and defendants calling for the federal standard. I suspect that if the class action proceeds, the implications of the word “recklessly” will be the subject of considerable debate. I also suspect that if Judge Nathan determines that an admission of recklessness doesn’t prove scienter, we’ll see future SEC defendants bargain for the same language as Harbinger.

For the purposes of deciding Harbinger’s motion to dismiss, the judge is supposed to accept the truth of the feeder fund investors’ allegations, so the defendants’ SEC admissions shouldn’t have a huge impact on her analysis of the motion presently before her. That will come later, if she permits investors to move forward, and may affect not just liability but also damages. Harbinger has argued that investors haven’t even alleged that they were injured by the conduct at issue in the SEC case. The investors say they lost money because Falcone and Harbinger damaged the reputation of the funds. Class counsel Zamansky told me Tuesday that the SEC’s recovery should not detract from the class’s potential recovery because it did not come in the form of restitution but as a fine, penalty and interest.

The Harbinger defendants are represented in the class action by Paul, Weiss, Rifkind, Wharton & Garrison, which declined to comment. Falcone’s SEC defense counsel Dontzin referred my call to a Harbinger representative, who declined to comment.

(Reporting by Alison Frankel)

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