This
year, the SEC brought a civil action against Harbinger fund manager
Philip Falcone for creating a short squeeze. The
SEC alleges that Falcone and two Harbinger investment management
entities he managed manipulated the market in distressed high-yield
bonds issued by MAAX Holdings Inc.
The
SEC alleges that Falcone and the Harbinger entities orchestrated an
illegal “short squeeze” – a market manipulation scheme in which
an investor constricts the supply of a security, through large
purchases or other means, with the intent of forcing settlement from
short sellers at arbitrary and inflated prices.
The
SEC’s complaint alleges that at Falcone’s direction, Harbinger
purchased a large position in the MAAX bonds during April and June of
2006. After hearing rumors that a Wall Street financial services firm
was shorting the MAAX bonds and also encouraging its customers to do
the same, Falcone decided to seek revenge. In September 2006, Falcone
directed the Harbinger-managed funds to buy every available bond in
the market, often purchasing the bonds from short sellers.
Ultimately, Falcone owned 13% percent more than the supply of the
bonds.
At
the time of these purchases, Falcone locked up the MAAX bonds the
Harbinger funds had purchased in a custodial account at a bank to
prevent his brokers from lending out the bonds to short sellers.
When
he had control of the supply of the MAAX bonds, Falcone then demanded
that shorts settle their outstanding short sales, but did not
disclose that it would be virtually impossible to find bonds for
delivery. The Wall Street firm bid daily for the bonds, which quickly
doubled in price.
Falcone
then engaged in a series of transactions with certain short sellers
at arbitrary, inflated prices, while at the same time valuing the
funds’ holdings on his books at a small fraction of the prices he
charged the covering short sellers.
To
re-state the pattern here, the SEC found it unlawful to (1) buy up
more than the outstanding issue, (2) put the bonds out of reach of
the short sellers so they could not borrow the securities, (3)
execute a buy in, and (4) demand much higher prices than the value of
the securities.
We
do not defend Falcone or this pattern of actions. However, this case
raises several interesting issues, mostly issues of how to determine
what conduct is prohibited. These are questions of degree – how far
can you go?
First,
do not see any mention by the SEC of a case against the short sellers
in this case who were obviously knowingly executing illegal naked
short sales. Do these illegal shorts have the right to sue Falcone
for manipulation and get damages? Are not Falcone's actions a form of
poetic justice on the shorts?
Second,
Falcone clearly had the right to buy securities – is it the SEC's
viewpoint that buying more than the outstanding issue is improper?
Would buying more than the outstanding issue be improper by itself or
are more actions needed to create an actionable case? Can you buy the
100% and then quit? Wouldn't buying a large amount of the
outstanding, for example 80% create a squeeze? If it did create a
squeeze, would that be illegal?
Third,
investors clearly have the right to buy in those who do not deliver
securities they have sold. Is it actionable to buy in the securities
in pursuit of a short squeeze and if so at what point does this
become a short squeeze? Do you have to own more than the outstanding
issue of securities or is owning some vast majority enough to be a
“short squeezer” and be denied the right to buy in?
Fourth,
property owners generally have the right to sell their property at
whatever price they choose. At what point is it improper for Falcone
to charge high prices to short sellers? Could he sell at at 5%
premium to the market? At a 25% premium? Did he have to sell at all –
can he be forced to sell his own property? What if he had simply sold
in the market instead of making private deals with the shorts?
Fifth,
the squeeze hurt those firms that made improper naked short sales.
Presumably, any bond holders other than Falcone profited by his
purchases and squeeze. Are his actions a fraud on the market or just
on the shorts? Didn't the shorts know that they ran the risk of being
squeezed?
Sixth,
Falcone did not announce that he owned more than the outstanding
issue, did not announce he was making the securities unavailable to
borrow, or otherwise make public information on his actions. To what
degree and under what rules is he bound to make such information
public? If he had said, “I plan to buy up more than the
outstanding, refuse to lend such securities, buy in the bonds and
only sell at higher than market prices to punish illegal short
sellers,” would he then be permitted to do so? Under what rules is
such disclosure required and if generally required, what disclosure
is sufficient? What if he bought up the bonds without thought of a
short squeeze and then later decided to buy them in?
In
summary, we are left without clear guidance as to what actually
constitutes “manipulation.” This lack of guidance is deliberate
and beneficial. If a bright line test is created, manipulators will
find it easy to game the rules. Leaving it vague gives the regulators
discretion to act in new cases.
In
this case, Falcone's actions put the price of the bonds at
unconscionable levels. That would seem to me to be manipulative.
