On August 19, 2013, in connection with its entry into a settlement with New York-based hedge fund adviser Phillip Falcone and his advisory firm Harbinger Capital Partners, the SEC for the first time implemented its new policy requiring defendants seeking to settle civil enforcement actions to provide admissions of wrongdoing, in contrast to the long-standing practice of allowing defendants to resolve the enforcement actions with a “neither-admit-nor-deny” settlement.


The SEC’s new policy requiring – in “egregious” cases — admissions wrongdoing in order to settle an enforcement action not only has important implications for the enforcement action itself, but potentially also has important implications for other related civil or criminal proceedings. Another issue that inevitably will also arise is the question of the impact of factual admissions on the availability of D&O insurance for related defense expenses and indemnity.


In June 2012, the SEC filed an enforcement action against Falcone and various Harbinger entities alleging that in October 2009, Falcone had used $113 million in fund assets to pay his personal taxes; that he had favored certain fund customers’ redemption requests at the expense of other investors; and that he had conducted an improper “short squeeze” in the bonds of financially troubled Canadian manufacturing firm.


The SEC and the Harbinger defendants, including Falcone, had actually reached an earlier agreement to settle the enforcement action. In May 2013, the agency and the defendants reached a settlement in principle to resolve the case. That earlier settlement agreement reflected the traditional “neither admit nor deny” approach. However, in July 2013, the SEC advised Harbinger that the SEC Commissioner has voted to reject the deal. The vote apparently reflected the SEC’s new policy, announced in June by new SEC Chair Mary Jo White, that going forward the SEC would require defendants settling enforcement actions to admit wrongdoing, at least in “egregious” cases.  


In connection with the revised settlement announced on August 19, Falcone and the Harbinger entities agreed to extensive admissions of wrongdoing. The factual admissions are set out at length in detailed Annex to a Consent that Falcone signed on August 16 on his own behalf and on behalf of the Harbinger entities. The admissions are also set out verbatim in the proposed Final Consent Judgment that was filed with the Court. Pursuant to the settlement, the Harbinger entities agreed to pay a total of over $18 million in disgorgement, civil penalties and interest. As part of these payments, Falcone himself must pay over $11.5 million. Falcone also agreed to a five-year ban from the securities industry.


The factual admissions detailed in the Annex and incorporated into the Final Consent Judgment make for some interesting reading. Among other things, the factual recitations detail that Falcone did not just walk down the hall and pull $113 million out of one of the Harbinger funds to pay his taxes, as if he were taking money out of a piggy bank; the transaction was actually suggested to Falcone by a prestigious outside law firm that counseled Falcone and Harbinger. The law firm prepared an extensive power point presentation proposing the transaction and also prepared a written loan agreement documenting the loan.


The admissions also detail the “short squeeze” Falcone orchestrated in connection with the bonds of MAAX Holdings, a Canadian manufacturing company. In a series of moves that seemingly defy the laws of physics, Falcone and the funds “purchased more than the available supply of bonds” (accomplishing this seemingly impossible feat by taking the long side of short sales in the open market). By capturing the supply of the MAAX bonds, Falcone and the Harbinger funds prevented Goldman Sachs from covering a short position that the investment bank held in the MAAX bonds.


The Consent also contains another of other provisions to which Falcone and the Harbinger defendants also agreed. Among other things, the defendants agreed that they “shall not seek or accept, directly or indirectly, reimbursement or indemnification from any source, including, but not limited to, payment made pursuant to any insurance policy, with regard to any civil penalty amounts” paid pursuant to the Final Consent Judgment.


The Harbinger Defendants also “acknowledge” in the Consent that “no promise or representation has been made by the Commission … with regard to any criminal liability that may have arisen or may arise from the facts underlying this action.”


The defendants also agreed that they “will not make or permit to be made any public statement to the effect that the Harbinger Defendants do not admit the allegations of the complaints, or that this Consent contains no admissions of the allegations.” However, the Consent also goes on to state that nothing in this agreement affects the defendants “right to take legal or factual positions in litigation or other legal proceedings in which the Commission is not a party.”


The admissions in the Consent are comprehensive – the defendants basically admitted all of the SEC’s allegations. Moreover, it appears that in pursuing its new settlement approach, the SEC will be requiring other defendants to provide similar admissions in order to settle SEC actions against them. For example, there are reports that the agency is seeking to require J.P Morgan to provide admissions of wrongdoing in connection with the agency’s actions against the firm in connection with the “London Whale” cases.


The SEC’s apparent requirement for admissions of wrongdoing in at least some cases has a number of significant implications. First and foremost, it means that, at least in the SEC enforcement actions where the agency will require admissions in order to settle that the cases will be much harder to settle. The defendants, wary of the possible impact the admissions could have in other proceedings, will be reluctant to provide admissions. One consequence of the new policy could be that the SEC will be compelled to try more cases, which could strain the agency’s resources.


The provision of the admissions potentially could have enormous consequences for related proceedings. The recitation in the Consent that the Harbinger defendants have been provided no assurances about the possibility of criminal proceedings has to be particularly chilling, especially for Falcone. The admissions in the Consent may or may not suffice to draw criminal charges, but at least some commentators have suggested that criminal charges could follow.


Another question that follows from the Harbinger defendants’ admissions is the collateral effect the admissions could have in related civil proceedings. As it happens, there is a pending civil action that Harbinger investors had filed against Falcone and the funds that could provide an early test of the civil litigation collateral estoppel consequences of admissions in an SEC enforcement action. In an interesting and detailed August 20, 2013 post in her On the Case blog (here), Alison Frankel examines the possible impact that the admissions could have on the fund investors’ pending civil action. As her post explains, the pending action may not be the perfect test of the admissions’ preclusive consequences, as the civil action is not filed under the federal securities laws and also largely relates to matters other than those involved in the SEC enforcement action. Nevertheless, the admissions could have an important impact on the case and bolster the plaintiffs’ allegations.


An issue that occurs to me is the question of the impact of the admissions on the availability of D&O insurance. The specific question is whether or not admissions of the type that the Harbinger defendants provided in the SEC settlement are sufficient to trigger the fraud and criminal misconduct exclusion in the D&O policy. The wording of these exclusions varies, but they typically preclude coverage for loss arising from fraudulent or criminal misconduct, but only after a final adjudication determines that the preclusive conduct has taken place. If the admissions were found to be sufficient to trigger this exclusion, coverage would no longer be available for the wrongdoer, and the insurer could even have the right to try to recover amounts that had already been paid (for example, the attorneys’ fees the wrongdoer incurred in defending himself or herself in the SEC proceeding).


On the one hand, there would seem to be some reason to be concerned that a settlement of the type that the Harbinger defendants entered into represents a “final adjudication.” The specific factual admission to which the defendants agreed were not only stated in the public court record, but they are incorporated verbatim into the Final Consent Judgment filed with the court. Upon the Court’s entry of the Judgment, there would seem to be grounds upon which it could be argued that there had been a final adjudication.


On the other hand, there would appear to be a substantial question whether the specific admissions to which the Harbinger defendants agreed rise to the level to satisfy the exclusion’s misconduct requirement. While the admissions represent an extensive concession that the defendants engaged in wrongdoing – and while the admissions expressly recite that the defendants acted “improperly” and “recklessly” — at no point to the defendants admit to “fraud” or to any other level of conduct that would expressly trigger the typical D&O policy’s conduct exclusion.


A related issue that could arise is the question of exactly how bound the admitting parties are by their admissions. The Harbinger defendants’ Consent specifically recites that nothing in the agreement affects the defendants “right to take legal or factual positions in litigation or other proceedings or other legal proceedings in which the Commission is not a party.” In effect, the Harbinger defendants seemed to have tried to preserve the right to argue that while they made certain admissions for purposes of the SEC enforcement action, they did not make those admissions for all purposes and for the benefit of all other parties who might seek to rely on them. The Harbinger defendants might well argue that notwithstanding their admissions in the Consent, they have the right to contest the factual matters in other proceedings, including for example, in the context of an insurance coverage dispute. 


The Harbinger settlement represents a significant development with important potential implications for other defendants in SEC proceedings. The admissions that these defendants may be required to provide in order to settle the enforcement action pending against them could have important collateral consequences, many of which at this point remain uncertain. The impact of these kinds of admissions in related civil cases remains to be seen. Among other questions that likely will also have to be addressed is whether admissions of this type have any impact on the continued availability of insurance coverage for the defendants that provide these kinds of admissions. 


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