Falcone Punch

Long Lost Tale of an Illegal Short Squeeze

Those of you who have made your way over to Cap Stack and hit the Subscribe button are probably already familiar with short selling.

You sell something you don’t own by borrowing it, with the hopes that when the price falls you can buy it back for less than what you paid and return it to its rightful owner.

A “naked” short is when you sell short an asset without borrowing it from someone else. That means you aren’t sure you’ll be able to find the asset and deliver it in time. Assets facing a surge in demand or have few sellers could be difficult to purchase or borrow. Naked short selling is generally considered illegal in the U.S., but it can slip through the cracks.

Before we get into why we’re telling you all this, let’s travel back in time.

Philip Falcone was born in a small-town in Minnesota in a household of 9 children. He went to Harvard on a hockey scholarship and started his career on Wall Street in high-yield bond trading at investment bank Kidder Peabody.

After rising up the ranks at Kidder Peabody, Falcone went on to work at Wachovia and Barclays where he honed his craft trading distressed debt.

The late ‘90s and early 2000s provided ample opportunity in the distressed space. The Asian Financial Crisis began in July 1997, starting in Thailand and spreading to other East Asian economies. These economies faced severe currency devaluation, a collapsing stock market and widespread bankruptcies.

This crisis reduced demand for crude oil, a key export for Russia, a country that was already facing economic challenges of its own. In 1998, the Russian economy collapsed in what’s known as the Ruble crisis. In addition to a devaluation of the Russian Ruble, Russia defaulted on domestic debt. Inflation skyrocketed and living standards plummeted. This led to the resignation of President Boris Yeltsin in December 1999 and brought Vladmir Putin into power.

From 1998 - 2000, Falcone was managing high yield trading and distressed at Barclays. By 2001, Falcone was ready to go off on his own and started a hedge fund called Harbinger Capital with a $25mm investment from Harbert Management.

According to Forbes, Falcone took home $1.7B after betting against the housing market in 2007. In 2008, Harbinger was up 43% by the end of June. The fund’s AUM peaked at $26B. By the end of November, the fund was down 23% for the year and redemptions were restricted.

In 2012, Falcone and Harbinger were charged with securities fraud by the SEC for “illicit conduct that included misappropriation of client assets, market manipulation, and betraying clients.”

Apparently, Falcone borrowed $113mm from his hedge fund to pay personal taxes. Oops!

Despite the entertainment value of exploring this maneuver, it’s not the reason for today’s post. Today’s post is also not about his little redemption scheme that benefitted certain investors over others, and not even the billions of dollars he torched in his investment in telecom company LightSquared.

What we’d like to bring into focus is that the SEC also alleged Falcone and two of his deputies manipulated a series of distressed high-yield bonds by engaging in an illegal “short squeeze.”

From 2006 to early 2008, the folks over at Harbinger constricted the supply of bonds issued by MAAX Holdings, a distressed manufacturer of bathroom products (we will refrain from making a snide remark here). Harbinger had built up a large position in MAAX bonds which were subsequently shorted by a “Wall Street financial services firm” (*ahem* Goldman). Apparently, Falcone decided to “seek revenge” and bought every bond on the market, including from shorts.

Harbinger owned 13% more than the total available supply of MAAX bonds. They had purchased more bonds than MAAX had ever issued. Then, Falcone locked the bonds in a custodial account so his brokers couldn’t lend them out.

If that wasn’t enough, Falcone demanded that shorts settle (deliver) the bonds. When the short sellers went out into the market to find bonds, they learned they weren’t available. As shorts bid for the bonds, the price shot up. He started wheeling and dealing with shorts and selling at high prices.

We have dubbed this (illegal) move:

Falcone… Punch!!!!

Why are we bringing up a 10 year old story?

A headline from 2011 reads “Phil Falcone: This Generation’s Carl Icahn.” Whether it was a puff piece, or written by an overzealous intern at Business Insider, this headline may end up being unintentionally prescient.

Earlier this month, short sellers Hindenburg Research shorted Icahn Enterprise’s (IEP) bonds. This comes after Hindenburg accused IEP of being ponzi-like. These bonds don’t trade much, and there’s high short interest.

To be clear, we’re not insinuating Icahn is engaging in a Falcone Punch (since of course, that’s illegal). The dynamics at play here (high short interest, low availability) could create quite the short squeeze in IEP bonds.

We’re taking a closer look at IEP out of personal interest. If you want us to write up a deep dive, drop us a like/comment or give this article a share to let us know.

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Disclaimer: We are not financial advisors. This content is for educational purposes only and merely cites our own personal opinions. All analysis, including valuation, debt, liquidity, etc. is illustrative in nature and subject to revision.