Hedge fund manager Philip Falcone's LightSquared has lost its main business partner, Sprint Nextel Corp , which returned $65 million in payments to the telecommunications startup.

Sprint said on Friday it will exercise its right to scuttle the $9 billion agreement that would have allowed LightSquared to use a network Sprint is building to sell its own high-speed wireless service.

The development, which was expected, is another setback for LightSquared, but it does provide the company more cash as it fights for survival.

Sprint had the right to back out of the deal if LightSquared failed to get regulatory approval. Regulators said LightSquared's network would interfere with the Global Positioning System used by airlines, the military and others.

Last month, the U.S. Federal Communications Commission proposed to indefinitely suspend LightSquared's authority to use its satellite spectrum for cellular use.

Since then, the company said it would lay off nearly half of its 330 employees. Sanjay Ahuja, a telecommunications industry veteran, also stepped down as chief executive just two weeks after the major blow from regulators.

We remain open to considering future spectrum hosting agreements with LightSquared, should they resolve these interference issues, as well as other interested spectrum holders, Sprint said in a statement.

LightSquared said previously it has just several quarters worth of cash left and the $65 million could help the company fight the FCC's proposal to strip its authority to use its airwaves for a cellular network.

For LightSquared, Sprint's decision will enhance our working capital and provide more flexibility, the company said in a statement on Friday.

FCC URGED TO RECONSIDER

Comments are due on the FCC proposal on Friday.

LightSquared argued that the FCC must exhaust all reasonable alternatives before reaching for the most extreme remedy, as the current proposal is a violation of LightSquared's rights, in comments it plans to file to the FCC on Friday.

The company also asserts that the FCC's proposal is not legally supportable, and that government testing of its network was deeply flawed and biased, according to an executive summary released by the company.

When you have a situation where significant investment was made on longstanding rules, you cannot then have a decision that is completely antithetical to that, Jeff Carlisle, LightSquared's executive vice president for regulatory affairs and public policy, said on a call with reporters.

On the law, on the technology and on the public policy here, those factors should compel the FCC to reexamine the assumptions it made in the public notice, he added.

The company's fate is critical to investors in Falcone's Harbinger Capital Partners, which once controlled $26 billion in assets but is now down to about $4 billion.

A little more than half of Harbinger's money is tied up in LightSquared. The hedge fund is the company's single largest equity investor.

A spokesman for Harbinger said the hedge fund has no separate comment from the one issued by LightSquared.

BATTLE RAGES ON

Clearly LightSquared is focused on spinning out resources as long as possible, and this gives them more cash, Tim Farrar, a veteran industry analyst and principal at TMF Associates, said about Sprint's return of $65 million.

But at the same time, by pushing this situation out further, some of the ability to recover assets in the event of a potential bankruptcy also drain away.

Some industry analysts had speculated that bankruptcy might be the ailing company's only option, but Falcone has steadfastly ruled that out, telling clients he is working on a solution but failing to give many details.

LightSquared has indicated it will not back down in its fight to win approval to build a wireless network. The company hired prominent conservative litigators Theodore Olson and Eugene Scalia - a sign it could be preparing to take the FCC to court.

Olson served as President George W. Bush's solicitor general and was recently named the No. 1 lawyer inside the Beltway by Washingtonian magazine. Scalia, the son of Supreme Court Justice Antonin Scalia, has several victories under his belt in corporate challenges to government policies.

The FCC's proposal to strip LightSquared's authority came after the National Telecommunications and Information Administration, which manages military and government spectrum use, said the planned network would interfere with GPS, and there was no practical way to immediately solve the problem.

LightSquared argued that any interference is a result of poorly designed GPS receivers that their manufacturers should be obliged to fix.

Carlisle said he still believes a resolution that protects GPS and lets LightSquared deploy its network can be reached, but if the FCC decides otherwise, the company is prepared to examine all options.

LightSquared planned to invest $14 billion over the next eight years to build its network, which would be used to sell wholesale wireless services to companies that would, in turn, resell the service under their own brand names.

(Additional reporting by Svea Herbst; Editing by Gerald E. McCormick, Andre Grenon, Gary Hill)

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