Fairfax gets a dose of short medicine

NEW YORK (Fortune) -- Back in 2006, Fairfax Financial Holdings (FFH), Canada's largest publicly traded insurance firm, filed suit against a group of short-sellers, investors who'd bet that the company's share price would decline. The suit alleged that the sellers had illegally conspired with analysts to drive down Fairfax's stock price.

Now it's emerged that the company itself may be no stranger to the intricacies of short-selling. In fact, if legal papers filed by a New York hedge fund against Toronto-based Fairfax are accurate, the insurer has benefited mightily from some well-timed short-selling in the not-too-distant past. Institutional Credit Partners (ICP), manager of $13 billion in various asset-backed and credit-default swap strategies, laid out these allegations in a counter-complaint filed Friday in New Jersey superior court.

The legal feud between ICP and Fairfax is bitter; Fortune's Bethany McLean wrote about another aspect of it last November. In June 2007, Fairfax amended its July 2006 suit against several hedge funds to include ICP and its senior portfolio manager Bill Gahan, accusing him and the fund of racketeering. In November, ICP and Gahan fired back, denying that charge, and alleged that it had uncovered a series of puzzling transactions and merely asked a Fairfax board member, Brandon Sweitzer, about "accounting peculiarities."

ICP has acknowledged a longstanding short position - or bet against the decline in value of - the credit default swaps of Fairfax's key subsidiary, Odyssey Reinsurance. And there's nothing illegal about that; many, if not most, hedge funds use short selling strategies - often giving big gains to their investors and headaches to the companies they short. That's probably not the case with Fairfax, however; its stock price was $105.54 on July 26, 2006 when it launched its suit; it closed last night at $317.41. Anyone betting on its decline could have lost not just his shirt, but an entire wardrobe.

What makes ICP's amended claim from last week interesting is that is the first of the 23 named defendants to publicly state why it continues to risk millions of dollars on a decline in Fairfax's financial health. More importantly, it does so using nothing but publicly available documents.

(A disclosure: Both ICP's amended claim, as well as Fairfax's original suit, refer to a series of investigative articles I wrote about the transaction in dispute for the New York Post in the summer of 2006.)

The narrative laid out in ICP's latest claim begins with Fairfax's dreary financial state in the winter of 2003. Like many insurers, Fairfax was wracked from catastrophe losses related to September 11, and had $450 million Canadian dollars worth of debt and interest payments due at the end of the year. Much worse though, was a looming cash crisis. At the end of 2002, Fairfax had C$517.7 million; by March 31, it was down to C$210.4 million. If it sank lower than C$350 million for too long, rating agency downgrades could have conceivably triggered a cut in insurance ratings at its operating subsidiaries, which would have restricted its ability to attract new business.

The company needed cash, and came up with a complex internal plan. According to ICP's claim, Fairfax executives, led by its founder and chief executive Prem Watsa, sought to take advantage of a peculiarity in the U.S. tax code via the purchase of 4.3 million shares of its subsidiaries, Odyssey Re, of which it owned 73.6%. If Fairfax owned 80% or more, Odyssey Re would be considered part of the same tax entity, which would ultimately lower Fairfax's tax bill. Such shuffling of ownerships for tax reduction are a common and legal part of modern multinationals' lives.

The problem, according to ICP's claim, is that Farifax did not have the cash to buy the 4.3 million shares it needed. In addition, buying 4.3 million Odyssey shares in the open market would be difficult, in that it represented about 25% of the 17.1 million shares publicly available.

To get around these roadblocks, ICP claims, Fairfax and its investment banker at Banc of America Securities (BAS), Robert Giammarco, came up with a series of transactions designed to lend the appearance of ownership without having to purchase the securities in the open market for cash. (Giammarco later became Odyssey Re's chief financial officer in 2005; in 2006, he quit and joined Merrill Lynch, where he is now an investment banker covering insurance companies in the financial institutions group.) Banc of America Securities used a Cayman Islands subsidiary, NMS Services Cayman Ltd., to sell short the 4.3 million shares to Fairfax in exchange for slightly more than $78 million in promissory notes on March 3, 2003.

ICP claims, however, that the stock ownership totals did not add up properly. Gahan's team analyzed the relevant Securities and Exchange Commission (SEC) investment manager filings for the March 31, 2003 quarter, which showed that unaffiliated money managers held over 15.8 million Odyssey shares, leaving only 1.3 million shares available for BAS to sell to Fairfax. Thus NMS necessarily delivered the stock to Fairfax via a giant short-sale, which while unusual, was not unheard of. Shirley Norton, a Bank of America spokeswoman, says, "As a matter of policy we don't discuss customer relationships, so we have no comment. [B of A] is not a party to this complaint."

Except, again, Gahan and ICP argue there is a major catch. They point to the monthly New York Stock Exchange short-sale figures for the period between February 15, 2003 and March 15, 2003, which increased by only 557,000 to just over 2.9 million shares from 2.34 million sold short. The ICP claim described this as proof of Fairfax's participation in a "naked short sale of its own subsidiary's stock." (A naked short sale is when an investor bets on the decline of a share price without ever borrowing the shares to be sold.)

At the very least, that claim, if true, is embarrassing to Fairfax. Its chief legal officer, Paul Rivett, has commented in federal filings about the negative effects of naked short-selling. The company also owns 16.5% of Internet retailer Overstock.com, which has launched lawsuits against a short-selling hedge fund, as well as numerous broker-dealers over their alleged role in facilitating so-called share counterfeiting.

In response to ICP's allegations, Fairfax spokesman Seth Faison said, "ICP's amended counterclaim remains nothing more than a weak and transparent effort to distract attention from the racketeering charges against defendants ICP and Gahan. These defendants first disseminated these same false and defamatory accusations over a year-and-a-half ago in, among other places, a series of stories in the New York Post that are a subject of this action. These accusations are baseless and we look forward to our day in court to demonstrate how these defendants have harmed Fairfax through the dissemination of these frivolous accusations."

The thrust of ICP's argument against Fairfax is that at no point did the insurer have true economic ownership of the 4.3 million Odyssey shares. In ICP's claim, these maneuvers allowed Odyssey to shelter $400 million in income over the life of the transaction and enabled Fairfax to receive a life-giving $140 million in cash during 2003 alone. In total, ICP argues in its claim that Odyssey might be on the hook for up to $700 million, which includes $300 million in penalties and interest.

Was Fairfax's transaction legal? When The New York Post asked Fairfax about the transactions in the summer of 2006, Fairfax's Rivett replied that [Fairfax] "had sought and obtained" an IRS ruling attesting to the validity of the transaction prior to doing it. On a July 28, 2006 conference call, CEO Watsa said much the same thing, telling an analyst point-blank, "We had an IRS ruling before we did this."

But did they? ICP says they didn't. The nearest they came to having the ruling, the claim argues, was an IRS opinion of October 29, 2004, 18 months after the deal was done. The IRS opinion actually dealt with a question related to the refinancing of the original March 2003 transaction, not the propriety of the March 2003 transaction itself.

ICP's claim is seeking compensatory and punitive damages, as well as attorney's fees based on intentional infliction of emotional distress, conspiracy and defamation, among other charges. ICP's Gahan declined comment to fortune about the case, saying only, "Our claim will speak for itself."

It's not clear whether the other hedge funds being sued will take ICP's aggressive posture, but they must surely take some comfort in Gahan's recent track record: He and his team are widely credited on Wall Street with uncovering the massive Parmalat fraud and were - along with Pershing Square's Bill Ackman - among the first analysts to question the viability of MBIA's business model.

Needless to say, the markets will likely issue their verdict about Fairfax's financial health long before this winds up in a courtroom.