The inside story of a Wall Street battle royal (cont.)

By Bethany McLean, Fortune editor-at-large

Fairfax fights back

On July 26, 2006, Fairfax filed its lawsuit alleging stock manipulation. But if there was a "Fairfax Project" to sink the stock, it hadn't been very successful. At the time the lawsuit was filed, Fairfax's stock was at about $115, more than double its lows from the spring of 2003 and well above its price at the time Fairfax says the campaign began.

One reason is that Fairfax never lost the support of its big investors. From 2003 through today, Fairfax has raised more than $1.5 billion by selling debt and equity in itself and its subsidiaries. A chunk of the buying has come from a group of longtime Watsa supporters, including Mason Hawkins, the widely respected head of Southeastern Asset Management, and firms controlled by Canada's Power Corp. Southeastern and Power now own more than 50 percent of Fairfax's stock. (Southeastern declined to comment; Power Corp. did not return calls.)

Ironically, if not for the short-sellers, Fairfax's stock might be much lower. A thinly traded, heavily shorted stock like Fairfax's can skyrocket if, for instance, investors who have lent their shares to short-sellers recall them, forcing the short-sellers to find another source of shares to borrow or buy stock to cover their positions.

While Fairfax charges that the defendants have reaped "immense, ill-gotten profits," at least some defendants claim the opposite is true. Exis Capital Management's lawyer David Zensky says that his clients never realized any gains on their short position in Fairfax and in fact have booked substantial losses. Others who have been short Fairfax's stock since the beginning of this decade have lost small fortunes.

The timing of the suit was curious. Kasowitz says that Fairfax filed suit to prevent a "massive attack. We were a day or two away from something very bad happening to the company."

But there may be another explanation. On July 27, just one day after it sued, Fairfax announced that it was working on an extensive restatement of its financials from 2001 to the present. Watsa said that Fairfax would have to reduce shareholders' equity by $225 million to $240 million (or about 7 to 8 percent) as of March 2006 because of accounting errors. Watsa called it a "very embarrassing" moment. But all the headlines were dominated by the lawsuit, and Fairfax's stock only dipped slightly.

In August, when Fairfax did restate its results, the new filings included warnings from both Fairfax's management and its auditors that they had found a number of "control deficiencies" that "could result in misstatements of any of the company's financial statement accounts." (Fairfax says it is "continuing to remediate the material weaknesses.")

A few months later there was another odd coincidence. On Nov. 7, Contogouris filed his own lawsuit against several Fairfax subsidiaries, PricewaterhouseCoopers and Sitrick, laying out his case against Fairfax. Then, on the evening of Nov. 13, Contogouris was arrested. In essence, the criminal complaint tells one side of the civil case between Contogouris and the Greek family for whom he worked, which dates back to 2002.

The next day Fairfax stock rose 10 percent. There's no connection between the criminal charges against Contogouris and Fairfax - but they had an effect. "I think people didn't believe what was in the [Fairfax] lawsuit until Spyro got arrested," says A.M. Best's Sharaf. "Then everyone said, 'Wow. This is true.'"

Fairfax's stock continued to soar, hitting over $200 in late 2006. Kasowitz says this is proof that Fairfax disrupted a conspiracy. The lawsuit "caused these people to restrain themselves," says Kasowitz. That, at least, is true. Contogouris has taken his lawsuit off his Web site and put out a note saying that at the behest of his lawyers, he would no longer analyze stocks. Gwynn also stopped covering Fairfax, citing a "litigation strategy designed by Fairfax to silence negative research."

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.