Tuesday, February 26, 2008

Correction: Fairfax's ICP Lawsuit

After a lengthy discussion regarding the last post, as well as more research, I have to issue a correction. And unfortunately, things have become much more confusing. I'm assuming in this that people have already read the last post.

First, the initial mistake. I had assumed that the convertible option on the debt would result in newly issued shares. But since it is Fairfax's holding company level which is holding the debt, this is actually not the case. The exchange option into Odyssey Re("ORH") shares must come from Fairfax itself, meaning it would be equivalent to giving back a portion of the shares it had purchased.

At first, I thought that would have still been fine. Based on what Fairfax announced, the first transaction involved the purchase of 4.3 million ORH shares for 78 million in debt and the option to convert into 2.15 million shares. In such transaction, ORH's stock would have had to rise 75% for the convertible feature to even be worthwhile, meaning that it was a legitimate transaction (the reasons for which were spelled out in the previous post).

However, I then ran across conflicting reports. On the one hand, I had the Fairfax press release, which stated that:
Fairfax Financial Holdings Limited, through a subsidiary, has purchased 4,300,000 outstanding common shares of Odyssey Re Holdings Corp. in a private transaction. As a result of this purchase, Fairfax beneficially owns 52,364,400 (80.6%) of the 65,003,963 outstanding common shares of Odyssey Re. As consideration, the subsidiary issued US$78,045,000 principal amount of 3.15% Exchangeable Notes due February 28, 2010 which are exchangeable into 2,150,000 Odyssey Re common shares for two week periods commencing on each of November 19, 2004 and February 16, 2005.
But then I found the SEC documents relating to this transaction, which can be found here and here. They state:
Amendment No. 1 to the Schedule 13D related to the purchase by Fairfax, through a subsidiary, pursuant to a master note purchase agreement, dated as of March 3, 2003, of 4,300,000 outstanding Shares (the "2003 Purchased Shares") in a private transaction. As consideration for the Purchased Shares, a subsidiary of Fairfax issued $78,045,000 aggregate principal amount of 3.15% Exchangeable Notes due February 28, 2010 (the "Old Exchangeable Notes"), exchangeable into 4,300,000 Shares.
In addition, two other passages which stuck out:
WHEREAS, the Issuer and the Guarantor intend that the transactions contemplated hereby result in the Guarantor being able to treat members of the consolidated group (within the meaning of U.S. Treasury Regulations section 1.1502-1(h)), of which Fairfax, Inc., a wholly-owned subsidiary of the Guarantor, is the common parent, as owning at least 80 percent of the outstanding Shares (as defined below) and therefore treat Odyssey (as defined below) as a member of such group for U.S. federal income tax purposes;
(Note: this is one of the first lines in the master purchase agreement)
And also:
it is acting for its own account, and has made its own independent decision to enter into this Agreement and each other Transaction Document and as to whether this Agreement and the other Transaction Documents are appropriate or proper for it based upon its own judgment and upon advice of such advisors as it deems necessary; each of the Issuer and the Guarantor acknowledges and agrees that it is not relying, and has not relied, upon any communication (written or oral) of the Purchaser or any affiliate of the Purchaser with respect to the or any other Transaction Document and that it has conducted its own analyses of the legal, accounting, tax and other implications hereof and thereof (it being understood that information and explanations related to the terms and conditions of this Agreement or any other Transaction Document shall not be considered investment advice or a recommendation to enter into this Agreement or any such Transaction Document); it further acknowledges and confirms that it has taken independent tax advice with respect to this Agreement and each other Transaction Document;legal, accounting, tax or other implications of this Agreement.
The combination of all of this leaves me scratching my head. I want to go with my trust in Prem, but as someone in the comments said: In this instance, Prem may have been "a bit too clever." So, the lawsuit remains a risk and I will have to settle for a "wait and see" approach. That is unfortunate too, because Odyssey Re is trading at a very discounted price on concerns over this lawsuit.


ICP Fan said...

I am scratching my head over why ORH is depressed vs. FFH. Wouldn't Fairfax Holdings be liable for the penalties and for the unpaid tax?

Anonymous said...

The legal liability to pay tax belongs to ORH.

There is however a standard NAIC tax sharing agreement - and under that the liability would go to FFH who would also pick up the liability for penalties and interest.

ICP Fan said...

I wonder if you could argue that FFH did make an economic investment in ORH by using its appreciation as a means to obtain more financing at a low rate. Note that the increase in the principal roughly matches the increase in ORH's market value over the period from 03/2003 to 11/2004:

"On November 19, 2004, Fairfax LLC purchased its $78,045,000
aggregate principal amount of Old Exchangeable Notes, in a private transaction,
from NMS Services (Cayman) Inc. (the "Purchaser"), an affiliate of Bank of
America, N.A., as purchaser under the Master Note Purchase Agreement (as defined
below). As consideration for the Old Exchangeable Notes, Fairfax LLC issued
$100,964,000 aggregate principal amount of New Exchangeable Notes. In addition,
in connection with the purchase of the Old Exchangeable Notes, Fairfax has
agreed to reimburse the Purchaser for certain costs."

Anonymous said...

Sorry ICP fan. You can't argue that. The convert killed any chance of the upside.

It really is quite hard to find the investment purpose.

That is the nub of the ICP case.

ICP will have filed to collect the bounty for reporting a tax avoider. The bounty is part of the penalties that Fairfax will eventually pay.

Brian said...

What is not being considered is the fact that had FFH not completed this transaction, they would have likely used another transaction (whatever the cost) in order to obtain 80% ownership, as this was almost necessary for survival. So, either way, the IRS isn't "missing" money.

Anonymous said...

Brian, you may be right.

If I had not found a phoney deduction from my tax I might have actually spent the money and obtained a real deduction.

Therefore the IRS is not missing money and should not impose penalties.

I hope you have better luck with the IRS than me!

ICP Fan said...

Anonymous, if I purchased an ounce of copper with a borrowed dollar and refinance so that I get 5 dollars on the same ounce, wouldn't you say that I had made an investment?

FFH used their asset's appreciation to draw in tens of millions of additional cash--and because the principal amount was capped by the number of shares, FFH only paid higher interest rates for their extra $30+ million.

Anonymous said...

I am sorry that I have to be anon - but I will sign anon.

If you buy an oz of copper with a hope that you will profit when the copper rises in price you have made an investment for tax purposes.

If you buy then borrow against the copper and wind up buying 5 oz of copper you have just made a bigger investment for tax purposes.

But lets pretend that you purchased 5 oz of copper and that you did it by borrowing with a convertible note.

And the note was converted to 5 oz of copper at some stage in the future.

And if the price of copper goes up there is no chance that you will profit because the note will just be converted.

Then there is some doubt (ok, raging doubt) that you have purchased the copper for investment purposes because the deal is structured so you can't profit.

If further the note is secured by the copper and it has in the clauses of the deal a whole lot of terms that make it impossible for the person who lent me the money to lose on the whole transaction including the convert then I really got problems with the "investment purpose" of the transaction.

This transaction was always questionable.

I wish I had filed to collect the bounty.

Its 1am now - so I am off to bed.

uccmal said...

Part 1:
Having dealt substantially with government over the years I know that they will generally not offer pre-approval for anything that is borderline. They will tend to say: "get your own advice" or something similar. So FFH/ORH would have had to hire and check the legalities of the situation. At this point both companies have been investigated by the DOJ and SEC thoroughly. Surely this issue has been looked at by the respective parties and the IRS by now.

Part 2: If ORH is on the hook for this somehow there will be a fine. There would also be a reversal of tax savings which would then go back into the account. They would then be applied elsewhere in the FFH consolidated group. This would mean minor re-statements at FFH and significant restatements at ORH. As to the present day these restatements are ORH are not going to make a material difference in BV now.

Anonymous said...

Wouldn't this have been somewhat similar to FFH buying stock and selling a deep-in-the-money covered call against it. This would have a high propability of a small return and being "called away" along with a low propability of taking a loss (if the stock falls below the strike price of the call). It sounds like this is what FFH did, althought they did it with borrowed money.

The end result is that this "investment" for FFH gave them a small return (seen as a reduction in the interest rate on the loan) and exposed them to loss if ORH dropped by a large amount. Sounds like a good conservative investment to me!


disclosure: long ORH and FFH

Anonymous said...

"This would have a high propability of a small return and being "called away" along with a low propability of taking a loss (if the stock falls below the strike price of the call). It sounds like this is what FFH did, althought they did it with borrowed money."

Yep - but they couldn't lose much money even if ORH stock cratered. AND if you work out the interest rates and the dividends they were almost certain to lose money given ANYTHING that happened.

The moneys that they were certain enough to lose were called fees to Bank of America.

They even had clauses in the loan which increased the interest rate on the loan if ORH increased its dividend beyond a certain amount - so they were not even speculating on ORH paying a higher dividend.

This "transaction" was designed so that no matter what happened Fairfax LOST money. It had no investment purpose.

Tax fraud is the name of the game...