Saturday, February 23, 2008

Fairfax: Any Merit in the ICP Counter-Suit?

As many of you are probably well aware, Fairfax reported its 4th Quarter earnings the other day. Since the CDS gains were expected and well covered earlier on this site, I do not think there is much more I can add over their own release on that matter. But what I wanted to talk about was the ICP press release released right before earnings, entitled:

Fairfax Financial is Asked to Answer Disclosure Questions on Conference Call

Essentially, ICP is counter-suing Fairfax, alleging that the transaction Fairfax entered into with Bank of America in 2003 was improper. In the transaction, Fairfax purchased 4.3 million shares of its subsidiary Odyssey Re's stock("ORH") in exchange for 78 million in debt that was also exchangeable into Odyssey shares. ICP is challenging two things with regards to this transaction. The first is that Bank of America did not really borrow the 4.3 million shares it sold short to Odyssey. The second is that the transaction's structure had no business purpose, but was executed for the sole reason of saving money on taxes. (Something which is not allowed)

Again, remember that I am no legal expert- I am just using common sense. But in this situation I think that is enough. I can throw out the first argument about the borrowed shares right away. There are several major banks who have been involved in naked short selling, so Bank of America was not doing something unheard of. And I can not see how Fairfax can be faulted because Bank of America did not uphold its responsibility to borrow the shares.

What about the merits to the second argument- that the transaction had no business purpose, and was commenced just to save money on taxes? Fairfax definitely did save on taxes from this transaction, because the purchase of the shares allowed it to consolidate Odyssey, and so use the holding company's past losses to offset Odyssey's profits. Well first, we have got to break the transaction down into two parts, because Fairfax first made the transaction in March of 2003, and then refinanced it in November of 2004 with different terms.

1. March 2003: Fairfax purchased 4.3 million ORH shares for $78 million in debt at 3.15% interest and exchangeable into 2.15 million ORH shares.

2. November 2004: Fairfax refinances the debt for 101 million in debt at 3.15% interest and exchangeable to 4.3 million ORH shares.

So let's begin with the first transaction. Hypothetically, if Fairfax was taking out a loan and buying ORH shares, there would be no problem whatsoever to that. And, if Fairfax wanted to save interest costs by adding a convertible feature, that would also be fine. Since the exchange feature involves only 2.15 million shares, there does not appear to be any doubt- Fairfax has ownership of these shares, profiting from any gain in price and suffering from any losses.

But when Fairfax refinanced the debt in November of 2004, the transaction appears to have some questionable features. If Fairfax bought 4.3 million ORH shares in exchange for debt that is also exchangeable to 4.3 million shares, has a proper transaction actually commenced? Will Fairfax really gain if the price goes up, or is it just paying a small interest fee so they can temporarily claim "rights" to the shares and save on its taxes?

My understanding is that it is a proper transaction. Let's look at a few hypothetical examples to see. First, if the stock price went down to $10, Fairfax does face a loss. This is because the value of it's 4.3 million shares are now much lower, but it still owes the 101 million in debt, which Bank of America would have no reason to convert. So, the transaction satisfies the risk of loss requirement.

Now, if the share price increased to $40 per share, would Fairfax profit? The 4.3 million ORH shares are worth 172 million. The Bank of America debt of 101 million would also be converted, meaning Bank of America also ends up with 172 million worth of stock- and Fairfax no longer owes 101 million in debt. Now, this is where ICP says that the two of these cancel out and none of them are better off. But that is not really correct. Fairfax's shares are now worth 172 million and they do not owe the debt, so they did receive the profits. In return they had to issue 4.3 million shares, giving up a piece of their ownership. The company's financial and capital position is clearly different than it would have been if the transaction did not occur.

Economically, Fairfax is also still better off. Before the transaction, Odyssey Re had 65.142 million shares outstanding, which Fairfax owned 73.6% of. When the transaction first completed, Fairfax's stake increased to 80.4%, satisfying the 80% ownership level for tax purposes. At the end of our $40 example when Bank of America converts, Odyssey would have 69.442 shares outstanding, and Fairfax would own 75.3%. So Fairfax can clearly say it benefited by doing this transaction because it ended up with a larger ownership of Odyssey Re without needing to lay out any capital up-front.

So overall, this leads me to believe that there is little risk to Fairfax from this ICP lawsuit. Of course I was never really worried because I trust Prem and there was this excerpt below from the conference call, but I felt it would be right to understand the transaction myself.

Q: Bill began, from ICP capital. I have submitted some very detailed and comprehensive questions related to your 2003 tax consolidation. First question is do you plan on responding to those in written form?

A: Yes, good morning, William. You put a press release out, so let me put this into perspective in relation ship to your press release. The press release was issued late yesterday afternoon by a company. This is for our shareholders just so that they know a little bit about the perspective on it called institutional credit partners or ICP and by William Gayen [ph] ICP employee accusing Fairfax from profiting from an improper tax transaction. ICP and Gayen [ph] had dependents in a lawsuit brought by Fairfax in which Fairfax alleges that they and others engaged in a racketeering conspiracy to harm Fairfax by disseminating information about Fairfax so that short sellers could profit. I just wanted to make two points. First we took great care and obtained expert advice before entering into the transactions raised in the release. We have reviewed the accusations in the press release and we are confident they are baseless and misleading. Second, when Fairfax first learned in October 2006 that GAyen was alleging fraud by Fairfax, our counsel requested that Gayen [ph] to provide any information he had about this alleged fraud and to meet to discuss this information. But he never responded to that request. Because these accusations have also been raised by ICP and Mr. Gayen [pn] in their response to the racketeering lawsuit brought by Fairfax, it would be improper to address these accusations now in any further details. So thank you for asking that, and Jane next question


Anonymous said...

I suggest you read the transaction documents in their original. You will find them in the SEC archives.

There was no way that Fairfax could profit on the transaction - and no substantial way in which they could lose.

It thus had no business purpose.

The IRS will reverse the transaction eventually.

The question is how long?

ICP is trying to speed up the process - and you can bet that they have filed for the bounty paid for successfully reporting a tax avoider.

Nnejad said...

I spent hours finding all the original and relevant filings on this and I'm pretty sure there is nothing I am missing. If you want to point out where the logic is flawed or my information is false, that would be great.

Alex said...

I agree that ICP is clutching at straws. Economically, it is as if FFH purchased ORH shares with debt, and then paid off the debt by issuing ORH shares in the future.

Anonymous said...

I could lead you through all of this - but the problem is that I can't really do so without two hours and that makes it impossible to stay anon.

If you do not stay anon Prem Watsa sues you.

So sorry - I can't help.

Anonymous said...

But there is a simple question:

If the ORH stock went up during the period at which Fairfax owned it did Fairfax make a profit?

ICP and the documents assert no.

If you are friends with Prem Watsa and do not regard him as likely to sue you then you can ask him what profit he made.

If there was no profit from buying ORH shares and having them rise then then was there any other investment purpose? If so what was it?

If there was no investment purpose then it was artificial tax avoidance.

So it is critical to determine whether Fairfax profited from the rise in ORH stock or if they could conceiveably have profited.

Determine that and you have your answer.

If they could profit then ICP is talking hogwash.

Nnejad said...

Well, did you read the post?

Anonymous said...

They did not book that profit. The issue is that BAC forced conversion denying FFH the profit. They then renegotiated without the profit.

John said...

How telling is it that someone that wants to argue something but won't state facts claiming it will take two hours spends hours rechecking the additional posted comments.

Why would anyone trust anyone who says- Such and such happened but I can't tell you how because it would take too long???????

ICP Fan said...

You could say that FFH obtained very limited upside by holding a slightly larger percentage of ownership after the transactions.

BUT, that doesn't change the main point, which is that the deal was made largely to avoid taxes. FFH obviously did not intend to maintain an 80% ownership, and the IRS will notice that their holdings swelled over the 80% mark just in time for tax season.

So while Mr. Nejad's point that FFH maintains a large stake in ORH after the transaction is true, it only demonstrates that FFH has a long term investment strategy with ORH, and NOT that the consolidation had any purpose aside from tax avoidance.

P.S., I am not short the stock and I respect Prem Watsa. In this instance, however, he was a bit too clever.

Anonymous said...

The terms of the convert were that Bank of America sold Fairfax the stock funded by the convert. The convert converted back into the stock.

So if the stock went up Bank of America was going to convert back into the stock denying Fairfax any profit on the deal.

That is what happened.

If you look further at the terms Fairfax insisted Bank of America deliver the stock to them. This meant that Bank of America could actually lose money.

But the terms of the deal made it that Bank of America got compensated if they lost money in any way.

This deal was deliberately structured so that it had NO economic content.

Because it had no content it was not necessary for BAC to borrow the stock - and they didn't.

Fairfax did not gain beccause the deal was structured so they could not gain.

BAC did not lose because the deal was structured so they could not lose.

There was no investment purpose.

It was tax fraud pure-and-simple.

That said - it delivered lots of cash to Fairfax when they needed it so it was a good deal for Prem.

The piper - in this case the IRS - might have to be paid now though.

Nnejad said...

With regards to ICP fan, I have to agree with you that the main benefit from this transaction was in all likelihood to utilize the tax losses. But to use a different example, what if Fairfax was not facing any financial difficulty at the time of this transaction, and so did not need to borrow money to buy the ORH shares? So once again, the company purchases 7% more of ORH shares so it just barely reaches the threshold level of 80%. You can not argue in this situation that the sole purpose is tax avoidance, even though it is likely the reason. Similarly, though the maximum profits from the transaction Fairfax structured are minimized, the ability to profit still exists. I see it hard for a court to rule this situation different.

Finally, addressing the last comment. The ICP letters are filled with manipulations, but I think one of the biggest mis-statements they make is that the BAC convertible feature exchanges for the SAME 4.3 million shares that Fairfax purchased. I believe this to be false, although I will contact Fairfax to confirm this. But regardless, I do know this: As I mentioned earlier, the transaction had two parts. In the first part, the convertible feature was for only 2.15 million shares. Since Fairfax purchased 4.3 million shares, there is no question that Fairfax still stood to profit from this transaction.

As for the second transaction, we know that Fairfax received a private letter ruling approving of the transaction. If the transaction was in fact structured to convert into the same subject, it appears silly for the IRS to have approved of this transaction.
Again though, I will contact the company to clarify this.

Anonymous said...

"I think one of the biggest mis-statements they make is that the BAC convertible feature exchanges for the SAME 4.3 million shares that Fairfax purchased. I believe this to be false, although I will contact Fairfax to confirm this."


This is not a mistatement. Read the documents.

Nnejad said...
This comment has been removed by the author.
Anonymous said...

I think it is plain enough

Nnejad said...

Okay, so you are correct with respect to the Odyssey convert. Although the convertible feature is an option for 4.3 million more shares, it is coming from Fairfax the hold co level, so whether it is the same shares or not doesn't matter. Economically, that wouldn't matter.

I will do another post tomorrow on this to clarify the mistake. But though I was wrong on that point, I still think overall what Fairfax did was okay. Again, looking at the transaction, it began with 78 million in debt convertible into 2.15 million shares, and Fairfax used the proceeds to buy 4.3 million shares. There was nothing wrong with this transaction. Now, one year later Fairfax still owns 4.3 million shares, and now 78 million in debt is coming due. Fairfax can either pay this debt back, or it can refinance it to conserve cash. Fairfax chose to refinance, and in this refinance they had to offer the new, stronger terms. So, if you look at it from this perspective, ignore the original share purchase and look at Fairfax 2004, the cash-strapped company which has 78 million in debt coming due. It can't afford to pay it back, and BAC has no reason to convert into 2.15 million shares. So Fairfax can default and give back the 4.3 million shares, or it can avoid the terrible reaction that this would cause by coming up with the transaction that it created. They perhaps understood the problems this might arise, so that is why they achieved a private ruling. What is needed to go against this would be evidence that Fairfax always intended to make this second refinance. I'll read the argument more closely tomorrow to see if their evidence really proves this.

Anonymous said...

Sorry - blogger cut it off...


Anonymous said...

One problem.

The private ruling says that the SECOND transaction (that is rolling over the first transaction) is OK if the FIRST TRANSACTION is OK.

It does not opine on the first transaction.

Anonymous said...

I need to look into more detail on this.

Nick , if a company like Fairfax (that was under immense financial pressure) increases its ownership of Odyssey re & & consolidates this subsidiary so that its capital/financial position improves, its less likely to receive ratings downgrades, its able to win new insurance business & continue to write existing accounts & it also receives advantageous tax treatment - then doesn't that seem to have a reasonable business purpose to it?

As you said they could have elected to default on the convert rather than refinance. Faifax was stretched at the time.