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