=DJ IN THE MONEY: Letter To BofA Directors Questions Fairfax Deal
Friday, February 08, 2008 12:31 PM
By Carol S. Remond
A Dow Jones Newswires Column
A hedge fund sued by Fairfax Financial Holdings Ltd. (FFH) for stock manipulation is now accusing the Toronto insurer of entering into a sham transaction to save millions of dollars in taxes.
In a letter sent to Bank of America Corp.'s (BAC) board of directors earlier this week, Institutional Credit Partners LLC alleges that the bank and its corporate client misrepresented the nature of an off-balance-sheet transaction that over the span of three-and-a-half years helped Fairfax save some $400 million in taxes.
Short on cash and looking to capture some of its carried-over losses, Fairfax announced in March 2003 it purchased enough shares of Odyssey Re Holdings Corp. (ORH) to consolidate the subsidiary for tax purposes.
But according to ICP, that "purchase" was nothing more than a loan disguised as a sale.
The fund contends in its letter, which was reviewed by Dow Jones Newswires, that Fairfax and Bank of America misled securities regulators about the nature of the transaction and that the bank facilitated Fairfax's "abuse of tax avoidance principles."
ICP also alleges that Bank of America failed to disclose a large short position in Odyssey Re stock to the New York Stock Exchange.
Fairfax is suing ICP and several other hedge funds in New Jersey state court, alleging that they conspired to denigrate its business and depress its stock price.
Bank of America declined to comment specifically on the ICP letter or details of the transaction it covers. In an email statement, the bank said it takes "its regulatory and legal obligations very seriously. We are confident we have complied with all laws and reporting requirements related to this transaction."
Fairfax through a spokesman said the transaction "was appropriate in all respects. Assertions otherwise are the latest in a long line of baseless claims that are now the subject of Fairfax's claims against those responsible."
The insurer said it didn't mislead the Internal Revenue Service and that the transaction wasn't a loan but a sale of bonds for stock. Fairfax called ICP's accusations baseless and frivolous and said that it looks forward to its day in court.
ICP made allegations similar to those detailed in its letter to Bank of America in a counter-complaint filed against Fairfax in late January. The fund manages about $13 billion in asset-backed and credit default swap securities and holds investments from which it could profit from declines in the creditworthiness of Fairfax or Odyssey Re.
As is the case for most structured transactions, regulatory documents covering Fairfax's purchase of 4.3 million shares of Odyssey Re from Bank of America in lieu of exchangeable notes backed by said stock aren't exactly revealing.
But filings with the Securities and Exchange Commission covering the unwinding of the transaction in 2006 suggest that Bank of America borrowed Odyssey Re stock that it then sold short to Fairfax.
Typically, short positions involve the sale of borrowed securities by an investor who hopes to earn a profit by buying an equal number of shares later, at a lower price, to replace the borrowed securities.
A short sale in essence is no different than a long sale of stock; general ownership is transferred from the seller to the buyer. But ownership doesn't not always mean the same thing, especially when it comes to tax law.
ICP argues that while Fairfax might have achieved the required 80% ownership threshold on paper, it failed to qualify as the beneficial owner of the Odyssey Re shares because the transaction was structured to insulate the insurer from the benefits and burdens associated with the stock.
In a similar fashion that the owner of a house is the person who benefits from the appreciation or loss, the beneficial owner of a security is typically the entity or person exposed to its upside and downside fluctuations.
ICP claims that Fairfax had no ability to profit from an increase in the value of Odyssey Re, since those shares were restricted while used as collateral for the exchangeable notes the insurer used to compensate Bank of America. The fund also argues that Fairfax didn't bear any risk of loss since Bank of America was predetermined to exchange the notes regardless of the fluctuation of Odyssey Re's stock price.
Similarly, the fund argues in its letter that Bank of America was oblivious to the price of Odyssey Re shares and simply served as a conduit through which borrowed shares were loaned to Fairfax. The bank was compensated by some $10.4 million in total fees for its efforts.
Beneficial ownership aside, ICP also raises questions about Bank of America's alleged failure to report its large short position in Odyssey Re stock as required by the NYSE.
A spike in reported short sales in thinly traded Odyssey Re stock would have been a red flag, which would have alerted the market back in 2003, long before any filing hinted at the nature of the structured transaction that helped Fairfax consolidate its subsidiary.
Short sales in Odyssey Re stock reported to the NYSE spiked to about 2 million shares in July 2002 from a few hundred thousand. The number of Odyssey Re shares sold short and reported to NYSE rose from 2.3 million shares Feb. 15, 2003, to 2.9 million shares Mar. 15, 2003, and 3.2 million on Apr. 16, 2003, never rising above that while the transaction was in place. That seems to indicate that at least a portion of the 4.3 million shares sold to Fairfax by Bank of America, if in fact sold short, weren't reported to the NYSE.
Fairfax sued several hedge funds, including SAC Capital Management LLC, Sigma Capital Management LLC, Exis Capital LLC, Rocker Partners LP and Third Point LLC, in Superior Court in Morris County, N.J., in 2006. The insurer alleges that the funds conspired to denigrate Fairfax and illegally send its share price lower. ICP and its fund manager William Gahan were added as defendants in an amended version of that suit.
Aside from the irony of Fairfax, a very public short buster, possibly benefiting from a short sale of the stock of one of its subsidiaries, a lot is riding on how the transaction was structured.
(Carol S. Remond is an award-winning columnist who won a Gerald Loeb Award in 2005 for best news service content with "Exposing Small-Cap Fraud," a series of articles that described how three small companies unscrupulously pumped up their stocks.)
-By Carol S. Remond, Dow Jones Newswires; 303-997-5783; carol.remond@dowjones.com
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(END) Dow Jones Newswires
02-08-08 1231ET
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