Is Fairfax Financial Holdings the Next Enron?

It has been some time since our last major corporate scandals. Sure there are backdating of options investigations and CEO pay debates everywhere. But, since the Enron and MCI-WorldCom days, nothing has really stood out and made me fume like the following story. This could be the most complex, twisted story since that of the Enron downfall, in which many parties and players are at stake.

To understand the situation, we need to examine how Fairfax became an insurance giant. In 1985, CEO Prem Watsa came about as a disciple of Buffetism (i.e. theories and management practiced by Warren Buffet within Berkshire Hathaway). According to Fortune, the stock price appreciated from $3 to $600 (in Canadian Dollars). In 2003, after the wake of 9/11 and other costly disasters, John Gwynn of Morgan Keegan placed an "Underperform" on the stock because of "loss reserve deficiencies" of around $5 Billion. Over the next few days, the stock price declined by around 20% and Fairfax issued claimed the number was wrong. Although Gwynn came out not long after and declared the number was closer to $3 Billion, Fairfax believed his actions were intentional, despite the fact that Fairfax itself failed to release any estimates relating to difficiencies or excess reserves.

According to Fairfax VP Paul Rivett, several hedge funds including SAC, Exis Capital and Third Point short-sold the stock after Gwynn's downgrade since they were able to obtain the report before the information became public. They claimed the hedge funds made huge profits through the short sales, but continued to keep large amounts of short positions. Since a "short squeeze" was inevitable when the hedge funds wanted to cover their shorts, Fairfax argued they saw the better option of driving the stock price further and further towards zero.

The problem with this theory of Rivett and the rest of the Fairfax group seems to be the actual resulting price of their stock. During the middle of 2003, Fairfax's stock price tripled and rose from around $50/share to over $150, closing near $170 by the start of 2004. If these hedge funds conspired against Fairfax, they surely would have been able to signficantly limit the increase in the stock price, especially growth as dramatic and quick as Fairfax experienced during mid-2003. Additionally, the stock price continuously hovered between $100 and close to $200 per share from 2004 until 2007, recently eclipsing $200. Any statistical evidence of a conspiracy to manipulate the stock price should end after just looking at the Fairfax charts.

In addition to these charges of desperation, Fairfax has also been involved in some real "shady business" and questionable practices. The first group of them involves their accounting and insurance irregularities. In order to increase profits, they have used several tax schemes to effectively decrease the amount of taxes to be paid by loaning and investing some of their subsidiaries into other subsidiaries in different countries. They are currently being investigated by the SEC and Justice Dept., among other agencies. Spyro Contogouris, an investor with a flawed reputation himself (he was charged with defrauding some Greek Businessmen back in 2004) wrote a report questioning these accounting and insurances practices. By September the SEC decided to issue subpoenas to Fairfax to investigate these "unique" transactions. However, in June of 2006, Fairfax filed suit with the SEC, claiming Spyro was conspiring against the company. Interestingly enough, the very next day after filing their lawsuit against Spyro, the company restated their balance sheets, reducing shareholder's equity (and ultimately decreasing their assets). Spyro may have a suspect background himself, but he was apparently onto something in pointing out these non-traditional transactions made by Fairfax. Reduction in Stockholders Equity of 7-8% seems like a significant mistake for "accounting errors," especially those done by PWC, one of the Big 4.

Although Contogouris was arrested the day after he filed a lawsuit against Fairfax, PWC & Sitrick (a PR consultant hired by Fairfax), things still didn't add up well. Contogouris took his analysis of Fairfax off his website due to a request by his lawyers, but Gwynn also resurfaced in an odd way. He stopped covering Fairfax (despite his several years of expertise) claiming "litigation strategy designed by Fairfax to silence negative research" (pg. 86). Although conspiracy could be an option, the insurer may actually bullying analysts into placing "outperform" ratings on their stock or dropping them from the list of companies they cover. This practice is not only unethical, but may result in legal action from the SEC and cause a drop from the NYSE if found true.

By this point, you would expect the story to be coming to an end with the endless twists, turns and finger-pointing. But, there is more. Institutional Credit Partners was becoming curious about the lack of research reports on Fairfax, given the size and growth of the company. When one of their portfolio managers looked into acquiring information about unique accounting methods, he was seemingly intimidated and threatened by Marc Kasowitz, the head lawyer for Fairfax. Soon after, ICP employees reported stalkers to the FBI who linked the culprits back to Kasowitz's law firm. Although "Kasowitz denies having Gahan followed", he admitted to beginning an investigation into ICP (pg. 86). They even cited ICP for "highly abnormal short trading," although ICP does not in fact trade any equities. The firm solely invests and trades credit swaps (pg. 86).

Lastly, Fairfax was cited for another obscure transaction uncovered from March of 2003, one that was weird enough to make the New York Post. When questioned about the transaction during a conference call, Watsa told the analyst that Fairfax was already given permission by the IRS. Now, they said they never brought the situation before the IRS (pg. 86).

After reading this article several times, it seems obvious to me that Fairfax is attempting to cover something up. For as much finger-pointing as they want to do, crying "conspiracy!", Fairfax itself has many questions to answer. Although the company is set up well and could become an insurance giant itself, the various sketchy tactics and questionable methods emplored by Fairfax would make me stay as far away as possible. Despite a stock price flying past $200/share, Fairfax may be uncovered as the biggest scandal since Enron. If I were you, I wouldn't put my proverbial eggs in their basket.


All facts, figures, quotes and the overall storyline are courtesy of Fortune Magazine's March 19th, 2007 issue, "The Inside Story of a Wall Street Battle Royal" by Bethany McLean; pg. 74-86.