The inside story of a Wall Street battle royal (cont.)

By Bethany McLean, Fortune editor-at-large

Fairfax makes its case

In a visit to Fortune's offices last fall, Watsa, a soft-spoken, gentlemanly figure, was accompanied by Fairfax vice president Paul Rivett, Kasowitz and Mike Sitrick, a public relations consultant with a reputation for aggressive tactics. (His Web site features press clippings saying things like Sitrick is "the PR guy you want in your corner if you want to play hardball with the media.") Watsa said he was surprised to find himself with both a lawyer and a PR man. For years he avoided the press, never gave guidance on earnings, and catered only to long-term investors. He cites "honesty and integrity" as Fairfax's core values and said that he had always believed, "Put your head down and the results will out."

The way the Fairfax executives told the story, Fairfax's poor performance was not what attracted the short-sellers. Rather, "They saw us as an easy target," Rivett said. "We don't talk to the media, our stock is thinly traded [meaning a relatively small number of shares change hands each day, making it easier to manipulate the price] and this is a reputational business."

Rivett said short-sellers started the "Fairfax Project" on Jan. 16, 2003, when John Gwynn, a research analyst at regional broker Morgan Keegan, released a report estimating that Fairfax's loss reserves were $5 billion smaller than they should be. Fairfax promptly issued a press release calling the report "totally wrong."

Even so, over the next few trading days Fairfax stock fell some 20 percent. A few weeks later Gwynn corrected his math, saying that the number was actually $3 billion. In the view of the Fairfax camp, Gwynn hadn't simply made a big mistake - rather, his report was an "intentional attempt to cause a massive stock price drop." (Gwynn and his firm are defendants in the lawsuit.) Fairfax says the $3 billion figure was also wrong, but between 2003 and 2005, Fairfax increased its reserves by $1.4 billion.

Because the hedge funds knew the contents of the report before its public release, Rivett said, they were able to make a killing - but they weren't done. The hedge funds kept "substantial" short positions and then, Rivett says, they couldn't get out. He is alluding to a market phenomenon known as a short squeeze. Because fewer than 16 million of Fairfax's shares trade, if a short-seller were to purchase shares to cover his position, that demand for the stock could quickly push the price higher. If shorts all began buying at the same time, the stock could soar. Thus, said Rivett, the only way the conspirators could get out of their positions was by sending Fairfax's stock to zero using an "ambitious campaign of disinformation and dirty tricks."

The hedge funds that Watsa says victimized Fairfax are a Who's Who of the industry, and many have connections to one another. There's SAC and Exis Capital, run by Adam Sender, who used to work at SAC. Third Point and its colorful CEO, Daniel Loeb, are defendants, as is a Third Point analyst, Jeff Perry, who used to work at SAC. But of all the people Fairfax sued, it reserved particular vitriol for Spyro Contogouris, conspicuously not a member of the Wall Street elite.

Contogouris, 45, splits his time between New York City and New Orleans, and his background is not in high finance but real estate - he managed properties for a Greek family with whom he eventually became embroiled in a lawsuit.

After New York attorney general Eliot Spitzer eviscerated Wall Street research, Contogouris went into business as an independent research analyst. He proved himself by writing critical reports on what officials have now alleged was a Ponzi scheme involving stamp collecting and eventually acquired about a half-dozen clients for his firm, which he called MI4 Reconnaissance.

When the insurance industry came under scrutiny in late 2004 thanks to Spitzer's investigation of industry giant AIG, Contogouris began to search for other companies that might have run afoul of the complex insurance accounting rules. He quickly zeroed in on Fairfax. In notes to clients Contogouris raised questions about Fairfax's use of finite reinsurance, as others had.

On Sept. 7, 2005, Fairfax announced that it had received a subpoena from the Securities and Exchange Commission regarding its use of "nontraditional insurance and reinsurance." Later that month Fairfax disclosed another SEC subpoena and said that the U.S. Attorney for the Southern District of New York was also participating in the review. Watsa reassured investors, telling them that "we have had a full review by us and by our independent auditors" and that all that turned up were several small contracts at its partly owned, publicly traded subsidiary, Odyssey Re.

But in March 2006, Fairfax announced that both the company and Watsa had received additional subpoenas regarding his reassuring comments, and that its auditor - PricewaterhouseCoopers - had also been subpoenaed. Fairfax's financial statements warned that "the ultimate effect on its business & could be material and adverse." On conference calls Watsa puts the subpoenas in the context of the industrywide investigation into finite reinsurance but otherwise declines to comment. Credit-rating agency Moody's says it is "comfortable" that "any adverse regulatory developments will be manageable."

Foreign intrigue

Contogouris and an associate, Max Bernstein, traveled around the world unearthing Fairfax financial documents. These papers provided tantalizing information on transactions that sent preferred shares - that were supposedly worth hundreds of millions of dollars - back and forth among a dense web of Fairfax subsidiaries in places like Ireland, Bermuda, Gibraltar and Hungary, where the disclosure requirements are limited.

Here's an example of the type of activity Contogouris and Bernstein highlighted for their clients. Start with a Fairfax subsidiary called nSpire Re, which is based in Ireland. Fairfax's documents say it reinsures the U.S. operations, is responsible for the claims of the European runoff and provided much of the financing for the acquisition of Fairfax's U.S. operations. Financial statements show that in 2004 and 2005, a company called Fairfax Liquidity Management Hungary sent nSpire Re more than $1.6 billion of dividends in the form of preferred shares in two other companies - Fairfax (Gibraltar) and FFHL (Bermuda).

In a presentation to Fortune, Fairfax executives explained that Fairfax used transactions like the one above as part of a strategy that was originally designed to reduce taxes. They explained that in essence, Fairfax's Hungarian subsidiary lent money to Fairfax Inc., the U.S. operation, to finance acquisitions.

As a result, the U.S. operations paid interest to Hungary, which had a lower tax rate. Over time the structure morphed; at one point Hungary owned 62.5 percent of the equity in the U.S. operation and was owed repayment of a $500 million loan. Fairfax will not disclose how much this arrangement increased its already large tax credits. Nor was Fortune allowed to keep a copy of the presentation.

Fairfax supporters aren't troubled by the company's complexity. "They [Watsa and his team] are incredibly smart people who think this is a good way to structure a company," says Joyce Sharaf, an analyst at credit rating agency A.M. Best. Robert Dye, a portfolio manager at Regis Management who bought shares in Fairfax in the spring of 2006, says, "I made the decision to believe Watsa and [Fairfax CFO] Greg Taylor."

Dye calls Fairfax's practices "creative" but says that the short-sellers have "tried to exploit" this. Fairfax's Rivett says this structure is "not unusual," that rating agencies, shareholders and other journalists have not found it "any more complicated" than that used by any other multinational company, and that it "had no impact on Fairfax's consolidated financial statements apart from the net tax savings realized."

Yet these internal dealings still raise questions. Insurance companies like to keep their subsidiaries separate so that trouble in one does not affect the whole. Both policyholders and bondholders are entitled to specific pots of money. Fairfax's financial statements say it does not engage in the "cross-collateralization by one group company of another group company's obligations." But Fairfax's subsidiaries are intertwined via loans and the stake that nSpire Re holds in the U.S. business. For example, the U.S. operation has sent well over $500 million to nSpire Re, at least some of which was used to pay claims in the European business.

In addition, the stake in the U.S. operation has been pledged to support Fairfax lines of credit. For instance, Hungary swapped its stake in the U.S. operation for preferred shares in Fairfax Gibraltar. In 2003, Gibraltar was pledged as collateral for a Fairfax line of credit, which, Fairfax says, the parent company used to back letters of credit. Rivett says that the letters of credit were not off-balance-sheet financing because Fairfax's financials disclose that letters of credit were issued to back internal reinsurance obligations. "I cannot say strongly enough that there has not been, and there will not be, any off-balance-sheet financing" in this structure or otherwise, says Rivett.

The biggest question, though, surrounds the cash. According to the presentation given to Fortune, the U.S. operations have paid roughly $1 billion in interest and loan repayment to the foreign subsidiaries. It's not clear where the U.S. operations got all this cash. (Fairfax says it came from interest income, dividends and the proceeds of a bond offering by one of its U.S. companies, but will not provide more detail.)

And Fairfax's explanations still don't account for all the cash that it says moved through the overseas subsidiaries. Its lawsuit also says that nSpire Re paid Fairfax a $500 million dividend. That fact was not in the presentation given to Fortune. When asked about this transaction, Rivett would only say that "further information & will be provided as the lawsuit progresses."

Contogouris, who found the documents that shed some light on this, had his own theory. He thought that Fairfax had found a way to circumvent insurance regulations and inappropriately use policyholder cash from the U.S. to pay losses elsewhere. Fairfax then replaced that cash with what he called "fake" preferred shares "to trick policyholders, insurance regulators and investors."

He conceded that he couldn't connect all the dots. As he wrote in one note, "We do work based on speculation, and last I checked, it wasn't illegal." But he didn't leave much doubt about what he thought. "Fairfax," he wrote in one note, is the "greatest known insurance fraud of the 21st century."

Fairfax says that Contogouris's theories are "groundless and defamatory." Rivett and Kasowitz argue that Contogouris's past discredits him - and the hedge funds he worked for. "No jury will believe these highly sophisticated hedge funds were paying this individual for his investment advice," says Rivett.

Fairfax also alleges that Contogouris misrepresented himself, stalked its executives, and sent threatening e-mails to Watsa and his secretary from anonymous accounts. Contogouris's lawyer, Joe Tacopina, calls these accusations "totally false."

One episode that Fairfax cites as evidence of Contogouris's misconduct occurred last summer, when Contogouris contacted a former Fairfax CFO, Trevor Ambridge, asking him in an e-mail about the "seemingly incomprehensible inter-company asset movements." He also told Ambridge he could introduce him to someone who would "act as a liaison to current regulators."

Truth be told, Contogouris is something of a mystery. In September the New York Post reported that he was working for the FBI when he contacted Ambridge - and that an FBI spokeswoman confirmed the FBI connection. The FBI says it asked the Post to retract the statement that an FBI spokeswoman had confirmed Contogouris's role but will not comment on whether it had a relationship with Contogouris.