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

By Bethany McLean, Fortune editor-at-large

Yet another curious deal

That might have been the end of the story but for Institutional Credit Partners - the firm for which Carlos Mendez works. ICP does not invest in equities, but it has bought credit default swaps on one of Fairfax's publicly traded subsidiaries, Odyssey Re, which means that it will profit if Odyssey Re fails to make payments on any of its debt.

ICP established its position before being contacted by Fortune and has not traded in any Fairfax or Odyssey Re securities since November. ICP executives provided Fortune with access to unedited research because they are deeply disturbed by the possibility that legitimate research may be being suppressed.

ICP portfolio manager William Gahan began to examine Fairfax in spring 2006. After months of research using only publicly available information, he called Brandon Sweitzer, a senior fellow at the U.S. Chamber of Commerce who is also a Fairfax director, and asked to discuss what he called "accounting peculiarities." Sweitzer, Gahan says, was surprisingly defensive. (Sweitzer did not return a call seeking comment.)

A few days later, on Oct. 12, Gahan got a letter from Kasowitz: "We understand that you have informed a director of the company that you have evidence of financial fraud at Fairfax." The letter went on to demand that Gahan forward any information and analysis he had done to Kasowitz, who also sent ICP a copy of Fairfax's lawsuit.

ICP viewed Kasowitz's letter as an attempt to intimidate Gahan and didn't respond. Shortly after that, Gahan and other ICP employees noticed cars lurking outside their building and following them home. ICP forwarded the license plate numbers to an FBI contact - which explains why the FBI called Mendez. ICP says the FBI confirmed that the pursuers were from Kasowitz's firm. Kasowitz denies having Gahan followed but says his firm has put ICP "under investigation."

Like others before them, the ICP folks ran into dead ends at Fairfax. But there was one deal that they felt showcased how far Fairfax was willing to go in its quest for cash. In March 2003, Fairfax announced that it would buy 4.3 million shares of its subsidiary, Odyssey Re, which would bring its ownership of the unit to just over 80 percent - enough to consolidate its results for tax purposes. That would allow Fairfax to use its big tax losses to offset Odyssey's taxes.

But Fairfax didn't simply pay the $78 million it would have cost to buy the Odyssey Re shares. Instead, Bank of America set up an offshore subsidiary that borrowed the shares - just as a short-seller would do - and sold them to Fairfax in exchange for a $78 million note. The note was convertible back into shares of Odyssey Re at specified times. Fairfax told investors it was buying the shares for "investment purposes" as well as "tax-sharing payments." But it isn't clear what the investment purpose was, because Fairfax would not benefit from an increase in Odyssey Re's stock price - and the IRS frowns on deals that are done only for tax reasons.

ICP spent countless hours dissecting SEC filings and hired tax lawyers and forensic accountants to provide independent validation of its work. "This is not an open and shut case, but there are significant question about whether there was a legitimate nontax business purpose to this transaction," says Bryan Skarlatos, a partner at tax attorneys Kostelanetz & Fink. "We have questions about the economic substance of the transaction," says Philip Kruse, a managing director at Alvarez & Marsal, a consulting firm.

In the summer of 2006, after the New York Post raised questions about this transaction, one analyst asked on a Fairfax conference call, "What risk is there that the IRS looks at the usage of this asset and challenges it?" Watsa reassured listeners that "we had an IRS ruling before we did this." Today Fairfax says it "never sought an IRS ruling on the 2003 transaction because none was needed," and "independent opinions were obtained from respected legal, tax and accounting firms that the transaction fell within IRS guidelines."

Fairfax and Bank of America have since unwound this transaction, and indeed, Fairfax did not benefit from the increase in Odyssey Re's stock price. In addition, Bank of America had to purchase shares to return the shares it borrowed and sold to Fairfax. It is not clear how many shares the bank purchased, but the buying helped Odyssey Re's stock increase more than 20 percent from August to December. And in December, Fairfax sold nine million Odyssey Re shares to investors, collecting $338 million.

All Bank of America will say is that "we do not comment on client matters." Kasowitz's firm says that ICP attempted to "derail" this offering and links ICP to "highly abnormal short trading" in Odyssey Re's shares. But ICP does not trade stocks, long or short.

In late February, Fairfax announced 2006 results. Thanks to the sale of Odyssey Re stock, it now has more than $700 million of cash on its balance sheet. Oddly, the lawsuit itself could be Fairfax's biggest risk. For if it proceeds to the discovery phase and the defendants have to turn over documents, they will surely request Fairfax's internal documents in return. What kind of tale will they tell?

Reporter associates Doris Burke and Patricia Neering contributed to this article.


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