The Divide: American Injustice in the Age of the Wealth Gap

by Matt Taibbi

  By that third week of July 2006, the war between the hedge funds and Fairfax had already been going on for three and a half agonizingly long years. Over that extended period of time, the argument against the company being put forward by its short investors and its allies in the investment banking world and in the press had evolved dramatically.

  The original complaint made in early 2003 by analyst John Gwynn, remember, had been that Fairfax was undercapitalized by $5 billion. By the spring of 2006, the new story being put out by Contogouris to reporters like Boyd was a brilliantly involved tale of conspiracy and international intrigue. In his sales pitch about Fairfax’s problems, Contogouris would bring with him a gigantic, conference-table-size poster purporting to show the structure of Fairfax’s accounting.

  The scam depicted in the chart was an Enronesque maze of phantom revenues and hidden budget holes, an ingenious robbing-Peter-to-pay-Paul scheme in which Fairfax was essentially borrowing billions against its European assets and capitalizing its subsidiaries with shares in other subsidiaries, a complex and indecipherable bookkeeping merry-go-round. Far different and more complex from the original charge of simply being undercapitalized, the new charges were a lurid and compelling suspense tale, complete with all the bells and whistles of great storytelling that had been absent from the original dry Gwynn report.

  It was a story that seemed too complex and idiosyncratic to be made up, and that was Fairfax’s problem. There were just too many amazing details out there for it not to be a little bit true. At the very least, the markets seemed to feel that way. By that critical period in late July, Fairfax really was on the verge of collapse. Its stock price was declining, long-loyal shareholders were slowly departing, it was being besieged by questions from ratings agencies, its executives were under surveillance by the FBI, and it was receiving subpoenas from the SEC.

  Beginning in late 2005, Rivett tried to get every regulator he could find to listen to his story of being mass-fragged by mysterious hedge fund gamblers. He got no help at all.

  “I went to the New York Stock Exchange first,” he says. “I went to the Ontario Securities Commission [the province’s version of the SEC], I went to the Royal Canadian Mounted Police.… They all look at you like you’re crazy.” The Canadian regulators, like everyone else, had seen the news stories and heard the rumors, which of course had mainly been generated by the hedge funds. “Their attitude was, where there’s smoke, there’s fire.”

  Rivett traveled to Washington and New York. He met with members of Congress and the Senate. He tried the FBI, tried the SEC, but had no luck, particularly with the latter crew. “They were hostile because they were investigating us,” Rivett explains. As for the congressmen and the other regulators, they weren’t interested. “I was like, ‘Jobs will be lost, everything will be lost, will you help us?’ But there was nothing.”

  By late spring of 2006, Fairfax’s situation was desperate. There was a great internal debate in the company over what to do. Many Fairfax executives were fearful of taking any kind of action against the likes of Chanos and Cohen. “These guys were the Masters of the Universe,” says Rivett. “People were like, ‘They’ll crush us.’ ”

  But Watsa by then had come to a conclusion. “We had no choice,” he said. He believed that if the company didn’t act, it was going to be destroyed anyway. Rivett was worried that unless the firm fought back, the story would end in some kind of Justice Department action, an arrest, something, and that would destroy the company and its eight thousand jobs.

  Moreover, the law firm it had retained to investigate its problems, Kasowitz Benson Torres & Friedman, had told the Canadians that they were in deep trouble—so deep that the funds were already planning a blowout victory party on the occasion of Fairfax’s bankruptcy. Like any financial firm, an insurance company can quickly implode in a run-on-the-bank-like crisis of confidence, and Fairfax was not only facing real regulatory inquiries but the possibility of mass defections by investors. If it didn’t answer its detractors soon, the law firm explained, the company’s share price might crater, and the firm might go out of business.

  So Fairfax ultimately made the only move it had left to make: it sued. It hired Kasowitz to draw up an extensive complaint that answered in detail all the accusations of fraud leveled by the hedge funds. Both sides in this war were racing to put their version out before the public in bold type at more or less exactly the same moment, at the end of July 2006.

  Boyd’s exposé came out on July 22, 2006; Fairfax filed its suit against the hedge funds four days later, on July 26.

  The filing of the lawsuit—not winning a lawsuit, but merely filing it—was what saved the firm. The detailed response spooked some short investors who had jumped on the bandwagon with Chanos and Sender and the rest. Jonathan Kalikow of the hedge fund Stanfield Capital, for instance, responded angrily when the Fairfax suit was filed. According to the discovery materials, Kalikow had been all but assured by people like Andy Heller at Exis Capital that Fairfax was about to be busted by authorities at any moment and was sure to go out of business. He had also been briefed about Boyd’s New York Post story ahead of time.

  So when he saw Fairfax file its suit, he was shocked that the Canadians had gone into such detail about all the allegations and was also displeased that the company appeared to be gearing up for a long battle instead of simply rolling over and/or surrendering to the authorities. It wasn’t the behavior of a guilty company.

  “It’s all out in the open,” Kalikow emailed Heller. “[The suit] mentions the Luxembourg sub, the Gibralter [sic] sub … why would they disclose their own fraud in such a way? Ans: they wouldn’t.”

  “No one can explain to me the fraud,” Kalikow continued. “Is money actually missing or not? Not even your experts know,” he barked at Heller. “Now this trade is a disaster. All the news that was supposed to take this lower hasn’t.”

  In depositions later on, Kalikow explained that the lawsuit was “the final straw … in believing that there wasn’t going to be any fraud disclosure, the way I assumed it was going to occur.” He explained in the deposition how he subsequently pulled out of his bet:

  Q: Did you exit the positions sometime after the lawsuit started?

  KALIKOW: Absolutely.

  Q: And did you take a loss?

  KALIKOW: Yes.

  Q: Do you remember how much?

  KALIKOW: Probably $60–70 million.

  Kalikow, relatively speaking, was only a minor player in the team of short sellers, yet he lost $70 million. In the deposition, Kalikow shrugged off the loss of such a sum, as if it were no big deal.

  Simultaneous to the filing of the suit against Cohen, Loeb, and the others, Fairfax issued a restatement, admitting to accounting errors in the 2001–2005 period. Under normal circumstances, admitting to a serious accounting problem in the middle of a swarming short attack would be disastrous, but the Fairfax restatement had the opposite effect. Instead of disclosing billions of hidden losses and off-balance-sheet transactions of the Enron type—the rumored problems—the restatement disclosed a serious but straightforward error in its accounting treatment of an old reinsurance contract with its subsidiary Swiss Re. The total impact of the error was around $240 million, less than the rumors guessed at.

  The combined impact of the lawsuit and the restatement convinced some investors like Kalikow to bail on their short bets. The simple decision to fight back proved to be a key to the company’s survival; other short targets were often vaporized and bankrupted before they could even get into court. “The anomaly is that Fairfax was one of the only companies that went out and defended itself,” says Bowe.

  Unquestionably, the filing of the suit stabilized the company’s share price in the summer of 2006, but what really turned the tide for Fairfax was a second event that year. In September 2006, in a story entitled “FBI’s Secret Source,” the Post’s Boyd reported that Contogouris, whom he described only as someone who “analyzes companies’ balance sheets”—
not as someone who had been introduced to him by one of the world’s biggest short sellers—had been “deputized by the FBI” to approach a Fairfax executive as part of an investigation.

  As one government source explained it, “The FBI went ape-shit” when they saw the Boyd piece. The sheer embarrassment of having a prank-calling Matchstick Men wannabe like Contogouris claiming in public to be a deputized FBI operative was a terrible black eye for the Bureau, which was eventually forced to answer questions about the incident in a Senate Judiciary Committee hearing. Asked about the Post story, and Contogouris specifically, FBI director Robert Mueller answered icily, “The FBI does not deputize members of the general public.”

  The writing was on the wall. About a month after the Boyd piece, Contogouris was fired by the hedge funds, which seemed anxious to leave a written record of their displeasure. “Not kicking a dog while he’s down, but I have to say how disappointed I am personally in the research,” Exis Capital’s Andy Heller wrote to Contogouris. “I just don’t think you’re qualified to be making the assumptions you make.”*12 He added, referring to Contogouris’s Dumb and Dumber “MI4” compadre Max Bernstein, “You should not be taking opinions from Max. U cant explain it. Don’t have Max try and make things up.”

  Contogouris, quite sensibly it would seem, exploded in response—now they tell him not to make things up? “Now you’re saying I’m not qualified?” he wrote back. He added (with his usual tortured spelling), “I didn’t have Max make up anything, are you accusing me of having MAX MAKE THINGS UP? Are you fukking kidding?”

  Within six weeks after the Post piece, on November 14, 2006, Contogouris was arrested in federal court on unrelated charges, apparently for defrauding his old Greek employer Manios out of $5 million. It was a curiously ancient offense, and people familiar with the case almost universally believe that Contogouris’s real crime was running his mouth in the New York Post in the Fairfax matter. “The Feds wanted to send a message to any idiot who goes around blabbing about being an FBI informant,” says Marc Cohodes.

  The complaint in that case was humorous:

  Even after CONTOGOURIS was fired in April 2002 due to CW’s concerns over the management of the Companies’ funds, CONTOGOURIS collected three tax refund checks, totaling over $770,000, that were issued to the Companies. Shortly after he received each check, CONTOGOURIS opened bank accounts into which he deposited the money. Then, CONTOGOURIS completed the fraud by wiring the funds to other accounts that he or his associates controlled.

  It had nothing to do with the company at all, but Spyro Contogouris getting busted for boosting tax refund checks from his old boss was the single most important thing that happened to Fairfax in the entire decade of the 2000s. Overnight the company’s stock jumped about 10 percent.

  In all, in the eight months after July 26, 2006, Fairfax regained about $2 billion in stock value. The two critical events, the filing of the lawsuit and the arrest of Contogouris, said absolutely nothing about the company’s performance as an insurer. The only thing that changed in that time was the attitude of the global investing community toward the company. It had nothing to do with justice, the regulatory system, or the wisdom of the good old-fashioned Adam Smith capitalist marketplace. Instead, what began as a confidence game ended as a confidence game. The entire thing was a battle of public relations. It had nothing to do with real economics.

  Morristown, New Jersey, early on a Friday afternoon in January 2012. There is complete silence in the small, well-kept, windowless courtroom. The place is teeming with lawyers. Up in the front of the courtroom, I can see Bowe, the lead counsel for Fairfax. An Irishman from northern New Jersey, Bowe doesn’t look like a white-shoe lawyer; he was probably a homicide detective or a bartender in an Irish saloon in another life. When he talks, he sounds more like an assemblyman from Monmouth or Cherry Hill than a corporate mouthpiece. He’s got a couple of other lawyers with him, but otherwise the plaintiff’s table is pretty spare.

  On the other side, however, the defendants’ table is crowded with what looks like dozens of lawyers. The lead dog is a Texan named Bruce Collins, a drawling, dark-haired hotshot corporate defense lawyer who made The Best Lawyers in America three years running, from 2011 to 2013. As it happened, I’d seen Collins in court before, back when he was Ken Lay’s lead attorney in the Enron criminal trial. Surrounding Collins, who is here on behalf of Morgan Keegan, is a small army of associates and cocounsel. The gallery is filled with clipboard-carrying men and women in suits and ties, most of them lawyers for the many hedge funds that are, were, or potentially still could be part of the historic lawsuit filed by Fairfax against its short attackers.

  In the entire courtroom I count two reporters—myself and a Bloomberg man—plus three plaintiff’s attorneys and roughly three dozen defense lawyers. There are no civilian spectators. The court junkies who show up and hang out in the back rows of murder and rape trials do not come to high-powered civil trials about market manipulation by hedge funds. In big-time civil trials of this type, virtually all the participants are paid to attend, and it’s obvious which side has more money to spend to pack the room.

  It’s been eight full years since Fairfax was first besieged, and nearly six years since Fairfax first filed suit. But the company is still miles away from gaining any relief. The Fairfax lawsuit would prove to be a textbook example of how hard it is to use America’s civil court system to stave off market manipulation.

  Although the key players in the case brazenly used emails and other written communications to discuss the various lowball moves against Fairfax, the Canadians found that it wasn’t easy even to keep the actual perpetrators of the scheme in the lawsuit. The hedge funds’ high-powered lawyers appealed to technicality after technicality to try to sever their clients from the case, and over and over again, judges accepted their arguments.

  By the fall of 2012, Steve Cohen’s SAC had been dismissed from the case by New Jersey Superior Court judge Stephan Hansbury, who accepted SAC’s argument that it couldn’t possibly have been part of a scheme to destroy Fairfax, since it was not short Fairfax for “most of 2004” and had no position at all in the company in 2005. In his ruling, Hansbury restricted his definition of “shorting Fairfax” to simple short bets against the parent company. Despite the fact that shorting subsidiaries like OdysseyRe had the identical effect, Hansbury dismissed evidence that SAC had done exactly that as irrelevant. The judge was also unmoved by the fact that SAC was a major investor in Exis Capital, which Hansbury himself ruled was indeed consistently short Fairfax during the time period in question.

  Hansbury also accepted SAC’s argument that much of SAC’s trading was done in so-called quant funds, in which trades were executed not by day-to-day decisions of human beings but automatically, by computerized formulas. Thus while SAC might have had positions shorting Fairfax, its lawyers argued, those investments had not been birthed in the mind of Stevie Cohen or anyone else at SAC, but by computerized formulas. Therefore, the lawyers argued successfully, there could not have been manipulation.

  A month or so after that decision, Hansbury bounced Chanos and Loeb from the case. Why? Mainly because they worked out of New York, not New Jersey.

  “One must establish that the defendants purposely availed themselves of the State of New Jersey,” he wrote, “and that the alleged improper conduct was expected or intended to be felt within the State of New Jersey.” Hansbury was apparently not impressed by the fact that Fairfax’s biggest American subsidiary, and its fifteen hundred or so jobs, was headquartered less than a few miles from where he sat in judgment, in the very city of Morristown, New Jersey.

  Fairfax had chosen to sue in the state of New Jersey for two reasons. One was that it was where Crum & Forster was located. Second, a corporate citizen based in New Jersey like Crum & Forster had a perfect legal avenue to pursue—a private racketeering claim. Unlike the state of New York, which doesn’t allow such lawsuits, New Jersey allows plaintiffs to file lawsuits under the Rackete
er Influenced and Corrupt Organizations (RICO) statute. A RICO suit is a powerful tool for a company in Fairfax’s position, because it theoretically prevents short sellers from dumping the whole of their legal responsibility on a low-level middleman like Contogouris.

  Under RICO, the leaders of a criminal syndicate are responsible for the actions of the people they hire to do their dirty work. In criminal law, it covers a mobster who orders a hit but doesn’t pull the trigger himself. In civil law, RICO is a perfectly appropriate net for use in catching a stock manipulator who hires a thug to depress a company’s share price artificially.

  The problem, however, is the one that confronts financial regulators everywhere. Since modern finance is an almost completely global enterprise, the major players can make a habit of regulator shopping. A large number of financial companies base their trading operations in London, for instance, because the regulatory framework there for certain kinds of trades (particularly derivative trades) is even weaker than in the United States. Other companies place subsidiaries in tax havens or other foreign locales and park profits there.

  In one sense, the maneuverings by Contogouris and Morgan Keegan and the hedge funds occurred everywhere—in New York (where many key emails and phone calls originated), in Toronto (where executives were followed and prank-called), in Washington (where key figures attempted to involve the SEC in investigations), in New Jersey (where Crum & Forster was located and a number of defendants kept offices), in London (where Contogouris met with FBI agents), and really all over the world, where potential investors received false information and moved the value of Fairfax stock by buying and selling shares.

  In another sense, though, the crime occurred nowhere in particular. If a hedge fund magnate in Westchester or Long Island sends an email to a bank analyst in Tennessee (where Morgan Keegan keeps its headquarters) to discuss the manipulation of the stock of a Canadian insurance company that’s listed on the New York Stock Exchange but retains a major subsidiary in New Jersey, where did the offense take place? It depended, entirely, on how you looked at things.