Today, short-selling hedge fund Rocker Partners paid Overstock.com (NASDAQ:OSTK) $5-million to settle the lawsuit filed against them in August of 2005. Rocker Partners also entirely dropped its own countersuit.

Overstock.com CEO Patrick Byrne is a frequent contributor to DeepCapture.com.

This is a major victory, not only for Patrick and Overstock.com, but for all public companies targeted by bear raiding hedge funds.

But thanks to the unusually skewed reporting surrounding it, chances are you either hadn’t heard about the suit, or were under the impression it was frivolous and certain to fail.

This presentation explains part of the story behind the coverage of the suit, using some innovative methods to explain why what you heard about the suit and its merits likely had little in common with the reality of it.

Fairfax Financial Holdings (NYSE:FFH) was first listed on the NYSE on December 20, 2002. During its first 15 trading days there, volume averaged well under 180,000 shares.

Then, on January 16, 2003 FFH volume exceeded 500,000 shares on an otherwise uneventful day in the life of a Canadian insurance company.

The next day, January 17, 2003 Morgan Keegan analyst John Gwynn initiated coverage of FFH with a scathing report and rating of “underperform”, making for one of the more eventful days in the lives of Fairfax shareholders, as their investments took heavy losses on extremely high volume.

Because information drives markets, one would expect to see extra activity in the wake of new information, such as that introduced by Gwynn on the 17th.

But what accounts for the unusually high volume observed the day before Gwynn’s report was published?

The answer to that question would come in October of 2008, when Morgan Keegan announced that Gwynn had been terminated for sharing his unpublished research on Fairfax with a small group of short-selling hedge funds.

Thanks to email messages and trading data recently obtained through discovery in the Fairfax Financial vs. SAC Capital, et al, lawsuit, we know that hedge funds Kynikos Associates, Third Point Capital, and SAC Capital all traded ahead of this material, non-public information. According to legal briefs filed by Fairfax Financial, Rocker Partners (later Copper River Partners) did as well (Rocker Partners denies this, while fighting manfully to prevent disclosing the trading records that would establish the truth, one way or the other).

Trading on material, non-public information, dear readers, is illegal.

In attempting to unravel how all this came about, one hedge fund name appears over and over: Kynikos Associates, run by James Chanos, who also serves as Chairman of the Coalition of Private Investment Companies, the hedge fund industry’s Washington DC lobbying organ.

It started on December 11, 2002 when Kynikos employee Mark Heiman alerted Chanos that he had just learned from an analyst at Ziff Brothers Investments that a Morgan Keegan analyst was about to publish a negative report on Fairfax.

From: Mark Heiman
Sent: December 11, 2002 11:06 PM
To: James Chanos; Douglas Millett
Subject: Fairfax
I just got off the phone with ZBI’s insurance analyst, Michael Ting. He just talked to a new insurance analyst at Morgan Keegan, and apparently that analyst is about to initiate FFRX at “Underperform,” with the thesis being that they are extremely under-reserved into the $3-$5 BN area. Also, there may be an article in Forbes or Fortune soon that will be similarly critical.
Ting said he thought that analyst was one of the best P&C analysts he has talked to, and wanted to give us the heads-up, as well as hear how we’re coming at it.

The next day, Kynikos employee Matt Cantrell apparently contacted Gwynn, as he sent Ting several documents relating to Fairfax subsidiaries, with the comment, “John Gwynn believes these might be of interest to you.”

Four days later, Heiman spoke to Gwynn personally, having a conversation which he summarized in the following report to Chanos:

From: Mark Heiman
Sent: December 16, 2002 4:46 PM
To: James Chanos; Douglas Millett; Charles Hobbs
Subject: Fairfax
Just spoke to John Gwinn at Morgan Keegan, and he was more critical of FFRX than I’ve ever heard a sell side analyst. It looks like his criticisms of from the top to the bottom–everything from underwriting to accounting to dishonesty. He gave me his basics, as he is somewhat restricted because he hasn’t officially launched. It will be interesting to see how much of this the people who run the research department there will let him publish!

On December 18, 2002, Chanos forwarded Heiman’s email to Jeff Perry, then an analyst at SAC Capital.

The day after Fairfax began trading on the NYSE, Gwynn’s revelations became much more explicit as he shared with Kynikos employee Heiman portions of his forthcoming report on Fairfax.

From: Mark Heiman
Sent: December 21, 2002 6:03 PM
To: James Chanos; Douglas Millett; Charles Hobbs
Subject: Fairfax
Last night John Gwinn at Morgan Keegan faxed over to me an outline detailing the issues at FFH, basically those he will be publishing on. He has been a huge help and even offered to talk to me from his home today. We can look at these and talk to him next week–I just wanted to come in today and take a look at what he sent to get a head start on what he sent.

In the days to follow, Gwynn and SAC Capital Portfolio Manager Forrest Fontana held a face to face meeting where they discussed Fairfax.

Fontana followed up on that meeting via email to Gwynn:

From: Forrest Fontana
Sent: January 06, 2003 8:57 AM
To: John Gwynn
Subject: RE: hope you had a nice holiday!
you available to touch-base on Fairfax sometime this week?

Followed by Gwynn’s prompt and eager reply:

From: John Gwynn
Sent: January 06, 2003 9:01 AM
To: Forrest Fontana
Subject: RE: hope you had a nice holiday!
Name the time.

Fontana proposed a conversation the following day and requested a spreadsheet summarizing Gwynn’s analysis on Fairfax, which Gwynn promised to send.

On January 13, 2003 Fontana sent his boss, Steven A. Cohen himself, a summary of his planned activities for the week, which included:

Tuesday 1/14: Morgan Keegan expected to launch on Fairfax with sell rating – we will be covering into this.

As it turns out, Gwynn’s report was published on the 17th of January, not the 14th as Fontana expected. Still, it’s clear that SAC Capital was formally planning to trade ahead of the information received by Gwynn.

Trading records produced by Kynikos and Third Point all tell the same story: heavy short selling in anticipation of Gwynn’s report, and highly profitable short covering in the days that followed.

What did John Gwynn get out of all this? That’s unclear, though upon his firing, Morgan Keegan went to great lengths to say that Gwynn’s opinions were his own and not influenced by the hedge funds that profited from advance knowledge of them.

The next question is: did Morgan Keegan get anything out of this arrangement?

The answer is yes: On December 21, 2002, the day after Kynikos received Gwynn’s unpublished analysis, Kynikos money manager Douglas Millett declared his intention to begin sending business to Morgan Keegan.

Apparently, that’s how big hedge funds like Kynikos operate, which makes Kynikos President James Chanos the logical person to represent his peers before Congress as that body considers long-overdue reforms.

Addendum: today (January 9, 2009) I received a letter from the attorney of Rocker/Copper River Partners protesting my suggestion that the firm was among those trading ahead of the Morgan Keegan report on Fairfax referenced above. In short, Rocker says the analysis was released on January 16, 2003 and their short position established the following day. The story has been slightly edited to reflect their position. I am currently examining the specifics of Rocker’s objections — though find that difficult given Rocker’s attorneys have taken steps to keep sealed what they insist is exculpatory evidence — and will return to this issue shortly.

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?“

Fairfax Financial Holdings (NYSE:FFH) was first listed on the NYSE on December 20, 2002. During its first 15 trading days there, volume averaged well under 180,000 shares.

Then, on January 16, 2003 FFH volume exceeded 500,000 shares on an otherwise uneventful day in the life of a Canadian insurance company.

The next day, January 17, 2003 Morgan Keegan analyst John Gwynn initiated coverage of FFH with a scathing report and rating of “underperform”, making for one of the more eventful days in the lives of Fairfax shareholders, as their investments took heavy losses on extremely high volume.

Because information drives markets, one would expect to see extra activity in the wake of new information, such as that introduced by Gwynn on the 17th.

But what accounts for the unusually high volume observed the day before Gwynn’s report was published?

The answer to that question would come in October of 2008, when Morgan Keegan announced that Gwynn had been terminated for sharing his unpublished research on Fairfax with a small group of short-selling hedge funds.

Thanks to email messages and trading data recently obtained through discovery in the Fairfax Financial vs. SAC Capital, et al, lawsuit, we know that hedge funds Kynikos Associates, Third Point Capital, and SAC Capital all traded ahead of this material, non-public information. According to legal briefs filed by Fairfax Financial, Rocker Partners (later Copper River Partners) did as well (Rocker Partners denies this, while fighting manfully to prevent disclosing the trading records that would establish the truth, one way or the other).

Trading on material, non-public information, dear readers, is illegal.

In attempting to unravel how all this came about, one hedge fund name appears over and over: Kynikos Associates, run by James Chanos, who also serves as Chairman of the Coalition of Private Investment Companies, the hedge fund industry’s Washington DC lobbying organ.

It started on December 11, 2002 when Kynikos employee Mark Heiman alerted Chanos that he had just learned from an analyst at Ziff Brothers Investments that a Morgan Keegan analyst was about to publish a negative report on Fairfax.

From: Mark Heiman
Sent: December 11, 2002 11:06 PM
To: James Chanos; Douglas Millett
Subject: Fairfax
I just got off the phone with ZBI’s insurance analyst, Michael Ting. He just talked to a new insurance analyst at Morgan Keegan, and apparently that analyst is about to initiate FFRX at “Underperform,” with the thesis being that they are extremely under-reserved into the $3-$5 BN area. Also, there may be an article in Forbes or Fortune soon that will be similarly critical.
Ting said he thought that analyst was one of the best P&C analysts he has talked to, and wanted to give us the heads-up, as well as hear how we’re coming at it.

The next day, Kynikos employee Matt Cantrell apparently contacted Gwynn, as he sent Ting several documents relating to Fairfax subsidiaries, with the comment, “John Gwynn believes these might be of interest to you.”

Four days later, Heiman spoke to Gwynn personally, having a conversation which he summarized in the following report to Chanos:

From: Mark Heiman
Sent: December 16, 2002 4:46 PM
To: James Chanos; Douglas Millett; Charles Hobbs
Subject: Fairfax
Just spoke to John Gwinn at Morgan Keegan, and he was more critical of FFRX than I’ve ever heard a sell side analyst. It looks like his criticisms of from the top to the bottom–everything from underwriting to accounting to dishonesty. He gave me his basics, as he is somewhat restricted because he hasn’t officially launched. It will be interesting to see how much of this the people who run the research department there will let him publish!

On December 18, 2002, Chanos forwarded Heiman’s email to Jeff Perry, then an analyst at SAC Capital.

The day after Fairfax began trading on the NYSE, Gwynn’s revelations became much more explicit as he shared with Kynikos employee Heiman portions of his forthcoming report on Fairfax.

From: Mark Heiman
Sent: December 21, 2002 6:03 PM
To: James Chanos; Douglas Millett; Charles Hobbs
Subject: Fairfax
Last night John Gwinn at Morgan Keegan faxed over to me an outline detailing the issues at FFH, basically those he will be publishing on. He has been a huge help and even offered to talk to me from his home today. We can look at these and talk to him next week–I just wanted to come in today and take a look at what he sent to get a head start on what he sent.

In the days to follow, Gwynn and SAC Capital Portfolio Manager Forrest Fontana held a face to face meeting where they discussed Fairfax.

Fontana followed up on that meeting via email to Gwynn:

From: Forrest Fontana
Sent: January 06, 2003 8:57 AM
To: John Gwynn
Subject: RE: hope you had a nice holiday!
you available to touch-base on Fairfax sometime this week?

Followed by Gwynn’s prompt and eager reply:

From: John Gwynn
Sent: January 06, 2003 9:01 AM
To: Forrest Fontana
Subject: RE: hope you had a nice holiday!
Name the time.

Fontana proposed a conversation the following day and requested a spreadsheet summarizing Gwynn’s analysis on Fairfax, which Gwynn promised to send.

On January 13, 2003 Fontana sent his boss, Steven A. Cohen himself, a summary of his planned activities for the week, which included:

Tuesday 1/14: Morgan Keegan expected to launch on Fairfax with sell rating – we will be covering into this.

As it turns out, Gwynn’s report was published on the 17th of January, not the 14th as Fontana expected. Still, it’s clear that SAC Capital was formally planning to trade ahead of the information received by Gwynn.

Trading records produced by Kynikos and Third Point all tell the same story: heavy short selling in anticipation of Gwynn’s report, and highly profitable short covering in the days that followed.

What did John Gwynn get out of all this? That’s unclear, though upon his firing, Morgan Keegan went to great lengths to say that Gwynn’s opinions were his own and not influenced by the hedge funds that profited from advance knowledge of them.

The next question is: did Morgan Keegan get anything out of this arrangement?

The answer is yes: On December 21, 2002, the day after Kynikos received Gwynn’s unpublished analysis, Kynikos money manager Douglas Millett declared his intention to begin sending business to Morgan Keegan.

Apparently, that’s how big hedge funds like Kynikos operate, which makes Kynikos President James Chanos the logical person to represent his peers before Congress as that body considers long-overdue reforms.

Addendum: today (January 9, 2009) I received a letter from the attorney of Rocker/Copper River Partners protesting my suggestion that the firm was among those trading ahead of the Morgan Keegan report on Fairfax referenced above. In short, Rocker says the analysis was released on January 16, 2003 and their short position established the following day. The story has been slightly edited to reflect their position. I am currently examining the specifics of Rocker’s objections — though find that difficult given Rocker’s attorneys have taken steps to keep sealed what they insist is exculpatory evidence — and will return to this issue shortly.

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?“

In a recent interview, SEC whistleblower Gary Aguirre offered his insights into the regulatory failings that allowed the Bernie Madoff scheme to reach such enormous proportions for so long.

Aguirre places particular blame upon the “revolving door” culture that hangs over the SEC’s workforce, with its attendant promise of a lucrative move to the private sector in store for those whose approach to regulation is deemed acceptable to the regulated.

As Aguirre puts it:

The system maintains itself, because those that stay know their turn will come if they play the game. They see a director or associate director move onto a $2 million job with a Wall Street law firm. Then, the departed employee calls back to his former colleagues and says, “you know I really don’t think there is much of a case against so-and-so, I’d like for you to take a look at it.” And the case goes away; the system goes on in perpetuity … [There’s a] culture of ‘don’t rock the boat,’ the industry does not want ‘boy scouts,’ and if you can be effective with the SEC through your contacts, that is a very valuable asset you can bring to the table.

To summarize, Gary Aguirre says that a large part of the SEC’s widely-acknowledged (though not as yet fully comprehended) dysfunction results from the self-reinforcing cycle of:

1. High level SEC staffers accepting positions with powerful institutional market participants, in order that they might…
2. Pressure their former associates to take regulatory action beneficial to their employers, and in the process…
3. Impressing upon former associates the value of regulating selectively – as the former staffer had done – in order to ensure their own eventual move to the private sector.

This revolving door dynamic is at the heart of the high degree of “regulatory capture” observed at the SEC and a central focus of this blog.

But enough of the theory of the SEC’s revolving door…let’s look at it in practice (as Mark Mitchell did in a superb item last month) through the example of Richard Sauer, former assistant director of the SEC’s Division of Enforcement.

First, a little background.

In June of 2003, after 13 years with the Commission – including seven as assistant director – Richard Sauer left the SEC for the law firm of Vinson & Elkins. There, among his clients, Sauer counted Rocker Partners hedge fund.

On October 6, 2006, the New York Times published Bring on the Bears, a rather lengthy opinion-editorial authored by Sauer, which argues, on the surface, that short sellers are as vital to healthy markets as predators are to healthy ecosystems.

Fair enough.

But set in the shadow of that well-worn market truism are some disconcerting clues as to Sauer’s mindset, both present and past.

For one, Sauer is dismissive of the uptick rule (a provision created to prevent bear raids intended to drive a company’s stock down) as an unfair vestige of a by-gone era, calling for its elimination.

For another, Sauer reveals that while at the SEC, he initiated many investigations into public companies based on the tips from short sellers betting on a drop in those companies’ stock prices. Indeed, he says short sellers were his only source for these kinds of investigations.

And for yet another, Sauer defends the relationship short-biased hedge funds have with journalists such as Herb Greenberg, Roddy Boyd, Carol Remond and Bethany McLean, while calling on the SEC to initiate enforcement actions against companies that “attribute their woes to conspiracies by short sellers,” and “retaliate against critics through defamation campaigns and manipulative short squeezes.”

As unsound as his logic is, on one point we can be certain: Sauer is at least telling the truth. A former co-worker confirms that while he and Sauer worked together at the SEC, Sauer had been involved, at least tangentially, in most of the investigations instigated by short-selling hedge fund Rocker Partners.

But the most telling sentence in Sauer’s op-ed piece is the one he didn’t even write, but which appears a the end, as an editor’s note. It reads:

Richard Sauer, a former administrator in the Securities and Exchange Commission’s enforcement division, joined the management at a short-biased hedge fund this week.

Of course, that short-biased hedge fund turned out to be Rocker Partners (which had recently changed its name to Copper River Partners).

In December of 2006 Institutional Investor Magazine published a small story on Sauer’s new gig, noting that “[hedge] funds regularly brought [Sauer] complaints of possible wrongdoing at companies they were betting against.”

When asked whether his job description at Rocker Partners might include getting future SEC investigations launched, Sauer responded, “it remains to be seen.”

In point of fact, thanks to emails produced through discovery in the Fairfax Financial (NYSE:FFH) vs. SAC Capital, et al, lawsuit, we know that there was nothing at all remaining to be seen, for by mid-November of 2006, Sauer had already emailed keyesr@sec.gov (someone he apparently knew well enough to address only as “Rob”), pointing him to one of the anti-Fairfax sites set up by Spyro Contogouris, and attempting to spin Contogouris’ then-recent arrest on embezzlement charges as a Fairfax-motivated act of retribution.

In light of what we’ve just learned, let’s revisit Gary Aguirre’s theory of regulatory capture at the SEC:

1. Former Associate Director of Enforcement Richard Sauer accepts a position with Copper River Partners, a short-biased hedge fund known to be heavily shorting Fairfax Financial.
2. Sauer pressures former SEC colleague Robert Keyes to take regulatory action likely to negatively impact the share price of Fairfax.
3. Keyes is impressed by the need to regulate selectively – as Sauer had most likely done while at the SEC – in order to ensure his own eventual move to the private sector.

And the cycle continues.

Of Aguirre’s three requirements, we can state with certainty that in the case of Richard Sauer, the first two are satisfied. It is my opinion that the third requirement has been, as well.

What all this means is not that Richard Sauer is a bad person, for I don’t know a thing about his character. What I do know is that he has spent most of his professional career enabling bad people, first from within a fatally flawed regulatory agency, and later from without.

Mr. Sauer, if you’re reading this, given your recent unemployment following Copper River’s collapse, I sincerely hope you’ll hold out for a job that breaks the cycle of regulatory capture and actually makes the world a better place in the process.

If this article concerns you, and you wish to help, then:

1) email it to a dozen friends;

2) go here for additional suggestions: “So You Say You Want a Revolution?“

In the adult novelty & video arcade shop that is our New York financial establishment, one of the mop-and-spooge-bucket boys is Roddy Boyd, formerly of the New York Post (for folks who move their lips when they read Entertainment Weekly), and currently, of Fortune Magazine (also known as “People Magazine for Capitalists”). I have met Roddy on occasion, and a more seedy and furtive character would be difficult to name. Many years ago I knew a one-eyed Chinese guy named “Chaney” who ran a Bangkok pawn shop/mail-drop who was (it was rumored) working for Taiwanese, Chinese, and Soviet intelligence, simultaneously, but by appearances anyway, Chaney was a model of probity and fair-dealing when compared to Mr. Boyd.

Admittance into Roddy’s New York financial journalism spooge-bucket-brigade is conditional upon acceptance of The Fundamental Principle and First Corollary of that august fraternity:

The Fundamental Principle – Hedge funds can do no wrong, particularly if they belong to a small constellation whose brightest lights are Stevie Cohen, Dan Loeb, David Einhorn, Jim Chanos, and David Rocker.

The First Corollary –  If any corporation or individual appears to have been wronged by activities of any of these hedge funds, using methods up to and including stock counterfeiting and manipulation, blackmail, harassment, and intimidation, use of private eyes and internal moles, inciting endless and expensive investigations that go nowhere, and so on and so forth, it must only be because they deserved it (for proof, see The Fundamental Principle).

Today Fortune Magazine’s Roddy Boyd gives fine illustration of these rules in an article on  Copper River Partners (née Rocker Partners). This is the same Copper River/Rocker Partners whose exploits are chronicled throughout DeepCapture, and who have been frequent beneficiaries of reportorial lotion-jobs from Roddy, Karen Richardson (WSJ), Herb Greenberg (CBSMarketWatch), Joe Nocera (New York Times), and Jim Cramer (CNBC & TheStreet.com), and have been long-time recipients of  Bethany McLean’s highly-regarded regulars-only service. (Full disclosure: Copper River is also on the business end of a Marin County lawsuit filed by Overstock.com, in which I played modest role.)

In today’s think-piece, Roddy treats us to such insights as:

• “But for noted short-sellers Copper River Management, a $1 billion hedge fund based in Larkspur, Cal., the month turned into a perfect storm. A devastating combination of counter-party failure, sudden regulatory edicts and margin calls conspired to turn the fund’s performance on its ear, leading to a 55% loss in just two weeks.” Translation: In the last two weeks Copper River lost over half of its billion dollars, though not through any fault of its own. Instead, counter-party failure, regulators, and those pesky margin calls “conspired” to create “a perfect storm” that lost the half-billion dollars.

• In case the point was lost that none of this had to do with the quality of Copper River’s investments, Roddy Boyd writes it out. He really does, in those words: “What’s worse for Copper River is that the battering had nothing to do with the quality of its investments.”

• We are treated to a bit of financial arcana: “On top of that, as Lehman unwound its own internal hedges to the Copper River trades, its trading desks bought shares of these companies, driving up their prices and leading to losses for Copper River.” Translation: Lehman sold puts to Copper River that Lehman then hedged by shorting stock (most likely in abuse of the option market-maker exception), and when Lehman covered those shorts it hurt Copper River, whose investment strategy assumed an environment where shorts rarely need cover (and understandably so). As far as Roddy Boyd is concerned, the possibility that a short might “cover” (that is, “at some point obtain and deliver that which they have sold”) and thereby cause loss to a favored hedge fund has “nothing to do with the quality of its investments.”

• As though that litany of impositions were not harrowing enough, Roddy chronicles further injustices suffered by Copper River: “That was bad enough, but on September 19, the bottom fell out for the fund. That was when the Securities and Exchange Commission ordered unprecedented restrictions in short sales” (as our nation’s financial system was imploding). And further, “As prices in those stocks shot upwards, Copper River was forced to cover – or buy back – some of its positions at steep losses. “ This is intolerable: how could a hedge fund such as Copper River make money if it has to deliver what it sells?

• And lastly, this chestnut: “The rising stock prices also led to a series of margin calls (demands for additional cash collateral to be deposited in a margin account) from Goldman Sachs, Copper River’s prime broker.” I’m with Roddy on this one: it’s damn inconsiderate of Goldman Sachs to insist that Copper River have funds to back its play.

But perhaps I am too hard on Roddy. “Out of the crooked timber of humanity no straight thing will ever be made,” said Kant. A gal moves to the big city, gets behind, does things of which she is not proud. Molded are we all of imperfect clay.

But normally, she doesn’t write home about it.

It’s just Roddy’s ill fortune to have to perform these acts in national print.