Overstock.com drama spurs lawsuits

Date: Thursday, November 29, 2007
Author: Bethany McLean, Fortune editor-at-large

In a raft of lawsuits and countersuits on Wall Street, companies allege conspiracy, and now hedge funds cry foul. Fortune's Bethany McLean reports.

(Fortune) -- In August 2005, a company called Overstock.com filed a lawsuit against hedge fund Rocker Partners and research firm Gradient Analytics, alleging that Rocker, which was short Overstock's shares and Gradient, which had published skeptical research reports about the company, were conspiring to push its stock price down.

The lawsuit seemed to start a trend. A drug maker called Biovail (Charts) soon filed its own lawsuit against a group of hedge funds and research analysts, and soon thereafter, a Canadian insurance company called Fairfax Financial -- which, oddly enough, now owns almost 15% of Overstock -- did the same thing.

The lawsuits read like novels, with allegations of sinister plots by powerful Wall Street players, accompanied by anonymous phone calls and threatening packages. Although the defendants have tried to get the suits dismissed, the courts have ruled that they can move forward. That seems like drama aplenty.

But now, there's more: Counterclaims.

Several weeks ago, Copper River (the successor firm to Rocker Partners) filed a counterclaim against Overstock.com (Charts), its CEO Patrick Byrne, and members of the company's board of directors alleging, among other things, that they have "tried to distract from Overstock's failures by making false and disparaging accusations against the company's critics, and by filing this meritless lawsuit."

A few days later, several of the defendants in the Fairfax Financial (Charts) case -- a research analyst named John Gwynn and his firm, brokerage Morgan Keegan -- filed a defamation action against Fairfax, alleging that Fairfax has waged a "media campaign" in order to make Gywnn "a scapegoat for Fairfax's financial, legal and accounting problems."

Then, late last week, hedge fund analyst named William Gahan and his firm Institutional Credit Partners (ICP) filed counterclaims against both Fairfax and its law firm, Kasowitz Benson, for "intentional infliction of emotional distress, defamation, prima facie tort, and injunctive relief." (Full disclosure: I'm mentioned in both countersuits because I've written about both companies for Fortune in the past.)
Ironies revealed

In both cases, the countersuits reveal some strange ironies about these cases. You might think that if a conspiracy of Wall Street's most powerful players targeted a company, shorted the stock, and tried to use their combined might to push the price to zero, that they might meet with some success. Instead, in both cases, the supposed agents of destruction were the ones who lost a ton of money. That's at least in part because the heavy short position in each stock led to "short squeezes," where the stock soared ever higher as the shortsellers were forced to buy to cover their positions.

The other irony is that as ugly as the alleged tactics of the shortsellers in the original complaints are, the shortsellers' countersuits allege equally ugly tactics by the companies. Do two wrongs (assuming there were wrongs in the first place) make a right?

In its countersuit against Overstock.com, Copper River alleges that that company "has never had a profitable year, and its cumulative losses to date exceed $238 million." Despite that, its stock soared from $16.50 in January 2004 to $77.18 in December 2006. (Overstock filed its suit against Rocker and Gradient in August 2005, when its stock was around $43.)

The stock has subsequently fallen to about $23, as a tidal wave of bad news washed over the business. In the past few years, Overstock.com has had three board members resign. The company is the subject of an ongoing SEC investigation into its "accounting policies...targets, projections, or estimates related to financial performance... communications regarding short selling, naked shortselling, purchases and sales of Company stock," and more, according to its filings. Last year, Overstock posted record losses of over $100 million.

Copper River alleges that the stock reached the peaks it did because of "concerted fraud and manipulation by Overstock, Byrne and other senior officers and directors." In March 2002, Byrne told a reporter that the company was profitable -- "that's real GAAP profit, not Amazon bullshit accounting profit," he said. Overstock's prospectus for its public offering, which was filed the next day, showed otherwise: In fact, the company lost $13.8 million in 2001.

According to the lawsuit, the defendants repeatedly lied about the company's performance and prospects by making "false claims that the company was profitable when it was not, false projections that it would become profitable when it could not..."

Copper River also alleges that CEO Patrick Byrne tried to silence critics by suing them, and by attempting to "threaten, bully and intimidate" them with "false accusations of wrongdoing and vicious personal slurs." In just one example of many, Byrne hired a guy named Judd Bagley to be Overstock's communications director.

Bagley runs a website called antisocialmedia.net, which, according to the complaint, he uses to "vilify those who criticize Byrne and Overstock." "Bagley and Overstock have also used electronic spyware embedded in emails and message board posts to spy on and intimidate Overstock's critics," alleges Copper River.

Overstock did not return a call for comment, but the company's lawyer, Jonathan E. Johnson, previously told the New York Post that "[Copper River] has threatened to launch this since day one, but now that it arrives it contains nothing but smoke. The fact that they did not submit it until all other avenues were exhausted speaks to the weakness of their claims."
Curious timing

As for Fairfax, its stock, which hit a low of less than $50 in the spring of 2003, now sells for almost $300. If you read Fairfax's original suit, you would think the company was a paragon of corporate virtue, and that any problems it suffered were inflicted on it by mean hedge funds.

But Morgan Keegan's countersuit notes that Fairfax has had more than its share of problems in the past. For instance, Fairfax filed its original complaint on July 26, 2006, which was "exactly one day before Fairfax announced that it had violated accounting rules and was required to engage in a massive $225 to $240 million restatement."

"Fairfax was beset on all sides by problems of its own making, including continued legal problems and investigations, poor financial results, and repeated accounting violations," says Morgan Keegan's suit suit.

While Fairfax's stock undoubtedly benefited from short squeezes, the company, unlike Overstock, has posted good results in recent quarters. Its insurance operations may have turned the corner, and CEO Prem Watsa has minted money by making a big bet against the credit markets. From today's vantage point, it's hard to see what damage the the alleged shortselling conspiracy managed to inflict on the company. (Fairfax has argued in the past that its lawsuit stymied the conspiracy.)

According to the countersuits, Fairfax also employed dirty tactics in its efforts to silence critics. ICP's counterclaim alleges that members of Kasowitz's security force "lurked outside the ICP office and followed ICP employees to their homes."

That's seconded by Morgan Keegan's complaint, in which Gwynn says that he "believes that Fairfax arranged for at least two individuals to approach Gwynn under the pretext of being a potential Morgan Keegan client who was interested in Gwynn's coverage of Fairfax. These individuals demanded that, as a condition of directing his brokerage business to Morgan Keegan, they be given advance notice of Gwynn's reports -- a request that Gwynn flatly refused."

Fairfax says that the counterclaims "have no merit" and are "nothing more than a weak and transparent effort by those defendants to distract attention from the racketeering charges against them."

What's next? Well, the discovery phase of the lawsuits should certainly be interesting. Stay tuned.