Flatiron Group, associated parties face $110M lawsuit

A lawsuit seeking $100-million for general damages, plus $10-million for punitive damges, has been launched by Performance Diversified Fund against the Flatiron Group, individuals who worked at that group, the Front Street Group, the Sprott Group and KPMG LLP.

Performance, which had invested more than $100-million in the Flatiron Market Neutral LP and which had an 85% stake last November, before redeeming its units last February, makes a series of allegations in its 22-page notice.

None of those allegations has been proven in court and the defendants have not yet filed a defence.

Performance, a Toronto-based investment fund, alleges that Flatiron, formed in 2006 and which lost about half its value in the fall of 2012, deviated from its investment philosophy in and around 2011 “by making risky and imprudent investment and trading decisions,” and misrepresented “the value of some of the securities it held,” from 2010 to 2012.

Because of the “inflated values to the securities it held,” Performance increased its investment; had it known (about the inflated value of the securities) it would have redeemed its investment.

The claim alleges the misrepresentation occurred after Flatiron bought the majority of an issue of warrants (say 60% to 100%) it would, near month end, purchase more as a “market majority warrant.”  The claim alleges that “the Flatiron Group valued the market majority warrants by looking to their reported month-end value on the active market and reporting this value to the limited partners via monthly reports. Their value was reported on the last day of each month after the concentrated purchase of the additional warrants.”

In its claim Performance alleges there was “no active market for the market-controlled warrants.” The claim also alleges that while Flatiron said it “used three levels of analysis in valuing the underlying securities in its portfolio,” it “did not proceed beyond the first level of analysis,” which was the prices quoted in the active markets.

“Had Flatiron Group employed alternative models for determining the Market Controlled Warrants’ value, as set out in the second level of analysis and third level of analysis, such as the Black-Scholes model, the portfolio would have been correctly valued,” said the claim.

The claim provides some examples: as of Oct. 31, 2012, the Flatiron Group controlled about 80% of the issue of New Gold warrants; almost 100% of an issue of Gran Columbia Gold warrants; about 80% of an issue of Mercator Minerals warrants and 50% of an issue of Kinross Gold warrants. In all cases, the allegation is that the additional warrants were purchased at a premium to their Black-Scholes value.

How much of a premium? The claim said it was $27-million as of December 31 2011.

KPMG was named because it was the auditor for the Flatiron LP. The claim alleges that it “failed to audit Flatiron LP in accordance with GAAP principles. Its failure to follow GAAP resulted in its failing to discover the manipulations of the value of Flatiron LP’s portfolio,” says the claim.

KPMG couldn’t be reached for comment.

Calls to Front Street Capital seeking a comment weren’t returned. (Front Street, along with Sprott, took over the management of the fund on Nov. 30, 2012.) We were unsuccessful in reaching Performance Diversified Fund.

Sprott, which bought the manager last August and which started the orderly liquidation of fund in November, said that it “denies any liability in connection with the claim and will vigorously defend the claim.” The fund was wound down by early February.