The story below on K12 is the last one for The Financial

Thank you profoundly for reading, your support and courtesy.

There is a reason for folding now: The type of reporting work done here is difficult and time-consuming. Started as a hobby and becoming something (much) more, frankly lacks the platform, reach and capital of other investigative organizations, nor do I have the raw talent of, for example, John Hempton or Carson Block’s Muddy Waters.

As you all know, the world of investigative reporting, or more accurately, the act of waving red flags at investors, has changed. wasn’t going to be able to change with it. I don’t short stocks, don’t cut corners and don’t, well, do much of anything but write and report.

Within a few months, I plan to have launched The Southern Investigative Research Foundation, a nonprofit focused exclusively on investigation’s into companies and other attention worthy sorts within the capital markets.

Size and reach matter in this game. SIRF will have the distribution, funding and, should things go according to plan, staff to tell some mighty interesting stories. I don’t feel you will be disappointed.

With thanks,

Roddy Boyd

Editor’s note: Over the past week, the NCAA notified K12 that it will no longer accept credits earned from Aventa Learning, a K12 unit whose internet coursework has been favored by college student-athletes or those prepping for professional debuts, because of concerns over rigor and standards. Language and documents discussing this have been inserted near the bottom of the article.

The new school year appears to be starting off with plenty of headaches for leading online educator K12.

Like a seventh-grader caught flipping to the answers in the back of the book, a Florida county nailed the one-time Wall Street darling for apparently misleading regulators and parents about who was teaching its students.

From the moment it secured its contract to run Seminole County’s Virtual Instruction Program in early 2009, K12 represented to Florida Department of Education officials that courses offered in a fast-growing virtual school were taught by certified teachers.

In many cases they were not.

Nor, according to documents obtained by The Financial Investigator via Freedom of Information Act, was this a one off administrative or judgement error.

A report Seminole County submitted to the Florida Department of Education’s Inspector General’s office seeking their involvement in the matter lays out the scheme clearly enough.

The trouble began for K12 in January with what appears to have been a series of tips from former company teachers upset over the matter.

The tips pointed investigators to a series of E-mails and phone calls in August and September 2009 between Patty Betoni, the then-Director of Virtual Instruction Programs at Florida Virtual Academies (the K12 unit running Florida’s county-level virtual instruction programs; she now holds the title of Head of School) and Diane Lewis, Seminole County’s Director of Instructional Technology.

At the time, K12’s Betoni and her staff were scrambling to come up with Florida-certified teachers to staff Seminole County’s growing online student population and in a pinch, Betoni had apparently inquired to see if they could fill in the gap using non-certified teachers. The answer was “no.”

Florida’s law on this, as Seminole County laid out to K12 (and in the FOIA documents) is unambiguous: The teachers had to be state-certified. Florida, which has staked out a claim nationally in publicly embracing virtual and charter schools as a cornerstone of its education policy, expressly promises parents that teachers in schools paid for with public funds will be certified.

Why K12 simply ignored Seminole County’s demand is not known. Regardless, per the internal E-mails, K12 continued to use what is known in education circles as a “teacher of class” and a “teacher of record” framework. It’s a simple concept: State-certified teachers sign the FTE, or full-time enrollment forms, showing the state that a student was enrolled full-time–thus satisfying Florida law–during the school year but the class instruction and grades were handled by a “teacher of class” who didn’t have to be certified in the subject matter. [Though state certification naturally does not guarantee expertise in the subject matter, it does ensure working familiarity with it and at least some experience teaching it.]

To education bureaucrats the distinction is a formal but necessary one; to K12 it is vitally important. Hiring certified teachers to instruct every class is an expensive proposition, and thus stood to hurt the Seminole County contract’s margins. Conversations with administrators of public and virtual schools reveal that the economics of staffing a faculty with only certified teachers makes a virtual school’s employee cost structure similar to a standard public school’s. In Seminole County’s case, a more likely scenario is that teachers with certification in one subject–science, for example–wound up instructing students in other courses too, such as math.

The fine points of education law aside, the economics of full compliance  almost certainly makes these contracts lower-margin for K12. The company’s business model was built on offering flexibility in education and its corporate income statement is likely most attractive to Wall Street with the same flexibility. Seminole County pays K12 $3,995 a student per year for virtual schooling, so an extra $5,000-$10,000 annual salary expense in each of the 42 school districts in Florida where K12 operates virtual schools would cut profits.

Still, from Seminole County’s point of view, after the position on certification had been driven home to K12, the matter was seemingly resolved.

Within K12, however, it was business as usual. According to E-mails obtained by Seminole County, in February of 2011 when it came time to certify enrollment via the FTE form, K12 project manager Samantha Gilormini sent a teacher named Amy Capelle an E-mail acknowledging that fudging the books had become policy.

Per the E-mail on page nine of the PDF, Gilormini advised Capelle that she would see “A few extra students on [her] class roll.” In her case, 105 of the 112 students on a class list were not hers. Capelle immediately protested that this was unethical and, a few weeks later, formally refused to sign the class list.

Regardless, Gila Tuchman, a K12 administrator who hadn’t taught those courses, signed off on the list “for” Capelle.

Seminole County did an internal audit of its February 2011 class rolls to get to the bottom of the “Teacher of class/Teacher of record” issue. One analysis they did that interviewed parents showed that 61 of the 88 students attending the school reported that they were listed as having at least one teacher who did not instruct them.

[K12 sought, but was denied, permission to run a charter school in Seminole County last year; it is expected to be receive a charter this year.]

Jeff Kwitowski, a spokesman for K12, was emailed a copy of the Seminole County investigation and asked for comment. His reply, via E-mail, took exception to Seminole County’s assertions.

“K12 has been working closely with the Florida Department of Education and Inspector General’s office on the issues discussed in the documents. K12 does not believe that allegations of any kind of violation are accurate. Because K12 is continuing to work with state officials on these issues, further comment would be inappropriate until that work is complete.”

Both Tuchman and Gilmorini remain with K12 in administrative capacities; Capelle is no longer with K12 and did not return a message left on her cell phone.

The back-and-forth with Seminole County is not the only bad news K12 has gotten as the school year begins.

The Georgia Department of Education cited the special education program of the K12 administered Georgia Cyber Academy for a host of violations in June; a letter discussing these issues issued last month is here. The letter leaves little doubt that the Department of Education means business: If GCA does not fix a host of problems by the end of October, steps to revoke the school’s charter will begin.

The issues read like a laundry list of evergreen complaints made against K12-run schools: High caseloads, high staff-to-student ratios, FTE reporting and questions over compliance with spending IDEA funds.

In K12’s defense, the letter notes that progress has been made in improving several areas. Asked for comment about Georgia, K12’s spokesman said matters are in hand.

“Georgia Cyber Academy (GCA) has been working with a consultant, recommended to GCA by the Georgia Department of Education (DOE), for the last several months on these issues. That consultant recently filed a report to the DOE indicating that the school has taken action to address each issue identified by the DOE. The consultant considers the school to be in substantial compliance and is awaiting final review and acknowledgement by the DOE.”

Still, as with Florida, both the problem and solution are rooted in money. Running an effective cyber education program for special needs children inarguably requires a tremendous amount of teacher time and interaction. In turn, this requires more teachers–specifically, experienced teachers–which, definitionally, is more expensive for the school.

K12′s message to parents and legislators has always been uniquely powerful: You and your child should have a choice in education. It resonated so thoroughly that K12′s backers, its longtime chief executive Ron Packard and, until recently, its shareholders, were handsomely paid for their faith in an education beyond a classroom’s walls.

But the educational benefits of the K12 choice don’t appear to have paid off, handsomely or otherwise, quite as neatly for the students. Rarely does a week go by without more headlines centering on concerns over the effectiveness of K12′s schools or programs. Specifically, the NCAA’s refusal to accept credits from Aventa Learning due to concerns over the rigor and standards of the courses is a potentially devastating blow for one of the company’s most high-profile business lines. (Click here to read a letter from a K12 executive discussing the issue; here is an internal K12 E-mail seeking information to comply with the NCAA’s investigation.)

The money that it takes to remedy the seemingly structural flaws in K12′s business model will ultimately come out of its bottom line. Until then, K12 remains stuck in a desperate race, effectively a reprise of the sub-prime mortgage origination business circa 2004: Enroll more students than drop out because financially stressed state governments likely cannot increase reimbursement levels.

All races, of course, end. There came a point when sub-prime mortgage investors decided they weren’t being paid enough for the true credit risk they were assuming and there will come a time when parents and school boards will decide whether the true cost of educational choice is being fairly allocated.





The Financial Investigator has obtained the actual resignation letter that PriceWaterhouseCoopers wrote to the Public Company Accounting Oversight Board when it stopped working for China Medical Technologies, a collapsed Chinese maker of cancer diagnostic devices.

The resignation letter, obtained via Freedom of Information Act and filed with the Securities and Exchange Commission’s Office of the Chief Accountant, is dated April 23 and is a brief, formal notification to China Medical chief financial officer Takyung (Sam) Tsang and the company’s board of directors that PWC resigned the account without providing any reason for doing so. Based on previous reports–and private PWC communication with investors that has reviewed–it appears that PWC had not been able to communicate with anyone at China Medical for months. This is congruent with the accounts of others, including former company board member Iain Bruce, the retired former senior partner of KPMG Asia, who wrote a resignation letter noting that he had been unable to hail anyone at China Medical since early January.

Seen plainly, evidence is mounting that save for some truly creative alleged machinations around February 9, China Medical has been dead to the world since the end of last year.

Tomorrow, July 27, the bondholders begin proceedings in the Grand Cayman judicial system to dissolve the company and seize its assets. While a standard tactic for defaulted bondholders to pursue, if the California complaint cited above proves true–and Stroock & Stroock & Lavan’s lawyers insist their claim is based on documents retrieved from Chinese corporate archives–then the bondholders may well recover little of value.

None of this helps answer why the Deutsch family have continued to hold on to a 40% stake in a company whose dissolution begins tomorrow.

Publicly and privately, the Deutsch’s advisors at AER Advisors insist short-sellers have manufactured much of the controversy surrounding China Medical Technology for their own unethical ends. Accordingly, the Deutsch’s, the wine importers turned distressed Chinese equity players, do not appear to have begun reducing their 10.1 million share position. reached out to David and Carol O’Leary, the husband-and-wife team running AER, for comment. They angrily insist that since China Medical is a foreign issuer, it does not have to file public notice of a change of auditors. Previously, Carol O’Leary had vocally argued PWC’s resignation had not been proved.


The situation surrounding China Medical Technologies continues to get more curious daily.

On July 13, in California Superior Court, three holders of the defaulted convertible notes filed suit against the chairman of China Medical, Wu Xiaodong, for allegedly engineering the transfer of most of the company’s operating assets to a pair of companies he privately controls.

The trio of hedge funds, WhiteBox Advisors LLC, GLG Partners LP and Visium Asset Management LP, holders of the 4% and 6.25% convertible notes, are seeking a jury trial and damages based on their ultimate losses. While all three funds have large asset bases, the losses appear material: Whitebox owns about $29.8 million of the two classes of notes, GLG has $26.8 million and Visium over $51 million.

If their argument is correct–that Wu transferred the majority of China Medical’s operating assets to himself–then their effective recovery is likely to be zero. For their part, a lawyer for the hedge funds told that their asset transfer claim was based on documents uncovered in China, but which are to be revealed in full at a later date.

The thrust of the hedge fund’s claims is that on February 9, Wu transferred 60% of the equity and personnel of China Medical’s operating subsidiaries, Beijing GP Medical Technologies Co. Ltd, Beijing Bio-Ekon Biotechnology co. Ltd., and Beijing Yuande Bio-Medical engineering Co. Ltd., to a pair of companies he owns.

According to the claim, the asset transfer was done at a minimal cost, with Wu paying only 5% of the (unspecified) amount China Medical paid to acquire the assets several years prior.

Given that there is substantive doubts China Medical Technology is even operational–one investigator told that its headquarters has been abandoned “for months”–personally suing Wu, who allegedly owns property in Orange County, California, is the most logical choice for a suit. There are few levers available, however, to either the U.S. government or the hedge funds’ attorney’s at Stroock & Stroock & Lavan to compel a response from Wu, a Chinese citizen.

After a 10-day SEC imposed trading halt, the shares reopened on Monday and promptly collapsed to $3 at Tuesday’s close from $10.78 two weeks prior. They have rallied to $3.48 today in light trading on the OTC Bulletin Board.

The most curious aspect of the China Medical saga, the massive amount of capital spent by the Deutsch family through their investment advisors at AER Advisors on shares of a company that has been delisted from an exchange for failure to comply with its listing standards, and whose auditors have resigned, appears no closer to resolution. attempts to get comment from AER’s Carol O’Leary or Peter Deutsch were unsuccessful; O’Leary asked that desist from contacting her. However, has obtained several E-mail threads between China Medical investors and researchers and the president of Carol O’Leary. She is steadfast in refusing to acknowledge that PriceWaterhouseCoopers has resigned, or that allegations of fraud have any merit, insisting that short-sellers such as Kerrisdale Capital Management’s Sahm Adrangi are involved in a manipulation scheme to discredit the company.




The secrets of China Medical Technologies are beginning to surface and they confirm what many openly suspect: The framework of its corporate control has long since collapsed and management has disappeared.

According to documents obtained by The Financial Investigator, China Medical’s auditor, PriceWaterhouseCoopers, resigned after failing to get responses from its management despite “repeated efforts to contact the company,” according to an E-mail from a PWC official reviewed by Under Securities and Exchange Commission rules, this constitutes a material development that China Medical was obligated to disclose, but did not.

The rule violations are quickly piling up: A public company must have an auditor and there are no circumstances in which they can present an annual report without one. While China Medical did not have to have another auditor in place before beginning the next audit, they were required to disclose PWCs departure within four days in a 6-K filing to shareholders. Moreover, the filing would have had to disclose if PWC resigned because of disagreements with management.

As it stands, these are merely academic concerns since two additional E-mail threads obtained by indicate that PWC resigned on April 23.

Iain Ferguson Bruce, the former senior partner of KPMG’s Hong Kong office and the company’s last independent director, resigned on July 3 after spending what he describes as fruitless months trying to get in touch with management. His last contact with management was on January 5th and despite directly requesting his resignation letter be disclosed, it was not. Another Bruce letter, dated May 22nd and demanding a special meeting of the board of directors, was also ignored.

From the standpoint of being a publicly traded company, China Medical Technologies appears to no longer exist. Its management has not been physically seen or heard from this year, it hasn’t had an auditor in almost four months, its registrar and lawyers are unable to communicate with officers and its board has either quit or ceased oversight.

Then there are the bondholders, angry over their $400 million in loans to a company that defaulted without notice, despite a reported $206 million in cash on its last balance sheet. Though this ad in Monday’s Wall Street Journal shows that the liquidation of China Medical is continuing apace, what will remain for bondholders to sell off in the hopes of obtaining a material recovery is highly uncertain.

On a human level, what this means for William and Peter Deutsch, father-and-son wine importers, and AER Advisors, a husband-and-wife run investment advisory in New Hampshire, is equally unclear. Recall that the Deutsch’s, having never appeared in a financial filing before February, built what would become a $43 million stake in China through AER, whose primary foray into active ETF management ended ingloriously when the ETFs shut down as performance suffered, at least partially because they owned some notorious Chinese frauds. The stake appears to be a material amount of Peter Deutsch’s wealth.

Carol O’Leary, the president of AER, declined repeated attempts to discuss the issue with, but has not been shy in discussing her views with other China researchers and investors via E-mail and phone. Put broadly, she dismisses most of the concerns raised by short-sellers as intentional distortions and expressed confidence that the Sarbanes-Oxley Act and the SEC’s oversight of the company was adequate.

On Monday trading in China Medical shares is slated to start again, per the SEC’s two-week administrative halt.

Matters, however, are indeed clearer for investors: they own an equity claim to a company that will almost certainly be liquidated and which fails to meet even the most rudimentary framework for being publicly held.

William Deutsch and his son Peter might not be names that are on the tip of investor’s tongues, but there is a fair chance that the wines they import have been. The New York area pair have done quite well for themselves importing and marketing some of the most popular wine brands on store shelves, including Australia’s [yellow tail] and Georges Duboeuf’s Beaujolais.

Finding previously little known vintners and peddling their wine to the middle class has paid off.

Starting out in a spare room in the family home 31 years ago, William–Peter joined in 1985–built a business generating $450 million in annual revenue. Through it all, the Deutsch’s managed to keep a generally low profile.

A low profile might not be in the cards for much longer, however, because of a stock market gambit seemingly gone off the rails.

The Deutsch’s have gotten themselves–and a handsome chunk of their fortune–enmeshed in a baffling securities investment scheme involving the shares of China Medical Technologies, a delisted Chinese company that appears to have fallen off the face of the earth. Per SEC filings, the Deutsch’s currently own a roughly $43 million stake–amounting to just over 13 million shares–or 40.4% of the float of a company that has not filed financial statements or communicated with investors or regulators in more than six months.

That has made for a long holiday weekend for the father and son since the Securities and Exchange Commission, noticing the frothy trading on the OTC Bulletin Board market, initiated a two-week trading halt for China Medical’s stock last Friday. The shares are slated to open back up on July 13, but there are risks: The SEC’s primary reason for the halt was the absence of corporate communications and shareholder filings and to date, The Financial Investigator has been able to identify a law firm or investor who has made contact with management. If China Medical’s shares have their registration revoked, or they do not reopen, the possibility exists for a loss of most or all of the Deutsch’s capital.

As things go, the trading halt is only the beginning of the incongruities surrounding what is fast becoming a saga.

At the center of everything is China Medical Technologies, a company whose stock is an unlikely platform for a pair of rich investors to make their SEC filings debut in. There is little doubt that few companies have ever had a six-month run as disastrous for investors as the Beijing-based maker of cancer diagnostic devices.

In December, Glaucus Research, a short-selling research outfit run by former Roth Capital Partners salesman Matthew Wiechert, issued an extensive report accusing the company of defrauding shareholders through rampant self-dealing. One week later the once $55 per share company, whose last issued financial statement claimed $206 million in cash, missed a coupon payment on its 6.25% convertible notes; in February, it missed the interest payment on its 4% notes. Its sole U.S.-based independent director, University of Washington Medical School professor Lawrence Crum, resigned, an event the company chose not to disclose (Crum, reached for comment by phone, declined comment “Upon instruction from [my] counsel.”)

NASDAQ delisted its shares in February when China Medical ceased filing financials; communication with investors, regulators and even lawyers, appears to have ended in mid December after it announced a balance sheet restructuring just weeks after reporting a 27% increase in operating cash for the first two quarters of its fiscal year. Liquidation proceedings have begun in the Cayman Islands to wipe out China Medical’s equity and hand over whatever corporate assets remain to the $400 million in angry bondholders. Topping it off, another short-seller, Bronte Capital’s John Hempton , who has had success identifying and writing about a series of Chinese frauds on his website, examined its technology and concluded it made little commercial sense.

So it’s easy to see how China Medical is widely understood as the stock market equivalent of a three-alarm fire. How the Deutsch’s got so close to the blaze can be pieced together through SEC filings.

North Hampton, N.H. based AER Advisors, run by the husband-and-wife team of David and Carol O’Leary, raised eyebrows when a series of 13-G filings listed the firm as being a massive buyer of China Medical’s seemingly doomed stock beginning in January. It wasn’t until the most recent filing that the Deutsch’s were even disclosed as the owners. Even the choice of filings merits a raised eyebrow: 13-G filings are for passive investments; 13-D filings, such as the one made on June 20, are done when an investor seeks to force the company to take actions such as a sale, merger or management change. [With China Medical completely silent and not opposing even its own dissolution--its website’s front page still lists its shares as traded on NASDAQ, with a last trade of $3.18--what corporate change the Deutsch’s might effect is unclear.]

Nothing in AER’s public history suggested a taste or skill-set for managing aggressive risk. Nor, from a corporate finance perspective, does the AER-Deutsch strategy of buying the stock as it traded upwards seem logical: AER could have merely tendered for the shares in February and March at between $1 and $2 and likely met many of their goals.

With four employees and just under $51 million in assets according to an SEC disclosure filing, AER’s non-Deutsch related business has been a mixed bag over the past two years. In September 2011, Invesco’s PowerShares shut down a pair of exchange traded funds AER managed for what appears to have been poor performance.

The only real link between the tiny New Hampshire money manager and a pair of wealthy wine importers from Fairfield county’s gold coast is through AER’s sole outside director, Thomas Steffanci, a former colleague of AER co-founder David O’Leary and the father of Tom Steffanci, the president of Deutsch Family Wines and Spirits.

[Multiple phone messages left with Peter and William Deutsch by phone at their homes and work were not returned. Carol O’Leary declined comment twice when reached by phone at her office. The Steffanci’s, both father and son, have unlisted phone numbers and were unable to be reached.]

If China Medical fails to open up again, it could be a financial body blow to Peter Deutsch, who owns 10.13 million shares (his father William owns 2.9 million.) A look at his September 2007 divorce filing suggests a net worth of between $40 million and $50 million based on an $18.42 million lump sum payment to his former wife, as well as giving the title to two houses and two cars (from a family law perspective, Connecticut practices “Just and Equitable Distribution” of marital assets, resulting in a generally even split of assets if there isn’t a prenuptial agreement in force.) With an obligation to pay a combined $350,000 annually in child support and private school tuition, amid a slowing economy and volatile markets, generating enough cash flow to buy $30 million worth of stock in a single company is not an easy feat.

The Deutsch’s and AER appear undaunted and are giving every indication that they are gearing up for a second round of stock purchases in the shares of a de-listed Chinese company of dubious provenance. This time it is ZST Digital Networks, a project of former penny stock banker and China Reverse merger impresario Richard Rappaport, whose WestPark Capital has structured and arranged a host of collapsed Chinese companies. WestPark’s regulatory problems, though unmistakable, pale in comparison to the sustained mayhem wrought upon investors by Rappaport’s former employers Cohig & Associates and its successor firm, EBI.

Remaining unanswered, of course, is a fundamental question: Why would otherwise successful business owners risk their good name and a measurable part of their fortune to play a short squeeze in a company that appears en route to being dissolved?

No definitive answer is likely forthcoming.

But China Medical Technologies made a host of institutional investors believe its tales of rapid growth and increasing profits when it raised $750 million in stock and bonds over the past five years. Next to those losses, the plans of a pair of winesellers and their struggling financial adviser are small beer indeed.





Theology and high finance rarely intersect but one place they likely met is at the Toronto headquarters of insurance conglomerate Fairfax Financial Holdings in the winter of 2003.

It was there, in the bitter cold of that early February, that V. Prem Watsa, Fairfax’s founder and chief executive, along with a handful of his closest colleagues, conceived a transaction whose effect has been nothing short of miraculous.

Certainly it didn’t seem like much: A then little known insurance company buying a block of shares in an even less well-known reinsurer it already virtually controlled hardly sparked chatter among insurance industry rivals or on Wall Street’s trading floors.

But it should have.

Fairfax’s purchase of 4.3 million shares of Stamford, Ct.-based Odyssey Re, increasing its stake to just over 80% from 74%, was the most consequential transaction in Watsa’s career. Though few understood it at the time, the March 2003 deal allowed the then money-losing Fairfax to take advantage of a little understood maneuver called “tax consolidation,” enabling Fairfax to claim (and receive) the profitable Odyssey Re’s tax payments.

Between 2003 and 2006, these payments amounted to more than $400 million.

That cash stream helped Fairfax avoid a brutal accounting charge that might have proven its undoing and boost its share price over several months to almost $250 from a January 2003 low of $57.

Ecstatic investors and nine-figure wealth was only the half of it for Fairfax and Watsa: The company launched a furious legal campaign in 2006 against a group of short-sellers who had (in some instances) quite publicly bet on the insurer’s demise, a campaign now entering its sixth year. Though developments and rulings in the case have recently been sharply unfavorable for Fairfax, its opponents have been silenced and their short-sales unprofitably covered.

With the breathing room the cash afforded, Fairfax was able to access the capital markets, allowing it the flexibility to wager more than $340 million on credit default swaps that exploded in value as the credit crisis worsened in 2007 and 2008. The bet paid off brilliantly and Fairfax ultimately reported a $2.1 billion gain, completing a five-year metamorphosis that saw almost $6 billion added to its book value.

Fairfax is now a full fledged cult stock among value investors, and its success led at least one well-known investor to announce his switch from being short to proudly owning the shares (he has since sold the stock.)

In a supreme irony, Fairfax’s own documents describing this transaction surfaced as part of attachments to a jurisdictional motion filed in the summer of 2011 by a then-defendant in Fairfax’s 2006 lawsuit.

Fairfax has long asserted, in full throat, that the Internal Revenue Service and Securities and Exchange Commission have closely scrutinized the March 2003 Odyssey Re transaction and found nothing wanting.

A careful reading of these filings, however raises many questions about Fairfax’s disclosure of this transaction and the quality of oversight from its auditors at PriceWaterhouseCoopers and advisors at Ernst & Young.

These documents show much of the approval process driven by trust in Fairfax’s claims that the transaction met all relevant standards. It is not clear from these documents that the faith analysts and regulators placed in Fairfax’s candor was warranted. At least one former key link in the approval process–Ernst & Young tax partner Richard Fung–acknowledged in a deposition that he now has concerns about approval of the deal in light of this new information.

The motion also included a 72-page analysis of the transaction from University of Southern California tax law professor and former chief of staff of the Congressional Joint Committee on Taxation Edward Kleinbard- a New York Times columnist described him as a “Rock Star” in the world of tax law–who, in a deposition, termed the transaction a “A sham in substance.” (Kleinbard was brought into the case by then-defendant Third Point Management; his analysis, for which Third Point paid him $1,000 an hour, is here.)

What follows below is how they did it.

The Odyssey Re share purchase was born in the desperation of a looming collapse.

Because of insurance losses from the September 11 attacks, the need to increase reserves and a bad acquisition, Fairfax’s auditors at PWC had concluded that an arcane tax asset then crucial to its balance sheet was going to have to be written down.

Called net operating loss carryovers (NOLs), they represent a company’s accrued operating losses that can be applied against future income to lower the company’s taxable income. Here’s how they work: a company with $500 million in taxable income and a $250 million NOL could apply it to cut the amount of taxable income in half. NOLs are certainly handy but they come with a firm proviso: they have a defined shelf life and can be used only when a company is “More likely than not” to generate the income to offset them, usually within seven years.

In other words, PWC had real doubts Fairfax could generate enough income in the future to warrant keeping the NOLs attributable to its U.S. operations. So in February 2003, the auditors informed the company that as of June 30, they were recommending half of its $795 million worth of U.S. NOLs on the balance sheet–or $348 million–be written down.

To be sure, companies large and small are constantly shifting the value of assets on their balance sheet for dozens of valid reasons.

But this was different.

PWC was demanding a material valuation allowance which would be accounted for as a charge against earnings. The charge would have given Fairfax their second massive annual loss in three years and prompt further share price declines–its market cap was around $1 billion at the time, and had dipped down to about $750 million that January–but where the real trouble lay was in the specter of credit downgrades, both on its corporate debt and its financial strength ratings, a key barometer of its claims paying ability. In early 2003, declining liquidity prompted Standard & Poor’s to reduce Fairfax’s credit ratings even further below investment-grade. Its insurance ratings from A.M. Best were affirmed only after the Odyssey Re deal was complete, a process Ambridge had spent weeks communicating with A.M. Best’s Joyce Sharaf about.

Thus buying the 4.3 million Odyssey Re shares that would take them to 80% ownership and tax consolidation was no longer an option, but a necessity.

There was a hitch, however, as Fairfax didn’t have the cash to spare.

To get around this, Fairfax’s Watsa and his staff, in conjunction with a Bank of America Securities team, came up with a three-step, cashless proposal whose final iteration was this:

1. NMS Cayman Services Ltd., an offshore affiliate of Bank of America Securities, borrowed the 4.3 million shares from 10 different institutions and then re-loaned the stock to Fairfax.

2. In lieu of cash, Fairfax issued a $78 million note to the same BAS affiliate as payment.

3. Fairfax then pledged the newly acquired Odyssey Re shares back to Bank of America Securities as collateral for the notes.

To outsiders, the Odyssey Re note deal was designed to appear like a convertible bond: It bore an interest rate and in March 2005 (two years after the transaction) was exchangeable into Odyssey Re stock, giving the holder–NMS, the Bank of America Securities affiliate–the right to swap back into the shares.

To insiders, including Bank of America’s credit analysis unit and Fairfax’s leadership, there was little doubt that the exchange would be made in two years: The Fairfax bonds carried a below-market interest rate of 3.15% and, according to then CFO Trevor Ambridge, the bonds represented “an inferior risk exposure” for Bank of America. Had Bank of America Securities held the bonds and not exchanged them back into stock, they would have been short 4.3 million, or 33% of the remaining Odyssey Re float, something the firm estimated would have taken 20 months to buy back in the open market and, quite likely, cost their trading desk tens of millions of dollars in losses.

Per Ambridge, in a July 2003 E-mail to a PWC partner, the transaction was structured to secure a block of stock for a limited amount of time for tax consolidation purposes without reducing the public “float,” or shares available for trading. He did not even want the extra 6% worth of Odyssey Re’s earnings included in Fairfax’s income statement since it was inevitable that Bank of America would exercise its exchange privilege and take the shares back in two years.

The transaction’s structure also casts doubt on whether Fairfax’s Odyssey Re maneuvers allow it to claim true ownership of the stock.

Robert Giammarco, a Bank of America Securities banker who helped design the deal, noted in an E-mail to colleagues that one of the transaction’s “disadvantages” was it “Does not provide true economic ownership” of the Odyssey Re stock to Fairfax. [Giammarco would go on to serve a 19-month term as CFO of Odyssey Re before joining Merrill Lynch prior to its purchase by Bank of America Securities in 2008. Fairfax asserted to the New York Times that he recanted his description of the deal in a 2011 deposition.]

Recall that Bank of America Securities did not sell Fairfax the securities, but borrowed the shares and then “sold” them to Fairfax for what both parties understood was to be a defined period; neither party ever exchanged cash as part of the deal because of the anticipated use of the conversion feature. Fairfax did not own them in any broadly understood sense of the word since it was not entitled to profit or loss from the 4.3 million Odyssey Re shares nor could they re-lend (or, in Wall Street parlance, re-hypothecate) them out. The company was also forbidden to sell any of the share block. Put simply, for all the deal’s complexity and hard work, the additional shares gave Fairfax no obvious economic privileges nor exposure to Odyssey Re.

Similarly, in agreeing to compensate Bank of America Securities for all of its hedging costs or losses, Fairfax was engaging in economic behavior entirely outside of market norms for a purchaser of securities. Edward Kleinbard, Third Point Management’s expert witness, noted in his opinion, “No bona fide owner of stock would agree to cover a short-sellers cost of maintaining its open short sale.”

The economic exposure argument is key since it appears there was no way Fairfax could profit from the Odyssey Re deal. If the stock price went up, Bank of America Securities would simply exercise their conversion privilege, without incurring any additional cost. On February 7, 2003, Prem Watsa wrote an E-mail to Sam Mitchell (a friend who would later become an executive with Hamblin Watsa, Fairfax’s investment subsidiary, and a board member of companies Fairfax had substantial investments in, Odyssey Re and Overstock) discussing an earlier version of the deal, noting that the “Purchaser [of the notes, i.e. seller of the stock] maintains upside/downside in ORH….”

Kleinbard terms this deal a “borrow to hold” because, in his view, its only conceivable goal was to show enough shares to convince the Internal Revenue Service to grant tax consolidation.

The one benefit that Fairfax did obtain from the Odyssey Re transaction was voting rights. Looked at plainly, however, the applicable law governing tax consolidation, IRS code 1504(a), offers the company little comfort, stating that tax consolidation applies only to companies owning 80% of the value of shares outstanding and 80% of the total voting power of those shares. At the end of the transaction, Fairfax still owned 74% of the shares outstanding and had constructed a proxy on 6.6% of the rest.


The circular path to regulatory approval for the March 2003 Odyssey Re deal began with Trevor Ambridge’s assertion to Ernst & Young–hired to write an opinion of the deal–that Fairfax “Will acquire good and marketable title to the Purchase Shares, free of any mortgage, lien, charge, encumbrance or adverse or other interest.” To comply with the IRS regulations above, Ambridge also wrote that, “Members of the Fairfax Consolidated Group will own Shares [of Odyssey Re Stock] representing at least 80 percent of both the total voting power and the total value of all of the issued and outstanding shares of Odyssey Re’s stock.”

Fortunately for Ambridge and Fairfax, E&Y’s opinion was entirely based on the assumption that share ownership was a settled matter.

Richard Fung, part of the E&Y team that worked on the opinion for Fairfax, said in a deposition that much of his firm’s work was based on a so-called rep letter from management asserting exactly what Ambridge claimed above. According to Fung, E&Y never examined how Fairfax obtained the shares and, had he and his colleagues understood that the entire goal of the transaction was based on exchanging the shares back to Bank of America Securities in two years, their opinion likely would have been different.

In a footnote at the end of Kleinbard’s opinion, he discusses his examination of Fairfax’s E-mails and internal correspondence in light of their assertions before the Internal Revenue Service about the transaction.

According to Kleinbard, Fairfax broadly misrepresented the deal to the IRS.

One example cited was the company’s claim that, “Fairfax had complete risk of loss with respect to the purchased shares, and the possibility of benefiting from their long-term appreciation.”

Ambridge, in the July 2003 E-mail above, argued a very different conclusion to the PWC auditors.

Even if the Odyssey stock price drops sharply, he wrote, there is no valid economic reason for Bank of America Securities to elect to hold Fairfax’s low interest-rate, then junk-rated debt. He estimated that the Odyssey Re “break-even” share price, or the point at which it would be reasonable to hold off on the exchange and keep Fairfax’s 3.15% debt, was $13.49. Even so, Ambridge (as Kleinbard argued) the price would be likely much lower than that since a drop to that level–Odyssey was then trading at about $18–would certainly imply Fairfax was also under economic stress, making ownership of its subordinated debt an even riskier proposition than taking the stock back.


A casual observer would conclude that Prem Watsa and Fairfax have matters well in hand.

The ledgers run thick with black ink (with some exceptions due to spikes in catastrophe claims) and if the lawsuit against short-sellers has not proceeded seamlessly, Watsa certainly has a much better reputation among investors than fellow short-selling litigants Patrick Byrne of Overstock and Eugene Melnyk of Biovail, both of whom have poor track records of building shareholder value.

So the IRS Whistleblower suit from 2007 pressing claims about the Odyssey Re transaction more than nine years later might well look futile given the scope of Watsa’s recent achievements with Fairfax. Investors, enjoying the recent elevation of the share price, and Fairfax’s legal and media advisors, who have earned tens of millions of dollars in fees from its legal, reputational and regulatory battles, may well downplay a complaint filed in an office known for its lethargy.

But it is unlikely Prem Watsa will. After all, few executives should have a keener appreciation of how narrow the line really is between good and ill fortune and desperation and the miraculous.

Fairfax was approached for comment on this article via E-mail through its longtime outside public relations advisors at Sitrick & Co. They declined comment.

A few words of disclosure: I was the first reporter to write about this transaction in July 2006 and I am the financial journalist described in their suit against analysts and hedge funds. In the summer of 2011, Fairfax subpoenaed me for a deposition but I fought it and won.

An April 23, 2010 E-mail from Kevin Corcoran to a host of his colleagues is likely the sort that, in one form or another, millions of Americans deal with regularly during the work day.

Bluntly noting “We have not made the progress we need to in this area,” Corcoran adds, “More than $1[million] in funding” is in the balance.”

“Anyone who has not fulfilled their obligation in this area should not be surprised….when it’s time to discuss performance evaluations, bonuses and raises.”

The $1 million in question isn’t from a customer but represents tuition and fees from Pennsylvania’s various school districts to an online public charter school called Agora. In turn Agora pays Corcoran’s employer, K12 Inc. many millions of dollars annually to provide the curriculum and administer the school. There is a lot at stake in collecting this money since Agora and a sister school in Ohio, the Ohio Virtual Academy, represent about 26% of K12′s annual revenues.

The relationship between a cyber charter school like Agora and K12 is an interesting one.

Agora, and many other schools like it, is a nonprofit managed by an independent Board of Trustees but K12, a publicly traded company founded in 2000, is most assuredly for profit, as the upwards slope of its income statement attests to. This rapid growth has made the company beloved of Wall Street’s research departments–the stock price run from 2008 to 2011 is self-explanatory–and until a lengthy New York Times investigation that was sharply critical of the company’s educational effectiveness, it was a core holding of growth stock managers.

In the E-mail, Corcoran, who is Agora’s financial chief, was miffed because 81 “IEPs,” short for individualized education programs–basically customized teaching plans for Agora’s growing populace of special education students–hadn’t received the necessary signatures; without them, various school districts would not release reimbursement of  $15,000 per pupil (or higher) to Agora, and thus K12, to educate a student populace that have had profound troubles meeting educational expectations.

[Of course nearly every school, public and private, struggles to keep up with the burgeoning cascades of paperwork various state and federal authorities demand and, to be fair, people on the E-mail list told The Financial Investigator that the 81 unfinished IEPs had been whittled down from a list of several hundred in the weeks before the E-mail was sent.]

Corcoran’s E-mail is a fair representation of the broader challenges K12’s growth-first business model brings both for the company and its teachers and students.

Consider the charts of monthly enrollment changes and churn calculations at three of the four virtual academies below:



Agora grew like a wildfire in the 2010 school year. A total of 7,578 students were signed up through the course of the school year, of whom 4,718 were in place in September. Throughout the year, a total of 2,688 dropped out for a student turnover, or churn rate, of 35.5%.

K12’s other virtual academies, Ohio Virtual Academy (OVA), California Virtual Academy (CAVA) and the Colorado Virtual Academy (COVA) show a similar level of churn.

–OVA enrolled a total of 18,743 students cumulatively throughout the 2010/2011 school year with 9,593 withdrawing by the end of the year, for an astoundingly high churn rate of 51.1%

–CAVA schools signed up a total of 16,934 students in the 2010/2011 school year (11,682 were enrolled in September) and 23.8% pulled out.

–COVA schools had 6,449 students registered through the 2010/2011 school year of which 4,163 were enrolled as of that August. A total of 2,330 dropped out for a churn of almost 36.1%

The charts are an effective numerical illustration of the dual realities of K12.

In the reality of Wall Street and K12′s marketing effort, there is the well-documented and remarkable growth of the schools themselves where a tidal wave of school district reimbursement dollars is whisked to its Herndon, Va. headquarters, propelling the share prices steadily higher. To this end, the growth of the student bodies themselves are a clear testament to the popularity of the school choice and charter school movement, as well as K12’s comprehensive online marketing and enrollment advisory efforts.

Just as evident, however, is another reality: the fact that these cyber schools might as well have a turnstile as their logo for the volume of withdrawals they experience. The growth that has made the company’s shareholders and founders–the Milken brothers, a fund capitalized by Oracle Corp. founder Larry Ellison, current chief executive Ron Packard, as well as former Reagan administration Education Secretary William Bennett–so happy is making many of the families whose kids attend the schools apparently much less so.

By way of explanation and comment on these numbers, after a week-long E-mail and phone effort to get a response, a K12 spokesman declined to offer an official comment to an E-mailed list of questions, at least in part because of concerns as to where The Financial Investigator got the student turnover numbers. [They were obtained from a variety of sources. In Agora’s case, the chart foots almost perfectly with the numbers listed in this record of a Board of Trustees meeting. For the Ohio Virtual Academy, an official provided a document with annual totals, but no monthly enrollment and withdrawal numbers broken out.]

K12 insiders have regularly said Cyber Charter schools “Aren’t for everyone, maybe not even for most students but are really good for some students.” To that end, the churn rates can be explained as a byproduct of the school choice movement being in its infancy and the fact that the virtual academies are public schools and have to take all resident students that apply within that state, even if it is clear to everyone–save for the student or their family–that cyber education isn’t in their best interests.

The stark velocity of the student withdrawal rates plainly suggests, however, that something has gone terribly wrong.

Chief executive Ron Packard has remarked that K12 has only begun to tap into the vast potential of its marketplace, using the phrase “manifest destiny” in a conference call with analysts to describe his hope that a K12 education would be available to every American child. These withdrawal numbers suggest a different destiny. There is a very good chance the company has drained the pool of the students most able to succeed in a virtual school–the ones coming from families who are willing to conduct themselves as home-schoolers and spend four-to six-hours daily directly involved with their child’s education–and will have to settle for an increasingly marginal applicant.

There is a lot more churn to come, in other words.

Remediating it won’t be an easy proposition for management or shareholders to swallow in that it would likely entail hiring more teachers and retaining more of the one’s they have on staff, both of which are moves that would weigh on the expense line. Moreover, the possibility of a unionized faculty, if enacted, would surely force pay increases, and constrain the ability of K12 to easily dismiss faculty (something it does with relative frequency.) Putting the matter another way, making the virtual academies into lower-churn, higher-performance schools is likely going to require a very different set of decisions from those that made running virtual academies an attractive business.

The battle over whether K12 provides a compelling education for its students is the educational equivalent of discussing abortion: opinions are religiously held and there is little quarter (or consideration) given to the other side. K12, for example, has quite plausibly asserted that the entire measurement regime of average yearly progress (AYP) is deeply flawed. They argue that they provide an independently administered test that shows, in many cases, students making impressive gains through the school year.

Stanford University’s Center for Research on Education Outcomes, on the other hand, put out a report last April that studied the effectiveness of Pennsylvania charter schools and concluded that students from Pennsylvania’s cyber schools were performing “significantly worse” in math and reading than their public school peers.

Both sides of the debate seem to ignore the central fact of life at a K12 managed cyber charter school: Outside of the students that are professionally motivated–the K12 program is popular with teenagers training to be elite athletes or for careers in the performing arts–there is strong anecdotal evidence that the students with the best chance of succeeding in virtual academies are effectively home-schooled.

More plainly put, to the extent they are as potentially effective as their advocates say, this makes K12’s virtual academies publicly subsidized home-schools.

Whether the parents embrace the cultural, religious or political traditionalism that is often associated with home-schooling or not, “Learning Coach” is a marketing term designed to be more palatable to prospective enrollees than “Parents-who-make-Johnny-turn-off-World of Warcraft-and-do-geometry-every-single-thankless-day.” It apparently works as these students (generally) score quite well relative to their peers across the state and leave capable of doing college-level work.

They are also a fraction of the virtual academy’s student populace, according to teachers, perhaps no higher than 30% of a given school.

In an economy such as this, where both parents are likely working harder than ever to make ends meet–if there are even two parents or guardians in the picture to teach children–students from households that lack the “home-school” orientation are the preponderance of students who are withdrawing from the virtual academies.

Anecdotally, however, these are just the sort of students making up the majority of the virtual academy enrollee waves every month.

The high churn rates doesn’t just effect students.

Conversations with current and former K12-run cyber charter teachers and administrators paint a portrait of institutions growing so rapidly that educators, most of whom had no experience with online education, were overwhelmed.

Heidi Gardner, an Agora special education lead teacher who resigned last year, said the turnover in enrollment led to a massive expansion in non-instruction work for teachers.

“If you weren’t trying to make initial [E-mail or phone] contact with new students then you were trying to keep on top of the ‘inactive’ [students who had not logged on to Agora’s web portal in a few days] or confirm if students who not been in contact with [teachers] for weeks or months were still enrolled,” Gardner said. “You could add four hours to your work day doing this.”

“When it came to the actual instruction, you’d be a secretary, scheduling in 10 minutes here and there for students who often had complex learning challenges. For the harder cases, [teachers] always put in the time and just carved it out of our lives.”

The E-mail cited above is evidence the first of the profound administrative challenges caused from this growth. One of the 81 incomplete IEPs that had annoyed Agora’s Corcoran was of a special education student categorized as “absent” for 141 straight days, but who had not formally withdrawn, so even though he hadn’t attended the school since the early autumn, his home district still (apparently) reimbursed Agora.

The mercurial growth also brought out some rather unintentional moments of comedy.

Gardner says that the special education department received a $200,000 federal grant under the American Recovery and Reinvestment Act for the 2010/2011 school year. As a function of trying to manage the ever-fluctuating class lists, the grant appears to have been completely forgotten about. Under the terms of the grant, however, funds had to be spent by September 1, and according to Gardner, the funds were “rediscovered in May.”

“I had direct orders to make sure it got spent. We were made to run around for weeks buying I-Pads and gift certificates to Barnes & Noble and ITunes, getting dozens of copies of voice translation software we just kept at the office, throwing parties for graduating seniors across the state and we still couldn’t finish the grant money,” recalled Gardner. “So dozens of extra $50.00 gift cards were given to teachers who had nothing to do with Special Ed, all of whom thought [Agora's Head of School] Sharon [Williams] was simply being very thoughtful.”

“They had no idea it came from the federal government,” said Gardner, who described herself as “Still angry that I was made to do that,” suggesting the story is “Basically the reason everyone who pays taxes should worry about something like ARRA.”

Financially, churn runs into some basic “laws” of business.

When any enterprise has high customer turnover, an increase in incremental expense, usually in marketing and advertising, is required to replace them, a scenario that appears to be already playing out. For example, in the most recent quarter, K12‘s selling, general and administrative line increased over 330 basis points (3.3%) on a year-over-year basis. In combination with a pronounced miss in forecast revenues, the increased costs contributed to 16 cents in earnings per share versus an analyst consensus of 27 cents, explaining how for the second time in a few months, K12 investors got a little lighter in the wallet.

Cash flow isn’t going great guns either.

Earnings before interest, taxes, deprecation and amortization dropped to $21.7 million from $24.3 million in the same quarter of the year prior, and free cash flow after capitalized costs–the cash K12 has left over after spending what it had to for software and other online education essentials–dropped to $2.74 million, down from $24.5 million in the fourth quarter last year.

The cash flow isn’t at red flag levels, to be sure, but they are proof that expenses continue to be a major drag on what many of the company’s proponents assert is an unalloyed success story.

In this vein, the fate of K12 and the CEO’s “Manifest Destiny” vision won’t be found in the microsurgery of parsing its cash-flow statements, but rather in the public hearing rooms of dozens of state capital office buildings across the country where regulators and legislators hash out state education policy.

Though K12’s lobbying prowess is legendary, there are mounting signs that states are openly questioning whether K12 and the idea of cyber charter schools are an effective use of declining pools of education dollars.

From Des Moines, where this editorial cautioned against a headlong rush into cyber schooling to Pennsylvania, where Agora’s Board of Trustees signaled (see underlined portion) that it wants to renegotiate its contract with K12 downwards in price when it comes up next. Even Florida is getting into the act, with K12 losing an appeal three weeks ago to expand its cyber charter school activity throughout the state.

The marketing allure of an argument for “educational choice” is justifiably powerful as is the deep-seated political and policy frustrations with well-entrenched teachers unions. But Packard’s “Manifest Destiny,” like the American justification for expanding westward in the 1840s, is eventually going to have to demonstrate results for its constituents. It wasn’t always pretty or just, but settling the West was an inarguably beneficial move for the American people, both then and now. Whatever the possibilities inherent in a K12 virtual education, with 25%-50% of a student body departing in a given year, there is a clear signal being sent about its reality.

K12 shareholders have profited mightily from Packard’s dreams of expansion. His other constituents, the parents and children in his company’s empire of virtual schools, might give him a very different grade.


Investigators with the New York office of the Federal Bureau of Investigation raided the offices of Benjamin Wey’s New York Global Group yesterday, seizing documents and conducting interviews with employees.

According to one NYGG official, Wey’s Manhattan apartment was also raided. As of now, no charges have been filed and it was not clear what NYGG transactions were of interest to the FBI. Attempts to contact NYGG and Wey were unsuccessful; a man answering the phone at the firm’s 40 Wall Street offices refused to give his name and would only reply, when questioned about the raid, “No one is here right now.” Follow up calls were not answered. Jason Marshall, an official at Wey’s longtime publicists, said Wey and NYGG are no longer clients.

The raid was in many ways surprising in that legal repercussions from the collapse of the China reverse-merger boom had been minimal, save for some occasional de-listing activity from exchanges.

Wey is the self-appointed poster-child of Chinese reverse merger promoters and has been no stranger to the readers of The Financial Investigator, arranging any number of Chinese transactions that have collapsed under dubious circumstances.

Moreover, Wey had just helped his most recent transaction, CleanTech Innovations, launch a lawsuit against NASDAQ stock market, “For racism and discrimination” over the self-regulated exchange’s decision to delist the then-recently listed company, purportedly for the role Wey played within the company.

On June 10th last year, a hedge fund manager named Kevin Barnes got a very direct E-mail from one Neal Marder, the head of Winston & Strawn LLP’s Los Angeles litigation group. In the E-mail was a PDF of a letter that made abundantly clear two things to Barnes: The first was that in many ways Marder thought Barnes was about as dull-witted a character as could be encountered in the capital markets and the second was that Barnes was going to be spending a great deal of money in the next several years on legal fees.

Marder’s letter to Barnes was full of strongly held opinions not just because he billed nearly $1,000 an hour, but because the PDF is more properly known as a demand letter and had been written on behalf of Winston’s newest client, SkyPeople Fruit Juice, a China-based manufacturer of fruit juices and concentrates. The letter existed because Barnes, in his role as general partner of Cheyenne, Wyoming-based Absaroka Capital Management, had released a 26-page report on June 1 that claimed that SkyPeople had an armful of issues.

Barnes and his researchers in China had discovered that SkyPeople didn’t, as they had long asserted, own the largest Kiwi fruit plantation in Asia, that its factories were smaller, idled and full of older equipment and the products were on a lot fewer shelves than had been disclosed. Most importantly, a study of the documents SkyPeople filed in China describing their financial condition with the State Administration of Industry and Commerce (better known as SAIC) painted a very, very different picture of its health than those filed for investors with the Securities and Exchange Commission. If Barnes had read them correctly, SkyPeople was telling the Chinese regulators they were 10% of the size they were telling Americans.

To Barnes, and most other investors, that was a decent working definition of the word “fraud.”

That day, SkyPeople’s stock price, which had been trending south for about a year, in line with dozens of other Chinese reverse merger companies whose prospects were now seen as problematic, dropped 18%, to $2.08 from $2.55 on heavy volume.

Marder, however, didn’t see it that way. He alleged that Barnes hadn’t read the filings correctly and had made one of the biggest mistakes in recent financial history. It wasn’t just a crappy thesis but was entirely false because he had used the wrong SAIC data.

In his demand letter, Marder doesn’t even entertain the idea that Barnes, a six-year veteran of J.P. Morgan’s Natural Resource investment-banking unit, would have pulled the wrong files back in China or simply inaccurately crunched numbers; the SAIC numbers Barnes cited could have only been “fabricated to appear genuine.”

In other words, Marder’s legal theory was that Barnes did what legions of pumpers and promoters have done with Over-The-Counter Bulletin Board companies for years: position the stock and then release scripted and embellished research or press releases that move the stock price favorably. Except with thinly traded pink sheet and OTCBB stocks everyone, including investors, is in on the joke and are investing because a pump is underway.

(The trick, of course, is properly timing the sale, or dumping, of the manipulated shares.)

Barnes, per Winston & Strawn, was playing the game with a listed Nasdaq stock and that is an order of magnitude more serious. Leaving aside the complete immorality of what Barnes was being accused of, it was a dangerous game that likely would prompt an invitation to discuss the matter from lawyers less well-paid, but sharply more powerful, than Neal Marder.

In case Barnes wanted to put the possibly nightmarish civil litigation behind him, helpfully attached to the demand letter was an affidavit Winston & Strawn had drawn up that retracted the entire report. To clarify his thinking on the matter, Marder had also sent along a copy of the suit the law firm was filing in two days if the retraction affidavit wasn’t signed.

This was crisply executed hardball worthy of much larger companies than SkyPeople Fruit Juice.

Barnes, as he saw it, was on the horns of a dilemma. If he stood by his report, as was his wont, his less than a year old fund would be engaged in a multi-year legal battle with a company that had nothing to lose and could use its working capital to pay its legal bills.

That was just the beginning, however.

As Marder surely understood, Absaroka’s investors, like all institutional investors, despise litigation. It distracts the manager from their work for long periods of time and the discovery process can unearth all the details investors prefer remain private, like E-mails discussing fee structure, investor risk tolerance and their investment rationale. Despite the fund’s excellent performance, few would invest in a fund under siege and fewer still would stick around to see how the suit ended up.

Then again, if Barnes folded and signed the retraction, his fund and his career were virtually finished. He would be, in essence, Barry Minkow without the interesting back story of redemption and sin.

So Barnes hired Arlene Fickler of Philadelphia’s Schnader, Harrison, Segal & Lewis, a lawyer with a good track record of experience in successfully representing short-sellers against aggrieved companies. He instructed her to try to negotiate a deal: He’d take the report off the website and wouldn’t write another if SkyPeople stopped the demand letters and litigation threats.

It didn’t work and on July 8 they sued Absaroka and Barnes.

The failure of negotiations struck Barnes as odd.

SkyPeople didn’t have a whole lot to gain from a protracted legal battle itself, and for the cost of a new Mercedes, it could have had about 70% of a victory, silencing a critic and taking a damaging report out of circulation. Barnes was short the stock in size at $5 and had made his money and although cutting any deal with the mouthpiece for what he considered to be a bunch of crooks was bitter, he was a businessman, not a hero or a crusader.

Over a series of bike rides in and around the foothills of Cheyenne last June Barnes tried to muscle his way through what he saw as the absurdity of it all, such as why a hastily constructed reverse merger company with, as he saw it, a lot to lose during the discovery production process would sue. Eventually, they would be forced to prove how, at their current growth rates, they were en route to overtaking Dole Fruit as the world’s premier fruit processor within the decade. He was certain that this explanation would end very, very poorly for them.

SkyPeople, he concluded, was betting everything that the best defense was to go on offense. It was a guarantee for long days, busted weekends and a drain on his once promising bank account.

On his lawyer’s advice he had just retrieved, for the second time, the company’s SAIC documents. Despite using a different service, they were identical. Moreover, a class action law firm had retrieved the filings and finding what Barnes had found, used them in their suit. GeoInvesting, a research shop who had done as much China fraud busting as anyone else, posted their own analysis of (two of the four) SAIC documents and noted that they matched Absaroka’s down to the auditor’s stamp.

Quite a coincidence, all of that.

When it became more interesting was when Barnes hired China counsel via Akin Gump Strauss Hauer & Feld LLP in August and they couldn’t retrieve the documents because they had been removed. Well, not all of them, to be fair, just the 2009 SkyPeople income statement and balance sheet which were what he had centered much of his analysis on, as well as documents from several subsidiaries where he had alleged self-dealing occurred.

And that’s where it got really curious.

Because whoever was behind the SAIC document caper hadn’t known that there were ample footnotes throughout the remainder of the SAIC files, all of which refered back to the sums and line-items that Barnes had used in the Absaroka report. In other words, Barnes was still on solid legal footing, readily able to cite official Chinese documents to support his claim of SkyPeople’s having two sets of books, albeit with a whole new level of sixth-grade quality intrigue mixed in.

The backstory would soon become the main issue when, on July 25th, another lawyer Akin Gump had hired in the city of Zhouzhi to pull documents on various SkyPeople subsidiaries and transactions received an anonymous phone call on his cell phone demanding to know why he was conducting an investigation and whether he planned on suing SkyPeople.

On August 1, another person called the Absaroka lawyer and told them to drop the investigation or else the caller “Would come down hard on [the lawyer.]”

It added a Grisham-esque quality to what was, at bottom, a ordinary company-versus-short-seller dispute. The missing documents and the phone call forced Barnes and his lawyers to spend hours puzzling out what SkyPeople’s end game could possibly be. There was also the real world dimension to be considered: this was China and threats made against corporate investigators had a disturbing probability of being implemented, so ignoring them as a prank or legal bluster was to put other people’s lives at risk.

On the other hand, even though Barnes had zero interest in being a poster boy for the first amendment, SkyPeople had devolved in his eyes from scammers to thugs. If these guys were going to play this rough out of the gate then this could only be taken in front of a jury where the company could explain and prove their side of everything.

For more money than he cared to reflect on, his lawyers went over everything he had done, said and written. It wasn’t enjoyable but the fine-tooth comb was clean at the end of it all: Absaroka, it appeared, had done nothing that couldn’t be explained in front of a dozen strangers. Everything Barnes wrote was backed up by veteran investigator accounts, photos, multiple onsite interviews and the company’s Chinese filings.

In case it was still in the back of his mind, settling wasn’t an option as Marder had, once or twice in passing, mentioned to Barnes’ lawyers that $50 million might be a workable sum in getting this all behind them.

Barnes clearly saw that he was in the right, legally and ethically, but Marder’s gambit had worked exactly as expected: Investors were pulling out despite returns on their capital that were approaching triple-digits. New investors were, in the main, telling him some version of, “Thanks, and we’re sure you’re right, but we’ll be on the sidelines until this blows over.”

He refused to plead with them but his arguments about good returns and bad companies fell on increasingly deaf ears; eventually, one investor who seemed to genuinely have empathy for Barnes and his plight, gently told him that as an allocator of capital, he wasn’t in the “Fighting fraud business,” but had to make a buck. He couldn’t expose his investors to Barnes’ problems.

So, rather like the First World War, where for many years the cost of making peace was worse to the combatants than the cost of fighting the war, the suit would continue. The truth aside, settling would cost Barnes his fund and career. The expense of fighting the suit was en route to accomplishing the same end, just more gradually.

All of which came to strike him as precisely the point.

People with more money at stake than he did had no real interest in the suit going away.

If SkyPeople settled the suit out of court, it was a tacit admission that Barnes was correct and would likely attract regulators. There was little need for that though since the company had raised about $33 million in a pair of financings over the previous two years and despite spending $15 million on a pair of (related party) deals they had plenty of cash for legal bills.

Winston & Strawn was building a handsome franchise out of defending SkyPeople, representing them in the shareholder suit as well as the Absaroka matter, raking in tens of thousands of dollars monthly. The law firm’s China-based associate on the case, Laura Luo, was intimately familiar with the reverse merger sector’s blues, having been a longtime legal advisor to RINO International Corporation as well as SkyPeople. Crummy Chinese companies were getting nailed left and right for every conceivable scam and making a go of it for SkyPeople was an impressive calling card.

Ironically, Marder, who runs the case, had never been to China nor worked on a reverse-merger case before this one. He certainly didn’t lack for initiative, asserting in a letter to Barnes’ lawyer that SAIC documents were not actually public documents–as has long been held–and that his forwarding them to Barnes would be a violation of Reg FD. [He has since backed off this claim, likely because it is wholly inaccurate.]

[Marder and his colleague Laura Luo did not reply to detailed E-mails seeking comment; a SkyPeople spokesman, David Rudnick, spoke briefly to The Financial Investigator last week but did not reply to a pair of E-mails seeking comment.]

From where Barnes sat, Winston had discovered the proverbial fatted calf: As long as there was a scintilla of enthusiasm on SkyPeople’s end for the fight, keeping the briefs and filings flowing was a means for them to wade daily in a river of shareholder cash.

Still, like all wars, the longer it went on the uglier things were that had surfaced from the wreckage of it all.

Barnes and his legal team pored over the various filings and press releases from the shareholder action with great interest. Originally studying them Talmudically for data they could use in their own battle, they soon came to view the growing body of SkyPeople filings as more akin to a train wreck and read them in a state of disbelief.

What company, for example, in their right mind would ever consider disclosing that their U.S.-based former chief financial officer did not own any stock but that her “day-trader” husband was regularly trading blocks of its stock? [A day-trader, it should be noted, who holds on to his positions for months at a time.]

Similarly, proudly announcing the dismissal of BDO Limited Hong Kong, their semi name-brand accountant (admittedly one with a track record of signing audits for a murderers row of epic historical frauds, like China Expert Technology and China-Biotics) for Paritz & Company of Hackensack, N.J. would have normally appeared to be a hoax; for SkyPeople, it represented their considered thinking on good governance.

It struck Barnes that such a move was a case of “Features versus Bugs.” Paritz had no offices in China and a Public Company Accounting Oversight Board review that noted departures from generally accepted accounting procedures, revenue testing failures and inability to identify related party deals. Rather than reject the hiring of such a demonstrably unsuitable firm, these were the best things that Paritz had going for it. The last thing the company wanted, Barnes supposed, was an auditor becoming demanding. He took some comfort from supposing that defending that move in open court would force Winston & Strawn to earn every cent of their fee, especially when they have to assert why it was the Audit Committee’s best available option.

Depending on the day, Barnes could be forgiven for thinking himself trapped in a poorly scripted avant-garde film, walking between light and shadow and truth and lies.

There is certainly an air of nihilism about the case: It is a virtual certainty that despite submitting hundreds of pages documenting their profound moral furor over Barnes’ allegedly fraudulent research, Winston & Strawn’s client wish to keep a large ocean between themselves and an American courtroom.

Barnes has no legal remedy he can pursue in China and even doing research there is now dangerous for him; U.S. courts have proven themselves unfriendly to short-sellers often enough, so betting on a summary dismissal involves more faith than reason. The SEC is nowhere to be found. The conclusion is inescapable: It will be a long fight.

There are no moral victories in these battles but if there were, Barnes could make a plausible claim for one. The market clearly does not believe SkyPeople has $76 million of cash on its balance sheet (or, for that matter, that it has nearly anything on its balance sheet or income statement) as its price of $1.69 per share attests to.

At the end of the day, there remains only the fight for Barnes and his hedge fund. The analyst-refugee from New York’s cavernous trading floors, he has come to accept his role as the unwitting champion of freedom of speech and the right to dissent, only wishing that at some point, it would all just go away.