|Shares Out. (in M):||15||P/E||0.0x||0.0x|
|Market Cap (in $M):||47||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-77||EBIT||0||0|
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1) Coventree failed to make full, true and plain disclosure in its prospectus by failing to disclose the fact that DBRS had adopted more restrictive credit rating criteria for ABCP in November 2006
2) Coventree failed to meet its continuous disclosure obligations by failing to disclose that DBRS's decision in January 2007 to change its credit rating methodology resulted in a material change to Coventree's business or operations
3) Coventree made misleading statements in April 2007 by telling the market that the total US subprime exposure in its sponsored conduits was 7.4 percent, but failing to provide investors with a breakdown of that exposure by conduit and ABCP note series. The exposure was higher than 15 percent in three conduits, and higher than 40 percent in one note series
4) Coventree failed to meet its continuous disclosure obligations by failing to disclose liquidity and liquidity-related events and the risk of a market disruption in the days leading up to the market disruption on August 13, 2007
I believe that the first two allegations above have substantial merit and that Coventree has a high probability of losing both of these allegations. The market seems to have fixated on the third and fourth allegations, both of which are questionable, and to be ignoring the first and second allegations. Both the first and second allegations essentially concern the same set of changes being made by DBRS, with the first alleged disclosure violation representing the initial communication by DBRS of the stricter ratings criteria and the second alleged disclosure violation representing the actual implementation of the change.
A close reading of the transcripts from the trials shows that the company committed a substantial omission in its pre-IPO prospectus regarding changes in the ratings criteria by Dominion Bond Ratings Service (DBRS). DBRS essentially decided to change the way that it rated arbitrage transactions in the asset backed commercial paper (ABCP) market in Canada such that new arbitrage transactions would not be possible. DBRS was the only rating agency covering the ABCP market in Canada. As the entire ABCP market was sold based on ratings and the buyers had no visibility into the underlying collateral behind any individual conduit, any ratings changes implemented by DBRS would effectively change the entire structure of the market. The changes DBRS was proposing would have the effect of causing a serious change to the future structure and profitability of the ABCP Conduit Sponsors such as Coventree. About 80% of Coventree's revenues were the result of arbitrage transactions, so this was a material negative event for Coventree. The change to the way that DBRS planned to rate arbitrage transactions was communicated to the sponsors in the period between when Coventree filed its initial prospectus and when it filed its final prospectus, yet Coventree never updated its prospectus to reflect this negative event. Moreover, the change to DBRS's ratings criteria which caused a change in Coventree's prospects was only communicated to the conduit sponsors and not to the general market. It was therefore impossible for the general public to understand that a material change was coming to Coventree's business without specific disclosure by Coventree in its prospectus.
Even though this seems as though it could be dismissed as a simple oversight by Coventree due to the timing of the change by DBRS, the reality is much more insidious. There were two reasons not to disclose these events. Most importantly, the shares being sold were secondary shares and this was a way for the company's shareholders and founders to cash out. Now that their business model was under threat, they had all the more incentive to move forward with the IPO. Second, Coventree faced an imminent liquidity crisis as a result of rights by the Caisse de Depots (Caisse), a major shareholder, to ask for a redemption (put rights). As a result of these put rights, Coventree was going to be forced to reclassify the equity owned by Caisse into the liabilities section of its balance sheet and this would threaten its creditworthiness as a sponsor. While a simple fix would have been to remove these put rights, Caisse had already communicated to Coventree that it planned to exercise its put rights in 2008. Put simply, Coventree had the choice of go public and cash out the owners or possibly go out of business. Faced with this threat, Coventree made a conscious choice to omit the negative events. After all, who would purchase the IPO of a company where 80% of its revenues were going away?
Many observers of the Coventree saga have wondered why the OSC included a section on the company's IPO prospectus in its statement of allegations. I believe that the above series of events gives a good overview as to where the real problems are with Coventree. The OSC is usually limited to collecting $5-million per fineable offense, but in this case the OSC can actually fine the sellers the entire three times the IPO proceeds since they are considered "gains" from the lack of disclosure. Since Coventree has indemnified the management, the 3x IPO proceeds at risk would need to be repaid by Coventree itself. In addition, the OSC has actually characterized the second allegation as an ongoing disclosure violation over a period of time rather than a one-time disclosure obligation. The OSC has therefore taken the position that it should be able to fine Coventree $5-million for each day of the ongoing disclosure violation rather than a single $5-million fine. This seems overboard to me, but it's clearly a downside risk.
So how much downside could there be? I think nearly 100%. At 9/30/2010, Coventree had $77 million in book value that might have been realizable in a liquidation. Conservatively assuming that the company's calendar Q4 burn equaled its calendar Q3 burn, that would now be down to about $72 million (based on the roughly $5 million in estimated calendar Q4 legal expenses, bringing the total to about $20 million since 2009). The company raised $45 million in its IPO and the OSC can triple this as a fine. In addition, I see $5 million in disclosure violations related to the second allegation (possibly more if this is characterized as multiple ongoing violations) and $20 million in reimbursable OSC legal expenses. It's not hard to see how we can get to zero from here.
Let's examine Coventree's defense. Coventree basically says that it already knew that the market was in trouble and it was therefore moving its business model away from arbitrage transactions and towards new lines of business, such as trying to start a bank, but the reality is that the prospectus does not adequately explain the threatened future of the sponsor/conduit business that was the core of Coventree. They also claim that they included some items in the prospectus to the effect that there was a risk DBRS would make its approval of transactions more restrictive; however, the reality is that this was boilerplate language and nowhere in the prospectus does it state that DBRS has actually made its approval more restrictive and that DBRS had literally just communicated the changes to the company (i.e. they were communicated between filing the preliminary and final versions of the prospectus) meaning that the historical earnings are not ongoing. More importantly, the prospectus does not make clear that these changes will effectively result in the gutting of Coventree's business model that accounts for 80% of its revenues as the existing assets mature. As regards the events of January, 2007, Coventree's defense is essentially that it could not quantify the effects of a tightening of DBRS's criteria. Just because you can't quantify a negative change does not mean that it's not material and not in need of disclosure, especially when it relates to 80% of your revenue. In summary, Coventree appears to have very weak defenses regarding the alleged disclosure violations in its IPO prospectus and in January, 2007.
The above analysis is based on my careful reading of several thousand pages of OSC hearings. I'm not aware of anyone else that has actually bothered to get the transcripts from the OSC hearings. They are extremely expensive ($10/page and thousands of pages) and the process of purchasing them is annoying (you need to send certified checks through the mail to the transcript service). If you want to get them yourself, you can request them from www.stenographers.com and go through the hassle. Moreover, my initial requests to purchase the transcripts were denied by the service and I needed to make multiple attempts to get them.
I don't think that the third and fourth allegation against Coventree are very strong, so I will not cover them in this write-up, especially since I think that the first two allegations plus legal costs of the OSC are enough to wipe out the company. However, should anyone wish to engage in dialogue on these two allegations, I would be happy to detail my thoughts.
I can't cut and paste the whole transcript, but I can give you some direct excerpts so that you can get a sense of just how strong the OSC's case is:
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