January 11, 2011 - 10:25am EST by
2011 2012
Price: 3.09 EPS $0.00 $0.00
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 $M): -77 EBIT 0 0
TEV ($): -30 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Coventree Financial (COF.H - TSE Venture) is a near-term donut if it loses its case with the Ontario Securities Commission (OSC). There is borrow in the stock available at the top rate. Coventree was originally formed as a sponsor for Asset Backed Commercial Paper (ABCP) conduits in Canada. Subsequent to the ABCP market disruption, Coventree's ongoing business evaporated and the company entered into liquidation, with the only remaining hurdle before implementing the liquidation being a series of allegations made by the OSC against the company regarding various disclosure violations. Many people have since grown constructive on Coventree's stock based on the apparent low penalties for disclosure violations, the OSC's history of small fines and lax regulation, and the wide gap between current book value ($77 million) and the market cap ($47 million). However, my analysis below will show that the company faces bankrupting losses when the tribunal rules on a now complete set of hearings held to determine the validity of the following four allegations against the company:

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 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:


  • Almost four weeks after the preliminary prospectus was filed, on November 10, 2006 DBRS sent an e-mail to various market participants including Coventree. Now, this e-mail was not available to the general public and it concerned ABCP. I'm going to ask you to pull out a copy of that e-mail which is in volume 3. You are done with that one. Tab 140. This is the document that we refer to in the statement of allegations, the November 10th e-mail and because it is going to be the subject of very much discussion in this hearing, I think we should go through it together fully...They continue: "However, consistent with DBRS's new approach to SFA transactions, market participants should also expect that the types of SFA transactions that will be approved going forward will be more restrictive than those approved in the past." And on the second page: "DBRS says this mandate is effective immediately."
  • You will also see evidence that will show that Coventree was aware that the DBRS November 10th notice was an important restriction on its business. For example, an immediate reaction of one Coventree employees was to say to Mr. Cornish that Coventry would not been able to meet its funding goals for 2007. Yet Coventree didn't change it is prospectus disclosure. Mr. Cornish wrote in an e-mail to Mr. Tai, which I will have you turn up if you could, it is in volume 3, tab 62, the top e-mail in the string is the one we're referring to. "Dean, FYI. We're going to have to get another rating agency in Canada or a U.S. conduit or both." Signed Geoff. Now, Mr. Tai was also reasonably quick to tell Coventree's subsidiary company, Nereus, that the DBRS November announcement threatened Nereus's business model.


  • Could I have you please pull up volume Tab 185. This is an e-mail December 20, 2006 from Mr. Tai to a number of people who are members of the board of the directors of the subsidiary company. Neurus. It is item number two that I would like to direct you to. He is basically talking about prioritization of the activities for the subsidiary company. So number two is find a strategic direction or business model that is sustainable and worthy of continued investment by the shareholders. "The LSS funded through ABCP is clearly dying. This is clearly a business that DBRS does not like and wants to regulate, both the players and growth. As a board member, (this is of the Neurus company) I have been saying this for quite some time with it falling on deaf ears or ears more focussed on short term profitability." So, that shows the significance of the DBRS announcement.


  • MS. WAECHTER: I'm sorry. This is a letter written to staff of the Commission post market disruption. And it is a response to a continuous disclosure inquiry by staff. And at page number, using top numbering, 4936, item 7: "Please provide us with the approximate revenue breakdown for credit arbitrage transactions for the three-month periods ending December 31, 2006, March 31, 2007 and June 30, 2007." And if you turn over the page there is a chart. And that's where the 80 percent number that I'm referring to comes from. As of December 31, 2006, it was 80 percent. At March 31,2007 it was 79 percent and in June 30, 2007 was 81 percent of Coventree's revenue came from credit arbitrage. Now, Coventree's prospectus doesn't really give any indication of how much of its revenues came from credit arbitrage. So we know this now because of the staff letter. But it was not knowable from Coventree's prospectus at the time. So Coventree's prospectus didn't give any indication of these revenues or the effect the notice would have on its business.


  • So in this press release, DBRS was advising that it had revised criteria for Canadian ABCP issuers who were engaged in arbitrage type transactions or SFA transactions and it was effective immediately... They continue: "DBRS has recently declined to approve many of the SFA transactions proposed by CP issuers and at this time believes it's appropriate to outline to market participants the basis on which DBRS would find new SFA transactions acceptable for the funding by ABCP."


  • So, what this meant for Coventree, this announcement, is that it could no longer use GMD's liquidity to support the assets purchased by its conduits. But it would have to use global style liquidity. And one of our respondents later commented on what this meant in an affidavit that was sworn in another proceeding. Could I have you pull up volume 6, please? It is page 337. There is an affidavit. There was a dispute between Coventree and its subsidiary and this affidavit was filed in connection with that. So if you could turn please to page 2094, paragraph 44, this actually goes backwards a little bit to the November announcement. But it is an affidavit sworn after the January announcement. Actually, in March after the January announcement. So it wasn't in the beginning. So over the summer, DBRS sent out proposed guidelines that would have severely curtailed the CDO business. Further to those guidelines on November 10, 2006, DBRS sent a letter to market participants saying and another quote, paragraph 45: "The most recent steps taken by DBRS was the issuance of a press release on January 19, 2007 in which DBRS announced a revised set of criteria for credit arbitrage entered into by conduits funded by ABCP. The DBRS press release outlines four criteria that it believes must be satisfied before it will approve a credit arbitrage transaction funded by ABCP conduits." All four represent challenges. But I believe the one that is most difficult is the third. The criteria that requires the transaction must be supported by the liquidity facilities that are not limited to market disruption and are not dependent upon confirmation of then current ratings. This represents a significant departure from prior rules. Previously conduit sponsors such as Nereus were able to fund credit arbitrage transactions using (a) extendable ABCP which did not require any liquidity facilities or (b) ABCP that would utilize liquidity facilities that were limited to market disruption and also were dependent on confirmation of the then current ratings of the underlying assets. Neither of these options is now available to Neurus. And in paragraph 47, he continues: "I know of no liquidity providers that are prepared to offer liquidity for credit arbitrage transactions on the terms required by DBRS. As a result I believe the Nereus current business model is no longer viable." Now, if that's true for Neurus, it is also true for Coventree.


  • So what staff say the evidence will show is that Coventree's then current model of ABCP funding for credit arbitrage transactions was finished. Coventree could continue to earn revenues on existing SFA assets underlying its conduits' ABCP, but this DBRS announcement meant that Coventree could not rely on its existing business model to add new credit arbitrage assets which were its main revenue generator to its conduits in the future. Coventree had deals awaiting approval by DBRS at the time and those deals didn't go through. Staff say that the DBRS announcement was certainly material to Coventree and was a change in its business operations that required disclosure. And we will be arguing that that material change required immediate disclosure under the Act.


  • So again at the time of the DBRS January press release, Coventree derived 80 percent of its revenue from credit arbitrage transactions and those were the very type that would be shut down by DBRS in the future. That revenue statistic is not in the public record and so there was no way for shareholders or potential shareholders to figure out what the impact on Coventree was from this announcement by DBRS. Despite the great impact on Coventree, the company issued no press release and failed to meet its obligation to make disclosure at the earliest opportunity. The first clear reference to this material change was in Coventree's MD&A dated March 31, 2007 which was filed on May 13, 2007. Basically approximately four months later.


  • The November 10th document was sent by e-mail; the January 19th document was issued by press release by DBRS. So there is a difference in public accessibility to those two documents, and the reason that we say additional disclosure should have been made in the January period by Coventree about the impact of the DBRS announcement is that it was not possible to figure out what the impact would be on Coventree unless they made a public announcement.


  • 2006 Company Annual Report Letter (before the company went public): Because of a recent accounting pronouncement called EIC 149, our auditors Deloitte & Touche initially informed us that even though this is not a standard "put" clause, we would likely need to reflect the Caisse's investment in Coventree as debt as opposed to equity and do it at a fair market value. It says: "This would have severe implications for our financial results because the difference in the fair market value of the Caisse's interest in Coventree and the book value of that interest directly negatively impacts our retained earnings. Since the fair market value of the Caisse's equity investment is likely much higher than book value, over time this accounting pronouncement has the ability to cause Coventree to have negative retained earnings or negative equity. This would significantly impair our ability to get a line of credit and may affect our ability to meet the minimum capital requirements established by third parties for Coventree to even carry on business."


OSC Hearings Resolution
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