The AmTrust Controversy In A Nutshell

| About: AmTrust Financial (AFSI)

I first wrote on AmTrust Financial (NASDAQ:AFSI) two weeks ago, calling the stock a "Potential Double with Little Downside." My thesis hinged on AmTrust's apparent tremendous and consistent profitability relative to equity and an improving pricing and interest rate environment. In that article, I disclosed that I "may initiate a long position in AFSI in the next 72 hours" and indeed I did, allocating 10% of my portfolio to the stock shortly thereafter and immediately updating my disclosure in the comments section of the article. In the days leading up and yesterday, the stock dropped a significant amount on no news, so I doubled my stake at $38.85, making my average price $40.42.

Today, shares dropped about 6% at the open before the article that everyone is talking about was released at 10:51am. This made me extremely concerned and I knew that something was up. After the article was published, shares dropped even more, going as low as 30.75 before rebounding somewhat. Despite the rebound, shares still closed at $33.67, down 12% for the day and are only up 2.5% from that after hours at the time of writing.

(Click to enlarge)

The controversial article that was published today was written by an SA Contributor "The GeoTeam" aka "Geo Investing" and claimed the following:

  1. AmTrust cedes losses to a wholly-owned Luxembourg subsidiary, AmTrust Capital Holdings Limited or "ACHL," and does not consolidate those losses in the financials that it posts on its IR website and submits to the SEC, thus overstating profits to investors.
  2. AmTrust uses a discount rate of 7.5% to value the life settlement contracts it owns versus the common industry practice of about 20%, overstating the value of the LSCs. Geo also asserts that about half of the LSCs were issued by Phoenix Life Insurance (NYSE:PNX), a company flirting with bankruptcy (insolvency, whatever you want to call it) and thus, the LSCs may not be fully honored at payout and are even less valuable.
  3. Geo points out that the company's CFO Ron Pipoly and COO Michael Saxon worked as executive officers at Central General "CGI" under CEO Robert Lucia at the time that he was discovered to have stolen $30mm from the company, thus damaging their credibility and making the case for foul play at AmTrust more believable.

The company responded in a press release at 3:21pm that vehemently denied all of GeoTeam's claims and asserted that GeoTeam released the article to make money off their short position, which is indeed disclosed in GeoTeam's article.

Much more significant, co-founder George Karfunkel and Leah Karfunkel (co-founder Michael Karfunkel's spouse) each bought about 200k shares today after the drop at $32.48 and $31.41 respectively. George Karfunkel bought his shares directly and Leah Karfunkel bought her shares via a trust for which she is the sole beneficiary. Taken together this represents a $13.1mm vote of confidence in the company, a big statement from insiders that would seemingly know whether there are any grounds to GeoTeam's claims.

This presents an extremely interesting controversy. I reacted quickly to the article and sold my shares at $35.70 today knowing that shares would go lower as the news spread. They did indeed but this was before the big insider buys. I also apologized to investors for my previous article if it was misleading. I did not pick up on any of the accounting issues that Geo did, though I am no forensic accountant and did not do the investigative work that was clearly done to produce their piece. While it remains unclear whether there are any grounds to the Geo claims, here are my thoughts:

Thought #1- GeoTeam, with their short stake, does have financial interest in shares tanking. I am somewhat torn in assessing GeoTeam's credibility. They've done this several times in the past- releasing a slanted article after already opening a long/short stake that would benefit from their article shifting sentiment in the direction they intend. However, they've also written some extremely high quality content, with a ton of Editor's Picks and Alpha-Rich articles to their name.

Thought #2- GeoTeam claims the company uses a 7.5% discount rate to value LSCs. The company claims they've addressed how the LSCs are accounted for in past conference calls. Indeed in the Q2 '13 call, the company pointed to a discount rate of 17.3% for the 2013:

Our expected discount rate for the life settlement portfolio for 2013 is 17.3%. The gross carrying value of the life settlement portfolio is $208.7 million. Our portion of that value is $104.3 million.

Thought #3- The company does cede losses to a Luxembourg subsidiary. The question is whether they consolidate those losses in their SEC filings. GeoTeam says no:

We are willing to accept that if the losses are being ceded, this is not necessarily a big problem as long as AFSI reports those losses on the 10-K and consolidates them for US GAAP purposes. However, they do not appear to be consolidated and so net income appears to be overstated.

AmTrust says yes:

The Company consolidates the results of all of its insurance subsidiaries, including the results of the Luxembourg reinsurance companies.

As a commenter on the Geo article pointed out, Geo does not make a firm assertion, but says "(the losses) do not appear to be consolidated." This wording implies that GeoTeam is not completely confident in the premise and possibly worried about legal liability for an absolute statement. Proving that something 'appears to be' is much easier than proving that it is.

Thought #4- If George and Leah Karfunkel know the inside scoop on AmTrust, why would they add such a significant amount to their stakes if the Geo claims weren't off base? They and Zyskind and Michael Karfunkel own most of the company. If they knew foul play was going on, you'd think they would have divested their stakes in the last few months, at a reasonable valuation. It certainly seems like they believe the company innocent and that is meaningful to me.

Thought #5- Pipoly and Saxon did indeed both work at CGI. They themselves did not steal the money. It's unclear whether they were aware of and/or aided Lucia steal the money, but it wouldn't make much sense for them to take such a risk if they weren't getting any piece of the pie. If their roles in that scheme were so obviously tainted, I would think they wouldn't be continuing to work as executives at a rather large insurance company.

I'm glad I sold my shares when I did considering they have indeed gone lower since, but considering these new developments and the fact that, if GeoTeam's arguments are disproved, my original bullish thesis remains intact and shares are much cheaper now, I'm considering getting back in on the premise that it's just manipulation. I intend to initiate a buy limit order for $35 later tonight, and we'll see where shares open tomorrow. I figured that, considering my prior article, investors would find my current thoughts meaningful, and considering the complexity of the situation, investors would appreciate a summary and an approach to handle this mess.

Investors should also consider AmTrust's non-cumulative 6.75% preferreds, which at their current price of $18.47, yield 9.12%. The preferred dividend is of course also safer than the common and even with the writedowns that Geo assumes, it would seem that AmTrust would still be able to pay the preferred dividend.

This is the most interesting thing to happen to me in my role writing at SA and young financial career, and I can't wait to see how it plays out.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AFSI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I intend to open a day limit buy order tonight for $35 per share of AFSI common stock, worth roughly 20% of my small portfolio.

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