The kettle The pot says hes black

Updated: Aug 31 2008, 08:34am hrs
A couple of weeks ago FE Investor featured Carl Icahn in the Guruspeak feature. He is known for his style of investor activism and as someone who could spot value picks and turn them around. Joe Nocera, however, has different views. Here is an article for those who like to idolise icons

It was mid-June, and I was writing a column about the end of Microsofts efforts to take over Yahoo. Carl C Icahn, the 72-year-old billionaire who had been trying to force Yahoo into Microsofts arms, was railing against Yahoos directors. How they had turned their backs on their shareholders. How they were just a bunch of cronies who cared only about keeping their cushy gigs. How they represented all that was wrong with corporate America. I get outraged at this stuff, he told me at the time.

Not long after uttering those words, Icahn settled his dispute with Yahoo and agreed to, well, join its board. So his total is now eight, including Blockbuster, ImClone and WestPoint Home. And, oh yes, a small telecommunications company based in Herndon, Va, called XO Communications, where he is the chairman and majority shareholder.

After my Yahoo column was published, several readers, tired of hearing me describe Icahn as a shareholder activist, suggested that I look into Icahns financial machinations at XO. Icahn, they said, wasnt exactly practicing what he preached when he took on big targets like Yahoo. He owns the vast majority of the company, wrote one shareholder. He has been involved with all the conflict of interests and self-dealing related to the companys financial situation, and his fingerprints are all over the cookie jar.

So I looked into it. And you know what The man has a point.

XO Communications is one of those companies that was born during the telecom bubble, a time when it was widely believed that the road to riches was paved with fiber optic cable. Originally called NextLink, it was founded by Craig McCaw, the wireless pioneer, who set up its original fiber optic network, and bought, at great expense, some wireless frequencies.

Then, at the dawn of the new century, just as the bubble was deflating, Forstmann Little & Company, the private equity firm, invested $1.5 billion in the company. It was a terrible investment; within months, XO was in bankruptcy. It was delisted from the stock exchange. Its shareholders were wiped out. The usual. In a bankruptcy, debt holders are the ones who hold all the cards. Since they are owed money the company cant repay, they are the ones with whom the company has to negotiate to emerge from bankruptcy. Those negotiations can often lead to the bond holders controlling the company. Vulture investors can make a lot of money buying up debt in bankrupt companies.

Is Carl Icahn a vulture investor Sometimes. Hes bought plenty of debt in his time, and he knows what to do once he has it. Thus it was that in 2003, when XO emerged from bankruptcy, Icahn was both its majority owner and the holder of 90% of its newly issued debt. He made himself board chairman and replaced XOs old board with - dare I say it - his cronies.

Icahn, however, was not the only vulture investor to take a position in XO. So did R2 Investments, a 14-year-old hedge fund that is part of a family of funds based in Fort Worth called Q Investments. Run by Geoffrey Raynor, formerly with the Bass brothers of Fort Worth, R2 deals almost exclusively with distressed debt and bankrupt companies. After the bankruptcy, the fund had a little more than 11 million shares in the company, or about 15 percent. At the time, Raynor believed that having a famous shareholder activist like Carl Icahn would be good for his investment. Now he describes Icahn as the original wolf in sheeps clothing.

Fast forward a few years. XO has made one acquisition, which hasnt turned out particularly well. With revenue of around $1.4 billion, it etches out a business-selling internet and telecom services in the cities where it has a fiber optic network. That wireless spectrum McCaw bought many years ago is essentially worthless - its just too difficult to commercialise. XO also has $2 billion in accumulated net operating losses.

Guys like Carl Icahn like net operating losses. If they can get their hands on them - which they can if they control 80% of the company with the losses - they can apply the losses against their corporate tax bill. So in November 2005, at a time when XOs stock was around $3 a share, Icahn proposed the following deal: He would buy the companys fiber optic assets for $700 million and take the net operating losses as well. The other XO shareholders would be left with the worthless wireless frequency - and they would have to use most of the $700 million to pay off the debt it owed to ... Carl Icahn!

Lets dwell on this for a minute. In his role as board chairman, Icahn was telling XOs shareholders that it was in their best interests to sell. And yet, he was also saying that it was in his best interest to buy. It couldnt really be both. Naturally, Icahns cronies on the board agreed to the deal. R2 Investments, however, reacted by filing a lawsuit, claiming that Icahn and the board were violating their fiduciary duty to the companys shareholders.

After a preliminary hearing in a Delaware court, Icahn and the board abandoned the deal. A few months later, he tried to insert language in the companys proxy that would have allowed him to buy the assets without shareholder approval. R2 caught him, and he backed away. (Icahn says that he was glad, in the end, that R2 kicked up a fuss because he was having buyers remorse and feared he was paying too much for the assets.)

One thing that would have really helped XO right around this time was debt refinancing. Its debt to Icahn was coming due in a few years, and it was in violation of several of its debt covenants, which Icahn had temporarily waived. And it would have been a great time to refinance - in mid-2006, anybody with a pulse could get debt refinanced, even struggling telecom companies. Yet XO declined to refinance its debt. Why Icahns team says that nobody was willing to step up and refinance the debt - the company simply had too many problems. But his critics believe he purposely refused to refinance because the weaker the company got, the better chance he had of gaining that all-important 80%- and getting hold of those operating losses. Indeed, they believe - though they cant prove - that he rebuffed takeover feelers for much the same reason. (The Icahn camp says there were never any feelers to rebuff.) The stock fell to 30 cent.

R2 Investments began sending letters to the XO board, warning that if Icahn and the board let XO slip into bankruptcy again - which would give him full control because he held virtually all its debt - it would sue. Under bankruptcy law, big debt holders are not allowed to use bankruptcy solely to take control of a company. Ah, but Icahn had one more trick up his sleeve. Late last month, XO announced a new transaction with its board chairman. This time, they did a deal in which Icahn paid $329 million - and agreed to retire $450 million of the debt - in return for a huge swatch of preferred stock. How huge a swatch Enough to largely dilute all the other shareholders - while pushing Icahns stake above the magic 80% mark. Imagine that.

When I spoke to Icahn about the deal, he made it sound akin to an act of charity. I like the company, he said. I think it has a great long-term future. I didnt want to see it go into bankruptcy. He added, I did a deal that nobody else was willing to do. If anybody else had wanted to do a deal on those terms, it was offered to them. And they turned it down. Indeed, Icahns allies point out that he even agreed to allow XO to keep 30% of the tax loss benefits - something he didnt have to do. But of course he didnt have to do any of this. He didnt have to dilute the shareholders. He didnt have to try to sell the fiber optic assets to himself. He didnt have to maneuver to claim the tax losses. As chairman, he could have tried to have helped the company rebuild - or sold the company to someone who was interested in doing so. But that doesnt really appear to have ever been his motive.

Oh, and heres the best part - the transaction he conducted with XO last month was never put to a shareholder vote. It was simply announced as a done deal. Under stock exchange rules, companies that plan to dilute their shareholders by a significant amount must allow a stockholder vote. So why wasnt there a vote Because after XO emerged from bankruptcy, its board never relisted it on any of the exchanges. Imagine that. One of the diluted shareholders, of course, is R2 Investments, whose stake is now around 2 or 3%. In recent weeks, the firm has gone back to court, asking for the right to look at XO documents to see whether Icahn played fair with shareholders. Icahns lawyers are resisting. The chances of this case being litigated are high - but in truth, the chances of R2 winning a lawsuit are low. The transaction is done, and unless there is a smoking gun, the courts will be reluctant to unwind it.

Carl is very smart and acts very aggressively in his own self-interest, said Robert Powell of, who has followed the XO shenanigans closely. And if you get in the way of his self-interest, he will trample you.

That would indeed seem to be the lesson of XO Communications. Something to think about the next time you hear Carl Icahn call himself a shareholder activist. Or, in my case, the next time I think about describing him that way.