Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (14 page)

BLX split the SBA loans into a government-backed guaranteed piece and an unguaranteed piece, which retains credit risk. Historically, BLX sold the guaranteed piece to banks at a 10 percent premium and retained an annual servicing fee of about 1 percent for collecting payments and working out problems. The premium reflected the value of the spread between the interest rate on the loan, generally the prime rate plus 2.75 percent—the maximum rate allowed in the program—less the servicing fee and the risk-free rate. BLX pooled the unguaranteed pieces and securitized them. This front-loaded income and meant that BLX only had exposure to the junior residual, which it retained.

Sweeney would explain how it worked in the next quarterly conference call: “If you originate a million dollars [sic] SBA 7(a) loan, you immediately sell $750,000 of that loan into the secondary market. Those are paying cash premiums today of ten percent. You get $75,000 of cash right on that sale. You then only have [$250,000] left in the loan . . . and you sell that via securitization, . . . but you sell off of that $250,000, $245,000 and you get cash back through a securitization. So, out of that million-dollar loan, you only end up with [$5,000] of equity capital required to capitalize it. So, [$5,000] in and your first year cash proceeds are the $75,000 gain on sale. You get $7,500 on your servicing fees that you get on that loan that you sold. And, you get $9,800 in interest on the [$245,000] piece sold for a first year . . . revenue of $92,000. So on a $5,000 investment, you get $92,000 of cash in the first year.”

Banks that purchased the guaranteed pieces of these loans were taking a hit on the 10 percent premiums they paid BLX. When a loan defaults, the government guarantee reimburses the owner the face amount of the guaranteed piece. However, the owner loses any premium it paid for the loan. As a result, though the SBA (which doesn’t track defaults efficiently) didn’t notice the rising default rate, the banks did, and became hesitant to pay a 10 percent premium. As a result, BLX had to accept a lower premium to sell the loans.

In response, BLX restructured its sales so BLX retained the early default risk by selling the guaranteed piece without any premium and keeping a larger servicing spread. This change reduced BLX’s cash flow because it no longer received cash premiums up front. Instead, BLX booked more non-cash revenue through gain-on-sale accounting, recognizing its estimate of the future value of the larger servicing spread it retained.

The former employee also gave us the names of representatives at financial institutions that purchased loans from BLX. We contacted several of them and asked about their dealings with BLX. We inquired about adjustments to the debt-service ratios—calculations designed to make sure that the borrower would have sufficient profits to make interest and principal payments on the loans, the adequacy of appraisals and the level of due diligence, verification of the sources of equity injections, history of first-payment defaults, and other related topics.

While a couple of the sources declined to speak with us and one had favorable things to say about BLX, the majority confirmed a negative view. A representative of Zion’s Bank told us that BLX works with riskier clients with less price sensitivity. The official from GE Capital looked at many BLX deals, but passed on most of them for a variety of reasons, including being outbid by other banks and not being comfortable with the credit risks. He said BLX is recognized as having customers with credit problems that keep them from going to other SBA lenders. Bank of the West told us they recently reviewed thirty BLX loans and funded just one due to credit quality concerns. The underwriting was “not what I’m used to,” the bank official said, and referred to BLX as a “production office. Get it in, get it out and get it funded. That’s how it felt . . . [in] dealing with them.”

As we synthesized our understanding of Carruthers’ work, the BancLab report, the views of the former employee, our field calls, and both Allied’s disclosures and refusals to disclose, it became clear that Allied’s exposure to BLX was a problem much bigger than excessive management fees and an inflated 25 percent interest rate on the subordinated note.

Allied formed BLX to get itself out of a mess. Instead, BLX was an even bigger mess, and Allied knew it.

CHAPTER 11

Disengaging and Re-engaging

At the end of June 2002, WorldCom, a large telecommunications company led by Bernie Ebbers, acknowledged it had issued fraudulent financial statements. It filed for bankruptcy in July. Greenlight held a large position in WorldCom’s debt, which fell overnight from about forty cents on the dollar to twelve cents. It was the biggest single day’s loss in our history. As the rest of the market reacted negatively to the fraud, we suffered additional losses in other positions. Between June and July we lost more than 7 percent, the second worst decline in the history of our fund.

At the same time, I was getting tired of the Allied fight. I like stocks. I enjoy finding provocative opportunities on the long side. I am an optimist and want to participate in the market’s long-term positive trend. We always have more exposure to longs than shorts. The press began referring to me as a “noted short-seller,” a label I didn’t care for. Allied had been calling me names that were far worse than “short-seller.”

Allied was just one position in our portfolio, so I decided I would be better off paying attention to other things. Obviously, this book proves this was a resolution not kept, but it was my intention. I reasoned that the Allied controversy would work its way out on its own. The SEC would surely investigate what I sent to them, and, perhaps
The Wall Street Journal
could tell the rest of the story. I decided I did not need to be the public spokesman for this any longer. Originally, I had asked James Lin to prepare a Greenlight response to Allied’s June 19, 2002 press release. Now, I asked him to stop.

On July 2, 2002, I was on the train on my way to work and opened
The Wall Street Journal
editorial page, where Holman W. Jenkins Jr. wrote about Allied’s dispute with us. The column headlined “One CEO’s War for ‘Investor Confidence’” with an enlarged “pull quote” that read, “Differences of opinion are increasingly phrased as accusations of fraud.” Clearly, Jenkins sided with Allied.

Jenkins did not contact us in preparing the article. Generally, people named in a story get an opportunity to comment. One would think that Jenkins would want to at least hear the other side of the story before publishing. Later, I learned that Jenkins was a columnist, and the rules for columnists are different than the rules for reporters. They can write their opinion and do not have an obligation to offer the opposing party a chance to respond.

As for the column itself, I had been careful not to accuse Allied of “fraud.” Actually, I did the opposite of what Jenkins was complaining about. I criticized Allied with toned-down language, using terms such as
improper
and
non–arm’s length.
I consciously did not used the “F” word—fraud—because at that point I was not certain whether Allied’s actions were intentional or merely unsophisticated.

Jenkins’s column said that auditors had not found any problems with Allied’s accounting and that Merrill Lynch had written that Allied had put up “meritorious defenses against the criticisms leveled.” Then Jenkins said my speech “smacks of a mugging” and linked it to the class-action lawsuits that followed, before finally concluding, “Somehow we prefer the example of Mr. Walton, a CEO who seems to be taking every chance he can find to answer any criticism thrown at him.”

When I read the article, I knew I was going to have to continue the fight. I believe that Allied planted the article. Another hedge fund manager called to tell me that Lanny Davis once boasted that he “owns
The Wall Street Journal
editorial page.” I e-mailed Jenkins and asked him to call me to discuss the article. When he called a little while later, I told him that he had his facts wrong. I had not, for example, been in contact with class-action lawyers. He seemed mildly amused at my call and suggested that he would like to learn more about the short-selling business and we could chat in late August after his coming vacation. But his curiosity stayed on vacation: He never followed up.

I took the issue to his editor. After several e-mails and phone calls, the editor suggested I write a letter to the editor, which I did. They printed a portion of it a couple of weeks later under the headline “Our Short Position in Allied Capital.” I wrote:

We are writing in response to Holman Jenkins’s . . . [July 2 Business World column] regarding our short position in Allied Capital . . . We are not critical of Allied because we are short and have an agenda; we are short because there is a lot to criticize at Allied.

For example, Allied does not carry its assets at fair-value as defined by the SEC’s interpretation of the Investment Company Act of 1940. We identified approximately 35% of Allied’s portfolio that appears to be carried above fair-value, because Allied uses the Small Business Administration’s (SBA) more liberal valuation policy, rather than the SEC’s. Allied generates low quality earnings through non-arm’s-length dealings with unconsolidated subsidiaries such as Business Loan Express, even as Business Loan Express’s portfolio has deteriorated. Allied has responded that the SEC rules are “difficult, if not impossible to apply” and “do not contemplate Business Development Companies (BDCs) and their unique portfolios,” and, therefore, are “not specifically applicable to BDCs.” Allied believes that “SBA guidance is far more applicable to the portfolio of a BDC than the valuation guidance set forth by the SEC.” We have spoken with the SEC and confirmed BDCs should use SEC rather than SBA guidance.

We were surprised that Mr. Jenkins gave voice to a conspiracy theory without contacting us to comment or at least to check his facts: Greenlight has had no contact with any of the law firms that are suing Allied. Linking us to them based on the motivated comments of a defensive CEO without corroboration is irresponsible, in our view.

The next day, I wrote Walton and Sweeney. In the letter, I pointed out that I had refrained from personal attacks and said they were not practicing similar professional courtesy:

We understand that you may not appreciate us in our role as whistle blower. We do not understand why rather than addressing our issues in a professional manner, you have engaged in a pattern of false personal attacks for which you have no basis. According to press accounts you have engaged professional assistance in public relations in an effort to better attack us. Be advised that no matter how far into the mud you roll, we have no intention of joining you there.

At the end of the letter, I pointed out:

We have published our analysis and do not believe it contains any misinformation. We have listened to three conference calls and read several press releases from you designed to refute our criticisms and have yet to hear any factual errors in our research. Generally, your responses have been non-responsive, out of context or refutations of your mischaracterizations of our actual criticisms. However, if we have made any factual errors, we invite you to point out specifically where in our analysis we are factually mistaken. In the event any such errors exist, we will publicly correct the record.

Allied’s name-calling was part of its playbook to distract people from the real problems, and I did not expect it to retract or apologize. However, we had put out a lengthy analysis on our Web site, and I sincerely wanted to be sure we hadn’t made any errors. Sweeney responded about a week later in a brief letter that said we were wrong, as they showed in the conference calls. She wrote about my “false statements” and innuendos without identifying them. “Your attack on Allied Capital is inaccurate and irresponsible; you are no ‘whistle blower,’” Sweeney wrote.

When she declined to identify any actual errors, I took that as yet further confirmation of the soundness of our analysis. I would just have to put up with their attacking our criticisms as a “campaign of misinformation for personal profit,” which sounded like a cheesy slogan in a dirty Senate race. A few weeks later,
Forbes
published an article outlining some of our criticisms, and Allied’s response was to continue the personal attacks by denouncing me as a “predator” and declaring, “We’re not going to let [the] shorts get away with this.”