Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (36 page)

Significantly, his failure to respond was after he had indicated that he would be happy to provide evidence of wrongdoing. There is simply no evidence to support a claim that Allied tried to access Einhorn’s phone records. We never received his records and all that the article points to in support of this claim is the word of Einhorn, an individual with a motive to depress Allied Capital’s stock. As you know, Allied has performed in exemplary fashion, despite Mr. Einhorn’s continued attacks. Indeed, we have had a 15.6 percent average annual total return to shareholders in the last five years ended September 30, 2006. Upon payment of our fourth-quarter preannounced dividend of $0.62 a share, we have distributed a total of $2.42 per share of regular quarterly dividends to shareholders for 2006. In fact, in the nearly five years from 2002 through September 30, 2006, Allied Capital’s paid about $11 per share in cumulative dividends to its shareholders. We all wish that Mr. Einhorn would give up his quest for a big payday, at the expense of Allied Capital and its shareholders, however we expect he has far too much money to lose to do this.

PART FIVE

Greenlight Was Right . . . Carry On

CHAPTER 28

Charges and Denials

Allied received approval from its shareholders to issue stock as part of its “stock ownership initiative” at their annual meeting in May 2006. But as the year unfolded, Allied did not launch its tender offer to take the insiders out of their stock options. On the second-quarter conference call, management attributed the delay to “volatility” in the stock price. It had fallen from around $31 to $28 per share. Apparently, they would wait until the stock was trading better.

When Allied released its third-quarter results, we saw that the first nine months of 2006 were a lot like the 2005 results, except without the big gains from a couple of the home-run asset sales. For the first three quarters, Allied had net investment income of $0.97 per share and earnings per share of $1.47. It paid $1.80 per share in distributions, with the deficit bridged by the gains from the prior year capital gains. Allied began expensing its employee stock options, and compensation costs grew more than 50 percent over 2005 levels. They grew about 30 percent, excluding the stock option expense. Net investment income improved over 2005 levels, mostly from reduced investigation costs, which fell to about $4 million from about $32 million.

Though Allied temporarily halted stock sales after the investigations were announced, the company resumed issuing new equity in earnest in 2006, selling almost $300 million worth of shares to new investors during the year through Deutsche Bank, Merrill Lynch, and Bank of America.

Allied continued writing down its investment in BLX in dribs and drabs. Allied reduced its carrying value from $353 million at the end of 2005 to $285 million on September 30, 2006. According to Allied’s filings, higher prepayments impacted the portfolio and a more competitive lending environment affected its originations.

Though Allied stopped disclosing BLX’s summary financial results at the beginning of 2005, Allied provided enough evidence to show that BLX’s problems were becoming severe and much more serious than the gradual write-downs indicated. In the nine months, Allied earned $11.9 million in interest and dividends from BLX, compared to $19.5 million the previous year. The cash portion of interest and dividends fell from $14.4 million to only $6.2 million. The dividend on the “Class B” equity interest fell from $9 million to nil. Further, the portion of BLX’s borrowings on the bank line that Allied guaranteed expanded from $135 million to $188 million. This meant BLX’s borrowing expanded from $270 million to $376 million. While it is possible that BLX actually needed to borrow more than $100 million in a single quarter, it is also possible that BLX saw that it was in big trouble and simply drew down as much of its line as possible. This is common practice when companies foresee significant problems with lenders, often immediately prior to filing for bankruptcy. Considering BLX wasn’t paying Allied as much, it raised the question of why BLX needed to borrow at such an accelerated pace.

Given the higher borrowing, we estimated that Allied reduced its calculation of BLX’s enterprise value by only 7 percent. Given the deterioration described above, it would be hard to justify such a modest reduction. Allied did this by yet again changing how it valued BLX. According to its SEC filings, “In addition, for the quarter ended September 30, 2006, we performed a
fifth
analysis whereby the value of BLX was determined by adding BLX’s net asset value (adjusted for certain discounts) to the value of BLX’s business operations, which was determined by using a discounted cash flow model.” (Emphasis added) Apparently, given BLX’s deterioration, they couldn’t justify the modestly reduced value using the four old methods, which already generated an unreasonable valuation.

Two days after the
Times
story about pretexting, I spoke to a large gathering at the Value Investing Congress in New York about a couple of stocks we owned long. After I finished, a man approached me in the hall and followed me into the private “speakers only” room. He asked if I was proud of the
Times
pretexting story. I said I didn’t see what there was to be proud about being the victim of a crime. Then he said, “I hear you’re writing a book. Is it more like the stuff you spoke about today or about Allied Capital?” Alarm bells went off in my head. Rather than answer, I asked him who he was. He identified himself as Seth Faison from Sitrick & Company, a public relations firm. I’d heard of Sitrick. It was known for its aggressive advocacy on behalf of companies that were suing short-sellers, among them
Overstock.com
, Biovail, and Fairfax Holdings. By reputation, they are even more aggressive than Lanny Davis. I guessed, and later learned, that Allied had hired them. At this point, one of the conference organizers noticed the tension and escorted Faison from the private area.

The following week, I gave a closer reading to Allied’s quarterly SEC filing. Buried on page eighty-two, under the section “Change in Unrealized Appreciation or Depreciation,” in the subsection “Business Loan Express, LLC,” the fourth paragraph read:

Furthermore, in determining the fair-value of our investment in BLX at September 30, 2006, we considered the following items. First, the bank-lending environment for small business loans remains very competitive and, as a result, BLX continues to experience significant loan prepayments in its securitized portfolio. This has also had an effect on BLX’s ability to grow its new loan origination volume. Second, the Office of the Inspector General of the SBA and the Department of Justice have been conducting investigations into the lending activities of BLX and its Detroit office. These investigations are ongoing.

I was on an airplane when I read this. I think even the pilots heard my “OH MY GOSH!”

This disclosure was new and meant that they knew this was
serious
. Allied does not disclose bad news unless it was
really
bad news. The fact that Allied buried this disclosure in an obscure part of the 10-Q meant that management didn’t want anyone to notice it, but needed to provide legal cover so they could later say they had, indeed, disclosed the material development. Of course, the disclosure wasn’t where you would expect an important regulatory development. For example, it wasn’t under “Legal Proceedings.” Allied’s disclosure under Legal Proceedings continued to say that the investigations by the SEC and U.S. attorney in Washington primarily pertained to “portfolio valuation and our portfolio Company, Business Loan Express, LLC,” giving the misimpression that the investigations were about valuation rather than lending practices. A week had passed since the filing. Was I the first person to actually read page eighty-two? It was so obscure, even Brickman missed it.

I also pointed out the disclosure to Carruthers, who did a search of legal databases and found a number of indictments in Michigan. On March 16, 2006, a federal grand jury issued a four-count indictment against Mohammed Mustafa, Ahmed Qdeih, and Abdulla Al-Jufairi. The indictment described the fraud as follows:

Al-Jufairi was one of the principals of Global Construction, LLC, which did business as APCO Construction and Management (“APCO”). APCO was engaged in the renovation and construction of gas stations and gas-station mini-marts. . . . Additionally, Al-Jufairi had a friendly relationship with one or more employees of BLX, essentially acting as a loan broker for BLX.

Advance Auto Service Center, Inc. (“Advance Auto”) was a Michigan corporation owned by Mustafa, its president, and Qdeih, its secretary. Advance Auto purchased a gas station/convenience store business at 25025 Hoover, Warren, Michigan in approximately January 1999, financed by a promissory note with a ten-year term.

On or about March 15, 2001, Mustafa and Qdeih signed a formal application and related papers on behalf of Advance Auto for a $1.1 million SBA-guaranteed loan to be issued by BLX. The stated purpose of the requested loan was—$712,500 to be used for land acquisition (i.e. the purchase of the real property); $150,000 to be used for construction, repairs and renovations; and the balance applied to working capital, debt repayment, and closing costs. The borrowers were to contribute $37,500 toward closing costs; and $22,000 toward debt-refinancing. The total amount to be contributed by the borrowers, $129,500, represented the “owner’s equity injection” required by the SBA as a condition of issuing it’s [sic] guarantee of 75% of the loan. The loan was approved.

Al-Jufairi was the person who introduced Mustafa and Qdeih to BLX, and acted as an intermediary between BLX and Mustafa and Qdeih during the processing of the loan.

The indictment indicated the $129,500 owner equity injection had not been made.

The $150,000 loan disbursement intended as payment to APCO for work it had supposedly already done was
not
paid to APCO. Rather, the $150,000 loan disbursement check was deposited into the account of Qdeih’s brother-in-law, less a cash-out of $25,000 which was deposited into an account of Al-Jufairi and his wife.

The loan went into default, and on or about September 1, 2005, the SBA purchased its guaranteed 75% share with allowable interest, paying a total of $798,186.18 [to satisfy its guarantee].

On June 13, 2006, the same federal grand jury issued a four-count indictment against Wladimir Mizerni, Halina Mizerni, and Abdulla Al-Jufairi. This indictment related to the Ryan Petro-Mart fraud that listed Amer Farran, Al-Jufairi’s brother-in-law. As mentioned in Chapter 19, Farran had indicated he worked as an engineer at the Ford Motor Company. Notably, Farran was not indicted.

The indictment raised many of the same allegations as the earlier indictment. The equity injection of $240,000 had not been made on the $1.3 million loan. There were forged documents. The SBA paid a claim of $1,039,260.01. According to the SBA’s Web site, “Arrest warrants have been issued, and all three defendants are fugitives. It is believed that the part-owner and his wife have fled to Australia, and the loan broker has returned to his native Qatar.”

Also on June 13, 2006, the federal grand jury issued a five-count indictment against Roman Novatchinski, Wladimir Mizerni, and Al-Jufairi. This indictment related to Palace One Stop Shop. According to the indictment:

Although it was intended from the outset that Mizerni was going to be an equal owner of the gas station with Novachinski, Mizerni was not listed as a member of Palace One Stop Shop, L.L.C., and his name did not appear on any of the loan documentation because Mizerni already had an SBA-guaranteed loan for a different gas station and he would not have been eligible to receive another SBA-guaranteed loan.

The indictment also accused Novatchinski of falsely stating that he was a U.S. citizen, that he had managed a Shell gas station between 1990 and 1994 and that he claimed to have $430,000 of cash on hand and in the bank. None of this was true. Again, the $250,000 equity injection was not made, and there were fraudulent and forged documents. The SBA paid a claim of over $1 million for its guarantee on Palace One Stop Shop on November 6, 2002.