Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (37 page)

Also on June 13, 2006, the federal grand jury issued a three-count indictment against Falamarz Zahraie and Daryoush Zahraie. This indictment related to D&F Petro, Inc. This was one of the loans associated with Imad Deaibes, who defaulted on several loans that I discussed in Chapter 19. Falamarz Zahraie operated Pars Petro, Inc. and had financial trouble. He was not a U.S. citizen, so he enlisted his brother Daryoush to help obtain a fraudulent SBA loan through BLX. Daryoush “purchased” the gas station from his brother, but he didn’t really buy it, he simply gave the money to his brother to repay his existing debt. The check for the $240,000 equity injection was never cashed. The loan defaulted, and on November 18, 2003, the SBA paid a claim of over $700,000. Notably, Deaibes was not indicted.

Carruthers called the U.S. attorney’s office and learned that this investigation was ongoing and they were working up the chain. More surprisingly, he learned in November 2006 that the investigation by the U.S. attorney’s office in Michigan did not originate from our efforts. It didn’t come from the Justice Department, the SBA, or the SEC. Apparently, the Department of Homeland Security detected that some non-U.S. citizens of questionable backgrounds received SBA loans in Detroit through BLX. This triggered the U.S. attorney’s office to investigate, where it found the large BLX fraud.

Carruthers found that the first indictments in the case came on October 5, 2005. Husam Fakhoury was indicted for falsely indicating he was not on probation and had not been charged, arrested, or convicted for any criminal offense other than a minor motor vehicle violation, when, in fact, he was on probation after being convicted of conspiracy to transport and sell stolen motor vehicles. On the same day, Sharif Affas was indicted for falsely indicating he was a citizen when he was not.

According to Carruthers, when the U.S. attorney’s office dug through the cases, it discovered a much larger fraud against the SBA. While we were obviously excited to find these developments, it was galling that these were some of the
same cases
we told the SBA about in 2003—and it did nothing about them. The very agency being defrauded showed no interest, because it knew it was part of the problem. Either it had little interest in correcting the problem because the agency was politically motivated to lend money and not ask questions, was too underfunded to check, or had been co-opted by BLX. Or
all of the above.
The SBA’s lack of concern that taxpayers were being ripped off, are being ripped off, and will be ripped off—all in its name—is nothing short of appalling.

CHAPTER 29

Charges and Admissions

On January 10, 2007, the Associated Press reported that nineteen Detroit-area residents faced federal charges for allegedly defrauding the Small Business Administration out of nearly $77 million. Federal prosecutors accused Patrick J. Harrington, a “former” vice president of BLX of “overstating or misstating loan applicants’ financial qualifications, and with falsifying the amount of money they contributed toward the business, witness tampering and lying to a grand jury.” The indictment said the defaults cost taxpayers more than $28 million according to the article, which also noted that there had been six previous indictments against Michigan residents—three of whom awaited sentencing and three of whom were fugitives.

The indictment was dated December 14, 2006, but had remained sealed until January 9, 2007. It indicated Harrington had been a principal with Allied Capital SBLC Corporation since September 23, 1998. After Allied acquired BLC Financial, Harrington was an executive vice president of BLX until September 2006. BLX closed its office in Troy, Michigan, on August 1, 2006.

According to the indictment:

Typically, the fraudulent loans involved one of approximately five individuals, or groups of individuals (collectively referred to herein for convenience as the “brokers”), who were orchestrating the purchase and resale of gas stations (or gas station/convenience stores), or, in some instances, party stores, restaurants, or small motels. The broker would locate (and sometimes purchase) a property that was for sale, and then would find a person willing to “buy” the property at an inflated price using an SBA-guaranteed loan issued by BLX.

In some instances, the buyer was truly interested in owning and operating a business. In other instances, the buyer was a “straw buyer” who did not intend to operate the business or to make loan payments, but was paid (or promised payment) by the broker to serve as a buyer. The broker profited from the mark-up in the price of the property. Harrington profited by being compensated by BLX based, in part, upon the amount of loans he originated.

The indictment described various false representations, forged documents used in the loan fraud, Harrington’s efforts to persuade other witnesses to lie to investigators, and Harrington’s own lies to the grand jury on October 6, 2005. It listed a number of loans, including several that Kroll and Brickman had flagged and we had passed on to regulators.

The indictment was attached to an affidavit by Stanley C. Chappell, a senior special agent in the SBA-OIG. Chappell said he was “one of several OIG Special Agents who, along with Special Agents of the U.S. Secret Service, are investigating a large number of fraudulently-obtained SBA-guaranteed loans issued by BLX.”

Chappell swore he had “participated in numerous interviews of Patrick J. Harrington, who . . . has admitted that between approximately 2000 and July 2006, he, and other BLX employees working at his direction, originated and issued approximately 96 SBA-guaranteed loans knowing that the financial and other qualifications of the principal(s) of the small business borrower were fraudulently overstated and/or misstated, and that the satisfaction of the equity injection requirement was falsely and fraudulently documented, in order to fraudulently qualify the borrowers for the loans.”

With the story finally in the public domain and picked up by other media, Allied immediately began to spin. It assembled talking points that appeared in numerous analyst research reports despite the inconvenient fact that the “talking points” were false and misleading. The first report came from Merrill Lynch. Merrill had switched analysts covering Allied, with Ken Bruce replacing Michael Hughes. Bruce seemed more objective about Allied than Hughes. He actually said in his report after the indictment that Allied’s critics appeared to be right. He wrote, “The shorts in ALD likely feel vindicated, as much of the short-argument now seems valid.” (He later told me he caught heat from Allied for that remark.) However, he continued, “Given the indictment involves only one former employee acting on his own, it seems premature to question all the lending practices in BLX and discount the company altogether.”

The other analysts covering Allied took the talking points from management at face value. Keefe, Bruyette & Woods wrote, “Management noted that this status (Preferred Lender) is granted by territory (there are roughly 70 territories within the US) and given that Detroit is only one office within one of these territories, this is less of a concern.”

Bank of America thought the stock price weakness was reason to upgrade the shares. “We believe the market is over-reacting as the investigation has been disclosed over the past two years and the latest development is the result of a corrupt employee in one of ALD’s 140 portfolio companies.”

Morgan Stanley repeated, “The problems at BLX seem isolated to one office and are not likely indicative of other issues at BLX or Allied’s other portfolio companies, in our view.”

Ferris, Baker Watts added, “Though this investigation has been going on since the summer (and discussed in Allied’s 10-Q filing), the actual indictment was unsealed on Tuesday. The BLX office in question was closed in August of 2006. The employee under investigation was fired in September 2006. The company factored this event into its valuation of BLX then and wrote it down by $34 million during the September quarter.”

A. G. Edwards also upgraded the stock. “BLX was notified of the fraudulent activity approximately six months ago and chose to fire Mr. Harrington and closed the Detroit office.”

And my favorite proclamation came from Citigroup: “. . . our view that the recent selloff is an overreaction, as BLX retains value even in a worst-case scenario in which it was shut down.” I don’t think it would be worth
anything
if it were shut down. In fact, the better question would be, how much further liability would Allied have?

These comments came from what Allied management told the analysts.
According to Allied, when BLX heard the news of a rogue employee it acted promptly, decisively and responsibly by dismissing Harrington and closing the office. Allied fully disclosed the circumstances in its quarterly SEC filing as soon as the company knew them. This was a case of a single rogue employee engaged in misconduct, and such behavior did not exist elsewhere at BLX. In fact, BLX was actually a victim of Harrington’s fraud. In any case, BLX was just one investment out of a large portfolio of 140 investments and Allied had relatively insignificant exposure to any loss.

Of course, almost none of this spin was accurate. Allied had not made good disclosure of what had happened. When it disclosed the SBA’s OIG and U.S. attorney investigations into the Detroit office deep in the middle of the wrong section of its September 2006 10-Q (BLX closed the Detroit office on August 1, 2006—eight days before Allied filed its second-quarter 10-Q, which made no mention anywhere of these developments), Allied did not disclose that it had fired Harrington or that it had closed the Detroit office. Allied waited to confess until the U.S. attorney unsealed Harrington’s indictment. Allied/BLX knew the U.S. attorney from the Eastern District of Michigan was investigating the Detroit office no later than October 2005, when its employees provided sworn testimony. It failed to make any disclosure of this for an entire year.

Further, when Allied announced its second-quarter 2006 earnings and held a conference call, Walton highlighted that Allied had lower legal and investigation related expenses. Don Destino, who was now covering Allied from JMP Securities, asked, “Could an enterprising analyst assume that that means you think that’s [the investigation] coming to an end, with not much of a punch line to it?” Walton answered, “One would hope. You know,
it’s obviously a lot quieter
.” He said this the day after BLX closed the Detroit office.

We, of course, knew that the fraud at BLX was much broader than a single employee in a single office, and in its article by Julie Creswell on January 13, 2007,
The New York Times
said the SBA knew it, too. The
Times
article said:

Federal investigators are now looking at loans issued by the unit, Business Loan Express, in other parts of the country, according to several people briefed on the investigation.

And the federal Small Business Administration—which typically guarantees 75 percent of the value of these small-business loans—is considering suspending the preferred lending status of Business Loan Express, pending the outcome of an investigation. That would mean that every loan Business Loan Express issues would have to be vetted by the agency, those people said.

The S.B.A. this week also suspended the unit’s ability to sell the loans it issues to large institutional investors in the secondary market, which could affect the ability of Business Loan Express to make loans, those people said. The unit can still originate loans, but only if it intends to hold those loans on its own books, which is not something the firm has historically done.

“Allied has been aware of misconduct by Mr. Harrington for half a decade and it won’t be hard to find many more similarly fraudulent loans in other parts of the country,” I told the
Times
. The
Times
article continued:

About a year ago, the S.B.A., which gives its lenders an internal rating on a one-to-five scale, lowered Business Loan Express to the lowest rating that would allow it to remain in the preferred lending program, based on a rising level of late payments and defaults on loans it had made, according to people involved in the investigation.

The article noted that the House Small Business Committee headed by Nydia Velázquez (who had received large contributions from BLX CEO Tannenhauser and other Allied executives, as described in Chapter 26), had begun its own investigation of the loans in Michigan and possibly in other states. “The committee will be investigating SBA’s involvement and how the agency could have failed to detect this,” Kate L. Davis, a spokeswoman for Velázquez, said. The article reported that the SBA planned to re-examine more than five years of loans and could seek restitution if there were additional cases of fraud.

“He [Harrington] says he made a mistake, but not near to the extent that the government claims,” Harrington’s lawyer said in the article.

Lanny Davis, now working for BLX, told the
Times,
“This is a good company, with good people, and I believe, in the final analysis, this will be borne out.”

Not one of the Wall Street analysts made a significant comment about the
Time
s article, which described a much larger problem than the analysts or Allied acknowledged. I asked Robert Lacoursiere, the Bank of America analyst, why Wall Street was not responding. In an e-mail he responded, “The
Times
article has no named sources at the various interested agencies who are willing to be on the record to support your concerns—it therefore is no better than speculation/rumor/innuendo—that’s different from information to rationally form an opinion on.”

Allied responded to the
Times
article by issuing a press release:

Allied Capital understands that BLX is working cooperatively with the Small Business Administration with respect to this matter. In particular, Allied Capital understands that BLX is working with the SBA so that it may remain a preferred lender in the SBA 7(a) program and retain the ability to sell loans into the secondary market [where they sell the guaranteed pieces]. Allied Capital anticipates that BLX will abide by certain terms and conditions under which they will operate going forward in the program and Allied Capital will stand behind any financial commitments BLX makes to the SBA in this regard to prevent any loss due to fraud.