Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (38 page)

The release also described Allied’s financial relationship with BLX. “Allied Capital’s total investment in BLX was $284.9 million at value at September 30, 2006, or 6.2% of Allied Capital’s assets. Allied Capital’s investment in BLX is in the equity of the company and this investment at value compares to BLX’s net book value at September 30, 2006, of $190 million. At December 31, 2006, BLX had outstanding borrowings under its line of credit of $322 million and BLX had estimated assets of approximately $600 million to support the borrowings on the line of credit.”

In reality, Allied’s exposure was much larger. Adding in Allied’s guarantee of BLX’s debt, Allied’s commitment was over $500 million. Further, Allied now promised direct restitution to the SBA and risked additional legal exposure from other victims of BLX’s fraud. The release continued, “BLX has a substantial cash flow stream from its residual interests and servicing assets and collected approximately $100 million in cash from its residual interests and servicing assets in fiscal 2006.” Apparently, this wasn’t enough to stop BLX from substantially increasing its bank borrowings.

Allied’s press release spin went further:

If scheduled loan payments were to be received as stated in the loan agreements with no future losses or prepayments, BLX would receive future cash flows of over $1 billion over time.

This was an extremely misleading picture of BLX’s financial status. Of course, prepayments and defaults are a fact of life. The future cash flows were not actually expected to be anything close to $1 billion. In fact, if BLX couldn’t sell new loans into the secondary market, they would have limited ability to originate new loans. No new loans meant BLX was on its way out of business.

The market holds credit rating agencies in a special place, because they are allowed to review confidential inside information in making their assessments. Fitch Ratings gave the all-clear signal. “The news surrounding the indictment suggests that the scope of improper practices may be limited to the Detroit office of BLX. This provides Fitch with comfort that BLX has a sound business model and that the large majority of its nearly $2.7 billion in serviced loans are viable assets.”

Shortly after the Fitch report hit the wires, Mark Roberts from
Off Wall Street
e-mailed me. “I spoke with Meghan Crowe, CFA, of Fitch, who wrote the Allied rating piece on
Bloomberg,
and told her that if she had more factual information she might come to a different conclusion, and I told her I could provide her with research that contained this information. She said she was not interested. I told her that I was amazed at her response, if she was at all interested in seeking the truth. She remained unimpressed. What can I say?”

James Lin called her and confirmed that her rating is based on the information disclosed by Allied in conversations with her, their filings, and the press releases. She was taking that information at face value in her rating assessment.

We decided to take the matter back to Allied’s board. We wrote a ten-page letter on January 22, 2007, which we released to the media. I reminded the directors of my 2005 letter, when I alerted them to the fraud at BLX. The letter told the board to remove “the present management team that has presided over the metastasizing fraud at BLX and Allied” and “end the dishonest culture perpetuated by current management.” I wanted new management brought in to clean house. I believed
any
new management would reveal even greater problems at Allied immediately, because it would not want to be blamed for lingering ethical lapses or accounting abuses.

I advised the board that the Harrington indictment was not the isolated act of a single, rogue employee. I identified seventeen other states where we identified fraudulent BLX loans. I detailed the mounting evidence of fraud at BLX based on Allied’s disclosures and legal and government records. This included the original loan-parking arrangement when Allied formed BLX and Allied’s knowledge of Harrington’s misconduct all the way back to at least Holly Hawley’s testimony about her car wash loans in 2002 with Allied’s lawyers present.

The Harrington indictment and related indictments came just before the deadline the judge gave us to serve BLX with the shrimp-boat False Claims suit, so we also told the board about the unsealed suit in the letter. We described other SBA fraud, Matthew McGee, and the Bill Russell USDA fraud. We described our compilation of the SBA and USDA default data.

Then, we pointed out that management responded dishonestly about the recent events. In summary, we challenged the spin that BLX had only recently learned of the fraud, that it involved a single rogue employee, that Allied’s risk was limited to its investment in BLX, that BLX was financially strong, and that management acted promptly and fully to disclose the event. “Each new revelation about the fraud . . . is met with escalating denials from Allied’s management and deafening silence from the Board,” I wrote.

Allied responded the same evening via a press release, saying my letter was “yet another example of his long-running attempts to manipulate the price of Allied Capital’s stock.” The company also said my letter had numerous inaccuracies. Of course, the company didn’t say what they were. “While Mr. Einhorn busied himself with repeated attacks against Allied Capital over the last five years, Allied Capital’s board of directors and management have maintained their focus on creating shareholder value and building the company.” In the press release, the company made a thinly veiled threat that it was going to sue us.

A friend joked, “My stock is up. Therefore, I am not a crook.”

The stock fell $2 per share to $28 on January 22 after my letter to the board became news. The next morning the stock fell another $1.50 a share, but began recovering when Allied spread word that it would come out with a point-by-point response to my letter. In contrast to the barrage of analyst reports following the Harrington indictment, almost all the analysts remained silent about my letter and Allied’s vague response. It seemed they would wait until Allied told them what to say.

One of the few analysts who didn’t defend Allied was Rick Shane of Jefferies & Co. The day after my letter, he wrote, “While some of our competitors have viewed recent declines as an attractive entry point, we remain more circumspect. The indictment of a BLX employee appears to have triggered both internal and external inquiries. As outsiders, we are uncomfortable predicting the outcome of these inquiries and feel that recommending ALD stock at this time based on valuation ignores incremental risk.”

On the other hand, the A. G. Edwards analyst, Troy Ward, was undeterred: “While Mr. Einhorn’s negative opinion of BLX seems to be in line with the Harrington indictment on fraud, in our opinion this does not substantiate his larger supposition that there is [sic] ‘wide-spread’ underwriting issues at BLX. We do not believe that fraud at the BLX Detroit office is necessarily an indication that BLX’s underwriting standards are sub-par.” Ward added, “We have difficulty believing that KPMG and third party valuation firms would approve ALD’s valuation methodology of BLX if there were rampant indications of fraud through BLX.”

Two weeks later, I heard that Allied’s point-by-point response to my letter would be “delayed.” Allied’s lawyers wouldn’t let them release it because it might offend the regulators they were trying to work with.

On January 25, 2007, Carol Remond reported on the
Dow Jones Newswire
that, “BLX has agreed not to resell loans on the secondary market, a move that could hamper its ability to make future loans. A spokesman for the SBA said BLX ‘voluntarily suspended’ sales of loans on the secondary market until a number of conditions set by SBA are met.”

For some reason, this article did not get picked up in any other news service that I saw. No analyst commented on the development, and Allied did not issue a release announcing the negative development.

Remond’s
Dow Jones
article included an interesting SBA perspective on how the Detroit investigation developed:

SBA said that its staff in Detroit reported suspicious irregularities in BLX’s loan portfolio to the Inspector General’s office as early as 2002. SBA’s Inspector General led the multi-year investigation resulting in the arrests announced on January 9, 2007. SBA’s Loan Monitoring System alerted SBA and BLX to the abnormally high default rate.

Following
The New York Times
article on January 13, 2007, which said the House Small Business Committee “will be investigating SBA’s involvement and how the agency could have failed to detect this,” I asked Greenlight’s lawyers from Akin, Gump to contact Chairwoman Velázquez’s staff to offer our assistance in helping them understand what happened. On January 26, 2007, our lawyers met three of her staffers, including Michael Day, her chief of staff. The staff was “stone-faced.” They were open to receiving information, but were not interested in seeking it out. It was clear they were
moving slowly.
It didn’t seem that Ms. Velázquez would get to the bottom of this, after all. I wasn’t surprised, remembering the contributions Velázquez received from BLX CEO Tannenhauser, his family, and other Allied executives, including Sweeney.

Just before I left my house for the train on February 6, 2007, I took a quick peek at my home computer for any news on Greenlight’s portfolio. At 7:03 a.m., Allied issued a press release titled “Allied Capital Comments on Recent Events.” I figured they were putting out the point-by-point response, after all.

Instead, though the press release was incredibly convoluted, it appeared they were admitting they stole not only my home phone records, but also Greenlight’s. The release read:

Allied Capital Corporation announced today that, in late December 2006, it received a subpoena from the United States Attorney’s Office for the District of Columbia requesting, among other things, the production of records regarding the use of private investigators by Allied Capital or its agents. The Board established a committee, which was advised by its own counsel, to review the following matter.