Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (39 page)

In the course of gathering documents responsive to the subpoena, Allied Capital has become aware that an agent of the Company obtained what were represented to be telephone records of David Einhorn and which purport to be records of calls from Greenlight Capital during a period of time in 2005.

Also, while Allied Capital was gathering documents responsive to the subpoena, allegations were made that Allied Capital management had authorized the acquisition of these records and that management was subsequently advised that these records had been obtained. The management of Allied Capital states that these allegations are not true.

Allied Capital is cooperating fully with the inquiry by the United States Attorney’s office and will have no further comment concerning this matter until that inquiry has been concluded.

Almost poetically, a half hour later, Allied issued a second press release announcing a one-cent increase to the quarterly distribution.

I had not known that Allied also obtained Greenlight’s phone records—or at least the “purported” records. The release also stated that the board was forming a committee to investigate. Funny, Allied had said in response to my letters to the board that it already investigated and found nothing. For them to admit this, the evidence must have been extremely clear. Certainly, the press release was not. Who made the allegations? Presumably, it was either someone at Allied or the “agent” who obtained the records. Was Allied, as a corporation, denying that its management knew, or was only the management denying it, with the company staying silent? I thought the latter, but the press reported the former. If Sweeney didn’t know, then why did she duck Greenberg’s inquiries on this topic in 2005?

“After five years, Allied Capital has acknowledged a tiny piece of its rampant misconduct,” I told the press that day. “The evidence was clearly always there; the board simply neglected its fiduciary responsibility to supervise the company appropriately.”

The next day, Greenlight released a somewhat longer statement. After briefly reviewing Allied’s history of ignoring my letters and quoting Walton’s blistering attack against me on the last conference call, the statement continued, “Now that Allied has admitted that its agent pretexted my personal phone records and one of BLX’s long-time senior executives has been indicted for the very fraud that I alerted the Board to, it is time for Allied to stop its dismissive attitude toward concerns I have brought to its attention and stop its personal attacks on me.

“Instead, Allied continues on with its usual pattern. Allied admits nothing until they are forced to do so. Allied did not acknowledge the loan practices until a BLX executive was indicted. Allied did not admit the pretexting until Allied was subpoenaed by federal prosecutors.” I called for the dismissal of management.

We received a call from Steven Pearlstein, a business columnist with
The Washington Post
. A quick review of his history showed he did not like hedge funds. For example, he wrote a column in 2005 that summarized a handful of reported hedge fund frauds and concluded:

This is not a case of a few rotten apples. It’s a case of an industry that has become so rich and arrogant—and so littered with charlatans and con men—that government must step in to protect the public interest.

He wanted to meet with me to discuss Allied. I decided to have Steve Bruce at Abernathy, McGregor return the call. According to Bruce, he accused us of trading on inside information. Bruce asked if he knew when Greenlight traded. Pearlstein didn’t. “Then how can you accuse them of insider trading?” Bruce replied.

Then Pearlstein complained that a lot of the information contained in my letter to the board didn’t come out of Allied’s 10-Ks. Bruce pointed out that the information came from Allied’s public disclosures, news accounts, legal filings, government Web sites, and inquiries we made under the Freedom of Information Act. Pearlstein apparently thought it was unfair for professional investors to do in-depth research, including using time and resources that individual investors don’t have.

We braced ourselves for what would surely be an attack. On February 9, 2007, the
Post
published his column headlined, “A Slugfest Gets Uglier:”

After five years of nasty accusations and name-calling, lawsuits and investigations, it’s hard to find the good guy in the high-stakes feud between hedge fund manager David Einhorn and Allied Capital.

Einhorn is a Wall Street punk—tough, smart, cocky. In his campaign to discredit Allied Capital and drive down its stock price, he’s been wrong about several things, such as allegations that the company inflated the value of certain investments on its books. And he’s grossly exaggerated the significance of other problems of a company that continues to post respectable profits and pay hefty dividends. His big bet—that Allied stock would fall—looks to have been a loser for investors in Einhorn’s Greenlight Capital.

But even punks can sometimes be right. In this case, it turns out that Einhorn was on to something when he alleged in 2002 that there was a pattern of fraudulent lending at one of Allied’s portfolio companies. Since then, a former loan officer has been indicted, the office he worked in has been closed, loan losses have increased, and the Small Business Administration has increased its oversight of the company’s lending.

And Einhorn was also right when he alleged that private investigators acting on behalf of Allied had improperly obtained his phone records. Allied admitted as much this week, and in time, it is likely that we’ll learn that his were not the only phone records involved. These disclosures are more than simply a huge embarrassment for Allied, a Washington outfit that lends to and invests in small and mid-size companies. They also call into question the judgment and competence of chairman and chief executive Bill Walton, the outside directors, and the high-priced legal team brought in to manage the response to Einhorn and other short-sellers. From the beginning, Allied spent too much time and energy questioning the motives of its critics and too little digging into the substance of Einhorn’s allegations. Company executives’ responses were at times evasive, at other times incomplete.

For me, the clincher was this week’s Hewlett-Packard–like admission that Einhorn’s phone records were stolen. When the allegation was first raised in 2005, the audit committee of Allied’s board responded that management and outside counsel had looked into the charges and found nothing—and then invited Einhorn to write again if he had more specific information to offer. It was the standard brushoff that directors and corporate counsel routinely give to whistle-blowers everywhere.

In fact, Einhorn’s letter was plenty specific on the “pretexting” issue, noting that someone had opened an online account in his wife’s name and directed the phone company to send copies of their home phone bills to an AOL account. Any chief executive or corporate lawyer worth his salt would have responded to it by immediately launching a thorough probe, turning over every rock to find out if anybody associated with the company had ordered such an inquiry or received any such information. Unfortunately, that wasn’t done until nearly two years later, when a subpoena was received from a U.S. attorney.

Belatedly, Allied’s board has now formed a “special committee” with a new set of lawyers to conduct a new investigation. But in other respects, Allied remains in its defensive crouch. Allied refuses to disclose which directors are on the committee or the identities of the new lawyers. And even before the inquiry has begun, it repeated its claim that nobody in management did anything wrong. The board was also careful to limit the scope of the new inquiry to the single set of phone records so far uncovered.

This is too little, too late—the kind of begrudging response you’d expect from a group of longtime directors (average tenure, 11 years) overly concerned about their own reputations and legal liability. The only way for the company to regain credibility with shareholders and regulators is to remove Walton as chairman and chief executive, replace the audit committee with new outside directors, and dismiss the outside lawyers and other key players on the Einhorn response team.

As for Einhorn, his campaign against Allied should be closely examined by the Securities and Exchange Commission and Congress as they consider how to rein in hedge funds that have gained undue influence in financial markets and the economy. (© 2007,
The Washington Post.
Reprinted with Permission.)

I didn’t like being called “cocky” or a “punk.” I also found it annoyingly perverse that my success in exposing fraud at BLX should lead to greater hedge fund regulation. Perhaps Pearlstein had so much antipathy toward hedge funds that he couldn’t help himself. But—here’s the important thing—he was really the first person in the media in five years to say I was right about anything regarding Allied, and he did it in Allied’s hometown newspaper.

CHAPTER 30

Late Innings

On February 19, 2007, I received a phone call from an Allied shareholder. We had debated Allied on several occasions over the years, always in a civil way. The shareholder had just spoken with COO Sweeney and wanted to share the conversation with me.

He said that Allied was really mad, that our fight had been going on for five years, and they were sick of it. Management and the board were “digging in.” Sweeney said my January letter to the board was “wildly misleading” and “grossly inaccurate.” When he pushed her to be specific, she admitted that everything in the letter “was technically correct,” but vaguely claimed that it doesn’t come to the right conclusion, nor did it include “all the facts.” When pressed to identify the missing facts, Sweeney declined, saying it wasn’t necessary to go “tit-for-tat.”

Sweeney told him that BLX “doesn’t need the SBA 7(a) program” and that the losses are nowhere near $70 million identified in the Harrington indictment. She said that the private investigator who stole my phone records was hired by Allied directly, not by an agent. However, the special committee of directors had limited its investigation to the pretexting, because “We don’t need an investigation to refute the [public] letter [Greenlight sent the board].” She wouldn’t comment on whether Allied took other people’s records, but claimed pretexting wasn’t even illegal back then—a rather odd interpretation of privacy law.

She also told the shareholder that the Inspector General of the SBA in Michigan was “personally close with David,” as evidenced by “whoever heard of the SBA calling a press conference to announce a fraud?” That was almost funny—I have never spoken with or met him. In fact, I don’t even know his name. Sweeney went on to say that nobody in management was resigning. By now, I was used to hearing Allied’s cockamamie claims. I simply thanked the shareholder—who I now believe has become a former shareholder—and waited for the next thing.

In 1998, Greenlight invested in the parent of the Virgin Islands Telephone Company. Jeffrey Prosser, its control shareholder, took the company private at a price we felt to be unfair to minority stockholders, including Greenlight. We sued in Delaware, where the company was incorporated.

In 2003, the Delaware court found that the fair price of the company was almost four times more than Prosser had paid. The court also found that Prosser and several others had committed fraud and breached their duties to shareholders as part of the transaction. The good news: The court awarded Greenlight over $100 million in damages. The bad news: After several years of negotiations, Prosser did not pay us, and, in 2006, he and his company filed for bankruptcy.

Enter Lanny Davis, now hired by Prosser. Prosser had a separate dispute with his company’s senior lender, the Rural Telephone Finance Cooperative (RTFC), which Prosser alleged to have interfered with his efforts to salvage value. Prosser filed suit against the RTFC in bankruptcy court in the U.S. Virgin Islands. Prosser’s key witness to support his allegation against the RTFC was none other than Davis himself. As part of the bankruptcy proceeding, we were allowed to depose Davis on February 1, 2007. This gave us the chance to question him under oath about Allied—an opportunity not to be missed.

Our lawyer:
“Have you ever stated that Mr. Einhorn was spreading some false and misleading information for his personal benefit?”

Davis:
“I don’t specifically recall that.”

Our lawyer:
“Do you recall telling a reporter at Reuters the following statement: ‘Every single allegation without exception made by these short-sellers,’ referring to Mr. Einhorn, ‘are false and in many cases we can prove they are knowingly false.’”

Davis, after reviewing the article:
“I believe I was referring to Mr. Einhorn’s charges made against both Allied Capital and Business Loan Express as being false, and in many cases I believed we could prove they were knowingly false.”

Our lawyer:
“And have you to date ever proven those statements to be false?”

Davis:
“Never filed a lawsuit against Mr. Einhorn, no.”

Our lawyer:
“Have you ever provided any information to show those allegations are false?”

Davis:
“Have I ever provided information to whom?”

Our lawyer:
“To the SEC.”

Davis:
“No.”

Sure, he didn’t. Greenlight’s lawyer asked him if he had seen the articles I wrote for
TheStreet.com
in 2002 criticizing Allied’s treatment of BLX. Davis didn’t recall ever seeing them. If he were telling the truth, how could he have complained to regulators and even gone on television to discuss my
Big Lie
when he had not read what I wrote?

Davis was then asked about the analysis we posted on our Web site in 2002. He vaguely remembered that he reviewed it, but didn’t “remember this specific document.”

Our lawyer:
“And you don’t recall whether these were the allegations that you said ‘every single allegation without exception made by these short-sellers was false and in many cases we can prove they are knowingly false?’”

Davis:
“I don’t remember if it’s this particular document, but I remember at the time the allegations made by Mr. Einhorn after examining all the evidence and interviewing all the individuals involved in the various companies that Mr. Einhorn claimed were being over inflated in value, that Mr. Einhorn’s charges were false. And I believe he was given a full documentation explanation as to why they were false and he repeated the allegations and that’s why I used the word ‘knowing[ly].’”

Incidentally, when Prosser was to prove his case against the RTFC, his star witness, Davis, did not show up to testify to support his claims, and Prosser withdrew his suit. The judge was not amused.

Allied released its year-end 2006 results on February 28, 2007. It announced that it wrote-down BLX by $74 million and put the investment on non-accrual. Allied said BLX might need to be restructured and recapitalized. On the conference call that day, management said BLX was now pursuing its non-SBA lending activities, and this required a secured lending agreement, as opposed to its current unsecured agreement. As a result, it was looking for a new bank lender.

Meanwhile, Allied injected another $12 million into BLX to help it remain “compliant with covenants” on its existing credit line. Management indicated that, otherwise, the debt-to-equity ratio would have fallen below the minimum threshold. It sounded as though the existing bank group had become unhappy with BLX, even though Allied guaranteed half the debt. It was clear that the banks would not permit Allied to extract additional management fees, interest, or dividends from its BLX investment. Even with the reduced value, Allied still determined BLX had an enterprise value of almost $600 million.

Walton tried to put his best spin on BLX: “And I think one of the pleasant surprises about BLX in 2006 was how they were able to transition from an SBA-oriented business primarily to a conventional real estate business. And I think that’s something that we think is potentially pretty valuable for the future.”

A few moments later, he added: “But we do think the [SBA] business has reached a nadir and it’s coming back from here, and we’re putting a lot of things in place we think this business was going to come back.
And this is not the problem that it’s been portrayed as being.
The business has gotten less profitable during 2006 because of the bank competitions for the loans. But
it remains profitable
, and we think as the business evolves in its new form is going to be very profitable again. And also I think the notion of keeping cash in there is a good idea because that’s—
they’ve always generated good cash flow.
”

Later on the call, management indicated BLX’s book value was between $180 million and $190 million. The previous time Allied disclosed BLX’s book value was at the end of 2004, when it was $155 million. Since then, Allied increased its equity investment by about $59 million through a combination of converting debt to equity and injecting fresh funds. I calculated that if BLX broke even, its book value should be about $215 million. Instead, it was $25 to $35 million less. Presumably, this is how much BLX has lost since the end of 2004. Considering BLX’s obviously deteriorating results—I don’t believe BLX “remained profitable”—and its legal and liquidity predicament, Allied’s valuation of BLX was far in excess of its unjustifiable June 2002 valuation—ridiculous!

During this Allied conference call, Brad Golding of Christofferson Robb asked: “My next question is, it was my understanding that up until recently that the senior management of Allied had been on the BLX board. I take it that’s no longer the case. What changed, why did you leave, and when did that happen?”

Walton responded: “There has been no change in the board of BLX. It’s been the
same
. And we think we’ve had an effective oversight at BLX. We’ve got a situation in Detroit that is what it is. And we continue to believe that
BLX is a very healthy business with very high lending standards and good internal controls
and has been and is and will be that, and we had problems in the Detroit office, and we think we took the BLX people took effective action at the time they knew things.”

Golding followed up: “Okay. Can you tell me who from Allied is on the board of BLX?”

Walton moved on: “We really don’t—I don’t want to—we really haven’t disclosed the board members of any of our portfolio companies. And I don’t think this is the time to set that precedent. Okay. We’ve got—sorry you almost done?”

It turns out that about a month before the conference call, Brickman discovered in a Florida regulatory filing, that BLX Commercial Capital LLC included Walton and Sweeney as managing members (the equivalent of directors) in 2005, but “deleted” them as members in its 2006 filing. By early 2006, the various investigations, including the Michigan investigation, were well known to Allied. Was this a sign that Walton and Sweeney saw trouble ahead and wanted to distance themselves from BLX? Maybe, but the executives weren’t talking.

On March 6, 2007, Allied announced that BLX had reached an agreement with the SBA to remain a preferred lender and would retain an ability to sell SBA loans into the secondary market, provided an independent third party reviewed them. BLX agreed to pay the SBA $10 million to cover some of the fraudulent Detroit loans and put an additional $10 million into escrow to cover potential additional payments to the SBA in the future.