Authors: David Einhorn
Tags: #General, #Investments & Securities, #Business & Economics
The SEC’s general process is that if it plans to take legal action it sends a Wells notice outlining the problem to give the accused a chance to respond before the SEC takes legal action. In the Allied case, Enforcement never sent a Wells notice. Instead, Allied’s lawyers asked for a “pre-Wells” meeting. According to the Enforcement Manual, there is no such thing as a pre-Wells meeting.
Nonetheless, on October 25, 2006, Enforcement met with a team of “heavily, heavily armed” lawyers representing Allied, including McLucas. Allied was told that the SEC was considering bringing fraud charges against the company and one of its officers. A week after the meeting, the Enforcement counsel running the investigation was told by his superiors that all possible fraud charges against Allied were going to be dropped.
One of the higher-ups took the point of view that in order to prove a fraud case they would have to look at every investment in Allied’s portfolio—not just the couple dozen that Enforcement had found to be overvalued. Using this twisted logic, unless every valuation is fraudulent, there can be no fraud charge.
One SEC official testified that the ultimate penalty was “a slap on the wrist,” but added that Enforcement was dealt a bad hand because of the pressure Allied could exert given its political connections as well as the Commission at that time acting in a very hands-off manner.
As for my continued complaint to the SEC that Allied violated the Cease and Desist Order by continuing to overvalue its portfolio, it appears that my letter was ignored. Enforcement has no policy for monitoring its own settlements. Several pages of related discussion were redacted from the OIG report.
In early 2009, the staff accountant realized that all of her Allied files, including spreadsheets, the examination report, interoffice memos, e-mails, and other work product, had been deleted from both the shared network J drive and her hard drive at the SEC. She testified that when she and her branch chief told Gohlke, he did not appear surprised or even concerned. She testified that his response was not normal. She also testified that she believed this was not an accident, and suspected Gohlke either directed the files be deleted or deleted them himself.
During his testimony, when Gohlke was asked whether he deleted the files from the J drive, he responded, “I don’t even go on the J drive,” which is not quite a denial.
We also learned a lot more about Mark Braswell. The OIG conducted several telephone interviews with Braswell, who refused to appear to testify. Braswell made numerous promises to provide a written narrative to the OIG, but never followed through.
Prior to my testimony in 2003, Braswell was already on a performance improvement plan. He did not complete his work in a timely manner and many of his subordinates asked to be transferred away from his supervision. As for taking my testimony, Kilroy, the other SEC lawyer during my testimony, believed that Braswell was over the top and tried to “put on a show” for my lawyer.
A few months after I testified, Braswell was asked to leave Enforcement, and he left the SEC that fall. He obtained clearance from the SEC ethics office to register as a lobbyist for Allied by claiming he never worked on any Allied-related matters while at the SEC.
However, there was no dispute that Braswell worked on the Greenlight investigation, and in the course of investigating, learned a substantial amount of sensitive, nonpublic information regarding Greenlight and Allied. He also met with Allied several times during the investigation. Braswell said the only thing he learned about Greenlight that he passed on to Allied after he left the SEC was the name of my lawyer.
In 2007, Allied’s lawyers told the SEC that Braswell was responsible for the pretexting of my telephone records. Allied’s lawyers said Braswell had hired a public relations firm, which hired a private investigator to obtain the phone records. The SEC took no action on the matter. As part of its investigation, the SEC-OIG inquired with the U.S. Attorney about its pursuit of the pretexting case, only to learn that the files had been placed in storage and could not be located. Maybe the DOJ does not even have a J drive.
According to the report, the SEC took no action because it could not find a violation of securities laws in the pretexting. While I don’t know how hard it tried, I do believe the SEC needs to have a role in protecting market participants from retaliation by issuers. If the SEC thinks there can be possible securities laws violations from investors discussing companies, certainly there must be corresponding protection for investors against companies behaving as Allied has in this story. In a 2005 response to a letter from a senator, Chairman Cox wrote that issuer retaliation is a concern and “we will tackle it.” It is high time to follow through.
Certainly, there are plenty of open issues the SEC or law enforcement could pursue, if it had any interest. There should be significant consequences for Allied’s officers, directors, and auditors, who were the enablers, as well as Braswell and Gohlke, who remains employed at the SEC. The SEC also needs to reevaluate the conflict within its soft-on-corporate-crime enforcement policy that avoids short-term ripples to share prices, but harms long-term investors and the integrity of the market.
Arguably, the biggest difference between Allied and Bernie Madoff’s Ponzi scheme is that Allied went through the motions of actually investing the customer money while Madoff didn’t even bother. During the boom years, so many financial institutions were doing so many bad things and behaving so dishonestly, with the regulators looking the other way in just about every instance, that it would be a big job to prosecute all but the most blatant crooks. So Bernie Madoff goes to jail, and Allied management walks free. I wonder whether Andy Fastow, the jailed Enron CFO, ponders why he doesn’t have many more cellmates, particularly since his crime provoked Sarbanes-Oxley—a law passed to make criminal prosecutions easier.
When my father read the OIG report, he sent a simple e-mail:
It has almost always been true that “the truth will out.”
CHAPTER 40
The Last Word
When I wrote the hardcover edition of
Fooling Some of the People
, I knew that I was telling an alarming story about the failures of our watchdogs and gatekeepers—government, media, underwriters, analysts, credit rating agencies, auditors, public company executives, and directors—to protect the integrity of our capital markets.
We charge government regulators with keeping the playing field level, honest, and open, and trust it to protect investors.
We expect the media to gather and report facts objectively and fairly and, in the role of the fourth estate, help expose wrongdoing.
We count on Wall Street underwriters to perform due diligence and sponsor only quality, suitable offerings to investors.
We rely on Wall Street analysts to disclose conflicts and provide complete and accurate research to assist customers in making sensible investment decisions.
We delegate credit analysis to credit rating agencies—to the extent we foolishly continue to use them in an official role—and they are supposed to, at the very least, attempt to analyze all available information in order to issue unbiased opinions.
We depend on auditors to ensure that financial statements conform to accounting rules and reflect reality.
We expect public company managers to provide truthful disclosure in regulatory filings and in public statements.
We hire corporate directors to oversee managers and rein them in when they stray.
Unfortunately, over the past eight years I have seen a systemic breakdown, as each of these groups failed in its responsibility.
I saw all of these failings collide in this case. As I watched these events, I worried about the corruption in our business culture and what I saw as rising lawlessness in our markets and government. In the two years since I completed the hardcover manuscript, our country has endured an enormous financial crisis. The magnitude of the recent financial crisis makes some of the Allied story seem like small potatoes. Today, with literally trillions of taxpayer dollars propping up our failed financial sector, the hundreds of millions of lost taxpayer and investor money described in this story seem almost trivial—except perhaps to the few who benefited from taking the illicit funds at everyone else’s expense.
The sad truth is that, if anything, I underestimated how typical the Allied story was of our system as a whole. Allied certainly didn’t cause the credit crisis, and, as such a small player, it is not very significant in the context of the global markets. However, the failures of our system to deal properly with Allied are the same failings perpetrated throughout the financial sector, if not the entire economy, and the result has greatly contributed to the recent financial crisis.
In a way, it is almost unfair that Allied received so much attention from me. While this doesn’t excuse Allied, it became clear to me as the crisis unfolded that Allied’s abuse of fair-value accounting was more prevalent in corporate America than I had realized. What caught my attention about Allied was that as a business development company (BDC), it had to show the value of each investment every quarter. Our larger financial institutions, including commercial banks and investment banks, don’t provide even remotely similar disclosure, so it is much harder for market participants to identify, let alone prove, abuse.
Allied’s decision to ignore accounting rules and instead attack short sellers for its self-created problems was replicated by many other larger firms during the recent meltdown. Many financial institutions were (and some likely still are) technically insolvent and simply refused to recognize that reality on their books.
They have received sympathy from regulators that wish to protect them from the consequences of following the rules. In February 2009, Federal Reserve Chairman Ben Bernanke pleaded for accounting leniency on behalf of the teetering banks when he told Congress, “Accounting authorities have a great deal of work to do to try to figure out how to deal with some of these assets, which are not traded in liquid markets.”
The rules of accounting should be set by accounting authorities, who are free to improve them as they see fit and as circumstances require. Companies should not be able to pick and choose which rules to follow, and regulators should not condone transgressors.
Instead of honestly confronting the problems, leaders of our largest financial institutions and, at their behest, public officials tried to buy time by blaming the crisis on short sellers. In a desperate attempt to prop up share prices, the Securities and Exchange Commission implemented a ban on short selling of financial stocks. This emergency action, approved outside the usual government rule-making process and unsupported by any factual finding that short selling was indeed a problem, caused a 21 percent two-day spike in the New York Stock Exchange (NYSE) Financial Index in September 2008. The SEC, charged with fighting market manipulation, instead sponsored the greatest manipulation in history. It was short-lived and ineffective, and ultimately contributed to investors losing confidence in the system. By the time the ban was lifted a month later, the NYSE Financial Index had already fallen 11 percent from its preban level—on its way to collapsing 68 percent between its September peak and the March 2009 low.
If we don’t learn the lessons from the Allied experience, we can’t fix the much larger problems in our capital markets. During the recent crisis, we have seen at great pain and expense our government gatekeepers and watchdogs fail and suffer no consequences whatsoever. Our problem with the regulations was not too many loopholes, but poor enforcement of existing laws. The recent financial reform legislation doesn’t address most of the obvious problems, including irresponsible government enforcement, the exaggerated power of credit rating agencies, the existence of derivatives that add systemic risk but provide little value to society, and the presence of too-big-to-fail institutions at sizes where they remain too big to fail. If anything, the so-called reform encourages poor behavior and will likely foster an even bigger crisis.
I remain worried that perhaps it will take an even bigger crisis to bring about more needed change. When that change does occur, it will be even easier to be an optimist.
Glossary
Audit Guide
Manual created by the American Institute of Certified Public Accountants setting forth guidelines for auditing.
Balanced price
The price of a stock that matches the demand of both buyers and sellers.
Business development company (BDC)
A company that is created to help grow small companies in the initial stages of their development. BDCs are very similar to venture capital funds. Many BDCs are a type of closed end funds. BDCs are investment companies regulated under the Securities Act of 1940.
“Buy side”
Shorthand for the “buy side of Wall Street.” Firms, such as mutual funds, pension funds, and hedge funds, that invest customer capital.
Carrying value
The value of an asset or investment as reflected on the balance sheet.
Charge-off
When a loan is taken off the books and acknowledged to be a loss. It does not relieve the debtor of his obligation and the lender can continue to try to collect. Any subsequent collection is called a recovery.
Clearing broker
A member of an exchange who is the liaison between an investor and a clearing corporation. A clearing broker helps to ensure that the trade is settled appropriately.
Closed-end fund
An investment fund that has a limited number of shares. To invest in a closed-end fund, one needs to buy an interest from an existing holder at the prevailing market price, which may be higher or lower than net asset value. They are one of three types of investment companies recognized by the Securities and Exchange Commission. The others are mutual funds and unit investment trusts.
Controlled company
A company in which a majority of the voting shares are held by another company.
David’s birthday
November 20. Remember to send gifts.
Debtor-in-possession (DIP) facility
A loan to a debtor-in-possession in bankruptcy that is normally a first lien superpriority loan.
Debt-service ratio
Ratio of net operating income to required debt payments.
Defaulted loan
A loan on which the borrower has violated the terms of the loan agreement, such as failing to make timely payments.
Delinquency rate
Percentage of loans that have failed to make timely payments.
Enterprise value
The total value of a company. It is market capitalization of its equity plus debt, minority interest and preferred shares, minus total cash and cash equivalents.
Equity “kicker”
An offer of an ownership position in a company in a deal involving a loan.
Equity warrants
Security that entitles the holder to buy stock of a company for a specified exercise price. In many mezzanine investments, the exercise price is a nominal amount.
Exercise date
The day on which an investor can exercise an option or a right.
“Fair value” accounting
Requires assets to be carried at their fair value—the amount at which that asset could be bought or sold in a current transaction between willing parties, other than in a liquidation.
Financial covenants
Financial restrictions under which a borrower agrees to operate as part of a loan agreement.
Fire sale
When a company sells its assets under financial duress.
Front-loaded income
Revenue that is recognized prior to receiving the cash.
Gain-on-sale accounting
Method of recognizing most of the income from a loan at the time of its origination.
Held its debt investment at cost
Valuing a loan at its original price.
High coupon
When a bond pays a high interest rate.
High-yield bondholder
Investor who has bought below-investment-grade (sometimes called “junk” or “high-yield”) bonds, which pay high interest, but are riskier than investment-grade debt.
“Hold-to-maturity” accounting
Accounting method to value assets based on what they will be worth at maturity. This contrasts with “fair-value” accounting, which values assets based on what they are worth today.
Impaired loans
Loans that will not recover full value.
Impairment test
A calculation designed to measure whether an investment will not recover its full value.
Investment company
Companies, such as mutual funds and business development companies, whose main business is to invest and hold loans or securities of other companies for investment purposes.
Investment-grade bonds
A bond that is considered safe, often having a rating of BBB– or above as determined by the bond rating companies.
Junior debt
Has a lower repayment priority than other debt if the borrower defaults.
Loan maturity date
Date on which all outstanding amounts on a loan must be repaid.
Longs
Investors who own a security, hoping that it rises in value.
Loss rate
The amount of losses on a portfolio as a percentage of the portfolio.
Mark
Another word for accounting value.
Mark-to-market
Recording the price of a security to reflect its market value.
Mezzanine lender
Investor who makes mezzanine loans.
Mezzanine loan
Usually junior debt unsecured by assets. Mezzanine refers to its middle spot, beneath senior debt, but above equity. Maturities usually exceed five years, with the principal payable at the end of the term. These loans sometimes contain a warrant (equity kicker), which lets the borrower buy shares of the company.
Narrow bid-ask spread
When the difference is small between the highest price that a buyer is willing to pay for a security and the lowest price for which a seller is willing to sell it.
Net asset value (NAV)
The value of an investment company’s assets less its liabilities. It is often measured on a per-share basis—the NAV divided by the shares outstanding.
Noncash (PIK) income
Income recognized on a loan, but paid in additional securities, rather than cash.
Nonaccrual loan
A loan on which the lender stops recognizing income, usually because of the borrower’s financial problems.
Non–arm’s length
A transaction between two related entities.
Operating income (recurring net investment income)
In the context of an investment company, this refers to profits earned from interest, dividends and fees after expenses. Operating income excludes gains or losses from the change in value of the investments.
Opinion letter
Auditor’s statement giving its opinion of the financial health of a company.
Origination fees
Money paid to a lender or broker for obtaining a loan.
Oversubscription rights
The opportunity of rights holders to subscribe for additional shares in a rights offering for any shares that other rights holders did not exercise.
Pairs trading
A strategy in which a long investment is matched with a short investment in a comparable industry.
Par
Face value of an investment.
Pari passu
Two or more investments, such as loans or bonds, that have the same seniority and thus equal rights of payment.
Payment-in-kind income
See Noncash (PIK) income.
Portfolio-Lending Accounting
Method of recognizing income from loans ratably over time.
Preferred Lending Provider (PLP)
A designation given to lenders who demonstrate a thorough knowledge of the Small Business Administration’s requirements that allows them to make and service loans in several SBA lending programs, including the 7(a), without prior loan approval by the agency.
Pretexting
Obtaining the phone records of another person or persons by impersonating them to their phone companies.
Private illiquid securities
Securities that are not registered with the SEC and for which there is no broad market and are thus thinly traded.
Recapitalize
To change the capital structure of a company. A strategy often followed by companies in financial distress, which may include the injection of additional funds.
Record date
The date an investor must own a stock in order to be eligible for distributions. Commonly used to determine who is eligible for stock dividends.
Reinsurance
Insurance for insurance companies, purchased as a way to reduce risk by spreading it to other insurers.
Residual assets
The assets of a company or special purpose entity that remain after the claims of senior debt holders are met.
Residual interests
The capitalized assets created through gain-on-sale accounting that reflect the up-front profits booked at origination.
Rights offerings
A means of raising capital by giving additional shareholders the right to buy additional stock at a set (discounted) price within a fixed period.
“Road show”
A series of meetings with existing or potential investors in an effort to drum up interest in a security.
Rollup
A company formed by purchasing a series of small companies in the same line of business.
SBA loans (guaranteed and unguaranteed)
Loans offered with the partial backing of the Small Business Administration (the federal government). The loan can be broken into two pieces. The guaranteed piece has the full backing of the SBA. The unguaranteed piece has no such protection.
Secondary market loan sale premiums
The profit made by an originator selling loans to an investor.