Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (11 page)

We called Doug Scheidt, the associate director of the SEC’s Division of Investment Management, who had written open letters to the Investment Company Institute clarifying the SEC’s views on fair-value accounting that appeared to conflict with Allied’s analysis. We asked him for the SEC’s view of Allied’s argument. We began the conversation in generic terms without bringing up Allied by name. I asked Scheidt whether the SEC’s 1940 Act current-sale test valuation standard is primarily for mutual funds, rather than for BDCs, which instead could use an SBA impairment test standard for valuation because they hold illiquid securities for years.

“Disagree,” Scheidt said. “The guidance that we were providing applied to all investment companies, open-end and closed-end. . . . Closed-end funds or BDCs, though, publish their NAVs (net asset values) if they’re trading on an exchange . . . and all of these NAV calculations that they are required to make or that they do make are subject to the 1940 Act and regardless of whether they redeem or repurchase or sell their shares. So it is, and for example, their publication of their NAV may have an effect on market prices.

“I know that closed-end funds have tried to argue that they shouldn’t be subject to the same standards because of the differences between closed-end funds and open-end funds,” he said. “But the Act and the law doesn’t differentiate between the two. It says for all investment companies, they are required to use market quotes and do fair-value. And we have had closed-end funds make the same argument that since they don’t have to do redemptions, that if they invest in a bank loan participation fund, they typically hold until maturity or they should be able to value it at what they can get for it at maturity unless there is some sort of impairment in the credit or the collateral that’s underlying the bank loan. So, and we said no, and . . . it’s inappropriate for a fund to value it at what the fund would expect to get for it at some point in the future because the appropriate standard is: What can you get for it today?”

Again, without mentioning the company by name, I asked Scheidt about Allied’s argument that since it custom-tailors the loans, which are illiquid, they know the borrowers better than any potential buyer and plan to hold the loans for five to ten years, any sale would have to be a “fire-sale.”

“I would say we’re not forcing you to sell,” Scheidt said. “The way that I’ve told people when they raise the argument about how do you value illiquid securities, how do you apply the standard that says you use the value that you would get today from a willing buyer when it would take me months or weeks to sell this thing. I say assume that weeks or months ago you started beating the bushes for a buyer. And it took however long it took, and now today you have a willing buyer who is willing to buy from you, what would they [pay]? So it’s not a fire-sale like ‘Oh my God, I’ve got to get rid of this, will somebody take this off my hands?’”

I pointed out that they might argue that these types of loans are rarely sold, and the only time anybody ever sells them is when either the loan is distressed or the owner of the loan is distressed. As a result, potential buyers would perceive any sale as a fire sale.

Scheidt shot back, “I would say that would be all the more reason to hold it at a lower value because that’s what it’s worth.”

We were quite pleased to hear the SEC so decisively support our view.

Though we conducted the majority of our call without mentioning the company in question, at the end we told Scheidt that Allied Capital had made these and other claims. We asked if it made sense to outline our concerns to the SEC and, if so, to whom should we address them? Scheidt said that we should, and that he was the guy. This was good.

We sent a letter and an eighteen-page summary of our analysis, describing our concerns that Allied was not complying with SEC valuation requirements and abusing intercompany accounting available for controlled companies. We detailed Allied’s responses and the various events that I have discussed here. As a betting person, I felt that Scheidt’s disagreement with Allied’s story made it only a matter of time before the SEC would resolve the dispute—and not in the way Allied’s shareholders hoped.

CHAPTER 9

Fact—or Maybe Not

O
ff Wall Street
is an independent researcher started in 1990 by Mark Roberts that publishes buy and short-sale recommendations. We have been customers for years. It is an expensive, high-quality publication, sold to hedge funds and traditional long-only institutional investors. Unlike most of its peers,
Off Wall Street
continues to follow up on its ideas and provides substantive updates until it closes out a recommendation. Whether long or short,
Off Wall Street
is deeply concerned about its track record and treats its recommendations similarly to how serious fund managers treat their portfolios.

On June 12, 2002,
Off Wall Street
published a twenty-one-page “Sell” recommendation on Allied that highlighted its own conversation with the SEC, an analysis of ASR 113 and ASR 118, and Allied’s white paper. It reviewed a number of Allied’s portfolio companies highlighted in my speech, and wrote its own analysis. Though Allied’s stock had recovered to over $25 per share—or almost all the way back to where it traded before my speech—the shares fell sharply, again, upon the release of the
Off Wall Street
recommendation.

Part of what was so compelling about
Off Wall Street’s
analysis was its research into Allied’s largest subsidiary, Business Loan Express (BLX). Allied Capital formed BLX when it bought BLC Financial Services Inc., and merged it with its own SBA lending subsidiary, Allied Capital Express (also know as Allied Capital SBLC).
Off Wall Street
reviewed BLC Financial’s SEC filings before Allied purchased it and determined that BLC Financial generated 63 percent of its revenue as a public company through gain-on-sale accounting. Gain-on-sale accounting, which allows the recognition of the value of assets when originated, is fundamentally more aggressive than traditional portfolio accounting, which requires recognition of earnings over the life of the assets.

We believed Allied refused to disclose financial information about BLX to conceal its use of gain-on-sale accounting. That accounting, which front-loaded revenue and assumed good loan performance, combined with BLX’s high delinquencies, were a potentially lethal combination. BLX’s earnings were of unusually low quality, and it was probably not generating much cash. This cast further doubts on the appropriateness of the 25 percent interest rate Allied charged BLX. Clearly, Allied used these related-party fees to prop up its income statement.

Off Wall Street
also questioned Allied’s $39 million carrying value of its loan to Galaxy American Communications Inc. (GAC). It pointed out that GAC was an affiliate of Galaxy Telecom LP, which went bankrupt and shared the same business address. While there were no public filings on GAC,
Off Wall Street
’s review of Galaxy Telecom’s SEC filings, which included information about GAC, confirmed that GAC had minimal revenues, lost money, and had more liabilities than assets.

A few days later,
Off Wall Street
followed up:

We think that the company’s approach now seems to be that it will attack the short thesis with a combination of
ad hominem
attacks, obfuscation, and specious syllogistic reasoning. A great deal of this approach has to do with the integrity or lack of integrity in using language, and with the use of language to distort and confuse, in our opinion. In the past, we have seen this approach used to good effect in the political arena . . . the integrity of language used might have some relationship to the integrity of the speaker.

Off Wall Street
concluded by asking:

By the way, who is writing this convoluted stuff for Allied? And, further, if its accounting is so obviously correct, why did Allied even think it had the need to issue the white paper in the first place, and why does it continue with these new tortured explanations to justify its methods?

We decided to put our analysis on Greenlight’s Web site. We wanted to share it with the public because we wanted everyone to be able to better understand it and to see for themselves how Allied mischaracterized it. I was tired of Allied’s putting words in my mouth, suggesting that my speech had been part of a secretive “whisper campaign,” claiming that we hadn’t done our homework and didn’t know what we were talking about.

As we put the finishing touches on the analysis, Allied announced it would hold yet another investor conference call on Monday, June 17, 2002. I had never before seen a company assemble everyone three times in a month. The Friday before the call I gave a nearly complete draft of our lengthy analysis to journalists who covered or expressed interest in Allied. I thought they would benefit by reading it in advance so that they could have time to prepare informed articles. In fact, none of the journalists wrote about our analysis. Worse, at least one of them passed our draft analysis to Allied.

On the morning of this third conference call, we posted the twenty-seven page report,
An Analysis of Allied Capital: Questions of Valuation Technique
, and issued a press release containing a summary and offering the public an opportunity to view the full report on our Web site. The analysis included our concerns over the accounting, valuation, Allied’s white paper, controlled company transactions, specific valuations, our conversation with the SEC, the payment-in-kind income, and the strange history of the Arthur Andersen audit letter.

The afternoon conference call had a different tone than the earlier ones, where management had spoken almost off-the-cuff. This call was organized, scripted and apparently well rehearsed. I believe having an advance copy of my analysis aided management. They had a clear message, and management’s confident, forceful presentation compensated for its lack of veracity. The phone call was quite a significant event, because the company recanted virtually all of its previous claims about how appropriate its accounting was. It capitulated by agreeing with the SEC, and with us, that it should use fair-value accounting. It removed its previously trumpeted white paper from its Web site.

Allied hired a world-class spin expert, Lanny Davis, to guide management’s presentation of the change. Management was effective at completely changing its story, while claiming it was “consistent.” Many listeners apparently fell for it and accepted Allied’s assertion that it had been the victim of a manipulative “Big Lie.” The hiring of Davis, known for spinning the Monica Lewinsky affair as White House counsel for President Bill Clinton, seemed to me like an admission of wrongdoing. “When you parachute him in, you know you’ve got a serious problem,” Ed Mathias of the Carlyle Group told
The Hill
, the newspaper that covers Congress, about hiring Lanny Davis generally. Davis’s clients have included Seitel, the seismic data shooting fraud discussed earlier; Lernout & Hauspie, a European speech recognition technology company that perpetuated a multibillion-dollar fraud; and HealthSouth, a significant accounting fraud. It was clear that Allied’s problems required a political-style spin job, and Davis was a perfect choice.

In the conference call, Walton recalled Allied’s forty-year history and described the issue as a battle between a great company and a group of stock manipulators. Walton’s description of the situation was, to my mind, blatantly misleading and scurrilously dishonest. Yet, his introduction to the subject represented a brilliant distortion of the facts:

The purpose of today’s call is to set the record straight in response to a systematic campaign by certain individuals who have been circulating statements about Allied Capital in recent weeks that are either misleading or downright false. Many of these individuals appear to be motivated by personal profit because they have taken substantial short positions in Allied Capital stock and, thus, stand to benefit by driving our stock price down.

Their core charge is that Allied Capital has deliberately and thus fraudulently inflated values of companies in our investment portfolio in order to inflate the value of our stock. That is a lie and the facts will prove it is a lie. Indeed, this is a classic example of the Big Lie, which repeated so many times and in so many different versions to so many different constituencies, usually behind closed doors, using whispers and rumors that the victims have had little chance to catch up and defend themselves with the truth.

Many public companies have been faced with systematic attacks by short-sellers. Sometimes those attacks have performed a public service when, for example as in recent months, they have helped to uncover an actual fraudulent financial reporting of wrongdoing. This has led to an unfortunate but understandable skepticism by many investors to the integrity of financial reporting by many public companies. But those engaging in the current misinformation campaign against Allied Capital are cynically trying to take advantage of the current post-Enron environment by tarring a great and honest company like Allied Capital with the broad brush of a Big Lie.

[Some] . . . companies under such attack choose to ignore such cynical short attacks out of a concern for dignifying them or publicizing them. Well, we at Allied Capital have made a fundamental decision. We are not going to let them get away with it. We owe it to our shareholders, we owe it to ourselves and we owe it to our famil[ies]. We are going to confront our accusers in the daylight with the facts and the truth until the truth prevails. Transparency goes both ways. It is time for our accusers to be held accountable in the light of day for the misinformation they are circulating. We would certainly welcome a full inquiry by the SEC and the New York Stock Exchange concerning the use of such misinformation to manipulate the market.

Walton continued his defense that Allied used fair-valuation methods and didn’t inflate the value of its investments. He repeatedly criticized the motivations of short-sellers. Here is Walton’s description of what he claimed to be a coordinated, greedy, and “tortious interference” attack against Allied by the short-sellers, lawyers, and the media:

I think it’s . . . [created a] whole industry of hedge funds who . . . [, now that the] stock market’s not going up, they’re trying to find things to go down. And they’re trying to find things that they can help go down and there seems to be a pattern. You develop a position; you then have some sort of an event; in our case it was a speech. One is closely linked with law firms who then very quickly file suits, everybody says the company’s been sued, so therefore, something must be wrong. . . .

There’s been a lot of rumors out there about articles that are going to get published, or this is going to happen or that’s going to happen. We’ve had hedge funds call the SBA to find out, to tell them we’re in trouble. We’re seeing a lot of things that I’d characterize as tortious interference of our business model and that sort of thing should be outlawed. And we’re going to do the best we can to be part of that process, and I think the fact that we’re speaking out the way we are I hope sheds some light on that, and maybe other people will maybe join us in fighting this stuff.

Walton wanted everyone to focus on our “motivation.” For Greenlight, Allied is one of many ways for us to make money. It is a part of a large portfolio. However, Allied’s management was quite “motivated” to say whatever they could to get themselves out of this pickle. Certainly, Walton and Sweeney had much more at stake personally than anyone else.
For management, Allied is the whole ball of wax
. If Allied is shown to be fraudulent, the consequences would be more dire than losing a few dollars. Top management players could lose their jobs and possibly go to jail.

Next, Allied recanted the white paper—acknowledging that SEC accounting rules applied to them after all—and came up with a fresh description of its accounting. Sweeney spoke about the valuation issue and described the white paper (incorrectly) as if she believed most people wouldn’t know what it said: