Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (20 page)

Lanny Davis appeared on CNBC’s
Kudlow and Cramer
on January 30, 2003, to suggest shareholders directly sue short-sellers. Echoing Allied management’s wording in the Davis-scripted conference call the previous June, Davis talked about short-sellers spreading the “Big Lie” about his clients. Jim Cramer asked Davis, “Why don’t the companies sue the short-sellers, and if the stuff—you know the libel laws—if it’s reckless disregard of the truth, sue the entities that are printing it on behalf of the shorts?”

Davis answered, “Actually, Jim, I’ve looked at that in several instances where I’ve been able to demonstrate to my own satisfaction, to a flatly false statement damaging to the company’s share value. Where we gave notice to the short shareholder, to say this is false, please correct. And afterwards, the retraction was not actually printed, but further the falsehood was repeated. The problem in a defamation action is that you have to prove damage to the company. And a shareholder is the one that could really bring that suit more than the company.” This seemed like a not-so-veiled suggestion to Allied’s shareholders to sue us, despite the fact that a shareholder probably would not have standing to bring such a suit. Allied probably would have liked for us to be sued, but the company was probably too scared about letting us have legal discovery into the company’s business records to risk starting a lawsuit itself.

Davis continued by calling for Congressional action to impose additional rules on short-selling. Larry Kudlow asked, “It’s not really personal. It’s about—these research reports are presumed to be just business. It seems to me that if you can show a conspiracy, both for positive stock research or negative stock research, you’ve got a case for fraud or criminal legality. But if there’s no conspiracy, Lanny, I don’t understand it. It’s just one person’s opinion—why prosecute?”

Davis responded, “Well, first of all, it’s a crime for one person to put out false information, manipulating the market by doing so, and then profiting. But the conspiracy that I believe that Attorney General Spitzer and I believe others are looking at, are when short-sellers and publications engage in spreading misinformation. And I have evidence in the case of several clients, where false information has been spread. And they are cashing out and making a profit, I think, based on misinformation. Now, the bar is very high, Jim and Larry, to prove that case, and I would not want any of my clients to make that charge unless we can demonstrably prove that there has been false information put out.” I wondered whether Davis would agree that management should be similarly prosecuted if it said anything that was false.

News of the investigations also caused the former BLX executive to stop replying to my e-mails. One of the last things he told me was that Keith Hohimer from the Office of Inspector General of the SBA contacted him to inquire about BLX. He questioned whether the investigation was serious, because Hohimer complained about the amount of work a thorough investigation would require. Nonetheless, at least something was happening.

On February 4, 2003, Allied announced two significant transactions at BLX. First, it purchased $122 million of performing SBA loans from Amresco Independence Funding. Adding a group of performing loans enabled BLX to mask the high delinquency and loss rates in its existing portfolio. Allied increased its investment in BLX by $50 million and converted $43 million of its subordinated debt investment in BLX to equity. Apparently, BLX needed an equity infusion and a debt-to-equity conversion to keep going. Nonetheless, Allied did not reduce the carrying value of its investment in BLX. Second, BLX changed its own corporate structure to an LLC, “for tax purposes and greater flexibility, should the company default,” as Allied management explained on its earnings conference call held the following week.

On that same call, I was allowed to ask another question. Since Allied had a habit of not disclosing bad news until forced to, I decided to put them on the spot, querying, “Could you comment at all relating to the Office of Inspector General in the SBA that I understand has been calling around to people close to Business Loan Express? What do you think they are looking into, and is there an investigation, and, if so, what do you believe the status to be?”

After a pregnant pause, Sweeney responded, “Yes, David, I don’t know. I mean, clearly, BLX is a regulated entity by the SBA. I know that the Office of Inspector General typically works with the SBA looking at its lenders. It is usually a routine, they are usually routine inquiries, if there is an inquiry. So that’s about all I can say. We don’t know the nature of any sort of inquiry. So, you know, again this happens routinely in the SBA lending markets.”

In March 2004, we discovered that Sweeney’s “play dumb” answer came only days after she had personally signed an agreement to shift defaulted loans from BLX to Allied. The SBA had determined that the loans were improper, demanded, and received a refund of over $5 million. Yet, she claimed to have no idea about this when I asked her about it.

Later that afternoon, after Allied’s conference call, I got a call from the SEC Division of Enforcement, asking me what my basis was for asking the question on the conference call. Obviously, Allied had the ear of the regulators and had complained. It impressed me that the SEC was following up the very same day. The questions they asked implied a concern that I created a phony issue to scare other participants on the call, rather than get an answer from the company. I explained what I knew of Carruthers’ work and the subsequent follow-up calls from Hohimer to the former BLX employee and to me. The SEC lawyers seemed satisfied that I wasn’t making this stuff up.

In early March 2003, we received a subpoena from Attorney General Spitzer’s office dated February 28, 2003. I was requested to appear on April 15 “to testify in connection with the offer and sale of securities including, but not limited to, false statements, fraud, and efforts to manipulate the market.” We were to provide an even more exhaustive list of material, including records relating to several companies on which Gotham published research, a list of all of our investors, communications with several other hedge fund managers, and communications with several journalists, including my wife.

On March 25, we received a subpoena from the SEC. The case had been recaptioned
In the Matter of Gotham Partners Management Co., L.L.C.
The attachment showed that on February 11 the SEC upgraded it to a “formal investigation.” This gave it subpoena power. I was asked to appear in Washington, D.C., on April 15 and 16. The investigation sought to determine whether Gotham and other hedge funds used false or misleading statements or engaged in manipulative trading to depress these stocks. The investigation related to Farmer Mac, MBIA, Allied Capital, and American Capital Strategies. American Capital Strategies was one of Allied’s competitors, which we had not shorted or criticized. In fact, we owned it in 1998–1999. It had the same business model as Allied, so some believed that our criticisms applied to it as well. In fact, most of our critique had nothing to do with the business model. I don’t believe there is anything inherently wrong with business development companies. Greenlight’s criticisms are specific to Allied Capital, its accounting and corporate behavior.

On April 4, the SEC sent a subpoena for documents to be produced by April 11. Was it a coincidence that these notices kept arriving on Friday afternoons? Now they wanted information on other companies, information on trading credit derivatives (we don’t trade these), our client list, client redemption requests, and our correspondence with several other hedge funds. As we turned over documents and prepared to meet the government, I was not at all worried that we were in trouble or had done anything wrong. But I found it irritating to have to hire lawyers to sift through e-mails and was frustrated that the government was investigating the wrong party. It seemed as though they were looking through the wrong end of the binoculars at the wrong (very small) person—me. I hoped that when we met, I could convince them to retrain their sights on Allied.

A couple of weeks later, a federal judge in New York dismissed the class-action suit against Allied over its accounting that had been filed shortly after my speech. The judge ruled:

Since Allied’s accounting policies were publicly disclosed in some detail in each of its SEC filings, the basis of plaintiffs’ theory of fraud must be either that the stated policies led to hidden overvaluations of specific investments, or that Allied did not adhere to its publicly stated policies. Because plaintiffs have not alleged sufficient facts to either theory, they have failed to plead that defendants made fraudulent or misleading statements.

First, plaintiffs have not sufficiently pled that Allied’s valuation policies resulted in its overvaluing some of its investments. The complaint simply states plaintiffs’ opinion that various valuations were inappropriate, and sometimes a brief reason for that opinion, but fails to allege what plaintiffs contend was the true valuation.

A few pages later, the ruling continued:

Even if plaintiffs had pleaded sufficient facts to support an inference that Allied may have overvalued some of its investments, plaintiffs have not alleged the extent of any such overvaluation. In order to plead fraud with particularity, plaintiffs must state by how much Allied overvalued the investments. . . .

Because plaintiffs have not alleged the amounts by which Allied allegedly overvalued the questioned investments, plaintiffs have not pleaded any facts that would permit a rational jury to conclude that a reasonable investor would have viewed the overvaluation as significant.

In other words, it was up to the plaintiffs to show the judge what the true valuations were. This was a Catch-22, because the lawsuit was dismissed prior to discovery. Since most of Allied’s investments were to private companies, where only Allied held the confidential information required to ascertain a precise valuation, plaintiffs were in a tough spot to show the true valuations without access to the information.

The judge was not worried by this, because he came to the questionable conclusion that “Allied’s actual valuation policies were public, as was all adverse information about the companies in which Allied had invested. . . .” Where did the judge think Allied disclosed all this adverse information?