Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (27 page)

Brickman informed Houck about the dubious $9 million loan transfer. Houck called Allied, which informed him that it was just one bad loan. Houck relayed this to Brickman, who indicated that it was ten bad loans. Houck went back to Allied. Allied said it fully disclosed the transaction in its SEC filings.

In Allied’s SEC disclosures, under a footnote titled, “Supplemental Disclosure of Cash Flow Information,” Allied wrote, “Non-cash operating activities . . . included . . . receipt of commercial mortgage loans in satisfaction of private finance loans and debt securities of $9.1 million.” Calling these loans, which had defaulted and, in some cases, been discharged, “commercial mortgage loans” was quite a stretch. Though the transaction occurred in February 2003, Allied did not refer to this deal in the March 31, 2003, 10-Q. Instead, it made its first reference in the June 30, 2003, 10-Q, which identified a $9.9 million transaction. Allied amended the amount to $9.1 million, which matched the repurchase agreement, in its subsequent filings. Though the June 30, 2003, 10-Q had pages of disclosure about BLX and, in fact, references “BLX” more than one hundred times, Allied chose not to reveal that this transaction involved BLX or describe the defaulted status of the “commercial mortgage loans” when it accepted them. This disclosure was about as non-disclosing as a disclosure can be.

Sweeney told Houck that BLX sold the loans to Allied pursuant to a
put agreement
, where BLX would have a contractual right to assign the loans to Allied at a particular price. Houck relayed this to Brickman. Brickman asked Houck to find out where Allied disclosed the put agreement.

Once more, Houck called Sweeney. This time she asked Houck whether he had been reading the Yahoo! message board on the company. Houck said he hadn’t, but heard there were concerns. Houck asked about the disclosure of the put agreement. Sweeney said that there isn’t anything in writing, just an oral agreement to buy back loans made at the time of the merger between Allied Capital Express and BLC Financial, Inc. to form BLX, and said Tannenhauser wanted to keep this clean for the SBA. Apparently, these were fraudulent loans that Allied transferred from its books to BLX as part of the merger. Tannenhauser didn’t want his reputation tarnished by these loans. She couldn’t talk about what loans they were, because of Regulation FD, but agreed that many of the loans were worthless.

FD stands for Fair Disclosure. The regulation requires companies to disclose material information simultaneously to all market participants. Allied would later claim that the transaction didn’t need to be disclosed because it was “immaterial.” Obviously, if it were immaterial, Regulation FD didn’t apply. Alternatively, she could have discussed what loans were involved in the put agreement, provided she disclosed it to the whole marketplace.

Oral business agreements are sometimes made because somebody doesn’t want someone else to know about them. Taking Sweeney at her word to Houck, that someone was the SBA, a federal agency. Perhaps there were others as well. Did Sweeney want the put agreement concealed from Allied’s auditors, investors, rating agencies, and, possibly, even its own board of directors? Surely, a binding put agreement should have been disclosed in Allied’s financial statements. It wasn’t.

The actual document where BLX assigned the loans to Allied did not reference a put agreement. Instead, it explained that BLX wanted to “prepay” its debt to Allied.

Houck concluded that this was fraud, but didn’t want to write a detailed explanation of what he understood. “Given who these individuals are and how they act, to me I don’t want a personal stake in this,” he told me. I empathized with Houck: I never wanted a
personal
stake in this, either. I viewed my speech as professional, but Allied responded with personal attacks. I understand why Houck didn’t want a similar experience.

Another problem was that Houck’s bank, Wachovia, had a strong relationship with BLX. Indeed, they underwrote a number of BLX’s securitizations. Houck decided to run his concern up the chain of command. Rather than write a detailed report, Wachovia and Houck decided to simply cease covering Allied. In a brief published research note, on April 26, 2004, the day before our scheduled meeting with the SEC, Houck discontinued his coverage of Allied. He wrote: “We believe the financial statement disclosure for the company is inadequate and the fundamental information provided with respect to ALD’s largest portfolio company, Business Loan Express, lacking. Our concern includes questions related to a repayment and assignment agreement dated February 3, 2003, between ALD and Business Loan Center. In our opinion, management’s response to our requests for additional financial disclosure has been unsatisfactory.”

“With BLX representing a significant portion (13% at Q4 2003) of ALD’s investment portfolio, and hence book equity, we believe additional disclosure for valuation purposes is warranted. Without additional disclosure/information on BLX, we lack a reasonable basis to value Allied Capital and the cash flows associated with the investment.”

After he dropped coverage, Houck explained to me, “I think the larger point here is that [it] wipes out a lot of earnings for Allied as a whole. And all the while they are selling stock. So this is securities fraud. If you want to take it to an extreme, how can you sell stock when BLX’s earnings were clearly inflated? Even if there was a put agreement, if it was in writing, it still is a scheme to inflate earnings.”

We then discussed Allied’s refusal to disclose BLX’s gain-on-sale assumptions. Houck said that Sweeney told him the reason for this refusal was that BLX generates so much cash and Allied didn’t want people to see how good it was. Houck agreed that BLX didn’t generate any cash and added, “If you tell a big enough lie, maybe people will believe it.” After discussing other problems in Allied’s portfolio, Houck concluded, “You start to see a pattern of fraud at an organization, you tend to think it is cultural.”

Allied, as it said about me, whispered that Houck just didn’t understand the company and how it did business. It claimed Houck insisted they violate regulation FD, and when it wouldn’t, Houck retaliated. Houck wasn’t able to defend his view or answer Allied because Wachovia told him to make no further comment.

I also told Kurt Eichenwald at
The New York Times
about the secret $9 million loan transfer. Houck’s dropping coverage of the company spurred Eichenwald to, at last, write something. The next day, April 27, 2004, the
Times
published his article about the transaction and Houck, headlined “Allied Capital Under Scrutiny Over $9 Million Transaction.” Eichenwald wrote:

The reason for the concern about the documents was simple: defaulted and troubled loans are not worth their full value; indeed, under most lender accounting, a defaulted loan must have its value reduced in the company’s books. That decline in value is then usually accounted for by a reduction in the lender’s profits.

In other words, by counting the loans at full value, the transaction raised concerns among some investors both that the income of BLX had been manipulated upward—raising dividend payments to Allied—and that it may be a signal of other undisclosed related-party transactions.

After explaining the oral agreement between Allied and BLX, the article continued: “‘The management of BLX did not want the loans. So they were placed with BLX under an oral agreement that they could be shifted back to Allied if their credit quality deteriorated further,’ she [Sweeney] said.” The original transfer caused BLX to owe Allied the face value of the loans. Ultimately, BLX invoked the oral agreement and transferred the questionable loans back to Allied, which forgave the related debt, according to the article.

This, at least, answered one question I had long had. I had always wondered why Allied paid such a hefty price for BLC Financial. Now I had a new theory: Allied Capital Express held a bunch of improper SBA loans on its books. In 1999, the SBA had conducted an audit and determined that a number of Allied’s SBA loans failed to meet SBA standards. At some point, the SBA would ask Allied to reimburse any losses on those loans. Rather than disclose the bad audit and write-down the loans in 1999, Allied purchased BLC Financial in 2000 (at a high price) and shifted the problem off its books by parking the loans at the newly formed BLX. Apparently, neither company took a write-down for the disqualified loans. Over time, some of the loans performed, while others deteriorated to the point where the SBA demanded a refund. In early 2003, Allied and BLX unwound the parking arrangement for the bad loans and repaid the SBA $5.3 million relating to these loans. This was the repayment the SBA bragged about in our meeting in August 2003.

During the time Allied parked the loans on BLX’s balance sheet, Allied raised almost half a billion dollars of fresh equity. The combination of some of the loans performing, which reduced the potential liability to the SBA, and Allied’s much larger size, meant that the loss was less material to Allied’s financials in 2003 than it would have been if Allied had properly recognized the loss when the initial problem surfaced years earlier.

Sweeney tried to distance Allied from the blame. As she told the
Times
, “These were loans that were originated by a prior management team, and we had agreed to take them back.” According to Allied’s description of Sweeney’s biographical information in its SEC disclosures in 2000, “Ms. Sweeney also has direct responsibility for the small business lending operations through Allied Capital Express.” Prior management, indeed.

Eichenwald also reported that federal regulators started an informal inquiry into the transaction. Allied issued a press release in response, saying it knew of no such inquiry “into this immaterial transaction that had a negligible effect on Allied Capital’s balance sheet or on BLX’s value.”

Steve Bruce, our public relations adviser, thought Eichenwald’s article was the first shot of his planned exposé. Eichenwald told Bruce that he couldn’t believe the number of hostile e-mails he received from Allied shareholders in response to the article. For a reporter, this is a good sign—he is on to something. He said shareholders were really angry with him for reporting that the SEC would investigate the company. They thought he made it up. Bruce thought the reaction of Allied and its shareholders would inspire Eichenwald to finish the job and report the larger story. We had not told Eichenwald about the SEC’s recent interest or about our pending meeting with the SEC, because we didn’t want to anger the agency. He had his own sources.

On the day the article was published, Brickman and I met with the SEC. It was the first time I met Brickman in person. He was just as he seemed on the phone and via e-mail: irrepressible.

Unlike my previous meeting at the SEC, this one was in a much nicer conference room on the main floor. They had four people there including Kilroy, the “good cop” investigator who had questioned me nearly a year ago. Kilroy indicated she would not be involved going forward, but was there to help the others with the history and to transition the work. The SEC staffers asked us to go through all our current concerns about Allied and BLX. They were engaged, polite and inquisitive. They even brought an accountant with them. The enforcement lawyers asked what kind of documents they should request from Allied and whom should they interview there. Basically, they were asking us to be their cartographers.