Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (48 page)

CHAPTER 37

If They Asked Me, I Could Write a Book

As mentioned in the Introduction, Allied’s lawyers sent a number of letters to both John Wiley & Sons and me hoping to stop this book’s publication. For months, both sides suggested meetings, though never on mutually agreeable terms. On April 8, 2008, just four weeks before the May 5 publication date, Allied’s lawyer sent a five-page letter to Wiley complaining about the book’s promotional copy, pointing out, among other things, that “corporations do not lie; people do,” and asserting that Wiley had no right to publish libelous statements that damage Allied’s reputation.

In response, my lawyer sent them a copy of the book, with a note offering, “Should you or your client identify any actual inaccuracies, please advise us and we will promptly correct any errors.”

We never heard back directly, but just a few days after Wiley sent prepublication copies of the book to reviewers, Allied issued a press release that began, “Allied Capital Corporation announced today that Joan M. Sweeney, Chief Operating Officer, intends to retire from the Company at the end of 2008.” Given the damning evidence in
Fooling Some of the People
, it was not surprising that Allied would want to distance itself from Sweeney.

To the media, Allied said this about the book: “Allied Capital has had to endure Mr. Einhorn’s relentless, self-serving campaign for seven years, and during that time no independent third party has concluded that his portrayal of Allied Capital has merit.” Even this narrow statement was false. In 2007, the SEC had found that Allied could not support its loan valuations, the SBA had declared BLX to be the largest fraud in SBA history, and Patrick Harrington, a former Allied/BLX executive, was on his way to jail. (In November 2008, he was sentenced to 10 years in prison.)

Still, given all the prepublication saber rattling, when Walton announced the first-quarter results in the May 2008 conference call, I braced myself. A 30-minute rant seemed as likely as an announcement that Allied was preparing legal action against John Wiley & Sons and me. What I didn’t expect was silence
—
Walton chose not to mention the book at all. And in a continuation of the Kabuki theater that exists between management and analysts, no one else on the call chose to mention the book, either.

The summer of 2007 marked the beginning of the turmoil in the credit markets. The changing environment forced Allied to step up its stock offerings, providing the necessary cash to keep paying dividends. In January 2008, it sold four million shares at $22.00 in an overnight offering underwritten by Morgan Stanley. In March it sold another four million shares at $20.35 in the same manner through Merrill Lynch. Then, in May, just after
Fooling Some of the People
was published, Citi, Deutsche Bank, Merrill Lynch, and Morgan Stanley teamed up to sell nine million shares at $20.45 each. Altogether, the regulatory failures at the SEC allowed Allied to bilk unsuspecting investors out of an additional $350 million.

Days after the May offering, while speaking to a senior Morgan Stanley executive about another matter, I asked how his firm felt about going forward with an Allied stock sale in light of this book. He assured me that the underwriting committee at Morgan Stanley had had a thorough discussion about my concerns before proceeding. I asked whether anyone on the committee had actually read the book. He told me that no one had.

Even as Allied continued its public offerings, it was preparing for disaster. Prior to the April shareholders meeting, Allied asked stockholders to approve a proposition authorizing the company, with approval of its board of directors, to sell shares of its common stock at prices below the company’s then-current net asset value per share in one or more offerings. Regulations forbid business development companies (BDCs), such as Allied, from selling shares below net asset value (NAV) without shareholder consent. Allied argued that it would be in the shareholders’ interest to raise capital
—
even at a discount
—
so that Allied could take advantage of “favorable opportunities” that might arise. In reality, it needed the infusion of new money to keep the pyramid from crumbling. The proxy advised:

If the Company were unable to access the capital markets as attractive investment opportunities arise, the Company’s ability to grow over time and continue to pay steady or increasing dividends to stockholders could be adversely affected. It could also have the effect of forcing the Company to sell assets that the Company would not otherwise sell, and such sales could occur at times that are disadvantageous to sell.

Since Allied’s shares were trading above NAV and had done so for many years, management had a hard time convincing shareholders to support the proposal. In a moment of poetic justice, Allied had done too good a job persuading its owners that it wasn’t a pyramid scheme. At the shareholder meeting in April 2008, management could not muster sufficient support to approve the discounted equity sales. Allied adjourned the meeting until May to give itself more time to find the necessary votes. Failing again, it adjourned the meeting until June in a last Hail Mary attempt to get the shareholders on board. It failed a third time. Walton blamed the defeat on Allied’s two-thirds retail shareholder base, suggesting that obtaining voting instructions can be difficult. Despite his claim, I can’t recall Allied having trouble obtaining shareholder approval on any other proposals.

There was no more new money to be had, and things began to unravel.

Allied’s inability to tap the equity markets to raise cash came just as the economy began to impact Allied’s portfolio. In the first quarter of 2008, Allied lost $0.25 per share due to unrealized depreciation in many investments, including $39 million at BLX. The loss was surprisingly small considering that the deterioration of the credit markets had taken a particularly large toll on Allied’s portfolio, which was littered with structured finance products. Allied’s subsidiary Callidus was a large player in the structured products market, and Allied had invested its own capital in the riskiest junior bonds and equity pieces of Callidus’s collateralized loan obligations (CLOs). According to Morgan Stanley’s credit research team, the value of junior pieces of CLOs created during the credit bubble (2005 to 2007) had fallen to between 35 percent and 55 percent of their original value. Allied took a small write-down, and marked its $317 million portfolio of CLOs at 90 cents on the dollar.

Meanwhile, management claimed that Allied’s opportunities were improving. Piper Jaffray analyst Robert Napoli supported that view and raised his earnings estimates, saying that Allied “is poised to capitalize on the wider spreads and a strong pipeline.” He concluded, “We also view the dividend as rock solid for the next few years.”

This view proved optimistic. On June 10, 2008, after the shareholders’ final rejection of its plan to sell discounted shares, Allied’s stock price fell below $16, reflecting a discount to stated net asset value for the first time. In an attempt to rebuild market confidence, Allied hosted an analyst day, but it proved to be a nonevent, adding nothing new to the story. As Friedman, Billings & Ramsey analyst John Stilmar observed, “The CEO remained emphatic about future ability to pay the dividend, but management was collectively vague about the future roadmap related to NOI [net operating income] coverage of the dividend.” In July 2008, Allied tried to hold things together by announcing both the third- and fourth-quarter distributions of $0.65 per share. Nonetheless, the share price continued to decline, falling below $13 by the time Allied announced its second-quarter results in August 2008.

The second quarter produced another, larger loss, this time of $0.59 per share. On the quarterly conference call, Walton misleadingly suggested a modicum of self-sacrifice, stating, “As part of this reduction, I will—I anticipate that I will receive no bonus in 2008.” (Ultimately, Allied paid Walton $5.1 million for presiding over a 90 percent shareholder loss in 2008.)

As for BLX, Allied capitulated. In one fell swoop it wrote off all but $9,000 of its $327 million investment. Five years after I’d first written to the SEC that BLX was probably worthless, Allied’s financial statements finally concurred. But there was still the matter of Allied guaranteeing hundreds of millions of dollars of BLX’s debts—a topic the analysts repeatedly raised on the conference call. Management assured everyone that this liability had been taken into account in the June 30, 2008, valuation, and that Allied did not need to take a write-down for it. In time, this too would prove false.

On September 26, 2008, the Department of Justice notified BLX that it was the defendant in a False Claims Act suit.

Four days later, BLX filed for bankruptcy.

The bankruptcy had two immediate effects: First, Allied announced that it would pay $320 million to BLX’s existing creditors to meet its guarantee obligations. Second, BLX was required to file publicly its near-term cash flow forecast with the bankruptcy court.

For years, Allied had touted BLX as being an income-generating machine, with Walton going so far as to call it a “cash cow.” According to BLX’s earlier financial statements, its balance sheet was full of “residual” assets that should throw off cash over time if the loans performed anywhere near management projections. Allied had used these wildly optimistic projections of future cash flows to inflate BLX’s reported earnings, and to justify huge management bonuses. And though I expected the near-term forecast to reflect numbers more in line with reality, even I was surprised to discover that BLX generated no cash flow at all. None. The bankruptcy documents showed that BLX’s cash flow barely covered the cost of collecting the money. At that point, it was clear that BLX would almost certainly wind up being a complete loss to Allied, including the full amount of all its guarantees. The alleged cash cow was all moo and no milk.

Allied, however, didn’t see it that way. Allied argued that the bankruptcy did not require it to exit the investment in BLX and swallow the realized loss. In fact, BLX’s bankruptcy was of such apparent unimportance, Allied wouldn’t even need to reduce the tax distribution. As analyst Robert Dodd at Morgan Keegan observed, “In actuality, there is no defined time line in which Allied must sell and realize the loss of BLX’s assets; as a result, the bankruptcy and liquidation process could take years to complete.”

However, Greg Mason at Stifel Nicolaus noticed a possible problem:

We estimate that if ALD had to take unrealized losses of $320 million on Ciena [BLX] and continued to pay out its spillover dividend out of book value, it would violate the BDC 1:1 debt:equity requirement in 2Q09. We are not assuming any additional writedowns in ALD’s portfolio, which may be too optimistic given the current dislocations in the credit markets and the potential for further economic deterioration. As a result, even if ALD does not realize its loss in Ciena [BLX], we think there is a very good chance that in 1Q09 ALD will cut its dividend in line with its operating income of $1.33 or $0.33 per quarter, down from the current rate of $2.60 or $0.65 per quarter.

He even acknowledged
Fooling Some of the People
in his report: “As many may recall this is the investment that David Einhorn @ Greenlight Capital has criticized since 2002 and published a book on the topic this past spring.” Allied’s share price, which was $12.55 before the BLX bankruptcy announcement, plummeted to $4.96 by October 10, 2008, nine trading days later.

A month later, Allied announced a $1.78 per share loss for the third quarter. Net asset value fell to $13.51 per share. Allied took $425 million of unrealized depreciation during the quarter, including a $152 million loss on its BLX loan guarantee. During the quarter, Allied sold its last remaining flower, Norwesco, for an $87 million gain. The earnings press release announced that Allied “currently anticipates that 2009 dividends will be reduced to a level that more closely approximates net investment income.”

The conference call to discuss the quarterly result brought only more bad news for shareholders as Walton announced, “We have made capital preservation our highest priority.” Allied would cut more costs, reduce staff, and “favor further deleveraging our balance sheet over making new investments.”