Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New by David Einhorn (tohfa e dulha read online TXT) 📕

The truth is that investors in corporate securities are risk takers making investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully. This sensitivity and other consequences will, in turn, deter dishonesty. In fact, I wonder if a few Allied shareholders have held the stock on the cynical theory that even if Allied is every bit as bad as Greenlight thinks it is, the regulatory consequences won’t be dire enough to hurt my investment. So far, that thinking has been spot-on, and indeed, rewarded.

The same moral hazard exists regarding workers. If employees of a dishonest firm believe that its poor ethics jeopardize their respective futures, they will act more aggressively to fight misbehavior. If managements know lying on conference calls will be prosecuted, they will tell fewer lies. Passing laws like Sarbanes-Oxley helps honest companies create better controls. It does nothing to stop top-down corporate fraud, unless it is enforced.

For our markets to work effectively, participants need to follow the rules. It is a matter of fairness, pure and simple, and, as we have seen with Allied, not so simple. When participants stray, there need to be serious consequences. The authorities need to enforce the rules, not just pretend to enforce them. (It reminds me of the joke about the former Soviet Union worker: “I pretend to work and they pretend to pay me.”)

Ultimately in 2008, as governor of New York, Spitzer would testify to Congress regarding the monoline insurance companies including MBIA, “when you have federal regulators who run away from fulfilling their job which is to ensure that the rules are enforced, that there is integrity in the marketplace, we generate these crises. What we have got to take away from this, as we should have from prior scandals, is that when regulators are asleep on the job the ultimate victim is going to be the investor, the taxpayer and government.” Plainly, the same is true of the regulatory failures over Allied and BLX. Of course, Spitzer was part of the problem; when these issues came to his office in 2003, he investigated the critics rather than the perpetrators.

If Sarbanes-Oxley is to be effective and taken seriously, the SEC can’t let behavior like Allied’s pass without prosecution. Walton was asked at the August 2002 investor day whether Sarbanes-Oxley created an issue for him. He told everyone he had no problem signing Allied’s financials. In poker, this is called being “pot committed.” This is when the pot is so large relative to your remaining chips, that, if necessary, you must put your remaining chips in the pot if there is even the slightest chance you can win.

SEC Chairman Cox’s view of expedience encourages a dishonest business culture. Allied Capital isn’t the only unscrupulous company out there. It is just the one with which I have the most experience. I would guess there are a couple of dozen significant companies with similar characteristics. If you are a fancy guy sitting behind a fancy desk, you can make a lot of money through illicit, dishonest conduct and still have a good chance of either not being caught, or not going to jail if you do get caught. If you are a regular person and walk into Home Depot or Old Navy and pilfer some merchandise, the consequences are likely to be far worse. “If you are going to steal, steal big,” is how the old saying goes.

Shortly after my speech in 2002, Walton told investors an old tale about a blind man and an elephant: a group of blind men (or men in the dark) touch an elephant to learn what it is like. Each one touches a different part, but only one part, such as the side or the tusk. They then compare notes on what they felt and learn they are in complete disagreement. The story is used to indicate that reality may be viewed differently depending upon one’s perspective.

Walton’s point was that the short-sellers only saw one or two parts of the Allied elephant. Velocita or Startec were just the tusk, BLX was just the tail. The wise management team could see the whole thing and supposedly knew better than anyone that the elephant was actually a healthy giant. In reality, it is Allied management who want investors to focus exclusively on a few parts: the distributions, the successful sale of a couple of key investments and the company’s chronic misfortune of being victims of a “short attack.”

There has been much coverage of bits and pieces of the Allied story. One difficulty in telling it to regulators, journalists, and investors is that it is so big, so long, and so complicated, that it is hard to describe the whole elephant. That is what this book is about: one sick elephant.

At its most basic level, Allied Capital is the story of Wall Street at its worst. Relative to most stocks, it has little institutional ownership. With the enormous fees it generates for Wall Street, there are plenty of financial incentives to support the scheme. Allied has spread its lucrative stock offerings around to many brokerages. The brokerage firm analysts writing their glowing reports on Allied know what they are doing. Allied is a retail stock that is sold to and owned by individuals, such as retirees looking for a fat dividend.

And yet, what Allied itself “owns” is a leveraged portfolio of mezzanine loans and opaque private-equity positions; that is, exactly the type of risky investments which the SEC generally restricts to “sophisticated investors” and strictly keeps away from retail investors, the very same investors . . . who own Allied stock. Or, to sum up from another perspective: Allied is a regulated investment company;