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 Company will record unrealized depreciation on investments when it believes that an asset has been impaired and full collection for the loan or realization of an equity security is doubtful.”

This, cleverly enough, is the SBA standard for valuation. But as a regulated investment company, Allied is subject to the tougher SEC standard that requires write-downs as soon as a willing buyer would no longer pay cost.

The 2001 annual report continued to echo Sweeney’s conference-call statement: “Under its valuation policy, the Company does not consider temporary changes in the capital markets, such as interest rate movements or changes in the public equity markets, in order to determine whether an investment in a private company has been impaired or whether such an investment has increased in value.”

Oddly, though, the previous year’s annual report lacked most of this language. Clearly, it was brand new in the 2001 report. Obviously, this could not be part of Allied’s forty-year-old “consistent” accounting practices. The new language plainly reflected new practices, with new prose now justified by the white paper. Had Allied modified its accounting policy to avoid taking write-downs in the mini-recession of 2001–2002?

Later, we learned that the white paper wasn’t Sweeney’s first attempt to obtain lenient SBA-styled accounting treatment for BDCs. In 1997, Sweeney represented Allied in the SEC’s annual Government-Business Forum on Small Business Capital Formation that recommended, “[a] safe harbor . . . be established in the ‘40 Act for the ‘mark-to-market’ evaluation of investment companies’ portfolio of illiquid investments in small businesses to protect directors of such companies from possible liability.”

The panel elaborated: “The Investment Company Act requirement of [sic] that fund boards determine the ‘fair value’ of portfolio securities for which market quotations are not readily available discriminates against the illiquid securities typically issued by smaller companies. Using an established valuation guideline such as the one developed by the SBA should provide sufficient information and consequently some protection for the investment company’s directors from liability under federal securities laws.”

The SEC never granted the requested safe harbor.

In summary, Sweeney went to the SEC and asked permission to use the SBA standard. When the SEC didn’t agree, Allied did it anyway. Then, Sweeney and Roll wrote a white paper to justify it. In 2004, when we learned of Sweeney’s 1997 failed attempt with the SEC, I realized Allied’s improper use of SBA accounting was no accident. Rather than an unsophisticated lack of understanding, it was a willful, intentional act—a sham that had been in the works for years.

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