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) 📕

In fact, Sweeney’s statement must have been knowingly false. In consolidation, Allied would eliminate the unrealized appreciation, fees, interest, and dividends it recognized from BLX and replace them with BLX’s actual earnings. Allied carried BLX at a premium to Allied’s cost, which was itself a large premium to BLX’s book value. Consolidation would have lowered Allied’s earnings and book value by eliminating the premiums.

Certainly, Allied’s management knew that the consolidation of BLX was far from black and white. Indeed, years earlier, Allied consolidated the financial results of BLX’s predecessor, Allied Capital Express, in its financial results. Why couldn’t it consolidate Allied Capital Express’s successor as well? Robert D. Long, a managing director of Allied, spoke to me at Allied’s investor day a couple of weeks later and contradicted Sweeney. He told me that BLX should be consolidated. He said that there is a way that they could do that if they wanted to.

Our subsequent review of the technical accounting literature indicated that investment companies are precluded from consolidating entities other than another investment company. BLX is a lender and could be structured as an investment company. Quite likely, Allied took pains to structure BLX so it wouldn’t have to consolidate it. In fact, part of the motivation to acquire BLC Financial and merge it with Allied Capital Express may have been to deconsolidate Allied Capital Express. Considering that Allied owned substantially all of BLX, guaranteed most of its financing, consolidated a predecessor entity, and considered and often referred to BLX as its small business lending “subsidiary,” consolidation was far from “absolutely black and white.” Further, since investments were being transferred back and forth between Allied and BLX, there are serious doubts as to whether BLX is even operated as a separate company.

During the Q&A, Todd Pitsinger, an analyst from Friedman, Billings & Ramsey, asked how much of BLX’s revenue came from gain-on-sale accounting—a low-quality revenue stream that investors often discount. Sweeney avoided the question and instead gave a lengthy response, which concluded with the erroneous statement that SBA loans last an average of about eleven years. A later questioner pointed out that she hadn’t answered the question and asked for an answer. Management ducked the question a second time.

Sweeney repeated the eleven-year loan life number at an investment conference sponsored by Bank of America on September 22, 2002. In 2003, Wachovia Securities published a report estimating BLX average loan life to be less than four years. Since one of the key assumptions in calculating the gain-on-sale is to estimate the life of the loans, if BLX assumed eleven years, then it dramatically overstated its revenues because the longer the term, the more interest payments are assumed to be paid. (If BLX used an assumption that was closer to four years, then Sweeney was misleading the market.) Its gain-on-sale assumptions remain top secret to this day. Incidentally, if Allied consolidated BLX, it would have to disclose the assumptions.

During the call, Allied said that Hillman had made a typographical mistake in the 10-K and Hillman’s senior debt was worth face value. The point refuted our analysis that Allied’s subordinated investment in Hillman was not worth par, because Hillman’s 10-K conceded that the fair-value of Hillman’s senior debt was only 75 percent of face value. We believed that if the senior debt wasn’t worth face, the subordinated investment wasn’t worth face, either.

We, of course, had assumed Hillman had filed an accurate report with the SEC. Indeed, in my next letter to the SEC, I wrote, “In our earlier analysis, we had relied on that disclosure in asserting that Allied’s investment in Hillman was impaired. Assuming that it was in fact a typo, we would withdraw the criticism based on their erroneous SEC disclosure. We would, however, continue to assert that the 18 percent rate of interest Allied charges Hillman is not arm’s-length or market and should not be permitted.”

Before Allied bought Hillman, it advanced an unsecured subordinated loan at 13.9 percent interest, while Hillman’s publicly traded preferred stock yielded 19 percent. By the time Allied obtained control, Hillman’s credit improved so that the preferred yielded only 12 percent. Nonetheless, Allied reset the rate it charged Hillman to 18 percent, increasing Allied’s reported interest income. A fair rate on a subordinated loan should be lower than the prevailing yield on the preferred equity. However, as Allied controlled Hillman, it set the rate as it saw fit. Though Allied eventually sold its equity investment in Hillman for a large gain and claimed vindication, Allied gave Hillman a new subordinated loan at a market rate of 10 percent, further confirming our view that the earlier 18 percent rate was not arm’s length.

More inaccuracies followed. Sweeney spoke about Galaxy American Communications (GAC) and explained that GAC, in which Allied held an investment valued at $39 million compared to the original cost of $49 million, was a different company from its affiliate company, Galaxy Telecom, which had gone bankrupt. She said the criticism of GAC was, “bogus . . . almost comically bogus.”

“It appears that our critics not only don’t do simple math, but they don’t do their simple homework,” she said, castigating us. “Is it possible that our critics, so quick to accuse and so oblivious to our facts, had confused these two companies? Or without evidence, are suggesting that the adverse results of Galaxy Telecom has [sic] any impact on the financial results of Galaxy Communications? Apparently so, which tells us all about their credibility.”

We hadn’t said anything about GAC. The only applicable comments we knew about came from Off Wall Street, which was certainly not confused. It clearly distinguished between GAC and Galaxy Telecom in its report. Since the vast majority of listeners did not have access to Off Wall Street, they would be unable to see that Sweeney was just making this up, with a fabricated attack on our “math,” “homework,” and “credibility.”

After several questions by brokerage firm analysts and