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) 📕

So I asked him why he held the stock. Stewart said that in the tough market he felt it was a good time to own a lot of high-yielding stocks and his Allied holding was really part of a “basket approach.” He hadn’t done the research we had, but he had spoken to Allied management. “They seem honest,” he said. “Have you found a history of fraud or other criminal behavior in their backgrounds?”

“No, not at Allied,” I replied. “But we have at BLX.”

I decided that if he came to the meeting with so little to say, there really wasn’t much sense in going into detail. I briefly described the work we had done and raised a couple of points. Stewart didn’t have much of a reaction.

So I wrapped up by telling him that if he read Greenlight’s report and wanted to discuss it, I would be happy to talk further. At his request, we followed up by sending him our Excel spreadsheet of Allied’s historical valuations so he wouldn’t have to recreate the work and could see Allied’s patterns of write-ups and write-downs for himself.

I left with a new understanding of what we were up against. It wasn’t an issue of investors understanding our views and disagreeing. In addition to the small investors, Allied’s other investors were big funds managing lots of other people’s money—too busy or too lazy to worry about the details, other than the tax distribution. I never heard from Stewart again, but a few quarters later I noticed that his fund had completely sold its Allied position.

Over the years, I’ve heard many rumors that companies can do things with their stock that create havoc in the stock-lending market. A sudden shortage of borrowable shares can force short-sellers to cover whether they want to or not. The resulting price spike is known as a short squeeze. About a month after my speech, Walton posted a letter on the Allied Web site telling shareholders, “Finally, you can help us protect your investment in Allied Capital. If you hold any of your shares in a brokerage account, please ask your broker to move your Allied Capital shares out of a “margin” account and into a “cash” account. By doing this, you prevent the brokerage firm from lending your shares to short-sellers. I have done this with my own shares. Any shares you own directly are not accessible to brokerage firms and cannot be borrowed.”

How does this protect an investment in Allied Capital? In a traditional sense, it doesn’t, because the value of an investment in Allied depends on how its portfolio performs and shouldn’t have anything to do with whether shareholders lend shares to short-sellers. What Walton wanted was a short squeeze, where owners recall stock lent to short-sellers. If the short-sellers are unable to find another stock lender, they have to purchase the shares at whatever the market price is in order to return the borrowed shares. I think efforts to coordinate this sort of action between shareholders are overt attempts to manipulate the market. To date, however, the SEC has never prosecuted these efforts. As a general matter, companies that engage in this sort of effort have large problems.

Some people believe that stock splits, stock dividends, and rights offerings can precipitate short squeezes. Actually, it does not work this way because the share-clearing system is able to adjust. In August 2002, Allied made another attempt to manipulate the clearing system by filing preliminary documents with the SEC to do a rights offering. The stated purpose was to “reward the long-term shareholder.”

The proposed method of this offering was something I had seen neither before, nor since. According to the proposal, Allied would issue “non-transferable” rights that allowed the holder to subscribe for more shares at a price to be determined, only after the holder irrevocably exercised the rights. By having the rights non-transferable, it appeared that Allied was trying to complicate the clearing and settlement process, which they hoped would force short-sellers to cover. Goldman Sachs, our clearing broker, suggested to us that market participants believed that Allied created the non-transferable rights to generate a short squeeze. If the rights could not be transferred, Allied hoped the short-sellers would not be able to create rights to return to the stock lenders. Allied was wrong; the clearing system was able to adjust for this.

According to the proposal, holders who wished to exercise their rights would be required to certify that they held the stock continuously from the record date to the exercise date. Generally, the purpose of having a “record date” for corporate actions is to enable anyone who held the stock on the record date to participate. Here, Allied proposed the unheard-of condition that if you sold your stock after the record date, you would forfeit the rights.

The exercise price would be determined during the period when the shareholders needed to certify that they held the stock continuously. Allied wanted to create a complete absence of sellers (if you sold, you would forfeit the rights), which, obviously, would make the stock rise. Then, Allied would price the rights offering at a modest discount to the artificially inflated price. This would have the dual effect of hurting the short-sellers on a mark-to-market basis and induce the existing holders to subscribe to the rights at a small discount to the inflated price. Since the investors would not know the purchase price until after they irrevocably committed to exercise the rights, there would be nothing they could do if the price turned out to be higher than they thought. Allied would pocket the inflated proceeds.

In case the scheme didn’t work, the company left itself an out: If the share price fell, it would have the option to cancel the offering and simply refund the investors’ money without interest. Of course, the board could not recommend to shareholders whether or not they should exercise their rights in these circumstances.

I wrote another letter