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) 📕

“BLX” more than one hundred times, Allied chose not to reveal that this transaction involved BLX or describe the defaulted status of the “commercial mortgage loans” when it accepted them. This disclosure was about as non-disclosing as a disclosure can be.

Sweeney told Houck that BLX sold the loans to Allied pursuant to a put agreement, where BLX would have a contractual right to assign the loans to Allied at a particular price. Houck relayed this to Brickman. Brickman asked Houck to find out where Allied disclosed the put agreement.

Once more, Houck called Sweeney. This time she asked Houck whether he had been reading the Yahoo! message board on the company. Houck said he hadn’t, but heard there were concerns. Houck asked about the disclosure of the put agreement. Sweeney said that there isn’t anything in writing, just an oral agreement to buy back loans made at the time of the merger between Allied Capital Express and BLC Financial, Inc. to form BLX, and said Tannenhauser wanted to keep this clean for the SBA. Apparently, these were fraudulent loans that Allied transferred from its books to BLX as part of the merger. Tannenhauser didn’t want his reputation tarnished by these loans. She couldn’t talk about what loans they were, because of Regulation FD, but agreed that many of the loans were worthless.

FD stands for Fair Disclosure. The regulation requires companies to disclose material information simultaneously to all market participants. Allied would later claim that the transaction didn’t need to be disclosed because it was “immaterial.” Obviously, if it were immaterial, Regulation FD didn’t apply. Alternatively, she could have discussed what loans were involved in the put agreement, provided she disclosed it to the whole marketplace.

Oral business agreements are sometimes made because somebody doesn’t want someone else to know about them. Taking Sweeney at her word to Houck, that someone was the SBA, a federal agency. Perhaps there were others as well. Did Sweeney want the put agreement concealed from Allied’s auditors, investors, rating agencies, and, possibly, even its own board of directors? Surely, a binding put agreement should have been disclosed in Allied’s financial statements. It wasn’t.

The actual document where BLX assigned the loans to Allied did not reference a put agreement. Instead, it explained that BLX wanted to “prepay” its debt to Allied.

Houck concluded that this was fraud, but didn’t want to write a detailed explanation of what he understood. “Given who these individuals are and how they act, to me I don’t want a personal stake in this,” he told me. I empathized with Houck: I never wanted a personal stake in this, either. I viewed my speech as professional, but Allied responded with personal attacks. I understand why Houck didn’t want a similar experience.

Another problem was that Houck’s bank, Wachovia, had a strong relationship with BLX. Indeed, they underwrote a number of BLX’s securitizations. Houck decided to run his concern up the chain of command. Rather than write a detailed report, Wachovia and Houck decided to simply cease covering Allied. In a brief published research note, on April 26, 2004, the day before our scheduled meeting with the SEC, Houck discontinued his coverage of Allied. He wrote: “We believe the financial statement disclosure for the company is inadequate and the fundamental information provided with respect to ALD’s largest portfolio company, Business Loan Express, lacking. Our concern includes questions related to a repayment and assignment agreement dated February 3, 2003, between ALD and Business Loan Center. In our opinion, management’s response to our requests for additional financial disclosure has been unsatisfactory.”

“With BLX representing a significant portion (13% at Q4 2003) of ALD’s investment portfolio, and hence book equity, we believe additional disclosure for valuation purposes is warranted. Without additional disclosure/information on BLX, we lack a reasonable basis to value Allied Capital and the cash flows associated with the investment.”

After he dropped coverage, Houck explained to me, “I think the larger point here is that [it] wipes out a lot of earnings for Allied as a whole. And all the while they are selling stock. So this is securities fraud. If you want to take it to an extreme, how can you sell stock when BLX’s earnings were clearly inflated? Even if there was a put agreement, if it was in writing, it still is a scheme to inflate earnings.”

We then discussed Allied’s refusal to disclose BLX’s gain-on-sale assumptions. Houck said that Sweeney told him the reason for this refusal was that BLX generates so much cash and Allied didn’t want people to see how good it was. Houck agreed that BLX didn’t generate any cash and added, “If you tell a big enough lie, maybe people will believe it.” After discussing other problems in Allied’s portfolio, Houck concluded, “You start to see a pattern of fraud at an organization, you tend to think it is cultural.”

Allied, as it said about me, whispered that Houck just didn’t understand the company and how it did business. It claimed Houck insisted they violate regulation FD, and when it wouldn’t, Houck retaliated. Houck wasn’t able to defend his view or answer Allied because Wachovia told him to make no further comment.

I also told Kurt Eichenwald at The New York Times about the secret $9 million loan transfer. Houck’s dropping coverage of the company spurred Eichenwald to, at last, write something. The next day, April 27, 2004, the Times published his article about the transaction and Houck, headlined “Allied Capital Under Scrutiny Over $9 Million Transaction.” Eichenwald wrote:

The reason for the concern about the documents was simple: defaulted and troubled loans are not worth their full value; indeed, under most lender accounting, a defaulted loan must have its value reduced in the company’s books. That decline in value is then usually accounted for by a reduction in the lender’s profits.

In other words, by counting the loans at full value, the transaction raised concerns among some investors both that the income of BLX had been manipulated upward—raising dividend payments to Allied—and that it may be