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) 📕

wrote, “The shorts in ALD likely feel vindicated, as much of the short-argument now seems valid.” (He later told me he caught heat from Allied for that remark.) However, he continued, “Given the indictment involves only one former employee acting on his own, it seems premature to question all the lending practices in BLX and discount the company altogether.”

The other analysts covering Allied took the talking points from management at face value. Keefe, Bruyette & Woods wrote, “Management noted that this status (Preferred Lender) is granted by territory (there are roughly 70 territories within the US) and given that Detroit is only one office within one of these territories, this is less of a concern.”

Bank of America thought the stock price weakness was reason to upgrade the shares. “We believe the market is over-reacting as the investigation has been disclosed over the past two years and the latest development is the result of a corrupt employee in one of ALD’s 140 portfolio companies.”

Morgan Stanley repeated, “The problems at BLX seem isolated to one office and are not likely indicative of other issues at BLX or Allied’s other portfolio companies, in our view.”

Ferris, Baker Watts added, “Though this investigation has been going on since the summer (and discussed in Allied’s 10-Q filing), the actual indictment was unsealed on Tuesday. The BLX office in question was closed in August of 2006. The employee under investigation was fired in September 2006. The company factored this event into its valuation of BLX then and wrote it down by $34 million during the September quarter.”

A. G. Edwards also upgraded the stock. “BLX was notified of the fraudulent activity approximately six months ago and chose to fire Mr. Harrington and closed the Detroit office.”

And my favorite proclamation came from Citigroup: “. . . our view that the recent selloff is an overreaction, as BLX retains value even in a worst-case scenario in which it was shut down.” I don’t think it would be worth anything if it were shut down. In fact, the better question would be, how much further liability would Allied have?

These comments came from what Allied management told the analysts. According to Allied, when BLX heard the news of a rogue employee it acted promptly, decisively and responsibly by dismissing Harrington and closing the office. Allied fully disclosed the circumstances in its quarterly SEC filing as soon as the company knew them. This was a case of a single rogue employee engaged in misconduct, and such behavior did not exist elsewhere at BLX. In fact, BLX was actually a victim of Harrington’s fraud. In any case, BLX was just one investment out of a large portfolio of 140 investments and Allied had relatively insignificant exposure to any loss.

Of course, almost none of this spin was accurate. Allied had not made good disclosure of what had happened. When it disclosed the SBA’s OIG and U.S. attorney investigations into the Detroit office deep in the middle of the wrong section of its September 2006 10-Q (BLX closed the Detroit office on August 1, 2006—eight days before Allied filed its second-quarter 10-Q, which made no mention anywhere of these developments), Allied did not disclose that it had fired Harrington or that it had closed the Detroit office. Allied waited to confess until the U.S. attorney unsealed Harrington’s indictment. Allied/BLX knew the U.S. attorney from the Eastern District of Michigan was investigating the Detroit office no later than October 2005, when its employees provided sworn testimony. It failed to make any disclosure of this for an entire year.

Further, when Allied announced its second-quarter 2006 earnings and held a conference call, Walton highlighted that Allied had lower legal and investigation related expenses. Don Destino, who was now covering Allied from JMP Securities, asked, “Could an enterprising analyst assume that that means you think that’s [the investigation] coming to an end, with not much of a punch line to it?” Walton answered, “One would hope. You know, it’s obviously a lot quieter.” He said this the day after BLX closed the Detroit office.

We, of course, knew that the fraud at BLX was much broader than a single employee in a single office, and in its article by Julie Creswell on January 13, 2007, The New York Times said the SBA knew it, too. The Times article said:

Federal investigators are now looking at loans issued by the unit, Business Loan Express, in other parts of the country, according to several people briefed on the investigation.

And the federal Small Business Administration—which typically guarantees 75 percent of the value of these small-business loans—is considering suspending the preferred lending status of Business Loan Express, pending the outcome of an investigation. That would mean that every loan Business Loan Express issues would have to be vetted by the agency, those people said.

The S.B.A. this week also suspended the unit’s ability to sell the loans it issues to large institutional investors in the secondary market, which could affect the ability of Business Loan Express to make loans, those people said. The unit can still originate loans, but only if it intends to hold those loans on its own books, which is not something the firm has historically done.

“Allied has been aware of misconduct by Mr. Harrington for half a decade and it won’t be hard to find many more similarly fraudulent loans in other parts of the country,” I told the Times. The Times article continued:

About a year ago, the S.B.A., which gives its lenders an internal rating on a one-to-five scale, lowered Business Loan Express to the lowest rating that would allow it to remain in the preferred lending program, based on a rising level of late payments and defaults on loans it had made, according to people involved in the investigation.

The article noted that the House Small Business Committee headed by Nydia Velázquez (who had received large contributions from BLX CEO Tannenhauser and other Allied executives, as described in Chapter 26), had begun its own investigation of the loans in Michigan and possibly