Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (17 page)

CHAPTER 14

Rewarding Shareholders

In an impersonal and anonymous market, we like to know what people on the other side of our investments are thinking. To succeed, we like to feel that we have an edge through deeper analysis or better information than those who disagree with our views. We knew most of Allied’s investors are individual investors. Some have held the shares and collected the tax distributions for years. They had probably not engaged in the analysis we had done and would probably hold the shares, at least until the company admitted a problem.

Allied often pointed to its institutional shareholder base as proof that sophisticated professionals held the stock. Shortly after the investor day, Ed Painter, our institutional salesman from UBS, arranged a meeting with another of his clients, Wasatch Advisors. Wasatch is a mutual fund and was the second largest Allied shareholder with five million shares. Wasatch had a great track record and an excellent reputation. Painter thought that the fund manager in charge of its Allied position and I would both benefit by hearing each other out. The fund manager turned out to be Dr. Sam Stewart, the founder of Wasatch.

Wasatch’s office was just down the street, so James Lin and I walked over with a briefcase full of our research. We met with Painter and Stewart in the conference room. Stewart brought nothing but a legal pad and pen. “Okay,” he said, “go ahead.”

I thought this was supposed to be a two-way dialogue. “First, what did you think of our analysis?” I asked him. “Do you see anything wrong with it?” He said he hadn’t read it.

While I could believe that Allied’s shareholders might generally be too busy to have read the lengthy analysis we put on our Web site, it was hard to imagine a professional, who was the second-largest Allied holder, would come to a meeting with us and acknowledge such lack of preparation.

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 to the SEC on September 3, 2002, where I pointed out the manipulative aspects of the rights offering. I don’t know if my letter had any effect. However, Allied amended the deal to eliminate the requirement for shareholders to hold the shares continuously between the record date and the exercise date. Allied set the pricing at a 7 percent discount to the market price on the date the rights expired. Investors did not have to hold the shares for an extended period to maintain the rights and would not be subject to the uncertainty of exercising the rights at an unknown value. Allied gave shareholders the right to purchase one additional share for every twenty shares they held. Allied also gave shareholders “oversubscription” rights, or the opportunity to subscribe for additional shares in the rights offering for any shares that other rights holders did not purchase.

The final prospectus no longer said that the purpose was to “reward the long-term shareholder.” Instead, it said, “Our board of directors has determined that this rights offering is in our best interest and in the best interests of our shareholders. The offering seeks to reward the long-term shareholder by giving existing shareholders the right to purchase additional shares at a price below market without incurring any commission or charge. . . . Our board of directors makes no recommendation to you about whether you should exercise any rights.”
Buyer beware
.

If the purpose were to reward long-term shareholders, it was a reward that the management and directors, for the most part, decided to forgo. According to the proxy, nineteen insiders were granted rights to purchase 123,000 shares, in addition to oversubscription rights. As a group, they exercised about one-third of their rights. Collectively, this was less than they receive in a single quarterly tax distribution check.

Speaking of insider purchases, Allied management made several small insider purchases between my speech on May 15, 2002, and the end of the year. As one Allied shareholder asked me, “Allied insiders have been buying shares and not selling. In fact, I think the last insider sell was more than a year ago. This does not seem like the behavior of management that is hiding something. If, as you suggest, they are privy to negative information that likely would be detrimental to the stock price, it’s inexplicable to me why they would put more of their own money at risk.”

This, of course, is a straightforward and logical analysis. I agree that insider purchases are
generally
bullish. However, in this case, the insider purchases were so small relative to the financial wherewithal of the participants and to their existing stakes in the company that they appeared to be simply an effort to “signal the market” with news of insider purchases, thus reassuring retail investors like this fellow. In context, this was not a serious effort to increase their stakes by taking advantage of discounted prices.

Walton earned $2.4 million in cash compensation for running Allied in 2001 and held about $10 million in stock, with options to purchase many more shares. For him to invest about $46,000 to purchase an additional 2,000 shares is hardly an increased commitment. (Walton did this shortly after my speech. In the rights offering he exercised rights to purchase approximately 11,000 shares, effectively reinvesting a single quarterly distribution back into the stock.) Considering his vested interest in the outcome, $46,000 is an awfully cheap form of “advertising” his “confidence.”

If insider purchases are indiscriminately believed to be a bullish indicator, bad actors can use them as false indicators at desperate times. Dennis Kozlowski and Mark Swartz of Tyco each spent about $15 million to signal the market with insider purchases in January 2002. In June 2005, Kozlowski and Swartz were found guilty on twenty-two of twenty-three counts of grand larceny and conspiracy, falsifying business records and violating business law. They were ordered to pay fines and restitution of over $200 million and given lengthy prison sentences.