Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (41 page)

Williams was curious about the significance of the $9 million. “That is the first thing everyone asks me.” He didn’t see what was special about them. He said there were about fifty such loans between Allied and BLX with a total value approaching $50 million.

Williams explained how the SBA monitored the workouts. BLX would prepare a liquidation plan and submit it to the SBA for approval. Williams’ team would always follow that plan. Many times, BLX would list a workout property for sale at too high a price. It wouldn’t sell. Sometimes the company would simply sit on a loan with a higher appraisal, not foreclose, and the SBA would let it sit forever. Because the company told the SBA what they were doing in advance, and the SBA had approved the plan, there was nothing the SBA could do about it.

The SBA would scrutinize the liquidation efforts by BLX, but almost never seemed to question the original underwriting. Williams said this wasn’t always the case. Before BLX got preferred (PLP) status, there was more oversight. The USDA did a better job than the SBA of questioning BLX originations. He said when BLX got a PLP license, apparently the SBA was supposed to review all the existing loans as part of the transition, but it never did.

Auerbach said McGee, the previously convicted felon who was the head of the Richmond office, had voting authority in the credit committee. The former BLX employee who contacted me by e-mail in 2002 had told me the same thing. When Jesse Eisinger from
The Wall Street Journal
confronted Allied about McGee’s role, they vehemently denied he was on the credit committee. Auerbach said McGee was treated differently. In one instance, Auerbach was told “never to contact McGee.” One of the loans in Auerbach’s portfolio was a 7-Eleven in Richmond, Virginia. Auerbach was working out the loan and wanted to send someone to look at the furniture and fixtures to buy. He called McGee, who told Auerbach he would take care of it. A bit later, David Redlener, a senior BLX executive, called Auerbach and told him to forget about the liquidation, that McGee would take care of it. The loan just sat on Auerbach’s list.

BLX held quarterly reviews of the workout loans. We were surprised to hear that Allied CFO Penni Roll usually participated by phone and Joan Sweeney usually appeared
in person.
During these meetings, Williams’s team produced binders of documents, and everyone discussed individual loans, reserves, and valuations.

Williams suggested we try to get the “Loan Loss Allowance Valuation” binders. Those books would contain all the detail behind the workout loan valuations. He told us that after the review meeting, Redlener would prepare a valuation report, which Williams and Auerbach did not see, used for setting reserves in BLX’s financials. Williams believed the reserves would not match the recommended valuations from the workout team in the Loan Loss Allowance Valuation binders.

Williams said the financial statement values were inflated, in part, because Roll had a concept of a “person value” for each borrower, because each borrower personally guaranteed the loans. This value acted as a valuation floor when there was inadequate collateral in the loan. Williams understood that if the person had any money, he wouldn’t default on the loan in the first place, and BLX almost never collected anything on the personal guarantees, but gave them value for accounting purposes.

At the time Williams and Auerbach were there, BLX had three categories of loans: SBA, USDA, and “Bobby family” loans. When working out a loan, “Bobby’s [Tannenhauser] family always got paid. It was all right for the SBA to get nothing.” We pressed them for details about the “Bobby family” loans. Williams and Auerbach had few, as those loans all had happy endings.

We believed that one or both of them had spoken to Carruthers years earlier and abruptly broken-off conversations with him around the time Allied stole its critics’ phone records. We asked Williams and Auerbach about this, but they recalled only minor contact with Carruthers and had vague memories on that subject.

Obviously, we were in no position with the government to broker an immunity deal for Williams and Auerbach. After our lunch, we tried to figure out how to help them. However, when we tried to follow-up with Williams to discuss matters, he didn’t return our calls.

One week after the Auerbach/Williams meeting, Allied announced that it agreed to sell Mercury Air Center to Macquarie Infrastructure Company. Mercury operated terminals for private jets. This sale generated a realized gain of $240 million for Allied. Based on our analysis, this was the last identifiably ripe flower left to pick in Allied’s garden.

On May 8, 2007, Allied released its first-quarter earning results. Net investment income fell to only 26 cents per share. The overall yield on the interest-bearing portfolio fell to only 11.6 percent. The results were hurt by higher nonperforming assets (6.4 percent of the portfolio compared to 5.3 percent at the end of the year, despite strong credit markets), lower deal-origination fees and higher investigation expenses. Allied invested $19.2 million in BLX (inclusive of the $12 million they disclosed earlier in the year) and held its valuation of BLX constant. On the conference call that day, Walton continued to insist that BLX’s “core business is profitable.”

Management was asked about the narrow gap between the value of the investments it exits and the most recent prior valuation on Allied’s books. Walton noted, “I think a lot of this has to depend on the timing of when we actually realize the gain versus how close it is to the end of the quarter. What happens is if you get—sometimes we have taken the gains just hard on the heels of a quarter where we know exactly what the gain’s going to be and we mark it up. One of the things that would be interesting, we haven’t done this yet, is to look back a couple of quarters to see where we were two quarters prior to exit. . . .”

Sweeney added, “When you have perfect knowledge, it’s really easy to get the valuation exactly right.”

I couldn’t have said it better myself. That had been our point back in the debate of 2002! The accuracy of the most recent marks prior to exit reflects exactly the status of the exit process and provides no comfort that Allied properly values the rest of the portfolio.

CHAPTER 31

The SEC Finds a Spot under the Rug

On June 20, 2007, came the moment we’d all been waiting for: The SEC released the results of the investigation of Allied it had announced in 2004. The agency released an “Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934” in the matter of Allied Capital Corporation.

The six-page order found:

From the quarter ended June 30, 2001 through the quarter ended March 31, 2003 Allied violated recordkeeping and internal controls provisions of the federal securities laws relating to the valuation of certain securities in its private finance portfolio for which market quotations were not readily available. During the relevant period, Allied failed to make and keep books, records, and accounts which, in reasonable detail supported or accurately and fairly reflected certain valuations it recorded on a quarterly basis for some of its securities. In addition, Allied’s internal controls failed to provide reasonable assurances that Allied would value these securities in accordance with generally accepted accounting principles. Further, from the quarter ended June 30, 2001 through the quarter ended March 31, 2002, Allied failed to provide reasonable assurances that the recorded accountability for certain securities in its private finance portfolio was compared with existing fair value of those same securities at reasonable intervals by failing to: (a) provide its board of directors (“Board”) with sufficient contemporaneous valuation documentation during Allied’s March and September quarterly valuation processes; and (b) maintain in reasonable detail, written documentation to support some of its valuations of certain portfolio companies that had gone into bankruptcy.

The order continued:

With respect to 15 private finance investments reviewed by staff, Allied could not produce sufficient contemporaneous documentation to support, or which accurately and fairly reflected, its Board’s determination of fair value. Instead, in some instances, the written valuation documentation Allied presented to its Board for these investments failed to include certain relevant indications of value available to it (as further discussed below) and sometimes introduced changes to key inputs used to calculate fair value from quarter to quarter without sufficient written explanation of the rationale for the changes (
e.g
., changes from EBITDA to revenue-based valuations and in some instances, changes in the multiples used to derive enterprise value). The written valuation documentation does not reflect reasonable detail to support the private finance investment valuations recorded by Allied in its periodic filings during the relevant period.

The order proceeded to give three examples labeled “Company A,” “Company B,” and “Company C,” which we can identify as Startec, Executive Greetings, and Allied Office Products, respectively.

Company A—During the relevant period, Allied held a debt investment in Company A, a telecommunications company. Allied was unable to produce contemporaneous written documentation, in reasonable detail, to support its valuation of Company A during the quarters ended June 30, 2001 and September 30, 2001. Specifically, Allied’s valuation of Company A for these quarters was derived, in part, by including revenues from discontinued lines of business to establish fair value. Allied maintains that it used a reduced multiple to offset any potential overstatement that would have otherwise resulted from the inclusion for those revenues, but it did not provide the Board with contemporaneous written documentation, in reasonable detail, to support this claim. In addition, Allied did not retain the valuation documentation it presented to the Board for Company A for the quarters ended December 31, 2001 and March 31, 2002. Allied valued its $20 million subordinated debt investment in Company A at $20 million (
i.e.
, cost) in its Forms 10-Q for the quarters ended June 30, 2001 and September 30, 2001. In its 2001 Form 10-K and its form 10-Q for the period ended March 31, 2002, Allied valued its subordinated debt investment in Company A at $10.3 million. Allied subsequently wrote down its subordinated debt investment in Company A to $245,000 in its Form 10-Q for the quarter ended June 30, 2002.

Company B—During the relevant period, Allied held a subordinated-debt investment in Company B, a direct marketing company. Allied was unable to produce contemporaneous documentation, in reasonable detail, to support the basis for its valuation of Company B for the quarter ended March 31, 2003. Specifically, Allied’s valuation was based, in large part, on a potential future buyout event by Allied that was preliminary in nature. Allied maintains that—as a general practice—the Board would have discussed why this particular potential future buyout event was significant enough to form the basis of its valuation of Company B, but it could not provide contemporaneous written documentation in reasonable detail to support this claim. Further, Allied’s valuation documentation did not fully reflect Allied’s consideration of competing buyout offers for Company B, which, if accepted, would have reduced the fair value of Allied’s investment. Allied valued its $16.5 million subordinated debt investment in Company B at $14.3 million in its Form 10-Q for the quarter ended March 2003. Allied subsequently wrote down its subordinated debt investment in Company B from $14.3 million to $50,000 in its Form 10-Q for the quarter ended June 30, 2003.

Company C—During the relevant period, Allied held a subordinated debt investment in Company C, an office supply company. Allied was unable to produce contemporaneous documentation, in reasonable detail, to support the basis for its valuation of Company C from the quarter ended September 30, 2001 through the quarter ended March 31, 2002. For example, Allied’s written valuation documentation failed to include all relevant facts available to it regarding Company C’s deteriorating financial condition, including the fact that Company C had lost one of its largest customers as a result of the terrorist attack on the World Trade Center. Allied valued its subordinated debt investment in Company C at $8 million in its Forms 10-Q and Form 10-K for the quarters ended September 30, 2001 through March 31, 2002 and subsequently wrote that investment down to $50,000 in its Form 10-Q for the quarter ended June 30, 2002.

Continuing through the order, the SEC found:

There were certain instances where Allied did not provide its Board (or its valuation committee) with sufficient written information to support the Board’s determinations of fair value. For example, in several instances, the written valuation documentation presented to the Board was incomplete or inadequate to support the fair value recorded by Allied (
e.g.
, enterprise values were listed on worksheets without any explanation; necessary inputs and/or calculations were either missing or incomplete). In other instances, Allied’s valuation documentation during the relevant period contained unexplained departures from, or changes to, key inputs from quarter to quarter.

The SEC found that September 2001 and March 2002:

Valuation processes consisted of quantitative worksheets that failed to provide an adequate explanation of the various inputs. For example, changes in valuation from quarter to quarter were not always explained in reasonable detail in the written documentation. Moreover, Allied did not prepare a written description of the quantitative and qualitative analyses used to develop its valuations until the quarter ended June 30, 2002. During this period, Allied also failed to maintain, in reasonable detail, written documentation to support some of its valuations of certain portfolio companies that were bankrupt. While Allied maintains that its Board members and employees engaged in discussions before and during the Board meetings to satisfy themselves with the recorded valuations for Allied’s private finance investments, the written documentation retained by Allied does not reflect reasonable detail to support the private finance investment valuations recorded by Allied in its periodic filings during the relevant period.

Finally, the SEC order found:

During the relevant period, Allied private finance department personnel typically recommended the initial valuations on the investment deals on which they worked. While there were some existing independent checks of Allied’s valuation process, these checks, standing alone, did not provide a sufficient assessment of the objectivity of valuations of the private finance investments. For example, the valuation committee assigned to review each investment on a quarterly basis was comprised, in large part, of private finance managing directors and principals.

All in all, the SEC found Allied to have violated three sections of the Exchange Act of 1934.

The SEC confirmed our analysis that Allied could not support its valuations. Further, the agency found that Allied made undocumented—certainly self-serving—changes to its valuations metrics. Documents were “not retained.” Allied did not even have documentation procedures to support its valuation analyses at the time of my speech; those began the following quarter, presumably in response to the speech. Allied did not consider negative information and events, such as its investments going bankrupt. Allied held an investment at a higher value based on the idea that Allied might buy the company. The SEC provided three clear examples and indicated it found a dozen others. Now, it was no longer just Greenlight and a few others pointing to Allied’s shoddy accounting. The SEC gave our analysis its stamp of approval.

For this, what was Allied’s punishment? The order noted Allied’s cooperation in the investigation and said Allied had improved its valuation process through more detailed record keeping, obtaining third-party valuation assistance and establishing a new “chief valuation officer” position to oversee the valuation process. Without admitting or denying any of the SEC’s findings, Allied agreed to “cease and desist” from violating the Exchange Act, (
e.g.,
to keep better records) and for the next two years to continue to use outside valuation assistance for its investments under the supervision of an internal “chief valuation officer.”

That was it. There were no fines. There were no penalties. There were no actions taken against Allied employees or directors. In the next day’s
Washington Post
, the SEC’s associate enforcement director said, “The valuation of those securities in the portfolio are not easily quantifiable. The message here is, we want to make sure companies adhere to the standard that has been laid out.”

The consequence of Allied’s illegal action was the lightest tap on the wrist with the softest of feathers. The SEC’s order did not make even a passing reference to BLX or to any of management’s conduct, including the many false statements to inflate Allied stock price. There was a gaping disconnect between the findings and the order. It was as if the SEC said, “Greenlight was right. Allied was wrong. Have a nice day.” It was an unimaginable Pyrrhic victory.

Back in spinland, Christopher Davies, a partner at Allied’s outside counsel at WilmerHale, told Reuters, “Nothing in the SEC findings calls into question the accuracy or reliability of Allied Capital’s valuations of its portfolio companies.” The findings actually found the opposite—again, a Big Lie is more palatable than a small one.

Different punishments for different people? It took Brickman about an hour to find the SEC’s release from August 26, 2004, in which it announced an action against Van Wagoner Capital Management and Garrett Van Wagoner. In that case, the SEC found that Van Wagoner misstated the valuations of illiquid, non–publicly traded securities held by its funds. In his case, Van Wagoner
undervalued
his holdings. In other words, he had been
too conservative
.

Van Wagoner paid an $800,000 fine, agreed to resign from his position, and agreed not to serve as an officer or director of any mutual fund for seven years. In substance, the SEC put Van Wagoner out of business. No doubt he didn’t have the former head of the Republican National Committee on his board.