Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (46 page)

Brickman called the SBA about Darr’s plight. Armed with Darr’s paperwork, his own research, and additional information he obtained from the SBA by a FOIA request, Brickman spoke with SBA lawyer Christa Brusen-Gomez about the Darr loan. He described to her how BLX sold the property to Darr for more than the appraised value and that Darr was being used to bail out old SBA loans. Under SBA rules, a new SBA loan cannot be made to replace an existing SBA loan. She told him, “If a buyer wanted to pay 120 percent of what a property in liquidation is worth, that is his problem.” When Brickman told her that BLX never gave him the appraisal showing the low value, she said, “Then, he should have gotten his own appraisal.” In short, it appears that the SBA does not care if borrowers can pay, if BLX issues SBA second liens that leave the SBA undersecured, or if BLX withholds appraisals that show the property is not worth the sale amount. The SBA helps its lenders, not its borrowers.

After the Senate hearing, we received unexpected bad news on our whistle-blower lawsuit regarding the shrimp boat loans. The False Claims Act is designed to encourage informed citizens called “relators” to bring suit on behalf of the government. Many relators have firsthand knowledge of the fraud. However, on the other extreme are the opportunists who read about a fraud in the newspaper, have no independent knowledge of their own, but rush to court to file a lawsuit and claim a share of the recovery. Congress sought to eliminate this sort of behavior by denying jurisdiction over actions brought by such relators, “based upon the public disclosure of allegations or transactions in a criminal, civil, or administrative hearing, in a congressional, administrative, or Government Account Office report, hearing, audit or investigation, or from the news media, unless . . . the person bringing the action is an original source of the information.”

BLX argued that Brickman and Greenlight were not an original source of the information, that there were news stories about problems in the shrimping industry, and that other pieces of our information had been obtained from public sources. BLX argued that for these reasons the court lacked jurisdiction to hear the case.

In response, we pointed out that Congress deliberately amended the False Claims Act to encourage the precise type of lawsuit that we brought, where the case is based not on public “information” but, instead, is based on specific “allegations or transactions” of fraud that had not previously been publicly disclosed. No one had publicly alleged fraud prior to our suit. The general news stories about the shrimp boat industry did not discuss allegations of fraud or any transactions. Neither did any of the pieces of information in our complaint. We, and no one else, had meticulously figured out the fraud from a variety of sources, including non-public interviews with former employees and the BLX delinquency report, which led us to the fraud in the first place.

Atlanta U.S. District Court Judge Julie Carnes surprised us by siding with BLX. She took a very broad view of what information is public (including information we used from depositions that were not part of a filed court record, U.S. Coast Guard vessel abstracts, and responses to FOIA requests) and determined that “most of the factual information in their complaint was available to any member of the public who cared to search for it.” As for our review of internal BLX records and interviews with former employees, Judge Carnes concluded that we had not identified clearly what facts we used from the nonpublic material in making our complaint.

Even though the “allegations or transactions” had not been publicly disclosed, Carnes reasoned that since both the misrepresented facts (that BLX had complied with various SBA requirements and regulations) and the true facts (that they had not done so) were public, it amounted to the same thing as a public disclosure of the allegations. As a result, she dismissed our case prior to discovery, on the technicality that the court lacked jurisdiction to evaluate the merits of our complaint.

On the second page of her ruling, Judge Carnes footnoted, “However, there is an additional financial motive behind this case. James Brickman and Greenlight Capital have been publicly identified as having a ‘short’ position in the stock of Allied Capital, Inc., a publicly traded company that owns approximately 95% of defendant BLX. A short seller borrows stock from a lender and sells the borrowed stock, hoping and expecting that the price of the stock will decline. If the price declines, the short seller will be able to purchase the stock later at a lower price, return the stock to the lender, and keep the profits. Brickman and Greenlight Capital thus stand to benefit from any decrease in the price of Allied stock that may result from this lawsuit.”

Though this finding supposedly had nothing to do with her decision, her gratuitous adoption of the irrelevant and misguided attack by BLX’s lawyers on our motives for filing the suit particularly galled Brickman; he hadn’t been short Allied for years and said so in our court filings.

Allied rushed out a celebratory press release, noting the judge’s findings relating to our motives, trumpeting, “Shortsellers of Allied Capital shares, including David Einhorn and his allies, have for many years been making false and unsubstantiated claims of wrongdoing against Allied Capital and BLX. So far, every court that has ever examined the shortseller claims has rejected them.”

Of course, Allied saw no need to acknowledge that the court hadn’t even considered the merits of the case. Indeed, the court never ruled that BLX did not carry out a fraud in its shrimp boat loans; it simply never reached the issue. The sad irony of Judge Carnes’s ruling, and Allied’s public gloating, is that Allied won this round in the litigation only because the judge ruled that the massive fraud had been a matter of public record for years. Brickman and Greenlight’s appeal of the dismissal was rejected in a one-page ruling.

In December 2007,
The Washington Post
ran an article by Gilbert M. Gaul on the Bill Russell Oil fraud in the USDA loan program. The article reported on the fraud involving the loans made to the company by BLX as I discussed in Chapter 25, but with a few more details. The article also pointed out the poor government oversight in response to the fraud.

The article reported:

A
Washington Post
analysis found that from 2001 to 2006, the USDA had to pay $34 million to buy back 13 BLX loan guarantees—representing one of every five USDA-backed loans made by BLX. The 13 loans included some to companies that were in and out of bankruptcy, saddled with tax bills, or struggling in declining industries.

A Maryland gas station operator received a $3 million guaranteed loan but soon lost its license for failing to pay millions in gasoline taxes. It defaulted on the loan and filed for bankruptcy two years later. A Pennsylvania mushroom farm received a $3.4 million loan while in bankruptcy and a loan of $1.7 million a few years later. It filed for bankruptcy again this year and is now defunct. A Hanover, Pa., wallpaper manufacturer with mounting losses got a $3 million guaranteed loan in November 2000. It filed for bankruptcy in 2005 and closed.

In each case, USDA officials relied on BLX employees to investigate the borrowers, conducting little due diligence on their own. Now, with questions being raised about BLX loans to Bill Russell Oil and others, USDA officials have turned to their inspector general to audit the company’s entire portfolio of loans. BLX could be asked to pay back millions.

The article pointed out how Bill Russell Oil borrowed $3 million from BLX through the USDA loan program, despite the Environmental Protection Agency’s citing Bill Russell for dozens of environmental violations and proposing a fine of $314,558.

The article said:

Shirley A. Tucker, the USDA’s director of business programs in Arkansas, said her office relied on the borrower and the lender to certify that Bill Russell Oil met all environmental requirements. Tucker added that she did not learn about the EPA investigation until she read about it in a local newspaper several months after the loan guarantee was approved. “I was surprised,” she said. “Under the conditional agreement, it was up to the lender to bring that to our attention.”

The loan was declared delinquent within a year. “It was hard to see how a loan could go south so fast,” Tucker said. Later, she went to look at some of the gas stations herself. “We found some didn’t have electricity on the day we closed the loan. There was no way they were operating,” she said. (© 2007,
The Washington Post
. Reprinted with Permission.)

He closed the article with an amazing statement from Tucker: “Yeah, we’re the government, but we really don’t have any enforcement. We can’t put them in jail.”

CHAPTER 34

Blind Men, Elephants, Möbius Strips, and Moral Hazards

If someone commits fraud, but shareholders don’t lose money and the regulators decide to ignore it, was it really fraud? The authorities are good at cleaning up fraud after the money’s gone. After a blow-up, with investors’ capital already lost, they know just what to do. If the blow-up is big enough, like Enron, they form a special task-force and pursue criminal cases against the insiders.

I recently attended a small presentation made by one of the Enron prosecutors. He laid out exactly how he made his case and the mistakes management had made, both in perpetrating the fraud and defending themselves at trial. I asked him if it were fair for Enron management to go to jail, when there are many other management teams that act as Enron’s did or worse, but don’t suffer the same prosecution because their companies haven’t “blown-up.” He really didn’t have an answer.

The authorities really don’t know what to do about fraud when they discover it
in progress
. The Arthur Andersen prosecution, which put the audit firm out of business for bungling Enron, cost a lot of innocent people their jobs. The government doesn’t want another Arthur Andersen. It seems that the regulatory thinking, espoused by current SEC chairman Christopher Cox, is that shareholders should not be punished for corporate fraud, because he believes they are the victims in the first place. Why punish the victims a second time? This thinking may be politically expedient in the short term, but creates a classic moral hazard—a free fraud zone. If regulators insulate shareholders from the penalties of investing in corrupt companies, then investors have no incentive to demand honest behavior and worse, no need to avoid investing in dishonest companies.

The truth is that investors in corporate securities are risk takers making investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully. This sensitivity and other consequences will, in turn, deter dishonesty. In fact, I wonder if a few Allied shareholders have held the stock on the cynical theory that
even if Allied is every bit as bad as Greenlight thinks it is, the regulatory consequences won’t be dire enough to hurt my investment
. So far, that thinking has been spot-on, and indeed, rewarded.

The same moral hazard exists regarding workers. If employees of a dishonest firm believe that its poor ethics jeopardize their respective futures, they will act more aggressively to fight misbehavior. If managements know lying on conference calls will be prosecuted, they will tell fewer lies. Passing laws like Sarbanes-Oxley helps honest companies create better controls. It does nothing to stop top-down corporate fraud, unless it is enforced.

For our markets to work effectively, participants need to follow the rules. It is a matter of fairness, pure and simple, and, as we have seen with Allied, not so simple. When participants stray, there need to be serious consequences. The authorities need to enforce the rules, not just pretend to enforce them. (It reminds me of the joke about the former Soviet Union worker: “I pretend to work and they pretend to pay me.”)

Ultimately in 2008, as governor of New York, Spitzer would testify to Congress regarding the monoline insurance companies including MBIA, “when you have federal regulators who run away from fulfilling their job which is to ensure that the rules are enforced, that there is integrity in the marketplace, we generate these crises. What we have got to take away from this, as we should have from prior scandals, is that when regulators are asleep on the job the ultimate victim is going to be the investor, the taxpayer and government.” Plainly, the same is true of the regulatory failures over Allied and BLX. Of course, Spitzer was part of the problem; when these issues came to his office in 2003, he investigated the critics rather than the perpetrators.

If Sarbanes-Oxley is to be effective and taken seriously, the SEC can’t let behavior like Allied’s pass without prosecution. Walton was asked at the August 2002 investor day whether Sarbanes-Oxley created an issue for him. He told everyone he had no problem signing Allied’s financials. In poker, this is called being “pot committed.” This is when the pot is so large relative to your remaining chips, that, if necessary, you must put your remaining chips in the pot if there is even the slightest chance you can win.

SEC Chairman Cox’s view of expedience encourages a dishonest business culture. Allied Capital isn’t the only unscrupulous company out there. It is just the one with which I have the most experience. I would guess there are a couple of dozen significant companies with similar characteristics. If you are a fancy guy sitting behind a fancy desk, you can make a lot of money through illicit, dishonest conduct and still have a good chance of either not being caught, or not going to jail if you do get caught. If you are a regular person and walk into Home Depot or Old Navy and pilfer some merchandise, the consequences are likely to be far worse. “If you are going to steal
, steal big
,” is how the old saying goes.

Shortly after my speech in 2002, Walton told investors an old tale about a blind man and an elephant: a group of blind men (or men in the dark) touch an elephant to learn what it is like. Each one touches a different part, but only one part, such as the side or the tusk. They then compare notes on what they felt and learn they are in complete disagreement. The story is used to indicate that reality may be viewed differently depending upon one’s perspective.

Walton’s point was that the short-sellers only saw one or two parts of the Allied elephant. Velocita or Startec were just the tusk, BLX was just the tail. The wise management team could see the whole thing and supposedly knew better than anyone that the elephant was actually a healthy giant. In reality, it is Allied management who want investors to focus exclusively on a few parts: the distributions, the successful sale of a couple of key investments and the company’s chronic misfortune of being victims of a “short attack.”

There has been much coverage of bits and pieces of the Allied story. One difficulty in telling it to regulators, journalists, and investors is that it is so big, so long, and so complicated, that it is hard to describe the whole elephant. That is what this book is about: one sick elephant.

At its most basic level, Allied Capital is the story of Wall Street at its worst. Relative to most stocks, it has little institutional ownership. With the enormous fees it generates for Wall Street, there are plenty of financial incentives to support the scheme. Allied has spread its lucrative stock offerings around to many brokerages. The brokerage firm analysts writing their glowing reports on Allied know what they are doing. Allied is a retail stock that is sold to and owned by individuals, such as retirees looking for a fat dividend.

And yet, what Allied itself “owns” is a leveraged portfolio of mezzanine loans and opaque private-equity positions; that is, exactly the type of risky investments which the SEC generally restricts to “sophisticated investors” and strictly keeps away from retail investors, the very same investors . . . who own Allied stock. Or, to sum up from another perspective: Allied is a regulated investment company; the SEC is its direct regulator. And yet, the SEC has shown itself incapable of doing that job—or perhaps more truly told, has proved unwilling to do that job. Lawlessness inside regulation, a Möbius strip of hypocrisy: the entire Allied saga has a
Through the Looking Glass
quality to it.

At one point, over a lunch in 2003, I had the opportunity to conduct a “reality check” by discussing short selling with Warren Buffett. He said he has shorted stocks before, the first one being AT&T when he was a teenager to irritate his high school teachers, who held their retirement money in it. Over the years, he said he had trouble getting the timing right on short sales and preferred to have a
public persona
as a long investor. I asked Buffett what he thought of the Allied Capital saga. Though he said he didn’t know about the company, he observed that it was tough to win being short something like that. As he saw it, for Greenlight, Allied is just one position in our portfolio. But, for the company and its management, it is the whole ballgame, so they will say and do things we wouldn’t consider doing in order to win.

Allied’s campaign against its critics has been quite effective. The story of Mark Alpert, the Deutsche Bank analyst who issued a “Sell” rating, only to wind up being investigated by the NYSE, has been a good deterrent. Joel Houck apparently got the message. While he was still at Wachovia, he re-emerged by reinitiating coverage of Allied with an “Outperform” rating in October 2006. Regarding his previous concerns (the October 2006 recommendation was issued before Allied resolved its SEC investigation) Houck took comfort that Allied and BLX had successfully sold debt and equity—thereby passing scrutiny from the SEC and others; and that BLX “is valued by an independent third party” and is a nationwide SBA preferred lender.

Houck’s report stated a single sentence investment thesis: “We believe
Allied has best-in-class management
and can generate a midteens internal rate of return, net of expenses, over the long run.” The same person who previously speculated that Allied was a culture of fraud wrote this. Houck has since left Wachovia and joined Allied’s competitor, American Capital Strategies. I contacted Houck to hear his explanation for his change of heart and newfound regard for Allied’s management. He declined to comment beyond referring me to his published research.

The vilification of critics, be they short-sellers, journalists or regulators, chills the free flow of ideas and analysis—indeed, chills free speech by making it so darn expensive. If posting an analysis on a web site or making a speech gets you an SEC investigation, why bother? Allied’s success has emboldened other questionable companies like
Overstock.com
, Biovail and Fairfax Holdings to take even more aggressive actions against critics. At a minimum, silencing critics through personal attacks will distract some investors from understanding and regulators from dealing with the real problems facing these companies.

There are all kinds of academic studies showing that short selling adds value to the market. One of my friends refers to short-sellers as the “de facto enforcement division of the SEC.” I wish the SEC enforcement division could take that on for itself. However, I think the point is much larger than the merits of short selling. The bigger point is the right to, and benefits of, free speech and the open discussion of ideas, especially critical ones, in the context of the American marketplace. The Allieds, the MBIAs (a short that finally became profitable in 2007 after five years), and the
Overstock.coms
of the world are doing the markets an enormous disservice. Through their toxic tactics, they make the cost of open analysis and open criticism much too high for participants. The reputational and legal cost of defending oneself against bogus manipulation charges deters public discussion.

Unless we wish to encourage the intimidation of critical thinking and speaking, there needs to be regulatory responses to these abusive companies, or we risk stifling the discussion or, at best, forcing it underground. If critical statements about companies are the basis for investigating investors, then managements should not be able with impunity to make the type of false statements seen in this story.