Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New Epilogue (49 page)

Sweeney added: “We also plan to seek an amendment to our net worth covenant with our private lenders during this quarter as the depreciation we experienced in the third quarter reduced our excess margin on this covenant . . . we may see additional depreciation in the portfolio.” Had Allied taken an additional $40 million in write-downs, it would have violated the covenant that quarter. Perhaps it held off taking the “additional depreciation” to avoid that event. As it was, paying the fourth-quarter distribution would put Allied in violation of the covenant.

On the quarterly conference call, an analyst asked whether Allied might try to raise equity through a rights offering to cure the default. Penni Roll, Allied’s CFO, explained, “You can look at a decrease in the dividend as almost like a rights offering in a sense because it has a similar effect in that not as much capital leaves the company and it’s being done with the incumbent shareholder group.” Somehow I doubted the individual investors who had bought shares at the top of the Allied pyramid would see it that way. Ironically, Roll’s statement is actually true but completely at odds with Allied’s multiyear propaganda regarding the meaning of equity raises and shareholder distributions. Allied finally admitted what I had been saying all along: Raising capital and paying dividends were related events
—
all part of a capital replacement cycle.

Walton finished his remarks by announcing, “The Board has asked Joan [Sweeney] to delay her retirement and she has agreed to remain our Chief Operating Officer.” I guess Allied decided that Sweeney didn’t need to retire after all.

Allied’s share price, which had recovered to $7.30 heading into the announcement, resumed its descent, closing under $2.00 on November 20, 2008. This brought on yet another round of paint-the-tape buying as more than a dozen insiders ponied up relatively small dollar amounts for between 1,500 and 15,000 shares. Walton sprang for a full week’s pay
—
almost $100,000
—
to buy 40,000 shares at $2.27 each.

On New Year’s Eve, Allied announced that it had amended its credit agreement with its banks. The minimum net worth covenant was reduced, but Allied still needed to maintain the 1:1 debt-to-equity test. In exchange for the amendment, Allied agreed to the following conditions: It would pay a small fee; pay a higher interest rate on its bank loan; and, by January 31, 2009, pledge a first lien on all its assets to its lenders. This last condition would allow the banks to take control of Allied’s investments if Allied went bankrupt. Allied also agreed to limit shareholder distributions to $0.20 per quarter through December 2010.

Never one to admit defeat, Merrill Lynch analyst Faye Elliot pounded the table once more: “Debt renegotiation terms better than expected. Buy.” The stock doubled to $4.80 by January 6, 2009.

When I learned of the New Year’s Eve amendment reinforcing the 1:1 debt-to-equity ratio limitation, it made no sense to me. Allied knew, or should have known, it would fail to comply with the new agreement almost immediately. With its distribution of an additional $0.65 per share to stockholders in December, combined with the post-Lehman deterioration in the capital markets, it was a near certainty that Allied would violate the ratio when it released its year-end balance sheet.

That truth hit home on January 28, 2009, when Allied announced it would again “re-open” negotiations with its lenders. Allied reneged on its promise to pledge its assets to the lenders by January 31. Allied defaulted under its amended agreement, which ended its ability to make further distributions to shareholders. And with Allied shares falling to $1.91 each, even Merrill Lynch’s analyst finally threw in the towel and downgraded Allied’s stock rating to “underperform.”

In February 2009, Allied announced that it was in formal default and sought a “comprehensive restructuring” of its debt. The shares spun lower, reaching $0.59 each
—
a price lower than the prior quarter’s distribution.

The year-end results announced in March 2009 were anticlimactic. Since Allied no longer needed to play the “taxable earnings” game, there was no need to defer realized losses
—
$142 million of which appeared that quarter. The total loss for the fourth quarter was $579 million. Now, Allied had $1.95 billion of debt and only $1.72 billion of equity ($9.62 per share). During the year, Allied paid out $456 million in shareholder distributions and lost $1 billion.

Allied discontinued its proprietary loan grading system because, according to Roll on the year-end earnings conference call, it was “no longer useful as a tool to measure portfolio quality.” She noted that there were many investments that would experience some loss if Allied sold them just then, but that might perform as expected if held to maturity.

Amazingly, even these write-downs didn’t seem particularly aggressive. Allied acknowledged that the collateralized loan obligation market had come to a complete stop. Yet it still carried its investment in Callidus, a company with a business that solely created and managed CLOs, at a sizable unrealized gain. Allied valued its $376 million of junior interests in CLOs (it had continued to add to the portfolio even as the crisis escalated) at $265 million at a time when comparable assets traded for just pennies on the dollar. Incredibly, bankrupt BLX, where Allied had increased its investment by buying out the banks, was still listed as worth $105 million.

There would be no carryforward income into 2009 and no expected distributions to shareholders. March 2, 2009, was the day the dividend died.

Toward the end of the earnings conference call, in an unwitting slip, Walton offered up to his shell-shocked shareholders: “We will be back in three months hopefully with our next quarterly report.” Then he corrected himself: “That will certainly happen.”

In March 2009, the board of directors granted management options to purchase four million shares at $0.73 each; Walton received 900,000 of them. Steven Pearlstein, writing for
The Washington Post
, drily observed that these would prove “to be a pretty generous gratuity for somebody who drove the company into a ditch in the first place.”

In the year-end audit letter, Allied’s auditors expressed “substantial doubt about the company’s ability to continue as a going concern.”

Greenlight covered most of its Allied Capital short as the shares declined. All told, the total profits slightly exceeded $35 million; the Greenlight employees’ share was 20 percent or about $7 million.

I concluded my speech at the 2009 Ira Sohn conference:

“I have one final area that I’d like to cover. Seven years ago, I first spoke at this conference and, as you all know, discussed our short thesis on Allied Capital. The staff of Greenlight pledged half its share of any profits on that position to the Tomorrows Children’s Fund. In 2005, when the investment took longer than we imagined, we made a down payment on that pledge of $1 million, as we felt that the children should not have to wait.

“When I published
Fooling Some of the People All of the Time
, we promised the other half of any profits to two other worthy organizations: the Project on Government Oversight (POGO), which is an independent nonprofit that investigates and exposes corruption and other misconduct in order to achieve a more effective, accountable, open, and ethical federal government, and the Center for Public Integrity, which produces original investigative journalism about significant public issues to make institutional power more transparent and accountable.

“Now our short has finally paid off. Allied would no doubt argue that it took an enormous collapse in the credit market for that to happen. I would respond that it took a historic credit bubble to prop up Allied all those years.

“At the end of my book, I tried to explain why, even though I was embroiled in a ridiculously unpleasant controversy, I felt optimistic it would end well. With the collapse of Allied’s balance sheet and stock price the matter is now finally resolved. I am honored on behalf of every member of Greenlight, each of whom is a part of this contribution, to donate an additional $6 million, to make a total of $7 million—”

Before I could complete my sentence, I was interrupted by a standing ovation. I melted a little on the inside; it felt like the end of the movie.

CHAPTER 38

Just Put Your Lips Together and Blow

As described in Chapter 23, “Whistle-Blower,”
qui tam
cases under the False Claims Act are brought under seal, which means that until the court unseals a case, you are not supposed to disclose its existence.

Jim Brickman and Greenlight filed the shrimp boat
qui tam
in 2005. This suit involved fraudulent loans made by BLX under the SBA’s General Program and was dismissed on a technicality in December 2007. We appealed, and the appellate court rejected our appeal in February 2009. It was not, however, our only
qui tam
involving BLX and the SBA. Earlier, in December 2004, Brickman and Greenlight filed a separate suit in Atlanta against Allied and BLX for their fraud against the SBA. A discrete suit was necessary for loans made under the SBA’s Preferred Lending Program, and because the 2004 case was still under seal prior to publication, it was not mentioned in the hardcover edition.

When we filed the first suit, the Department of Justice (DOJ) nearly rejected it based on SBA claims of having lost only $3 million on BLX’s entire portfolio. After Brickman provided information suggesting that the losses were in the hundreds of millions, the DOJ agreed to do a limited audit of some of BLX’s loans.

Using the criteria that the loans be in excess of $85,000 and must have defaulted within 20 months, the DOJ audited 15 loans. In February 2006, the DOJ informed us that the audit had found serious problems with 14 of the 15 loans. Laura Bonander, the Atlanta DOJ lawyer assigned to the case, told our lawyer, “Their loan practices are so egregious that I can’t imagine them going to trial.” The DOJ said it would audit an additional 40 files and, based on the percentage of defaults it found from among those 40, they could extrapolate how many loans would be in default across BLX’s entire portfolio. That percentage would then provide the basis to approach BLX with a damage claim by June 2006. We were foolishly optimistic.

We expected the DOJ to do the audit using 40 randomly selected defaulted loans. Yet, without consulting the DOJ or Bonander, the SBA interfered in the loan selection by limiting the audit to loans that had defaulted within 18 months. Given that many fraudulent loans involved instances where not a single payment is made, it might have appeared that the SBA was doing us a favor
—
earlier defaults would produce an above-average number of fraudulent loans.

Unfortunately, that was the problem. By limiting the sample to early defaults, BLX would then be able to argue that the DOJ could not use the audit to extrapolate anything. And it was clear that the SBA preferred it that way. Bonander had told us that the SBA was fighting intervention by the DOJ, and that the DOJ lawyers had never seen an agency push back so aggressively. Without a useful sample, the DOJ would be forced to add up all the bad loans it could find, one by one, and calculate a damage figure accordingly. Rather than trying to help us recover the misused taxpayer money, the SBA was doing quite the opposite, determined to do whatever it could to protect its reputation.

It was obvious to me at the time that the SBA was choosing to protect BLX, and we said as much to the DOJ. Nonetheless, Bonander assured our lawyer that the audit’s focus on early repurchased loans would not mean that damage calculations would be limited to early defaults.

In June 2006, the DOJ reported that the draft audit had been completed and showed that 40 out of 47 (85 percent) of the audited loans had significant problems with their documentation packages. The loans had originated from many different BLX offices and were made to many different types of borrowers. Clearly the problems went far beyond one rogue employee in Michigan as BLX had claimed.

We ran into a delay because the U.S. Attorney in Michigan prosecuting the criminal case against Patrick Harrington needed an additional six months of unimpeded investigation and asked the Atlanta office to stall our
qui tam
case.

In late 2006, Harrington was indicted. When the indictment became public a month later, the Atlanta DOJ learned that the government had evidence that higher-ups at BLX were told numerous times what Harrington was doing, that BLX was now the target in the criminal case, and that the government would be seeking an indictment against it as well.

Again, we were hopeful that we would be able to proceed with the damage claim, only this time Bonander told us the DOJ was worried that the damage payment “could bankrupt BLX.” The DOJ said it needed yet another six months to get its work done. Meanwhile, despite two audits clearly showing that BLX was an atrocious lender nationwide, the SBA continued to approve BLX as a “preferred lender” so that it could originate new loans and service its $1.5 billion portfolio of SBA loans.

There were still more delays, and by the time the DOJ eventually approached BLX, it was in such a depleted state that the government would find it hard to collect a fair restitution. I shouldn’t have been surprised when Bonander contacted our lawyers to float the idea of settling the damages claim for about $20 million. So much for Bonander’s earlier assurances about not letting the SBA’s efforts interfere with the DOJ’s ability to extrapolate a damage claim.

We responded by recommending that the DOJ use the completed audits and other evidence to estimate the damages across BLX’s entire portfolio as initially intended. Our lawyers prepared a detailed memorandum outlining how and why we believed that the audits showed that 64 percent ($226 million) of the $354 million of payments the SBA made to BLX were false claims, which under law would be trebled to $678 million in restitution for taxpayers.

The DOJ proposed a lawyers-only meeting for February 18, 2008, to discuss the case. After some persuasion, the DOJ permitted me (but not Brickman) to attend the meeting as well.

In addition to the DOJ lawyers, Glenn Harris, chief counsel for the SBA inspector general’s office, attended the meeting. He made it quite clear that the SBA was embarrassed by the revelation of the fraud in Detroit and would not welcome additional evidence of its poor oversight coming to light.

According to Harris, our charges “did not pan out.” He claimed that
nothing in our complaint could be substantiated
, and the only reason we were still here was because we were lucky to have the diligent efforts of the DOJ lawyers. Harris was seemingly unaware that our original complaint had detailed the roles of Abdullah Al-Jufairi and Patrick Harrington. Since our complaint, Al-Jufairi had been indicted and fled the country and Harrington had pled guilty to conspiracy to commit fraud against the SBA. And Harris’s ignorance did not end there.

Harris admitted that with its oversight under congressional scrutiny, the SBA simply could not afford to let it be known that it had missed another $250 million of fraud under its watch.
Harris said that the SBA believed that such a revelation would call into question the SBA’s oversight over its multibillion-dollar portfolio.

Harris’s belligerent tone surprised me. If he’d been hoping to bully me, it didn’t work, and his denials only served to reinforce my belief that the SBA was looking to cover up the fraud. Unfortunately, the DOJ lawyers were not as immune; it was clear that they were being worn down by the SBA’s campaign, and despite our efforts to help, they were not inclined to view us as their ally. I left the meeting dismayed and disgusted.

My lawyers followed up with the DOJ lawyer to correct several of Harris’s misstatements, but it would appear not to matter. Bonander left the DOJ a short time later to go into private practice, and we started over with her replacement, Gerald Sachs. Fortunately, after several months of meetings with our lawyers walking him through the evidence, Sachs decided to move the case forward. He asked and received permission from the court to lift the seal for the purpose of letting Allied and BLX know about the case, and to begin negotiating a settlement. As described earlier, four days after the DOJ notified Allied and BLX about the case, BLX filed for bankruptcy.

In early 2009, the DOJ entered settlement negotiations and mediation with Allied and BLX over our False Claims Act suit. We were excluded from participating in the mediation, and the government refused to tell us the result. The DOJ promised to “consult” with us before any final decision was made.

On October 16, 2009, we heard from the DOJ. It had the basic terms of a settlement of the case in hand and wanted our approval. The case would be settled for only $26.4 million, which included the money BLX had already reimbursed the government at the time of the Harrington indictment, plus $8 million more from BLX’s bankrupt estate. The government did not intend to seek damages from any of the individuals responsible for the losses.

As predicted, the government had decided not to use the various audits to estimate additional damages across the entire portfolio. According to the government, because the audits considered only early defaulted loans, they were not statistically reliable for extrapolation. The SBA’s earlier interference in the criteria selection had successfully compromised the audit’s usability.

Instead, the government tallied up the defaulted loans that it had determined were unqualified through the various investigations and audits. Even so, the amount totaled $112 million, which could be trebled under the False Claims Act; $336 million would make a dent in repaying taxpayers for BLX’s fraud. Unaccountably, the government decided that only single damages should be sought in this case, due to BLX’s bankruptcy. When asked, the government lawyers admitted that the DOJ’s usual policy is that bankruptcy does not prevent the DOJ from collecting trebled damages, but it had inexplicably decided to make an exception in this case.

And still, there was the question of their actual offer. There was no way to credibly explain how a $112 million claim that could be trebled could be reduced to the proposed $26.4 million settlement. Apparently, the government assigned a series of large discounts, taking into account the risk of losing or having trouble collecting damages. We later learned the government might have traded away part of the damages in exchange for resolving other disputes between BLX and the SBA. I also suspect the defendants and a recalcitrant SBA wore out the DOJ lawyers, and though the taxpayers would be the largest beneficiary of the settlement dollars, Brickman and Greenlight would collect as well. It was easy to see why they wanted to settle and move on.

Though it had taken the government years to reach this point, the DOJ informed us that we’d have just a week to decide whether we would support such a settlement. Surprised by the sudden urgency, we said we needed more time to evaluate our options. The reason for the government’s rush to settle became apparent soon enough. The following Monday, October 26, 2009, Allied announced that it had agreed to be acquired by Ares Capital for cash and stock valued at $3.47 per Allied Capital share. The government seemed to prioritize Allied’s sale over appropriate restitution for the taxpayers, and must have secretly hoped that we would agree to the settlement before the deal was announced.

The government also decided not to hold Allied responsible for the losses. We had argued that BLX was really an alter ego of Allied, and that the false claims had commenced at Allied prior to the formation of BLX. After Harrington was indicted, Allied had also publicly promised to “stand behind any financial commitments BLX makes to the SBA” to prevent any loss due to fraud, with the intended effect of allowing BLX to continue churning SBA loans. We wanted the government to hold Allied to its word.