Chapter 1
When Wall Street Meets Washington: The Allied Capital Saga
Imagine uncovering a massive financial fraud, presenting irrefutable evidence to regulators, and watching as nothing happens for years while the perpetrators continue raising billions from unsuspecting investors. This is precisely what hedge fund manager David Einhorn experienced in his decade-long battle with Allied Capital. The story has become legendary in financial circles, with Warren Buffett calling it "a must-read for anyone concerned about business ethics." Even Bill Gates included it on his recommended reading list, noting it reveals "how our financial and regulatory systems can fail spectacularly." What makes this tale particularly compelling isn't just the financial detective work, but how it exposes the intersection of Wall Street, Washington politics, and regulatory capture. As we navigate today's complex financial markets still plagued by similar issues, Einhorn's experience serves as both warning and playbook for those seeking truth in a system often designed to obscure it.
Chapter 2
The Making of a Financial Detective
I trace my business roots to my father and grandfather, who built and ran Adelphi Paints, a successful family business, until the 1970s energy crisis forced its sale. Growing up in suburban Milwaukee profoundly shaped my worldview - I became a passionate Milwaukee Brewers fan and found my competitive spirit in high school debate, where I learned to analyze arguments from multiple angles and think several steps ahead. These critical thinking skills would later prove invaluable on Wall Street. My parents' contrasting business philosophies created a balanced foundation: Dad exemplified patient capital allocation and persistence through adversity, while Mom's natural skepticism and tough-minded approach to negotiations taught me to question everything.
After graduating, I endured two grueling years at investment bank Donaldson, Lufkin & Jenrette (DLJ), working punishing 100-hour weeks analyzing deals and preparing pitch books. The experience was brutal but educational. A fortuitous connection through a headhunter led me to Siegler, Collery & Company, where I found my true mentor in Peter Collery. He revolutionized my approach to investment analysis, teaching me to look beyond reported earnings to understand a company's fundamental economics - examining cash flows, return on capital, and sustainable competitive advantages. This methodology would become the cornerstone of my investment philosophy at Greenlight Capital.
When Jeff Keswin and I founded Greenlight in 1996, we deliberately inverted traditional value investing methodology. Instead of screening for statistically cheap stocks and then investigating why they were undervalued, we developed detailed theories about potentially misvalued securities first, then conducted thorough analysis to confirm our hypotheses. While many hedge funds chased quarterly returns to please investors, we maintained a longer-term perspective, often holding positions for 18 months or longer. We also distinguished ourselves through radical transparency, regularly communicating both successes and failures to investors - a rarity in an industry where many managers tried to hide their mistakes.
Our early successes came from several distinct strategies. We profited significantly from insurance company demutualizations, where we could buy shares below intrinsic value during the conversion process. Corporate spin-offs provided another fertile hunting ground, as newly independent companies were often misunderstood and mispriced by the market. Our short positions proved particularly profitable, though they required strong conviction through periods of adverse price movements. Boston Chicken exemplified our approach - we identified how their accounting practices artificially inflated revenues by recognizing franchise fees up-front while concealing the underlying unprofitability of their franchisees through complex financing arrangements. Similarly, with Samsonite, we recognized that their aggressive price increases and rapid distribution expansion would inevitably lead to inventory problems when retailers couldn't move the product at higher price points.
By the end of 1997, our disciplined approach had generated a 57.9% return, growing our assets under management to $75 million. Rather than yield to the temptation to accept more capital and potentially compromise our strategy, we made the unusual decision to close to new investments until we could properly deploy additional funds. This discipline of matching our capital base to our opportunity set would prove crucial in navigating the volatile markets ahead, including the dot-com bubble and its aftermath.
Chapter 3
Navigating the Dot-Com Bubble and Its Aftermath
From the 1998 low, the Internet bubble launched to full glory, with technology stocks reaching unprecedented valuations. Companies with no earnings and questionable business models commanded multi-billion dollar market capitalizations. Throughout this period, we maintained strict discipline, avoiding shorting stocks merely for silly valuations - a strategy that saved us from the fate of many hedge funds that imploded trying to fight the mania. Instead, we focused on companies with misunderstood fundamentals, deteriorating prospects, and preferably, fraudulent practices that offered concrete catalysts for price decline.
We found several good frauds in 1999, including Seitel, a seismic data company that inflated earnings through aggressive accounting practices. Their capitalization method guaranteed 60% margins on licensing revenue, but detailed analysis revealed they weren't generating enough actual cash flow to justify their investments in seismic data. The company used complex accounting maneuvers to mask deteriorating economics, booking future revenue estimates as current earnings. Despite our correct analysis of the fundamental problems, the short position became a three-year battle before Seitel finally went bankrupt in 2002. The vindication was complete when the CEO was sentenced to five years in prison for securities fraud and insider trading.
Early 2000 proved particularly difficult as capital fled traditional industries into anything dot-com related. February became our second-worst month ever with a 6% loss, followed by more losses in March until the Nasdaq peaked on March 10. We learned painful but valuable lessons from shorting Chemdex, a B2B chemical network that promised to revolutionize chemical trading but had no path to profitability. Despite shorting at $26, we watched in disbelief as it soared to $164 where we covered our position, only to see it continue climbing to $243 before ultimately collapsing to $2 after the bubble burst. This experience reinforced the dangers of fighting powerful market momentum, even when fundamental analysis proves correct.
Our Conseco capital structure arbitrage positioned us to profit from the company's fundamental problems in both equity and debt markets. When new CEO Gary Wendt arrived with a shocking $45 million signing bonus and grandiose promises of implementing fancy GE management concepts like Six Sigma, we remained deeply skeptical. At a memorable meeting in Conseco's office, Wendt sat in a specially brought throne-like chair and couldn't answer basic numerical questions about the business operations or financial structure. His focus on superficial changes rather than addressing core business problems confirmed our thesis. Eventually the market lost faith, the shares imploded, Wendt resigned in disgrace, and Conseco filed for what was then one of the largest bankruptcies in U.S. history.
By year-end 2001, our fund returned an impressive 31.6% with assets reaching $825 million, while the broader markets continued falling amid the dot-com collapse. These experiences through the bubble period reinforced our core conviction that with patience, persistence and disciplined fundamental analysis, the truth eventually wins in financial markets - a philosophy that would be severely tested in our next major battle with the housing bubble and financial crisis.
Chapter 4
The Allied Capital Investigation Begins
In early 2002, after starting the year up 12.9%, we began researching Allied Capital following a meeting with managers from a financial institutions hedge fund. Allied Capital, founded in 1958 by former FBI employee George C. Williams, was the second-largest publicly traded Business Development Company (BDC) in America.
We assigned analyst James Lin to build a database tracking Allied's investments over several quarters, revealing patterns similar to what we'd found in our successful Sirrom Capital short. Allied consistently marked down equity portions of troubled investments while maintaining related loans at cost - a pattern that predicted future write-downs. The company often invested additional money into troubled situations without taking proportionate markdowns, apparently to delay recognizing losses.
When I questioned Allied's investor relations team about their valuation methodology, Joan Sparrow described what she called Allied's "Mosaic Theory" - a mix of quantitative and qualitative factors. She admitted Allied only wrote down investments when they believed there was "permanent impairment," rather than adjusting values based on increased risk. This contradicted BDC requirements to use "fair-value" accounting.
During a follow-up call with CFO Penni Roll, she claimed Allied's credit loss rate was under 1% annually - an absurdly low figure for high-risk mezzanine loans. Roll falsely claimed certain troubled bonds weren't actively trading to justify carrying them above market value. Based on this research, Greenlight put 7.5% of the fund into shorting Allied at $26.25 per share, which I then presented at the Tomorrows Children's Fund charity conference.
The market reaction was immediate and dramatic. Allied hastily organized a conference call where management attempted to spin the substantive issues. CEO Bill Walton suggested using principal repayments to fund distributions - essentially burning furniture to heat one's home. He falsely claimed Allied recapitalizes businesses when buying senior debt at discounts, but our research showed this simply didn't happen at three portfolio companies where Allied delayed write-downs.
Chapter 5
The Corporate Spin Machine Activates
Allied's response to my criticisms exemplified the classic corporate defense playbook: attack the messenger while avoiding the substance of the message. Their COO Joan Sweeney, a former SEC enforcement attorney, cleverly invented the term "fire-sale accounting" to discredit our analysis, effectively creating a straw man by redefining what I had actually said. This rhetorical sleight of hand was particularly evident when prominent investor Dan Loeb questioned the glaring discrepancy in Velocita debt valuation - carried at 40 cents when market prices showed it trading at just 2 cents. Management's response was a masterclass in deflection and obfuscation.
The investment banking establishment quickly rallied to Allied's defense. Merrill Lynch, who had earned tens of millions in underwriting fees from Allied's numerous securities offerings, published a supposedly independent report defending the company. Their analysis claimed Allied provided "meritorious defenses" to my criticisms while making the fundamentally incorrect assertion that Allied was required to mark investments to "long-term value, not mark to market" - a clear misrepresentation of accounting standards. Wachovia followed suit, resuming coverage with a conspicuously bullish "Strong Buy" rating, dismissively claiming my analysis "didn't raise anything new."
The facade began showing cracks during direct confrontations. When I challenged analyst Joel Houck on his claims, he made several revealing admissions in private. He acknowledged that some of Allied's valuations were "almost indefensible" but tried to justify his position by suggesting there was offsetting upside elsewhere in the portfolio. Most tellingly, when pressed about potential fraud, Houck's response - "nobody knows" - betrayed the uncertainty beneath the confident public stance, though he attempted to reassure by citing Sweeney's SEC Enforcement background.
Allied's accounting methodology increasingly appeared to defy both basic investment principles and regulatory requirements. During a particularly revealing exchange, when hedge fund manager Larry Robbins pressed management about loan classifications, CFO Roll admitted their unorthodox approach: most Grade 4 loans (where contractual interest was impaired but principal supposedly wasn't) were carried at original cost. Only Grade 5 loans with explicit principal impairment would be written down - an approach so absurd it warranted what I termed the "you-have-got-to-be-kidding-me" method of accounting.
The company's defiance reached new heights when they challenged SEC accounting rules directly through a white paper authored by Sweeney and Roll. They argued that SEC-mandated valuation rules requiring a "current-sale test" shouldn't apply to Business Development Companies (BDCs), instead advocating for more lenient SBA accounting standards where assets are written down only when "permanently impaired." This creative interpretation was definitively shot down when we contacted Doug Scheidt at the SEC's Division of Investment Management. His response was unequivocal: "The Act and the law doesn't differentiate between [fund types]. It says for all investment companies, they are required to use market quotes and do fair-value." This authoritative rejection exposed Allied's attempts to create their own accounting rules as both desperate and legally baseless.
Chapter 6
Uncovering Business Loan Express Fraud
As our investigation deepened, we discovered increasingly troubling practices at Business Loan Express (BLX), which represented Allied's largest and most significant investment. Lead investigator Jim Carruthers methodically uncovered an elaborate fraud scheme where Allied executives Patrick Harrington and William Leahy systematically attempted to cover up mounting losses by granting additional loans through a complex web of newly formed entities. In one particularly egregious case, they pressured a struggling borrower to put a substantial loan in her daughter's name. When that application was rejected, they brazenly had her forge her brother's signature right in Allied's office - a clear violation of multiple banking regulations.
The scope of the fraud became clearer when a former BLX senior vice president came forward with detailed testimony. He painted a picture of systematic portfolio mismanagement and revealed that BLX deliberately installed underwriters who lacked basic lending experience - some had never evaluated a single loan application before being hired. The company routinely failed to verify borrowers' equity injections, a fundamental step in responsible lending. Most alarming was the discovery that BLX's Richmond office was led by Matthew McGee, a convicted felon who had been explicitly banned from working with investment companies. Despite this prohibition, McGee maintained a position on BLX's credit committee, directly influencing lending decisions.
Independent analysis from BancLab's comprehensive report revealed the stark consequences: BLX loans defaulted at three times the rate of average SBA loans, a staggering difference that should have raised immediate red flags. BLX's business model relied heavily on gain-on-sale accounting, allowing them to recognize income immediately while transferring 75% of the risk to taxpayers through SBA guarantees. As default rates continued to climb, traditional banks grew increasingly wary of paying premiums for BLX loans, forcing the company to dramatically restructure its sales approach and seek alternative buyers.
When challenged, Allied mounted an aggressive defense of its BLX valuation practices during a contentious conference call. Management insisted that debt securities should be valued at par whenever enterprise value exceeded outstanding debt - an argument that financial experts quickly identified as fundamentally flawed since it completely ignored the increased default risk associated with declining enterprise values. CEO Sweeney made matters worse by falsely claiming that consolidation was "absolutely black and white" and would boost earnings. This directly contradicted financial reality: consolidation would have eliminated the premium valuations Allied assigned to BLX, significantly reducing both reported earnings and book value.
By June 2002, after months of intense investigation and mounting evidence, I found myself growing weary of the Allied fight. The situation reached a critical point when WorldCom's bankruptcy filing caused Greenlight's debt position to plummet precipitously, contributing to the fund's second-worst decline in its history - a devastating loss exceeding 7% between June and July. Faced with mounting pressures and believing that regulatory authorities would eventually take action, I made the strategic decision to step back from the Allied controversy, concluding that the SEC's inevitable investigation would bring the truth to light and the story would ultimately resolve itself through official channels.
Chapter 7
Regulatory Failure and Political Protection
On July 23, 2002, Allied announced second-quarter earnings that fell well short of expectations. Non-accrual loans more than doubled from $40 million to $89 million in a single quarter. Allied suddenly wrote down numerous investments, including completely writing off the "money good" Startec investment and taking $67 million in other write-downs.
To offset these negatives, Allied found numerous write-ups. They suddenly discovered their CMBS portfolio was worth $20.7 million more using a valuation method they claimed to have always used but clearly hadn't. Most problematically, Allied increased Business Loan Express's value by $19.9 million through a convoluted valuation that defied logic.
Despite these dramatic accounting changes, Allied's management repeatedly emphasized their "consistent" accounting methodology. Allied's previously steady, predictable earnings became volatile and unpredictable. Net investment income per share, which had grown steadily for years, reversed course and never again approached its first-quarter 2002 peak.
In late 2002, I hired Kroll to investigate BLX and American Physicians Services (APS), another suspicious Allied investment. Around this time, New York Attorney General Eliot Spitzer announced an investigation into Gotham Partners, examining whether they manipulated stock prices through published research. Shortly after, the Wall Street Journal reported that the SEC and Spitzer were investigating Greenlight and others for allegedly conspiring to manipulate stocks through research and conference call questions.
The SEC sent us a letter requesting all our Allied research, trading records, and organizational information. The Journal article damaged not just Greenlight's reputation but also led to my wife Cheryl being fired from her decade-long position at Barron's over "appearance" concerns about being married to someone under investigation.
Allied's political connections became increasingly apparent. Based in Washington on Pennsylvania Avenue, Allied was founded by former FBI agent George Williams Jr., employed former SEC official Joan Sweeney, and had board members with powerful connections. Most troublingly, Mark Braswell, the aggressive SEC lawyer who had questioned me and obtained our confidential materials, left the SEC to become Allied's lobbyist just four months later - an apparent ethics violation that the SEC's Office of Inspector General failed to investigate despite our formal complaint.
Chapter 8
The Slow Path to Vindication
Kroll's BLX investigation produced a twenty-three-page report revealing "a series of loans originated by BLX that appear to be frauds against the SBA." BLX systematically violated SBA underwriting requirements by making loans that could never be repaid, issuing new SBA loans to pay off existing ones, not verifying borrower equity contributions, accepting inflated real estate appraisals, and prioritizing loan volume over quality.
Armed with Kroll's damning report, Greenlight's team met with the SBA, SEC, and New York Attorney General Spitzer in August 2003. The meetings proved deeply disappointing. At the SBA, officials appeared drowsy and disinterested as we presented evidence of systematic fraud. They asked basic questions like whether we had SBA loan numbers, and seemed unsurprised by the violations, saying "We see this all the time; what is special about these?"
In October 2003, I sent the SEC a thirty-nine-page follow-up letter with statistical analyses proving Allied had changed its valuation methodology despite public denials. Our analysis showed with 99.9% confidence that Allied artificially "managed" its write-ups and write-downs, creating an unnatural positive correlation between gains and losses that helped fabricate smooth performance.
On February 6, 2007, Allied finally admitted they had obtained my home phone records and Greenlight's records. The convoluted release stated Allied had received a subpoena from the U.S. Attorney's Office requesting records regarding their use of private investigators. While gathering documents, Allied "became aware that an agent of the Company obtained what were represented to be telephone records of David Einhorn and which purport to be records of calls from Greenlight Capital during a period of time in 2005."
On January 10, 2007, the Associated Press reported that nineteen Detroit-area residents faced federal charges for allegedly defrauding the Small Business Administration out of nearly $77 million. Patrick J. Harrington, a former BLX vice president, was accused of falsifying loan applicants' qualifications, lying about equity contributions, witness tampering, and lying to a grand jury. The fraud had cost taxpayers over $28 million.
Chapter 9
Lessons from a Financial Detective Story
If fraud occurs but shareholders don't lose money and regulators ignore it, was it really fraud? Authorities excel at cleaning up after financial disasters but struggle with fraud caught in progress. SEC Chairman Christopher Cox's philosophy that shareholders shouldn't be punished for corporate fraud creates a dangerous moral hazard - a "free fraud zone" where investors have no incentive to demand honesty.
The truth is that fraud risk is inherent in investing. The best deterrent is enforcing penalties for dishonesty, which would make investors more careful with capital allocation. Some Allied shareholders may have cynically held the stock believing regulatory consequences wouldn't hurt their investment - a theory proven correct for years.
Allied Capital represents Wall Street at its worst - a retail stock marketed to retirees seeking dividends, while owning exactly the type of risky investments the SEC normally restricts to "sophisticated investors." The SEC proved unwilling to properly regulate this investment company under its direct oversight - lawlessness inside regulation, a "Mobius strip of hypocrisy."
By June 2008, Allied's stock fell below its stated NAV for the first time. In the second quarter, Allied finally wrote off virtually all of its $327 million BLX investment, five years after I'd warned the SEC it was worthless. BLX filed for bankruptcy in September 2008, requiring Allied to pay $320 million to meet guarantee obligations. The bankruptcy filings revealed BLX generated no cash flow whatsoever, contrary to Walton's "cash cow" claims.
By year-end 2008, Allied had amended its credit agreements, limiting distributions to $0.20 per quarter. But by January 2009, Allied defaulted on these agreements, ending all shareholder distributions. The stock collapsed to $0.59 per share. The year-end results showed Allied had $1.95 billion in debt against only $1.72 billion in equity, having paid out $456 million in distributions while losing $1 billion. On March 2, 2009, "the dividend died."
Despite being proven right, I'm more troubled now because so little has fundamentally changed. Despite clear evidence of wrongdoing, Allied's officers, directors, and auditors faced no significant consequences. Bill Walton and Joan Sweeney walked away with fortunes intact, and Robert Tannenhauser even started a new SBA lending exchange. Our regulatory systems still reward bad behavior rather than discourage it.
The Lehman Brothers story that followed mirrored Allied's in many ways - beginning with a speech, ending in bankruptcy, and featuring personal attacks, media vilification, and an SEC investigation in between. The same gatekeepers failed: regulators, auditors, directors, media, analysts, and rating agencies. The difference was timing: the deteriorating economy after my 2008 Lehman speech left the firm little room to maneuver, while the economic recovery after my 2002 Allied speech gave Allied years to expand its business and bilk taxpayers and investors of hundreds of millions more.
This story serves as both warning and guide for investors, regulators, and citizens concerned about financial integrity. The patterns of deception, regulatory capture, and institutional failure continue to repeat themselves in our financial markets. Only by understanding these dynamics can we hope to create systems that truly protect investors and the public interest.
