Fooling some of the people all of the time: Allied Capital--a long, short story

Summary of Fooling some of the people all of the time

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   When the Watchdogs Sleep: A Decade-Long Battle Against Financial Fraud

   

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   What happens when you discover a massive fraud, present irrefutable evidence to regulators, and watch as absolutely nothing happens? For years, the perpetrators keep raising billions while you become the villain in their carefully crafted narrative. This isn't a hypothetical-it's the story of hedge fund manager David Einhorn's decade-long confrontation with Allied Capital, a tale that Warren Buffett called "a must-read for anyone concerned about business ethics." The story reveals something far more unsettling than corporate malfeasance: it exposes how our financial system's supposed guardians-regulators, auditors, analysts, and media-can become complicit protectors of the very fraud they're meant to prevent. As we navigate markets still plagued by similar dynamics, this saga offers both cautionary tale and survival guide for anyone seeking truth in systems designed to obscure it.

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   The Education of a Short Seller

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   Growing up in suburban Milwaukee, Einhorn absorbed his father's patient capital allocation and his mother's natural skepticism. When the 1970s energy crisis forced the sale of his family's Adelphi Paints business, he learned about both persistence and vulnerability. High school debate sharpened his ability to analyze arguments from multiple angles. After two brutal years at DLJ, Einhorn found his mentor in Peter Collery, who taught him to examine cash flows, return on capital, and competitive advantages over reported earnings. Founding Greenlight Capital in 1996, he inverted traditional value investing - developing detailed theories about misvalued securities first, then analyzing thoroughly to confirm his hypotheses. This disciplined approach generated 57.9% returns in 1997. Rather than accepting more capital and potentially compromising strategy, Greenlight closed to new investments, matching capital to opportunity rather than chasing growth.

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   Surviving the Bubble by Avoiding the Obvious

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   The dot-com mania tested Einhorn's principles as worthless companies commanded billion-dollar valuations. Greenlight avoided the fatal mistake of shorting stocks merely for high valuations-a strategy that destroyed many hedge funds. Instead, they targeted companies with misunderstood fundamentals, deteriorating prospects, and preferably fraudulent practices offering concrete catalysts. Seitel, a seismic data company, inflated earnings by capitalizing costs while masking deteriorating cash flows. Despite correct analysis, the short became a three-year battle before Seitel's 2002 bankruptcy and the CEO's five-year prison sentence. Chemdex taught a harsher lesson: they shorted at $26, covered at $164, then watched it soar to $243 before collapsing to $2-reinforcing the dangers of fighting powerful momentum. Their Conseco position illustrated evolved methodology. New CEO Gary Wendt arrived with a $45 million signing bonus. At a memorable meeting, Wendt sat in a specially brought throne-like chair and couldn't answer basic questions about operations. His focus on superficial changes rather than core problems confirmed their thesis. Wendt eventually resigned, and Conseco filed for one of America's largest bankruptcies. By year-end 2001, Greenlight returned 31.6% with assets reaching $825 million.

4. Chapter 4

   Discovering Allied Capital's House of Cards

   In early 2002, Einhorn began researching Allied Capital, America's second-largest publicly traded Business Development Company. Analyst James Lin uncovered a troubling pattern: Allied consistently marked down equity portions of troubled investments while maintaining related loans at cost-predicting future write-downs. They often invested additional money into failing companies without proportionate markdowns, apparently delaying loss recognition. When Einhorn questioned Allied's investor relations about valuation methodology, Joan Sparrow described their "Mosaic Theory"-a vague mix of quantitative and qualitative factors. She admitted Allied only wrote down investments when they believed there was "permanent impairment," rather than adjusting for increased risk. This contradicted BDC requirements for "fair-value" accounting. CFO Penni Roll claimed Allied's credit loss rate was under 1% annually-an absurdly low figure for high-risk mezzanine loans-and falsely claimed certain troubled bonds weren't actively trading to justify carrying them above market value. The most alarming discovery involved Business Loan Express (BLX), Allied's largest investment. Investigator Jim Carruthers uncovered systematic fraud where Allied executives pressured struggling borrowers to put loans in relatives' names, even having one borrower forge her brother's signature in Allied's office. Most shocking: BLX's Richmond office was led by Matthew McGee, a convicted felon explicitly banned from working with investment companies, yet he sat on BLX's credit committee.

   Chapter 5

   The Corporate Defense Playbook in Action

   Allied's response exemplified classic crisis management: attack the messenger while avoiding substance. COO Joan Sweeney invented "fire-sale accounting" to discredit Einhorn's analysis-creating a straw man by redefining what he'd actually said. When Dan Loeb questioned why Velocita debt was carried at 40 cents versus market prices of 2 cents, management deflected with pure obfuscation. The investment banking establishment rallied to Allied's defense. Merrill Lynch, having earned millions in underwriting fees, published a supposedly independent report claiming Allied marked investments to "long-term value, not mark to market"-a clear misrepresentation of accounting standards. Wachovia followed with a "Strong Buy" rating, dismissively claiming Einhorn's analysis "didn't raise anything new." The facade cracked during direct confrontations. Analyst Joel Houck privately admitted some Allied valuations were "almost indefensible" and when pressed about potential fraud, responded "nobody knows"-betraying uncertainty beneath his confident public stance. Allied's defiance peaked when they challenged SEC rules, arguing mandatory valuation rules shouldn't apply to Business Development Companies. Doug Scheidt at the SEC's Division of Investment Management responded unequivocally: "The Act and the law doesn't differentiate between fund types."

   Chapter 6

   When Regulators Become Accomplices

   On July 23, 2002, Allied announced catastrophic second-quarter earnings. Non-accrual loans more than doubled from $40 million to $89 million in one quarter. Allied wrote down numerous investments while finding offsetting write-ups, including a suspicious $20.7 million increase in their CMBS portfolio using an inconsistent valuation method. Shortly after, the SEC and Attorney General Eliot Spitzer launched investigations-not into Allied, but into whether Greenlight manipulated stocks. The fallout turned personal: Einhorn's wife Cheryl was fired from her decade-long position at Barron's over "appearance" concerns. Mark Braswell, the aggressive SEC lawyer who had questioned Einhorn, left the SEC just four months later to become Allied's lobbyist-an apparent ethics violation the SEC's Office of Inspector General refused to investigate. Armed with Kroll's damning report revealing "a series of loans originated by BLX that appear to be frauds against the SBA," Greenlight met with the SBA, SEC, and Attorney General Spitzer in August 2003. SBA officials appeared drowsy and disinterested, asking, "We see this all the time; what is special about these?" Systematic fraud had become so routine that regulators considered it unremarkable.

   Chapter 7

   The Long, Bitter Vindication

   Years passed. On January 10, 2007, nineteen Detroit-area residents faced federal charges for defrauding the SBA of nearly $77 million. Patrick Harrington, a former BLX vice president, was accused of falsifying loan qualifications and witness tampering. The fraud cost taxpayers over $28 million. On February 6, 2007, Allied finally admitted-only after receiving a U.S. Attorney subpoena-they had obtained Einhorn's home phone records and Greenlight's records. By June 2008, Allied's stock fell below its net asset value for the first time. Allied finally wrote off virtually all of its $327 million BLX investment-five years after Einhorn warned the SEC it was worthless. BLX filed for bankruptcy in September 2008, requiring Allied to pay $320 million on guarantee obligations. By year-end 2008, Allied had $1.95 billion in debt against only $1.72 billion in equity. On March 2, 2009, "the dividend died." Despite being proven right on every point, Einhorn found himself more troubled than vindicated. Allied's officers, directors, and auditors faced no consequences. Bill Walton and Joan Sweeney walked away with fortunes intact. The SEC's philosophy created a dangerous "free fraud zone" where exposing fraud became more dangerous than committing it.

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