Fooling Some of the People All of the Time, A Long Short (and Now Complete) Story, Updated with New Epilogue

1. Unmasking Allied Capital: A David vs. Goliath Battle in Finance

"I may be a 'whistle-blower,' but I'm no Erin Brockovich. I am one of the luckiest people in the world."

David Einhorn's journey. David Einhorn, founder of Greenlight Capital, stumbled upon Allied Capital's questionable practices while preparing for a charity speech in 2002. His initial research revealed inconsistencies in Allied's accounting methods, particularly in how they valued their investments and recognized income.

Allied's business model. Allied Capital was a Business Development Company (BDC) that invested in small and medium-sized businesses. They claimed to generate steady income and capital gains from these investments, distributing profits to shareholders as dividends. However, Einhorn discovered that Allied was:

• Inflating the value of their investments
• Recognizing non-cash income as if it were real cash
• Using aggressive accounting practices to maintain the appearance of profitability
• Potentially defrauding government programs through its subsidiary, Business Loan Express (BLX)

2. The Power of Short-Selling: Exposing Corporate Misconduct

"We are not critical of this company because we are short; we are short because we are critical of this company."

Short-selling as a tool. Einhorn's decision to short Allied Capital's stock was based on his belief that the company's true financial condition was far worse than reported. Short-selling involves borrowing shares and selling them, hoping to buy them back at a lower price in the future.

Benefits of short-selling:

• Provides incentives for investors to uncover fraud and misconduct
• Adds liquidity to markets
• Helps correct overvalued securities

Challenges faced by short-sellers:

• Aggressive counterattacks from targeted companies
• Negative public perception and accusations of market manipulation
• Regulatory scrutiny and potential legal challenges

Einhorn's experience with Allied Capital demonstrates how short-sellers can play a crucial role in exposing corporate wrongdoing, despite facing significant obstacles and personal attacks.

3. Business Loan Express (BLX): A Fraud Factory Within Allied Capital

"BLX was just one piece of Allied Capital, and these loans represented only a small piece of BLX. I didn't see how a handful of bad SBA loans could make a difference in view of what we perceived to be the much larger and broader problems at Allied itself."

Uncovering the fraud. As Einhorn dug deeper into Allied Capital's operations, he discovered that its subsidiary, Business Loan Express (BLX), was engaged in widespread fraud against government lending programs, particularly the Small Business Administration (SBA) and the U.S. Department of Agriculture (USDA).

BLX's fraudulent practices:

• Falsifying loan applications and documentation
• Inflating property appraisals
• Ignoring borrower creditworthiness and ability to repay
• Making loans to ineligible borrowers
• Concealing defaults and delaying charge-offs

Impact of the fraud:

• Millions of dollars in losses to taxpayers through government guarantees
• Inflated earnings for Allied Capital
• Misrepresentation of BLX's value on Allied's books

The BLX scandal demonstrated how a seemingly small part of a larger company could harbor significant fraud, ultimately threatening the entire organization's integrity and financial stability.

4. The Perils of Payment-in-Kind (PIK) Income and Fair Value Accounting

"Allied generates low quality earnings through non-arm's-length dealings with unconsolidated subsidiaries such as Business Loan Express, even as Business Loan Express's portfolio has deteriorated."

PIK income explained. Payment-in-Kind (PIK) income is a form of non-cash income where interest payments are made in additional securities rather than cash. Allied Capital heavily relied on PIK income to boost its reported earnings.

Problems with PIK income:

• Inflates reported income without generating actual cash
• Can mask underlying problems with investments
• Creates a mismatch between reported earnings and cash available for distributions

Fair value accounting issues. Allied Capital used aggressive interpretations of fair value accounting to maintain inflated valuations of its investments.

Allied's questionable practices:

• Valuing investments at cost even when performance deteriorated
• Using "enterprise value" to justify high valuations of debt investments
• Delaying write-downs of troubled investments
• Matching write-ups with write-downs to smooth reported performance

These accounting practices allowed Allied to present a rosier picture of its financial health than reality warranted, misleading investors and regulators alike.

5. Regulatory Failure: The SEC and SBA's Inadequate Oversight

"Where are the regulators? Where is the Securities and Exchange Commission (SEC)? Who works at these government agencies that are so uncaring about misuse of taxpayer money?"

SEC's slow response. Despite Einhorn's detailed complaints and evidence of accounting irregularities, the SEC was slow to act against Allied Capital. Initially, they seemed more interested in investigating Einhorn for potential market manipulation than in examining Allied's practices.

SBA's lax oversight. The Small Business Administration (SBA) failed to properly monitor BLX's lending practices, allowing fraud to continue for years.

Factors contributing to regulatory failure:

• Limited resources and understaffing at regulatory agencies
• Political pressure to maintain high loan volumes in government programs
• Complexity of financial instruments and accounting practices
• Reluctance to challenge large, established companies

The case highlights the need for stronger, more proactive regulatory oversight to protect investors and taxpayers from corporate misconduct.

6. The Dark Side of Corporate Defense: Personal Attacks and Pretexting

"Allied Capital has launched a very unusual and very aggressive shoot-the-messenger campaign."

Allied's counterattack. Instead of addressing Einhorn's concerns, Allied Capital launched a aggressive campaign to discredit him and other critics.

Tactics employed by Allied:

• Personal attacks on Einhorn's character and motives
• Accusations of market manipulation and conspiracy
• Misleading public statements and selective disclosure
• Hiring high-profile PR firms and lobbyists to spin the narrative

Pretexting scandal. Allied eventually admitted that its agents had obtained Einhorn's phone records through pretexting, a form of identity theft.

This aggressive defense strategy ultimately backfired, damaging Allied's credibility and drawing more attention to the underlying issues Einhorn had raised.

7. Persistence Pays Off: The Gradual Unraveling of Allied's Deceptions

"Fraud can persist for a long time, and investors, analysts, and the SEC miss things. But, sooner or later, the truth wins."

Years of investigation. Einhorn's battle with Allied Capital lasted for over five years, requiring persistent research, analysis, and advocacy to bring the truth to light.

Key milestones in exposing Allied:

• 2002: Initial speech raising concerns about Allied's accounting
• 2003-2005: Continued research and attempts to engage regulators
• 2006: Indictments of BLX employees for loan fraud
• 2007: Allied admits to pretexting and writes down BLX investment

Lessons learned:

• Corporate fraud can persist for years, even in plain sight
• Persistence and thorough research are crucial for exposing misconduct
• Truth eventually prevails, but the process can be slow and challenging

Einhorn's experience demonstrates the importance of tenacity in uncovering and exposing corporate wrongdoing, even in the face of powerful opposition.

8. The Role of Media and Wall Street in Corporate Accountability

"It is hard to believe how the legal system, government regulators, and the financial press can all come together and fail so miserably."

Media shortcomings. Throughout the Allied Capital saga, mainstream financial media often failed to investigate thoroughly or report critically on the issues Einhorn raised.

Problems with media coverage:

• Tendency to present "he said, she said" narratives without fact-checking
• Reluctance to pursue complex financial stories
• Influence of corporate PR and advertising relationships

Wall Street's conflicts of interest. Many Wall Street analysts continued to recommend Allied Capital despite mounting evidence of problems.

Factors influencing analyst behavior:

• Investment banking relationships with covered companies
• Pressure to maintain access to management
• Tendency to accept company explanations at face value

The case highlights the need for more independent, investigative financial journalism and greater skepticism from Wall Street analysts to hold companies accountable and protect investors.

Last updated: January 24, 2025