Fooling Some of the People All of the Time, a Long Short (And Now Complete) Story, Updated With New David Einhorn (best classic books of all time .TXT) 📖

its opinion. I called Greenlight’s auditor to check whether this was true. The partner on the audit researched the subject and concluded that the relevant sections were identical between 2000 and 2001. We also checked the bond prices on some of the other troubled Allied investments like Velocita and Startec and determined that Allied valued its holdings well above the quoted market prices.

Based on our independent research and what I learned on these lengthy calls with management, Greenlight put 7.5 percent of the fund into the Allied short sale at an average price of $26.25 a share.

Having been invited to speak at the Tomorrows Children’s Fund charity conference on May 15, 2002, and asked to present my most compelling investment idea, now I knew I had one. Nervously, I stepped up and made the speech. (If you have not done so already, you can see it for yourself at www.foolingsomepeople.com. It makes the story much easier to follow.) And yet, at that moment, I had no idea the story was really just beginning.

PART TWO

Spinning So Fast Leaves Most People Dizzy

CHAPTER 6

Allied Talks Back

After my speech, the reaction was immediate. When I showed up for work the next morning, a junior analyst from a mutual fund company that held a large long position in Allied was waiting outside our locked door. He heard that I said something important about Allied and came over to get a first-hand account. I brought him into a conference room and summarized what I had said. When I started discussing BLX, he said he hadn’t even heard of it.

When I finally got to my desk, my e-mail inbox was full of complimentary messages from people who had attended the speech, and I took a number of kind phone calls. When the stock market opened a few minutes later, there were so many sell orders for Allied that it took the specialist about thirty minutes to find a balanced price to open the stock. When it did open on May 16, 2002, the price was $21, almost a 20 percent drop. I was surprised the stock fell so far so quickly. Even so, I did not for even a minute consider covering any of our short.

I heard that Merrill Lynch told people that someone made a speech characterizing Allied Capital as another Enron. They didn’t know exactly what had been said in the speech, but they were confident that whatever was said was wrong. Obviously, one way to find out what I had said would be to contact us or ask for a copy of my speech. Though there were about a dozen analysts at brokerage firms covering Allied, not one reached out to us on that day to find out for themselves. In fact, to the date this book went to press, no brokerage firm analyst has ever done so. Whatever contact I have had with them has been at my initiation.

Allied announced it would hold a conference call later that morning to respond. When we dialed into the conference call number, we were unable to connect because the call was so well attended that Allied had not reserved enough phone lines. We called another fund that we knew was participating and listened through its connection partway through the call. Though no one from Allied contacted us to find out about my speech, nonetheless, Bill Walton, the chairman and CEO, began the call, saying, “We’ve been gathering information on this speech throughout the morning, and I think some people have actually gotten to the person who gave the speech, and so we’ve got some items here that we think we ought to discuss, but because of the fact that we’re not really fully apprised of what we know were said last night, all of which we feel are misguided and talk you through those and then we plan to open it up for Q&A.”

Walton began what would become a pattern of making general comments and taking personal shots, while Joan Sweeney, the chief operating officer, spun the substantive issues. Allied said it charged BLX and Hillman comparable interest rates to the rates Allied charged for mezzanine investments. Management claimed the rates were not as high as they seemed because Allied did not earn a current return on the equity investments they made to those companies. Allied encouraged investors to concentrate on the “blended” return on their combined debt and equity investment, which Allied said was not excessive. Besides, according to Allied, the controlled companies could afford to pay.

Despite management’s claim, the rates charged to the controlled companies were not customary, as no other companies paid Allied 25 percent interest. At the time, Allied charged most companies about 15 percent interest. Guiding investors to focus on a blended return that included the return on the related equity investment was a red herring, because from a legal and accounting perspective Allied treated the debt instruments as discrete from the equity instruments. In fact, Allied did earn a return on the equity investments through realized and unrealized increases in the fair-value of the investments and from dividends.

The high interest rates padded Allied’s earnings, even if BLX and Hillman could afford to pay them. Future disclosures ultimately showed that BLX didn’t have the ability to pay anyway, as it did not then, nor does it now, generate any cash. Instead, Allied periodically injected money into BLX to enable BLX to pay the 25 percent interest rate and other fees back to Allied. Sometimes, rather than have Allied infuse more money, BLX borrowed on its bank line. Since Allied guaranteed the banks against the first 50 percent of any loss on the bank line (and charged BLX a hefty fee for the guarantee), bank borrowings weren’t substantively different from Allied simply adding to its investment in BLX directly.

Next, on the issue of Andersen omitting its confirmation language from its audit opinion, Sweeney repeated Roll’s line about the Andersen audit language being removed, “The Audit Guide simply changed.”

On the issue