In spite of the financial crisis of 2008, regulators continue to be ill-equipped to tackle corporate malfeasance.
I read David Einhorn’s Fooling Some of the People All of the Time (for a second time) over the past week. Einhorn is the founder of Greenlight Capital and has been known to discover short selling opportunities among many companies with dubious financial reporting. In a courageous position, he questioned Lehman Brothers’ health while the stock still traded at $60 per share in 2007.
But his most famous short, and the subject of the book, is his seven year campaign to expose the fraud at Allied Capital. The book is part detective story and part financial thriller. Unfortunately, it is not a work of fiction. It depicts regulators asleep at the switch – if not willfully ignoring misconduct. It shows the lengths to which a corporate leaders will stoop to manipulate the system (ultimately Allied admitted to even hacking the phone records of Einhorn and various investigators). It shows how investment banking analysts and rating agencies can be easily led astray by the corporate party line in the face of bold malfeasance. And the book depicts the conflict of interests among government agencies and politicians.
Here are the red flags that serve as warnings to all investors. These are scents that Einhorn and other skeptics picked up on their bloodhound path through corporate swamps of misinformation:
Red Flag #1: The off balance sheet subsidiary with opaque financials. Just like the Andy Fastow’s “Raptor” vehicle at Enron that hid losses from the market, Allied used BLX to shield losses on SBA and USDA loans from the public. Ultimately, the lack of transparency not only concealed poor underwriting and inflated values, it hid outright fraud.
Red Flag #2: Failure to mark assets to fair values. This was Einhorn’s major discovery that led him to the conclusion that Allied was lying to investors. It formed the basis of his short position and was the subject of his introduction to the public at a charitable investor conference in 2002. Allied systematically held assets that should have been written down in spite of non-performance or deterioration. Instead, they carried the assets at cost, in some cases for as long as ten years, before admitting the loans to portfolio companies could not be collected.
Red Flag #3: Gain on sale accounting. BLX would originate SBA loans, sell the government guaranteed portion to banks and securitize the non-guaranteed portion. They would also include the present value of future servicing revenue in their current income for the quarter. This worked fairly well until it became clear to banks that the loans were poorly underwritten and stopped puchasing loans at a premium. BLX started keeping more of the non-guaranteed positions on their books and increased their present value recognition of higher future servicing fees. Over time, more and more of the gain on sale events were non-cash calculations of future residual values. Most of them never materialized.
Red Flag #4: Smoothing quarterly results. Allied was careful to “write up” many assets at the same time that they gradually wrote down assets over many years, thus concealing the true loan portfolio condition.
Red Flag #5: Paying distributions or dividends in excess of net income. Allied came to rely on selling winners and holding losers in their portfolio to subsidize a dividend that was unsustainable from basic operating earnings,
Red Flag #6: Continual equity raises. Allied bordered on the edge of a Ponzi scheme by continually issuing stock that was billed as dry powder for new asset origination. Instead, much of it was used to prop up the failing BLX and fund the distribution.
Red Flag #7: Revising stock option plans to unfairly benefit employees. Allied shifted to a cash compensation structure when it became apparent that most options would soon be under water. It also prevented the dilution of current shares outstanding. It decoupled the executives from having “skin in the game”.
As a parting word, to me, the most shocking area of the book relates to the failure of the media to expose the story. Not only did financial journalists balk at publishing corporate malfeasance due to its complexity and lack of “sexy” headlines, the openly hostile reception of venerable publications such as the Wall Street Journal and the Washington Post calls into question the objectivity of media and the undue influence wielded by corporations. The end result of such “journalism” amounts to little more than a friendly public relations piece rather than a full vetting of the facts. Einhorn even sadly recounts his presentation to a Harvard Business School professor of his detailed investigation in order for the prestigious business school to produce a case study. Once the case study was published and reviewed by students, Einhorn was shocked to read Allied was portrayed in a favorable light.