Fooling Some of the People All of the Time

David Einhorn · 2008

Thesis

A company can misstate its finances for years in plain sight, and the institutions meant to catch it, regulators, the press and analysts, may fail to act; an investor who exposes the problem through short selling should expect to be attacked, investigated and ignored long before he is proved right.

The main ideas

Allied Capital, Einhorn argued, carried troubled investments at inflated values instead of marking them down.
A subsidiary, Business Loan Express, made fraudulent loans guaranteed by a government agency.
When Einhorn said so publicly, the company attacked him, and regulators investigated him rather than the company.
Allied obtained his phone records through a private investigator's pretexting.
Regulators and the press were slow to act on detailed evidence.
Short sellers do useful work exposing fraud, but the system treats them as villains.

The short

David Einhorn founded the hedge fund Greenlight Capital in 1996. In May 2002, speaking at the Ira Sohn Investment Research Conference, a charity event where investors present ideas, he recommended selling short Allied Capital, a Washington-based business development company that lent to and invested in small and medium-sized businesses.

His argument concerned valuation. Business development companies hold illiquid private loans and stakes, whose values are estimated by the company itself. Einhorn argued that Allied was not marking its troubled investments down to their fair value and was slow to recognize losses, so its reported earnings and assets were overstated. In the book, published in 2008 with a foreword by the investor Joel Greenblatt, he goes further, charging falsified appraisals and loans to businesses that could not survive.

The book follows the dispute from April 2002 to December 2007.

Implication: where a company sets the value of its own assets, ask how it marks down investments that go bad, and treat slow write-downs as a warning.

Business Loan Express

Einhorn's case extended to Allied's subsidiary Business Loan Express, which made small-business loans guaranteed by the Small Business Administration, a federal agency. He argued that it was making loans that should never have been made, collecting the guarantees when they failed.

Events bore out part of the charge. In January 2007, federal investigators arrested Patrick Harrington, who had run Business Loan Express's office near Detroit. He admitted to dozens of fraudulent SBA-guaranteed loans totaling tens of millions of dollars and was sentenced to ten years in prison. The investigation led to 27 indictments, and the SBA began reviewing the subsidiary's loans.

Einhorn also filed a whistle-blower suit on the government's behalf against the subsidiary; the Justice Department declined to join it.

Implication: government guarantees remove the lender's incentive to judge risk carefully, so lenders that rely on them deserve extra scrutiny.

The counterattack

Allied did not respond by addressing Einhorn's evidence, in his account, but by attacking him. He was portrayed as an opportunistic short seller spreading falsehoods to profit, and shut out of the company's conference calls. After Allied met with officials of the Securities and Exchange Commission in 2002, the agency opened an inquiry into Einhorn's own conduct, which remained open until December 2006.

The most striking episode came in 2007. Allied disclosed that an agent acting for the company had obtained what were represented as Einhorn's telephone records, through pretexting, impersonating someone to get records from a phone company. Allied said management had not authorized it. Einhorn later testified to a House committee as a victim, supporting legislation against the practice.

The mechanism is that a company under attack can turn the debate from its own conduct to the motives of its critic, and short sellers are easy to cast as villains.

Implication: when a company responds to criticism by attacking the critic rather than answering the evidence, treat the response itself as information.

The system that did not act

The book's larger argument is that the institutions that should have acted were slow or ineffective. Einhorn expected that once he set out his evidence, regulators and the press would pursue the company. They largely did not.

The SEC's eventual finding, in June 2007, was a settled order that Allied had violated record-keeping and internal-control rules in valuing its private investments from 2001 to 2003. Allied neither admitted nor denied the findings and paid no fine. In 2010 the SEC's own inspector general reported that the agency had failed to properly investigate the allegations against Allied.

Einhorn argued that the fight was costly and unpleasant, and that it deterred others from publishing critical research. In an updated edition, he drew parallels between Allied's practices and those of Lehman Brothers before its collapse in 2008.

Implication: do not assume that regulators or the press will act on evidence of wrongdoing. The burden of proof often falls on the critic.

The outcome

Allied's troubles deepened in the financial crisis. In 2009 it defaulted on covenants with its lenders, and its shares lost about 90 percent of their value from the level before Einhorn's 2002 speech. In 2010 it was acquired by Ares Capital for about $3.47 a share, a fraction of its price when the dispute began.

Einhorn pledged his share of the profits from the short, and the book's proceeds, to charity, including organizations that investigate government and corporate wrongdoing.

Implication: a short seller can be right on the facts and still wait years for the market to agree. Size short positions so you can survive the wait.

Limits

It is a one-sided account by an interested party. Einhorn profited from Allied's decline, and Allied denied his allegations; the SEC's finding was a record-keeping and controls violation without a fine, not a finding of fraud.
Reviewers found it overlong and self-regarding. Forbes wrote that it reads like a laundry list of his grievances, and a review for the CFA Institute, while praising its research, criticized its self-congratulation.
Its detail can overwhelm its argument. Much of the book traces filings, valuations and correspondence at a level only specialists will follow.

You Can Be a Stock Market Genius — Joel Greenblatt, who wrote the foreword, on finding mispriced securities through close reading of filings.
Devil Take the Hindmost — the long history of financial manias and the frauds they shelter.
The Big Short — other investors who saw a collapse coming and were ignored until it happened.