Short Seller’s Vindication; SEC Scandal

Chidem Kurdas

There is a frightening implication in the government’s settlement of fraud charges against a small-business lender called Business Loan Center and another business, both of which owned by Allied Capital, a business development company.

This is the Allied Capital David Einhorn talked about at a 2002 charity event, where he made a case that the company was mis-valuing its investments, among them Business Loan Center. I was in the audience that day and was struck by the wealth of detail Mr. Einhorn provided on Allied Capital’s problems. Of course, Mr. Einhorn was short Allied.

In general it is not accurate to call him a short seller. He buys stocks more than he sells, as he noted in his 2008 book about the Allied debacle, Fooling Some of the People All of the Time (published by Wiley). But he became famous – or infamous, depending on your view – as the pugnacious critic and short seller of Allied.

Besides making these issues public, Einhorn told the Securities and Exchange Commission about them. Having discovered that Business Loan Center was making fraudulent loans with money from the Small Business Administration (that is, from taxpayers) he told SMA—in 2003.

SMA showed scant interest and renewed BLC’s status as preferred provider of largely government-backed loans. As for the SEC, that bureaucracy  investigated Einhorn himself.  In his book he described a scene of being grilled in a hot, minimally furnished basement by SEC functionaries, including a very aggressive lawyer named Mark Braswell. This investigation came to nothing but cast a pall over Einhorn’s hedge fund firm, Greenlight Capital, for several years.

Eventually, in 2007, the SEC gave Allied a little slap on the wrist for over-valuing its portfolio. This week, the government confirmed Einhorn’s criticism of BLC.  The lender “submitted false claims for payment on loans made through the Small Business Administration” according to a May 6, 2010, release from the US Department of Justice.

From the $26.3 million settlement with BLC, Einhorn and another whistleblower who independently discovered Allied shenanigans will get $4.3 million. That must be sweet, right? Except that it comes so late and is small relative to the fraud. The whistleblower attorney who represents Einhorn says the government should have recovered some $100 million more.

The seriousness of the fraud can be gauged from a related criminal case. BLC executive Patrick Harrington pleaded guilty to conspiracy to defraud the US and was sentenced to 10 years for his role in the loan scheme, which included falsifying loan documents, inflating property appraisals and using straw purchasers to do sham transactions.

The government was exceptionally patient and gentle with Allied, including this minimal settlement. Why is that?  Located in Washington, Allied had extensive connections in the political and regulatory worlds. It was founded by a former FBI person and employed former SEC enforcers. Mr. Braswell, the SEC attorney who interrogated Einhorn, subsequently became Allied Capital’s lobbyist.

According to the Project on Government Oversight, in 2002 Allied successfully lobbied the SEC Enforcement Division to investigate Einhorn and Greenlight. The SEC subpoenaed boxes of documents and demanded his telephone records and list of clients. Nothing illegal was found and the investigation was in  effect over by mid-2003, but Einhorn was never notified. It was quite an intimidation campaign.

Allied merged with Ares Capital this year and is no longer listed. But the newly announced modest settlement about loan fraud suggests the political network is still active.

Einhorn found out about the Allied shenanigans eight years ago. They must have been going on for at least a decade. Just the compound interest would be substantial. So it is hard to know what to make of Small Business Administration General Counsel Sara Lipscomb’s statement, “we have recovered a significant amount of the loan loss,” regarding the settlement money.

But I guess that’s that. The implication is chilling. To quote from Einhorn’s book: “If posting an analysis on a web site or making a speech gets you an SEC investigation, why bother?” Turns out the Madoff whistleblower was fortunate—at least they did not go after him!

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