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The Accounting Cycle
Einhorn v. Allied Capital

March 2009David Einhorn documented his case against Allied Capital in his book Fooling Some of the People All of the Time. When I read the book, I felt the evidence compelling against Allied Capital. Today I am less sure. Discovering the role played by one Michigan operator has led me to a different take on this story.

David Einhorn documented his case against Allied Capital in his book Fooling Some of the People All of the Time.  When I read the book, I felt the evidence compelling against Allied Capital.  Today I am less sure.  Discovering the role played by one Michigan operator has led me to a different take on this story.

Allied Capital is a business development company (BDC); it supplies debt and equity financing to private, middle-sized companies.  Its stated goal is “to invest in stable, less cyclical companies that have the ability to generate significant free cash flow.”   In 1990 it purchased Business Loan Express (BLX), a preferred lender in the Small Business Administration (SBA) 7(A) Guaranteed Loan Program.  Essentially, BLX made loans to qualified companies and sold them to secondary lenders.  The loans were guaranteed by the SBA, so if the borrower defaulted on the loan, the SBA would reimburse the secondary lenders (typically 75 percent of the loans).

Unfortunately, Patrick Harrington, who headed up the Troy branch of BLX, was engaging in fraudulent transactions.  In particular, he worked with a variety of brokers and bankers to obtain loans for various businesses throughout Michigan.  Harrington misrepresented the qualifications of these entrepreneurs so they could obtain the financing from BLX.  This included the misrepresentation of their personal history, the amount of their financial contributions to the entity, the value of the property, and even in some cases their citizenship.  The buyers defaulted on the loans and the SBA was stuck with the guarantees.

After being caught, Patrick Harrington pled guilty in October 2007 to conspiring with various third parties to defraud BLX and the SBA.  He later stated that he acted alone; nobody higher up at BLX was aware of his activities.  Harrington even took a lie detector test on July 16, 2007.  The examiner asked him whether he informed Robert Tannenhauser—the CEO of BLX at the time—that he was making loans based on false information, whether Tannenhauser knew that he was making loans based on false information, and whether any superior at BLX knew that he was making loans based on false information.  Harrington answered no to all of these questions.  The examiner James Murphy concluded that Harrington told the truth.

As described in Einhorn’s book, his firm Greenlight Capital took a short position in Allied Capital.  He and his staff were able to pierce the accounting filings and perceive that something shady was being carried out at BLX.  Einhorn felt that Allied Capital was committing an accounting fraud; today it appears that the fraud was limited to Patrick Harrington and his conspirators.

While I congratulate Einhorn for correctly analyzing the SEC financial reports to assess that something was amiss and profited from that ability, I think it too strong for Einhorn to conclude the existence of accounting fraud at Allied Capital.  Given Harrington’s comments and the SEC’s lack of finding accounting fraud (I realize that the SEC has been a paper tiger much of the last decade), the evidence suggests that Allied Capital was itself a victim of this fraud.  This is not to say that Allied’s managers did not massage the numbers to make themselves look good, as managers often do; however, Einhorn does not present evidence that Allied’s managers actually committed accounting fraud.

Allied Capital discusses the impact of this fraud in its SEC filing of Form N-2 on April 3, 2007.

On March 6, 2007, Business Loan Express, LLC (BLX), one of our portfolio companies, entered into an agreement with the U.S. Small Business Administration (SBA). According to the agreement, BLX will remain a preferred lender in the SBA 7(a) Guaranteed Loan Program and will retain the ability to sell loans into the secondary market. As part of this agreement, BLX has agreed to the immediate payment of approximately $10 million to the SBA to cover amounts paid by the SBA with respect to some of the SBA-guaranteed loans that have been the subject of inquiry by the United States Attorney’s Office for the Eastern District of Michigan. The SBA will increase oversight of BLX’s SBA-related lending operations. The agreement provides that any loans originated and closed by BLX during the term of the agreement will be reviewed by an independent third party selected by the SBA prior to the sale of such loans into the secondary market. The agreement also requires BLX to repurchase the guaranteed portion of certain loans that default after having been sold into the secondary market, and subjects such loans to a similar third party review prior to any reimbursement of BLX by the SBA. In connection with this agreement, BLX also entered into an escrow agreement with the SBA and an escrow agent in which BLX agreed to deposit $10 million with the escrow agent for any additional payments BLX may be obligated to pay to the SBA in the future. BLX remains subject to SBA rules and regulations and as a result may be required to make additional payments to the SBA in the ordinary course of business. We invested a total of $19.2 million in the Class A equity interests of BLX during the first quarter of 2007.

The Office of the Inspector General of the SBA and the U.S. Department of Justice are conducting civil and criminal investigations of BLX’s lending practices in various jurisdictions. These investigations are ongoing. There may be other investigations initiated by the SBA Office of the Inspector General or the U.S. Department of Justice in the future, and government investigations and related litigation may or may not have an adverse effect on the valuation of our investment in BLX.

These statements indicate that Allied Capital has had to pay money to various parties as a result of Harrington’s fraud.  No taxpayer money has been used to satisfy any deficiencies arising from this altercation.  And let’s hope that we never do.

I am just as eager as others to ferret out those who abuse accounting reports, but I also want to be careful to place blame where the evidence leads.  The evidence in this case leads squarely to Patrick Harrington and his associates.  Maybe it leads beyond that point, but Mr. Einhorn has not yet made a convincing argument on that point.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) published by BNA in 2007.

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