I am not sure what led me to a 400 page book about a single investor’s single short position on a single company, but once I entered the book I could not put it down until I finished it. Fooling Some of the People All of the Time by David Einhorn clarifies many of the deficiencies in our financial system.

Einhorn is a very bright and very young investment manager who has successfully built Greenlight Capital into a very respectable hedge fund with great results. Like many hedge funds David Einhorn takes short positions as well as long. He picks short candidates by engaging in research to find reasons that companies will not perform as expected. Sometime this is because he sees a flaw in the business model that others do not, and sometime he sees a flaw in valuation and reporting that seems intended to mask true results. In some cases he sees outright fraud and activity that merits reporting to the authorities. This book was about one of those cases.

David took a short position in Allied Capital in 2002. At an investment conference each speaker was asked to give his most interesting investment idea at the time and his pick was to short Allied Capital. He did not expect much of an impact from the speech, but a firestorm ensured that lasted for the better part of a decade.

To compress a lot of pages of the story Allied Capital and its subsidiary BLX was guilty of violating SEC guidelines, and SBA lending rules becoming one of the SBA’s worst losses. Allied delayed write-downs, financed dividends by raising capital, and through ABX ran an extremely shady loan business as a preferred lender for the SBA.

David Einhorn

At substantial expense Einhorn investigated the business practices and confronted the management and board of directors through normal shareholder channels and conference calls. He was rebuffed and demonized by the company and by many of the investment houses with a stake in Allied.

Over the years Einhorn found that the ratings agencies were not interested in his research, nor were any of the investigative reporters for the business press. The problem was that Allied loan business was complicated and most did not want to spend the time to understand the issue as Einhorn had done.

One would think that the SEC and the SBA would welcome a whistle blower that brought detailed reports on how a company was blatantly violating regulations and bilking taxpayers, but David found himself investigated more than respected. Allied and its officers succeeded in demonizing Einhorn because he was a hedge fund manager and a short seller. This became the emphasis of their complaint rather than addressing any of the very specific and very clear concerns surfaced from Einhorn’s investigation. Allied seemed successful in deflecting concerns with generalizations, intimidation, and demonization while ignoring facts, often just blatantly lying.

While the SEC and the SBA delayed actions for years, Allied succeeded in raising hundreds of millions of dollars in additional capital which delayed the day of reckoning. They also delayed an accurate accounting by selling good assets and keeping bad assets until there were no more “flowers” to pick and only “weeds” remained.

A combinations of slick maneuvers by Allied and a tepid response from the regulators kept the inevitable at bay for about five years, but eventually the truth that so few other than Einhorn recognized became clear and the company collapsed. It took patience and commitment but his short position did finally pay off.

The company got off light and few of the officers were either fined or jailed.

Einhorn’s story showed that short positions are not evil, seeking to take advantage of weak businesses. They are a valuable source of market information. Unfortunately few of the government regulators are capable of the kind of research Einhorn did and worse yet they could not recognize the value even when it was handed to them on a silver platter . They prefer smaller criminals who lack the political influence to make their task difficult. Einhorn notes we do not suffer from a lack of regulations; the agencies we have are almost incapable or often unwilling to enforce the regulations we already have.

The SBA was so embarrassed at the defaults from its lack of oversight it sought to minimize the reported size of the damage and pushed back against the Department of Justice. Even when Einhorn’s accusation were all proven correct the agencies we depend on to protect us let the offenders off light.

Allied was able to hide behind complexity, political influence and lax regulators. Government agencies ended up enabling those they should have been prosecuting.

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