Working on Short Notice
Allied Capital Executives Take an Unusual Tactic Against Their Critics
By Nicholas Johnston
Washington Post Staff Writer
Monday, June 24, 2002; Page E01
washingtonpost.com
Chief executives rarely respond directly to their detractors, and even more rarely take them on in public. So it was an unusual scene that unfolded last week in an Allied Capital Corp. conference room, with chief executive William Walton reading a carefully, if sharply, worded statement.
"The purpose of this call," Walton began, "is to set the record straight in response to a systematic campaign by certain individuals who have been circulating statements about Allied Capital in recent weeks that are either misleading or downright false."
Walton, surrounded by lawyers and other Allied executives at a large and polished wooden table, was addressing his remarks to a speaker phone. On the other end of the line, analysts and scores of Allied's shareholders listened to his surprisingly personal plea.
"We owe it to our shareholders. We owe it to ourselves, and we owe it to our families," he continued, reading calmly and deliberately. "We are going to confront our accusers in the daylight of the facts and the truth. Until the truth prevails."
That is how Walton, who runs one of Washington's oldest business investment companies, has cast his fight with short sellers -- investors who borrow then sell shares, hoping to pay them back with shares they have bought at lower prices. Short sellers bet that a stock price will go down. And, in Allied's case, some of these short sellers have made public accusations that Allied's accounting is improper.
Allied's "short interest," the amount of Allied stock borrowed by investors who are betting the price will fall, has more than tripled in the past 30 days.
For more than a month, Allied executives have taken the unusual and, some say, risky tactic of publicly fighting short sellers. Walton's team believes it has been unfairly targeted by short sellers, whose allegations have helped drive down Allied's share price by as much as 30 percent from its March peak. More than a third of that drop came one day last month after a speech by investment manager and noted short seller David Einhorn.
Allied's first conference call, an affair planned the night before it took place, came the day after Einhorn's speech. A month later, the company has become much more organized and forceful, assembling a phalanx of lawyers and public relations specialists to mount a campaign to discredit Einhorn's claims. And more might be in the works this week, though the company declined to specify its plans.
"We are not going to let them get away with it," Walton told shareholders last Monday.
Such tactics against short sellers are rare, said Frank Goldstein, a corporate finance attorney at Sidley Austin Brown & Wood LLP in the District. Usually public companies try to ignore or simply downplay growing short interest in their stock. Mounting a counteroffensive can only serve to draw attention to criticisms of the company, valid or not.
"The way it usually works is if you see some short activity you leave it alone," he said. "It's not typical for companies to respond to short sellers so vociferously."
That is not to say that it never happens. MicroStrategy Inc. chief executive Michael Saylor publicly enlisted the help of his shareholders in April 2001 to fight short sellers. The gambit, which asked investors to carry shares in their own names instead of their brokers' to cut down the pool of stock that short sellers could borrow from, helped boost MicroStrategy's stock price to $5.64 the next day from $2.97. (MicroStrategy closed Friday at 72 cents a share.)
And more recently the Federal Agricultural Mortgage Corp., better known as Farmer Mac, held a conference call with investors to reassure them about earnings expectations and loan risks. But Farmer Mac's single call last month dealt with a broad array of issues raised by investors. It was not as specific or personal a response to the activities of short sellers as Allied's, though some short sellers have targeted Farmer Mac.
Short sellers play an important, though often despised, role in public markets. If they find a company they think is ripe for a fall, they will borrow shares from a brokerage house and sell them in the open market. Eventually they must repay those borrowed shares with ones they buy, so they only make a profit if the stock falls.
From the minute they sell a stock short, the short sellers thus have an interest in promoting information that might cause the stock to fall, just as "long" investors, who own the shares outright, want to promote information that will make it rise. And by profiting when stocks go down, they invest considerable time and money researching companies, looking for ones that might be vulnerable, dishonest or even downright criminal.
Einhorn's fund, for example, was one of the first to point out that Computer Learning Centers Inc., a Northern Virginia education company, was running into trouble with several states for not providing the computer training students paid for and was running afoul of federal student loan laws. The company went into bankruptcy last year after the Department of Education revoked its ability to accept federally guaranteed student loans and after several states, including Maryland, made allegations that students were being given shoddy training for their money.
Allied's battle with short sellers began on May 15 when Einhorn, the manager of $1 billion New York hedge fund Greenlight Capital Inc., gave a brief presentation at an investor conference outlining some of his thoughts on the company.
Allied's core business is loans and investments in small- to medium-sized companies of every persuasion, including electric guitar makers and telecommunications companies. It makes money on interest, dividends and, eventually, selling its investments when the value of the companies increases over time. Einhorn said that Allied was carrying a number of those investments at inflated values. He cited, for example, Allied's loans to Velocita Corp., a telecommunications company in bankruptcy protection that Einhorn said Allied valued too high after other investors, such as Cisco Systems Inc., had written down or written off their investment.
Einhorn and other short sellers point to a "white paper" recently released by Allied outlining the methods it uses to value its holdings in private companies. Short sellers claim those methods are suspect under Securities and Exchange Commission regulations.
Allied responds that it has consistently and correctly valued its portfolio for decades, and if anything, is holding most of its assets below fair market value. Over the past five years, the company said, realized gains on its portfolio have exceeded their carried value by nearly $80 million.
Einhorn also contends that Allied was not properly disclosing the financial relationships it has with companies it owns, and that some of those relationships were inappropriate.
In particular, Einhorn alleges that Allied artificially pads its profits by charging high fees to companies it owns, and that it has not done a sufficient job explaining to investors how these fees are assessed.
Allied responds that as an investment fund that takes an active role in many of its portfolio companies, fees for consulting services, marketing and human resources advice, for example, are completely justified. And rules governing investment companies that Allied follows are clear as to how to account for revenue from companies in its portfolio.
"I think the short sellers have brought up some various interesting points, that collectively have some validity," said Todd Pitsinger, an analyst at Friedman, Billings, Ramsey Group Inc., an Arlington investment bank. "Where I believe they've missed the mark is overemphasizing the importance of some of those issues."
FBR has no banking relationship with Allied Capital, but it does count Einhorn as one of its trading clients.
On May 16, the day after Einhorn's speech, shares in Allied fell $2.77 to close at $23.20 on trading volume of almost 16.2 million shares. On an average day, 2.5 million shares of Allied change hands. Allied responded by quickly scheduling a morning conference call to address Einhorn's arguments.
Two weeks later Allied went one step further, holding a second conference call after reports showed that the number of shares held short in the company jumped 80 percent from April to May, rising to 6.2 million shares. Again, Walton and other executives publicly refuted the claims made by Einhorn.
In response Einhorn then took the rare step of posting Greenlight's analysis of Allied Capital on the fund's Web site.
"We've never done this before," Einhorn said. "The company is saying things like we didn't talk to them, and like we didn't do our homework. We wanted to make it very clear within the industry that we didn't open our mouth without doing our homework."
The day after Einhorn's speech, the first of eight class-action shareholder lawsuits was filed against Allied. All of the lawsuits make many of the same allegations made by Einhorn, namely that Allied has been overvaluing its investments and using inappropriate accounting methods in a way that misled investors.
And in the midst of the lawsuits, a second research firm, Off Wall Street Consulting Group Inc. put out its own report on Allied Capital, making many of the same arguments as the Greenlight report. Based on the similarities, Allied executives said they were victim of a concerted campaign to drive down the price of their stock.
Einhorn refuted Allied's claim that there is coordination between short sellers, and he denied ever talking with class-action lawyers involved in bringing suit against Allied. But he has shared information with Off Wall Street Consulting, as he does with numerous other research firms. He contends Allied has his intentions backward.
"We're not critical of this company because we are short," Einhorn said. "We are shorts because we are critical of this company."
Off Wall Street did not return calls for comment.
It was Off Wall Street's report that pushed Allied to schedule its third conference call June 17. The company held another round of meetings with executives Monday morning to firm up a defense and brought in former special counsel to President Bill Clinton, Lanny J. Davis, to help. And the company prepared a 17-page, point-by-point response to Einhorn's claims.
"This is absolutely costing our shareholders money," said Joan M. Sweeney, Allied's chief operating officer. "This is a waste of resources."
"We want people doing work," said Walton, who spent much of last Monday morning meeting with attorneys and executives. The conference call lasted about an hour and a half, wrapping up a little after 2:30 that afternoon. There were about 30 minutes of questions, including a few from other short sellers, though not Einhorn. Einhorn listened to the call but said he was unable to ask any questions. Allied said it was not screening the calls.
Shortly after the call, Suzanne Sparrow, Allied's director of investor relations, walked in with a Post-It note and stuck it to the folder in front of Walton. Allied's shares were up about 40 cents after the call. The stock closed the day up 3 cents on trading volume of more than 2 million shares.
"We've got the ultimate voting machine," Walton said. "The markets are going to work their magic."
Though not necessarily to Allied's advantage. Since the most recent call the company's shares have resumed their slide. Allied shares closed Friday at $21.10 a share, down$1.38 orabout 6 percent for the week.
So far, it seems that Allied's attack on the short sellers has not been working. As of June 15, short interest in Allied stock skyrocketed to 20 million shares, a three-fold increase in one month. Shorts account for nearly 20 percent of the company's outstanding shares. And the stock price is still near its 52-week low.
"This company has done a fine job of answering its critics," said Doug Poretz of Qorvis Communications, and an experienced investor relations manager. "So why isn't the stock up?"
One hedge fund manager said it could be that the publicity surrounding the back and forth between Allied and investors has served to amplify the charges against the company. It is the fear of that kind of added attention that keeps most firms silent in the face of short sellers.
"These guys have a credibility problem now, and you can do one of two things: You can slink away and hide or you can go out there and fight," said the hedge fund manager, who has a short position in Allied, but requested anonymity.
Walton seems to relish his new role as the champion of anti-shorts. On his side, Allied executives gleefully point out, are Allied's individual shareholders, many of whom are in the Washington area, who have been filling online message boards and the company's e-mail in boxes with their support.
Chuck Findley, a retired private investor in Seattle, e-mailed his congratulations less than 10 minutes after Walton closed the most recent conference call. Sparrow passed a copy of his e-mail around the room, and Walton read it and smiled before passing it on.
"My sense is the management of [Allied Capital] in the conference call just nailed it," Findley said in an interview later that day. "I really applaud them just taking this head on. I don't think enough companies do that."
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