Tuesday, March 23, 2010

The Allied Capital story

Left-wing theory holds that government regulation is both a means of protecting consumers and ensuring the integrity and stability of the marketplace. Freed from the corrupting influence of money, regulators survey the market landscape from their lofty perches in Washington with an unbiased perspective, meting out justice to those who mistreat or deceive consumers, exposing boardroom shenanigans and tamping down on the market's sometimes wild gyrations to ensure it remains on a more even keel.

Those of us who favor increased economic freedom and generally skeptical of such government interventions take a dim view of this approach. Regulators are not Solomon-eque watchdogs wisely and impartially rendering their judgment, but fallible humans who take orders from their political masters. Those political masters, in turn, are subject to considerable influence from various special interest groups, including those they are tasking with providing oversight.

From a very practical perspective, one also cannot help but wonder why regulators would possess any special insights into the market's inner workings. Indeed, if they were gifted with an unusual level of understanding their talents would probably be employed on Wall Street rather than Washington, where they would command top dollar. In addition, how can regulators, even in large numbers, possess information superior to the collective knowledge of the millions of participants in the market?

Lastly, the better guardian against malfeasance is the market itself, with competition serving to protect consumers and profit incentives for investors to punish and even bankrupt those who misrepresent themselves in their financial dealings.

This debate is brought into sharp relief through an article in today's Washington Post about the role played by the Securities and Exchange Commission in investigating a private-equity company called Allied Capital. Allied Capital was suspected by at least one investor of misrepresenting its financial assets:
The case explored by the inspector general began in 2002, when a hedge fund manager named David Einhorn explained in a speech that he bet against Allied Capital's stock by short-selling it because he thought Allied overvalued its holdings.

Other investors proceeded to short Allied's stock, which declined sharply in value.

About the same time, Einhorn began contacting the SEC by phone and letter to explain his skepticism about Allied Capital's accounting techniques.
Einhorn, having suspected Allied Capital wasn't being entirely truthful, decided to put his money where his mouth was and short the company's stock (incidentally, it is worth noting that short selling is under attack from some left-wing members of the political establishment). He also contacted the SEC. The story looks at what happened next:
Allied responded by waging a public relations campaign against Einhorn, questioning his motives. The war between Einhorn and Allied became well known in legal and financial circles.

Allied also worked behind the scenes to urge the SEC to investigate whether Einhorn was engaging in illegal behavior to undermine the company's shares, according to the inspector general's report.

Without any specific evidence of wrongdoing, Allied met with SEC investigators in June 2002 to urge them to investigate Einhorn. Shortly thereafter, the SEC opened a probe, questioning Einhorn about his trading activities, subpoenaing documents, and seeking his telephone records and a list of clients.

Soon after investigators started looking at Einhorn, they concluded that he had done nothing wrong. Investigators finished their review by mid-2003, but they refused to tell Einhorn the case was closed.

The probe was supervised by an enforcement bureau chief named Mark Braswell; he soon left the agency and went to work a Washington law firm, where he landed Allied Capital as a client.
This is just stunning. Not only did the SEC fail to heed Einhorn's warnings and investigate a company whose offices were located a mere two miles away from their own, it then turned the table and decided to investigate him after some skillful lobbying by Allied Capital. When nothing turned up they failed to notify Einhorn that the case was closed, likely to keep him scared and reined in. That a high-level member of the SEC left the agency to make more money in the indirect employ of Allied is icing on the cake.

But that's not all:
The inspector general confirmed what Einhorn later wrote in a book, that he wrote a dozen letters to the SEC with detailed information alleging that Allied overvalued its portfolio.

Two separate agency offices -- unaware of each other's activities -- opened probes into Allied Capital based on Einhorn's letters.

The inspector general wrote that the first probe, conducted by the Office of Compliance Inspections and Examinations (OCIE), was prolonged by delays and involved just two officials.

One OCIE official overseeing the review told the inspector general that he trusted an Allied officer contacted because that person formerly worked for the SEC and was "not going to be doing anything illegal."
Two investigations were ultimately launched which -- in typical government fashion -- were uncoordinated, possibly duplicative and beset with delays. Allied was given the benefit of the doubt, meanwhile, because one their employees used to work at the SEC and thus was a confirmed good guy.

The story concludes:
A year later, the SEC was persuaded not to pursue fraud charges against Allied, according to the report. Allied instead faced a more modest charge that allowed the company to settle without paying any penalties.
The SEC, even when alerted, not only failed to pursue Allied Capital but instead investigated the whistle-blower. The good old boy club kicked into high gear and the company was spared penalties of any consequence.

That doesn't mean, however, that Allied exactly escaped scot-free. It's just that the only real punishment was dealt by the market, not regulators:
The firm has struggled amid the financial crisis, defaulting on debt and credt agreements. Its shares have lost most of their value in recent years, and the firm has accepted a buyout offer from New York-based Ares Capital.
Left-wing political thought, while motivated by good intentions, once again falls short when confronted with reality. This is certainly worth keeping in mind as Sen. Chris Dodd bandies about a 1,300+ page financial reform bill which hands even more power to the government. It didn't work for George W. Bush and there is little reason to think this time will be any different.

Related: See this post from last summer on the SEC's role in the Madoff scandal.

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