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Ira W. Sohn Investment Research ConferenceDavid Einhorn, Greenlight Capital, “Accounting Ingenuity”May 21, 2008
I appeared at this conference six years ago and joked that my wife, while trying to help meprepare my presentation of the Allied Capital analysis, had a hard time staying awake.This is pretty ironic, since the ensuing fallout from that speech has cost us a substantialamount of sleep. Over the past six years I have learned a lot and grown a little, and formedsome strong views about Wall Street regulation and the muzzle it often places on freespeech.I think that research conferences like these are important. Of course, this one isparticularly worthy because it supports a great cause: The Tomorrows Children’s Fund.Further, it is important for investors to discuss market information and analysis to help sortthe good companies from the bad. But, there is a structural impediment in our financialmarkets that creates a massive disincentive to share research about companies doing badthings.I can fully understand why other investors might decline to appear in this forum or to sharea critical analysis. Who could blame them? The cost is high (think lawyers here), itextracts an enormous personal toll, and there are better ways to raise money for a goodcharity. I have decided to persist because I believe it is important and the right thing to do.Since the Allied speech, I have developed a thicker skin. Back then, when Allied COOJoan Sweeney said that my “plan was to scare the little old ladies,” it actually bothered me.When Holman Jenkins at The Wall Street Journal equated my presentation to a “mugging”– a violent crime – I was incensed because it wasn’t fair. Now, when I read book reviewers of
Fooling Some of the People All of the Time
calling me naïve because of how Iused to believe the system worked, I’m just happy if they like the book.The Allied experience gives me less confidence today than I had six years ago that theregulators are even trying to enforce rules to protect investors from dishonest publicdisclosures and outright lies by unscrupulous corporate managements. Maybe they areunderstaffed or too busy with other priorities. Maybe they are not as sophisticated or closeenough to the issues. However, my experience leads me to fear that maybe they just don’tcare.In
Fooling Some of the People All of the Time
, I point out that the SEC is not enforcing theexisting anti-fraud rules against corporate managements. I wonder if part of the reasonBear Stearns lost the market’s confidence was a sense that Bear had undisclosed losses andthat the SEC was not taking proper measures to ensure that Bear reported accuratefinancials. The large losses that JP Morgan has now acknowledged on Bear’s bookssupport this theory. The lack of confidence in the SEC’s oversight ultimately underminesinvestor confidence.
2When I speak of investors I am including hedge fund managers. An author onInvestopedia defined hedge funds as “lightly regulated, private investment funds that useunconventional investment strategies and tax shelters in an attempt to make extraordinaryreturns in any market…these factors have given them a secretive and shady aura in thefinancial community.” Forbes has called us “The Sleaziest Show on Earth.” Basically,according to some in the media, elected officials, government regulators and individuals,hedge funds are really gambling operations amounting to ticking time bombs with secretplans to destroy the galaxy. Good thing they don’t say what they really think. In truth,hedge fund managers at their core are simply investors.The SEC seems much more interested in whether investors share analysis, particularlycritical analysis, of public filings rather than whether management teams made accuratepublic filings in the first place. The SEC seems more interested in whether investorsdiscuss investments among themselves on private phone calls than in whether managementteams make truthful statements on public conference calls. The SEC seems more likely tobring a case against an individual investor over a small crime than it is to prosecute a largecorporation that fudges its numbers for years on end and pays out management bonuses inthe millions based upon inflated accomplishments.Imagine what would happen if a whistle-blower made a detailed public presentationshowing a hedge fund cooked its books. Under no circumstance would the immediatefocus start by investigating the accuser. How long would it take for the SEC to arrive andhow tirelessly would the media investigate and cover the story? What would the chance bethat the SEC would take five years to find exactly the type of record keeping violationsthat were alleged in the first instance and, then, inflict no meaningful penalty on theoffender? How likely is it that the SEC would permit additional sales of equity in thathedge fund to new investors? How likely is it that our most prestigious investment bankswould line-up to introduce that hedge fund to new capital?Imagine if a hedge fund operated a unit that defrauded the SBA federal lending programout of millions of dollars – engaging in what the SBA inspector general would call “thelargest fraud in SBA history.” How long would that hedge fund be in business?Imagine if a hedge fund hired a private investigator to impersonate the spouse of a CEOand obtained his home and business telephone records. Imagine if after making loud,public denials, the hedge fund admitted to obtaining the records, but did not explain orapologize, or even return the stolen records, when requested. How long would it be beforesomeone was arrested?Of course, I don’t know of a hedge fund that has done these things. Everybody now knowsthat Allied Capital has. The Allied situation persists only because of lax regulatoryenforcement and Wall Street’s continued willingness to sell new shares to unsophisticatedretail customers.
3The double standard is evident. And Allied Capital is a primary example. Three yearsbefore my speech, Allied Capital’s CEO, Bill Walton, made the following statement in amagazine interview:Open and consistent accounting starts with an attitude of zero tolerance forimproprieties. People need to see that people are rewarded for candor inreporting and punished for slipshod practices. The CEO really has to set themoral tone. Without that, nothing happens.There's enormous pressure on public companies to maintain quarterlyearnings momentum, and it's probably growing worse. The bigger thingthat firms get punished for are surprises, particularly negative ones. It'sbetter to face up to bad facts and reporting the business as it is, rather thantrying to hide things and make it far worse later on.If you develop a reputation for candor with securities analysts and investors,that's about the best you can do. At the end of the day, investors understandthat building a business is not an uninterrupted, smooth road. First, youhave to determine whether it's a systematic problem or a people problem.
If there's a dishonest person involved, you get rid of the person.
If Mr. Walton is correct, why is he still employed…and making tens of millions?
I want to go outside the usual format for this event and ask this audience by applause…who agrees with me that there should be some significant consequence to the folks atAllied for what they have done?One of the key issues I raised about Allied six years ago was its improper use of fair valueaccounting, as it had been unwilling to take write-downs on investments that failed in thelast recession. That issue has returned on a much larger scale in the current credit crisis.Recently, we had the CEO of a financial institution in our office. His firm held somemortgage bonds on its books at cost. The CEO gave me the usual story: The bonds are stillrated AAA, they don’t believe that they will have any permanent loss, and there is noliquid market to value these bonds.I responded, “Liar! Liar! Pants on Fire!” and proceeded to say that there was a liquidmarket for these bonds and they were probably worth 60-70% of face value at the time,and that only time will tell whether there will be a permanent loss.He surprised me by saying that I was right. He observed that if he said otherwise, theaccountants would make them write the bonds down.The issue of the proper use of fair value accounting isn’t about strict versus permissiveaccounting. The issue is that some entities have made investments that they believedwould generate smooth returns. Some of these entities, like Allied, promised investors
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