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David Einhorn is the president of Greenlight Capital and the author of Fooling Some of the People All of the Time, a compelling account of his battle with Allied Capital (NYSE: AFC ) . Einhorn also presciently called attention to Lehman Brothers' irregular accounting practices just prior to that firm declaring bankruptcy in September 2008.
Many of us at the Fool admire Einhorn for his investing ability and dedication to the principles of transparency and honesty. In the first part of our interview, he spoke about Allied, the Securities and Exchange Commission, and the ongoing threat to our financial system.
John Reeves: What are the lessons for retail investors from the story of Allied Capital?
David Einhorn: The takeaway for retail investors is that they should be appropriately skeptical of the various gatekeepers that are supposed to be there to protect them. The gatekeepers such as the SEC and sell-side analysts might not be acting on their behalf. Retail investors shouldn't just assume a seal of approval from the SEC because it hasn't brought any action against a company, for example. And sell-side analysts often have huge biases that aren't aligned with ordinary investors.
Reeves: It's ironic that Allied was mostly owned by retail investors.
Einhorn: Yes, Allied preyed on the failures of the gatekeepers. Allied believed that as long as it persisted in paying its dividend, it could continue its questionable practices.
Reeves: What are your thoughts about the SEC? Are things getting better there? Is the Goldman Sachs (NYSE: GS ) case an example of improvements there?
Einhorn: The SEC -- post Enron -- sees its role as protecting investors from other investors instead of protecting investors from the huge structural problems on Wall Street and abuses by corporate issuers and managements. In order for real change to occur, the SEC will have to actually inflict meaningful penalties on wrongdoers. That's what's necessary to deter bad behavior. I think the Goldman case was a peculiar choice. Ultimately, there hasn't really been a substantive case against a company that was misrepresenting its books during the financial crisis. And to date there have been no prosecutions that I am aware of as a result of Sarbanes/Oxley.
Reeves: The SEC recently investigated its own handling of the Allied case and concluded, "While we did not find any evidence of specific wrongdoing on the part of current SEC employees, we found that serious and credible allegations against Allied were not initially investigated, and instead Allied was able to successfully lobby the SEC to look into allegations against its rival Einhorn without any specific evidence of wrongdoing." What's your response to that statement?
Einhorn: There's a lack of accountability in that statement. Also, there were numerous redactions in that report. I feel the public has a right to know the entire story. One individual, for example, took enormous steps to quash the investigation of Allied and appears to be accused of trying to cover it up by deleting files on the SEC's computer. Ultimately, there were no internal consequences and no external consequences; he is still in his job today. The heavily redacted report, which conceals his identity, even shields him from public accountability for his actions.
Einhorn: The main reason ratings agencies exist is for the convenience of Wall Street. Wall Street uses them to make money at the expense of passive long-term credit investors like pension funds. Wall Street firms make money when the ratings are wrong. They are able to front-run the passive buyers of bonds who depend on ratings by dumping bad bonds on them. People sometimes ask how can passive investors survive without the protection of the ratings agencies. Actually, they would be the biggest beneficiaries of a system without the ratings agencies. As for Wall Street needing ratings to assist in the capital raising process, if we didn't have official ratings, underwriters like Bank of America (NYSE: BAC ) , for example, would just figure out a different way to market new bonds.
Reeves: What must happen before we'll get real reform of our financial system?
Einhorn: The financial crisis exposed a lot of serious problems. But the special interests have been able to protect themselves so far from having the obvious, necessary reforms implemented. Things will likely persist as they are until we encounter another, bigger crisis.
Reeves: What is your view of the media as a result of the Allied experience?
Einhorn: I actually see a big improvement in the media since the beginning of this story. At the beginning, the media just wanted to hear from management and sell-side analysts. Now, the media is far more willing to consider critical information and analysis. The media is still tempted to highlight personalities and attractive headlines. There is a lot of sensationalism at the expense of substance.
Reeves: Is it possible that news organizations don't have the budget to do serious, in-depth stories?
Einhorn: Yes, but different organizations have different capabilities when it comes to telling a complex story. I definitely don't expect every outlet to cover something like the Allied case. I do believe the media is better now, though.
Reeves: Has the reputation of short-sellers improved of late?
Einhorn: I still think there are headwinds there. Investors and the media still prefer the long side of things.
Stay tuned for Part 2 of our interview with David Einhorn.