Washington, D.C.-based business development corporation (BDC) Allied Capital's (NYSE:ALD) stock dropped more than 10% in trading today after the company disclosed it's the target of an informal SEC investigation.

At the center of the investigation is the transfer to Allied Capital's balance sheet of $9 million in loans previously held by one of the company's investees, Business Loan Express (BLX). BLX makes loans backed by the Small Business Administration and is Allied Capital's largest portfolio holding, at about 11% of its entire equity portfolio. Allied Capital owns approximately 95% of BLX, thus requiring its operations to be consolidated into Allied Capital's financial statements.

Allied Capital has long been a favorite whipping boy of several high-profile short sellers, most notably David Einhorn from Greenlight Capital, who announced he held a large short position in May 2002. Allied Capital and similar BDC companies have a fairly complicated business structure. Einhorn and other short sellers have criticized the company for a seeming mismatch between how it values some of its investees on its balance sheet and how the market does. Additionally, they contend that Allied Capital maintains its substantial (now 9.5%-plus) dividend in part by raising money on the open market. If this is the case, this would mean that investors are exchanging a dividend for dilution of their equity. Not a very palatable situation.

In April, an analyst for Wachovia (NYSE:WB) dropped coverage of Allied Capital, stating that he was uncomfortable with the company's disclosure of loans, including the one to BLX, and thought they were insufficient. At the time, The New York Times reported that the SEC was investigating a transfer of loans from BLX. Allied Capital denied it at the time, saying that it had disclosed the nature of the transaction in full. This is the exact transaction that the SEC is investigating today.

Allied Capital makes its money by purchasing controlling stakes in closely held (and some public) companies, and then loaning these same investees capital in the form of subordinated debt. Allied then collects interest on these loans, and uses this to pay its dividends. But because much of these are closely held companies, Allied Capital has a large amount of leeway in how it values them. The question that has come up repeatedly is whether Allied Capital inflates their value, or keeps from writing them down long after similar institutions would have done so. Such aggressive accounting would give Allied Capital access to more capital at lower cost than it would otherwise be granted -- and consistent, cheap access to investment capital is a big deal for BDCs.

There are two ways to look at this. First, we're talking about $9 million out of a nearly $2 billion portfolio -- a mere rounding error, if you will. There is no threat at all to Allied Capital's balance sheet even if the SEC says that the company handled this transaction badly.

The second is the safer of the two for those completely unsure of the facts of the case -- "SEC investigation = sell." It is, of course, a knee-jerk reaction, and there are plenty of companies that are investigated by the SEC for which nothing substantive is found. But as an old SEC enforcement official once told me: The Commission isn't prone to idle fishing expeditions. It's also possible that any improprieties regarding treatment of this loan are the above-water evidence of an iceberg of problems beneath the surface. Allied Capital's entire asset base could be built on $3 bills. Allied Capital has repeatedly denied any wrongdoing. It could, of course, prove its case by opening up its books, but what level of public disclosure should a company be subjected to in order to provide its investors comfort?

The outcome of the SEC investigation at this point is unknowable. After years of deep scrutiny, this particular loan issue strikes me as a particularly thin reed for hanging some larger conspiracy to defraud investors. At the same time, Allied Capital has to have known over the past several years that it's been under the microscope, that there are people who scrutinize everything it does searching for wrongdoing. That the SEC is involved at this point tells me that the company didn't do enough to keep its nose clean even under those circumstances. For shareholders, that small fact ought to be worrying.

Bill Mann does not have beneficial interest in any company mentioned in this article.