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Fiduciary Duty to Cheat? Stock Market Super-Star Jim Chanos Reveals the Perverse New Mindset of Financial Fraudsters

American business has always had cheaters and crooks, but today they are escaping prosecution and are incentivized to cheat more.

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LP: You’re known for your early detection of Enron’s problems. How does a company like Enron stay in business for years? How is the fraud sustained over time?

JC: It’s one of the great questions, Lynn, and I think that in the case of Enron, there were a lot of people getting rich aiding and abetting what turned out to be to be a fraud. They may not have known it was go-to-jail fraud, as it turned out to be (and most fraud certainly does not end up in jail sentences for the perpetrators, as we know).

But if you look, for example, at the investment banks that were in on structuring the offshore vehicles that Andy Fastow used to offload bad investments from Enron the parent to these vehicles without telling Enron shareholders that he’d also given them a secret agreement that they would made good any losses by issuing Enron stock (that, by the way, was the crux of the fraud of the firm), when you see just how much in fees a lot of the banks and brokers made in these things, there’s an awfully strong incentive to look the other way and not ask the tough questions. That’s really one of the big flaws, I think, in our current market structure.

LP: What do we know about the timing of frauds? When are they most likely to happen?

JC: One of our models is the Kindleberger-Minsky model, named after Hyman Minsky and Charles Kindleberger. It’s a macro model, and basically it takes a look at various market cycles. What we find is that the greatest clustering of fraud in the financial markets occurs, as you might imagine, during and immediately after the biggest bull markets. As I like to tell my students, it’s basically a period in which people suspend their disbelief. Everybody’s getting rich and it becomes increasingly easy to sell more questionable schemes and investments to investors. Typically the major frauds are uncovered or unmasked after the markets decline, for example, Bernie Madoff or Enron, when investors need money from other losses (and often these things have a Ponzi-like nature and can’t finance themselves from a self-sustaining basis) or people simply begin to build back their sense of disbelief and begin to ask tough questions that they didn’t ask during the bull market. So we do see that the fraud cycle generally does track the broader financial market cycles we see with a little bit of a lag.

LP: One look at your Yale syllabus shows that fraud has been rife through business history. Yet for the last 20 years, many people have insisted with near-religious conviction that markets are efficient and therefore resistant to fraud. Where is this belief coming from, and why is it a problem?

JC: It rests upon an assumption that is deeply flawed, and that is that the people who are stewarding your capital in the marketplace -- the boards of directors and the people that the boards hire – management -- are acting not only in your best interest, but are playing by the rules all the time, so that, for example, the accounts that the company puts together for the accountants (and keep in mind, management prepares financial statement, not accountants, not the auditors) are accurate. The auditors simply review them, and that’s an important point I always stress to my class. If there are games being played, and if you read the boilerplate of any auditor’s opinion, it says “we rely on the statements of management” – and so if, again, the people in the corporate suite have ethical flaws, we have a system based on truth-telling that may not be exactly always accurate.