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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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I point out to my class that in 1998 there was a survey -- Business Week (which is owned by McGraw-Hill) and McGraw-Hill (which also owns Standard and Poor’s) had a conference for the S&P’s 500 chief financial officers. They asked these chief financial officers if they’ve ever been asked to falsify their financial statements by their superior. Now, the chief financial officer’s superior is the chief executive officer, or the chief operating officer—basically the boss. It was a stunning—of course anonymous – survey. 55 percent of the CFOs indicated they’d been asked, but did not do so. 12 percent admitted that they’d been asked and did so. And then 33 percent said they’d never been pressured to do that. In effect, only one third of the companies in the S&P’s 500 at that time did not have a CEO or COO try to pressure their financial officer to falsify financial results.

So this is agency risk writ large. Investors need to know that. They need to know that an awful lot of games are being played with the numbers and with disclosure and they’ve got to be on their guard. As Tony Soprano once said, as he exhorted his minions to redouble their efforts in the rackets, “We don’t got one of these Enron things going.”

LP: How much of the American economy do you think is built on fraudulent business models? How do we compare with other countries?

JC: Surveys have been very consistent –anonymous surveys of CFOs -- and we’ve seen it in some other data we present in our class from various global entities. It appears that incidents of fraud in publicly traded corporations (globally) is somewhere in the order of 10-15 percent of the companies.

Now, that does not mean they’re all Enrons. An awful lot of fraud is, well, I didn’t reserve for bad debts and my earnings were overstated for a few quarters but then we reversed it later, and it’s probably not go-to-jail-type fraud. But it is misrepresenting numbers to the marketplace and to investors. And I think that you can still lose money if it gets revealed when you own the securities. So investors do have to have a healthy skepticism even when it comes to reasonably well-regulated markets like the U.S. and the U.K., because there are incentives, given the stock option-type compensation or the bonuses based on profitability. It gives management an awful lot of latitude to play games with accounting.

LP: Let’s talk about bubbles. Being mistaken or overly excited isn’t fraud. How do you distinguish investor euphoria from fraud? What’s the role of fraud in creating and sustaining bubbles?

JC: If we look at the recent global financial crisis, a lot of people say: why were there no prosecutions? One of the first sort of default defenses you heard over and over again is well, stupidity is not a crime, and making bad decisions is not a crime. It may certainly lead to grievous losses, but that’s the marketplace. And I agree with that 100 percent. The problem is that financial crimes, unlike crimes of passion and crimes of opportunity, come with their alibis already built in.  You build a veneer of legitimacy about what you’re doing. You get accountants to sign off on what you’ve done. You don’t look at any emails or get sent any emails –- at Enron Jeff Skilling never saw any emails (so how do you run a global trading powerhouse and never use email, right?).  We teach this legal concept called “willful blindness,” and that is, in some cases senior executives are cut out intentionally from controversial things because they don’t want to be able to say, well, I approved that or I saw that. Someone below them is compensated quite handsomely for taking the fall, if you will.