The fraud detective

yalealumnimagazine.com /articles/3737-the-fraud-detective

Julie Brown

"International Business Times" has called Jim Chanos 80 the best short-seller in the
world.

On a muggy Thursday in the dog days of August 2011, the news broke that the American technology giant Hewlett-
Packard was about to acquire British software maker Autonomy Corp. The offer price represented a 64 percent
premium on the previous days close. At his office in mid-Manhattan, hedge fund manager Jim Chanos 80 did not
rejoice.

Only a few weeks earlier, his firm, Kynikos Associates, had put together a report on Autonomy, calling its chief
operating officer unqualified, its customers unenthusiastic, its market share and growth numbers questionable, its
financial disclosures very poor, and its margin profile suspiciously high.

We thought this was one of the great shorts of all time, says Chanos, who specializes in ferreting out corporate
bad behavior and then short-selling the companies that indulge in it. (That is, he borrows shares in a company and
sells them at the current price, in the expectation that he will be able to pay back the loan, or cover the short, with
shares purchased at a much lower price when the truth comes out. See boxes, pages 41 and 43.) Autonomy was
the firms largest short position in Europe. So Hewlett-Packards decision to more than double the value of the
company wasand here Chanos laughsvery painful.

Chanos passed along a copy of his Autonomy analysis to a friend who had friends on the board at HP, saying, You
should look at this. This is going to be a disaster. The deal closed anyway, and Chanos was soon shorting HP as
enthusiastically as he had shorted Autonomy. Thirteen months later, in November last year, HP management woke
up, said there were serious accounting improprieties at Autonomyand handed shareholders an $8.8 billion loss
on the deal. (Autonomys ex-CEO denied the charge.) By then, Chanos had already covered most of his short,
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pocketed the profits, and moved on.

You would think that by now financial types would stop to listen when Chanos says Uh-oh. He has been raising the
red flag on companiesfrom the merely troubled to the outright fraudulentfor more than 30 years, often while
corporate executives and Wall Street analysts were still eagerly flogging those companies to gullible buyers. Hes
been pretty much right about everything, says Nell Minow, a leading advocate for responsible corporate
governance. Hes a smart guy. The investments he has shorted constitute a nearly complete chronicle of bad
business behavior in our time. The most famous among them landed Chanos on the cover of Barrons in 2002 as
The Guy Who Called Enron. But the list of his targets stretches from Michael Milkens junk bond empire through
the real estate boom of the late 1980s, the telecom bubble of the late 1990s, Dennis Kozlowskis Tyco and Bernie
Ebberss WorldCom at the turn of the century, subprime mortgage lenders and homebuilders in 2007, and most
recently an entire nation. (China, he says, is on an economic treadmill to hell.)

Chanos has inevitably also been wrong about some companiesor right, but too soon, as with his first go-round on
Autonomy. He has taken losses, sometimes for years on end, that, according to a longtime friend, would make an
average man go out and shoot himself. Even so, he has managed not only to survive but to prosper and put an
exuberant face on a notoriously treacherous line of work. Jim Chanos, International Business Times declared in
2011, is the best short-seller in the world. In certain circles, this is a bit like saying he is the worlds best agent of
Satan. But Chanos turns out to be a more complex character than the labels hedge fund manager and short-
seller might suggest.

I hope you are here, Chanos tells a packed classroom at the Yale School of Management, on a Monday afternoon
in March, for Financial Fraud through History: A Forensic Approach and not for How to Run a Hedge Fund 101.
Hes just flown up from a weekend in Florida. His hair, still sand-colored at 55, sweeps down over his forehead. He
wears thick-lensed rimless eyeglasses and a blue blazer over a purple cashmere sweater, which make him look at
first like an Episcopalian minister gone astray. But he quickly shows himself a confident guide to the topic he will be
covering for three hours once a week over the next eight weeksthe rogues and charlatans who have cheated
investors through history.

Chanos has been teaching this class for three years, starting soon after he mentioned to thenYale president
Richard Levin 74PhD that his fantasy was to come back to New Haven to earn a graduate degree in history. As an
undergraduate, Chanos had been a student of Levins. (He says the only reason I uncovered Enron was because
of what I learned in his class.) Levin countered that Yales fantasy was to have Chanos teach. Then, says Chanos,
Levin heard the course description and joked that hed had second thoughts: He said, Youre not going to teach
them how to commit fraud, are you?

Thats not the plan, Chanos tells the class. But it is almost inevitable that you will come across fraud in the course
of your careers. It has already happened to a former student, whose first job confronted him with a discrepancy that
ended up in the corporation counsels office. Corruption is everywhere in the business world, he warns, citing a
survey in which 45 percent of chief financial officers said their CEOs had asked them to falsify financial results.

The point of the class, Chanos says, is always to look beyond face value and to spot the fudging and the fraud in
time to protect their employers, as well as their own wallets and reputations. Just such a moment of recognition,
early in his own career, set him on a thin line between finding his calling and getting fired.

Chanos grew up in a Milwaukee suburb, in a Greek immigrant family that operated a chain of dry-cleaning shops.
He helped pay his way through college with a summer job as a union steel worker. At Yale, he majored in
economics and political science. His non-academic credentials included lightweight crew and two years as social
chairman at Davenport College, where his roommate, Keith Allain 80, now coach of the Yale hockey team, once
inadvertently slapped a puck through the window of the masters house. (Allain has described his former roommate
as one of those special guys who could light the candle at both ends and never get burned. He had Chanos go
inside to explain the puck.)
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After college, Chanos got his start as a bottom-rung analyst for Blyth Eastman Dillon in Chicago, working 80-hour
weeks at $12,500 a year. It began to dawn on him, he says, that I couldve made more money shoveling snow in
Milwaukee. But when a group of partners split off to start their own firm, Gilford Securities, they took Chanos along.
And there Baldwin-United Corp. entered his life.

Baldwin was a piano company that had transformed itself, by a series of acquisitions, into an insurance giant and
Wall Street darling. When it announced its latest acquisition in the summer of 1982, Chanos got the job of figuring
out if the proposed deal would be good for Gilford clients, among them hedge fund titans like Michael Steinhardt.
And I started looking at this mess of a company and couldnt figure out how they were making money and what
their disclosures were saying. I was just simply calling up people and asking questions and trying to figure this thing
out.

Then one night when he was working late his direct line rang. Is this Jim Chanos? the caller asked. Youre the guy
asking all the questions about Baldwin-United?

Yes, Chanos answered. Whos this?

Its not important who this is.

The caller proceeded to point Chanos to public files of correspondence between Baldwin and state insurance
regulators in Arkansas. Those files turned out to be a beginners guide to financial shenanigans. The regulators had
belatedly discovered, among other things, that Baldwin was improperly using insurance reserves to finance its
acquisitions. Chanos put out his reportsaying, sell Baldwin and sell it shortin mid-August, 1982, the start of what
would become one of the longest bull markets in Wall Street history. Baldwins stock price promptly doubled. So my
sense of timing was impeccable, says Chanos.

Steinhardt and other clients were soon flushing money down the drain on his advice and not happy about it. The
firms New York partner wanted to hand them the 24-year-old analysts head, but the Chicago partner fended him
off. Chanos went home for the holidays feeling miserable about screwing up on his first real job. Then, on Christmas
Eve, the Chicago partner phoned to give him the news: Arkansas had just seized the assets of Baldwin-United.

Until then, Chanos had never felt any predisposition to be a short-seller. But Baldwin was a good early lesson, he
says, because it was painful as heck and I was almost fired, and yet we were sitting on all this evidence that the
market was ignoring. And it was completely accurate and completely predictive. Baldwin developed into what was
then the biggest financial bankruptcy in US corporate history, and the question soon came filtering down from
clients: What else does Chanos not like?

Today Chanos manages his hedge fund out of a not-particularly-grand office in a midtown neighborhood known
more for art and restaurants than for high finance. (Theres also a London office, and for grandeur, Chanos, who
was divorced in 2006, has an apartment on Fifth Avenue and a sprawling shingle-style house on the ocean in East
Hampton, Long Island.) The conference room features a library of financial calamityincluding such titles as
Conspiracy of Fools and A Colossal Failure of Common Sense bookended with bears, not bulls.

Though Chanos doesnt put it quite this way, short-selling goes against some of the most basic proclivities of the
financial marketplacenot to mention human nature and, some would say, God. It is an article of faith among
investors that stock averages rise over the long term, and even market professionals tend to believe that their own
chosen stocks will turn out, like children in Lake Wobegon, to be above average. Moreover, for those who go long
that is, buying and holding stocksthe potential gain is limitless (at least in theory), while the potential losses are
limited: once a stock hits zero, you cant lose any more on it than youve already lost. The really treacherous thing
about short-selling is that it works the other way around. Its the losses that can be limitless. And the agony can go
on for months or even years as a bad company, puffed skyward by a charismatic CEO and a chorus of fawning
analysts, ascends into the stock market heavens.

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Beyond the financial pain, short-selling also exacts a psychological toll. Stock markets are giant positive
reinforcement machines, says Chanos, and theyre built for the sole purpose of selling stocks. So almost
everything is positive, everything is bullish. For short-sellers, that means the rest of the market is constantly
shouting (sometimes literally and in the most personal terms) that they are wrong. And studies show that peoples
rational decision-making breaks down in an environment of negative reinforcement, says Chanos. Good short-
sellers drown it out. It means nothing to them. But I think most people cant do that.

Chanos got his first public taste of the corporate worlds ill will in 1985, when the Wall Street Journal ran a front-page
article about, as he puts it, this cabal of evil short-sellers. Corporate executives and investors told the Journal that
Chanos epitomizes all that is wrong with modern short-sellers. The article alleged that Chanos and his ilk
sometimes resorted to innuendo, fabrications, and deceit to batter down a stock. Chanos denied any wrongdoing
and otherwise shrugged it off, telling the Journal: People think I have two horns and spread syphilis.

Soon after, Chanos and a partner put together $1 million of their own capital and $15 million from a single client to
form Kynikos. The name came from the Cynics, philosophers in ancient Greece who stood for self-sufficiency,
mental discipline, and proper judgments of value. Less conveniently, the Cynics also stood for poverty. One of them
lived in a tub on the street. After a year of watching the stocks they had shorted rise in the continuing stock boom,
Chanoss partner couldnt stand the negative reinforcement. He offered to sell his share for $1 so he could write off
the tax loss and sleep at night. Chanos took the dollar bill out of his wallet on the spot. The crash of 1987good
news for short-sellerscame soon after. It was the best purchase I ever made, ironically, says Chanos. He jokes
that the ex-partners wife still wants to kill him over it.

Kynikos went on, however, to lose almost everything as the markets recovered in the first half of the 1990s. Clients
defected, the firm was on the brink of collapse, and Chanos was paying staff out of his own pocket, while also
supporting four young children. He eventually reorganized the firm with his original clients and devised a
compensation scheme that took overall market movements out of the calculation. Today, Kynikos has $5 billion
under management.

The peculiar chemistry that enables Chanos to handle the stress is largely a mystery, even to him. Good short-
sellers have something in the DNA, he offers. Or maybe we were dropped on our heads as babies. His friend
James Grant, publisher of Grants Interest Rate Observer , quotes Bernard Baruchs line about a celebrated
financier being all nerveand no nerves. Its maybe not an absence of certain feelings, but an ability to set them
aside. To blow off steam, in the 1990s Chanos started playing basketball, working out, and lifting weights. (He says
he bench-pressed 340 pounds last year, but is down to 310 at the moment.) When his gym on the Upper East Side
was going bankrupt, he bought the place and now runs it at a slight loss.

Another factor may be his sense of himself as a Wall Street outsider. This may seem improbable, given his wealth,
his longtime position as board chairman of a coveted Upper East Side private school, his frequent appearances on
CNBC, and his many Yale connections. But until the late 1980s, Chanos was probably the only hedge fund manager
who was also still a dues-paying member of the Pipefitters and Boilermakers Uniona holdover from his summer
job in college. He also often talks an anti-management line, and not just because hes shorting a companys stock.
In 2011, he spoke out in defense of the Occupy Wall Street movement: People are angry, he told a reporter. They
feel the game is rigged, that they didnt get their fair shake.

His sense of moral outrage at financial chicanery has at times trumped his political loyalties. Chanos is a frequent
contributor to Democratic candidates. (A right-wing website recently dubbed him the presidents billionaire playboy
bundler.) But when Attorney General Eric Holder commented early this year that bringing criminal charges against
some large companies is difficult because it might hurt the economy, Chanos lashed out, saying too big to jail
would aggravate public mistrust of the markets. Then he declared that the last time the justice department showed
real leadership on corporate crime was when it put away executives from Enron, Tyco, and WorldComunder
Attorney General John Ashcroft 64, who served in the second Bush administration.

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in his class, Chanos constantly nudges his students to challenge established opinion. When one of them remarks
that a scandal-ridden firm had a reputable auditor signing off on its reports, he says, They all have reputable audit
firms. Thats one thing I want you to take away from this course: every big fraud had a great audit firm behind it. He
likens auditors and government regulators to archaeologists. Theyll tell you what happened after the damage has
been done.

What Chanos tries to teach is how to predict the damage: look for tip-offs, look for patterns of bad behavior that
repeat from one scandal to the next. Unlike some other hedge funds, Kynikos boasts no ingenious market model,
no trademark quantitative analysis. Instead, Chanoss brand of short-selling typically comes down to basic financial
detective work. He seems to rely largely on a heightened instinct for bad behavior, a willingness to follow up with
phone calls and legwork, and an inordinate appetite for hieroglyphic footnotes and disclosures buried deep in
corporate 10-Q and 10-K reports.

Chanos also routinely invites analysts and other interested parties to lunch in the conference room at Kynikos. This
is mostly to persuade them that the bad news he has dug up is accurate; if theyre convinced, his short-selling is
more likely to succeed. But also, says his friend James Grant, really successful investors, including Jim, make it a
point to be open-minded and seek out opinions, all in the interest of knowing everything they can about a situation.
Chanos, he adds, would have made a good investigative reporter, if only journalism paid as little as $25 million a
year.

As in journalism, good stories like Enron have often started with a seemingly trivial item in the news. In September
2000, an accounting column by Jonathan Weil in the Wall Street Journal noted that Enron traders were signing
energy contracts that would deliver income over a standard 10- or 20-year term, but booking them as if the total
anticipated profit were already safely in the bank. Enron was then one of the hottest stocks on Wall Street, but
incredibly the item ran only in the papers Texas regional section.

A friend sent a copy to Chanos, and the mark-to-market accounting instantly caught his attention, partly because it
echoed one of Baldwin-Uniteds favorite tricks. Chanos spent hours that weekend circling questionable items in
Enrons SEC filings. What mostly interested him were a few simple numbers available to anybody who took the time
to look: the companys ostensibly brilliant managers were earning just seven percent a year on capital that was
costing them more than ten percent to borrow. Enron was bleeding itself dry.

Kynikos began shorting the company in November, when the stock was at about $60. Then Chanos exhibited the
cabalist behavior that has gotten him labeled as a company-bashing trafficker in innuendo: he spoke to the press.
(And you know, Chanos once mused to an interviewer, there are ten thousand highly paid analysts and investment
bankers and PR agents who are out shilling for corporations all day along and no one seems bothered by that.) In
January 2001, when Enrons stock was at $80, a young reporter named Bethany McLean phoned up scrounging for
story ideas, and Chanos told her what he knew about Enron. The resulting article, published in Fortune magazine
that March, began to gently pull apart the loose threads of the Enron rats nest.

There was no way to know then that this was a fraud, Chanos tells his students at SOM. All he had was a
suspicion that the company was overstating earnings. But over the next few months, the whole sordid tale emerged.
It had all the telltale signs of ethical collapse that make up the theme of his class: the larger-than-life CEO (Jeff
Skilling was still posing manfully on magazine covers as late as that February), the weak board of directors, the staff
of loyal youngsters, the culture of fear, the conflicts of interest, the willful ignorance, and the willing suspension of
disbelief by investors caught up in Enron euphoria.

For Chanos, there was a great postscript, he tells the class. A me-too company called Dynegy tried to buy Enron
as it was spiraling down to bankruptcy. Someone said, Have you looked at Enrons books? And Dynegy said,
Thats the good news. Weve looked at the books and their accounting is exactly the same as ours. I backed up the
truck on Dynegy at that point. We made as much on Dynegy as we did on Enron.

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And at that moment, you can begin to see why Wall Street insiders might just hate Chanos, why they might publicly
praise him as a hero and privately wish him to be caught in a very bad, possibly terminal, short squeeze. You can
even understand why ordinary investors, standing over the $62 billion black hole that used to be Enron, might
sometimes share these misgivings. Revealing the ugly truth, while making lots of money at it, isnt necessarily a
great way to win friends.

But that evening at Pepes, where he regularly takes a group of students out for beer and pizza, Chanos is looking
ahead, not back. There are other SEC filings in need of careful scrutiny, other companies to short, other forms of
corporate entitlement and bad behavior to stoke his sense of outrage. The idea that he might give all this up to go
back to Yale for a graduate degree in history is just a fantasy. Right now, he is too busy burning the candle at both
ends, and still not getting burned.

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