Jim Chanos, the famous shortseller who nailed Enron, has been dragged into a Wall Street research scandal, along with Steve Cohen’s SAC Capital.
A suit by Canadian insurance company Fairfax Holdings claims Chanos’s Kynikos and SAC colluded with a Wall Street research analyst to drive down the price of its stock. Both firms vehemently deny this, but they do acknowledge receiving advance notice that the analyst would publish a scathing report on the company. And Kynikos increased its short position in the stock the day before the analyst’s report was published, which will likely be the hardest fact to defend.
Tthe SEC is now reportedly looking into the matter.
Bloomberg and the WSJ have detailed write-ups of the evidence released so far, and we’ve analysed some of the background below. Based on a review of the facts we’ve seen, the case against Chanos and Kynikos is problematic, while the one against SAC is very weak. The risk to Chanos and Kynikos is not “conspiracy to drive the stock down,” which is what Fairfax is trying to prove, but insider trading. Specifically, the charge could be that Kynikos traded while in possession of material non-public information (advance knowledge of the publication of a specific, negative report).
- Analysts are not prohibited from informally sharing thoughts about companies with investors, and investors are not prohibited from trading on information gleaned in those conversations. (If this were illegal, most professional trades would be illegal. Analysts and investors talk about companies all day long.) The only violation here is the specific knowledge that a negative report would be published on a certain day.
- Kynikos had advanced, written information about the impending report, and it increased its short position the day before the report was published, which looks bad. The firm’s lawyer says the firm learned of the report’s publication only after it had made the trade, but this may be hard to prove. (An email proves the firm knew about the report, but it is not clear how and when the firm actually learned about it.)
- The case against SAC looks especially weak: The firm’s lawyer says it was buying Fairfax stock during the period in question, not shorting it. And no evidence has been released suggesting that SAC knew exactly when the report would be published.
The analyst, meanwhile, John Gwynn of Morgan Keegan, has been fired. Sharing advance notice of reports is, if nothing else, a compliance violation.
Kynikos was short Fairfax stock in December, 2002, when the trouble started:
On Dec. 11, 2002, [Kynikos analyst Mark] Heiman wrote his boss Chanos that an insurance analyst at another investment firm told him that Gwynn was going to initiate Fairfax coverage “at ‘underperform,’ with the thesis being that they are extremely under-reserved in the $3-$5 BN area,” according to an unsealed e-mail.
So in early December Kynikos had secondhand info about an impending report (which, by itself, is meaningless). Heiman then talked to Gwynn himself–and, importantly, updated Chanos:
“Just spoke to John Gwinn at Morgan Keegan, and he was more critical of FFRX than I’ve ever heard a sell side analyst,” Heiman told Chanos in a Dec. 16, 2002, e-mail, using Fairfax’s former ticker symbol. “Everything from underwriting to accounting to dishonesty.”
Chanos, on Dec. 18, 2002, forwarded that e-mail to Jeff Perry, then of New York-based SAC Capital, who’s also a defendant. Perry didn’t return a call for comment.
Heiman then got advance, written information about the impending report from the analyst himself:
“Last night John Gwinn at Morgan Keegan faxed over to me an outline detailing the issues at FFH, basically those he will be publishing,” Mark Heiman, then an analyst at Kynikos, wrote in a Dec. 21, 2002, e-mail to Chanos that was filed in the case.
That’s bad… It clearly demonstrates that Kynikos had early knowledge of the report and of what was going to be said. And then the kicker: On January 16, a day that Kynikos increased its short position, Heiman apparently learned that the report would be released the following day.
Heiman wrote Chanos on Jan. 16: “Just got off the phone with Gwynn at Morgan Keegan — his piece that rips FFH apart is supposed to be published tomorrow. Should be interesting to see how the street reacts.”
Heiman’s challenge will be to explain what he meant by “just got off the phone.” Kynikos’s lawyer implies that the conversation took place after the market close, which will likely be important. But there is no denying that Kynikos knew that a report was coming and what was likely to be in it, so the strong inference will be that a tipoff about the timing of publication triggered the trade.
“Kynikos continued to reduce its short position in Fairfax after receiving information in mid-December 2002 about the views of Morgan Keegan’s analyst,” he said. “Kynikos increased its long-standing short position in Fairfax by a modest amount on January 16, 2003, but it did not receive information about the imminent release of the Morgan Keegan report until after the close of trading that day and after Kynikos’s trading on that day had occurred.”
Bottom line: We have seen no evidence of a “conspiracy” to drive the stock down, which is what Fairfax is trying to prove. But Kynikos clearly had information it should not have had, and Jim Chanos knew about it. The question, therefore, is whether this information constitued material non-public information.