Jim Chanos, Steve Cohan Caught With Potential Dirty Laundry

Submitted By Trader Mark
You always wonder what exactly is going on behind closed doors in the nether regions of the investing world... with our SEC clearly shown as an inept organization, the few things we find out make us ask the question: what is happening out there that we never catch or hear whispers about? One can only imagine.

Both the Wall Street Journal and Clusterstock weigh in on a potential scandal involving 3 of the largest names in hedge fund world - noted short seller Jim Chanos, Third Point's Daniel Loeb, and SAC Capital's Steve Cohen. Loeb is already under fire

Third Point Management fund manager Daniel Loeb told his investors last night the firm is the target of a formal investigation being conducted by the Securities & Exchange Commission. According to Loeb, the subject of the investigation is his communications with other hedge funds.

While (if true) this would be an egregious misuse of an analyst report before it hit the Street, I don't think something like that would be "too common". What I really wonder about is how many "innocent phone calls" happen among the big guys to allay forces against ABC stock. (which is what the Loeb investigation from last year is about) It is very easy, especially in the small cap stock world, to see "outsized" moves - which trigger technical traders to jump in - and a pattern can self reinforce itself; obviously much easier to create downside than upside. But in theory there is nothing illegal about making phone calls or "sharing strategy". So let's see what the latest story is emerging in the Wild Wild West atmosphere of our markets.

WSJ: SEC Looks at Hedge Funds' Trades

The Securities and Exchange Commission is investigating whether several hedge funds traded improperly after being given advance notice by a research analyst of his negative report on a prominent insurer, people familiar with the agency's investigation said. That case, filed in a New Jersey state court in 2006, unearthed documents indicating that executives at the hedge funds discussed the coming report of the analyst and made bets that the company's stock would decline.
Companies routinely bar analysts from distributing reports to investors before publication to prevent the trading of nonpublic information. Analysts who give out information that isn't public but is market-moving and violates company policy can violate the securities laws. It also is improper for investors to trade using information that they know they've received improperly.
In the civil suit, Toronto-based Fairfax alleged that the hedge funds, the analyst and his firm conspired to profit by driving down the company's stock, which is listed on the New York Stock Exchange. The suit alleges that SAC Capital Advisors, Third Point LLC, Kynikos Associates LP and others acted together, paying the analyst, his investment firm and other defendants in the suit to spread false and defamatory information about Fairfax from 2002 through 2007.
At issue in the civil suit and the SEC investigation is a research report by analyst John Gwynn of Morgan Keegan Inc., a Memphis, Tenn., investment firm. Mr. Gwynn initiated his coverage of Fairfax on Jan. 17, 2003. His report said Fairfax was $5 billion short of the reserves it should have been holding to cover potential insurance claims, and rated it "underperform." It also said the company's strategy of acquiring troubled property and casualty insurers had backfired, saddling the company with assets that would have to be written down, potentially erasing most of shareholders' $2 billion of equity in the company.
Fairfax's shares fell 13% the day Mr. Gwynn's report was released and slid to a two-day loss of 20% the next trading day, closing at $59.30. (Fairfax's stock closed Thursday at $318.11 a share.) Mr. Gwynn issued a revision 13 days after the original report that reduced the reserves shortfall to $3 billion.
Morgan Keegan, a subsidiary of Regions Financial Corp., fired Mr. Gwynn in August 2008 for what it claims was the advance disclosure of the timing of the report and what his recommendation would be, the company said.
Documents in the case reviewed by The Wall Street Journal, primarily emails and instant messages submitted as exhibits by Fairfax, show that some of the hedge funds knew of Mr. Gwynn's report more than a month before it came out. On Dec. 11, 2002, a Kynikos Associates executive wrote the hedge fund's founder, James Chanos, saying he had heard from another hedge fund that Mr. Gwynn was going to issue a research report rating Fairfax stock "underperform" and warning about a reserves deficiency, according to a court exhibit.
A week later, Mr. Chanos forwarded an email to Jeffrey Perry at SAC Capital Advisors, a New York hedge fund founded by Steven Cohen. The email, written by another Kynikos employee who said he had talked to Mr. Gwynn, said the analyst "was more critical of [Fairfax] than I've ever heard a sell side analyst ... everything from underwriting to accounting to honesty," according to a court exhibit.
On Jan. 16, 2003, a Kynikos executive wrote Mr. Chanos, saying he had just talked with Mr. Gwynn. "[H]is piece that rips FFH [Fairfax] apart is supposed to be published tomorrow. Should be interesting to see how the street reacts," he wrote, according to a court exhibit.
Trading records obtained by Fairfax through discovery in the lawsuit show that Kynikos put on a $5 million "short" position, or a bet against Fairfax shares, in the month after Mr. Chanos learned of Mr. Gwynn's report, including $2.5 million the day before the report came out.
On Jan. 14, three days before the release of Mr. Gwynn's report, an SAC Capital executive sent an internal email to Mr. Cohen and others, outlining coming events for that week, according to a court exhibit. One line read, "Morgan Keegan expected to launch on Fairfax with Sell rating -- we will be covering into this." Fairfax contends that SAC locked in gains as the stock got hit in the wake of the report.
Trading records also show that another defendant in the civil-court case, hedge fund Third Point, shorted $1.5 million of Fairfax shares the day before Mr. Gwynn's report was issued.

From Clusterstock...

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.

I'm sure it was just "coincidence".

If true, these alleged charges are damning. Very. However, I am sure it will be explained away by lawyers as a gray area that is not "a bad thing". Slowly but surely the curtain is being pulled back on the Wizard of Ozes. And any "small guy" confidence in the integrity of our markets, eroded even further.

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