How widespread is corporate fraud?

Bernard L. Madoff smiles on Dec. 17, 2008, in New York. Don Emmert/AFP/Getty Images

(MoneyWatch) Whenever a major corporate scandal is uncovered, we are regularly told that it is the exception, not the rule. Whether in the case of Bernard Madoff or the smartest guys in the room over at Enron, the 'bad apple' argument crops up, suggesting that a few corrupt people distorted a fundamentally honest marketplace. That is almost certainly a na»ve and ignorant hope; Jim Chanos thinks fraud is to be found in 10 to 15 percent of public companies.

Chanos, the short seller made famous by his exposure of Enron, teaches at Yale and argues 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."

Chanos isn't basing this view on pure theory: He cites a 1998 Business Week survey in which 55 percent of chief financial officers said they had been asked by their bosses to falsify financial statements but had refused. Another 12 percent said they had agreed. In only one third of companies had financial officers not been asked to misrepresent the firm's financials. And that was in the relatively temperate 1990s.

Management, Chanos says, has profound incentives to manipulate earnings to their advantage. And the Justice Department appears concerned about the potential systemic impact of aggressive fraud prosecution. Just think what that really means: if fraud isn't going to be aggressively prosecuted, then at what point does it just start to look like creative business leadership? And if it generates big payouts to shareholders and executives, what's to stop them?

Chanos argues -- as you would expect -- that short sellers and journalists are the only really active investigators of what companies are up to. That shouldn't make any of us sleep better at night. Serious journalists are thin on the ground these days and the budgets for investigative research shrink daily. That leaves just the short sellers. And although I'm a very big fan of Mr. Chanos, the idea that our markets depend on him scares me -- and I suspect it scares him too.

  • Margaret Heffernan On Twitter»

    Margaret Heffernan has been CEO of five businesses in the United States and United Kingdom. A speaker and writer, her most recent book Willful Blindness was shortlisted for the Financial Times Best Business Book 2011. Visit her on www.MHeffernan.com.

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