Chapter Four

Fraud for Thought

Where there is greed, ignorance, and a great deal of money, fraud can't be far behind. Investment scams are becoming the fraud of choice for many con men, con women, and gangsters as consumers are gradually becoming more aware of other scams such as free trips and phony sweepstakes.

The press keeps feeding anecdotal evidence to the public of young kids and old ladies who, with a little ingenuity, have made it big in the stock market. Neighbors and friends tell friends and neighbors how they have been making 35% a year on their mutual funds with little risk over several years. People who have missed that boom, often the less financially sophisticated, feel the need to catch up, and thus become perfect targets for fraud. But it can happen to sophisticated investors as well.

Several books could, and should, be written about how, and how often, individual investors fall prey to fraud perpetuated from some very unlikely quarters. The

SEC website is full of people or companies caught scamming investors, but the public appears to be unaware, or unwilling to believe that fraud in the financial circles is prevalent, the regulators sometimes work against the individual investors interests, and the laws are either inadequate or to hard to enforce. Individual investors are

1 complacent; they prefer to believe that someone is looking out for them (auditors, the

Congress, government agencies, law enforcement agencies, the SEC or NASD Dealers

(National Asssociation of Securities, the private-sector overseer of the securities industry).

If investors look at NASD, they will find that with only 2000 employees NASD oversees 5,160 brokerage firms, 108,685 branch offices, and 663,938 registered security representatives—also known as stockbrokers. Since, 1990 the number of brokers has increased by 58%, and since 1992 the number of disciplinary actions has increased by

53%1. In 2004 alone, NASD conducted 8,000 arbitrations and 1,000 mediations, between stockbrokers and investors. The task is daunting if not overwhelming.

The general public tend to forget that the stock market is a multi-trillion dollar business and hence a very lucrative avenue for criminal elements and unethical individuals. It is so lucrative that no amount of policing can provide full deterrence.. If the government has not been able to stop theft, gambling, and drug trafficking, one can only conclude that no amount of policing will stop all investment frauds. In some cases it may be possible to avoid falling prey to the scam, but only with due diligence and with incorporating into our core values the belief that “There is no free lunch”.

In this chapter we will present a sampling of the types of schemes which have victimized individual investors.. Some of these schemes work due to the lack of due diligence from the investors who preferred to believe outlandish claims, due to what appeared as high moral ground of the criminal, the analysts, the auditors or the companies. Other schemes are so well concieved that no amount of homework can protect individual investors, professional investors, banks, and investment houses.

2 Indeed we can only scratch the surface of the myriad of schemes that have been hatched on the public. The criminal mind can be very creative and adaptive to new technologies, or new laws.

The most well known financial fraud scheme is the old Ponzi scheme, named after the infamous Mr. Charles Ponzi who, in 1919, moved from Italy to Boston via

Canada. Ponzi offered 40% to 100% returns in 3 months by buying postal coupons in one country and selling them in another. The press actually disposed of its duties well in this case (unlike the press in the leading scandal of current times– the US savings and loan debacle) and pointed out that given the size of funds under Mr. Ponzi's

"management", there weren't enough postal coupons in the world to support his scheme.

The Boston district attorney then got into the act and found out that against the $10 million he had taken in from investors, Ponzi had only bought $30 of postal coupons!

The way the scheme worked was that money from later investors would, in addition to supporting Mr. Ponzi's lifestyle, finance the returns promised to earlier investors, who would then unwittingly aid the scheme buy telling friends and acquaintances that Ponzi had indeed delivered on his promises. In other words Ponzi would take say $1000 from 10 new investors, give say $300 to three old investors (who had invested $100 each and thus made 100% returns in three months) and Charles would pocket the $700 difference. The three investors would then swear (truthfully) to all their friends that they had indeed gotten a phenomenal 100% return in three months. Being good and upright citizens they would attract more investors still.

As long as the number of investors keep growing this type of (illegal) scheme works well. As soon as no more new investors are sucked in (because they read the

3 articles in the press, or run out of disposable income, or get smart, or for whatever other reason) there will be no money to pay off the old investors and the whole scheme unravels and the Ponzi pyramid collapses.

Ponzi himself went to jail for a while, and then sold swampland in Florida before being deported to Italy. Yet his scheme was so simple and brilliant that it has made his name immortal, and today it is still used in countries all across the globe: new money from recent investors propping up the value of the investments of earlier investors. In fact, it describes aptly how the stock market works when it is in a mood of euphoria and takes leave of its senses and of fundamental valuations.

Consider the following examples of modern day Ponzi schemes:

Fairfield Investments of Dallas promised compound returns of as high as 160% per year on first and second mortgages. Mortgage rates between 1992 and 1996 were below 10% and so somebody should have been suspicious. Still the company raked in about $56 million from over 3500 investors before it stopped operations consenting to a

“cease and desist” order from the SEC without admitting or denying guilt:2

Ponzi schemes can be dolled up to look very respectable and genteel. Take the case of the Foundation for New Era Philanthropy. Based in Radnor, Philadelphia it collected millions of dollars from prominent non-profit groups, including universities. It promised that it would double their money by matching contributions from wealthy, anonymous donors. Leading philanthropists and donor, many from Wall Street, also gave their funds to New Era hoping it would double their money for them with matching contributions from anonymous donors. The problem was that there were no anonymous donors. New Era was a classic Ponzi scheme. When the scheme unraveled, John G.

4 Bennett Jr., New Era's founder was charged with 82 federal criminal counts. But he is not the only person to get into trouble over New Era.

The foundation's bankruptcy trustee and almost three dozen other charities that had been defrauded by New Era $160 million sued the well known financial powerhouse

Prudential Securities Inc., which held a large part of New Era's assets. The trustee claimed that Prudential had overlooked obvious signs that the charity was fraudulent out of a desire to earn commissions and interests.3 Prudential Securities paid $18 million to settle the various lawsuits arising from its involvement with New Era.

In what the FBI termed the largest pyramid scheme in U.S. history, Bennet

Funding Group, once the pride of Syracuse, NY, sold phony leases, according to the

SEC, and used fraudulent financial statement to sell $150 million of promissory notes.

Massively insolvent, it addressed its problems by selling the same leases (usually leases of equipment to governments) over, and over, and over again, and it would sometime pledge the sold lease as collateral for loans as well. By the time the scheme was uncovered, Bennet Funding Group was accused of defrauding 12,000 investors for a total of $700 million in 46 states.

Elderly and conservative investors were among the victims but so were 200 banks, plus casinos, and hotels. To achieve such an impressive result the individuals indicted in relation to the scam had resorted to conspiracy, securities fraud, mail fraud, bank fraud, money laundering, and topped it off in a cover up that included perjury and obstruction of justice.4

The government got in the case, and retrieved $205 million from the company, which it disbursed, not as you would expect to the small investors who had lost their life

5 savings, but to the banks.5 As for the Bennett group, in addition to spending their ill gained money to obtain a lavish lifestyle, and to pay off early investors in the pyramid scheme, they used it to heavily invest in gambling properties and lost their shirt in every one of them.6 There is always a smarter shark waiting in the wings.

Pyramid schemes are certainly not limited to the United States or even to countries with a long history of financial entrepreneurship. In 1994 huge numbers of

Russian lost their savings in a variety of pyramid schemes, the most notable one was carried out by a company called MMM, named after its founders last name initials:

Sergey Panteleevich Mavrodi, Vyacheslav Mavrodi and Maria Muraviera.. Between mid-1993, and July 22, 1994 MMM collected as much as $1.5 billion from two million investors. Through aggressive and effective TV ads and word of mouth news that the company could return up to 1,000%, the company was able to attract new investors that paid the current ones. In July 22, 1994 the police closed the offices of MMM for tax evasion and stopped MMM from continuing to deceive its investors or recruit new ones to pay for current ones— to whom it was estimated to owe between up to $1.5 billion.

In the aftermath, at least 50 of its investors committed suicide.

In 1997 MMM declared bankruptcy, but Sergey Mavrodi, one of its founders, with the help of a distant relative in the US went on to create a similar scheme in the US under the company Stock Generation Ltd. The company created an internet site where one could trade non-existent companies' stocks in a form of the "stock exchange game".

A bold-letter warning on the main page stated it was not a real stock exchange, but this did not stop between 20,000 and 275,000 people to invest in the scheme. By the time

6 SEC caught up with the scam, these investors had lost approximately $5.5 million.

Finally, in 2003, Sergey Mavrodi was found and arrested; His criminal case consisted of

650 volumes, each 250-270 pages long. As of 2005, he remains in custody7.

In addition to MMM, Russians were also victimized by their own government. In

February 1993 the government issued short-term bonds called GKO which the state defaulted on in 1998.

In 1997, two-third of Albanians had invested in a Ponzi scheme. In fact, at its highest valuation the scheme’s liabilities amounted to almost half of Albania’s GDP.

When the scheme finally collapsed due to lack of cash, the whole country was thrown in chaos: the government fell, many citizens lost their savings and their homes, universities were burned, and around 2000 people were killed—in the violent, near civil war atmosphere ensued.

In 1997, a ring made up mostly of Russian émigrés and led by a 30 year old

Russian named Alexander Shindman, operating out of Boca Raton Florida, were charged with running a boiler room, also called chop shop, operation to sell the stocks of an internet service provider called the Globus Group Inc., which actually provided no such services and was just a shell company. Investors were told, among other fancy fabrications, that Globus had won a $12 billion suit against AT&T. Meanwhile the share of Globus rose from 25 cent to $8, which allowed the gangsters to sell the shares they secretly held for a tidy profit. Gangster is the right word because they intended to hire a hit man from Canada to kill individuals who were trying to blackmail them out of

7 a part of their ill gotten gains. The murder plot lead investigation to eventually uncover the financial fraud—800 investors lost on average between $6 and $10 thousands each..8

Another type of scam involves surreptitiously taking over the stock of a publicly traded company, then inflating its value, and selling the stock at a significant profit. An example of this is the case of Comprehensive Systems Inc. of Brooklyn, N.Y. and Alter

Sales Co, a Florida auto parts company. A convicted bank fraudster and a convicted drug trafficker, a former SEC lawyer, and the chief operating officer of Comprehensive, to name a few, dominated the target companies and had them begin issuing stock to fake companies around the world. These companies supposedly rendered services to the target companies, but no such services were actually performed.

The phony companies were a vehicle for the ring to control the companies surreptitiously. The ring then went on to pay $60,000 plus 20,000 shares of Alter to an unnamed individual to arrange television stories on the two companies. Illegal bribes were also paid to brokers to push the companies stock on investors, hundreds of whom lost a lot of money, according to Mark Pressler, assistant U.S. Attorney in Brooklyn.

The charges stemmed from an investigation of Dan Dorfman who was then a leading financial commentator for CNBC. Mr. Dorfman was not named in the indictment and a

CNBC spokesman said CNBC conducted its own probe of Mr. Dorfman and found no evidence of wrongdoing. In the end six men, including the former SEC lawyer were indicted in relation to the scheme.9

When it comes to your investments, you should do due diligence research, and you should not blindly trust anybody and that includes people who have garnered the public trust.

8 A case in point is Irwin Sonny Bloch. Sonny Bloch was one of this country's most trusted investment advisers and the leading radio financial talk show host. His show was broadcast over 200 radio stations six times a week. He was the author of six financial books. People flocked to his seminars to hear him dispense financial advice.

He was characterized by such words as "wise uncle", "straightforward", "home spun".

You know, the same warm and fuzzy feeling the Sunday TV news magazines give you.

You can't get more credible than that.10 And he turned out to be a crook.

He bought three fading radio stations for a total of $1.3 million. In 1994 he began selling 25% of those radio stations through promotions on his daily radio show.

People flocked to buy a piece of the radio business owned by Mr. Radio Financial

Advice. He sold the 25% share of the radio stations through what he termed

"membership in limited liability companies" for $3.8 million or about 11.5 times what he had paid for it--nothing illegal in making a killing from gullible people. But Sonny refused to register the memberships as securities with the SEC. So the SEC, under Dan

Schippner, senior trial counsel of its enforcement division and its examiner Darleen

Solebello began investigating him, even though in such cases the SEC had historically been very careful for fear of violating the media person's First Amendment rights.

Sonny didn't show up for his SEC interviews. Instead he feigned rage, and ranted against the SEC. His radio station vouched for his innocence, his advertisers stayed with him, and, most importantly, his audience trusted him as much as ever.

However, Dan Schippner, and Darleen Solebello, continued their investigation. They followed the money trail: from the investors to Bloch accounts, and from there to the

9 Dominican Republic, to condos in Florida, and to personal legal bills. Sonny feeling that his scam would be soon exposed fled the US.

He went to the Dominican Republic where he started broadcasting his show. He greeted his listeners "from the mountains of the Dominican Republic" and called himself

"America's only broadcaster in constitutional exile". He still reached millions of

American who listened to him rave against the federal authorities' "persecution" and

"Gestapo tactics".

The U.S attorney in Newark, New Jersey brought a 35 count indictment against

Uncle Sonny after the SEC gathered enough evidence. He was not only indicted for the radio stations scheme, but also for a wireless cable scam, and for referring unsuspecting investors, many of them elderly who had place their life saving with him, from one scam to another so they could be taken for a second time. To be precise, he had defrauded the people who had put their faith in him out of more than $21 million.

Finally, on May 26, 1995 Dominican police arrested and deported him to the

United States. In April 1996, the SEC obtained a default judgement against him for the amount he had defrauded the radio stations investors. Unfortunately, it was unclear SEC would get its hands on the money: The radio stations were unprofitable or dormant or not under Bloch's legal control and Sonny had pleaded poverty, and thousands of investors were suing him in civil suits11. In 1998 after going to prison, Sonny Bloch died of Hepatitis C.

10 Sometimes choosing financial advisers without checking them properly can be detrimental to ones financial health. The story of Ms. Michael Kostoff , a retired teacher in St. Augustine FL illustrate this point “properly”. In 2004, Ms. Kostoff gave her

$114,000 nest egg to Mr. Vincent Cervone, a financial adviser recommended by her brother-in-law, a doctor. Instead of putting her money in a safe investment vehicle, Mr.

Cervone invested Ms. Kostoff’s money into highly speculative micro-cap stocks. The result was a total loss of her money, and a gain of $19,000 for the brokerage firm.

Fortunately for her, NASD arbitration panel rules against the back-office work for the brokerage and was able to retrieve not only her initial investment but also additional punitive damages12. In the SEC jargon the fraud on Ms. Kostoff was a form of unsuitability—the financial adviser put clients into a trade that is not suitable for their financial standing, knowledge, objectives, risk tolerance.

You cannot and you should not expect the SEC to police all the advisers. There are just too many advisers. To be precise, there are 11.000 registered advisory firms, and

173,000 registered advisers from which only 48,000 are certified financial planner.

Unlike, what you may think, individual, or firm managing less than $25 million are registered with the local state not the SEC. You can check on the standing of the 10,000 advisers, or the approximately 8,300 mutual funds that are registered with SEC at www.sec.gov under “Check Out Brokers and Advisers”. However, to be registered only means that one understands and abide to the laws and regulations that the government or

SEC have implemented, it does not mean that one is good at providing advice,.

Investment scams can be very sophisticated and no one is immune, not even the top investment management firms. An excellent illustration of this is the Bre-X case.

11 Bre-X was involved in the biggest gold-mining scam in history, a scam that required great technical and scientific sophistication and which managed to fool hardened investment managers and geologists.

Bre-X was an unknown publically traded Canadian mining company with a track record of only nine years and a stock that was trading for a few pennies a share. In 1994 it announced that it had struck a great lode of gold in a very remote jungle in Indonesia.

It estimated of the lode at 2.5 million oz. It gradually raised this figure to an eventual

200 million oz., or about $70 billion worth of gold.

The investors came in droves; As a result the shares of the company raised from pennies to over $20 a share. After all venerable investment bank J.P.Morgan was an adviser to Bre-X. Blue chip Canadian dealers like the Bank of Montreal's Nesbitt Burns,

Inc. were strongly recommending the stock. The stock was listed on the TSE 300,

Canada's main stock index. The company became the 30th largest corporation in

Canada. The country's 10 largest brokerage firms recommended it. The well known

U.S. mining firm Freeport-McMoRan Copper and Gold was ready to invest $1.2 billion to develop the mine; Fidelity Investment was Bre-X's largest investor through over a dozen of its funds, with a holding in December 1996 of some 15 million shares worth over $200 million.

. The company's president David Walsh (a former bankrupt mining stock promoter in Canada) and his wife took in over $20 million from the stock advance, while its chief geologist John Flederhof took $29 million,

A mysterious fire at the site , heavy insider selling by Bre-X's key executives a prospectus that was 8 (yes eight!) years old, Bre-X's stubborn refusal to reach an

12 acquisition deal with any one of the major firms that had approached it, and a policy by the firm not to talk to any skeptical analysts caused Freeport-McMoRan Copper and

Gold, and other companies to become suspicious of Bre-X claims, and to call on outside independent mineral services companies to make assessments of the claims. It turned out that there was no gold. Bre-X geologist Michael Guzman had skillfully salted in a pattern that fool even professional geologists hired to check the claims of the firm.

The investors who stayed with the shares lost their shirts. In March 1997, when

Freeport first announced it had found insignificant amounts of gold in preliminary digging Bre-X stock plunged in less than one hour 83% from C$15.5 to C$2.69. In May

1997, when an independent auditor announced the mine was a fraud "without precedent in the history of mining" the stock plunged another 97% from C$3.125 to C$0.085 in one day.

Fifteen Fidelity funds still had some Bre-X stocks when the value evaporated.

American Express Financial Advisors had 600,000 shares of the stock when the scandal started unfolding. The huge Ontario Teacher's Pension Plan lost $73 million. Caisse de

Depot et Placement du Quebec, Canada's largest fund manger, with C$57 billion under management, lost C$70 million. Ontario Municipal Employees Retirement System lost

C$45 million. Toronto Dominion bank's Precious Metal Fund lost C$ 10 million, or over

78%, of its investment in Bre-X. Financial brokerage houses have lost approximately

$360 million from loans they extended to their investors who purchased Bre-X stock.

Even the closest associate of then Indonesian President Suharto was not spared; two of his companies wound up owning 30% of worthless Bre-X stock

13 In short everyone was taken: mutual funds, pension funds, investment banks, geological companies, small investors, mining companies, and brokerage houses.

Everybody got taken by group of probably no more than three men who orchestrated the whole scheme. At the center stood Philippine geologist Michael Guzman, who

"discovered" the "mine" and who worked feverishly to prove that it was the mother lode.

He "fell off" a helicopter just as the scam was unraveling. Some say he was murdered, some say he was killed, some say his death was also faked; nobody knows.

.

With appropriate due diligence a great deal of the pain inflicted on investors might have been avoided. Robertson Stephens Investment management, well known for its bets on lessor known mining companies, stayed away from Bre-X after its founder

Paul Stephens and the funds own geologist made a detailed due diligence on Bre-X and recommended not to invest. Other huge funds and brokerage houses either did not have the expertise, the interest, the energy, the professionalism, or the luck to follow

Robertson Stephens' example; they invested blindly in Bre-X in spite of the plenty warning signs.13

Unfortunately old scams, tried and tested, come back again more often than

Lazarus--old wolves in new sheep's costumes. Each new technology offers the prospect of a new way to package an old scam to fleece the public. Fraudulent schemes involving hot new investments hold a place of honor right up there with Mr. Ponzi's great contribution to mankind. These days it is technology: Biotechnology, electronics, and wireless cable the possibilities for the fraudsters are infinite. The SEC has prosecuted dozens of cases involving over 20,000 investors and hundreds of million of dollars from

14 con artists who actually go and get a license from the government to build the wireless systems, then use the license to gain credibility and attract investors, then promptly set about to defraud those very same investors.

According to the SEC, in 2000, Enron executives created a fictitious new department called EBS which supposedly dealt with broadband network, and a proprietary “network control software”, and valued it at $30 billion. This fictitious department caused the analyst following Enron to upgrade the stock valuation, and consequently caused to stock price to increase.

In the stock market, fraud in pennies stocks, stocks that are equal or cheaper than

$5.00, is prevalent. They are not only cheap but also they have low liquidity and hence criminals can easily manipulate them. In addition, they tend to be in new technologies, such as biotechnology, and telecommunication, that the general public still does not understand. As an example, in biotechnology if the individual investors do not know what animal cells, bacteria, and viruses look like, and how they function They cannot comprehend how genetic therapy works and why it works, thus, putting themselves in a vulnerable position at the hands of crooks who can weave a plausible tale relatively easily..

Just in October 1996 the FBI charged 45 stock promoters, brokers and company officers with securities fraud after a nationwide sting operation. Government agents posing as brokers were paid bribes up to 40% of the price of the stock they were supposed to peddle to customers in order to inflate their prices for the benefit of insiders.

The government actually collected over $100,000 of payoffs from the penny stock

15 promoters. Bringing criminal charges is a positive development from the point of view of the investing public because up to that time slaps on the back (usually civil administrative or barring the culprits from the securities market) was all the punishment the crooked promoters received.

According to a NASDAQ vice president the volume of suspicious dealings has become so high that just the process of checking them out is "putting a strain on our resources".14 According to Mary Jo White the U.S. Attorney in Manhattan the action represents "only the tip of the iceberg" and "reveals a sordid picture of greed and indifference for the investing public". According to William McLucas, head of the enforcement division for the SEC, the growth in stock investing "has increased the opportunities for con men and crooks."15 Buyers beware for the con artists are moving in droves to the investment field.

The problem is that as the number of stocks on the NASDAQ has soared to over

6,000 and as the volume of shares has ballooned to where 500 million shares traded on the NASDAQ is considered a normal day, determining which of the various spikes on various stocks on a given day are due to illegal activity has become a nearly impossible task. Any give spike could be due to legitimate market forces and speculation, or it could be due to illegal manipulation by company insiders, or by outsiders who victimize both investors and the company.

On major way of scamming individual investors is via a chop shop. Chop Shop is a huge industry estimated at about $10 billion a year that launder stocks. Chop shops buy stocks cheap from people who are not allowed by law to sell them until a certain

16 waiting period and sell them in the market at a wide spread. These stocks are "restricted" or "letter" or "legend" stocks (because they carry a legend on the stock that indicates they are restricted). They are issued under Rule 144 of the securities laws, whereby companies are allow to award employees with equities. Regulation S covers stock issued overseas to raise capital.

The chop houses fool customers into buying by never showing the stock bearing the restricted legend. The shares are traded in book entry form only, and discourage customers who want to see the stocks. If there are warrants on chop stocks, the fraud is leveraged by the warrant leverage and the returns to the crooks become truly astronomical.

The network of chop houses is vast (involving an estimated 200 firms and literally thousands of cold callers) and well-organized (so well organized that there is clear evidence of organized crimes' hand in these operations). The NASD and SEC will not even provide a public estimate of how widespread the problem is but a Business

Week investigation showed that up to half of the 85 million shares traded daily on the

OTC Bulletin Board could be chop stocks.16

For the chop shops to work they need brokerage houses. Contrary to what one may expect, these brokerage houses can be the top ones from Wall Street not just some obscure ones. For example, Bear Stearns and Co., and Schroder Wertheim & Co. clear trades for chop houses in situations where there are sometimes huge commissions and unreasonable spreads.17 Bear Stearns is not some little backwater outfit, it represents fully 10% of the New York stock exchanges daily clearing volume so any pattern of misbehavior by it could have important ramifications for the market and for individual

17 investors. Still, Bear Sterns has cleared for several chop houses including PCM

Securities, Meyers Pollock, and Paragon Capital.18

Paragon may be the country's largest dealer in OTC Bulletin board stocks, and may have been charging commission as high as 25-30%. Bear Stearns can easily figure out the commissions by examining the trading records, even if they are not legally required to do so19. Still one hope that one of the country's leading financial firms will be more concerned with quality and ethical control.

In fact in August 1999 SEC ordered Bear Stearns to pay $38.5 million to end a two year SEC probe into its clearing activities for the now-defunct A.R. Barons & Co. brokerage firms.

A.R. Baron (which filed for bankruptcy in July 1996) and 13 of its former employees were indicted on 174 counts on May 13, 1997 on charges they had cheated thousands on investors including New York University, the Duke of Atholl, and a lot of ordinary folk out of more than $75 million. According to Robert M. Morgenthau, the

Manhattan District Attorney, the firm was created and existed for no other reason than to line the pockets of its executives and employees at the expense of unsuspecting members of the public. The criminal activities the prosecutors referred to in the indictment included: lying to investors, manipulating the markets, making unauthorized trades, refusing to follow customer instructions, outright thefts from investors, ignoring complaints, and forging documents.20

The SEC said that Bear Stearns was aware of Baron's unauthorized trading in customers' accounts and assisted Baron in staying in business when it knew Baron's lacked the requisite capital and was engaged in fraud. Bear Stearns paid the settlement

18 (including $30 million to repay defrauded investors), did not admit or deny the SEC findings, and accepted the resignation of the president of Bear Stearns Securities

Corporation. The SEC made clear that clearing firms cannot just turn a blind eye to illegal activities. "A firm's status as a clearing broker does not immunize it from the consequences of participating in a fraud" said the SEC's director of enforcement Richard

Walker.21

Another source of chop stocks are stocks and warrants issued to consultants for their services, a perfectly legal practice that was supposed to help start-ups low on cash.

This practice is widely abused by some companies where the "consultants" are nothing more that shady stock promoters who sell the stocks to an unsuspecting public at exorbitant prices.

Like pennie stocks, crooks like IPO’s. Somebody comes to you and says they can take your company public cheaply be merging it with a penny stock company (i.e. a public company whose share sell for less than $1). You guessed it: High chance of a scam, since there is often no liquidity in the penny stock.

In a previous chapter you read about how IPO's are not individual investor friendly even when you are dealing with a broker or underwriter of high repute. When you are dealing with a crook, the combination becomes deadly. The best way to illustrate this is through a specific case study.24 There are, of course, numerous variations but the case is illustrative enough.

In October 1996, NASD accused Sterling Foster, a chop shop located in

Melville, NY brokerage firm, and 15 of its employees of making $51 million in illegal

19 gains in a nine month period through three alleged crooked underwritings. Sterling

Foster gained $15 million from only one IPO deal for a voice mail company called

Advanced Voice. Everyone accused has, of course, denied all wrong doing.

Advance Voice had a prospectus as required by law. It disclosed a good deal of the company's problems: operating losses, delinquency in accounts payable, the unwillingness of some suppliers to deal with the company other than on a cash basis.

Also, an independent auditor's report raised "substantial doubt about the company's ability to continue as a going concern".25 So all clients of Sterling Foster had to do was read the prospectus and, unless they had a financial death wish, avoid Advanced Voice.

Sterling Foster gave Advance Voice prospectus only to the few clients who pressed it for it.

In August 1994, Sterling Foster won lead underwriter mandate for the IPO of

Advanced Voice. 1.15 million units (each consisting of a share and a warrant) were offered. Investors affiliated with Advanced Voice (founders, consultants, and so forth) already owned about 1.5 million shares which they got for pennies. So after the offering about 2.65 million shares were outstanding. Between August and November 1994, it took control of the majority shares of Advanced Voice, and controlled the 1.5 million affiliated shares plus Sterling Foster allocated 74% (about 850,000) of the 1.15 million units for its IPO offering. Therefore, the firm had control of about 2.35 million shares or about 89% of all shares after the IPO.

In November 1994, Sterling Foster filed with SEC Registration Statement for

IPO. the prospectus stated that unless they sold them at Sterling Foster's discretion the affiliated investors (the owners of the $1.5 million) had to wait between 13 and 24

20 months before they could sell their shares. This is called a lock-up agreement and is not unusual. What Sterling Foster should have done at this stage: Sell its allocation of

850,000 shares at IPO price of $5.50. What it actually did: It placed these shares with favored customers or with persons who agreed to a tie-in via the promise to purchase additional shares after trading began. This type of tie-in is illegal.

According to the NASD, once trading started, Sterling Foster brokers used high pressure sales tactics to persuade clients to buy more than two million shares of

Advanced Voice--that was more shares than it controlled. They made some buyers think they would get the $5.5 per share IPO price, when in fact they had just committed themselves to the much higher price that would prevail once trading actually began. For their efforts, its brokers, 175 of them, got $1.75 a share for selling to clients (about 10 times the normal commission) and only 10 cents if the client sold. The effect on this incentive system is easy to fathom.

On first trading date, February 7, 1995 at about 10:00a.m. Sterling Foster bought

2/3 of other brokers' IPO allocation or about 200,000 IPO units, further strengthening its lock on the issue to 96% of all shares that would exist after the IPO. Consequently,

Sterling Foster was able to ensure that the price of the shares would not fall in the after- market in case of a flood of sales orders. By noon, within eight minutes of the start of trading the price went from $5.5 to $11 and then to $14. The firm wrote buy orders tickets for the clients it has lined up before the IPO. The buy orders were for 2.4 million shares, more than double the 1.05 million shares that had been officially allocated to

Sterling Foster (the original 850,000 plus the 200,000 it had obtained from other brokers). The orders were filled at between $12.25 and $12.75 per share.

21 By day end, the shares closed at $13.50 on the offer side. Sterling Foster had gone ahead and sold 2.1 million shares more than were publicly available. To fix such discrepancy, it bought back the 1.5 million shares owned by affiliates, who got their shares for pennies, at about $2 a share (compared to a market price of $13 a share).

Given the industry the company was in, the affiliated investors decided to sell their shares for $2.00 knowing that if they waited the required 13 to 24 months to sell these shares, these shares could be worthless.

Sterling Foster then sold these shares for the next three weeks at $13.5. Sterling

Foster violated the rules by buying at discount and selling at full price without notifying

NASD. The NASD stated that if Sterling Foster had notified it, it would never have approved the deal.

After Sterling Foster had stopped propping up the price the shares began to slide.

It dropped to $9 per share in the first quarter of 1995 and then to below $4 in 1996 and now Advance Voice is de-listed. As expected, there were denials of wrong doing all around. Not surprisingly.

Padding earnings and phony accounts to lure investors is another tried and true scam: In 1993, such companies as Cascade International, a women’s clothing retailer,

College Bound, a college entrance exam trainer, Phar-Mor, a major discount drug chain,

Fidelity Medical, a medical product firm, and MiniScribe, a computer manufacturer were all guilty of these accounting frauds.26

The same year, Senator Ron Wyden introduced the Financial Fraud Detection and Disclosure Act to the House of Representatives to force the auditors to disclose any

22 accounting shenanigan by the companies they cover. By 1995, this act was passed by the congress. Unfortunately, such acts do little to stop financial frauds.

SEC Chairman Arthur Levitt in a September 1998 speech criticized the business community for reacting to "accounting hocus-pocus" with only "nods and winks". He mentioned improper revenue recognition and inappropriate "big-bath" restructuring charges, so called "cookie-jar reserves", abuse of materiality, and acquisition accounting as examples of such unsavory practices.27 Such managed earnings obviously affect the perceived value of a companies stock and hence directly impact the investor.

While many firms and their officers have been convicted of this practice

(Underwriters Financial Group, Donnkenny, California Micro Devices, Health management, Home Theater Products International, FNN, Crazy Eddie, Towers

Financial, Miniscribe, WorldCom, Enron, Sunbeam, and so forth) these convictions have been only for the more egregious and blatant book cooking and accounting irregularities, such as reporting revenue that did not exist, creating false invoices, recording sales of products that were not even manufactured, altering books, hiding debts, creating fictitious customers, and falsifying inventory data.

Just to name a few, between 1999 and 2001, SEC fined Xerox $10 million for deceptive accounting and forced it to restate its earning in 2001 and it indicted Rite-Aid executives for overstating earning by $1.6 billion, and WorldCom for exaggerating its profit by $7 billion. On July 2nd, 2003, it forced WorldCom, whose current name is MCI

WorldCom, to pay $750 million in fine--$250 million in MCI common stock and the rest in cash. In 2005, the SEC investigated Refco, whose CEO Phillip Bennett has

23 allegedly hidden $430 million of uncollectible debt, in so doing propped up Refco's earnings and share price.

However, until the Sarbanes-Oxley Act, many in the business community found nothing wrong with msssaging earnings. Wallace Timmeny, (a former SEC staff member) the lawyer of former W.R. Grace CFO Brian Smith said: "If you think what my client did constitute fraud, then every company in the FORTUNE 500 is engaged in fraud”—emphasis ours.29 Others such as the CFO’s of Enron, and WorldCom considered a right and duty of management to smooth out earnings to ensure smooth sailing for the stock. Indeed experts can justify in some cases when smoothing is not necessarily wrong, but while the experts are pondering, the individual investor is investing his life savings in the dark and under false impressions and misrepresentations.

To understand how far a company can go, you just need to look Enron. Enron went on for years cooking the books and most professional financiers did not know or decided to ignore the implications of its actions.

During 1990 Enron was presented as the 7th largest energy company, had $11 billion in reserve cash, and paid $323 million for banking fees. Its auditor, Arthur

Anderson certified its books, its Merrill Lynch, Citigroup, and other top financial institutions lent it billion of dollars and helped it to shovel cash out of the firm without questioning its financial standard or practices.

The firm was touted by reputable financial analysts from the major investment houses, given accolades by professors at Harvard and other business schools. No one except for Chanos questioned why Enron needed to have thousands subsidiaries and

24 limited partnership, or why these subsidiaries were located in the Cayman Island. Every one assumed that the company was protecting its assets from the US taxes, when the reality it was concealing information in a way that investors and analysts who did superficial analysis would never uncover the real financial state of the company.

If one plant was losing money, Enron executives just found and brought an investor that could buy at least 3% of that company and would help the investor get a bank loan for the remaining amount using as collateral Enron stocks. In the process they would hide their losses in this company. If a partnership defaulted the executives just took some of the reserved cash and put it in the partnership and did not record the transaction. Unfortunately, one of its partnership defaulted on its $560 million loan, and the reserved cash dried up. This in turn caused the banks to demand that Enron give the stocks it put as collateral. When default became news the stock price tanked and banks demanded more shares to cover the loan resulting in the stock depreciation. This in turn diluted its share value even further and led to the eventual collapse of the company.

If its stock price appeared to be tanking, Enron executives would decide to reorganize the company, or create a new venture that would prompt the analysts to give a positive recommendation for it.

Sometimes the criminal mind can be very creative indeed, and the Enron executives involved in the fraud were very creative. Only a criminal creative mind could have thought to create a partnership whose income increased as Enron’s stock increased and then used a series of transactions to recognize approximately $85 million in earning as a result of the manufactured increase. This $85 million helped the stock price stay high, and the analysts touting the company.

25 As we saw with Enron, phony announcements don't always have to be limited to accounting. You can have phony announcements for products, plant capacity, hiring plans (via bogus want ads in trade journals), you name it, whatever can pique the greed of the investing public, can and probably has been used in a bogus way to lure the unwary investing public.

In early 1970s, analysts were promoting STP Corporation even though the firm’s major product, oil thickener for cars, was alleged to be worthless. In fact, in May 17,

1971 an analyst was quoted in the Wall Street Journal saying: “The risk is that it is difficult to prove what exactly the product accomplishes, and people fear that the FTC might attack the company on an efficacy basis. We feel there is a very low probability of that happening and in the meantime consumers think the product works and that’s the important thing. It is sort of a ‘cosmetic company’ for the car.”30 Fortunately, in July

1971, consumer reports published the results of the efficacy of STP oil thickener; it concluded that the oil thickener harm the cars engines in such a way that the warranty terms may be affected.

On April 4, 2005 United States District Judge of the Middle District of Florida found Aaron Tsai, Dr. Jui-Teng Lin, the former CEO of Surgilight, and his wife, Yuchin

Linguilty of artificially inflating the market price of Surgilight stock in April 2002.

With the help of Dolores Easthom, an investor relation consultant, they propagated a series of false and misleading press releases that detailed the company alleged ability to cure an eye disorder known as “Presbiopia”, while simultaneously dumping 1000 shares of Surgilight stock on an unsuspecting investing public by trading two nominee accounts that they controlled

26 If bogus good news can be used to push up investors' interest through manipulating their greed, bogus bad news and rumors can be used to stroke their fears and push the value of a stock down to make it a better buy for the stock manipulators, scare off individual investor into selling stocks that they would otherwise hold, or selling it more cheaply that they would otherwise agree to, and so on. With the internet, such bogus news tends to spread fast and consequently have almost instantaneous consequence on companies’ stock price.

For instance, in August 24 2000, Mark S. Jakob a 23 years old college student who worked at Internet Wire, a service that distributes press releases sent a release from a bogus relations firm stating that SEC was investigating Emulex, a designer and developer of fiber optics which we were invested in, for bad accounting practices. The release also stated that the company was reducing its earning estimates and its CEO was resigning. The next day at 9:30 am when the news was released the stock lost $2.45 billion of its market value within an hour and Mr. Jakob, who shorted the stock, made a profit of more than $241,000. Before the end of the day, the hoax was discovered and the stock recovered most of its value31. The funny part is that we were some of these investors that held Emulex.

Crooks easily adapt their scams to new technology. On April 7, 2000 someone created a web page that looked exactly like Bloomberg’s—same color, same links to real Bloomberg news, and same layout--to post a fake Bloomberg story about acquisition of PairGain Tech, a maker of communication equipment, by an Isreali firm called ECI Telecom. Then, the crook posted the rumor on a Yahoo! chat board with the notation “Just Found it on Bloomberg”32

27 In August 1999, Business Week rushed reports onto its websites saying that

Yahoo! had been in talk to acquire Excite@home--itself the product of a recent internet merger—for more than $1.7 billion. The story attributed “sources close to the companies” and quickly picked up by CNBC, pushed Excite stock by 7% the next morning. Unfortunately for Business Week Yahoo! and Excite flatly denied the report that afternoon “Excite@home is not Yahooing” Insana dead panned, hours after his network reported that it might be33.

From the few examples that we have presented, it is clear that the internet is a very good vehicle for spreading bogus news and to scamming the public. In 1999 only, the SEC swept criminal action against 44 individuals and companies for touting stocks of companies from whom they had allegedly received payments without disclosing such payments.

These criminals used electronic newsletters, Web sites, electronic bulletin boards, and e-mail. They gave respectable sounding names to their companies and newsletters and Web sites such as: Barrow Street Research, The Equity Journal,

Princeton Research, Stock-line, Starwood Media Group, Emerging Company report,

Next Wave Stocks, Portfolio Prospects, High Growth newsletter, IBJ Observer, Russ

Reports, National Investors Council, Portfolio Pick, Carlisle Communications, Sitra

Enterprises, The Future Superstock, Jay Greig's Liberty Letter, Global Penny Stocks,

The Financial Hour, International Alliance Trading, Sun Pacific Capital Group,

Investors Edge, Global Information services, Investment Hotlines and TKO

International.34 Internet investment fraud is so widespread that the SEC has created an

Office of Internet Enforcement with 125 surveillance staff.

28 No company is immune to bogus news, huge corporation can be the victim of these types of rumors, witness the body blows to Proctor and Gamble when the rumor started that its logo had something to do worth the devil and to McDonald's when the rumor circulated of worms as an ingredient of its hamburgers. Developing the ability to filter these rumors, along with plain bad advice and analysis, is one of the main skills that good professional traders develop. One way to develop it is by understanding the companies you are investing in.

Some of the frauds we have presented all dealt with ponzi schemes, creative accounting, bogus news, bogus products, chop shops, and financial adviser fraud. Beside the chop shops where the brokerage firms are also involved in the frauds, we have not addressed the issues related to possible frauds that your broker or your brokerage firm can inflict on you. In most cases, you are not aware that you broker or your financial adviser is cheating you until it is almost too late.

The reality is a whole laundry list of shady practices from these entities to separate investors from their money exists.

Sterling Foster was guilty of hard sell, failing to provide a prospectus (even when clients demanded it), parking (buying a stock for it on a temporary basis and without authorization and creating artificial demand for that stock in order to push up its price) ,flipping (inflating the price of IPO’s and quickly selling them through front operations), vig (a very wide bid-ask spread in manipulated stock), selling house stocks

(pushing stocks that are controlled by the seller), and churning (over trading an account to generate commissions).

29 Surgilight executives used scalping (selling a stock immediately after recommending it), making outrageous claims and predictions, tooting (receiving, but not disclosing, payments from companies the stock of which are being promoted) and inside trading while SSS used boxing the stock (controlling and manipulating the price of a stock through trading it among a network of secretly controlled or cooperating brokerages).

The following example illustrates how hard for even brokerage firm to oversee that your money is managed professionally. Veronika Hirch, Fidelity’s Canadian Equity

Fund Manager, in 1996 used front running to acquire her ill gotten gains. Canadian authorities found her guilty of front running when she was a fund manager for AGF

Management in Toronto, before she joined Fidelity. According to statement filed with the regulators Ms Hirch while a fund manager at AGF bought 65,000 special warrants of

Oliver Gold, a Vancouver company, and shortly thereafter bought 295,000 of the same warrant for the AGF Growth and Income Fund which she was managing, at more than double the price what she had paid. And according to press reports she used a false address when doing so.35In short, she bought special warrants for her own account at one price and sold them at a profit to the fund she was managing. Hence, she committed front running: she profited from her transaction by selling her private special warrants at a profit to the fund she was supposed to manage.

In addition to front running, rat running (making number of traders, wait to see how they perform, and then book the profitable one for him/herself), unauthorized trading (trading clients account with out their knowledge), baiting (broker builds the

30 confidence of the investors by investing first on profitable and well known stocks and then she move to risky and overvalued stocks), not executing sell orders (Saying it is not possible or it is not a good time).check kiting (brokers issue checks to customers in excess of the funds they have. By the time the checks clear the brokers have obtained an interest free loan from unaware clients), playing the float (the brokers do post the money sent by customers to their accounts for a few days and keep the interest from the funds for themselves). and post-dating and predating time stamps (the brokers illegally manipulate the spreads made off the customer by accumulating or disposing stock at variety of favorable prices during the day and then filling the customer at the single worst price of the day) are undetectable to the investors. One cannot protect oneself from Ms Hersh and the likes; one can only hope that the investment houses, or the brokerage firms will catch the crooks among them.

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.

The minutes of the hearing panels of the major exchanges are full of references to violations and one comes across such terms as falsification of documents, misrepresentation, misappropriation of fund, theft, breach of contract, breach of fiduciary duty, forgery and so on. And the names of brokers with many of the country’s leading financial powerhouses are found as defendants in cases of these violations of securities laws.

From the examples cited in "Lies Your Broker Tells You" by Thomas D. Saler36 these frauds haved touched many prominent brokerage firms: Merrill Lynch, Dean

31 Witter Reynolds, E. F. Hutton, Paine Webber, Thomas McKinnon, Prudential, among them.

(WHY DID YOU DELETE THESE EXAMPLES SPECIFICS ARE USEFUL)

To give the major brokerage houses their due if a broker illegal activity comes to their attention it is usual for the broker to be dismissed and some restitution made to the customer. But no one knows how many brokers get away, and furthermore, some of the most famous financial firms themselves have been accused of shenanigans as a firm

(e.g. First Boston: illegal trading; Kidder Peabody: insider trading; E.F. Hutton: playing the float to name just a few38 .

Furthermore, the names of the same institutions appear again and again in legal proceedings and settlements. For example, in the mid-1990's SEC disclosed that Bankers

Trust had been involved in unethical practices in the sale of derivatives. In 1999, SEC fined the same bank $63.5 million for diverting $19 million of it customers’ accounts to inflate it financial performance.39 We won't tolerate such actions! The bank cried as it fired 19 employees. Never again, we are asked to believe yet again.

Here's one other situation of wrong doing from quarters you might not expect.

In April 1997 British regulators fined the prestigious (then) Deutsche Morgan Grenfell

(now Deutschebank Securities) 2 million pounds sterling (then about $3.8 million) and ordered the firm to pay $1 million in costs. The reason was that the firm has played a role in inflating some non-listed stocks in three European funds. The regulators said the firm had been too slow to detect and react to the stock price inflation.40

Other famous names have been charged of wrong doing. The police in Jersey, the channel Island, the UK offshore financial center charged one of the subsidiaries of

32 the venerable Union Bank of Switzerland, a global leader in asset management and private banking, with fraud involving concealing losses by traders. In addition, a lawsuit on behalf of 82 investors, about half of them Americans, was brought.41

In another case of financial fraud by the high and mighty, DTI, the department of

Trade and Industry a british equivalent to SEC, charged the late media mogul Robert

Maxwell for allegedly looting from the savings of thousands of pensiones approximately

$6.2 billion to prop up Maxwell business.43

Perhaps it is because of all these problems that one of the world's leading publications, The Financial Times, felt justified to print a cartoon where the prospective employee is being told by the financial institution: "You can start work in our derivatives department as soon as we have checked these fraud convictions are genuine".44

There are many variations on the theme of investment fraud and the line between ethical and unethical, legal and illegal sometimes becomes blurred and what is legal may not be ethical and vice versa.

And then there is the entire area of clerical and administrative errors by brokers which result in losses to customers, which we will mention but not dwell upon.

There are numerous other examples of the biggest institutional names in finance themselves becoming victims of investment fraud. The most famous example is how the venerable Barings crumbled at the hand of Nick Leeson, a 27 years old settlement clerck brought down. He created a secret “error account" which he used to manipulate the reported results of his trading and his manager did not or could not follow what he

33 was doing until his losses mounted to $1.2 billion and brought down one of the City of

London's best known banks.50 Baring was sold for 1 pound to another bank.

The Sumitomo Corporation lost some $2.6 billion its chief copper trader engaged in authorized trading that lasted undetected for over a decade and involved forged documents and phony signatures of senior Sumitomo managers of documents relating to trades with Merrill Lynch and several other North American and European firms, and routine fabrication hundreds of position statements from international brokers each month. This resulted in the wiping out of about 40% of Sumitomo's net worth once the scandal became public.51

At the beginning of this chapter we mentioned that even regulators can work against the individual investors. In fact, the NASD (National Association of Securities

Dealers), the self regulatory organization for the brokerage industry, (which runs

NASDAQ) itself has on occasion come under scrutiny. One such case was in October

1996 when the SEC began a fact finding action to look into the lawsuit filed by Theresa

Carr.

Ms. Carr an ex-examiner for the NASD was the lead investigator into the NASD's investigation into alleged payments by Wall Street underwriters to Armacon--a small brokerage (now out of business) with ties to Jim Florio (the then New Jersey Governor), and where Joseph C. Salema, the Governor's chief of staff, a part owner of Armacon62.

After three years of investigation into the $1.3 trillion municipal bond market, Ms. Carr recommended that NASD take action against about a dozen underwriters for their dealings with the small and politically well connected Armacon. Instead of taking

34 action, NASD did all it could to quash her investigation and forced her to resign in 1996.

Hence, it forced her to sue NASD. 64

As we stated at the beginning of the chapter, even foreign mafia have an interest in the US stock market. One may think that the example of Sergey Mavrodi, the founder of MMM, was an isolated example of foreigners trying to manipulate the American stock market, the reality is that the securities business is so lucrative for the criminal element that it has attracted organized crime from overseas as well. Enforcement cases have been brought against Russians in New York and California. The Russian mob targeted Russian immigrants as a prime target group. They used unlicensed brokerage firms to sell unregistered stock in worthless companies.

In one case, one Igor Shekhtman was accused of taking the brokers exams for more than a dozen individuals. He pleaded not guilty to 152 felony charges. Another group of Russians sold stocks in Mugs Plus, a producer of mugs and T-shirts whose plant had been destroyed by a chemical explosion, via a fake brokerage firm with the very Anglo-Saxon and misleading name of Campbell and Prudential Securities which in turn was owned by Mugs Plus. The principals of Mugs Plus settled with the authorities and their lawyer stated that they had unintentionally violated state laws. In another case

Stella Bella, a company which sells coffee and is owned by one Vladislav Steven Zubkis published projections for consumption by investors that the company would have revenues of $1.25 billion and pre-tax profit of $470 million by 2000 and compared the company to Starbucks. In reality in 1995 Stella Bella had sales of only $920,000 and losses of $2.8 million. The NASD has asserted that Mr. Zubkis secretly ran a Los

35 Angeles broker firm named Cartwright and Walker, which is very convenient for some interested in pushing stocks.83

From the examples that we have presented you may assume that fraud is only in the stock market, and that the bond market is safe. The reality is wherever there is a lot of money at stake there is fraud and mishandling.

For instance, investors buy municipal bonds, or muni, because they are state and local tax-exampt and if one lives where the bonds are issued than that person pays no tax on the munis. So for someone who has a lot of money and wants to preserve the wealth this is a good vehicle. The municipalities as required by the IRS keep the money raised selling munis in escrow accounts managed by securities firms until they are ready to invest the money in a municipal project: such as roads constructions. The money raised is large enough and tempting enough to bring all kind of shenanigans and to bring problems to the investors.

If the Federal Government determines that it is owed taxes, and if municipalities fail to pay, or are unable to pay, the back taxes (which is the case for many cash- strapped cities and states), then it is entirely possible that investors will have to foot the tax bill arising from the alleged illegal practices of Wall Street firms. Furthermore, if the shenanigans in the muni-bond market lead some muni-bonds to lose their tax status, then according to Richard Lehmann, president of the Bond Investors Association in Miami

Lakes, Florida, recent court rulings make it more likely that investors cannot sue issuers of muni securities that lose their tax exempt status, and so it will be investors, and not issuers or municipalities who will be stuck with the taxes.84

36 Frauds in munis are not obvious, and it is a wonder that SEC is able to clam on them: A Wall Street firm gives kickbacks to get the contracts, the municipalities decide to spend the invested money before it gets hold of it, or the Wall Street firm charges excessive and even illegal prices for securities sold to local governments.

For instance, in 1993, Municipalities paid Lazard Freres—one of the county's leading figures in municipal bond finance, with a seven figure annual income and a list of clients that included the State of Michigan, the United States Postal Service, the

Massachusetts Water Resources Authority, and the nation's capital—to provide them with independent advice. Instead of the independent advice, Lazard Freres through its employee Mr. Ferber recommended Merrill for financial transactions, and in return

Merrill paid Lazard $2.6 million. In October 1995 both firms settled with SEC without, of course admitting wrongdoing, and each paid the SEC $6.4 million, which is a drop in the bucket for the financial giant. As for Mr. Ferber, he was fined $1 million and sentenced to 33 months in prison85.

The Los Angeles County Metropolitan Transportation Authority in comments prepared for the Internal Revenue Service contends that securities firms have overcharged municipal escrow accounts and therefore cheated the government to the tune of about $1.15 billion.86 For this service the securities firms overcharge the municipalities in what is called “yield burning”—by overcharging for securities the securities firms are lowering or “burning” the yield payable to municipalities on the escrow accounts.

You shouldn't think for a moment that the municipalities are all innocent victims in this. Some municipalities are not above using the monies in their muni escrow

37 accounts for trading and speculative purposes. This is an out and out violation of IRS regulations, regulations that make a lot of sense in that tax subsidized funds should not be used for speculative or any other purposes other than those intended by law.

One example is the North Carolina Eastern Municipal Power authority which did over 1,200 trades turning a $1.5 billion of treasuries six times in a three week period while waiting for its muni deal to close. Since the deal had not been closed yet, the trading had to be done on margin offered on the knowledge that there would be future bond proceeds to back it up. And this claimed the issuer's lawyer is therefore not illegal because was on margins and not on bond proceeds. As the man said, depends on what the meaning of "is" is. And not just North Carolina, but the City of Rochester, the Austin

Independent School District in Texas, Los Angeles County MTA, Massachusetts, and so forth have all done such speculative trades.87 It may be arguable that these are not a violation of the letter of the law, but what about the spirit. If these major municipalities cannot be above suspicion, what in the world can one expect of issuers and brokers.

Another pertinent example is the city of Miami and Dade County that put muni for sell but did not disclose to investors information regarding the ballooning budget deficit (and hence the questionable valuation of the bonds these investors were buying).

In addition to shifty security firms and municipalities, sometimes even people who are not directly involved with the issue and management munis can have an effect of how the munis are managed. In Kansas, a dentist named Billy Collins, who happened to be married to then governor Mary lane Collins, repeatedly asked for payments from

Wall Street firms as a condition for their doing muni bonds business with the state. On

38 one occasion the well known Wall Street firm Donaldson, Lufkin & Jenrette acceded to his demand for $35,000 which he used to buy grand piano for his wife the governor. 88

Unfortunately, muni fraud deals are not concentrated in one state or one locality,

or to a specific firm. SEC has investigated Merrill Lynch, Smith Barney (now Salomon

Smith Barney), Paine Weber, Lazard Freres, to name a few;89 The federal government

has investigated Florida New Jersey and Massachusetts, and Pennsylvania to name a

few. In fact, all the states have come under scrutiny for non-kosher muni bond deals.

SEC started looking into 120 transactions and then focused its efforts on about two

dozen issues in only one year. The federal government and SEC did not stop with the

usual suspects but have also questioned lawyers, and lobbyist90.

This chapter could literally go on to thousands of pages. The numbers and variety of the investment frauds investors are falling in is that large. New traps are designed to catch the unwary very day as new possibilities arise from market and technological developments (like the Internet), and new players (like the foreign Mafia), while the old scam are just refurbished and put in operation again (witness the Ponzi schemes still being hatched), and old players (crooked firms and individuals) continue their unsavory actions. The amount of money the public is investing is large, so the incentives and opportunities for the criminal (many of them white shod and blue blooded) are increasing. As we have seen even the most sophisticated firms have fallen victim to investor fraud, and even some of the most trusted institutional firms have engaged in this activity.

The individual investor is like a babe in the woods and the wolf are circling around her. We hope that the examples we have presented here will help make you

39 more aware of the common ones, and convince you of the importance of doing thorough due diligence when investing. If you are hiring someone to look after your money ask a lot of questions to evaluate the level of her expertise, know the companies your adviser is investing in, check your monthly or quarterly statement in detail to detect any discrepancies. The SEC, in its website, has a page that tells you the questions to ask while choosing your adviser. If you are investing in a single company learn to read financial statements and get in the habit of reading the annual reports to spot red-flags.

What all good investors have in common is that they do their homework. They investigate companies looking for clues of mismanagement and they go beyond earnings and PE when deciding to invest.

The investor could seek refuge in financial advisors, safe investments, or and the protection of regulators. In the next three chapters we will show why these protections are woefully inadequate and that there is no real refuge as thing stand now.

1 Dean Starkman,”ISO: An Adviser to Trust,” Washington Post, September 18, 2005, pp. F1, F5 2 John Waggoner, "Hard lessons in shortcuts to Easy Street", USA Today, */19/96 &11/26/96 (w). 3 Steve Stecklow, Prudential is Set to Settle Suits in New Era Case. 4 Benjamin Weiser, 4 at Syracuse Finance Firm Indicted in Pyramid Scheme, New York Times, Friday June 27, 1997, p. C2, and Associated Press, Four Charged in Alleged Biggest U.S. Pyramid Scheme, 6/26/97 (w), and Waggoner, Ibid. (w). 5 Leslie Eaton, Bennett funding executive in Guilty Plea, New York times, April 11, 1997, p C13. 6 Ibid. 7 http://en.wikipedia.org/wiki/MMM_(pyramid) 8 Joseph P. fried, 18 Charged in Stock fraud that Cost investors Millions, New York Times, Apr 3, 1997, p D2. 9 Francis A. McMoorris, Ex-SEC Lawyer, 5 Others are Indicted for Fraud, Following Dorfman Probe., Wall Street Journal. October 7, 1996 p. B12. 10 Ed Leefeldt, Everybody loves Sonny Bloch, Bloomberg Magazine, November 1996, p. 30. 11 Leefeldt, Ibid. 12 Dean Starkman, Washington Post, September 18, 2005, pp. F1, F5. 13 David Thomas, , "Bre-X Scandal Took Expertise and precision, Report Concludes", May 6, 1997, Bloomberg News , Tim Quinson, "Mutual Funds: Robertson Stephens Avoided Bre-X After Review, Bloomberg News, May 6, 1997, Paul Brent, "Bre-X minerals stock Crash Leaves large Paper Losses for Funds", Bloomberg News, May 7, 1997, Caroline Van Hasselt, "Bre-X Investors file Lawsuit against

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Brokerage House", Bloomberg News, May 9 1997. Anthony Spaeth, "The Golden shaft", Time, May 19, 1997, pp. 54-58. Suzanne McGee and Mark Heinzl, "How Bre-X Holders Passed Warnings, Got Lost in Glitter", Wall Street Journal, May 16, 1997, p C1. 14 John R. Emshwiller, Manipulations of NASDAQ-Listed Stocks are rising, but Investors Keep buying, Wall Street Journal, September 13, 1996, p.C1. 15 Jill Dutt, 45 Charged in Scheme to Manipulate Stock prices, Washington Post, October 11, 1996 p. F1 and Deborah Lohse and Francis McMorris, Big FBI Sting Collars 45 Penny-Stock Figures, Wall Street Journal, October 11, 1996, p. C1. 16 Ibid. 17 Gary Weiss, Investors Beware: Chop stocks are on the rise, Business Week, Web Site, December 15, 1997. 18 Ibid. 19 Ibid. 20 Peter Truell, Baron Firm and 13 Charged with Cheating thousands, New York Times, May 14, 1997, p D.4. 21 Sri Ramakrishnan, Bera Stearns Settlement to End SEC Probe, Washington Post, August 6, 1999, p E3. 24 This case is drawn from the detailed description provided in Micheal Siconolfi and Deborah Lohse, Inside a Dubious IPO: Sponsors, It appears, Held All the Cards, Wall Street Journal, November 5, 1996, p A1. 25 Ibid. 26 Ed Leefeldt, Economical Truth, Bloomberg magazine, September 1995, p8. 27 Carole J. Loomis, Lies, Damned Lies, and managed Earnings, Fortune, August 2, 1999, pp 75+. 29 Ibid. 30 Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton & Co., New York, 1999, p. 175 31 Neal Becton, Robert O’Harrow Jr, Washington Post , August 31, 2000 32 Fortune Tellers, pp. 92-93. 33 Fortune Tellers, p.187 34 USA Today, SEC Unveils Internet stock fraud sweep, Website, October 29, 99. 35 A Fund manager Under Investigation, New York Times, November 4, 1996. 36 Thomas D. Saler, Lies Your Broker Tells You, Walker publishing Company, 1989, pp . 101-112. 38 Ibid pp. 115-119. 39 Kathleen day, Bankers Trust Fined for Diverting Accounts, Washington Post, March 12, 1999, p. E3. 40 Investment bank Fined $3.2 million by Britain, New York Times, April 17, 1997 p D 18. 41 Michel R. Sesit, UBS Unit Faces Charge of fraud in UK's Jersey, Wall street Journal, October 29, 1996, p B9. 43 John mason and Robert Rice, Judge calls off second Maxwell fraud Trial, Financial Times, September 20 1996, p 14. 44 Financial Times, 9/20/96. 50 John Gapper and Nicholoas Denton, Baring tapes reveal lack of control over Leeson, Financial Times, September 20, 1996,p. 1. 51 Suzanne McGee, Stephen E. Frank, Norihiko Shirouzu, Japanese Authorities Arrest Key Figure in Sumitomo's Copper-Trading Debacle, Wall Street Journal, October 23, 1996, p. C 1. 62 Antonio Argandona (Ed.), Ethical Dimensions of Financial Institutions and Markets, Springer, Berlin- Heidelberg 1995, p. 160. 64 Charles Gasperino, SEC Studies Accusations Against NASD, Wall Street Journal, October 9, 1996, p. C1. 83 Leslie Eaton, Russian Émigrés Run Afoul of Stock Regulators, New York Times, January 14, 1997, p D1. 84 Charles Gasparino, October 16, 1996, Ibid. 85 Ibid. 86 Peter Truell, Municipal Bond Dealers Face Scrutiny, Wall street Journal, December 1, 1996, p D1. 87 Terrence P. Parr (check spelling), Ibid. 88 Terrence P. Parr (check spelling), Ibid.

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89 Charles Gasparino and John Connor, SEC Focuses Its 'Yield-Burning' Probe on About Two Dozen Muni-Bond Deals. Wall Street Journal, January 23, 1997. 90 Charles Gasparino and John Connor, Muni-Bond Probe Turns the Spotlight on Pennsylvania, Wall Street Journal , May 9, 1997, p C1.

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