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Chapter Four Fraud for Thought Where There Is Greed, Ignorance

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Chapter Four Fraud for Thought Where There Is Greed, Ignorance 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.
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