Tips To Avoid Investment Frauds

King Solomon’s Mines TABLE: A SMALL LIST OF BIG SCAMS

Ponzi scheme

Matchbox scheme

Junk bonds

Bre-X Minerals Ltd.

Hedge fund fraud

Name of scam Financier

Charles Ponzi

Ivan. Kreuger

Adnan Kashoggi

Mike Milken

J. Felderhof *

B. Madoff Plot of the scam

Sell postal coupons for more than cost

Earnings overstated to attract investors

Reopen ancient mines to find biblical loot

Junk bond default rates understated

Gold added to core samples

Fake financial statement Date of disclosure

1920

1929

1988

1989

1997

2008

In the roll call of great fraudsters, Bernie Madoff will probably reign as king of scams for many decades to come. He played hard to get and eased his victims into his funds first in relatively small sums, later in big amounts. He got Steven Spielberg, Kevin Bacon, the crme de la crme of Palm Beach society and even Nobel prizewinner and holocaust scholar Elie Wiesel to give him their money. Recently, he admitted guilt in his crimes and is expected to go to jail for the rest of his life. Now in his 70s, it will ironically turn out to be a sentence of only moderate length.

Madoff practiced securities fraud and took what has widely been reported as US$58 billion from his trusting victims, a record sum for now. Yet the range of scams has gone from postage coupons — the asset used by Charles Ponzi in the U. S. in the 1920s, to matches — the method of Swedish fraud Ivar Kreuger about the same time, to salad oil swindler Anthony de Angelis in the late 1950s to junk bond king Michael Milken in the 1980s and, lately, to Toronto theatrical producer Garth Drabinsky who scammed money through fake accounting in the 1990s.

All of these frauds had one thing in common: people wanted to believe in the fairy tale of impossibly huge returns (or impossibly steady returns in Madoff’s case) coming out of an investment system that the big guys in their fancy suits kept for themselves. Madoff’s victims wanted to get into something that Spielberg and Bacon, Wiesel and even some major Wall Street bankers were bankrolling. Their victims even included a Viennese private banker and a New York-based French aristocrat who killed himself, overcome by the grief of losing the fortunes of his clients. Vanity was the driver for many, not just the relatively dull task of making money. The victims made themselves ripe for deceit.

The man who created the model for several successive frauds was Charles Ponzi, an immigrant who arrived in Boston in 1903. He worked as a grocery clerk for a few years, then went to work for a bank in Montreal that stole money from its clients. Convicted of fraud, he spent 20 months in jail in Quebec, telling his mom that he was a “special assistant” to the warden. He returned to the U. S., and did another two years for smuggling immigrants into the U. S. illegally.

Back on the street, he discovered international postal reply coupons, which were a way of prepaying postage. The holder could use one of the coupons to buy a stamp in five dozen countries that used the system. He noted that the price of the coupon was less than the cost of the stamps. The price discrepancy was the basis of his next and greatest fortune.

He created that Securities Exchange Company in 1919, more than a decade before Franklin Roosevelt used the same words — minus Company — to help deal with the Great Depression. Ponzi paraded around his base in Boston with a gold tipped cane, gave good quotes to reporters, and swaggered in the Niagara of money that poured in — a million dollars a week. He played the part of a defender of the poor, giving them access to a plan so transparently simple that no one could say no.

But postal authorities in several countries were repelled by the scheme and stopped selling postal reply coupons. The U. S. Postmaster in New York City said that there were too few coupons in the world to allow the Ponzi plan to work. But it did seem to work. What the victims did not know was that fresh money coming into the fund was used to pay early investors. Ponzi never really bought many coupons. Convicted of fraud, he did five years in a state jail in Plymouth, Massachusetts, where he had business cards printed that said “Charles Ponzi, Plymouth, Mass.” The tale, related by financial writer Ron Chernow, biographer of such luminaries as John D. Rockefeller, graces the pages of the March 23 issue of The New Yorker.

Ivar Kreuger’s, the Swedish match king, was the next great fraudster. In the months before the stock market crash of 1929, Kreuger controlled two-thirds of the world market for boxed safety matches. He did make matches and he did

make profits. The problem was that his dividend payout ratio was too high to be sustainable, rather like a modern income fund that pays out more than it makes. Kreuger fooled just about everyone, using theatrical tricks like long pauses in his speeches — the better to make his listeners think he was very wise — and dressing in the best suits money could buy.

John Maynard Keynes, the architect of much of modern economics and the designer of the modern gold standard known as the Bretton Woods agreement, called Kreuger “perhaps the great constructive business intelligence of his age.” His undoing was his inability to make his business work as expected. He used off balance sheet entities to hide losses — a method Enron used 70 years later to do the same thing. Kreuger took out bank loans to maintain dividend payments, perhaps convinced that growth and his own investment acumen would sustain his business. And to some extent, it worked. Kreuger’s maze of companies would put money into then-poor little countries like Liechtenstein, negotiating high interest rates for his loans to them. When it unraveled, he forged Italian bonds to keep going, unfortunately misspelling the names of an official. Hounded by creditors in 1932, he could no longer borrow. In March of that year, he went to his Paris apartment and, with a new Browning 9 mm. pistol, shot himself in the heart. All along, a close reading of financial statements to see where dividends came from could have led to a decision not to invest or to get out while there was still time.

Kreuger and perhaps Madoff, too, appear to have believed they were making sustainable business propositions. Each tried to make it hard to get into his investments, playing hard to get and maintaining high dividends for investors. Chernow recalls that some people have called Madoff an industrial psychopath, suggesting that he was a kind of serial killer of other people’s fortunes. The New York Times wrote that Madoff did to wallets what serial killer Ted Bundy did to lives.

Could Madoff’s victims have known what awaited them in a market crash few expected to happen? Not likely. But there were signs that should have told potential investors to stay away:

SIGNS THAT AN INVESTMENT IS TOO GOOD TO BE TRUE

1. Dubious auditors: Madoff’s auditor and the auditors of recently unmasked hedge fund con artist James Nicholson and of Caribbean entrepreneur R. Allen Sanford were tiny entities without the ability to sort through the paperwork of billion dollar accounts. Madoff’s auditor was a tiny office in Brooklyn with one active partner. Stanford’s was an office in Antigua with a phone nobody answered. Nicholson’s was a mail drop in Manhattan. These were “Larry, Moe and Curly” accounting firms,” said a law professor at Duke University in Durham, North Carolina. The reference to the three stooges is just about right, given the evident lack of oversight by the accounting firms. Madoff’s accountant has been arrested and charged with securities fraud, according to Bloomberg.com,a financial reporting service.

2. Recruitment by social climbing: Madoff’s investor recruitment was through circles of acquaintance in each major fraud. It was the same as Charles Ponzi’s method, but with high society glitz. Madoff made it seem hard to get into his inner circle. That gave a cachet to actually getting him to take money. Those who succeeded in getting in where not inclined to ask too many questions, lest they be tossed out.

3. No explanation of how business works: The “how does this work” question was brusquely dismissed in every fraud by the answer that if you don’t trust the master, you don’t deserve to be in. The method of profit was concealed and, in the hedge fund business, managers don’t have to disclose their methods of operation.

4. Inadequate verification of performance: Victims could also have used a little math to check the legitimacy of returns. If earnings in a company are said to grow at 30 per cent per year, then the price of shares that are, say, ten times earnings, will have to grow even faster and sustain that pace. So if a company earns $4 per share in year one and if the market gives it a price to earnings ratio of 10, then shares will be valued at $40. If next year, earnings rise to $6, the stock will have to rise by 50 per cent to $60 at the same multiple. If earnings rise in year three to $12, the stock will have to hit $120. So an $8 bump up in earnings will generate a triple in the stock price. It happens, but it is rare. And few companies can sustain this kind of growth for more than a few years. Any projections that rely on long-term extension of a 50 per cent annual growth rate have to be suspect.

When you combine the idea of gaining some of the glamour that rains from the shoulders of the famous with improbable financial claims, it’s time to get informed or to get out. If the information you need can’t be obtained or doesn’t make sense, then do the latter and scram.

Andrew Allentuck’s latest book, When Can I Retire? Planning Your Financial Life After Work, was recently published by Penguin Canada Ltd

About the author

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Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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