Bernie Madoff didn’t invent it, Gordon Gecko didn’t perfect the “Greed is good” philosophy, and the regulators won’t end it. Scams, fraud and fat cat greed have been with us for millennia. It’s the way we’ve done business.
The South Sea Bubble
In 1711, the English government was wallowing in debt, so an enterprising group of merchants (read: crooks) calling themselves the South Sea Trading Company bought a load of the debt, and started hawing its shares on the market. Within months, the stock had soared from L100 to L1000, with no end in sight. The British government gave them exclusive trading rights to some ports Spain was allegedly willing to part with in Chile and Peru. They imagined piles of gold and sold their shares as the economic opportunity of a lifetime. But according to historians, “The Earl of Oxford declared that Spain would permit two ships, in addition to the annual ship, to carry out merchandise during the first year … [but[ the first voyage of the annual ship was not made till the year 1717 [the deal had been made six years earlier], and in the following year the trade was suppressed by the rupture with Spain.” Unfortunately, nobody was listening, instead followed a rumor that trading was unlimited.
Investors went giddy, the Company made boatloads of cash from them, and imitators came and went quickly, along with the investor’s money. Stock prices soared and the higher they went, the more the investors fought to get in (kind of like Madoff, now that I think about it). The Company insisted profits were just around the corner, just like those lying bastards at Enron. The “bubble burst”, as all bubbles do, when nobody wanted to buy stocks anymore and those that had them couldn’t sell them.
According to historians, the now wealthy directors of the South Sea Trading Company told investors what great things the Company had done for England. Then they bolted with the money. (Sounds like, well, any of the companies we talk about.)
Ponzi
Carlo Pieto Giovanni Guglielmo Trebado (“Charles”) Ponzi was born in Parma, Italy, in 1882. He emigrated to Canada in 1907, where he operated a scam similar to his future “Scheme”. Ponzi served almost two years in prison for forgery before being released. His next run-in with the law was in 1911, for involvement in smuggling illegal immigrants into the United States from Italy. For this crime, he spent another two years in prison in Georgia. Released in 1913, he took up residence in Boston, where he was to develop the criminal enterprise that today bears his name.
The scheme was simple in its essentials. I) Find investors. 2) Find more investors. 3) Use the money from the second group of investors to pay off the first group. 4) Profit. 5) Repeat until indicted. This is what is now known as a Ponzi Scheme.
At first, his life in Boston was unremarkable. He married one Rose Maria Gnecco, and managed several legitimate small businesses, with little success, before taking a job as a translator. In the year of his marriage, Ponzi obtained a loan of $200, and with it established the Old Colony Foreign Exchange Company, selling “Coupons” to be repaid in International Reply Coupons (a type of stamps used for return postage of international mail). The profit from buying and selling these securities was miniscule. Ponzi promised a 50% return for investors within 90 days. This was impossible. In order to generate enough profits to pay off investors, Ponzi sold more “Coupons”. And more. And more. And MORE.
These “Coupons” sold so well that Ponzi was able to repay the $200 loan in full within half the allotted time, bringing in more eager investors. The profits, of course, were entirely fictitious. Ponzi never bought the International Reply Coupons, and relied on additional investors to provide the “profits” for previous investors. At the height of the scheme, Ponzi was making a million dollars a week (more than ten million dollars in modern money, although in reality this fortune was worth even more considering that the purchasing power of money was much greater at that time). People were cashing in their life savings to buy Ponzi’s worthless “Coupons”, and reinvesting their profits, doubling down their bet, like risking everything on a 100:1 long shot at the racetrack.
The rapid development of Ponzi’s company drew attention from the suspicious eyes of the police, and of skeptics everywhere. When someone suggested he could not generate such high returns with the investment process he claimed to use Ponzi would sue for libel (and win). Investigators from the police, the press, and the Massachusetts Banking Commission were unable to find conclusive evidence of any crime, since all of Ponzi’s paperwork was in order.
Then, in the summer of 1920, the house of cards collapsed. As rumors circulated, turning to speculations and then allegations, investors began to pull out. With no new money coming in the door, Ponzi could no loner repay his previous investors fast enough. An audit of his books showed a seven million dollar shortfall. Investigative reporting discovered a glaring discrepancy: the number of “Coupons” issued by Ponzi exceeded the actual number in circulation by a factor of five thousand (that is, Ponzi claimed to have sold more than one hundred and fifty million “Coupons” when there were fewer than thirty thousand International Reply Coupons in circulation). Ponzi hired a public relations firm and kept issuing his “Coupons” and paying off old investors with money from new investors.
The scheme was revealed. Ponzi was charged with 86 counts of mail fraud (a federal crime) and was also found guilty of additional charges of larceny by the state of Massachusetts. A lawsuit was filed alleging that the government was violating the rule of Double Jeopardy in prosecuting him in both state and federal court for the same crime. The case went all the way to the Supreme Court before being rejected–the Court ruled that if an action was criminal under both federal and state law, the defendant may be tried separately for two crimes. When asked about his crimes, Ponzi replied, “I came to this country looking for trouble, and I found it”.
After serving nine years in federal prison, Ponzi was granted bail to prepare his state case. He fled to Tampa, Florida, and launched another scheme, this one selling Florida swampland. It was not long before the law caught up with him again. While trying to flee by boat to Italy, he was apprehended by Texas police in New Orleans, extradited to Massachusetts, and imprisoned until 1934. Upon leaving prison, he was deported to Italy (in addition to his other crimes, Ponzi was an illegal immigrant).
Later in life, Ponzi moved to and worked as an English teacher in Brazil, where he died in poverty in 1949. In a deathbed interview, he remarked that, “Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over”. Today, Ponzi looks like an amateur. Hell, Bernie didn’t even get caught the first time until he was over 70.
The Teapot Dome Scandal
When President Warren Harding gave Senator Albert B. Fall, his Secretary of the Interior, control of the Teapot Dome, Wyoming, oil fields in 1921, Fall promptly leased the Teapot Dome to his pal Harry Sinclair’s Mammoth Oil Company. In return, Fall received about $400,000 from the oil barons. He tried to keep it secret but his new-found wealth caught attention. A committee of the U.S. Senate uncovered the crooked dealings and went public in 1924. Fall was the subject of criminal trials, hearings and so on, until finally he was found guilty of bribery in 1929, fined $100,000, and sentenced to one year in prison. Harry Sinclair, who refused to cooperate with the government investigators, was charged with contempt and received a short sentence for tampering with the jury. Overall, the Teapot Dome scandal came to represent the corruption of American politics, which has become more prevalent over the decades since the scandal. Nothing like what we have today, though.
The Thieves Are Smarter Than We Are (How do you like your new condo, Bernie?)
“I am not a crook”, Richard Nixon
Bernie Madoff was a legend on Wall Street. He was an icon, regarded by many as one of the smartest investment minds on The Street. He was the Bice Chairman of the NASD–head of the Regulatory Oversight Committee, a member of the NASDAQ Board of Governors and on the Executive Committee of the NASDAQ QMX Group (whatever that is). His clients numbered the most prestigious Foundations and Endowments and the best Corporations, along with some of the finest investment management firms in the country. (And a few lucky individuals.) His web site boasts that, “Bernard Madoff has a personal interest in maintaining an unblemished record of value, fair dealing and high ethical standards that has always been the firm’s hallmark”.
Bernie Madoff was hauled away in cuffs by the FBI on December 12, 2008, for perpetrating a fraud on his elite investors for well, roughly 17 years, stealing somewhere around $50 billion.
He had been operating a massive Ponzi scheme of “epic proportions”, fleecing investors by paying off earlier investors with the money from new investors, and then reporting phony return numbers. Not surprisingly, he had great returns, so much so that people wondered how he did it. Now we know.
As I said, Bernie was smart. He fooled colleges, corporations, sophisticated investors, the Securities and Exchange Commission, auditors, top investment professionals, and it took a two year “sting” operation by the FBI which infiltrated his organization to figure out what he was doing. When the FBI knocked on his door, he reportedly said, “I guess I know why you’re here”. I guess.
A Ponzi scheme works as long as new money keeps coming in, but the tough economic climate hits the crooks, too. When investor requests for their money (to offset market losses) reached several billion dollars, Madoff threw up his hands and admitted that his investment firm was a fraud and had been insolvent for years. The guy with high ethical standards was going to use the last few hundred million dollars left to pay bonuses to his employees. “There’s no innocent explanation. Investors were paid with money that wasn’t there,” he supposedly said.
The total fraud is said to top $50 billion. That’s a lot of rounds of golf, even in Palm Beach. At the time of his arrest, the assets that were supposed to be there were about $17 billion. A spokesperson said $15 billion went to “money heaven”.
The criminal charges got him 25 years (we hope that’s life!), and a multi-million dollar fine. The SEC suit will seek some restitution for investors. Madoff’s lawyer called him, “a person with integrity”. I guess that’s because he told the FBI that he was just about to go turn himself in. At his firm, a spokesperson reportedly said things were “business as usual”. God, I hope not.
If there is a lesson we learn from the biggest fraud every perpetrated by Wall Street, it is the following:
1. The regulators can’t stop the crooks.
2. If you can’t see it, touch it and get it quickly, there’s something wrong with it.
3. Caveat emptor.
But it didn’t stop there. Oh, no. Read on.
Allen Stanford
“Mini Madoff” Allen Stanford owned Stanford Financial Group of Companies. In early 2009, Stanford became the subject of several fraud investigations, and on February 17, 2009, was charged by the SEC with fraud and multiple violations of U.S. securities laws for alleged “massive ongoing fraud” involving $8 billion in certificates of deposits. The FBI raided three of Stanford’s offices, in Houston, Memphis, and Tupelo, Mississippi. On February 27, the SEC said that Stanford and his accomplices operated a “massive Ponzi scheme”, misappropriated billions of investors’ money and falsified the Stanford International Bank’s records to hide their fraud. “Stanford International Bank’s financial statements, including its investment income, are fictional,” the SEC said. Federal agents who raided the offices of Stanford Financial on February 17, 2009, treated it as “a kind of crime scene”–cautioning people not to leave fingerprints.
Stanford’s assets, along with those of his companies, were frozen and placed into receivership by a U.S. federal judge, who also ordered Stanford to surrender his passport. CNBC later reported that Stanford tried to flee the country on the same day as the raids on his headquarters: he contacted a private jet owner and attempted to pay for a flight to Antigua with a credit card, but was refused because the company would accept only a wire transfer. On February 19, FBI agents, acting at the request of the SEC, located Stanford at his girlfriend’s house near Fredericksburg, Virginia, and served him with civil legal papers filed by the SEC.
On April 20, Stanford denied any wrongdoing. His companies had been well-run, he claimed, until the SEC “disemboweled” them. On June 18, 2009, Stanford was taken into custody by FBI agents. According to DeGuerin, “Federal agents in black SUVs surrounded his girlfriend’s house this afternoon, and just sat there. I told him to walk out and introduce himself. So he did, and he asked them, ‘If you’ve got a warrant, take me into custody. If you don’t, I’m going to Houston.’ And they did, so they arrested him”.
On June 25, 2009, Stanford appeared in a Houston court and pled “not guilty” to charges of fraud, conspiracy and obstruction. With the civil cases going on in June, 2010, the criminal trial is scheduled for January, 2011. I can hardly wait. Until then (and I’m certain, after then), he sits in jail.
At least it ended with Stanford. What? Who? Michael Rutherford, Scott Rothstein, Baskaran Thargarasan, Raymond Londo, and we’re not halfway into 2010 yet? No end to them.
Over the past five years, we have been witnessing the most dramatic events ever in the treatment of fiduciary responsibility with dynamics on THE CORPORATE LEVEL. Once reserved to the ERISA world, or used in lieu of “Investment fiduciary, the corporate regulatory community has adopted the word ‘fiduciary’ and is using it to fuel their periodic witch hunts. Once upon a time, corporate regulators, usually states attorneys general, urged courts to apply the Delaware Chancery Court’s Safe Harbor standard known as the “Business Judgment Rule”. BUT, Common Law, like “The Times”, “they are a changin”, always changing and these same states attorneys general are now apparently adopting ERISA standards as a model. “Fiduciary” means much, much more today.
Generally when we write about fiduciary issues, the attention is focused on ERISA and its standards of care relating to prudently investing employee benefit plan participants’ money. The reason for this is obvious–it is easy–the path of least resistance. ERISA has black letter law, administrative opinions and thousands of court cases to interpret the law. Media report celebrity scandals in screaming headlines. But, there are other incantations of fiduciary responsibility, which have an equal or even greater effect on our clients–everyday shareholders.
There are two questions that are being asked now by lawyers, judges and juries:
1. Do corporate officers and Boards of Directors have a fiduciary responsibility to shareholders, from 401(k) employees to mom and pop investors, to truthfully report and comment on the financial condition of their company?
2. Do these same corporate servants have a fiduciary duty to not abuse the assets of the company, instead work for the benefit of those same shareholders
The Courts in some high profile cases are answering a resounding, “Yes”.
The perpetrators:
On the corporate level–companies of all sizes and forms are being found liable for defrauding shareholders, for lying about the financial condition of their companies. The breach of fiduciary responsibility knows no discrimination–it encompasses big corporations, small corporations, foundations, endowments and trusts.
Who is Affected?
On the corporate level, it is not just the crooked perpetrator who is liable for these fiduciary injustices. Ultimate responsibility rests at the highest corporate levels–CEOs, CFOs, presidents, officers, boards of directors, trustees. Liability extends to their paid service providers, and sometime cronies–money managers of employee benefit funds, and various financial advisors.
Who is Safe?
No one.
Where is the Reform Headed?
Toward Corporate Board Transparency.
Who Will Benefit?
Ultimately, reform will be good for corporations, will be good for shareholders, and will benefit you. Investors are tired of reading about Joe Nobody in Yeehaw Junction, Florida, bilking millions from the former Orange County farmers and earth tillers. So, the long-term benefit will go to:
Your company,
Mom and Pop shareholders
And You.
RESULTS COMING
Hard on the heels of the civil penalties and regulatory fines and criminal actions are the most feared scourge of all–TRIAL LAWYERS–looking for plaintiffs who are asking, “On whose Watch did this occur?” Shareholders are agitated, motivated, empowered, and they’re represented by good firms like Millberg Weiss of Atlanta. Courts are being asked by plaintiffs to assume directors have “suspect” ties to management, and to consider management’s role in setting selection and the compensation of Boards.
And this is only the beginning. Where will it end? “It looks like a small patch of icy water”, the captain of the Titanic.
NEXT UP — ADVISORS AND PLANNERS
The impact of this ERISA and non-ERISA fiduciary litigation will be felt at the financial advisor, financial planner, investment advisor level.
The charge of the financial advisors will e to provide full disclosure and adequate education to your clients, while ensuring that the due diligence effort is complete and accurate.
Financial advisors will: evaluate investment options solely according to your client’s investment objectives, document your recommendations, fully explain market risks, provide full disclosure including all fees and cost comparisons, explain that past performance is an unreliable predictor of future performance, keep the investment process an ongoing one and be a fiduciary.
At the end of all of this, we will have the age of corporate and investment transparency. The end result of these developments will be a more open, more shareholder-oriented investing world. Those who play by the rules will be winners, and will benefit.
Above all, we WILL remember we’re dealing with Somebody Else’s Money.
The dynamics are on three levels, affording an enormous opportunity for Financial Advisors (those who do it right, and play by the rules).
On the corporate dynamic, it’s “White collar (with an Hermes tie) crime”. Companies of all sizes, their Officers and Directors are being found liable for breaching their fiduciary responsibility to shareholders, especially 401(k) and ESOP participants by lying about the financial condition of their companies. This breach of fiduciary responsibility knows no discrimination–it has been perpetrated by big corporations, small corporations, foundations, endowments, and trusts. Ultimate responsibility rests at the highest corporate levels–CEOs, CFOs, Presidents, Offices, Boards of Directors, and Trustees. Victims from these billion dollar train wrecks are strewn from toney condos to trailer parks, and include your clients:
Employee 401(k) participants who dutifully followed the urgings of their management to continue investment in “The Company”, because it’s “good for everybody”. Presumably by “Everybody”, CEO Bullmoose meant “Me and my fat cat cronies”.
ESOP participants, socking nickels and dimes away for retirement blindly believing the financial lies being pandered to them by The Company ivory tower elite.
Shareholders who hate the reams of proxy voting garbage they get every February, and don’t read it, only to find out later that obscene bonuses have been authorized to corporate bigwigs who have pandered away the company coffers, while gifting huge consulting contracts to their Saturday morning golfing partners at Dead Possum Country Club.
The resulting fraud being perpetrated upon the shareholders is being dealt with by regulatory fines and firings, followed by class action lawyers. Although Dante would have dealt with it differently by turning up the heat.
On the Investment Management dynamic, it’s, “The Wall Street Tango” (Oooh, I love a little sidestep). Shareholders have been taken advantage of by mutual funds, broker dealers, investment management firms, independent RIAs, celebrities like Martha Stewart and industry insiders like Rich Grasso. Some unscrupulous investment management professionals have breached their responsibility to investors in situations like the following:
Late trading allowed favored investors to take advantage of after hours activities and trade on information not known by us.
Market timing of mutual funds gave certain firms an undisclosed advantage by allowing them to get in and out quickly while we poor long-term investor slobs are waiting for tomorrow’s USA Today to see how we’ve done.
Front running portfolio managers so fervently believed in their own research that they traded ahead of the rest of us to test it out.
Regulatory sales practice rules have been blatantly disregarded.
Revenue sharing deals have not been disclosed to investors.
401(k) expenses have been allowed to run rampant.
Principals have been arrested, barred from the industry, or “Retired”, and more than $3 billion in regulatory fines have been assessed.
On the Financial Advisor dynamic, it’s, “The Financial Adviser Hall of Shame”. Clients have been ripped off perhaps intentionally, or even unintentionally by untrained financial advisors, rogue financial advisors, and in some cases, criminals. In the first six months of 2004, there were 4384 arbitration cases filed by disgruntled investors. Not all were valid, but some were, and only a small percentage have been settled.
An Introduction to Fiduciary Responsibility (or, “Who, Me?”)
Fiduciary responsibility is not rocket science. You can exhaust the legal definitions and interpretations of fiduciary under ERISA, the UPIA, and UMIFA, and come to the same conclusion we reach by describing it as, “The ethical treatment of Somebody Else’s Money”. The same legal treatises can be scoured to understand WHO has fiduciary duty, or we can simplify it as the courts have done, “A fiduciary is someone who is responsible for somebody else’s money”. Recent Courts have been consistently more eager to apply a sophisticated legal theory called the “Duck” theory (although not actually by that name). If it looks like a duck, walks like a duck, smells like a duck, and acts like a duck, it’s a duck. Forget about legal definitions, fiduciary status is being defined by the actions of the party in question. If the client believes the party is acting in a fiduciary capacity, that party will be one.
How does this impact YOU, and more importantly, what do you do about it? What we have as a result is an opportunity for Financial Advisors and their clients because:
Advisors who guide their clients to investments based on fees earned instead of rendering independent, unconflicted investment advice are dead.
Financial Advisors, Investment Advisors, and Fund Managers who aggressively rush to raise new assets at the expense of their investment expertise integrity will be gone.
Investment recommendations without fiduciary responsibility are gone.
Advisors will be expected to evaluate investment options solely according to the client’s investment objectives, document their recommendations, fully explain market risks, provide full disclosure including all fees and cost comparisons, explain that past performance is an unreliable predictor of future performance, keep the investment process an ongoing one and be a fiduciary. Those that do will thrive in the new age of corporate and investment transparency.
Financial Advisors, who treat somebody else’s money with the ethical treatment demanded will be winners, and we will all benefit from a more open, more shareholder- oriented investing world.