You Can't Cheat an Honest Man (2 page)

The Supreme Court Offers Its Opinion

A number of lawsuits followed the collapse of Ponzi’s scheme. The most important of these was the civil suit
Cunningham v. Brown et al.
Cunningham was the heir of one of Ponzi’s investors. Brown was another investor, who’d received preferential treatment—that is, had been paid—by Ponzi. Cunningham wanted the money Brown had received to be returned to Ponzi’s bankruptcy estate for even division among all creditors.

In April 1924, the case went all the way to the Supreme Court. The resulting decision, written by Chief Justice and former President William H. Taft, set a precedent for dealing with wreckage left in the wake of a Ponzi scheme.

Both [lower] courts held that the defendants had rescinded their contracts of loan for fraud and that they were entitled to a return of their money.... We do not agree. [W]hen the fund with which the wrongdoer is dealing is wholly made up of the fruits of the frauds perpetrated against a myriad victims, the case is different.... [This] is a case the circumstances of which call strongly for the principle that equality is equity, and this is the spirit of the bankrupt law. Those who were successful in the race of diligence violated not only its spirit, but its letter, and secured an unlawful preference.

So, the money repaid to Brown was what lawyers call “voidable”— which means it could be ordered returned to the bankrupt estate. The concept of voidability is critical to the legal battles that usually follow the collapse of a Ponzi scheme.

Ponzi served some time in jail. But, like many of the people who would follow in his steps, he got right back to work after his release. He set to selling Florida swampland. Eventually, he was deported to Italy, divorced and destitute. “I bear no grudges,” he said in his final interview with an American newspaper. “I hope the world forgives me.”

Forgets
is closer to what the world actually did. In the 1930s, under the mistaken impression that Ponzi was a banking wizard, Benito Mussolini gave him a senior job in the Italian government. Treasury officials soon figured out that the wizard couldn’t handle basic math. Realizing he was about to be discovered...again, Ponzi stuffed cash into several suitcases and boarded a boat for South America.

But no one made bags big enough for the little con man. When Ponzi died in Brazil several years later, he’d been living on charity for a long while.

Elegance and Financial Alchemy

Ponzi schemes have a larcenous elegance. They’re a kind of financial alchemy, promising to turn basic human impulses like greed, trust and fear into piles of cash. For a brief time, they can make losers look like winners.
In legal terms, a Ponzi scheme is one in which money entrusted to the perpetrator is never invested in any legitimate for-profit venture. Instead, it’s gradually handed back to the investors under the fraudulent pretense that the returns are profits. They aren’t. They’re just small pieces of the capital originally invested.

The Ponzi perp will usually divert some portion of the money received for his own use. This creates a need to expand the number of investors in order to cover repayments of principal and promised returns to the existing investors. The more money the perp siphons off, the more rapidly he needs to find new investors.

Typically, investors are promised large returns on their money with little chance of losing it. “Low risk” and “no risk” are defining promises made in the early stages of most Ponzi schemes. Initial investors are actually paid the big money as promised, which attracts additional investors. But, eventually, the schemes get so big that they run out of new investors willing to support the structure.

Pyramid schemes and chain letters—close relatives of Ponzi schemes— induce people to participate in a plan for making money by means of recruiting others, with the right to encourage or solicit new memberships in the pyramid passed on to each new recruit. These schemes get their name from the flow of cash, from new members to old. The person at the top of the pyramid collects cash from all the people at the bottom.

Members are enticed to join a pyramid scheme by promises that they will earn a lot of money on a modest investment. They’re told that all they have to do is convince friends and family members to make similar investments. In reality, more people must lose money than make it. The only way for the perp to get his ill-gotten gains is to keep the money moving long enough to complete a couple of wire transfers to Zurich or the Cayman Islands. When the money finally stops moving, everyone at the base of the pyramid loses his entrance fee or investment.

As far as most cops and prosecutors are concerned, though, Ponzi schemes and pyramid schemes are victimless. People who lose money in the things have usually participated willingly.

Ponzis Versus Pyramids

The terms
Ponzi scheme
and
pyramid scheme
are used interchangeably by most consumer advocates and many law enforcement people. And the schemes are quite similar. Technically, the main difference is that in a Ponzi scheme money is handed over to be invested; in a pyramid scheme, money is handed over in exchange for a right to do something (most often to open a franchise or to solicit new members). Ponzi schemes are always illegal; pyramid schemes are sometimes, depending upon how they are structured

The result, in both cases, is usually the same. As a Utah court wrote in the 1987 bankruptcy decision
Merrill v. Abbott
:

A Ponzi scheme cannot work forever. The investor pool is a limited resource and will eventually run dry. The perpetrator must know that the scheme will eventually collapse as a result of the inability to attract new investors. The perpetrator nevertheless makes payments to present investors, which, by definition, are meant to attract new investors. He must know all along, from the very nature of his activities, that investors at the end of the line will lose their money.

This book will treat Ponzi schemes and pyramid schemes like nearly identical twins. In the contexts and circumstances in which the two are not the same, the differences will be highlighted and explained. As is often the case, these subtle differences shed important light on the mechanics and uses of the schemes.

Ponzi schemes thrive in cycles. They were big in the 1920s, late 1940s,
1970s and—most recently—have started to flourish again in the mid
1990s. Starting in 1995, the Securities and Exchange Commission began a campaign warning investors about a rise in Ponzi schemes and investment pyramids—especially ones using religious organizations for exposure and ones targeting the elderly.

In 1995, the SEC investigated 24 Ponzi schemes involving losses of more than a million dollars—a record for a single year. “We’re finding Ponzis these days with a depressing regularity,” Tom Newkirk, the SEC’s associate director of enforcement, told one newspaper in late 1996.
Andrew Kandel, who handles securities fraud cases for the New York State Attorney General, sees one major reason for this: In the age of personalized pension plans (401k’s, Keough’s, IRA’s, etc.) more people have direct control of substantial amounts of money. “They can easily recall 10 percent CDs. So, a smart Ponzi scam doesn’t offer a 25 percent promissory note—which might excite suspicion—but a quite plausible 12 percent piece of worthless paper.”

The SEC’s Newkirk goes one step further to offer a theory about why this is so: “Ponzis often seem to be an appeal to the populist streak in Americans.”

The subtext of many of the schemes is that acheiving wealth is a matter of knowing the right techniques and the right people—secrets that the rich are in on and that the Ponzi perp is willing to share with the little guy.

The Schemes Often Spin Out of Control

A Ponzi scheme is structurally simple, hard to control beyond its first few levels and ultimately doomed to fail. For these reasons, the schemes often grow in directions—and take turns—that even the crooks creating them don’t anticipate.

One of the common side-effects: Publicity. Because people tend to associate financial success with wisdom, courage and other virtues, Ponzi perps are often heralded as geniuses or heroes. A scheme will build the illusion of a highly successful business that’s paying big money to people “smart” enough to have bought in. Of course, these impressions are all as bogus as the underlying fraud.

The truth is usually that the Ponzi perps aren’t either wise or brave. In fact, they often aren’t very smart at all. Most Ponzi schemes collapse dramatically because they mushroom so fast the perps can’t keep up with the lies they’ve told. (The smartest perps try to limit the speed with which their schemes grow. Doing so, they can let time build trust and blur memories.)

Amtel Communications, a San Diego, California-based telephone equipment leasing company, had a Great Idea to pitch to investors. The premise was simple: Amtel would sell pay phones to investors for several thousand dollars and then lease them back, locate them and service them.

The investor never had to take possession of the pay phones. He’d just get leases, a description of where the phones were located and a check for $51 per phone each month. The monthly payments worked out to an 18.5 percent annual return.

The pitch worked well...and for a long time. From 1992 to 1996, Amtel took in more than $60 million. But, as early as 1993, salespeople hired to bring in investors were complaining to Amtel management that delays in getting the pay phones placed were causing problems. One salesman wrote Amtel’s sales manager: “Listed below are phones that I sold [recently] for which no phones have been provided. Some of these participants have purchased additional phones since and are apprehensive that we are conducting a Ponzi scheme.”

The salespeople—and the company’s on-time monthly payments— were persuasive enough that Amtel stayed in business for more than three years. The company was placing some pay phones...just not enough to generate income to cover all the investment money it was taking in. This is a common tactic in larger Ponzi schemes: Do some legitimate business in order to ward off the most skeptical inquiries.

By mid-1996, though, the scheme was collapsing. Amtel filed for bankruptcy protection and regulatory scrutiny followed. In October 1996, the SEC and a California bankruptcy examiner determined that Amtel was, in fact, a Ponzi scheme.

Lawsuits were filed from various sides in late 1996. The bankruptcy court allowed investors to vote on a reorganization plan proposed by new management. Although the plan would mean waiting even longer to recoup money, most investors supported it. The alternative was to accept a two-cents-on-the-dollar settlement that would protect the company’s previous management from liability.

Minor Schemes Can Do Major Damage

Ponzi schemes don’t always have to be as big and official-sounding as Amtel. Greensboro, North Carolina, interior designer Cynthia Brackett had a simpler story.
Brackett made as much money selling antique furniture to yuppies moving to the area as she did in actual design fees. The mark-ups on old furniture were plenty rich. Her only problem was that, while she had plenty of clients, she didn’t have much capital. So, she was having trouble getting as many Queen Anne chairs and Chippendale dressers as she needed.

Short-term financing would help her buy the right things at bargain prices from estate sales, dealer close-outs and other sources that required a buyer to move quickly and pay in cash. She’d pay well—as much as 10 percent for a 30-day note.

A lot of Brackett’s story checked out. She did have a design firm that seemed to be doing well. She was charming, attractive and traveled in the right circles. There were a lot of yuppies moving into the area. And banks did shy away from lending to “creative” businesses like interior decorators. So, some wealthy locals invested. However, “no money was used to purchase antiques,” an FBI agent would tell a federal court some time later. “It went to pay back investors and finance her own lifestyle.”

That lifestyle included a Mercedes, a home in Greensboro’s high-end Irving Park neighborhood, a vacation house in nearby Myrtle Beach and tuition for her children at the tony Greensboro Day School.

Like most smart Ponzi perps, Brackett was careful to repay her loans on time and with full interest. She was so conscientious that lenders were happy to increase their loans with her when she came back to them.

But the most impressive part of Brackett’s scheme was that she was able to convince each of her investors that he was one of a small group of big shots with whom she did business—that is, borrowed money.

By 1991, when the scheme collapsed, Brackett owed almost $1.5 million to more than 60 investors. In the early part of that year, Brackett had hit the wall. She’d run out of swells willing to loan her more money. Her checks started bouncing and her company declared bankruptcy.
In May 1995, the 46-year-old Brackett pleaded guilty in a Greensboro federal court to one count each of mail fraud and tax evasion. The judge threw the book at her. She was sentenced to 30 months in jail—the maximum time allowed under federal sentencing guidelines.

Ponzi Perps are a Distinct Type

How was Brackett able, single-handedly, to keep her fraud going on for more than five years? As we’ll see through the course of this book, it takes a definite type of personality to organize and execute a Ponzi scheme. Unfortunately, these people usually combine two key characteristics: They’re persuasive and they have few scruples.

Joshua Fry owned a small investment advisory firm near Baltimore, Maryland, called Stock and Option Services Inc. He impressed clients with detailed explanations of the program he’d developed for investing in the volatile derivatives markets. He was also witty and charismatic.

Fry said he had a method for maintaining the profitable upside of derivatives investments while reducing the downside risk. In the years before derivatives investments destroyed the prestigious British bank Barings and wounded giant American consumer products maker Procter & Gamble, this talk was convincing. Nearly 200 investors gave Fry a total of more than $5 million. “There’d always be some risk, but he said he had it down to no more than what you’ve got buying [stock in] General Motors,” said one investor.