The more money Ponzi took in, the more money he paid out. The more money he paid out, the more money he took in. The chain reaction continued until he had incoming money littering his office, stuffing his closets, and overflowing into his wastebaskets.
One day, the Boston Post dug up Ponzi’s past record and revealed that he had spent time in prison in Canada for check forgery and in Atlanta for smuggling aliens. That was enough to cause some of the Ponzi investors to hold up. And, of course, as soon as the new money stopped coming in, the scheme collapsed, leaving forty thousand people, many of them poor Italian immigrants, broke.
Stock Market Fraud
p. 229 It might be accurate to say the whole market is a fraud, and indeed some people think so. Al Capone, when he was arrested for income tax evasion, said that he was always puzzled that the government was trying to close him down and yet let the stock market continue. Like the insurance business (one of the greatest gyps in history), the stock market is an example of a legitimate business effort evolving into widespread fraud. Don’t believe me? Consider the evidence.
Cold-calling brokers from New York, who don’t know you from Adam but who tell you they can make you rich as Croesus by next week if you open an account with them and buy some penny stocks, are really out to benefit not you but themselves. If the stocks they tout are so great, why do they need you to buy them? Why don’t they just buy them themselves and keep all the profits themselves?
Many penny stocks are fake shares in fake corporations formed by fake brokers who want to dupe the public. And even if you get a nice-looking certificate by return mail, that doesn’t mean much. Certificates are easy to print. Chances are the certificate is fake, too.
If you send these cold-calling brokers the money to open the account or to buy shares, chances are you won’t see that money again. The cold-calling broker isn’t even a broker. He is a fake. He is a con man sitting in a boiler room and reading a script to help him get you to buy into the scam. If you listen to him, you will amuse yourself by recognizing the six classic parts of the swindle, with heavier than usual emphasis on the pressure to do something right now rather than miss the golden opportunity that will soon pass away.
Even if the penny stocks are real, the other thing bad about penny stocks is that they are likely to be owned by people of limited means, who are easily frightened and typically obliged to dump stocks, in times of stress, for what they can get.
Recently, penny stocks have become part of the updated version of the classic market manipulation known as pump and dump. As you read about pump and dump, try to figure out how it resembles the pedigreed dog scam.
In pump and dump, someone sets up a free Web site promising investors hot tips on penny stocks. He then buys the stocks in advance of the tips and sells them at a profit as soon as the followers bid up the prices. The stocks then plunge back to earth, causing losses for the p. 230 unwary investors and profits for the tout. Not only is this not nice, it is also illegal. Yun Soo Oh Park—also known as Tokyo Joe, the Internet’s best-known stock guru—according to the Security and Exchange Commission, enriched himself at the expense of subscribers by urging his disciples to buy certain stocks that he was often selling for a tidy profit for himself.
Current FBI and congressional investigations show that Initial Public Offerings (IPOs) were, during the ’90s, manipulated in the same manner such that insiders made millions on the first day’s run ups, and the public lost millions on the subsequent run downs. Analysis of the situation should have raised the puzzling question of why the stock prices of those IPOs ran up so fast without underlying financial performances to warrant such escalations. It was also puzzling that such rises were often short lived.
Now we know that it had to be like that because the IPOs were being pumped and dumped. The IPOs were part of a bubble artificially inflated with hot air. Participating investment bankers colluded and agreed among themselves—without the knowledge of the regulatory authorities or the investing public—to bid up the IPOs prices for the first few days or so. It was also agreed when the artificial pumping would stop so that the insiders knew when they could safely dump.
Pump and dump and the IPO game resemble the pedigreed dog scam in that they tout as valuable something that is not. What’s the lesson?
Lesson: Stay away from pump and dump and from IPOs with the same vigor that you would stay away from that pedigreed dog scam.
By the by, if you have to invest in the stock market, avoid the error of IPO future fact. Stick with companies that have proven, not prognosticated, financial performance. The focus is in the same markets but at a much later, and safer, stage of development.
Did you forget your thinking skills yet? I hope not. Refresh your skills by working out the current examples of how the con men took $8.6 trillion out of the hands of the public. Study the situation and then outline the errors in thinking. Check your answers against mine. My answers are incomplete but suggest some of the ways you might have approached the analysis of the situation described. In each case, the come-on was the same. Because of greed and avarice, CEOs particip. 231pated in the frauds. The come-on was, “Want to make some real money, really fast?” In each case, a high degree of skepticism would have saved you money. Here’s how.
Dynergy. Energy sales are not profitable. But you convince investors that they will be in the future. Then you enter into agreements with other energy traders. Under the agreement, each of you buys millions of kilowatts of energy from each other. Or pretend to buy—no need to go to the trouble of actually moving electricity anywhere. Suddenly, you look like a big player. The stock rises. You cash out at high prices.
Defects. Reasoning contrary to fact: The energy business was lousy. There were no sales. There were no profits. The belief that there might have been sales, profits, or even hope was based on fake evidence, which is not evidence at all—it is the opposite of evidence, leading away from reality to error. Decisions based on fake evidence are likely to be wrong. In this case, they were wrong, dead wrong.
The future is not determined. It can’t be predicted with accuracy. Therefore, the so-called projected profits (and the costs of generating those profits) are not determined. In a sense, the projected profits are not real since they don’t yet exist. They are certainly not currently real and should not be counted as such on the balance sheet. Future fact is not a fact at all. Future fact is at best contingent. In the case of Dynergy, it wasn’t even contingent. It was impossible. In fact, it is highly possible that Dynergy has no future. Stock price, September 2002, $2.07, down from $95. Percent loss: 98 percent.
Adelphia. You sign contracts with customers and get investors to focus on the volume of contracts rather than on their profitability. This time you don’t invent imaginary trades, you invent lots of imaginary customers. With your subscription base seeming to grow so rapidly, Wall Street stock analysts give you high marks. The stock rises. You cash out at high prices.
Defects. Reasoning contrary to fact: The business was not growing. The customers were not real. There were no sales; there were no profits. The belief that there might have been sales, profits, or even hope was based on fake evidence, which is not evidence at all—it is the opposite of evidence, leading away from reality to error. Decisions based on fake evidence are likely to be wrong. In this case, they were wrong, dead wrong.
The future is not determined. It can’t be predicted with accuracy. Therefore, the profits (and the costs of generating those profits) are not determined and not real since they don’t exist. They are certainly not p. 232 currently real and should not be counted as such. Future fact is not a fact at all. It might be a fact in the future. Then again, it might not be a fact in the future. It all depends. We simply don’t know because the future is contingent. In the case of Adelphia, because of the egregious nature of the frauds involved, including insider trading, loans to executives that were tax-free transfers of money never intended to be repaid, fake customers, and so forth, future profits a
re not contingent. They are impossible. Adelphia current stock price: 1 cent, down from $105. Percent loss: 99.99.
Enron. Sign contracts to provide energy for the next thirty years. Deliberately underestimate the cost. Book the projected profits on those future sales as part of this year’s bottom line. Suddenly, you appear to have a highly profitable business. Sell shares and cash out at inflated prices.
Defects. Special pleading. Profits and costs should be handled the same way at the same time. To treat profits one way and to treat costs another way is inconsistent, is special pleading, distorts the reality, and is wrong.
The future is not determined. It can’t be predicted with accuracy. Therefore, the profits (and the costs of generating those profits) are not determined and not real. They are certainly not currently real and should not be counted as such. Future fact is not a fact at all. Stock price, September 2002, 18 cents, down from $83. Percent loss: 99.78.
(It is possible that the Enron fiasco included a more involved business fraud called the bust-out. Although simple in principle, it often requires months or years to execute. The first point in bust-out is for the con man to get power in the business and direct the money from the business into his own pockets. In the bust-out, there is usually a front man, called the “pencil,” an honest or stupid executive who is not in on the fraud. He is the one who runs the routine operations of the company while the fraud artist concentrates his efforts on the scam. The pencil is also the one whose feet will be in the fire after the fraud artist leaves town or bows out or (and this is the usual end of the game) the company goes bankrupt. At that point, the pencil will have a hard time proving that he wasn’t a party to the scheme. Ken Lay, former CEO of Enron, could have been the pencil in Enron, and Fastow, the executive who ran off-the-books companies called “raptors” that concealed Enron’s costs and debts, might have actually been the con artist.)
WorldCom. Here you don’t create imaginary sales. You make real costs disappear by pretending that operating expenses are part of the p. 233 purchase price of new equipment. The operating expenses are charged off as capital expenses and, therefore, the real costs are shifted to the future. With the costs deflated, the unprofitable business seems on paper to be highly profitable. Wall Street analysts give you high marks. The stock rises. You cash out at high prices.
Defects. Reasoning contrary to fact: The business was not growing. The profits were not real because the costs were not real. If the costs had been charged to current profits, the profits would have disappeared. Thus, there were no profits. The belief that there might have been profits or even hope of profits was based on fake evidence, which is not evidence at all—it is the opposite of evidence, leading away from reality to error. Decisions based on fake evidence are likely to be wrong. In the case of WorldCom, the decisions were dead wrong and over $7 billion of so-called profits had to be restated because they were not profits at all. This is the largest accounting fraud in the history of the world (so far).
Special pleading. Profits and costs should be handled the same way at the same time. To treat one one way and the other another is inconsistent, is special pleading, distorts the reality, and is wrong. Stock price, September 2002, 13 cents, down from $60. Percent loss: 99.78.
Global Crossing. As mentioned, Global Crossing crossed over to the dark side. As Global Crossing emerges from bankruptcy, Gary Winnick, former CEO, ends up with $936 million while shareholders end up with nothing. Somehow, the fiber optical network that Winnick said was worth $27 billion in June 2002 only brought $250 million at auction in September 2002. This sharp change in evaluation raises the important question: Where did the money go? How could $26.75 billion disappear? Current stock price of Global Crossing stock as of September 2002, 1 cent, down from $61. Percent loss: 99.97.
Recent stock market disasters (Enron, Global Crossing, WorldCom, Adelphia, etc.) involve something more serious than business reversals. They involve misrepresentation of the financial positions, with executives becoming richer as the stock prices soared, and then, when the frauds were exposed, employees and shareholders were left with little or nothing.
In view of the present uncertainty of the true condition of corporate finance, especially in the United States, where government deregulation of business was deliberate, the market price of stocks must factor in that uncertainty to arrive at a price significantly lower than would have been otherwise justified.
p. 234 Well, what do we do now?
That, my friend, is up to you. It’s no fun to lose money. In 2003, Standard & Poor’s was down 40 percent from its peak in March 2000. The Bear Market of 1973-74 saw that index decline 48 percent. It took eight years to replace that drop. The Dow Jones Industrial Average was about 9700 in 2003. It could go lower or stay where it is for a while. Or it could go up. Who knows?
I predict a final market sell off. After that, sometime between 2004 and 2008, it might be the time for the intelligent investor, using the know-how gained from this book on basic clear thinking, to make a fortune. In the meantime, investor, those boots were made for walking.
Gaslighting Hoax
Gaslighting is a systematic array of techniques designed to destroy the target’s mental equilibrium. Most of the techniques are subtle and never clearly point to a malevolent or vengeful other party such that the hapless target never believes things are being done to him; he just thinks he is having a string of bad luck. The term comes from the 1944 Hollywood movie Gaslight, starring Charles Boyer and Ingrid Bergman. In the movie, the Boyer character tries to convince his wife that she’s going insane by contriving incidents designed to make it appear as if she’s forgetful, disoriented, and confused.
We don’t have the space or time to discuss more on gaslighting, nor can we do proper justice to other deceptions such as health-care frauds, drug burns, intentional accidents, insurance, gambling dangers, postal fraud, real estate scams, quiz show hoaxes, tangential cons, and so forth. If you are interested, consult The Rip-Off Book by Victor Santoro and Hoaxes and Scams by Carl Sifakis. My own book Investment Pearls for Modern Times discusses stock market frauds. Fleeced! by Fred Schulte gives a good discussion of telemarketing rip-offs and how to avoid them.
These books and others and your background in clear thinking will protect you from swindles, but not entirely. When someone sticks it to you, don’t take it too seriously. And don’t be hard on yourself. Learn from the experience. Do better next time.
Review
p. 235 See if you can figure out this scam that has been worked successfully several times in Queens, New York, where my father, Bernard M. Patten, was in charge of the Complaint Bureau and Racket Squad of the Queens district attorney’s office:
It’s Sunday afternoon. A well-dressed man appears at a Lincoln dealership and wants to buy a Lincoln Continental right away. He is willing to pay the sticker price because he wants the car right away. But there’s a snag. Because it’s Sunday, the dealer won’t be able to check with the bank to make sure the well-dressed man’s check is good. However, the well-dressed man does have good credit and proper identification, and he insists that he will not wait. “If you don’t sell me the car now, I will find another dealer who will.” The dealer sells the car, takes a check for $42,000, and issues a bill of sale.
One hour later, the well-dressed man is at another dealer’s place. He wants to sell that same Lincoln. He says he needs the cash fast. He is willing to sell for $20,000. Dealer number two is suspicious because he notices the bill of sale is only one hour old. So dealer number two calls dealer one and tells him that he thinks the well-dressed man has passed a bad check and is now trying to make a fast buck. Dealer one is outraged. Dealer one tells dealer two to keep the guy around while he (dealer one) calls the police. The police note the complaint and arrest the well-dressed man.
Question: What is the scam? What is the come-on? What is the incentive? Who is the shill? What is the switch? What is the pressure? What is the block?
Give up?
The scam is that when Monday morning comes, the bank honors the check. That means well-dressed man has been falsely accused and falsely arrested. Furthermore, well-dressed man will explain that he needed the money because he had a hot tip on the third race at Belmont, a tip that happened to pay off at 22 to 1. If he had gotten the money he needed to place the bet, he would have made $440,000! So p. 236 dealer one, dealer two, and the police are now responsible not only for the consequent damages of the false arrest but also for the economic damages of the lost opportunity.
Usually, dealer one foots the bill with a big settlement, which includes, of course, a free Lincoln.
The come-on is that dealer one will make a big profit from a sale at the sticker price. No one in his right mind goes into a dealer and offers the sticker price. The incentive is the fast buck. The shill is the well-dressed buyer in that he is a con man and not a real buyer. The switch is that the check is real, not fake. The pressure initially is to make the sale and then prevent a big loss by having the sale rescinded and the buyer arrested for fraud. The block is that it is perfectly legal to sell your automobile at a markedly reduced price. Since the race at Belmont is already over and the result registered and official, there is no way of disproving the buyer’s contention that he would have put his money on the nag that won.
Truth, Knowledge, or Just Plain Bull: How to tell the difference Page 28