by James Walsh
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.
In fact, there was no risk at all...because Fry wasn’t buying an
y derivatives. Rather than investing the money in an ingenious investment program, he spent indulgently on himself. He used more than half a million dollars to start a stable of race horses. He spent almost that much in Atlantic City casinos. (Like many Ponzi perps, Fry loved to gamble and usually lost.)
Throughout the scheme, Fry kept a jokey attitude that disarmed doubters. The vehicle that he used for collecting investors’ money was called the GTC Fund. Fry would happily tell investors that “GTC” stood for Good Till Canceled or Gamblers Trading Consortium.
As often happens in these situations, the insouciant smirkiness made Fry all the more convincing. Who else but someone who knew what he was doing would treat serious money so unseriously?
In the end, the joke was on Fry’s investors. During 1993, dividend checks to investors started bouncing. Angry investors called state authorities who promptly got a court order freezing Fry’s assets, both personal and corporate.
Fry fled, leaving a note which said—in shades of his old form—that he was going to a place where “the weather will be warm and the primary tongue one other than English.” But, again like most Ponzi perps, he didn’t run anywhere exotic. He was arrested in Cincinnati 14 months after he’d left Baltimore.
Fry pled guilty to four counts of theft, securities fraud, lying to the Maryland securities commissioner and willfully failing to file a tax return. In early 1995, he was sentenced to eight years in state prison and ordered to pay restitution of $3.8 million to his investors.
State law enforcement officials seized a little less than $1 million in various assets under Fry’s control. They doubted there was much of the GTC money left.
But the state couldn’t keep an ambitious felon down. Less than a year after Fry moved into a Maryland prison, he posted his resume on an Internet Web site that offered fee-based financial advice. For an annual fee of $500, he would teach investors the intricacies of the stock options markets.
The posting made vague reference to “an unfortunate event” in which a client had defaulted on several hundred thousand dollars worth of trades and that Fry had made the “tragic mistake” of diverting other investor funds to cover the loss. (He didn’t mention that he was writing from jail.)
Fry tried to put a positive spin on his bitter experience. His posting beseeched, “who better to advise against the pitfalls of... options trading than one who has been sucked into the abyss by utilizing them?”
Investors Also Define the Ponzi Equation
The perps are only part of the equation, though. In order to understand why these schemes are becoming so common, we need to consider the investors who enable the crooks.
In August 1996, the Nevada state attorney general’s office arrested five women and filed suit against 27 other people in what it characterized as a “classic” Ponzi scheme1 taking place in a city that wouldn’t seem to need one: Las Vegas.
Actually, the Las Vegas scheme was more like a pyramid plan than a Ponzi scheme. It was surprisingly simple. Participants would receive $16,000 from a $2,000 investment if they could recruit a large enough number of family members, friends and co-workers. Time didn’t matter that much, only the number of people a person could convince to join. The scheme’s organizers didn’t hesitate to admit that people who joined early would be paid by the people who followed.
The organizers of the pyramid scheme tapped a rich source when they got involved with the Las Vegas Metropolitan Police Department. Police sergeants, patrol officers and corrections officers were among the people actively recruiting co-workers to join the scheme.
By early 1996, the scheme collapsed and more than 200 people in the Las Vegas area lost their $2,000 entry fees.
The fact that many of the participants were cops upset many people. A local newspaper complained:
Not only have they embarrassed themselves, their badges and their department, but they also have spent their precious credibility by recruiting others into the basest sort of get-rich-quick scheme.
Like more flagrant forms of corruption, Ponzi schemes thrive on the special, intense level of trust that police officers have in one another. And, like the more flagrant forms of corruption, the schemes undermine that trust.
1 Law enforcement officials almost always refer to Ponzi schemes as “classic.” A California lawyer who has prosecuted the things says, “It’s a way that the cops can say these people should have known better than to get involved in a get-rich-quick scheme.” In other words, it’s a way for them to show the contempt they feel for everyone involved. In the Nevada case, this included some of their own.
One Las Vegas cop added some insight that seems to support the populist/class envy theory of why the schemes work. “This is a place where all kinds of bad people are making all kinds of good money. It’s very hard to toe the straight line as a law enforcement professional. A lot of [police officers] looked at the scheme like a kind of honest graft.”
A Global Phenomenon
Ponzi schemes aren’t limited to San Diego leasing companies, North Carolina decorators or Las Vegas cops. Though the schemes are distinctly American phenomena, their resurging popularity is global. During the early and mid-1990s, several eastern European countries, newly relieved of the financial burden of Marxism-Leninism, plunged into Ponzi schemes that were national in scope.
In Albania, which had suffered for 40 years under a Marxist regime too extreme for even the Soviet Union to support, private moneymaking schemes that promised huge dividends soaked up the savings of between 50 percent and 90 percent of the population. Most of these cons promised big money from the development of technology companies and international banks to people who barely understood the concept of currency. Almost $3 billion flowed into the schemes from people who could barely feed themselves. As ever, the first few successes created huge demand.
By late 1996, when the schemes started to collapse, street riots and political chaos followed. The outrage was understandable. The Albanian government, long suspected of being corrupt, had licensed most of the schemes. Although the government acknowledged what it called a “moral responsibility” to pay back at least some of the losses, its treasury didn’t have enough cash to make a significant dent.
International Monetary Fund officials had warned the Albanian government about the schemes in 1995. Two years later, the same economists worried that the government could only meet its moral responsibility by printing money...and courting hyperinflation. “There can be very serious implications,” said one IMF official. “There are risks to the stability of the currency and to the long-term economic stability of the country.”
Albania wasn’t alone in these troubles. In Romania, more than 500 pyramid schemes were hatched in the five years following 1989’s overthrow of Nicolae Ceausescu. The biggest fund, known as Caritas, promised 800 percent profit within 100 days. In early 1994, the scheme collapsed with more than $1 billion in debts to three million investors.
“People are Greedier than They are Smart”
As the eastern European countries develop their economies, they may find—as the West has—that people have short memories when it comes to get-rich-quick programs. As one investor in a New Jersey real estate pyramid said, thinking about all the money he lost, “People aren’t stupid. They’re just greedier than they are smart.”
And perps are forever coming up with variations on Ponzi’s scheme. In the precedent-setting Ponzi scheme decision Kugler v. Koscot Interplanetary, Inc., the New Jersey State Supreme Court wrote:
Fraud is infinite in variety. The fertility of man’s invention in devising new schemes of fraud is so great, that the courts have always declined to define it.... All surprise, trick, cunning, dissembling and other unfair way that is used to cheat anyone is considered as fraud.
Almost all modern Ponzi frauds contain some semi-plausible business “explanation” for the astounding growth of the initial investors’ money. It might be quick gains made from equipment leases, bridge loans, mortgages or currency futures. T
hese things are echoes of Carlo Ponzi’s Great Idea.
Also, the schemes always have perpetrators and promoters desperate enough to sell hard. These people are echoes of Ponzi himself.
CHAPTER 1
Chapter 1: The Mechanics Are Simple Enough
A Ponzi scheme isn’t a complicated thing, mechanically. The perpetrator collects money from investors, promising huge returns in a matter of months or weeks. He has to do one of two things:
1) return a portion of the invested money as “profit” while convincing investors to keep their “principle” (which is dwindling fast) invested; or
2) recruit new investors, whose money is used to produce the promised windfall to the earlier ones.
Even if the perp does the first thing, he’ll eventually have to do the second.
Finding the second level of investors is usually the hardest part of the scheme. Once they are recruited, the scheme often drives its own growth. This is why a certain level of word-of-mouth publicity is essential to a scheme’s success. When word of early profits and ritzy investors spreads, new investors pour in. With more dollars, the Ponzi perp is able to pay off more people.
Basically, a lot of cash is moving around but none...or very little...actually goes to anything that could legitimately turn a profit. The Ponzi perp can maintain the charade and skim off money for himself only as long as new suckers are feeding him with dollars. When this cash flow dwindles—even slightly—the whole scheme collapses.
The schemes can yield large returns for those who start them or join early on. As long as there are enough people to support the next level of the scheme, people above are safe. In financial circles, this is known as the “greater fool” theory. As long as you find someone willing to take your place in the scheme—a greater fool—the fact that you were a fool to invest doesn’t matter.
The greater fool theory applies to more than just crooked schemes. Paying $40 million for a French Impressionist painting, $500,000 for a baseball card or a year’s salary for a tulip bulb might make sense if there is someone willing to pay even more. But it’s absolute folly if there’s not. This fiscal relativism blurs many people’s judgment about all investments.