You Can't Cheat an Honest Man
Page 8
So, aside from all the other problems a pyramid scheme poses, it isn’t as safe a place to hide expenses as a more traditional business. Since the things are suspect mechanisms to start, it’s not a good idea to load up tax-shelter pyramid schemes with questionable write-offs.
Federal courts have relied on a number of factors—the legal term is indicia—to determine that tax fraud exists in an investment scheme. Although no single factor is necessarily sufficient to establish fraud, the existence of several can be persuasive. These factors include:
• understatement of income,
• maintenance of inadequate records,
• failure to file tax returns,
• implausible or inconsistent explanations of behavior,
• concealment of assets, and
• failure to cooperate with tax authorities.
As you can see, all of these factors can apply to a pyramid or Ponzi scheme at the same time. As a result, the IRS will often have identified a Ponzi scheme as suspicious before it collapses.
Unfortunately, the Feds have a hard time moving on a scheme before it crashes. This is partly because federal regulators have so much ground to cover that they move slowly on any one case; but it’s also partly because Ponzi schemes tend to collapse quickly—often in less than two years.
To help the regulators—and, in turn, investors—some federal courts have added other warning flags to identify illegal schemes. The U.S. Ninth Circuit Court of Appeals (which includes Ponzi-heavy states like California and Nevada) has been active in this regard. Indicia that it has offered include:
• a history of illegal activity on the part of principals,
• a preference for cash transactions of less than $10,000,
• failure to make estimated tax payments, and
• offering any “guarantee” of tax-advantaged status.
Case Study: Home-Stake Mining
Despite the IRS’ efforts to identify the characteristics of an illegal tax scheme, tax-advantage Ponzi schemes have continued to flourish.
In late December 1996, a federal judge in Tulsa, Oklahoma, approved a settlement in a case that had started in 1973. It involved one of the biggest and most protracted tax shelter Ponzi schemes in American history.
During the early 1950s, Robert Trippet organized Home-Stake Energy Co. to develop oil and gas properties. He raised money for socalled “wildcat” exploration by selling percentage interests or units of participation to investors through private placements.
Home-Stake organized separate annual programs, units which were registered with the SEC and sold to the public. Each of the programs was supposed to develop a particular oil and gas property or properties in the Midwest, California or Venezuela.
Home-Stake’s salespeople pushed the things hard. They told prospective investors that they would reap big profits from proven oil reserves and that the tax deductions for intangible drilling costs and oil depletion allowances were advantageous. An investor could shelter as much as $700,000 of $1 million in income in one of Home-Stake’s yearly programs.
The Home-Stake salespeople also tailored each pitch to each investor or prospect. Often, the salesperson would find out the details of an investor’s tax situation and then offer participation in a Home-Stake program as a perfect solution.
This customized tax planning was of dubious legality but had an outstanding effect on sales.
Home-Stake investors included the rich and the famous, such as entertainers Bob Dylan, Liza Minnelli, Barbra Streisand, and Walter Matthau. Also involved were some captains of industry, such as the entire board of General Electric Co.
Home-Stake salespeople closed their deals with written sales materials, which included unregistered “black books.” For all practical purposes, a black book served the same sales function as a prospectus. It provided a general description of the program, explained the nature of participating interests, and contained engineering reports for the properties, descriptions of the various tax advantages, and projections of substantial profits.
At first, Home-Stake’s operation seemed successful. Its quarterly progress reports indicated that substantial oil was being produced and early investors received large payments which were supposedly proceeds from the oil drilling program. In truth, however, very little oil was being produced. The payments came from money paid for units by later investors. And, as a tax shelter, Home-Stake was useless. Even with the Ponzi payments, there were some investors who complained that their returns did not match Home-Stake’s promises. This was due in part to the fact that Home-Stake was going broke from the day it started. Since there was no real profit from oil operations, each succeeding year reaped less bogus profit for investors than the salespeople had promised.
The dwindling return on investment (to use that term loosely, since no real investments were ever made) led to a number of complaints to Home-Stake management. Various efforts were made to deal with those complaints. In some cases, Home-Stake repurchased program units from dissatisfied investors; in others, it offered investors the opportunity to “roll over” their units, typically exchanging units in a past program for units in a program that was currently being marketed.
Nevertheless, these efforts couldn’t keep up with the growing number of complaints. In March 1973, two investors who were dissatisfied with their investment returns and one who’d been told that the IRS was going to disallow his intangible drilling deductions filed a lawsuit in California on behalf of all participants in the Home-Stake programs.
These investors alleged that Home-Stake management and its professional advisers engaged in “an unlawful combination, conspiracy and course of conduct that operated as a fraud and deceit.” They also charged that Trippet and his salespeople made untrue statements and failed to disclose material facts.
By July 1973, the investors sought to inspect Home-Stake’s documents. The federal court in California ordered that they be allowed to begin discovery. At this point, the collapse of Home-Stake accelerated. Within weeks, new management had taken over Home-Stake and discharged Trippet, investigators from the SEC had arrived at Home-Stake’s offices in Tulsa, and Home-Stake had filed bankruptcy. After the collapse of Home-Stake in September 1973, numerous other lawsuits were filed in federal courts around the country.1
1For more details on these Home-Stake lawsuits, see Chapter 19.
Home-Stake had done many of the things that a Ponzi scheme often does at various points in its life cycle. These included:
• paying illegal commissions to various persons in connection with the sale of participation units;
• entering a management contract with Trippet that granted him 50 percent of Home-Stake’s interest in any oil and gas drilling programs sponsored by Home-Stake;
• financing equipment receivables which were listed as assets when there was no reasonable probability that this asset would be realized; and
• including various loans receivable when there was no reasonable probability that the loans would be collected.
However, because the Home-Stake scheme was so complicated...and involved so many investors...it would take more than 20 years to litigate all of the issues surrounding the mess.
In the mid-1990s, Trippet had an opportunity to invest again in several companies related to Home-Stake but he passed. The 77-year old said, “I have a bad reputation in Tulsa, and it would not have been good for me to surface” in the deal.
You could say that.
CHAPTER 6
Chapter 6: Sure-thing Investments and Sweetheart Loans
Managing financial investments is a complicated mix of science and art. Regulatory standards take this complexity into account—the SEC, IRS and state investment rules allow a fair amount for leeway in which good faith and trust are supposed to rule. So, investments remain an appealing market to con men and Ponzi perpetrators. After all, it’s the market that attracted Carlo Ponzi in the first place.
According to the North American Securities
Administrators Association, which conducts surveys of fraud in the financial planning business, some 22,000 investors lost about $400 million in financial planning frauds between 1986 and 1988. That’s a stunning 340 percent increase in the investments lost to fraud between 1983 and 1985.
Some people are surprised that so many wealthy investors are drawn into these old-fashioned schemes. But they shouldn’t be surprised. For generations, bogus deals have been a staple of idiot sons from successful families who talk about doing business in vague terms besuccessful families who talk about doing business in vague terms be Q filings.
People who know investments—like people who know any business— talk about their interests in detail. They will welcome the chance to explain the mechanics of what they do, because they know there are no secret recipes for success.
But the 1980s and 1990s have generated armies of loosely-defined “investment advisers” and “financial planners.” Many of these have come out of the insurance industry—former agents looking for new markets. They can pose a considerable risk of promoting—knowingly or not—pyramids and Ponzi schemes.
Who is an Investment Adviser? In relevant part, the federal Investment Advisors Act provides that an investment adviser is:
[A]ny person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.
In defining the business standard for investment advisers, the SEC notes:
The giving of advice need not constitute the principal business activity or any particular portion of the business activities of a person in order for the person to be an investment advisor.... The giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity.
Another important point: Federal securities law holds that anyone involved in a fraudulent scheme must understand that the scheme is fraudulent. (Bad investments made in good faith aren’t illegal.) Courts refer to this knowledge as scienter.
While all courts agree that a scienter requirement exists in securities fraud cases, “at least to the extent that something more than ordinary negligence is required,” they don’t all agree on a single standard. Some courts require “knowledge” while others require “general awareness that [a party’s] role was part of an overall activity that is improper.”
Perhaps the best summary of the standard for establishing scienter is that “[s]ome knowledge must be shown, but the exact level necessary for liability remains flexible and must be decided on a case-by-case basis.”
In this context, the surrounding circumstances and expectations of the people involved are critical.
One of the purposes of the Investment Advisors Act was to protect the public’s confidence in the financial markets. As one Senate Report warned: “Not only must the public be protected from the frauds and misrepresentations of unscrupulous tipsters and touts, but the bona fide investment adviser must be safeguarded against the stigma of...these individuals.”
The Investment Advisors Act sought to regulate “investment contracts,” which it described as any of a variety of investment devices and securities.
In its 1946 decision S.E.C. v. Howey, the U.S. Supreme Court set up a test for courts to use in determining whether an investment contract was, in essence, a security and therefore within the reach of the act. The court ruled that an investment contract is a transaction:
[W]hereby a person [1] invests his money in a [2] common enterprise and [3] is led to expect profits [4] solely from the efforts of [others].
In the more than 50 years that have passed since the Howey decision, federal courts have had little difficulty applying the first and third elements of the test. They’ve had more trouble applying the second (“common enterprise”) and fourth (“solely from the efforts of others”) elements.
The confusion has centered on whether so-called horizontal commonality between one investor with a pool of investors is required, or whether a vertical commonality between an investor and a promoter will satisfy the common enterprise element.
Horizontal commonality exists whenever “the fortunes of each investor in a pool of investors [are tied] to the success of the overall venture.” Strict vertical commonality exists whenever “the fortunes of the investors [are tied] to the fortunes of the promoter.” Broad vertical commonality exists whenever “the fortunes of the investor [are linked] only to the efforts of the promoter.”
In the 1973 federal appeals court case SEC v. Glenn W. Turner Enterprises, Inc., the court held that a pyramid scheme involving the sale of certain “Adventures” and “Plans” constituted the sale of investment contracts within the meaning of federal securities law.
In the case, a program called Dare to Be Great offered investors four different Adventures and a $1,000 Plan. For Adventures I and II, at a cost of $300 and $700 respectively, participants received tapes, records, and other self-motivation material, as well as the right to attend group sessions. For Adventures III and IV and the $1,000 Plan, purchasers received the same things received by the purchasers of Adventures I and II, plus the opportunity to sell the Adventures and the $1,000 Plan to others in return for a commission.
The court held that Adventures III and IV and the $1,000 Plan were investment contracts because they met the tests established in Howey. Obviously, the Adventures involved an investment of money. The court found that the money was invested in a “common enterprise,” in which “the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment of third parties.”
It was with the final element, requiring profits “to come solely from the efforts of others,” that the court had the most difficulty. Because the income opportunities through Dare to Be Great required individuals to sell Adventures and Plans to others, the income was not based solely on the efforts of others.
Still, the court held that the word solely “should not be read as a strict or literal limitation on the definition of an investment contract, but must be construed realistically, so as to include ... those schemes which involve in substance, if not form, securities.” The court concluded that the Dare to Be Great scheme was “no less an investment contract merely because [the investor] contributes some effort as well as money to get into it.”
So, this is how the courts connect Ponzi schemes to investment and securities laws. But it’s just a technical connection. The practical applications take various forms.
Projections
Many investors are swayed by ambitious projections—which paint seductive pictures of big riches to be had in six months...or six years. For this reason, projections are heavily regulated in most legitimate financial markets.
Ponzi perps know both of these things—that projections are compelling and that they are regulated. So, they find artful ways to use projections without running afoul of regulations.
According to the SEC, financial projections are fraudulent if:
1) the promoter “disseminated the forecasts knowing they were false or that the method of preparation was so egregious as to render their dissemination reckless,” and
2) the investors reasonably relied upon these projections in making their investment decisions.
That reasonably can be a tricky matter. In general, reliance on projections as a forecast of the future is unreasonable as a matter of law if those projections are accompanied by language that clearly discloses their speculative nature. That’s why so many ads for financial services or investment opportunities will include disclaimer language that reminds investors that past performance is not a guarantee of future performance, that certain investments are speculative and that some investors do lose money.
The Ponzi perp’s challenge is to make the stuff that comes before these disclaimers so appealing that investors don’t pay attention to the “legal mumbo-jumbo.”
But there’
s more than just this. Just because an investment goes bad, the investor doesn’t automatically win a lawsuit—even if the people selling it fudge on the risk issues. In order to make a successful case under the SEC guidelines, a burned investor must “allege facts which give rise to a strong inference that the defendants possessed the requisite fraudulent intent.” That can be tough to pull off.
Loan Programs
One common variation on the standard investment Ponzi scheme is the loan program. In these schemes, investors are encouraged to put money into a fund which, in turn, makes profitable loans. The only problem: Often these loans are made to other investors in the scheme. The whole situation quickly becomes just one more pretense for spinning money.
In the late 1980s and early 1990s, Melvin Ford ran an operation called the International Loan Network. ILN’s pretenses were few and flimsy. It was a scheme to move money around quickly, so that a lucky few could siphon off enough to get rich quick.
Ford’s scheme shouldn’t have lasted more than a few weeks. Instead, it lasted several years. In revival-like assemblies targeting black and Asian-American investors, Ford promised huge returns on investment in foreclosed real estate properties around the country. Among other blustery things, he said, “ILN is a financial distribution network whose members believe that through the control of money and through the control of real estate you can accumulate wealth and become financially independent.”
True enough. But most people have to work for years in order to control enough money and real estate to be considered wealthy. Ford’s short-cut? The ILN mantra: “The movement of money creates wealth.” This was daring. The slogan came close to admitting ILN was a Ponzi scheme.
To become a member of ILN and have a chance of obtaining “the organization’s stated goal of financial independence,” a person had to pay a $125 basic membership fee. The basic fee entitled the investor to a variety of “benefits and services”—consisting mostly of discount coupons for travel, car rental and high-ticket consumer goods. It also allowed the person to become an Independent Representative of ILN.