Author(s): Philip A. Feigin
Published: 07/24/2009
The Ponzi scheme: a financial oil spill, a devastating disaster that, when discovered, invariably begs the question, how could this have happened? These schemes are often at the core of one of the most vexing problems faced by the management of any brokerage firm, "selling away" from the books and records of a firm. News that a broker has been freelancing, selling investments on the side that the firm doesn't know about, will sour any compliance officer's morning. Brokers are lured by what are usually much higher front-end payouts than firm products. Firms may train, warn, inspect, and investigate all they want or can, but there will always be some reps who try to get away with it, and some of them succeed, at least for a while. In the aftermath, all too often, regulators, hearing officers, judges, juries, and arbitration panels turn a deaf ear to all those firm efforts in the face of massive investor losses.
Ever since the revelations about Bernie Madoff's massive Ponzi scheme, it seems not a week goes by without reports of another Ponzi scheme busted and shut down somewhere. Much of this is due to at least three factors. First, in a classic example of "shutting the barn door after the horse is out" and in an effort to show the Madoff lapses were a fluke, the SEC is paying more attention to investigating and moving against such frauds, and making sure the public—and Congress—hear about their aggressive actions. Second, Ponzi schemes make for good press, and Madoff and Stanford have left business reporters across the country thirsting to uncover one of their very own. Third, the recession caused many investors to seek liquidity through redemptions of illiquid investments at the same time it became much harder for the companies to find new capital. Too much outflow and not enough "new blood" led to the demise of many legitimate enterprises and exposed many a Ponzi scheme.
Whether there has been an increase in the number of Ponzi schemes or just the number of Ponzi schemes uncovered, it matters little. An understanding of how the schemes get going in the first place may help CCOs in their efforts to shut down rogue reps looking for a quick buck before they get started.
True "Scammers" are those people who set up their operation to rip people off from the start. The Scammers are usually the ones who locate in North Miami Beach or Newport Beach (beaches are big), they have no conscience (their first victim was probably their mother), and they blow the money they scam on "wine, women, and song," drugs, gambling, and Ferraris. You don't usually find Scammers in places like Bismarck or Lubbock. Scammers are the ones pulling off the prime bank schemes, the "Yamashita's gold" guys, the factoring scams (buy for nothing, sell for a fortune), and the like.
On the other hand, there are the "Geniuses." You can find them anywhere. The Geniuses may do some of the high living, but they are often a bit more subdued than the Scammers. These people usually start off operating investment programs with the best of intentions, and probably have some initial success. Then, somewhere along the line, they suffer some losses. Out of embarrassment, pride, fear— whatever—they make the fatal mistake of hiding the losses from their investors, believing themselves to be so brilliant they will just make up the losses next month and the investors will never know the difference. Of course, they don't make up the losses next month, the losses pile up, and our Geniuses are now trapped in a descending spiral into the Black Hole of securities fraud. They start having to "rob Peter to pay Paul" to handle payouts, they can't raise enough new money to cover the outflow, and it's then just a matter of time until it all falls apart.
The scams need fuel to keep them rolling, and that means a constant supply of new money. They can depend on some affinity group to supply the capital, or branch out and develop their own sales force. That often involves recruiting someone else's sales force, often from the ranks of securities, insurance, and real estate salespeople. These reps may be complicit in the scam, but quite often they are dupes. Sometimes, these sales reps start out investing themselves. Perhaps they reap initial returns and then turn to sharing their new great opportunity with the clients they serve, for a hefty commission to boot. Or perhaps it's a sexy private placement that sounds almost too good to be true, and in a natural effort to assure themselves they haven't been taken, they seek validation for their own investment decision by luring others.
It is a common human conceit that in engaging in a conversation with a stranger, most people will do almost anything to avoid sounding uninformed about anything. Nowhere is this more true than with regard to money matters. The Scammer pitches a potential victim (or rep) saying that with the funds raised from investors, the company "speculates in polonium on the Rotterdam Metals Exchange," and adds, "You know, with all the hybrid cars coming out, polonium is crucial to production of the new generation of batteries." Most people nod their heads in understanding, remembering having read something about that somewhere, although they really have no clue as to what the fellow's talking about. Unfortunately, it is months after they invest when they discover there is no Rotterdam Metals Exchange, polonium is not used in car batteries, and it is actually a radioactive metal that almost completely vaporizes at room temperature.
In making almost any purchase decision, at least two opposing forces are at work in anyone's mind. The "financial id" warns it isn't worth it; the "financial ego" promises it will be a steal. In investments, it's the fear of loss on the one hand and greed on the other. Fear of losing money battles with a yearning to make lots of it. Fraudsters know this too. For most people, the fear of loss usually wins, stopping them from making foolish or risky investments. The old adage "If it sounds too good to be true, it probably is" works most of the time.
But Scammers know that trust is a perfect solvent for this fear of loss. If a Scammer can find a way to overcome an investor's fear of loss by earning his trust, the only thing left is greed. The "con" in "con man" comes from "confidence." Smooth talking and a slick presentation may succeed in winning over some complete strangers, but by far the most underhanded and despicably successful tactic used to defraud is to be part of a particular affinity group, like a religious congregation, an ethnic community, or the like, groups held together by some insulating common bond. People united by such a common bond trust each other implicitly and without reservation. They don't have to think or reason; they simply accept each other, and without hesitation. When a Scammer finds his or her way into such a group, the financial carnage can be devastating. Enforcement types call them affinity frauds. Many of the reps I've dealt with in selling-away cases were themselves part of such a group, either pulling off their own scam or, more innocently, becoming the unwitting dupes of someone else's scam.
So what can a brokerage firm do to protect itself from reps selling away? I'd be a wealthy man if I had a lockdown answer. There are the standard approaches, of course: careful selection and training of reps; clear written policies and procedures; repeated warnings and topical updates; monitoring of transaction and commission patterns; and comprehensive, regular, and insightful audits of independent and home office locations. They are only partially successful.
However, there is one approach I have not seen used to any great extent: direct contact by the firm with its clients. Perhaps it is because reps can resent what they view as the firm's interference with their client relationships. The wrong approach can undermine the trust their clients have in them, unnecessarily worrying the clients and giving rise to suspicions without any justification. In my view, that is more a problem of execution than concept. A monthly or quarterly firm newsletter to firm clients might have been prohibitively expensive in years past, but the Internet has deep-sixed that argument. Friendly and regular tips to clients from the firm on how to be a good and prudent investor might be of both general and specific benefit to firms trying to avoid reps' selling away and the adverse fallout that may later plague them.
In addition to publicizing frequently asked questions about online access to account information, new developments, where to call with a problem, and the like, a section devoted to recent Ponzi schemes, any scam crossing the nation that regulators have already warned about (the Nigerian scams, those e-mails you get from Hong Kong, "medium terms notes," etc.), could go a long way to alerting both a firm's clientele and its reps about avoiding them.
Soliciting firm clients to contact the Compliance Department to check on any investment they may have been offered or sold might prove a very effective early warning system. Learning that a rep has offered someone an interest in the ABC Limited Partnership that Compliance has never heard of is something any CCO would pounce on immediately. Clients might also call about offers not involving the firm or the rep. Even generally sage advice that the client may wish to contact their attorney or state or federal securities regulators to check it out before investing may redound to both the client's and the firm's benefit. Finally, as an evidentiary matter, regularly circulating such general and specific warnings would be powerful evidence in a subsequent "selling away" proceeding, to show both the firm's overall concern for its clients and that the firm provided a hard and detailed warning that may be tough for the claimant to overcome.
Philip A. Feigin is a securities partner at RJ&L in Denver. Before joining the firm in 2000, he was Executive Director of the North American Securities Administrators Association, the trade association of state securities regulators in Washington, D.C., and before that, the Colorado Securities Commissioner for 10 years. Mr. Feigin can be reached at 303-628-9509 or by e-mail at pfeigin@rothgerber.com.