Frauds, Old and New

Newfound transparency in the wake of the unfolding financial crisis will expose a scale of prior fraud, corruption, and self-dealing that many will find almost impossible to comprehend. Day in and day out, reports will surface about hidden losses, false accounting, inflated appraisals, sizable off-balance-sheet obligations, valuation discrepancies, unregulated offshore entities, phantom profits, insider trading, and businesses bled dry to enrich a few individuals at the expense of employees, investors, bankers, and bondholders. Other revelations will reinforce the idea that companies, governments, and individuals are in far worse shape than people had assumed only a few years earlier.
— Financial Armageddon

When I wrote those words three years ago, I didn’t have any specific knowledge about Bernie Madoff’s massive fraud or the alleged house of cards put together by Allen Standford. But it didn’t matter. History and the extraordinary excesses of the go-go years meant such scams were bound to be out there, just waiting to be uncovered. In "Economic Downturn Accelerates Collapse of Ponzi Schemes," the Washington Post reveals the breathtaking extent to which one type of crime managed to worm its way into the economic landscape.

The great recession has decimated many industries; home builders, automakers and bankers are obvious casualties.

Now, add Ponzi schemers to the list.

Ravaged by the same fiscal turbulence pounding the nation’s legitimate businesses, Ponzi operations have been collapsing at a record clip, exposing prolific, rampant and colossal frauds that have bilked investors of billions of dollars.

The FBI, which is handling about 20 such cases in the Washington region, has almost 500 open Ponzi investigations nationwide — up from about 300 in 2006, bureau officials said. Law enforcement officials with other agencies have noticed similar trends, and authorities said they expect to turn up many more cases in coming months.

"We have more open Ponzi scheme cases than at any time in FBI history," said Special Agent David G. Nanz, chief of the FBI’s economic crimes unit. "We anticipated a spike, but the numbers we are seeing are even greater than expected. . . . There is an old saying, though: ‘When the tide goes out, you can see who isn’t wearing a bathing suit.’ And that definitely applies to Ponzi" operators.

Pyramid schemes like those named after Charles Ponzi, a notorious rip-off artist who stole millions in 1920, involve investors who are told that they are buying real estate, securities and other assets. But no investments are ever made, and the flow of new money is used to pay "returns" to earlier investors. Eventually, the flow of new money dries up and everything collapses.

Authorities said the schemes blossomed during good times. But their very nature — the constant solicitation of new investors to pay off old ones — makes them vulnerable to the harsh economic climate. Federal officials said they also have become more aggressive in trying to uncover schemes before they implode and the assets evaporate.

The cases range from the $65 billion fraud orchestrated by Bernard L. Madoff, a former chairman of the Nasdaq stock exchange, to what is now considered a relatively minor rip-off — a $23 million fraudulent hedge fund run by a Jacksonville, Fla., man guaranteeing a 50 percent rate of return.

In the Washington region, federal prosecutors recently charged five people in a $70 million mortgage fraud Ponzi scheme that targeted many in Prince George’s County. Last week, they announced that they had charged a Vienna man with stealing $17 million in a sophisticated Internet Ponzi operation that led investors to believe that he had offices in the District, New York and London. In reality, the man rented a box from Mailboxes Etc., prosecutors said, and spent investors’ money on expensive cars such as a Bentley and Ferrari.

"It has been a flood," said veteran postal inspector James H. Tendick, who supervises the Justice Department fraud team. "We don’t have to go out scouring for these things. They are all just coming in the door."

As recently as a few decades ago, most Ponzi schemes were relatively small, relying on word of mouth, direct mail and advertisements in magazines. They generally burned out after two or three years. But through the Internet and modern communications, Ponzi schemes have grown in size, scope and sophistication.

During the economic boom years, many schemes lured investors — including huge hedge funds and financial firms — into putting up billions of dollars. Smaller investors, drawing on home equity loans, also flooded Ponzis with cash.

The largest operations were the one run by Madoff, who is scheduled to be sentenced this month on fraud charges, and what authorities say was an $8 billion scheme managed by R. Allen Stanford, a prominent Texas businessman.

Then the housing bubble burst, and the stock market began to sag and the financial markets went into cardiac arrest. Soon, Ponzi operators couldn’t find new investors to keep their wheels spinning. Investors began screaming for their money back. When their calls were not returned or they were blown off, they started calling authorities. Cautious potential investors, bombarded with news reports about Madoff, quickly alerted regulators and federal agents to deals that seemed too good to be true.

"A lot of investors have become more aware of the risks and are asking harder questions," said Scott Friestad, deputy director of enforcement at the Securities and Exchange Commission, adding that he was "surprised that there are so many instances where people have raised hundreds of millions of dollars from thousands of investors and been ripping them off as pervasively as they have."

With the walls crashing down, insiders even started reporting each other, and some Ponzi operators surrendered to federal agents, hoping to cut deals.

That is what happened to Joseph S. Forte, 54, of Broomall, Pa., federal prosecutors said.

Authorities said that over 12 years, Forte collected $80 million from at least 80 investors who believed that he was putting their cash into Standard & Poor’s index futures contracts.

By 2008, Forte’s revenue dried up because he could no longer find anyone willing to invest with him, authorities said. Then he couldn’t pay off redemption requests, and he turned himself in to authorities, postal inspectors wrote in court papers. Forte has pleaded guilty to fraud charges.

Federal agents uncovered what they allege is a $3 billion pyramid operation allegedly operated by one of Minnesota’s most prominent businessmen, Thomas Petters, after an employee tipped them off to the operation.

The employee reported the fraud, her attorney has said, because she had lost confidence in Petters’s ability to pay back investors. Petters has pleaded not guilty.

And in April, a California man was indicted on charges of operating a $40 million scam that promised investors, many of whom he met at church, huge returns in a hedge fund. Suspicious about the firm’s financial performance, a potential investor approached federal authorities, court records show.

"This kind of climate is death on Ponzis," said William K. Black, a law and economics professor at the University of Missouri-Kansas City School of Law and a former executive director of the Institute for Fraud Prevention.

But Black said the same trends that pumped up the Ponzi industry and then tore it apart will eventually lead to new opportunities for scam artists who manage to escape the law and financial carnage. The crooks know that potential investors, some desperate for a quick return, will not always be so wary.

And what might those "new opportunities" be? I think you’ll find at least one answer in the following MarketWatch report, "Fraudsters Eye Huge Stimulus Pie, Consultant Says":

Companies will face extra requirements to prevent problems

Swindlers, con men, and thieves could siphon off as much as $50 billion of the government’s planned stimulus package as the money begins flooding the economy in coming months, according to David Williams, who runs Deloitte Financial Services Advisory and counsels clients on fraud prevention.

Williams predicted that about $500 million of the total $787 billion stimulus would be channeled into the traditional procurement network for government contracts, while the rest will be spent directly by the government or outside the corporate network.

"The rule of thumb typically is that of the about $500 billion worth of money that’s going to run through the procurement process, somewhere between 5% and 10% of that usually finds it way into potential problems," Williams said. "That’s sort of the benchmark that I use."

Companies will face increased pressure to try to stem the tide, and need to be prepared to safeguard data as well as the cash, according to Williams.

Williams said this week that the money flowing from the current stimulus package is particularly vulnerable to fraud because almost all movement of money is now done electronically.

"We’re telling our clients to be very careful and to make sure their firms are resilient in terms of dealing with the potential opportunities for fraud and waste," Williams said.

That means keeping an eye out for the traditional scams such as billing for services not performed. But it also means firms must become even more diligent about electronic records and network security.

"It becomes ever more important that firms remain diligent about their data," Williams said.

Earlier this month, FBI Director Robert Mueller warned the nation to brace for a potential crime wave involving fraud and corruption related to the economic stimulus package. "These funds are inherently vulnerable to bribery, fraud, conflicts of interest, and collusion. There is an old adage, that where there is money to be made, fraud is not far behind, like bees to honey," Mueller said. See full story.

Earlier this month, Vice President Joe Biden said some stimulus-related scams had already happened and that some mistakes were inevitable. President Barack Obama said Monday that the White House is trying to make sure the stimulus money isn’t being ill-spent.

He said many of the safeguards and transparency measures "so far seem to have worked" but added his administration will have to stay vigilant.

"At a time when everybody is tightening their belts, the last thing the American people want to see is that any of this money is being wasted," Obama said.

Potential damage

Williams suggested that the fraud and theft losses from the roughly $787 billion stimulus package approved earlier this year could reach about $50 billion.

Williams said firms would be well advised to beef up monitoring of their transaction systems, and that his firm is helping clients develop software and computer systems to predict and catch fraud before it gets started.

Williams acknowledged that the FBI has geared up its efforts to focus on financial scams. He said other agencies, including the Department of Justice and industry watchdogs, are also beefing up oversight.

"They are going to spend their time making sure that this money gets to being used in the way it’s supposed to be used," Williams added.

After 9-11, counterterrorism became the FBI’s top priority, even as the agency grappled with corporate crime such as the Enron and WorldCom scandals, said Mueller, who took the helm of the FBI on Sept. 4, 2001, just one week ahead of the terrorist attacks.

The 9-11 attacks prompted the FBI and other government agencies to divert resources from financial fraud and other corporate crimes to fighting terrorism, including the transfer of 2,000 agents tracking white-collar crime to counterterrorism, Mueller said.

But now the focus is returning to white-collar crime and fraud in a big way.

"These rules will come right back to haunt companies if they are not careful," Williams said. "So firms need to make sure that their organizations are ready to receive funds and protect those funds diligently as the potential for fraud surfaces."

He said that for the largest companies used to doing contract work with the government a high level of oversight will be business as usual.

"But there will be others where this is unprecedented and they will have to do more to comply," Williams added.

Meanwhile, Obama said the White House will keep trying to make sure citizens know where the stimulus money is going.

"We’re going to do it continuing to operate in a transparent fashion so that taxpayers know this money is not being wasted on a bunch of boondoggles," Obama said at the White House on Monday.