By hook or by crook

If something seems too good to be true, then it probably is. This piece of folk wisdom is so well known that you would expect to find it engraved on the hearts of investors as the most fundamental principle of personal risk management it is possible to have.

Yet time and again it is ignored.

Why? In a word, greed. The lure of achieving startling returns on an investment acts like a hallucinogenic drug, eclipsing common sense and leading individuals, companies, even governments to believe that they have found an infallible method of becoming richer than Croesus. And on the back of this delusion, the fraudsters clean up. It matters little whether the context is medieval Europe or our globalised, risk-aware 21st century society: there are always new suckers to believe the same old dodges.

In the ten years since Strategic Risk launched, we have witnessed several gigantic frauds, from WorldCom to Madoff, and a continuing background of low level frauds, scams and wheezes designed to part individuals from their money. Two things stand out. Firstly, there is nothing new. Every fraudulent or dodgy scheme has a history behind it, but they are histories which we have apparently failed to read. Secondly, fraudulent behaviour flourishes best whenever regulation is inadequate or badly enforced.

Good regulation, effective enforcement, and risk management controls which work do a great deal to constrain the ability of the defrauder to get away with it. In the atmosphere of easy credit and light-touch regulation which characterised the past decade, it is small wonder that the old scams and dodges have re-emerged to plague us.

The Ponzi Scheme

The principle is simple. Amazing returns are paid to investors, supposedly from investment in some sure-fire way of making money. In fact, early investors are paid from the contributions of newly-joined ones. Pay-outs are minimised by encouraging investors to re-invest their ‘profits’.

Charles Ponzi (1882-1949) was not the inventor of this scam, but it bears his name because of the sheer size of his fraud. His pitch to investors was that by arbitraging international reply-paid postage coupons he could double their investment in 90 days. After the first few investors had indeed achieved this remarkable return a frenzy ensued. At one point in 1920, Ponzi was making $250,000 a day. Suspicions arose when it was pointed out that there would need to be 160 million reply-paid coupons in circulation to cover Ponzi’s ‘investments’, when in fact there were only 75,000. But Ponzi managed to stave off collapse for several more months through a combination of charisma and borrowing, until a newspaper exposé combined with a state investigation put an end to the scam. Six banks collapsed as a result.

Ponzi was always something of a dubious character. It was difficult to say the same of Bernard Madoff, the 21st century’s most notorious Ponzi scheme operator, responsible for the largest ever Ponzi fraud, estimated at $64.8 billion.

Madoff, a pillar of the Wall street establishment, lured investors through consistent returns of 10% or more, rather than a promise to double their money. His fund cultivated an air of exclusivity – some would-be investors were turned down – but used the old technique of a ‘secret investment strategy’, couched in today’s financial jargon. He concentrated on charities – unlikely to demand all their money back at once – and on his fellow Jews. Madoff claims his Ponzi scheme started in 1990, and despite financial analyst Harry Markopolos’s stream of complaints to the Securities and Exchange Commission (SEC), it continued until December 2008, when the economic downturn, rather than doubts about Madoff, caused investors to start withdrawing money. Eventually, Madoff confessed to his sons that his investment fund was ‘one big lie’. Markopolos reserved his harshest criticism for the SEC’s investigators, testifying that: “My experiences with other SEC officials proved to be a systemic disappointment and lead me to conclude that the SEC securities' lawyers, if only through their investigative ineptitude and financial illiteracy, colluded to maintain large frauds such as the one to which Madoff later confessed.”

The internet provides a fertile ground for Ponzi fraudster. The brief fashion for ‘investment autosurfing’ (where you pay a membership fee, then are paid for looking at advertisers’ websites) netted a US website, 12DailyPro, $50 million in less than 9 months from 300,000 investors. Its owner, Charis Johnson, was promising a 44% return in 12 days. The SEC found the site’s revenues were almost entirely generated from the fees of new members, and 12DailyPro was shut down in February 2007.

....Paved with gold

The prospect of easy money to be got from developing land exercises a hypnotic attraction over people who should know better. A skilful hustler can clean up.

Take the extraordinary figure of Gregor McGregor, who appeared in London in 1820, after fighting in South America. He claimed that he had been appointed cacique (prince) of a country called Poyais, close to Honduras, which had a core of English settlers and 32,000 sq km of fertile land ready for development. He needed funds and settlers. He got both, even setting up a legation for Poyais in London, selling off land at 4 shillings the acre and raising a £200,000 loan. To encourage investors, he wrote a guidebook to Poyais, using a pseudonym.

Needless to say, Poyais did not exist, and when the first two shiploads of settlers arrived, they found only virgin jungle, and had to be rescued and taken to Honduras. By this time, McGregor had already decamped to France, where he started the whole scam again. The French authorities were slightly quicker on the uptake, and he was brought to trial, only to be acquitted. He continued to promote Poyais in London right up until 1839, when he retired to Venezuela on a pension. There is no record of how much money he made.

Our own times may not produce quite such flamboyant figures, but the pre-2008 property boom together with easy credit found no shortage of promoters of the money to be made from speculating in land or housing. In behaviour reminiscent of the Florida land boom of the 1920s, or the Florida swampland scams of the 1960s, Europeans from the UK to Bulgaria jumped on the idea that investment in property was a sure-fire winner. In the UK, ‘land banking’ companies sprang up, buying agricultural land close to cities, splitting it into plots, and selling to speculators at 10 to 100 times its cost; the pitch being that planning permission for development was likely to be fast-tracked and the plot would rocket in value.

Of course there was never any contractual guarantee of this. The UK government’s consumer advice website states: ‘In reality, the land may be totally unsuitable for development and have little hope of ever getting planning permission.’ In December 2009, petitions were presented to the High Court to shut down five land banking companies (four of which have the same sole director). The petitions will be heard in March. Whether the money paid over by investors will ever be found, is another matter.

Cooking the books

Ivar Kreuger (1880-1932), known as ‘the Swedish match king’, provides the historical precedent for the WorldCom and Enron scandals. His industrial empire rose on the back of the Swedish match industry, and he hit on the idea of making big loans to European governments after the first world war in exchange for a monopoly on matches. He eventually controlled 75% of world match production.The return paid to investors was highly attractive, and Kreuger appeared to survive the inter-war depression unscathed. By using complex financial structuring of his companies and taking liabilities off balance-sheet, Kreuger anticipated many of the methods that were to be used by Enron. When the company went bankrupt in 1932, $250 million of claimed assets were discovered simply not to exist.

Although Enron used many of the same techniques to disguise the true state of its afairs, it refined the method. Aggressive revenue accounting (by which the revenue from a deal stretching over years could all be booked when the deal was signed) gave the appearance of rapid, massive growth, while ‘special purpose entities’ were used to remove liabilities from scrutiny. Additionally, there was a conflict of interest with auditors Arthur Andersen, who came under pressure not to look too carefully into the corners.

Ironically, Enron was praised for its governance structure and for its risk management controls. But in the event, so deliberately opaque were the company’s internal transactions, and engineered at such a high level, that internal controls were never likely to discover the fraud. The eventual collapse of Enron lead directly to the Sarbanes-Oxley act.

The WorldCom scandal of 2002 throws a much better light on risk management. Senior managers at the giant telecoms company were traducing accounting practice by booking running costs as capital expenditure, thus making its profitability appear much greater than it actually was. The fraud was uncovered by the firm’s own internal audit department, working in secret once they had been alerted to some questionable transactions. The external auditors (Andersen again) were less than helpful. It was evidence brought to the company’s full audit committee that led to the immediate downfall of WorldCom bosses Sullivan and Myers – and eventually to the bankruptcy of the company, the world’s biggest corporate failure at the time.

Interestingly, during the trial that followed, Melvin Dick, a former partner at Arthur Andersen noted that auditors rely "on the honesty and integrity of the management of the company”. The Enron and WorldCom scandals suggest that this way of thinking is dead. If it isn’t, it should be.

Payment in advance

Everyone has heard of the ‘419’ or ‘Nigerian letter’ fraud, but the advance fee fraud, of which this is one example, has a long history. In the last decade of the nineteenth century, it was an unjustly imprisoned Spaniard (with a beautiful daughter and a trunkful of cash stored in a bank) who needed help, in exchange for a large proportion of the funds. There was an outbreak of ‘Spanish Prisoner’ letters in the US, noted by the New York Times in 1898 – the perpetrators at that time being organised in France and South America.

Now Nigeria is the centre of the scam, e-mail the preferred means of communication, and the sum involved is in a bank account and reaches several millions of dollars. But the prinicple is the same. In order to get a huge amount of money, you must first pay over somewhat lesser sums, to oil the wheels, or bribe officials. Once you have paid, the correspondence mysteriously ceases, and your money is gone forever.

The scam would be laughable if it were not so successful. Ultrascan, a Dutch company which specialises in tracking the fraud, estimates total losses to date as $41 billion with $9.3 billion in 2009 alone. This is fraud on a Madoff scale, and there is plenty of evidence that companies as well as individuals fall for it. Ultrascan considers the fraudsters are increasingly targeting Japan and Asia as Europe and the US become more alert to the fraud. The scale of the fraud is still growing exponentially.