MACROECONOMIC ANALYSIS AND POLICY
The Sophisticated Investor’s Worst Nightmare
The Sophisticated Investor’s Worst
*
Nightmare
Tom Frame never imagined he would fall victim to
a Ponzi scheme. Frame, a semi-retired real estate
financier based in California, has spent his
professional lifetime checking out deals.
Yet he and 158 other high-income investors -
including a retired partner at one of the Big Five
global accounting firms - were bilked of $330
million in the PinnFund scheme, one of the largest
ever perpetrated in the United States. Frame's
personal loss: $8 million.
Frame and the other investors were told they
were putting up money to buy up pre-approved,
sub-prime-rate mortgages that could be quickly
sold to banks at a 2 percent markup. The idea
worked, briefly, at the beginning, investigators
said. But most of the returns to early investors
came from funds from later investors - many of
them recruited by those same early investors.
Then, when the mortgage market started to dive in
1999, PinnFund's founders started tapping bank
credit lines to continue paying "dividends."
Frame, who became involved with PinnFund on
the recommendation of a longtime friend and
former business partner, did demonstrable due
diligence, before and after investing in the fund. He
asked for audits, visited PinnFund's offices' in
California, read monthly loan reports and
participated in drafting trust agreements for
invested funds.
Though it may have begun legitimately, PinnFund
was bankrupt when it was finally shut down last
year by the U.S. Securities and Exchange
Commission. Yet its losses – due partially to
embezzlement by the fund's manager, Michael
Fanghella, as well as the downturn in mortgage
interest rates - were completely hidden to Frame
and his fellow investors. Falsified loan reports and
company audits, sent out judiciously every month,
kept up the ruse until just before the end.
Ponzi-style investor fraud schemes targeting
well-heeled investors such as Frame are
proliferating at an alarming rate worldwide. A poll
of 60 regulators, law enforcement officials and
*Source: International Herald Tribune, June15-16, 2002, p.
13-14.
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banking executives from nine countries, conducted
at an anti-fraud conference in London in March, put
the worldwide losses from Ponzi schemes at $35
billion.
While such schemes have been around since the
1920s, when a con artist named Charles Ponzi
swindled thousands on U.S. investors in a postal
coupon scheme, they are experiencing one of their
periodic resurgences. In addition to PinnFund, the
following have made headlines since the beginning
of the year:
EarthLink. In March, Reed Slatkin, a co-
founder of the U.S. online service provider,
was found guilty of defrauding some 800 in-
vestors of $254 million. One of the victims, a
former senior executive from the San Fran-
cisco area, said that Slatkin came recommen-
ded to her by fellow professionals and kept
her on the hook by mailing her fraudulent
monthly statements showing falsified trading
activities and account balances.
Metals trading. In May, four men were in-
dicted in New Jersey for setting up a
fraudulent metals trading scheme that
operated out of London and the United States
and bilked more than $600 million from at
least nine banks, including such big names as
J.P. Morgan Chase & Co., Fleet Boston
Financial Corp. and PNC Bank.
Evergreen Security. Another New Jersey
man, William Zylka, pleaded guilty in May to
stealing $27.7 million from investors in a
Ponzi-style offshore fund that purported to
invest in limestone, diamond, sapphire and
timber projects. Zylka, who will be sentenced
July 16, faces up to 18 years in jail.
Why the bumper crop? Some historians and law
enforcement officials blame the current economic
slump, which has created a new generation of
investors who are willing to search farther a field
for returns – leaving them vulnerable to pitches
that sound too good to be true.
Michael Dunn, director of consumer com-
munications for the Australian Securities and
Investment Commission in Sydney, sees a direct
connection between the growing number of so-
called experienced investors falling prey to Ponzi
schemes and a compulsion in the marketplace to
make up for the unprecedented high yield returns
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investors had come to expect as a result of
overvalued technology, stocks and the like.
Susan Wyderko, who heads up investor
education for the U.S. Securities and Exchange
Commission, has seen this trend up close. For the
past year she has been setting up fictitious
investment sites on the Internet. One of those,
which cannot be named in print since it is still
active, offers investors the opportunity to get in on
the ground floor of an offshore investment fund
offered by a "30 year old registered dealer."
Despite the sketchiness of the offer, the site
receives thousands of bits daily, from all over the
world.
In a hospitable environment for investment
fraud, investigators say, Ponzi schemes seem to be
the scam of choice. For one thing, the basic idea is
simplicity itself. For another, it works, even in the
legitimate world: The Yale economist Robert Shiller
has likened the entire stock market to a "naturally
occurring Ponzi process," where the prosperity of
later investors depends on the willingness of the
earlier generation to put its money down.
While often based in America or Europe, Ponzi
schemes are by no means confined to investors in
those countries. Colin Holder, detective sergeant in
charge of the New Scotland Yard’s Metropolitan
Police Fraud Squad Intelligence Unit is currently
investigating dozens of cases involving Ponzi-style
investment fraud. A big chunk of those cases, he
said, involve wealthy professionals, including
doctors, lawyers, judges and accountants from
around the world.
Today's Ponzi schemes come in many different
forms, ranging from bogus private investment
funds involving equities, real estate loans and
offshore partnerships to "exclusive" high-yield bank
paper trading programs, referred to by regulators
and law enforcement officials worldwide as "Prime
Bank Instrument Fraud." It is the latter that has
regulators particularly bothered. According to
Holder, investor losses due to this brand of scheme
are believed to far exceed even those racked up to
the infamous Nigerian-based investment frauds,
which accounts for hundreds of millions of dollars
of lost funds annually.
Here's how it works: Investors are told they are
putting up money to buy financial instruments
called Prime Bank notes. They may also be called
by other names, including Medium-Term notes, roll
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programs, international certificates of deposit, ICC
3039 and 3034 instruments, or International
Monetary Fund Backed Securities.
The fraudsters play to investors' egos by telling
them that they have been preselected, in part
because of their asset base, to participate in the
trading of these specialized "bank-sanctioned"
securities. The securities are allegedly bought at a
discount and sold at a premium many times during
the course of year and will yield returns from 6
percent to 100 percent per month.
The investors are also told that this trading is
conducted in the strictest secrecy. All of the top 50
world or "prime" banks operate a program such as
this, the story goes, and the banks will deny its
existence if asked.
The fraudsters position themselves as authorized
"traders" or "master commitment holders" charged
to resell the securities between the prime banks.
As the scam plays out, the investor will send
money to a designated foreign bank. While the
investor may receive an initial payout, it is usually
only a matter of time before either the fraud
becomes unsustainable or the con artist simply
transfers all remaining funds offshore.
Even though every major financial organization,
including The World Bank to the International
Monetary Fund, categorically denies sanctioning
any sort of "secret" or "exclusive" trading of bank
securities - and even though these denials can be
found readily published on their Web sites -
investors continue to gravitate toward these scams,
experts say.
James Byrne, a law professor and director of the
International Institute of Banking Law & Practice,
admitted to being somewhat baffled by the vast
propagation of these schemes, which he admits,
offer returns that are "simply preposterous."
"There is no discount for investment-grade paper
such as that issued by major banks," said Byrne,
adding, "The thought that they or anyone holding
such paper would sell it below market value or go
to a secret market to get a price lower than that
available on the capital markets is just silly."
Byrne, whose institute sponsored an anti-fraud
seminar last week in Washington, said the investors
he most often saw falling victim to these schemes
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were not mom-and-pop types but people who
trade, often successfully, in stock and bonds and
who know very little about the technicalities
surrounding bank instruments.
"They are the only ones who can afford the
minimum investments in these things, which can be
as much as a million dollars," he said.
The fraudsters are counting on the fact that
investors, flattered by an invitation to participate in
such exclusive trading and titillated by the prospect
of returns, will not come to terms with their own
ignorance on the subject of bank paper trading
procedure, Byrne said.
While some Ponzi schemes can be hard to detect
to the untrained eye (see related article above),
there are some basic steps all investors should take
when evaluating an investment opportunity
promising higher returns that the market average:
Find out if the investment vehicle is
registered in its country of origin, and check
to see if the person offering the vehicle is
licensed to do business in your country of
origin.
Ask to see, beforehand, independent
financial audits. Make sure the audits were
done by credible sources. Investors who
suspect there is anything out of the ordinary
are strongly encouraged to contact a
regulatory body in the country of origin.
Don't be dazzled by numbers that seem too
good to be true. The Australian/Securities
Exchange and Investment Commission has
developed research offered on its Web site that
outlines for investors what a realistic rate of
return is in today's Australian marketplace. It
also tells investors how to calculate a rate of
return as well as look at compound annual
growth. Bottom line: If the financial vehicle
being pushed an investor's way in Australia is
higher than 15 percent a year, Dunn said, that
person "better consult a licensed professional
and possibly a fraud specialist to find out if the
opportunity is truly legitimate."
Consult online sources. Anti-fraud
discussion forums such as The Diligizer Board
and Quatloos.com allow you to plug in the
name of the investment vehicle and its
principle under writer or a type of investment
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proposal, and see what sort of commentary
comes back. The Diligizer Board, which is run
out of London by a handful of anti-fraud
specialists, is a privately run concern not
affiliated with any government or police
department. Be forewarned, though: The site,
as one of its founders acknowledged,
periodically attracts the con artists themselves
who make mostly vain attempts to contradict
the serious fraud debunking that goes on in the
discussion forums.
Don't be afraid to be suspicious, even if
the person proffering the deal is a trusted
broker or good friend.
Frame first learned about PinnFund through a
longtime friend and business partner, James
Hillman, who was raising money for the loans
Fanghella, the fund's manager, was pitching to
banks. While Frame believes that Hillman did not
intentionally set out to rob him or the other
investors, he acknowledges that he let friendship
cloud his judgment and undermine his instincts.
"Had it not been a friend, I would have done
more up-front fact checking," Frame said. "I would
have found out all this about ten times sooner and
probably would not have invested in this."
Though still incredulous that a 25-year friendship
could lead him down the path to fraud, Frame
continues to believe that high-risk, high-return
deals are worthwhile. "The concept I thought was a
good one," he said. "Had I lost money because it
failed or went out of business, I wouldn't have
been unhappy - particularly not after having
received 17 percent returns for a couple of years."
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MACROECONOMIC ANALYSIS AND POLICY Topic Three
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You can always spot a scam – or can you?

If you think you are a sophisticated investor and can tell the difference between a legitimate
opportunity and a scam, think again. The differences, according to an experienced financial
investigator, are usually "very slight and not easily visible."

Niko Paape, who works out of Amsterdam along with a partner in London, researches and analyzes
investment deals, including their business plans and target markets, for individuals and institutions in
Europe, the United States and Canada. Of the 40 or so investment proposals Paape expects to
analyze this year, he expects approximately 12 to involve some form of fraud, including the bank
paper trading scams regulators are so concerned with.

Paape, whose work has brought him in contact with regulators and detectives on both sides of the
Atlantic, said con artists pushing investment scams can be extremely savvy, often emulating
legitimate business models in order to advance Ponzi-style schemes. They go to "great lengths," he
noted, "to keep up the pretense of legitimacy" by producing audits about "mergers," "statutes" about
meetings as well as prospectuses - all drawn up according to regulations.

Another example is the New Anaconda Co. scam, a debt-for-equity investment proposition floated
five years ago by two con artists, Paul de Rome and Fred Taylor.

The scheme was based in the United States but operated out of London. De Rome and Taylor
invited people to invest a minimum of $100,000 in 48 companies they had organized in exchange for
a 48 percent annual rate of return on investment.

According to Paape, "In the first two months the victims got paid as promised. In the third month
some remarks were being made as to 'restructuring,' 'talks of takeovers, mergers' and whatever
nonsense you can think of. In the fourth month, victims were informed that the company could no
longer payout either profit or return the invested amount in cash but a 'debt for equity' deal was
offered." Most of the victims, he said, felt they had very little choice but to accept. The debt
securities, of course, were worthless.

To Paape, the New Anaconda case epitomizes the type of scams that threaten more sophisticated
investors, in part because they are so challenging, even for regulators and specialists, to dissect. All
parts of the New Anaconda organization were related to each other in some way or another, Paape
said.

"Many of these companies traded with each other only," he said. "If you would not know
how these companies were related, you would see this as perfectly normal."

In addition, the international aspects of the case made investigation "very hard and complicated,"
Paape said. Although New Anaconda was based in the United States, the operation was led from
London. The providers of the "bank guarantees" were located in the United States and Australia and
on the islands of Cyprus and Nauru. The insurance company that "covered" the "bank guarantees"
was located on Cyprus but operated from London. The agent for the "shares" was based in the
United States.

After four years, regulators have yet to conclude their criminal investigation of the case.
Holly Hubbard Preston (International Herald Tribune, June 15-16, 2002, p 14.)

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