Whenever you hear about a “prime bank” investment opportunity, walk away. A prime bank opportunity generally is described by the sponsor as an international investing program involving complex financial instruments that are too technical and complicated for non-experts to understand. If it’s too technical for you to invest why would you? – Astronomical returns are promised in exchange for secrecy about this lucrative international banking platform.

The SEC’s case against Frank L. Pavlico and his firm, The Milan Group, was just another prime bank scheme. It caught my eye because the SEC also brought charges against a lawyer involved in the scheme, Brynee K. Baylor.

What kept my attention was this quote from Stephen L. Cohen, Associate Director of the SEC’s Division of Enforcement:

“Pavlico and Baylor produced paperwork dotted with legal-sounding gibberish designed to deceive investors into believing this is a highly-sophisticated investment opportunity.”

And in the complaint:

“These documents were legal-sounding gibberish dotted with meaningless legal and financial terms that were designed to deceive investors into believing they were participants in a legitimate investment.”

A complaint by one of the deceived investors (.pdf) lays out what the scheme was offering. if the investor would deposit $325,000 into Baylor’s trust account Milan would provide a leased instrument with a value of $10 million. This would then be monetized and the resulting funds would be used to acquire a larger instrument.

These are just allegations, nothing has been proven and the defendants have not settled the charges.

Sources:

• SEC Halts Prime Bank Scheme by Washington D.C. Law Firm and Pennsylvania Company – SEC press release
• SEC Complaint against the Milan Group, Frank L. Pavilco, Rynee K. Bayor, et al (.pdf)
• Princeton Development v. Brynee Baylor et al. (.pdf)
• SEC’s Prime Bank Fraud Information Center
• FBI’s Prime Bank Note Fraud

The Securities and Exchange Commission brought charges of securities fraud for concealing a significant error in the computer code of the quantitative investment model. I found this case to be interesting because it was not flawed human decisions, but flawed computer decisions. However, we still live in the age where computers do what we tell them to do. So, if the computer is doing something wrong, then a person is behind it.

Barr M. Rosenberg developed complex automated models and an “optimization” process to create and manage client portfolios. Barr Rosenberg Research Center LLC was the registered investment adviser. In April 2007, BRRC put into production a new version of the Risk Model, one component of its quantitative trading program. Two programmers linked the Risk Model to the Optimizer, a second component of the quantitative trading program. However, they made an error in the Optimizer’s computer code.

In June 2009, an employee noticed some unexpected results when comparing the new Risk Model to the existing one that was rolled out in April 2007. Some Risk Model components sent information to the Optimizer in decimals while other components reported information in percentages. That meant the Optimizer had to convert the decimal information to percentages in order to effectively consider all the information. That screwed up the inputs and the outputs resulting in the Optimizer not giving the intended weight to common factor risks.

As with most mistakes that lead to SEC action, the error caused the portfolios to underperform. The error impacted more than 600 client portfolios and caused approximately $217 million in losses. Obviously, this is a bad result.

The problems came, as they usually do, when someone tried to hide the problem. Mr. Rosenberg concealed the error and told his employees not to disclose the error to the investment officers or managers of the firm. That meant the firm was making material misrepresentations and omissions concerning the error to their clients, including:

(i) omitting to disclose the error and its impact on client performance,
(ii) attributing the Model’s underperformance to market volatility rather than the error, and
(iii) misrepresenting the Model’s ability to control risks.

The SEC charged Rosenberg with willful violations of  Sections 206(1) and 206(2) of the Investment Advisers Act. Section 206(1) prohibits any investment adviser from, directly or indirectly, “employing any device, scheme, or artifice to defraud any client or prospective client.” Section 206(2) prohibits any investment adviser from engaging in any “transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.”

Rosenberg was aware of the problems, but did not disclose the error and directed others not to disclose. As a result, the firm misrepresented that the underperformance was attributable to factors other than the error and inaccurately stated that the model was functioning when in fact it was not. In addition, Rosenberg’s caused a delay in fixing the error leaving it uncorrected for several additional months. Rosenberg caused his clients to continue sustaining losses from an error that could have been promptly fixed.

Rosenberg has to pay the $2.5 million penalty fine and he received the ban from the SEC. He is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and prohibits him from serving as an officer, director or employee of a mutual fund.

Lesson learned. If the computer is broken, fix it right away. And don’t lie about it.

Sources:

• SEC Charges Quant Manager with Fraud
• Administrative Order in the Matter of Barr M. Rosenberg (.pdf – 6 pages)
• Quant Manager Charged With Fraud by Steven Meyerowitz in Financial Fraud Law

The United States Government forced online poker sites to the fringes of the financial system. The U.S. government has long argued that online poker gambling is illegal under the Wire Act, a 1961 law that explicitly prohibits sports betting conducted over electronic communication. In 2006, Congress made it illegal for financial institutions to process funds for online gambling.

It should be no surprise that an online poker site would run into legal problems. The complaint against Full TItle Poker caught my eye because

“By March 31, 2011, Full Tilt Poker owed approximately $390 million to players around the world, including approximately $150 million to United States players. However, the company had only approximately $60 million in its bank accounts.”

Many Ponzi schemes started off as legitimate enterprises. When funding shortfalls or an unexpected loss hits, the managers try to hide the bad news. This creates a spiraling downfall leading from poor management to criminal behavior. In this case, Full Tilt was having trouble moving the cash around the financial system to collect wagers from players and make payments to the winners. It sounds like Full Tilt was funding winnings without withdrawing initial bets from the player accounts.

But was it a Ponzi scheme? While there is no official definition of a Ponzi scheme, these are what I think are the elements:

(1) A promise of financial reward.

(2) Current contributions to the scheme are not invested, but are spent to make good on returns promised to earlier contributors.

(3) The manager of the scheme maintains his ability to pay the returns only by getting other contributors.

(4) The contributors think the manager is investing their contributions to make the return (not necessarily in a fully legal way).

(5) If future contributors do not arrive in sufficient numbers, the Ponzi scheme will have too little money to pay current returns/redemption.

Full Tilt was not an investment scheme. Sure you can argue about whether poker success is based on skill or luck, with luck being a key element of gambling. (I think it’s a combination of both.) But it’s not an investment and you are not buying a security. The contributors did not think the manager was doing anything with the money other than keeping it safe. They were winning or losing based on the hands the contributors played.

It does seem that current winnings were being paid from new contributions. According to the complaint, the mangers were taking more cash out than the business could support. The company had a funding shortfall because it was having trouble moving the wagers and winnings through the financial system.

You would hope that a leading federal prosecutor would know the difference between different types of fraud. Full Tilt was not a Ponzi scheme. As good as you may be at poker, your wagers are not investments.

Sources:

• Feds: Full Tilt Poker site was Ponzi scheme, customer accounts were looted of $440 million in the Washington Post
• U.S. Alleges Poker Site Stacked Deck by Alexandra Berzon in the Wall Street Journal
• First Amended Complaint in US v. PokerStars, Full Tilt Poker, et al. (pdf- pages)
• Further Thoughts on Whether or Not Social Security is Ponzi Scheme by Don Boudreaux on Cafe Hayek
• Full Tilt Ponzi by Felix Salmon
• Press Release from the US Attorney for the Southern District of New York (.pdf – 3 pages)

The New York magazine interview with Bernie Madoff has finally been published.  Steve Fishman spoke with Madoff on the phone (collect calls from Madoff’s prison) for several hours.

And so, sitting alone with his therapist, in the prison khakis he irons himself, he seeks reassurance. “Everybody on the outside kept claiming I was a sociopath,” Madoff told her one day. “I asked her, ‘Am I a sociopath?’ ” He waited expectantly, his eyelids squeezing open and shut, that famous tic. “She said, ‘You’re absolutely not a sociopath. You have morals. You have remorse.’ ” Madoff paused as he related this. His voice settled. He said to me, “I am a good person.”

There aren’t many who would agree.

According the the interview, Madoff was already a wealthy man before he starting stealing from his clients and lying about their investments.

In the early days, Madoff mostly employed technical and fairly low-risk arbitrage techniques built around his market-making business. “I always had a good feel for the direction of the market because of the order flow I was seeing,” he said. In the eighties, he said, he produced consistent returns of 15 to 20 percent, and he insists he did it legally.

To me it sounds a bit like he was taking advantage of his trading business to help out his investment advisory business. Madoff had long been suspected of front-running trades to make money for his advisory business.

In the interview, he claims that the fraud started after the crash of 1987. Clients pulled out capital and he was forced to unwind long-term hedges on unfavorable terms. Then his trading scheme was no longer working because the market lacked the volatility needed for his arbitrage. And because trading spreads were narrowing because of the rise of electronic exchanges.

In the interview, Madoff displays some of the classic criminological behaviors of a fraudster.

He blames his victims: “Madoff says that he waved red flags, issued caveats that should have been obvious to even an unsophisticated investor.”

He denies his victims: “Everyone was greedy,” he continues. “I just went along. It’s not an excuse.” “Look, none of my clients, even if they lost every penny they put in there, can plead poverty.” In the tapes he claims that very few of the early investors will have lost their invested capital.

He condemns his condemners: “The whole new regulatory reform is a joke. The whole government is a Ponzi scheme.”

He claims everyone else is doing it: “It’s unbelievable, Goldman … no one has any criminal convictions.”

I think Madoff’s prison therapist told him the wrong answer. Or Madoff lied to Fishman about the therapist response.

Sources:

• The Madoff Tapes by Steve Fishman in New York

• A Criminological Perspective on Business Ethics – prior post on Compliance Building

The Securities and Exchange Commission filed charges against Monroe L. Beachy, a 77-year-old Amish man from Sugarcreek, Ohio. They found the Bernie Madoff of the Amish.

Beachy targeted his fellow Amish in his alleged fraud. He raised more than $33 million from as early as 1986. Beachy enticed investors by promising interest rates that were greater than banks were offering at the time. Beachy told his investors that their money would be used to purchase risk-free U.S. government securities. Many of Beachy’s investors treated their investment accounts with Beachy like money market accounts, from which they could withdraw their money at any time. In reality, Beachy used the money to make speculative investments in junk bonds, mutual funds, and stocks.

By the time Mr. Beachy filed for bankruptcy in June 2010, less than $18 million of the original $33 million of investor money remained.

I would guess that Beachy started off doing the right thing, but made a bad investment along the way. Rather than be honest with his investors, he took greater risks to try and make back the earlier loss, missing again and again.

Like Madoff, it sounds like he was offering a modest rate of return. That would allow this Ponzi scheme to go on longer and longer.

Like Madoff, the fraud continued for decades. Because of the length of Mr. Beachy’s alleged scheme, generations of families were affected. Older generations of Amish investors would referred their children to Beachy.

Unlike Madoff, Beachy had actually invested the money. Just not in the safe investments he promised to his investors.

UPDATED: The Washington Post has a great story with some background on the fraud: In an Amish village, the SEC alleges a Madoff-like fraud by David S. Hilzenrath.

Sources:

• Securities and Exchange Commission v. Monroe L. Beachy – Litigation Release
• SEC Complaint in Securities and Exchange Commission v. Monroe L. Beachy
• Adviser in dutch for allegedly scamming Amish clients By Jessica Toonkel in Investment News
• SEC Charges Amish Man with $33 Million Affinity Fraud in Investor’s Watchdog

Amish Buggy Sign is by Daniel Schwen

Apparently, many of the recent financial fraud actions in the news have been part of a nationwide operation organized by the Financial Fraud Enforcement Task Force to target investment fraud: Operation Broken Trust.

“To date, the operation has involved enforcement actions against 343 criminal defendants and 189 civil defendants for fraud schemes that harmed more than 120,000 victims throughout the country. The operation’s criminal cases involved more than $8.3 billion in estimated losses and the civil cases involved estimated losses of more than $2.1 billion. … Starting on Aug. 16, 2010, within a three-and-a-half month period, Operation Broken Trust involved 231 criminal cases and 60 civil enforcement actions. Eighty-seven defendants have been sentenced to prison, including several sentences of more than 20 years in prison.”

The Association of Certified Fraud Examiners is urging organizations worldwide to participate in International Fraud Awareness Week, November 7-13, 2010 to help cast a spotlight on the problems arising from fraud.

This weeklong campaign encourages business leaders and employees to proactively take steps to minimize the impact of fraud by promoting anti-fraud awareness and education.

In its 2010 Report to the Nations on Occupational Fraud & Abuse the ACFE found that:

• Fraud schemes are extremely costly. The median loss caused by the occupational fraud cases in the ACFE study was $160,000. Nearly one-quarter of the frauds involved losses of at least $1 million.
• Schemes can continue for months or even years before they are detected. The frauds in the study lasted a median of 18 months before being caught.
• Occupational fraud is a global problem. Though some findings differ slightly from region to region, most of the trends in fraud schemes, perpetrator characteristics and anti-fraud controls are similar regardless of where the fraud occurred.
• Small businesses are especially vulnerable to occupational fraud. These organizations are typically lacking in anti-fraud controls compared to their larger counterparts, which makes them particularly vulnerable to fraud.
• Tips are key in detecting fraud. Occupational frauds are much more likely to be detected by tips than by any other means. This finding reinforces the need for promoting awareness to foster an informed workforce.

The 2010 Report to the Nations is available for download online at the ACFE’s website: ACFE.com/RTTN. The Report is in PDF format

Become an Official Supporter
There’s no charge to become an official supporter of International Fraud Awareness Week. You will receive downloadable anti-fraud resources, as well as a logo to post on your company or organization’s web site. You will also be provided with a customizable press release to send to local media announcing your involvement in this important movement.

Influence Future Professionals
Speak to local university students enrolled in business, management and accounting courses about the importance of being trained in the detection and prevention of fraud.

Reduce Risk
Send an email to clients outlining the risks and cost of fraud. Encourage them to reduce their fraud risk.

Spread the Word
Encourage other colleagues and students to become involved with the ACFE in the fight against fraud.

Host an Anti-Fraud Seminar
Hold a free fraud prevention seminar in your community. Download anti-fraud resources or contact info@ACFE.com for more information.

I find looking at fraud cases instructive, seeing common themes, failures and techniques. Since my company is in real estate, real estate fraud catches my eye. Recently the SEC brought a case against Rosand Enterprises and one of its principals, Robert A. Anderson.

The Securities and Exchange Commission came in late. The Illinois Secretary of State had already filed an order against Rosand Enterprises, Rossetti and Anderson.

In the Illinois order, they alleged that the enterprise had solicited investors to loan them $2.735 million, with repayment at 15% per month for a six-month note or 20% for a twelve-month note.

The SEC found a broader network of $12 million solicited from 77 investors. (I wonder why the SEC did not include Mr. Rossetti their complaint.) The US Attorney also got involved and announce criminal charges.

Let’s look at some of the red flags.

Extremely high returns should be a big warning. Rosand was offering returns of 15% or 20% per month on loan payments. If the business is that profitable, why bother getting outside collateral. They are doubling their money every six months.

The money was guaranteed. Risk equates to reward. If money is in a safe investment, you should only get a small return. If there is a high rate of return then the investment is going to be risky. Any promised returns above 10% per year should immediately be suspect.

They were offering the notes to non-accredited investors. If you make less than $200,000 per year or have a net worth of less than $1 million you are non an accredited investor. That means you are not generally able to purchase unregistered securities like the notes offered by Rosand.

One aspect of real estate is that ownership is part of the public record. Anyone can walk into the registry of deeds and see who owns a piece of property and who they bought it from. In most places, you can also see the price paid.  If Rosand was buying and rehabilitating houses, a potential investor could easily look up the information in the land records.

The Cook County Registry of Deeds is online. I ran a quick grantor/grantee search on “rosand.” No surprise, Rosand Enterprises has not bought or sold any real estate in the past 15 years.

Like most Ponzi schemes, eventually you will run out ways to get new money in the door to cover the money going out. Rosand stopped making payment in June 2008. Two years later, the State of Illinois and the SEC stepped in to protect investors.

Sources:

• SEC Complaint: SEC v. Robert A. Anderson and Rosand Enterprises
• SEC Litigation Release No. 21688
• SEC Press Release: SEC Charges Purported Real Estate Business and Owner for Conducting Ponzi Scheme
• Illinois Secretary of State order against Rosand Enterprises, Rossetti and Anderson

The New Face of Evil?

His crime was simple: collect money from investors, fake the returns, pocket the money, and repeat. His crime was the biggest: $20 billion in cash plus $45 billion of fake returns.

Should Bernie Madoff be the new name for evil? Christine Hurt of University of Illinois College of Law contrasts Madoff with the original Ponzi schemer, Charles Ponzi himself.

Judge Chin at the Madoff sentencing cast him with the label of evil:

Here, the message must be sent that Mr. Madoff’s crimes were extraordinarily evil, and that this kind of irresponsible manipulation of the system is not merely a bloodless financial crime that takes place just on paper, but that it is instead, as we have heard, one that takes a staggering human toll

His 150 year sentence is a staggering sentence for a non-violent crime. Financial fraud sentences are rapidly increasing in length and severity.

Perhaps, as Hurt point out, this increase in penalty is a reflection of the American society. We are now more afraid of outliving our retirement savings than of home invasion. (But not of people taking pictures of planes.)

Unlike the complexity of the WorldCom and Enron financial misdeeds, Madoff’s were much more straight-forward. It’s an easier story to tell the judge. It’s easier to lay the blame. Bernie kept his mouth shut and did not implicate anyone else.

We are already seeing the “Madoff” label being applied to other fraud schemes. Kenneth Starr’s fraud is being labeled “Madoff-Like.” other frauds are being called “Mini-Madoff.”

Maybe the Madoff label will stick.

Sources:

• Hurt, Christine, Evil Has a New Name (and a New Narrative): Bernard Madoff (August 18, 2010). Michigan State Law Review, p. 947, 2009; U Illinois Law & Economics Research Paper No. LE10-021. Available at SSRN: http://ssrn.com/abstract=1661462
• New Paper on SSRN: Evil Has a New Name (And a New Narrative): Bernard Madoff by Christine Hurt in the Conglomerate

Is the CEO or CFO lying during the quarterly earnings call? How can you tell?

David F. Larcker and Anastasia A. Zakolyukina of the Stanford Graduate School of Business turned to the rich data set of quarterly calls and subsequent financial restatements. After studying Q&A sections of transcripts of hundreds of calls with CEOs and CFOs, the researchers then looked to see whether financial statements being discussed were substantially restated at some point after the call. If they were restated, Professor Larcker and Zakolyukina (a PhD student at the school)  reasoned that the executive had been “less than candid.”

They found that answers from deceptive executives:

• have more references to general knowledge
• fewer non-extreme positive emotions
• fewer references to shareholders value and value creation
• use signisignificantly fewer self-references, more third person plural and impersonal pronouns
• more extreme positive emotions
• fewer extreme negative emotions
• fewer certainty and hesitation words

Their performance is only 4% to 6% better than a random guess. So it’s statistically significant, but not determinative.

Sources:

• Larcker, David F. and Zakolyukina, Anastasia A., Detecting Deceptive Discussions in Conference Calls (July 29, 2010). Rock Center for Corporate Governance at Stanford University Working Paper No. 83. Available at SSRN: http://ssrn.com/abstract=1572705
• How to tell when your boss is lying in The Economist