Tag: Ponzi schemes

Shkreli Gets His Holiday Gift… Handcuffs

One of the most hated men in American business was grabbed by the FBI and put in handcuff. The Securities and Exchange Commission slapped a “me too” suit on him as well. Martin Shkreli did the perp walk last week for running a ponzi scheme.

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Shkreli became the face of what is wrong with the American health industry when he jacked the price of treating a life-threatening parasitic infection from $13.50 a tablet to $750.

With his engorged wallet he spent $2 million to purchase the sole copy of Wu Tang Clan’s latest album. To prove that it was just an expensive trinket, he claimed to have not listened to it.

That all just makes him gross, but not a criminal.

But it turns out that he got there through running a ponzi scheme. He pulled off the rare ability to exit from a ponzi scheme.

The vast majority of ponzi schemes collapse under the weight of promised payouts exceeding the inflow from new investors. The original investment scheme fails and the sponsor is scrambling to find anything that might work to score the redemptive returns. Given that the supply of capital is significantly smaller, the returns need to be astronomical.

Skreli had lost all of his investors’ money. He had just settled a FINRA Arbitration over naked short-selling that took the last few dollars out of his hedge fund accounts.

He started MSMB Capital, a hedge fund company, in his 20s and drew attention for urging the Food and Drug Administration not to approve certain drugs made by companies whose stock he was shorting. The strategy did not work.

Nonetheless he send a message out to investors that he had doubled their money.

Mr. Shkreli started Retrophin, which also acquired old neglected drugs and sharply raised their prices. The company was wildly successful and went public.

As a public company, Retrophin can’t pay off Mr. Shkreli’s disgruntled hedge fund investors. But fiduciary obligations were apparently not important to him and he caused the company to write the checks.

Retrophin’s board fired Mr. Shkreli a year ago. Last month, it filed a complaint in Federal District Court in Manhattan, accusing him of using Retrophin as his personal piggy bank to pay back disgruntled investors in MSMB Capital.

The DOJ and SEC piled on and brought their own suits.

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How Do You Exit a Ponzi Scheme?

Charles Ponzi

It looks like Bernie Madoff was $45 billion short of funds in his “investment strategy.” How was he ever going to get out of this?

The original Ponzi schemer, Charles Ponzi, seems to think he could get out of his situation, at least according to Mitchell Zukoff, author of Ponzi’s Scheme: The True Story of a Financial Legend.

It sounds like Madoff and Ponzi fell into the same trap. At some point early on they did not realize their promised investment goals. Instead of being honest with their investors, they posted a fake return. The hope was that they could make up for the miss later on.

The central characteristic of a Ponzi scheme is that current returns to investors are paid from new investments instead of a return on the invested capital.

The duration of a Ponzi scheme is dependent on a few factors.

The first factor is the promised return rate. The higher the promised return the shorter the duration. One of the reasons Madoff continued for so long is that his promised return was typically low. He was generally in the 15% range. Since Ponzi was promising returns of 50% in three months, he had a short fuse on the length of his scheme.

The second factor is the redemption rate. The promised return is only meaningful when you have to pay out cash. The better the schemer is at getting investors to keep rolling over returns, the longer the duration. Madoff was undone by the 2008 financial crisis, crushed by a wave of redemptions as people were desperate for cash.

The third factor is the investment rate. The better Ponzi schemers can keep the cash flowing in. As long as the investment rate of cash flowing is in excess of the redemption rate, the scheme will not collapse unless discovered. Once the redemption rate exceeds the investment rate, the schemer will not have the cash to make payouts and the scheme will likely be discovered.

The fourth factor is discovery. This is a wild card. Once an accusation of fraud is made, there will likely be an sharp increase in the redemption rate and a reduction in the investment rate. Ponzi has high profile and attracted attention. Madoff was very secretive. If you can’t stand up to scrutiny, the less scrutiny the better.

The fifth factor is actual returns. I would theorize that many Ponzi schemes start as a legitimate investment proposals. So there may be some actual investment returns that could offset the need for a higher investment rate. Ponzi never made a legitimate investment so this factor was zero for his scheme. Madoff was apparently investing legitimately at some point, but ended up at zero for many years leading up to the collapse. Stanford was generating returns in his banking empire. Just not enough.

The obvious exit is to increase the actual returns to meet the promised return rate before the redemption rate exceeds the investment rate. You can look at Sam Israel who seemed to think he was always just a few trades way from making back all of the promised money.

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Was Full Tilt Poker a Ponzi Scheme?

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.

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The Amish Madoff

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.

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Amish Buggy Sign is by Daniel Schwen

The New Face of Evil?

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.

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Dealing with Losses From the Madoff Fraud

Charles Ponzi

One of the many repercussions of the Madoff fraud is how to treat investors who had money in his Ponzi scheme.

There has been plenty written about how the trustee is treating the direct investors. He is only treating net cash. If you took out more cash than you put in, you are on the hook. That is regardless of how massive your paper losses may be. This clearly hurts the early investors with Madoff.

The other aspect is how the feeder funds or other investment funds treat the losses and pass them through to their investors. The case of Beacon Associates caught my eye when it popped up. (There is no connection to my employer.)

Beacon Associates had placed a big chunk of its assets with Mr. Madoff. That has lead to a class actions suit by its investors and ERISA lawsuits.

The losses have also left the fund in the lurch as to how to treat the losses and which period to attribute the losses. Between 1995 and December 2008, Beacon issued monthly financial statements reporting substantial gains on Beacon’s investments. Beacon allocated those gains to its members in proportion to each member’s interest in Beacon and reflected those gains in its financial statements. As we have now discovered, Madoff never invested the capital and those gains allocated by Beacon never existed.

As a result, Beacon ended up commencing liquidation and needed to figure out how to distribute its remaining assets to its investors. Beacon lost approximately $358,000,000 through investments with Madoff and had just $113,283,785 of remaining assets.

One way to treat the loss is the valuation method. You treat the losses to have occurred on December 2008 when the Madoff fraud was uncovered. Any investor who was fully redeemed before then would not be allocated any loss.

An alternative treatment would be the restatement method. They would treat the losses to have occurred when Beacon made each of its investments with Madoff. That would allocate the Madoff losses over a much longer period of time.

Not surprisingly, the different methodologies “provided dramatically different results.” While the capital account of one member was calculated at $4,750,866 using the Valuation method, it had a balance of $2,735,636 under a Restatement method. Another member’s capital account was valued at $1,815,576 under the Valuation method, but exceeded $3,000,000 under a Restatement method. Beacon polled its investors. Eight-two percent preferred the Valuation Method, 10% preferred a Restatement Method, and twenty-five (8%) did not make a selection.

The court ended up ruling:

“Because Beacon’s Operating Agreement requires that capital accounts be maintained in accordance with Federal Treasury rules, and because the IRS has ruled that losses attributable to Ponzi schemes be reported in the year they are discovered, Beacon’s Operating Agreement must be read as requiring that Madoff theft losses, including those losses owing to “fictitious profits,” be allocated among its members’ capital accounts in proportion to their interest in Beacon as recorded in December 2008, when Madoff’s fraud was discovered.”

The net investment method is similar to the one being used by the Madoff and is appropriate for Ponzi scheme cases. Here, the court points out that Beacon itself was not a Ponzi scheme. The valuation method is the proper choice.

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SEC Censure for Failing to Conduct Due Diligence

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The SEC censured and fined an investment adviser for due diligence lapses. Yosemite Capital Management, LLC and its managing director, Paul H. Heckler, got a wrist slap for failing to disclose to clients that they had encountered substantial problems when attempting to perform the due diligence.

The big problem is that Yosemite had made a promise to at least two clients prior to placing his clients into the investment. They had promised to conduct due diligence. We saw a similar action by the SEC against the Hennessee Group for their failure to conduct their promised due diligence.

Yosemite ended up putting their clients’ money into a Ponzi scheme. Yosemite placed $3.25 million of four clients’ funds through a feeder fund, Ashton Investments LLC which was supposed to make bridge loans arranged by Norman Hsu and Next Components, Ltd. Heckler’s clients’ funds became part of a Hsu’s $60 million Ponzi scheme.

Yosemite missed some bright red flags:

  • The business cards from Ashton’s representatives that listed their position as “Represenative” [sic].
  • Ashton gave Yosemite a brochure riddled with spelling errors and mostly general, unverified information.
  • In addition to the business cards and the brochure, the only other written information concerning Ashton and Hsu that Yosemite received were emails, without any identifying information, that summarized a few of the loans.
  • Heckler was told that he could not contact Hsu’s lawyers or accountants because Hsu was a  private person.
  • Heckler was told that the bridge loans were safer than stocks or bonds.
  • When Heckler requested a disclaimer in the loan agreement, he was told that it was unnecessary because the investment was not risky.
  • Because Ashton had no offices, Heckler met the Ashton representatives at local restaurants to discuss the investment.

Heckler and Yosemite willfully violated Section 206(2) of the Advisers Act, which prohibits any investment adviser from engaging in any transaction, practice, or course of business, which operates as a fraud or deceit on any client or prospective client, and Heckler caused Yosemite’s violations of Section 206(2) of the Advisers Act.

The “wrist slap” was a disgorgement of the fee earned ($26,000), prejudgment interest and a $50,000 fine. Heckler invested $275,000 of his own money in the scheme and lost $150,000 of it.

Of the $3.25 million of the clients’ money invested, they lost $1.95 million when Hsu’s Ponzi scheme collapsed.

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How Did Madoff Go Bad?

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Last Friday, the SEC published the exhibits for Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme (Report No. OIG-509). That was 536 separate exhibits tying to fill in the background on what happened with the SEC and Madoff.

The one that caught my eye was exhibit 104pdf-icon that summarized a June 17, 2009 interview of Mr. Madoff while he sat in Metropolitan Correctional Center. Inspector General H. David Kotz and Deputy Inspector General Noelle Frangipane were the interviewers.

For me, one of the issues with Madoff was “What made him go bad?”

Personally, I don’t think he intended to start off with a Ponzi scheme. Most Ponzi schemes start off legitimate, then something goes wrong. They fudge the returns hoping to make it up later. Those later returns are elusive and the promoter keeps the lie going.

According to the summary on page 8 of exhibit 104pdf-icon that is what happened to Madoff. The problem occurred when Madoff “made commitments for too much money” and “couldn’t put his strategy to work.” he could not get the returns he wanted. Then he thought:

“Fine, I’ll just generate these trades and then the market will come back and I’ll make it back… and it never happened. … It was my mistake not to just be out a couple hundred million dollars and get out of it.”

Unfortunately, the summary does state when this transgression happened. So we don’t know when his company began the Ponzi scheme. At least as far as Madoff is claiming

Personally, I think this may have been the biggest transgression and the one that clearly put it into the Ponzi scheme category. But that sounds like a big position for your first lie.

Hopefully, we will hear more about what really happened. Until then, here are some other takes on the Madoff information:

You’re a Victim of a Ponzi Scheme, But What About Your State Taxes?

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You missed the warning signs and got suckered into a Ponzi scheme. The IRS offered some tax relief for long-term Ponzi scheme investors (like some of the Madoff victims) who have paid taxes on gains from the investment. The IRS clarified the federal tax law governing the treatment of losses in Ponzi schemes. They also set out a safe harbor method for computing and reporting the losses.

The revenue ruling (2009-9) addresses the difficulty in determining the amount and timing of losses from Ponzi schemes and the prospect of recovering the lost money. The revenue procedure (2009-20) simplifies compliance for taxpayers by providing a safe-harbor for determining the year in which the loss is deemed to occur and a simplified means of calculating the amount of the loss.

But what about state taxes?

California: On March 25, 2009, the California Franchise Tax Board announced that the federal guidance (Revenue Ruling 2009-9 and Revenue Procedure 2009-20) regarding the treatment of Madoff-related or other Ponzi scheme losses would be generally applicable for California purposes.

Connecticut: On April 9, 2009, the Connecticut Department of Revenue Services released Connecticut Announcement No. 2009(7), which describes the effect for Connecticut income tax purposes of the reporting of Madoff-related or other Ponzi scheme losses under the Revenue Procedure 2009-20 safe harbor and under Revenue Ruling 2009-9. In general, Connecticut does not allow federal itemized deductions for Connecticut income tax purposes. Thus, any theft loss deduction claimed by a taxpayer under the Revenue Procedure 2009-20 safe harbor will not affect a taxpayer’s 2008 Connecticut income tax liability. However, if the amount of a taxpayer’s theft loss deduction allowed under Revenue Ruling 2009-9 or Revenue Procedure 2009-20 creates an NOL, then the taxpayer must file amended Connecticut income tax return(s) for the year(s) to which such NOL may be carried back for federal income tax purposes.

Massachusetts: On March 20, 2009, Massachusetts issued: “Notice—Individual Investors; Investments in Criminally Fraudulent Ponzi-type Schemes and Reporting of Fictitious Investment Income.” Massachusetts did not adopt the Revenue Procedure 2009-20 safe harbor in the case of individual investors since Massachusetts tax law does not recognize the theft loss deduction provided under federal tax law.

New Jersey: On April 2, 2009, the New Jersey Division of Taxation had issued guidance on the treatment of Madoff-related
or other Ponzi scheme losses for New Jersey gross income tax purposes. Under this guidance, taxpayers are allowed a theft
loss deduction for New Jersey gross income tax purposes in an amount equal to the original investment plus the income
reported in prior years minus distributions received in prior years. New Jersey does not allow NOL carrybacks or carry
forwards.

New York: On May 29, 2009, the New York State Department of Taxation and Finance issued guidance TSB-M-09(7)I (.pdf) on the
reporting of Madoff-related or other Ponzi scheme losses. In general, New York State will recognize the Revenue Procedure
2009-20 safe harbor.

For more information, Seyfarth Shaw put together some information: Some States Have “Weighed In” on Tax Treatment of Madoff-Related and Other Ponzi Scheme Losses (.pdf)

Arthur Nadel Indicted

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Florida fund manager Arthur Nadel was indicted Tuesday on criminal charges for allegedly soliciting hundreds of millions of dollars in investor money under false pretenses and misappropriating client funds. Mr. Nadel, 76 years old, was charged in a 15-count indictment with mail fraud, securities fraud and wire fraud.

“It’s a much more complex story than the indictment may suggest,” said Mark Gombiner, Mr. Nadel’s lawyer. “We’re going to be evaluating what our defenses are.” Mr. Gombiner said his client will plead not guilty.

Previously, the SEC had filed a complaint against Mr. Nadel related to the same frauds perpetrated on his investors. “Nadel solicited prospective clients to invest in the funds by making various misrepresentations about the performance and value of the funds, including that the net asset value of each of the funds was tens of millions of dollars,” the U.S. Attorney’s Office in New York said in a statement. “Nadel also claimed to investors that his purchases and sales of securities in the Funds had generated cumulatively more than $271 million in gains. In truth, Nadel’s trading resulted in an overall net loss in the funds.”

Back in January, Nadel went on the run and spent two week in hiding. He had ditched his car in an airport parking lot. One of his investors had demanded an independent audit after the fallout form the Madoff scandal.

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