Why This Decade's Spate of Fraud Recalls Patterns and Players of Other Golden Ages
By E.S. BROWNING Staff Reporter of THE WALL STREET JOURNAL
Future generations no doubt will look back on the 1990s as a golden age of prosperity in the U.S. -- and probably also as a golden age of financial fraud.
It was in this decade that a Canadian gold-mining company called Bre-X Minerals Ltd. saw its stock value soar to $4.5 billion, until its miracle
Indonesian mine was exposed as a hoax. Fraudulent trading brought down
two eminent investment banks in succession, Kidder, Peabody & Co. and
Baring Bros.
Just this fall, reclusive, would-be insurance mogul Martin Frankel and
garrulous market guru Martin Armstrong were arrested within days of each
other, each charged by federal prosecutors with swindling investors out of
hundreds of millions of dollars. A San Antonio group called InverWorld
Inc. in August was accused by the U.S. Securities and Exchange
Commission in a civil lawsuit of defrauding Mexican clients of the bulk of
their $475 million in investments.
Long-Running Epidemic
And while these scandals have gotten the big headlines, regulators say the
most devastating fraud for ordinary people has been the long-running
epidemic of small-stock scams. Mushrooming faster than prosecutors can
shut them down, they feature pushy telephone and Internet salesmen
stealing billions from gullible investors each year.
The amounts at stake today certainly
dwarf past swindles, both because of
inflation and because technology helps
money flow at a rate never seen
before. But some of the characters at
the center of allegations today bring to
mind characters of the past. Mr.
Armstrong, for example, is accused of
using a method popularized by Charles
Ponzi, whose pyramid scheme based
in Boston took in $15 million in 1920,
equivalent to about $125 million today.
When the fugitive Mr. Frankel was
found this summer hiding in a
Hamburg, Germany, luxury hotel with a cache of diamonds and cash, he
looked like a character in a novel by Agatha Christie or Dashiell Hammett.
(Mr. Armstrong denies any wrongdoing, and Mr. Frankel's lawyer says his
client is contesting the extradition charges against him.)
Intriguing Parallels
Financial historians don't find it surprising that so many swindles and
alleged swindles are blossoming now. Periods of affluence, they say, are
precisely when ordinary people and sophisticated investors alike, seeing
friends and relatives striking it rich, put aside their good sense and fall
victim to greed or envy. But the historians are intrigued by the parallels they
see between this era's frauds and those from past periods of financial
frenzy.
"It happens year after year after year after year; it never changes," says
Samuel Hayes, professor emeritus of finance at the Harvard Business
School. "Often the victims are people who are supposed to be very
sophisticated investors who shouldn't get caught like that. But they do."
Consider Sir Isaac Newton, one of history's most brilliant thinkers. He lost
the equivalent of a modern-day $1 million in an 18th-century scam called
the South Sea Bubble. Mark Twain, that great 19th-century skeptic,
repeatedly squandered his writing income on questionable investments,
including a turn-of-the-century version of biotechnology.
Promises of New Era
Or consider the unusual case of William Simon, the former Treasury
secretary and Wall Street power broker, who says he lost $1 million in a
charity fraud involving something called the Foundation for New Era
Philanthropy. New Era promised to line up anonymous donors to match
people's multimillion-dollar donations to charity if they would just funnel the
money through New Era.
Mr. Simon, Laurance Rockefeller, hedge-fund manager Julian Robertson
and John Whitehead, former Goldman, Sachs & Co. co-chairman, all fell
for it.
But Mr. Simon insists he wasn't really the victim of a scam. He has visited
New Era founder John Bennett in jail and has offered him a job if he is
paroled. Mr. Simon says that, while Mr. Bennett committed a fraud by
failing to match the money, he simply got in over his head and couldn't
meet commitments. "People have said to me, 'Well you were fooled,' and I
suppose it is true that I was fooled because I don't believe he did anything
to defraud me," says Mr. Simon, who today devotes most of his time to
philanthropy. "To this day I believe his intentions were correct."
Mr. Simon's willingness to forgive a million-dollar loss may touch on
something else about financial frauds: They burgeon at times of great
prosperity, when normal skepticism is overcome by the sight of enormous
wealth.
"The bull market creates conditions that are favorable to pulling off a
fraud," says Richard Sylla, professor of financial history at New York
University's Stern School of Business. "Ten years ago people weren't
interested in jumping into the market," he continues, but "it begins to burn
you when you know some people who are getting rich. You say, 'There is
nothing special about them, I know them, they were C students and I was
a student, so I'd better get in.' "
The Netherlands was rising to the height of its mercantile power when
tulip-mania struck in the 17th century. Investors briefly paid more for a
tulip bulb than for a house. Stocks were booming and empire was building
in early 18th-century Britain, when smooth operators, relying at times on
commentaries written by such renowned authors as Jonathan Swift and
Daniel Defoe, pumped up the shares of a trading group called the South
Sea Company. And it was at the start of the Roaring '20s, with the U.S.
entering a period of unprecedented prosperity, that Charles Ponzi ran his
fraud.
Does that suggest that today's golden age for fraud may herald an end to
the bull market? NYU's Prof. Sylla says he has a "feeling in my bones that
something bad could happen."
Markets and Mentality
But past experience is mixed. The popping of Britain's South Sea Bubble
did lead to a period of economic decline. The speculative excess of the
1980s culminated in the '87 crash, but stocks bounced back with amazing
speed. Dutch tulip-mania, although it destroyed some fortunes, didn't much
affect the broader economy. And while the Roaring '20s certainly ended
badly, it wasn't Charles Ponzi's fault; he went to jail nine years before the
crash.
Either way, the bull-market mentality seems to foster fraudulent schemes. It
may have driven Japanese financial institutions to seek big commodity and
currency gains through Mr. Armstrong's Princeton Economics
International, which according to court documents filed in federal court in
New York may have lost a big part of the institutions' several hundred
million dollars in investments. Mr. Armstrong strenuously denies stealing
any money and says he will be vindicated. "This case is far more
complicated than anyone expects," he said outside a courtroom this month
after pleading innocent.
The sky's-the-limit mentality also may have helped spur the New Era
charity scheme, as wealthy donors saw their donations doubled. It certainly
fanned the fires of the Bre-X gold mania, and put pressure on traders at
Baring and Kidder to falsify accounts.
Sir Isaac and Gravity
That kind of euphoria also appears to have clouded the vision of Sir Isaac
Newton, a pioneer in explaining the laws of gravity who apparently forgot
that they also can apply to the stock market. Newton was a savvy public
figure, active in university life and at one point a member of Parliament.
When 18th-century promoters developed a complicated scheme to help
pay off the national debt through the South Sea Company, Newton
acquired some shares.
As talk spread in London that the company was a huge bubble,
manipulated by the promoters, the share price leveled off. Newton then
apparently sold out at a big profit, the present-day equivalent of hundreds
of thousands of dollars.
But the great man's skepticism was clouded by the sight of the stock
continuing to soar. Although he is said to have considered the whole thing a
bubble, Newton apparently found it too tantalizing to avoid. Economists
call this the "bigger fool" theory of investing. An investor buys a stock --
maybe nowadays an Internet issue with no profits but a skyrocketing
market value -- knowing it is of dubious value but confident of selling it to
someone even more foolish before it falls. "They call it momentum investing
now," Prof. Sylla says.
In a 1990 anthology called "Crashes and Panics," Larry Neal, professor of
economics at the University of Illinois at Urbana-Champaign, estimates that
South Sea stock rose more than 640% in the space of six months at the
start of 1720. Some of today's fraudulent boiler-room stocks, and some
Internet-related stocks as well, have risen faster.
In any case, Newton bought back in and the South Sea stock collapsed.
His losses totaled 20,000 pounds, which economist John Kenneth
Galbraith has calculated as the current equivalent of more than $1 million,
wiping out the earlier gains and much more.
Legitimate Beginnings
What makes many of these swindles work devilishly well is that they often
begin, or appear to begin, as legitimate investment projects, turning into
frauds only after the initial plan goes bad.
Some victims of the New Era scheme, for example, point out that
anonymous donors, matching gifts and relationships of trust are common in
the charity world. Even Ponzi's scheme appeared to be based on a
perfectly legitimate plan to benefit from exchange-rate differences.
Ponzi found that he could buy a postal-reply coupon in Spain for a penny
and redeem it, in the U.S., for a dime. Trouble was, there never were
enough such coupons to cover the millions of dollars he got from investors
who formed lines outside his office. He simply paid big profits to old
investors with money flooding in from new ones. That pyramid system
already had been used many times before, notably by a turn-of-the-century
hustler nicknamed "520% Miller," who promised his dupes 10% profit a
week for 52 weeks. But Ponzi's investors were so faithful that, even after
press exposes were published, people continued putting in money until he
was arrested and jailed.
Famous names also can lull investors into a false sense of security. "There
will always be this piling on and piggybacking on respectable names who
you assume have done the homework, and who haven't," says Harvard's
Prof. Hayes. He speculates that the famous-name factor played a role in
Japanese investments with Mr. Armstrong. "The Japanese investors were
substantial firms with good connections and plenty of opportunity to do
their due diligence, and apparently they didn't," Prof. Hayes says.
"Someone gave them assurance that there was imprimatur and they just got
in."
Mr. Bennett, New Era's founder, played up an association with
mutual-fund legend John Templeton, himself a philanthropist, who invited
Mr. Bennett to serve on the boards of some of his funds. Mr. Templeton
stresses that he never put any money into New Era.
What Looks 'Real'
"We believed in him," former Treasury Secretary Simon says, referring to
Mr. Bennett. "When you get people like John Templeton, Ray Chambers,
the Rockefellers, who are all people who are involved in the world of
charity, it looks like this is real."
Mark Twain appears to have been swayed by investments linked to
well-known businessmen or politicians. His losing bets ranged from a
health-food company to a new printing process and an Austrian
carpet-weaving machine. At least he was able to make fun of himself, and
his experiences spawned some classic Twain one-liners.
"There are two times in a man's life when he should not speculate: when he
can't afford it, and when he can," he grumbled in "Following the Equator,"
an 1897 travel book. At around the same time, in "Pudd'nhead Wilson," he
issued this still-topical lament: "October. This is one of the peculiarly
dangerous months to speculate in stocks in. The others are July, January,
September, April, November, May, March, June, December, August and
February." |
