Category: Ponzi Schemes

Is a “Man Camp” a Security?

There was a land rush in North Dakota because of the stuff in the ground. Fracking for shale oil turned towns around the Bakken oil field into boom towns. It takes people to run those rigs, so the local population swelled in size, resulting in a shortage of housing. Some of the housing was minimally designed “man-camps” designed to meet the basic housing needs of a worker. An enterprising developer came up with an idea to finance construction by selling fractional interests in the real estate. The Securities and Exchange Commission just filed a securities fraud case against the developer.

Can a man camp be a security?

man camp

According to the SEC’s complaint North Dakota Developments marketed “units” to investors”. But since the units were managed collectively, the SEC took the position that the units are actually securities. An investor could purchase a unit for $50,000 to $90,000, rent space at the NDD project and let NDD manage the unit.

So far that sounds like a real estate investment, not a securities investment. Ignoring the alleged fraud for now, the SEC only has jurisdiction over securities fraud and needs to show that this investment involved a security.

The securities laws define “security” to include an “investment contract.”  The Supreme Court, in 1946, defined an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” SEC v. W.J. Howey Co., 328 U.S. 293(1946). The requirement that profits be expected “solely” from the efforts of the promoter has been given a liberal reading and has largely dropped the term “solely” from the investment contract test.

According to the complaint, NDD charged a high land rent for the unit. But NDD was willing to waive the land rent if the investor let NDD manage the unit. The SEC alleges that every investor had NDD manage the unit. The SEC described the land rent as punitive. Under the management agreement, investors could chose a guaranteed rate or a variable rate based on actual income received in a pooling program.

Typically, if the real estate investor is giving a choice to manage the unit separately, the developer can escape the transaction being designated as an “investment contract.” In this case the investor is given a choice, but the separately managed choice pays a large financial penalty. The SEC is going to argue that the choice is there in name only.

My view is that NDD took clever steps to avoid the treatment of the investments as securities. It may be enough to avoid the SEC’s case.

That does not mean there was or was not fraud involved in the investment scheme. The SEC’s complaint alleges some bad actions. It’s now up to NDD to defend itself from the SEC.

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Pyramid Scheme or Ponzi Scheme

Charles Ponzi
Charles Ponzi

The Securities and Exchange Commission brought charges against James Evans for engaging in a “Ponzi scheme.” The names of his scheme caught my eye: Cash Flow Bot and Dollar Monster. After digging around, I was puzzled as to what to call the scheme.

A Ponzi scheme purports to be a real investment opportunity, but payouts come from new investor money instead of the returns of the underlying investment (if any). The scheme’s sponsor needs some cover of respectability to convince his prey that he or she is really investing the money and generating returns.

How could an investor think that something called “Dollar Monster” was a real investment?

The websites are gone, but I found this 2010 description of DollarMonster:

DollarMonster is a simple straight-line matrix which is simply a one level payment system. The person at the top gets paid and the entire list below moves up every time 2 purchases in this line are bought.

Pyramid schemes promise consumers (or investors) large profits based primarily on recruiting others to join the program. The scheme is not based on profits from any real investment or real sale of goods to the public. The participant makes money by hoping he or she is near the beginning of the line and many more people come after.

Then I discovered this world of money cyclers. Dollar Monster looks like one of those. You put in a dollar. Two more people behind you put in a dollar, so you get their dollars, and they get paid when four more people put in a dollar. It’s impossible to sustain. By level 11 you need the number or participants to be in excess of the US population. What happens is the money keeps being recycled, crediting each others accounts, then implodes when more people cash out than new recruits join.

I don’t think it’s securities fraud. That may put money cyclers outside the grasp of the SEC. There is no investment contract. There is no pretense that you’re buying equity or debt. You’re just hoping that more people get in line behind you. It’s a game of chicken, keeping your money in and hoping to redeem before the inevitable collapse.

It looks like Dollar Monster went through several iterations over the years. In late 2013 Dollar Monster made the mistake of putting on a cloak of actual investment. That put DollarMonster into the SEC’s scope. According to the SEC complaint, DollarMonster stated its mission was to “provide our investors with a great opportunity for their funds -by investing as prudently as possible – to gain high rates in return.”

Money cyclers are easy to find and don’t pretend to be anything else. Look at the lists here:

None are legitimate ways to make money. It’s largely a gamble that you get in line early enough and can redeem your gain before everyone else. Collapse in inevitable. In the United States, money cyclers fall in a grey area of legality. As long as the platform does not misrepresent itself or make false promises, it may not be illegal.

Dollar Monster made the mistake of misrepresenting itself, making it look like a Ponzi scheme. That makes it securities fraud instead of merely being a sucker’s game.

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Personal Foul Called on Athlete Lending Firm

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A professional athlete’s cash flow can be choppy. As an ex-NFL player, Will Allen knew about the cash flow problems. He also realized that fans could be lured into being lenders to professional athletes. It looks like Allen miscalculated the amount of investor interest against athletes looking for loans.

The Securities and Exchange Commission charged Mr. Allen with running a Ponzi scheme. According to the complaint, his firm paid $20 million to investors while only receiving $13 million in loan repayment proceeds. In all, Allen allegedly only made $18 million in loans while raising $31 million from investors.

Rumor has it that the SEC action is a fallout from the bankruptcy filing by NHL player Jack Johnson. The SEC complaint notes a purported $5.65 million loan to an NHL player, but filed only a $3.4 million loan in the bankruptcy filing. The SEC also claims that Allen and his firm lied to investors stating that the loan was still performing as expected. The firm also continued to make payouts to investors as if the loan was performing.

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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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When a Real Estate Investment Empire Turns Into a Ponzi Scheme

money compliance ponzi real estate

Real estate investment is capital intensive. Most opportunistic and value-add real estate investments are not cash flow positive for the entire ownership of the asset. As some point, an investment may be using equity to pay outstanding interest on debt. The line between a ponzi scheme and long term investment can hinge on the nature of disclosure and the form of financing.

The use of notes issued to investors instead of partnership interests is going to cause a cash crunch when times get bad. There is not enough equity to take the loss. Proper disclosure can help. It’s theoretically possible that the proper disclosure that new investment money is being used to pay interest on other notes will cure the problem. (Of course, it will greatly diminish your chances of getting new investors.) Lying to the new investors will get you into trouble.

Michael Stewart and John Packard  are charged with lying to investors. SEC and DOJ charges against real estate companies usually catch my eye. Bad behavior reflects poorly on the industry as a whole. Stewart and Packard got into trouble with their Pacific Property Assets empire. Like many real estate investments, the investments were not cash flow positive. The investments realized returns when the real estate had appreciated in value and was either sold or re-financed. I assume things were running fine for several years as the company was investing, refinancing, and selling apartments in southern California and Arizona.

Then 2007 came along and the real estate debt markets starting cooling down and residential real estate started decreasing in value. According the criminal indictment, this is when they stepped over the line. (Stewart and Packard have not had a chance to defend themselves and I only have the government’s side of the facts.)

According to the indictment throughout 2008 and the early part of 2009, they continued to solicit new investor but failed to disclose the changing fortunes of the company. Stewart and Packard raised over $35 million in promissory note offerings. According to the prosecutors, the disclosure documents were materially misleading, deceptive or fraudulent.

Stewart and Packard claimed to have obtained over $15 million in refinancing proceeds during the first six months of 2008. According to the indictment, they actually obtained $0.

Their last offering was an opportunity fund in 2009 in which they raised $9 million claiming it would be used to “acquire, renovate and operate additional workforce level apartments.” Instead, the proceeds were used to pay other investors and their own salaries.

The investment scheme collapsed in May 2009 when they defaulted on repayment of the notes and filed for bankruptcy in June 2009.

The FBI dug deeper and also found bank fraud. In applying for a loan from Vineyard Bank, Stewart and Packard submitted false financial statement for Pacific Property Assets. That got them the mortgage loan, but also got them a criminal charge for bank fraud under 18 U.S. Code §1344.

To top it off, Stewart and Packard transferred cash out of the company after they defaulted on the loans but before they declared bankruptcy. They hoped to save some cash. Instead, they got another criminal charge.

I read the complaint as two guys trying to hold their real estate empire together as times turned hard, hoping they could hold out until prices once again increased. But instead they great recession grabbed hold and they had no hope of getting out of the hole they dug. They dug the hole deeper each time they lied to their investors and banks.

That didn’t seem to deter them because they came back in 2010 with a new partner and new company: Apartments America. The SEC brought charges against them in 2012. (The DOJ filed the charges on the older scheme in January 2014 and just beat the statute of limitations.)

The new scheme involved selling membership units in LLCs that would purchase apartment buildings. They used general solicitation to do so, with newspaper ads, websites, and cold calls. They cherry-picked investments and showed great returns. They failed to disclose the Pacific Property bankruptcy.

In looking through the defense motions, the lawyers did not challenge the jurisdiction of the Securities and Exchange Commission. I see the potential that the LLC membership interests might not be securities. It would depend on the investors rights under the LLC agreement. It appears from the pleadings that the SEC approached them and they made some changes to the advertisements. But the SEC was not happy with the changes to the website. That lead to enforcement and likely lead to the DOJ involvement.

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What Was It Called Before Mr. Ponzi Did It?

ponzis scheme zuckoff

When Bernie Madoff’s fraud was exposed it was labeled a Ponzi scheme. Madoff was not investing the money as promised. He was using new investment money to pay old promised returns. I thought it would useful to look back at the original Ponzi scheme to see if offered insight to today’s world of compliance. I just finished reading Ponzi’s Scheme: The True Story of a Financial Legend by Mitchell Zuckoff.

When Charles Ponzi sailed from Italy in 1903, his father told him that America’s streets were paved with gold. Ponzi had landed in America at the end of the Gilded Age. He thought he could earn a fortune. He looked for one one get-rich-quick scheme after another and that lead to two stints in prison before settling in Boston.

He tried setting up a international listing of import-export companies and selling advertisements. One respondent requested information and included an international reply coupon. This coupon was effectively a return stamp for foreign correspondence. Ponzi realized that he could theoretically arbitrage the difference in foreign currencies to generate big returns. It was a theoretic return because he would have to find someone to buy the coupons overseas and someone to sell them to here in the U.S. to convert the coupon back to cash.

The idea was solid enough that he could convince investors to give him money. In exchange, he promised a fifty percent return in three months. Eventually, he had investors lined up to give him money. Unlike Madoff, Ponzi carried out his scheme in the open. It was even briefly approved by Boston’s newspapers and financial sector. (If you wonder why private placements could not be advertised for decades, you need to look no further.)

Perhaps it was the wealth of media coverage that got Mr. Ponzi famous enough for the fraud that now bears his name. Of course, he couldn’t have been the first.

In one of the court pleadings, Ponzi’s lawyer states that his client was not a “520 percent Miller.” This was a recall of an earlier fraud by William Miller and his Franklin Syndicate. Mr. Miller was promising a 10% return each week during his heyday of 1899. It was a Ponzi scheme before it was called a Ponzi scheme.

What about before 520 percent Miller? Mr. Zuckoff uses the older expression of “robbing Peter to pay Paul.” That expression refers back to the Reformation when taxes had to be paid to St. Paul’s church in London and to St. Peter’s church in Rome, so people would neglect the Peter tax in order to have money to pay the Paul tax.

Mr. Zuckoff provides a detailed look at the life of Charles Ponzi. Although it is non-fiction, Mr. Zuckoff has written the story in the narrative form, imposing some insight into the thoughts of Mr. Ponzi and those involved. The result is a nuanced and insightful look into a fraud.

 

The Fall of Sam Israel

octopus sam israel guy lawson

Sam Israel is a scumbag. He is a liar and a cheat. He admits so in Octopus by Guy Lawson. Israel was the nefarious trader behind the Bayou Funds, one of biggest hedge fund ponzi schemes, at least until Bernie Madoff finally fell to Earth.

Lawson met with Israel while Israel was in prison. He want to write about Israel’s fraud at the Bayou Fund. Lawson found him to be devious, defiant, impossible to not like.

Israel started as a trader, not an investor. He made his money on the short movements of stocks. He made his big money by cheating. He would front run client trades. He would trade on inside information.

Then he decided he want to be his own boss, so he started the Bayou Fund. But he was not successful. Rather than disclose this to investors, he rebated a big chunk of brokerage fees to show a good return. He figured he could make it up in the next trade.

Then he missed again. Again, he didn’t want to admit his shortcomings so he chose the path of deceit. But now the amount was too much to fix with creative bookkeeping. He turned to a complete fabrication of financial results. Israel called this “The Problem.”

He kept trading to try to fix The Problem. He thought the next trade could make enough to fix The Problem. But it kept getting bigger as his actual results continued to be well below the result he was telling investors.

Then Israel ran into a shadowy figure that told him about a secret market for prime government bonds sold at huge discounts. He could get enormously wealthy by trading in the secret market. Israel thought he had found a solution to The Problem.

The publisher was nice enough to send me a copy of the book. It caught my eye because it offered an insight into the mind of a fraudulent fund manager and the machinations of a ponzi scheme. It’s a twisted mind. The tale of trying to fix The Problem is even more twisted.

A History and Analysis of Con Artists and Victims: The Ponzi Scheme Puzzle

The-Ponzi-Scheme-Puzzle-Frankel-Tamar

Professor Tamar Frankel of Boston University School of Law tackles investment fraudsters and their victims in her book, The Ponzi Scheme Puzzle. As a scholar of investment fraud, Frankel has studied cases for years to find common themes and patterns. The books offers descriptions of the offers and red flags the ways in which fraudsters mask their deception through their methods of advertising and pitching their “product”.

There is a lot in the book. I just wish there were more. It’s hard to lump Enron, Madoff, Multi-level marketing, selling the Brooklyn Bridge, and selling fake securities fraud schemes into one book, especially one as short as this. Frankel skips from subject to subject and fraud to fraud very quickly, drawing broad conclusions.

Perhaps I’m naive, but I think many Ponzi schemes start off as legitimate investment opportunities, but derail as they grow and the strategy falters. Charles Ponzi himself saw a legitimate opportunity. He saw a potential for profit in the difference in currency for return stamps. He failed to execute on the vision and failed to tell his investors when the investments didn’t work.

Enron started off a legitimate company taking an innovative approach to energy. It became so focused on hitting its earnings that it started doctoring the books to hit the numbers. The guy on the street corner trying to sell foreign tourists an interest in the Brooklyn Bridge is a different kind of criminal.

Professor Frankel does point out some interesting ways that society views investment fraudsters and their victims. We take a much harsher view of the scam artist that convinced an elderly pensioner to invest her small amount of lifetime savings, than millionaire scam artists skimming millions from other millionaires.

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Another Real Estate Ponzi Scheme

The Securities and Exchange Commission is claiming that Wayne L. Palmer and his firm, National Note of Utah, were operating a real estate-based Ponzi scheme that bilked $100 million from investors. U.S. District Judge Bruce Jenkins issued a temporary restraining order, froze the assets of National Note, and appointed attorney Wayne Klein as a receiver to take over the company’s operations.

So far, the statements in the SEC complaint have not been proven and Mr. Palmer is contesting the charges. As I have with other cases, I look at lessons from the filings, assuming they are true, to highlight issues that should be warning.

A first warning is the use of bank account names.

National Note investors initially deposit their funds into an account at JP Morgan Chase Bank titled “investor trust account.” National Note immediately wires nearly all these investor funds to an account at Wells Fargo titled “investor interest account.” National Note’s internal accounting classifies the investor funds as income upon transfer to the Wells Fargo investor interest account. From the Wells Fargo investor interest account, the funds are used to pay returns to other investors.

Why the need to fund interest payments? According to the SEC complaint, the Palmer companies only generated $300,000 in revenue and was obligated to pay $1 million in interest to not holders. Palmer was selling notes that paid a 12% interest rate.

Another warning sign is that the notes were marketed as guaranteed, with a complete safety of principal. The safest investment is US treasuries and it pays less than 2%. You can’t expect a 12% return to not have significant risk.

Another is his use of EMS  and CCFMB after his name. They are impressive acronyms, but I can’t figure out what they stand for. EMS typically stands for Emergency Medical Services, but that doesn’t sound right for a real estate professional. I searched LinkedIn for CCFMB and Mr. Palmer was the only person who came back.

Another warning is where the money from the sale of notes is being deployed. The claim is that it purchases real estate notes and real estate equity that generates returns of 15% to 20 annually. According to the complaint all of the capital is being deployed into related entities controlled by Palmer.

It looks like Palmer’s scheme unraveled in October 2011 when it failed to make interest payments. The complaint does not point out when Palmer’s business went from legitimate to Ponzi. The SEC goes as far back at 2009 when the scheme raised $18.6 million while paying back $14 million in investors.  Palmer has been in the real estate business for many years. So I’m skeptical that his operation has been a fraud from the outset. I would guess that he ran into trouble in 2008, just like everyone else on the planet. Rather than be honest and open about losses, he tried to cover them up and hope things would recover fast enough to dig him out of his hole.

Scott Frost, Paul Feindt, Matthew Himes and Alison Okinaka of the SEC’s Salt Lake Regional Office conducted the investigation; Thomas Melton will lead the litigation.

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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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