Financial fraud. We all hope it doesn't happen to us, but time and again con men have demonstrated there's always someone who can trick people with promises of outsized returns, or who can game the system to hide fraud. (For more, see: The Pioneers of Financial Fraud.)
Scams range from the venerable Ponzi scheme — using current investors' money to pay out previous ones — to the "chop stock" in which brokers buy penny stocks at deep discounts and sell them to customers, to pump and dump schemes. The latter two are technically legal in the U.S., so they aren't considered true fraud by the authorities, but other countries take a different view. Lastly, there's simply falsifying reports to investors and auditors.
Read on for a rundown on history's best-known financial scammers.
The one for whom the Ponzi scheme is named, Ponzi's fraud was remarkably simple: postal coupon arbitrage. Postal coupons were a way to send a self-addressed stamped envelope overseas without having to buy foreign postage. Each country agreed that the coupons could be exchanged for stamps. However, the value of the coupons could vary because of currency fluctuations and differing postal rates. Theoretically one could buy postal reply coupons in one country and sell them in another, taking advantage of the spread between the two. For example: postal rates between Italy and the U.S. might be the same initially, but inflation in Italy would make those coupons cheaper (in dollar terms). One could then buy coupons in Italy and exchange them in the U.S. for the stamps, which could be re-sold for a profit. (For more, see: What Is a Pyramid Scheme?)
This is essentially what Ponzi was advertising — offering profits of 50% in just 45 days. For a while it worked because so many new investors came in that he was able to pay off previous ones. But eventually it came crashing down. Ponzi never bought that many postal coupons, and on top of that, there were not enough of them in circulation for the investment to work. In fact, it's almost impossible to make much money in this fashion because of the overhead — the sheer number of coupons needed and the costs of sending them — in addition to the costs of the currency conversions.
Ponzi cost his investors some $20 million in 1920, which would be on the order of $230 million today.
The man whose name became synonymous with financial fraud in the 21st century, Madoff started off as a relatively honest businessman.
The asset management business Madoff ran, Bernard L. Madoff Investment Securities, started in 1960 as a market maker, matching up buyers and sellers and bypassing the major exchanges. The firm was an innovative one in its use of technology. Eventually the same systems Madoff developed would be used in the Nasdaq. (For more, see: The Unrelenting Claw of Bernie Madoff.)
It was only after several years that he started to think he needed to lie about returns. Madoff has said the trouble started in the 1990s; Federal prosecutors say it was in the 1970s.
The scheme's genius was, in part, that it didn't promise the outsized returns that Ponzi schemes do. Instead Madoff offered returns a few percentage points above the S&P 500 Index. For example, at one point, he said he got about 20% per year, which is only a little higher than the roughly 16% average the S&P 500 offered from 1982 to 1992. Madoff built up a who's who of clients and managed money for several charitable foundations.
When customers wanted to withdraw their money, his firm was famous for getting the checks out quickly. To avoid filing disclosures with the Securities and Exchange Commission, Madoff sold securities for cash at specific intervals that allowed him to skirt reporting requirements.
He told interviewers that he used puts and calls to mitigate the downside of the portfolio, which was just a set of blue-chip stocks. But cracks started to show when outside researchers, using the historical price data, couldn't duplicate the performance. One of Madoff's funds published returns claiming only a few down months in the course of 14 years, a mathematical impossibility. (For more, see: Madoff No Mystery Man to the SEC.)
Eventually everything came crashing down. One catalyst was the financial crisis that was brewing in 2008, when investors were more likely to make withdrawals to begin with. Madoff couldn't keep paying out investors and falsifying statements.
The losses: about $18 billion, according to the trustees tasked with liquidating the firm's assets.
Stanford Financial Group
Initiating a classic Ponzi scheme, Stanford Financial Group was founded by Allen Stanford, who claimed the business was an outgrowth of a family insurance firm. In fact Stanford had made a substantial sum in real estate in the 1980s and used that to start the business as Stanford International Bank, in Montserrat, the Caribbean island. He relocated to Antigua; there was also a headquarters office in Houston. By 2008 Stanford Financial was one of the larger firms of its kind, with an assets under management reaching $51 billion, according to Forbes.
Stanford's scam was offering certificates of deposit at 7%, at a time when most CDs in the U.S. were about 4%. For many that was too good to pass up. The problem was Stanford did exactly what Ponzi schemes have done since they were invented: he used incoming deposits to pay off existing investors. He also used the money to fund a lavish lifestyle. (For more, see: Investment Scams: Introduction.)
In 2012 Stanford was sentenced to 110 years in prison, after defrauding investors of $7 billion.
Paul Greenwood and Stephen Walsh
Paul Greenwood and Stephen Walsh were once investors in the New York Islanders hockey team. After they sold their stake in 1997, they set up a hedge fund, WG Trading and WG Investors. Prosecutors said their Ponzi scheme started in 1996 and kept going until the two were arrested in 2009. Greenwood and Walsh targeted big, institutional investors as well as wealthy individuals with what they claimed was an "index arbitrage" fund. Greenwood in particular was famous for his collection of teddy bears.
Greenwood pled guilty to securities fraud in 2010, while Walsh pled guilty to similar charges in 2014. Greenwood cooperated with prosecutors, so he got 10 years. Walsh did not, and he received 20.
Federal authorities put the misappropriated funds at $550 million (at minimum). The two were also charged by the SEC and the Commodities Futures Trading Commission with defrauding investors of $1.3 billion during the period of the scam. (For more, see: Top 10 Common Mortgage Scams to Avoid.)
James Paul Lewis, Jr.
Over a 20-year period starting in the 1980s, James Paul Lewis took in some $311 million in investments from unsuspecting clients. It was one of the longest running Ponzi schemes — most don't last more than a few years.
Lewis headed up a company called Financial Advisory Consultants, managing $813 million divided among 5,200 accounts. Lewis' tactic for reeling in investors was to work through church groups, as he himself was a member of the Church of Latter-Day Saints.
Two funds in particular were highlighted when the SEC finally charged Lewis with fraud in 2003. One was called the Income Fund, which claimed an average annual return of 19% since 1983. The other was the Growth Fund, described as buying and selling distressed businesses. It claimed an average return of 39% since 1987. Both numbers were, of course, false. When investors tried to get their money out, Lewis claimed the Department of Homeland Security had frozen the funds.
Lewis pled guilty to mail fraud and money laundering in 2005, and was sentenced to 30 years in 2006.
The Bottom Line
Be astute when working with financial advisors. If an investment sounds too good to be true, it probably is. (For more, see: Stop Scams in Their Tracks.)