A bewildering array of financial fraud of all flavors has been revealed in recent months and an axis of financial evil has emerged.  With the ardor of a “Law and Order” detective, we at Westlaw Business thought it helpful to sort the different forms of financial mayhem.  Our goal: to better understand the (alleged) crimes, their perpetrators and likely directions going forward for both regulation and enforcement.  This analysis is telling, as new regulatory and enforcement zeal, with a budget to match, are being advocated by both President Obama and SEC Chairwoman Schapiro.

As background, for those who missed it, it has recently come to light that millions of unsuspecting investors have been cheated out of billions of dollars, in schemes both high-profile and low.  Among the highest profile schemes were the $50 billion Madoff Ponzi scheme, the alleged “massive fraud” involving an $8 billion CD program perpetrated by Texas billionaire Robert Allen Stanford and the recent SEC charges against two New York residents accused of misappropriating more than $500 million in an investment scheme.  Each is unique and worth understanding in greater detail. But first, even though fraud is not new, it’s worth considering how SEC disclosures place the notion of fraud before the increasingly watchful public eye.

SEC filings are rich with disclosures related to fraud. Many companies highlight the internal controls that they have implemented to prevent financial fraud.  This family of disclosures includes National Retails Properties, Inc., Diodes Inc., and Arrow Electronics.  Companies facing allegations of fraud have made disclosures about litigation, including Citigroup and AIG. Likewise, McGraw Hill Companies disclosed that its directors and officers had been accused of fraud for their alleged role in the issuance of “excessively high ratings” by Standard’s & Poor’s and purported misstatements and omissions in filings. Then there are companies which disclose that their executive officers have been involved with committing financial fraud. Firms in this unfortunate position include HealthSouth Corp and CA, Inc., with the latter disclosing that its Special Litigation Committee recommended that it would be in the company’s best interest to pursue litigation against executives who had pled guilty to securities fraud.

Dismantling the pyramid of fraud requires distinguishing between Ponzi schemes, “mere” mis-investment  and outright theft.  From a legal perspective, they differ both in the nature of the violation and the nature of the enforcement and remedy sought. To explain, the following three main types of fraud have emerged: 

• Ponzi schemes where legitimate investments are cast aside (if they were ever used), in the attempt of guaranteeing outsized investment returns to early investors (and in some form, typically, to the alleged fraudster);
• Misguided pursuits of investments outside the purview of the offering documents, even though on the surface appear to be legitimate investments, are still rendered wrong by carefully thought out securities laws; and
• Most flagrantly, some schemes take the form of outright theft, where funds raised from investors are used to immediately line the pockets of the principals, with no pretense of investing.

Over the past few months, we’ve seen examples of all three.  The common thread tying them together runs with a single theme: a profit-loving zeitgeist, in which relentless pursuit of shiny profit blinded many, perhaps willfully so, until the shine had worn off. There is under-regulation of innovative, private investment vehicles. And finally, the schemes are characterized by under-enforcement against suspicious behavior and returns.

Ponzi schemes may now be forever associated with Bernard Madoff, in perverse testament to  Madoff’s $50 billion Ponzi scheme – possibly “The Godfather” of all financial frauds. This scheme is noteworthy not only because of the sheer monetary size and global scope, but it is also intriguing because of his investment strategy. He didn’t invest funds in anything he was supposed to.  Rather, he lured customers by creating an illusion of unusually high returns and paying back original investors through a typical Ponzi scheme structure. On the upshot: the probe into Madoff’s financial dealings prompted the SEC to further investigate a Texas billionaire who had evaded the agency for years.

Another type of financial fraud that we identified shows that milder forms of fraud are still fraud. Consider Bear Sterns, whose hedge fund managers, Ralph Cioffi and Mathew Tannin, were accused of fraudulently misrepresenting or omitting important information in communications to investors. The $8 billion fraud operated by Allen Stanford and Stanford International Bank was originally thought to be in the same camp. In its complaint, the SEC alleged that the Texas financier operated an $8 billion fraud surrounding the certificates of deposit he sold to investors through Stanford International Bank by promising unlikely high interest rates.  Earlier thinking was that Stanford was investing his clients’ money in a portfolio which included risky real estate and private equity, contrary to what the offering documents promised.

The Stanford fraud can be categorized as a mis-statement of investment strategies.  Over the last several days, some have asserted (the SEC included, in its most recent amended complaint) that Stanford may have fallen over the line into orchestrating a Ponzi scheme. Those individuals involved could also be facing criminal liability as the Stanford Group’s chief investment officer, Laura Pendergest-Holt, was arrested for federal obstruction charges related to the fraud investigation.

Possibly the most egregious fraud perpetrated in the last few weeks falls into our last category: the alleged theft orchestrated by Paul Greenwood and Stephen Walsh, who took millions from their clients and boldly used the money for their own personal gain.  As one sign of how seriously this matter is viewed: the U.S. Attorney’s Office has already filed criminal charges against Greenwood and Walsh, while they have yet to be filed against Madoff and Stanford. The SEC alleges that the two men told investors that their money would be invested in a stock index arbitrage strategy, but instead the investments were used by the fraudsters as a “personal piggy bank” to purchase homes, a horse farm, lavish cars, and rare collectibles. The personal nature of this scheme shocks the conscience as these two men had no qualms with using someone else’s money to feed their own personal needs.

It has become clear that preventing future fraud of this caliber will require, in part, regulation and vigilant enforcement.  Lucky for the investment community, the SEC, through its new chairwoman, Mary Schapiro, has reaffirmed its dedication to rooting out these schemes. Fraud detection, in particular, requires significant monetary resources.  To this end, the Obama administration has proposed a budget for the SEC which includes a 13 percent increase to help to continue to prevent these sorts of deceitful schemes from occurring in the future. All that said, the frauds uncovered over the last few months give credence to the old adage that some things really are too good to be true. 

Published: March 3, 2009