Market Above the Filth of Fraud

Posted: Apr 15, 2009 12:01 AM
Market Above the Filth of Fraud

Body text: It's not every day that somebody defrauds investors of $50 billion in the fashion of Bernie Madoff.

But he's not the only person to rip off investors. From small-scale con artists to billionaire scoundrels, history is replete with hucksters. Alchemists tried to turn metal into gold; "ship scuttlers" deliberately sank ships in ancient Greece for the insurance money; some have tried to sell famous landmarks and even land in a country that did not exist.

Stories of fraud are in turn scandalous and heartbreaking. But the truth is, the world goes on. Investors keep investing. Businesses keep growing. The U.S. economy continues to expand.

Don't believe me? Consider that one of the earliest examples of investment fraud in the United States occurred in 1792 and involved a founding father. To finance the Revolutionary War, states sold war bonds to citizens. Afterward, the first U.S. Treasury Secretary, Alexander Hamilton, crafted a plan to have the federal government take over the states' debts and repay bondholders. But before the plan became common knowledge, word spread to New York, enabling speculators to buy the bonds from farmers and veterans for pennies on the dollar.

As a result, the country's first public investment enriched speculators instead of those who financed the revolution. Still, rather than destroy the country, Hamilton's plan established the U.S. government's credit.

The Ponzi scheme Madoff pulled off got its name from Charles Ponzi (although he was certainly not the first to try this type of scam -- it was once known as "Robbing Peter to pay Paul"). In 1919 and 1920 Ponzi promised investors a 100 percent profit in just 90 days by buying postal coupons in foreign countries and selling them in the United States for a profit. Ponzi collected about $8 million (nearly $100 million today) and instead repaid old investors with new investors' money. The scheme unraveled when a journalist discovered there weren't enough postal coupons in existence to justify the volume of investments. "Match King" Ivar Kreugar controlled nearly 75 percent of the world's match production in the 1920s and used his empire to buy other international companies, including banks, lending large amounts of cash to foreign countries. With nearly 200 companies under his control, Kreugar cooked the books to report profits that didn't exist, pay increasing dividends and loot acquired companies. The deception was revealed when Kreugar died in 1932, creating a "Kreugar Crash" that caused many investors to go broke. Congress reacted by passing security reform legislation in 1933 and 1934.

Like Bernie Madoff, Richard Whitney used his clout as former president of the New York Stock Exchange to cover misdeeds in the 1930s. He was busted for embezzling from charities, the yacht club where he was treasurer and his father-in-law's estate. He served three years in prison.

Meanwhile, Oscar Hartzell convinced investors in Iowa with the last name Drake (and eventually others) that they were entitled to a portion of Sir Francis Drake's fortune, which supposedly had been collecting interest for 300 years and was worth billions. The catch: The investors needed to give Hartzell cash to sue the British government to release the fortune. Hartzell raised millions, and donations continued to come in even after he went to prison for the fraud in 1933.

In the 1960s and 1970s, Equity Funding Corporation made a name for itself marketing packages of mutual funds and life insurance, which were sold to reinsurers for cash. The problem: The insurance policies were fake. Hundreds of employees knew about the fraud and helped it along by creating fake computer printouts and other documentation. As with Madoff, several people reported suspicions to the Securities and Exchange Commission, but the story was written off as preposterous. When a whistleblower finally convinced the SEC in 1973 that the fraud was real, the firm's stock was wiped out, costing investors $300 million.

The 1980s brought about the movie Wall Street, which told America that "greed is good." Based on the stories of junk bond king Michael Milken and infamous insider trader Ivan Boesky, it depicted the excesses and hostile takeovers of the 1980s. The movie made millions and so did Milken and Boesky -- until they went to jail.

Barry Minkow also took greed to unprecedented levels. In 1986, at the remarkable age of 21, he raised $100 million from some of the biggest firms on Wall Street when he took his carpet-cleaning company, ZZZZ Best, public. But his company dealt with more than dirty rugs. Tricking dozens of lawyers, accountants and bankers, Minkow used forgery, credit card fraud, check kiting and mobster loans to maintain his phony business and hide money-laundering activities. Minkow went to prison for more than seven years; his investors lost $50 million.

More recently, the implosion of energy firm Enron sent shockwaves through Wall Street. At the time, Enron was one of the country's leading and most innovative firms. The firm collapsed when massive accounting irregularities were revealed, causing thousands of Enron employees and investors to lose their entire life savings. It was a tragic loss for those individuals, and the country was outraged -- especially as word spread that those responsible for cooking the books, including CEO Jeffrey Skilling, sold their shares ahead of time.

The demise of Enron kicked off a series of other accounting scandals that included telecommunications firm WorldCom, cable company Adelphia and manufacturer Tyco International. Investors lost billions of dollars, people went to prison and Congress passed the Sarbanes-Oxley Act of 2002 to reform public companies.

Around the same time, a 20-year, $311 million Ponzi scheme operated by James Paul Lewis Jr., of Lake Forest, Calif., unraveled. Preying on elderly church members, he stopped paying investors dividends in 2003, claiming the Department of Homeland Security froze the fund. In reality, he spent most of the money on himself and was sentenced to 30 years in prison for his scheme.

These are just a handful of examples. Thousands of others exist. But the lesson is that despite the action of ne'er-do-wells and other unsavory people, investing is still the best way to build wealth and increase your financial security. Frauds will be revealed from time to time, but the market will still grow. The important thing is to ensure that you are making smart investments with people you trust.