Avoiding Ponzi Schemes

It’s a safe bet there are a number of Ponzi schemes operating right now. Ponzi schemes are actually a lot more common than you might think and are often offered to retirees and other investors who are seeking higher income. Retirees are especially vulnerable to Ponzi schemes that offer the appearance of consistent high interest or dividends because so many retirees are trying to make ends meet.

Over the years I have seen a local real estate developer (whom everyone loved for his charity work in the community) borrow money to fund his developments by selling promissory notes secured by first trust deeds on real estate. After a while it was discovered that he had sold notes secured by the first position on the same property to dozens of different people and the developer just pocketed the difference.

I have seen real life schemes similar to The Producers where non-existent films and Broadway stage productions were funded. I have seen millions of dollars raised for non-existent new drugs and non-existent gold mines and oil wells. I have seen investors shocked when the young entrepreneur who was building a new business took their money and moved away.

A more typical Ponzi scheme takes some of the investors’ money and gives it back to them, every month, seemingly paying a high dividend. People hear about this great investment or some broker tells them about it and the Ponzi scheme suddenly has millions and millions of dollars. The operation of a Ponzi scheme is all about appearances.

The difference between a high yield investment in the private securities market and an investment into a Ponzi scheme is often the honesty of the people who are running the company into which you are investing. Some people will take your money and really try to make their business work. The operator of a Ponzi scheme is a thief.

The promise of consistent high income is common to all Ponzi schemes. High yield is the bait that snares investors and makes Ponzi schemes profitable for the thieves that operate them. Each scheme always comes with a great story about how the company can earn enough money to pay out 12% or 15% or more to investors and still make a profit.

I cannot remember a Ponzi scheme run by someone who was trying to secure cancer treatments for their impoverished parents. When the forensic accountants add up the swag accumulated by most Ponzi scheme operators there are frequently yachts, expensive jewelry and lavish lifestyles all paid for with the investors’ money.

No one is surprised when the brokers who helped to bring investors into the scheme are also found to have been well compensated. I have witnessed a succession of less than honest operators who paid themselves high front-end fees and who lavished golf trips and big parties on the stock brokers and others who would bring trusting investors to their door.

There was one particular Ponzi scheme that was a little different and which I saw played out twice about 10 years apart. In both cases, the high returns were supposedly generated by medical receivables that were purchased at a discount.

In the 1990s a company called Towers Financial raised hundreds of millions of dollars from investors. The funds were intended to purchase medical receivables from smaller, private hospitals. Investors were told that the medical insurance companies were paying slowly and that buying these receivables helped the cash flow of each small hospital.

Towers Financial allegedly bought the receivables at a discount of 8% and claimed to collect the bulk of them in 90 days as opposed to the 30 days that the hospitals needed. This supposedly allowed Towers to roll investors’ money over 4 times per year generating more than a 30% return; more than enough to pay 18% to investors. The operators never actually bought any receivables and used money from newer investors to pay investors in its older funds.

What I especially remember about Towers is that they employed a group of actors who occupied desks in an office one floor below the corporate offices. When a brokerage firm showed up to investigate Towers, the company executives would walk the party down one flight of stairs to the “bull-pen”. Someone would call ahead and the actors would pretend to be hard at work on the telephones making collections. When the group left, everyone hung up their phone and laughed.

Beginning in 2003, a similar scam was repeated under the name of Medical Capital Holdings which also claimed to be buying receivables from smaller hospitals and health-care facilities. Once it allegedly bought the receivables of those companies, interests in the receivables were sold to investors in the form of private Medical Capital Notes.

Medical Capital Holdings issued more than $2.2 billion of Medical Capital Notes to some 20,000 investors across the country. These notes were sold by stockbrokerage firms in almost every state.

By the time the SEC sued Medical Capital for fraud in July 2009 Medical Capital had almost $550 million in phony receivables on its books and had lost over $300 million on various loans that it did make. Meanwhile, the company had collected over $300 million in fees for managing the money-losing loans. The bankruptcy receiver discovered that Medical Capital spent $4.5 million on a 118-foot yacht and another $18 million on an unreleased movie about a Mexican Little League team.

Despite the fact that Medical Capital was essentially a re-do of the Towers Financial fraud of a decade earlier quite a few brokerage firms sold Medical Capital notes without an adequate investigation.  The individuals who organized and ran Medical Capital had previously had serious problems with insurance industry regulators. These problems were not disclosed to potential investors. That fact alone should have been a red flag to any stockbrokerage firm that had actually conducted a reasonable investigation of Medical Capital.

Ponzi schemes do not spend the money that they raise in the way they promise investors. Who keeps track of the money that a company raises and how it is spent? Auditors. Medical Capital and many of these other questionable investments had none.

Medical Capital refused to hire a reputable accounting firm to audit their books. That reason alone should have been enough for any reputable stockbrokerage firm to have refused to offer Medical Capital securities for sale to its customers.  At least one large brokerage firm, Securities America, apparently questioned the fact that Medical Capital was not audited and allowed it brokers to sell the notes anyway.

Auditors play a crucial role in the public securities markets. They make certain that companies publically report specific financial information about their business and their balance sheets. Auditors provide a transparency and a consistency in our evaluation of the firms who are seeking capital.

Audited financial statements are much rarer in the private securities market. That is partly because regulations governing the private sale of securities do not require audited statements for all private offerings. It is also because there is a presumption in the private markets that participants are more sophisticated and that they can fend for themselves.

If you do invest in a private placement, you know that these are almost always considered to be speculative, high risk investments. You can lose all the money you invest and a lot of people do.  If you cannot afford to lose your money, this market is not for you.

Even in the current very low income investment environment there are still listed companies and funds that pay dividends or interest in the 4%-5% range. There are REITS and real estate funds that pay even more. Too much more and you are buying a speculative investment; a lot more than that and there is a good chance that you are getting scammed.

Staying with listed securities that pay market rate dividends or interest is the best way to avoid losing you money in a Ponzi scheme. If you deal with a major brokerage firm there is less of a chance that they will offer one to you and a greater chance that you will be able to recover your losses if they do.



Suing Your 401(k) Plan

Let me begin by saying that I appreciate that class action suits have a role in the general scheme of commerce. Class actions have helped to compensate many people who were injured by asbestos, tobacco, many medications and medical devices. Defective products can injure a large and diverse group of people. Class actions can also provide a remedial action that protects consumers and the markets going forward.

Over the years I worked briefly on one class action and on another quasi-class action suit, what was then called a private attorney general action under California law.  In both cases the defendant was in the financial services industry which, after all, is my area of expertise.

If I learned anything about class actions, it is that they can be lucrative for lawyers. They are frequently long, drawn out litigations that can be costly to defend. The plaintiff’s lawyers often put in many thousands of hours, on the come, as it were. If they win or settle, they can apply to the court for payment of their bill sometimes with a multiplier awarded by the court for their efforts on behalf of the class.

There have been many class actions brought by employees of companies over issues of wages and working conditions. More recently, there has been a spate of litigation by employees concerning the operation of their corporate 401(k) plans.

Several suits by employees of financial firms who are claiming that they have been damaged because the financial firm included its own mutual funds in the employees’ plan caught my eye.   These particular suits illustrate how foolish suing your 401(k) plan can be.

The administrators of a pension or 401(k) plan, that is those people who work for the company and who either invest the plan assets on behalf of the employees or who select the investments in which the employees can invest are fiduciaries. That has been true for at least 40 years. These new lawsuits are suggesting that these administrators have been doing it all wrong for all of that time.

Fiduciaries have special duties and are held to a high standard of commercial conduct. They are always expected to put the interests of the employees first; they are always expected to protect plan assets; they are always expected to invest plan assets prudently.

I have reviewed more than a few of the employee vs. plan administrator lawsuits.  Allow me to break down the most common allegations in the sub-set of those suits brought by employees of mutual funds and financial services companies.  In theory at least, people who work for these companies should have a pretty clear idea of what the company is doing wrong.

First, there is the allegation that the firm is self-dealing; that is the company is offering its own mutual funds for the employees to purchase. That, of course, is exactly what is occurring.  In what universe would a company be expected to direct employees to purchase a competitor’s product?  Companies are not prohibited from investing the plan’s assets in their own stock, nor should they be. A company that is in the business of managing mutual funds that are available to the general public should always be expected to offer those funds to their own employees.

Second, and most common, is the allegation that the mutual funds are too expensive; specifically that other funds that were not offered charged less.  Actually, there is no requirement for a 401(k) plan to offer only the least expensive funds.

The US Supreme Court looked at this specific issue just about a year ago and said that it was never appropriate for plan administrators to “waste” plan assets. Given that paying internal management fees cuts into the fund’s return to investors there is an argument that higher fees waste the investors’ money.

I would argue that this may be true in some, but not all cases.  If a plan offers an index mutual fund, for example, the argument can be made that all index funds from all mutual fund providers are strikingly similar and all will contain virtually the same securities, those that make up the index.  So the least expensive index mutual fund might be appropriate.

It is also true that an index ETF will usually have a lower internal management fee than an index mutual fund. An ETF is not really managed and will just track the index. If a passive investment is what you want, then an index ETF is made to order.

Most of the 401(k) plans that were defendants in the various suits offered the participants the opportunity to invest in several ETFs. No one put a gun to anyone’s head to purchase the company’s mutual funds.

If you follow the argument that the least expensive investments are the only ones that should be offered to 401(k) plan participants, then reason suggests that no index mutual fund will ever be suitable for any plan. Index ETFs are almost always less expensive and provide a very similar investment.

No court has adopted this idea, yet, but much of the discussion about what is and is not appropriate for plan participants is centered on the idea that fees and only fees matter. Someone should throw a bucket of cold water on that idea before some judge unknowingly sends the mutual fund industry to the scrap heap.

If you do want a managed fund, the question becomes, or rather should be, is the manager of the fund worth what it is getting paid? More precisely, are lower fee funds better just because they charge less?

Vanguard Funds were put up as examples in several of the cases. Vanguard has a low fee structure and a long track record with many happy and loyal investors.  There is nothing suspect about the portfolio managers or securities analysts that Vanguard employs and nothing to suggest that they are not competent professionals.

Assume for the sake of argument that JP Morgan has more analysts than Vanguard and pays them more. JP Morgan also has people on the ground doing business in every major money center in the world, every day. There is an added value to working in the market rather than just analyzing it. JP Morgan charges a higher fee to manage its mutual funds than does Vanguard.  Who is to say that JP Morgan is not worth a higher fee?

In a previous article I suggested that if I were asked to serve in a fiduciary capacity on the investment committee of a pension plan or charity, I would not hesitate to recommend mutual funds managed by Dimensional Fund Advisors.  Dimensional was founded by Eugene Fama, the 2012 Nobel Prize winner in Economics. It should cost more to have a Nobel Prize winner manage your mutual fund.

Is it a waste of the fund participant’s money to offer more expensive mutual funds if there is a demonstrable reason why the fund charges more?  Would not the fund administrator be doing the fund participants a disservice by recommending only the least expensive funds as the plaintiffs’ suggest?

Third, there is the allegation that the mutual funds lost money. Against the backdrop of a rising market, this would seem to be a problem. But in the context of these particular lawsuits the results that the investors receive is probably not relevant.

The argument here is that the fund administrator should not have selected the mutual fund in the first place. There may have been good and valid reasons to have selected the fund five or six years ago, even if the subsequent results were lousy.

A fund manager or investment advisor is expected to predict the future. That is not always easy to do.  Investment advisors and fund managers are professionals. In other fields we do not judge a professional’s competency based on their overall results.

I know that when two lawyers enter a courtroom, one of those lawyers will come out the loser, every time. That does not make the lawyer who loses a bad lawyer. It is often not a question of the lawyer’s skill. There are a great many intangibles in any case that are difficult to predict or evaluate.

Underlying all of this is the idea that investment advisers are not truly professional; that they are overpaid hacks, the majority of whom fail to manage their funds up to the level of the benchmark to which their fund is pegged.  Some of that is caused by the ebb and flow of money in and out of the fund.  Just because a lot of people invest in the fund at the end of a quarter, does not mean that there are attractive stocks on that date for the fund to buy.

Assuming one of these class actions moves forward to trial, it is probable that the fund advisor will be able to point to research done by other firms that suggested that the stocks that the fund was buying were rated as “buys” by other analysts at the same time.  So how would the fact that the fund lost money be actionable against the plan administrator?

If any of the law firms try to suggest that the plan administrator should be liable for the fund’s losses, then going forward, the only way for an administrator to protect themselves is to allow only the purchase of US Treasury bonds.  Any other investment that the plan offers the employees has a risk of loss and even US Treasury bonds may be up or down when you decide to purchase or when you reach the dates mandated for your distributions.

Most 401(k) investors lose money not because they bought the wrong investment or fund but because they failed to sell that fund when the market began to turn against them. As far as I know, none of the 401(k) plans that are the subject of these class actions offer the participants individualized advice. If the investors are never advised to sell, then the investors are guaranteed to see their portfolios decline when the market declines.

There is no penalty for employees who are prepared to say that their company makes a great product but has a lousy 401(k) plan. The penalty for employees who work at a company whose products are the same investments that are in their 401(k) plan should be obvious.

What will be the collateral effect to the mutual fund if the employees are adjudged to be correct; that the advisors to the mutual funds for whom they work are greedy and stupid.  Obviously, the mutual fund company will suffer because administrators of other 410(k) plans will stay away. Employees will be laid off and in some cases the company may merge out of business. Also the costs of the litigation and any award against the 401(k) administrators will reduce the value of the 401(k) plan. How did this win help you?

It certainly begs the question of whether the lawyers who are bringing these class actions have their client’s best interests fully in view.



Blogging for Fun and Profit

Why blog?  For many people the answer would seem to be that they blog to bring attention to themselves and their business; they blog with the idea that it will help them to make money.

I started blogging just about a year ago. It began at the suggestion of the editor of my book.  She advised me to start a blog to help get my name out there and sell the book. Blogging is free, she told me, and I had no budget to promote the book.  I receive nothing from the proceeds of the book, all of which go to cancer research.

She also advised me to publish the blog on Linked-in, rather than Facebook where she thought more “serious” people would see it. At the time, I knew very little about either writing or publishing and I willingly took her advice. If I am doing something that I have never done before, I always hire someone who knows what they are doing or seems to know.

The blog follows the basic theme of the book. Its avowed purpose is to call out “foolishness” in the mainstream capital markets. There is certainly enough foolishness to go around. Much of what I write is a reaction to what I see or read elsewhere.  Many of the articles were inspired by conversations that I have with friends or strangers.

Because I write about foolishness in the financial markets, several articles have gravitated to two subjects, Robo-advisors and Crowdfunding.  Both are championed by fools who put a lot of bad information into the marketplace.  I try to counter that bad information with reason.

Robo-investing is foolish because it cannot work.  If you invest with a Robo program you are guaranteed to lose money when the market turns down.  Automated trading programs have been around in the commodity markets for a long time and are universally rejected by regulators and people who understand that a computer program cannot predict the markets.  If you are not investing to make money and are happy to lose, then in my mind, you are foolish.

Robos-advisory programs have become big because they eliminate the most expensive part of the investment transaction, the human advisor, which leaves much more profit for the firm that is offering the program.  A theme of the book, which carries over to Robos is that if the financial industry offers a product it is more likely than not designed to make money for the industry not the investor.

I get a little pushback from the Robo industry when I write negative articles about it. A number of people who contacted me after one article in particular, told me that whatever I thought about Robos, human advisors were terrible. In my experience not all investment advisors are terrible. I responded by inviting people to contact me for the name of my advisor who is very intelligent, competent and hard working and who gets good results for his advisory clients because of it. A few people took me up on my offer and seem to be happy to be working with him.

I get a lot more pushback when I write negative articles about Crowdfunding. I personally think that Crowdfunding has a lot to offer for the companies in need of funding. Unfortunately the Crowdfunding industry is populated by many people with zero experience raising money for small companies. Much of the activity in Crowdfunding is people giving seminars to other people teaching useless information and patting each other on the back.

Pointing out that fact makes those people very angry but it does not change the fact the Crowdfunding industry is remarkably unsuccessful at raising money. It takes money to raise money. The Crowdfunding industry is busy telling people just the opposite; that an inexpensive  social media campaign is all a company needs to successfully attract investors.

Many companies who try Crowdfunding do not get the funds they want. That is a shame because it really is not that difficult for a good investment to attract investors.

There is a very small group of Crowdfunding platforms that close every offering that they list. The people who run those platforms don’t give seminars because they are too busy being successful.  Several are run by people who came out of the mainstream financial industry and understand what works and what doesn’t.

One of the reasons Crowdfunding is failing is because not every company that wants to be funded is a good investment.  Early on I offered to read any company’s pitch deck and make comments for free. That has brought me into contact with a fair number of entrepreneurs, most of who I have found to be quite interesting and appreciative.

I also write about the markets themselves, especially regulations of the markets, FINRA and FINRA arbitration.  If I write fewer articles about these subjects it is because there are a great many lawyers and others who put out good information. The mainstream securities industry is usually careful to stay within the regulatory white lines.

So has blogging been good for my business?  Yes, but in unexpected ways.

Blogging has certainly gotten my name “out there”.  When I started the blog I had about 200 Linked-in connections, mostly friends, colleagues and former clients.  I add new connections with every article and the number has increased 8 fold and continues to increase weekly with each new article.

My articles on the investment industry got me the opportunity to write articles for a mainstream digital publication serving the investment advisor market. Some of those articles reach thousands of readers. I am still very much at the Jimmie Olsen, cub reporter stage but the editors there have been very patient and supportive.

The articles on Crowdfunding, especially the negative ones, put me in touch with a several groups that want to do Crowdfunding correctly, with due consideration to what investors want and deserve.  I have been helping these Crowdfunding platforms move from the planning to the implementation stage. Each shares a goal of funding every company that it lists. I expect that other groups seeking to start Crowdfunding platforms or make existing platforms more successful will seek me out as well.

The articles on arbitration and market regulation have resulted in a few expert witness gigs in FINRA arbitrations and a consulting assignment for one of the larger Wall Street investment banks. I suspect that more will come.

The best part of blogging has been that it has put me in touch with a large number of people with whom I would not otherwise have been in contact.  I speak to 2 or 3 people every week. Some of those conversations go on for an hour or more.

During most of the conversations I find myself laughing over a good joke or comment.  For me it is these personal connections that are the best thing that comes from blogging.  A good laugh in the middle of the business day seems harder and harder to find.