Financial frauds - history, regulations and the way forward - II | Ireland EU

Financial frauds - history, regulations and the way forward - II | Ireland EU
Financial frauds – history, regulations and the way forward – II

Financial frauds – history, regulations and the way forward – II

Continuing with our series on large scale financial crimes, we turn our attention to the past century. It has witnessed frauds of unprecedented magnitudes and complexities that wiped billions of dollars off stock exchanges and robbed people of their life savings.

With the advent of 20th century, the world started getting closer. The new manufacturing practices originating from Industrial Revolution had matured and been taken to different parts of the globe. International trade volumes were swelling like never before and advantages of doing trade in different parts of the world were becoming known to global business community.

As is the case with any developing system, it had its own sets of demerits which were exploited to the fullest by a few very cunning men. The world came to learn about the hard way – through economies crashing and the seemingly unsinkable financial institutions collapsing like a pack of cards.


Charles Ponzi’s globally (in)famous “The Ponzi Scheme”

History is awash with examples of conmen who were able to rob thousands of victims simultaneously. Though it does require extraordinary smartness and courage to pull it off, lot of people have done that with great success. None of them could manage to get a fraudulent scheme named after them, though.

Charles Ponzi, also named as Charles Bianci, Charles Ponci, Carlo, etc. managed to scale up his fraud to such unprecedented scales that he remains a case study to date and any similar attempts at frauds in the modern world are still called “Ponzi” schemes.

An Italian who migrated to US and Canada in 1903, Ponzi tried his hands at different non-conventional, grey jobs, including forging bank checks, smuggling Italian immigrants across to America, etc. Sooner or later the law caught up with him and he had served prison time on a number of occasions. Later on, he later saw an opportunity to make money by exploiting the arbitrage loophole that appeared in postal system. Though there was nothing wrong with the idea itself, his greed and inherent urge to make windfall gains by swindling people served the ingredients of what would go on to be his biggest scam – to be remembered and referenced even in the next century!

Ponzi returned to Boston and married a stenographer Rose Gnecco in 1918 and that was the time he came up with an idea that earned him a place in history. Letters with International Reply Coupons (IRCs) were very common back in the day and their prices varied across countries. He worked upon an idea to buy IRCs in one country that sold them cheap and sell it in another country with stronger currency (like USA). He recruited agents in different countries and sent them money to buy stamps and send them to him in the US. He would then sell them and make big profits, sometimes to the tune of 400 percent. This model did not satisfy his greed and he started seeking investor money by promising them 50% returns in 45 days and 100% in 90 days.

Needless to say, his business wasn’t that profitable so he paid few initial investors from the investment of the later ones. In those times, he reportedly made as much as $250,000 a day. In August 1920, The Boston Post launched an investigation which prompted investors to start withdrawing money. His scam was out in the open within days and he pleaded guilty to his mail fraud, landing him 14 years of prison time. His wife divorced him and he died penniless in Brazil in 1949.


Bernie Madoff Scandal (1991 – 2008)

The year 1938 saw the birth of Bernard Lawrence “Bernie” Madoff, the central figure who ran a Ponzi scheme in the modern, electronic trading era. Globally recognized as the pioneer of modern, electronic trading, it is interesting to note that Madoff was borne while Charles Ponzi was serving jail time (symbolically “passing the baton”, if you will!). Despite the central idea of both schemes being the same, there is a striking difference – Charles Ponzi was not an influential figure in the money markets. Bernie Madoff, on the other hand, enjoyed several positions of power.

Madoff started his own firm back in 1960 which made profits by trading penny stocks. It initially acted as a market maker (quoting buy and sell prices for securities) via the National Quotation Bureau. Amidst competition from NYSE affiliated member firms, he pioneered the use of computers and information technology for quote generation. This technology then went on to become NASDAQ.

He climbed up the hierarchy and was an active member of National Association of Securities Dealers (NASD) in addition to serving as the chairman to board of directors and board of governors. He was also an advisor to Securities and Exchange Commission. These positions earned him a reputation of unquestionable integrity and he used exactly that to lure investors in.

True to any Ponzi scheme, he paid off his older investors through the money from new, incoming investors. Unlike Charles Ponzi, he was able to run his fraud for nearly two decades as he didn’t promise unrealistic returns. He promised regular, consistent gains that lent credibility to his “investment strategy”. In order to minimize his outgo in terms of returns to investors, he encouraged them to stay invested for long term for higher gains and provided them regular updates of their earnings.

Ponzi schemes eventually get busted as finding new investors becomes more and more difficult after the initial period of exponential growth. Madoff’s scheme fell apart when clients started requesting their money back – to the tune of $7 billion. He only had $200 – $300 million to pay them back

Though there have been other Ponzi schemes of note that were busted in past few decades (including Allen Stanford’s $8 billion and Tom Petters’ $3.7 billion scams), Madoff’s $65 billion (full list of his clients is published by Wall Street Journal here) heist makes him the runaway winner and his prison term of 150 years is a vindication. This episode brings to light a common theme across large scale financial frauds – the involvement of an influential financial industry insider who abused his reach and reputation to do away with billions.


Fall of a Wall Street darling: Enron scandal (2001)

An American energy company with a long list of subsidiary businesses, Enron was awarded “America’s Most Innovative Company” by none other than Fortune for six consecutive years – 1996 to 2001. Enron’s fall is another example of how a “too big to fail” giant crumbled under its own weight in a matter of months and the stock prices dropping to irreversible lows.

Jeffery Skilling was chosen to head the company in 1990 and tweaking Enron’s accounting methods was one of his most prominent, early contributions. Mark to Market (MTM) was a perfectly legal, accepted accounting method in which accounts were represented in terms of “fair market value” instead of actuals. Although the company was allowed by SEC to adopt this accounting methodology, it left scope for manipulation of assets and liabilities – something that Enron cashed upon big time.

It coincided with the dot com boom of 1990s which allowed Enron to alter record books for many of its sister concerns which did business with the parent. Skilling’s era saw the company build an asset and immediately bring its “potential” profit into its record books, even though the venture was not making a single penny.

For loss making ventures, the company would shift the asset to an off the books firm, where such reporting would not be noticed. This increasingly became the norm for mounting liabilities and losses and Andrew Fastow, promoted to CFO in 1998 and focused explicitly to project the company in sound financial health by hiding the losses through off-balance special purpose entities. Enron’s eventual fall came at the dawn of this century with Enron Corporation’s bankruptcy.

Estimated at $75 billion, its fall was the largest in American history at that time. Here is a report on how Enron’s executives pocketed millions of dollars and kept reporting inflated profit numbers to shareholders to keep the fraud running. The “external auditors” Arthur Anderson LLP. were known to be deeply involved in the accounting fraud and themselves admitted in the year 2002 that company documents were destroyed by its employees.

This admission was followed by voluntarily surrendering its license to practice as Certified Public Accountants in the United States. Arthur Andersen’s conviction was later reversed by the Supreme Court owing to serious errors in trial judge’s instructions. However, its stature as “Big Five” auditing firm took a serious hit and it never recovered – forcing its former consultancy and outsourcing practice to separate from accountancy practice. The consultancy vertical continues to operate till this day as Accenture.


Satyam Scandal (2009)

B. Ramalinga Raju, founding member and Chairman of Satyam Computer Services, found himself outsmarted by the Indian Tax and Law Enforcement agencies in 2009. Although the magnitude of Satyam scandal – to the tune of $1.1 billion – didn’t stand tall in comparison to Ponzi or Bernie Madoff, the manner in which it was pulled off presented a case study in corporate governance – or rather the lack of it. Raju was once the poster boy of the booming Indian IT scene – rubbing shoulders with top global CEOs and politicians, including Bill Clinton. He was even named “Ernst & Young Entrepreneur of the Year” and his company became the official IT services provider of FIFA World Cups 2010 and 2014.

This was yet another case of people in power abusing their position to run a scam and eventually turning investor money into dust. Infamously called as “Enron of India”, the scam came to light in the most straightforward manner possible – the perpetrator Ramalinga Raju himself writing to employees, investors and the government on January 9th, 2009 confessing to the crime. He had rigged the record books to misled the markets – revenues, operating profits, cash balances and interest liabilities were all fudged up to present the company in good financial health. He had done it to prevent a possible takeover and the fraud started as a marginal gap between actual and reported numbers. However, it became a habit over a period of time and was reported when it had grown to unmanageable proportions. About 94% of reported revenues were non-existent and the fraud was supported by auditors, promoters and executive board members.

As always, the industry and law enforcement authorities were quick to react to it. Bodies such as CII (Confederation of Indian Industries), NASSCOM (National Association of Software and Services Companies) SEBI (Securities and Exchange Board of India), Ministry of Corporate Affairs, etc. issued a long list of guidelines and advisories for voluntary compliance. The Company Law was amended in the year 2013 – yet another case of regulators not being proactive enough and too little done too late in the wake of a financial fraud.

Recollecting these episodes on financial crimes once again re-iterates how firms and officials perceived as having the highest level of integrity gave in to their greed and ended up ruining lifetimes savings of hundreds of thousands of people who trusted the with their hard earned money. Regulators and government departments, if not directly involved with these frauds, were never found to be proactive. Accounting scandals such as Enron did bring about the Sarbanes-Oxley Act (S-OX) that expanded the set of requirements to all U.S. company boards, management and public accounting firms.

Private companies were also brought under the lens, with stringent punishments brought in for those involved in acts impeding federal investigation – such as willful destruction of evidence. Role of government agencies and regulators has always been under the scanner for such large scale frauds and crimes – such as the origin and functioning of Mexican Drug Mafia which is entirely run by U.S. prison cell networks.

In the next (and concluding) part of this series on financial frauds and the insufficient, reactive steps taken by governments around the world to curb them, we pick out incidents and technologies from the digital age of past decade or so. It was a time when banking, currency and transactions evolved like never before – and the attackers had a larger “surface area” and more vulnerable victims to target, helped by modern technology.

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