You Can't Cheat an Honest Man (3 page)

In fact, there was no risk at all...because Fry wasn’t buying any derivatives. Rather than investing the money in an ingenious investment program, he spent indulgently on himself. He used more than half a million dollars to start a stable of race horses. He spent almost that much in Atlantic City casinos. (Like many Ponzi perps, Fry loved to gamble and usually lost.)

Throughout the scheme, Fry kept a jokey attitude that disarmed doubters. The vehicle that he used for collecting investors’ money was called the GTC Fund. Fry would happily tell investors that “GTC” stood for Good Till Canceled or Gamblers Trading Consortium.
As often happens in these situations, the insouciant smirkiness made Fry all the more convincing. Who else but someone who knew what he was doing would treat serious money so unseriously?

In the end, the joke was on Fry’s investors. During 1993, dividend checks to investors started bouncing. Angry investors called state authorities who promptly got a court order freezing Fry’s assets, both personal and corporate.

Fry fled, leaving a note which said—in shades of his old form—that he was going to a place where “the weather will be warm and the primary tongue one other than English.” But, again like most Ponzi perps, he didn’t run anywhere exotic. He was arrested in Cincinnati 14 months after he’d left Baltimore.

Fry pled guilty to four counts of theft, securities fraud, lying to the Maryland securities commissioner and willfully failing to file a tax return. In early 1995, he was sentenced to eight years in state prison and ordered to pay restitution of $3.8 million to his investors.

State law enforcement officials seized a little less than $1 million in various assets under Fry’s control. They doubted there was much of the GTC money left.

But the state couldn’t keep an ambitious felon down. Less than a year after Fry moved into a Maryland prison, he posted his resume on an Internet Web site that offered fee-based financial advice. For an annual fee of $500, he would teach investors the intricacies of the stock options markets.

The posting made vague reference to “an unfortunate event” in which a client had defaulted on several hundred thousand dollars worth of trades and that Fry had made the “tragic mistake” of diverting other investor funds to cover the loss. (He didn’t mention that he was writing from jail.)

Fry tried to put a positive spin on his bitter experience. His posting beseeched, “who better to advise against the pitfalls of... options trading than one who has been sucked into the abyss by utilizing them?”

Investors Also Define the Ponzi Equation

The perps are only part of the equation, though. In order to understand why these schemes are becoming so common, we need to consider the investors who enable the crooks.

In August 1996, the Nevada state attorney general’s office arrested five women and filed suit against 27 other people in what it characterized as a “classic” Ponzi scheme
¹
taking place in a city that wouldn’t seem to need one: Las Vegas.

Actually, the Las Vegas scheme was more like a pyramid plan than a Ponzi scheme. It was surprisingly simple. Participants would receive $16,000 from a $2,000 investment if they could recruit a large enough number of family members, friends and co-workers. Time didn’t matter that much, only the number of people a person could convince to join. The scheme’s organizers didn’t hesitate to admit that people who joined early would be paid by the people who followed.

The organizers of the pyramid scheme tapped a rich source when they got involved with the Las Vegas Metropolitan Police Department. Police sergeants, patrol officers and corrections officers were among the people actively recruiting co-workers to join the scheme.

By early 1996, the scheme collapsed and more than 200 people in the Las Vegas area lost their $2,000 entry fees.

The fact that many of the participants were cops upset many people. A local newspaper complained:

Not only have they embarrassed themselves, their badges and their department, but they also have spent their precious credibility by recruiting others into the basest sort of get-rich-quick scheme.

Like more flagrant forms of corruption, Ponzi schemes thrive on the special, intense level of trust that police officers have in one another. And, like the more flagrant forms of corruption, the schemes undermine that trust.

¹
Law enforcement officials almost always refer to Ponzi schemes as “classic.” A California lawyer who has prosecuted the things says, “It’s a way that the cops can say these people should have known better than to get involved in a get-rich-quick scheme.” In other words, it’s a way for them to show the contempt they feel for everyone involved. In the Nevada case, this included some of their own.

One Las Vegas cop added some insight that seems to support the populist/class envy theory of why the schemes work. “This is a place where all kinds of bad people are making all kinds of good money. It’s very hard to toe the straight line as a law enforcement professional. A lot of [police officers] looked at the scheme like a kind of honest graft.”

A Global Phenomenon

Ponzi schemes aren’t limited to San Diego leasing companies, North Carolina decorators or Las Vegas cops. Though the schemes are distinctly American phenomena, their resurging popularity is global. During the early and mid-1990s, several eastern European countries, newly relieved of the financial burden of Marxism-Leninism, plunged into Ponzi schemes that were national in scope.

In Albania, which had suffered for 40 years under a Marxist regime too extreme for even the Soviet Union to support, private moneymaking schemes that promised huge dividends soaked up the savings of between 50 percent and 90 percent of the population. Most of these cons promised big money from the development of technology companies and international banks to people who barely understood the concept of currency. Almost $3 billion flowed into the schemes from people who could barely feed themselves. As ever, the first few successes created huge demand.

By late 1996, when the schemes started to collapse, street riots and political chaos followed. The outrage was understandable. The Albanian government, long suspected of being corrupt, had licensed most of the schemes. Although the government acknowledged what it called a “moral responsibility” to pay back at least some of the losses, its treasury didn’t have enough cash to make a significant dent.

International Monetary Fund officials had warned the Albanian government about the schemes in 1995. Two years later, the same economists worried that the government could only meet its moral responsibility by printing money...and courting hyperinflation. “There can be very serious implications,” said one IMF official. “There are risks to the stability of the currency and to the long-term economic stability of the country.”
Albania wasn’t alone in these troubles. In Romania, more than 500 pyramid schemes were hatched in the five years following 1989’s overthrow of Nicolae Ceausescu. The biggest fund, known as Caritas, promised 800 percent profit within 100 days. In early 1994, the scheme collapsed with more than $1 billion in debts to three million investors.

“People are Greedier than They are Smart”

As the eastern European countries develop their economies, they may find—as the West has—that people have short memories when it comes to get-rich-quick programs. As one investor in a New Jersey real estate pyramid said, thinking about all the money he lost, “People aren’t stupid. They’re just greedier than they are smart.”

And perps are forever coming up with variations on Ponzi’s scheme. In the precedent-setting Ponzi scheme decision
Kugler v. Koscot Interplanetary, Inc.
, the New Jersey State Supreme Court wrote:

Fraud is infinite in variety. The fertility of man’s invention in devising new schemes of fraud is so great, that the courts have always declined to define it.... All surprise, trick, cunning, dissembling and other unfair way that is used to cheat anyone is considered as fraud.

Almost all modern Ponzi frauds contain some semi-plausible business “explanation” for the astounding growth of the initial investors’ money. It might be quick gains made from equipment leases, bridge loans, mortgages or currency futures. These things are echoes of Carlo Ponzi’s Great Idea.

Also, the schemes always have perpetrators and promoters desperate enough to sell hard. These people are echoes of Ponzi himself.

CHAPTER 1
Chapter 1:
The Mechanics Are Simple Enough

A Ponzi scheme isn’t a complicated thing, mechanically. The perpetrator collects money from investors, promising huge returns in a matter of months or weeks. He has to do one of two things:

1) return a portion of the invested money as “profit” while convincing investors to keep their “principle” (which is dwindling fast) invested; or

2) recruit new investors, whose money is used to produce the promised windfall to the earlier ones.

Even if the perp does the first thing, he’ll eventually have to do the second.

Finding the second level of investors is usually the hardest part of the scheme. Once they are recruited, the scheme often drives its own growth. This is why a certain level of word-of-mouth publicity is essential to a scheme’s success. When word of early profits and ritzy investors spreads, new investors pour in. With more dollars, the Ponzi perp is able to pay off more people.

Basically, a lot of cash is moving around but none...or very little...actually goes to anything that could legitimately turn a profit. The Ponzi perp can maintain the charade and skim off money for himself only as long as new suckers are feeding him with dollars. When this cash flow dwindles—even slightly—the whole scheme collapses.

The schemes can yield large returns for those who start them or join early on. As long as there are enough people to support the next level of the scheme, people above are safe. In financial circles, this is known as the “greater fool” theory. As long as you find someone willing to take your place in the scheme—a greater fool—the fact that you were a fool to invest doesn’t matter.

The greater fool theory applies to more than just crooked schemes. Paying $40 million for a French Impressionist painting, $500,000 for a baseball card or a year’s salary for a tulip bulb might make sense if there is someone willing to pay even more. But it’s absolute folly if there’s not. This fiscal relativism blurs many people’s judgment about all investments.

The Numbers Never Add Up

“There’s not a lot to be done about pyramids” or Ponzi schemes says Larry Hodapp, a senior attorney for the Federal Trade Commission in Washington D.C.. “People just have to be educated that the return rates these operations suggest are ridiculous.”

A Ponzi scheme or pyramid plan, like a chain letter, is dependent on each new level of participants securing more persons to join. The new participant makes payment to the person on top of the list or pyramid, who then is removed, and replaced by those at the next level.

The fraud in the scheme is that when participants pay, they must assume that they and those that follow will be able to find new participants until all of the levels are filled.

In a four-level scheme, for all of the first group of new participants to be paid, 64 people need to join. After 20 levels of new participants, 8,388,608 additional investors would be needed. And there would be a total of 16,777,200 people in the scheme. These numbers are a practical impossibility.

Ponzi schemes are usually more secretive about these details than pyramid schemes. Ponzi perps keep their growing need for new money quiet—while pyramid perps usually announce their growing need as part of their pitch. In either case, the ultimate problem is the same: The schemes have to keep doubling, tripling or quadrupling in size just to avoid collapsing.

A Simple Four-level Pyramid

In 1987, a number of Wilmington, Delaware, residents were drawn into a pyramid investment scheme which was so simple in structure that it serves as a good primer for the basic mechanics.

The investors attended meetings where promoters pitched what they called an “airplane” scheme. If an investor bought a “seat” on the airplane for $5,000 and brought in two other people, he or she would receive $40,000. The scheme was a four-level pyramid:

1) When you paid your $5,000, you joined the group as a “junior sales executive.”

2) After recruiting two other investors willing to pay $5,000, you moved up the ladder to a “senior sales executive” position.

3) After each new junior sales executive introduced two new investors (a total of four) to the group, you were promoted to “branch manager.”

4) After each of those new people introduced two new investors (a total of eight) to the group, you became a “division manager.”

The division manager would receive the money invested from each of the eight junior sales executives several levels below. At that point, he or she left the group or started the process anew.

The Delaware pitches were made by two men: John Ferro and Robert Jorge. They assured potential investors that the investment was riskfree and that the scheme was legal as long as investors declared the income.

Ferro and Jorge also waived off another possible problem: not having the $5,000 to invest. They could arrange financing in the form of personal lines of credit through several sources, including Chrysler First Financial Services Corp. Jorge passed out Chrysler First application forms at some of the meetings and introduced potential investors to Larry Doub, an employee of Chrysler First who attended several pitch meetings and participated as an investor in the scheme. Chrysler First approved dozens of personal lines of credit connected to Ferro and Jorge’s scheme. Many of these people borrowed the money (very expensively, with loan origination fees and high interest rates considered), invested in the scheme and got nothing out. The scheme collapsed after a few weeks when Delaware state police arrested Ferro and Jorge.