History Says Scams Won't End With Madoff

The 150 year jail sentence of Bernard Madoff is meant to be a statement to scam artists in training: don't even think about committing financial fraud.    But will Madoff's life sentence and the government's rush to create new regulation help prevent economic fraud in the future?    History, American behavior and even wine tell us it won't.

Frank Partnoy's excellent book "The Match King"' outlines the true story of Swedish financier and fraudster Ivar Kreuger.  Kreuger was an introverted, quiet and enigmatic Swede who for years in the 1920s and 1930s ran a legitimate match business.    He would sign long-term, exclusive match contracts with various governments and securitize the cash flow, paying huge dividends.    Investors clamored for these investments, and soon Kreuger, who kept paying 20-plus percent dividends year after year, was perceived as a financial genius.    Even as the financial markets began to collapse with the Great Depression, Kreuger continued to convince his American investment bank to sell more and more preferred stocks and debt.    Few questioned him or his companies, despite shockingly little auditing.  In the end, the depression and Kreuger's greed exposed the fraud and thousands of investors lost hundreds of millions of dollars.

It is wine, not financial instruments, that drives the story in another terrific book.    Ben Wallace's "The Billionaire's Vinegar" details how many wealthy and experienced wine investors were duped into buying pricey bottles of wine that ostensibly belonged to Thomas Jefferson.    Even as doubts about their origin grew, more bottles were sold, and the entire old wine market witnessed prices driven to frenzied levels.    Throughout Wallace's page turner one gets a clear sense that the buyers of these expensive wines refused to heed the warning signs.   Many seemed to rely on belief and blind optimism alone, even as modern science began to debunk some of the claims.

Charles Ponzi became the namesake of scams, even though he wasn't the first major fraudster in America.   In 1899 William "520%" Miller took investors for more than a million dollars by claiming to have inside stock information.    In fact, in the grand scheme of schemes the diminutive Ponzi was a small fry of fraud.   Consider these other scams, all occurring post-Miller, Ponzi and Kreuger:

Daniel Heath was sentenced to 127 years in prison for running an investment scam in Southern California that bilked 1,800 people out of $187 million in the early 1990s.   Prosecutors said he preyed on the elderly in a scheme that involved money-losing real estate and small-business projects.

James Paul Lewis Jr. told investors he made money by buying and selling distressed businesses, leasing equipment to medical offices and financing medical insurance premiums.  He was sentenced to 30 years in prison for a scheme that ran from 1985 to 2003 and cost nearly 3,300 investors around $70 million.

Reed Slatkin, co-founder of Earthlink Inc. and once a Scientology minister, was sentenced in 2003 to 14 years in prison for swindling investors out of about $240 million over 15 years.

Lou Pearlman, the mastermind behind the Backstreet Boys and 'N Sync, operated a $300 million stock and investment scam. He was sentenced earlier this year to 25 years behind bars.

Ponzi followed Miller,  Kreuger followed Ponzi, and Madoff followed everyone above.   History repeats itself, despite many of these frauds occurring close enough in time that investors may still have had memory of the previous one even as the new one began.

Those cases are just a smattering of the fraud in America each year.   They grab headlines because of their size.   Each year though countless other scams occur, smaller in scale but no less devastating to those they impact.    In many of these frauds the man (and it almost always is a man) behind the fraud didn't even have to do much selling.   Instead it is often victims who unwittingly do the selling for them, touting their spectacular returns.   In Kreuger's case, it wasn't just other investors but also a respected investment bank selling his stock.   Rather than sell on his own, Madoff used wealthy, connected individuals and so-called 'feeder' hedge funds to find new investors.    This kind of selling makes it easier for potential investors and victims to believe the story.

Even non-frauds often bring investors in by using others just like them to make the sell.  How often during the peak of the housing bubble did we see lengthy infomercials touting the ability to make millions flipping homes, usually with no money down?   Many of those were also filled with the "testimonial sell" of others who followed the model.    They can do it, so can you.    Although some home speculators did make money in the early part of the housing game, it was the ones holding the homes when the walls came down who were burned.     And this was, let's remember, a housing bubble that inflated even as many began to sound the alarm that price increases were unsustainable.   It also inflated just a short time after the Nasdaq bust reminded the world nothing is infallible.

The government wants to create a new agency to better protect consumers and investors.   The SEC is making promises about tightening its investigative priorities.   Lawmakers are holding press conferences and making big promises.    History will be judge of whether any real change will come from the Madoff scam, or whether we will be better protected by those in power.    Let's hope so.   But history also screams that whether it is stocks, bonds, postal note or wine, there will always be those out to scam and defraud us.   Ultimately we have to be our own best line of defense.    Stay vigilant.   Know that no stock, fund or other investment goes up every year.  Entrust people with your money, but trust yourself as the ultimate policer of that money.   Ask tough questions and don't hesitate to just show up every once in a while.    History demands it.