Ponzi Schemes Poised To Topple In Bear Market

Paul Radvany in Law360.com, December 13, 2008

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Law360, New York (December 13, 2008) -- The Ponzi scheme underlying famed trader Bernard L. Madoff's investment firm was revealed after clients, squeamish in a bear market, tried to redeem billions in investments. As confidence in financial markets wanes and investors rush to pull deposits, more Ponzi schemes are sure to unravel and their masterminds will face tough treatment from federal prosecutors, securities experts agree.

Ponzi schemes, whereby old investors are paid with money from new sources, are ripe for exposure in a bear market, when funds freeze up, securities attorneys told Securities Law360. And in bad times, they agreed, prosecutors are especially aggressive against perpetrators of financial crimes.

In the case of Madoff, whom federal prosecutors indicted Thursday for bilking as much as $50 billion from investors in his funds, the U.S. Securities and Exchange Commission moved in after learning Madoff had told two senior employees that his business had been insolvent for years, according to documents filed Friday in the U.S. District Court for the Southern District of New York.

Madoff is facing criminal and civil charges from the government and a group of investors who claim Madoff defrauded them are already gearing up to file suit in order to recover at least a portion of the $700 million they say they entrusted to Madoff's firm, Dow Jones reported Friday.

While Ponzi schemes inevitably fail, a deflated stock market can catalyze the process by prompting old investors to ask for their deposits and dissuading potential investors from buying in.

“A lot of the time, the way these things unravel is they run out of money,” said Bennett Lasko, a partner in the securities litigation practice at Drinker Biddle & Reath LLP. “It is harder in this environment to attract new investors that a Ponzi scheme needs to pay off its existing investors.”

“This economic environment, the stock market, the bear market — will flesh out a lot of these schemes that were artificially propped up,” said Bill deStefano, chairman of Buchanan Ingersoll & Rooney PC's white collar criminal practice group.

Madoff, for example, enticed investors by consistently posting high returns for the funds managed by his company, Bernard L. Madoff Investment Securities LLC, in exchange for relatively low fees.

When the market went down and investors asked for their money back, Madoff's plan unraveled, deStefano said.

Ponzi schemes are difficult to bring down before they collapse on their own because they are so hard to detect, said Manning Warren, a professor at the University of Louisville's Louis D. Brandeis School of Law.

“The people running them are usually well-regarded, and frequently, their schemes will start out as legitimate and 'turn Ponzi' down the road when the investments do poorly,” said Warren, adding that even the most sophisticated investors and celebrities have been duped by them.

Experts expect both regulation and prosecution against the perpetrators of Ponzi schemes to increase in this bearish market.

“I think prosecutors are going to be very focused on financial crimes because of the extent of money people are losing out there,” Lasko said. “That's the prosecutor's job — to go after people who are harming the public at large and certainly, there is a lot of pain in the public at large right now.”

“Most U.S. Attorneys' Offices in big cities prosecute these things aggressively because a Ponzi scheme is about as fraudulent of a fraud scheme as you can get,” said Christopher Hunt, a partner at Bartko Zankel.

The problem is that the person masterminding such a scheme is often destitute by the time the fraud is uncovered, Hunt said. Putting that perpetrator in jail may give victims some satisfaction, but it does not make them whole, he added.

As far as regulation, experts generally said that the new president and a Democrat-controlled Congress will try to reinstate some regulatory measures in the financial markets, including increased transparency from traditionally secretive hedge funds.

“Everyone expects an increase in regulation and legislative activity,” deStefano said. “A lot of these products that are being sold are new products. Hedge funds are not that old, when you think of it, and it takes time for regulations to catch up with products.”

So how can investors avoid falling into the tempting trap of a Ponzi scheme?

In a sluggish market, cautious investors generally do some extra due diligence when it comes to picking funds, so they may be less susceptible to the lofty-but-vague promises that generally earmark a Ponzi scheme.

“I think it is more likely that as the market goes down, people will be more concerned about their investments,” said Paul Radvany, a professor at Fordham University School of Law and a former federal prosecutor. “Cases like [Madoff]'s will lead people to pay greater attention to their investments.”

Most investors should stick to the world of regulated investments and avoid putting money into unknown funds, even if the deal seems like a sure bet.

“If you are getting your account statement from Charles Schwab, you can be a lot less worried about a Ponzi scheme,” Lasko said. “If you are getting your account statement from Bernard Madoff, then you are trusting Bernard Madoff and you should do your due diligence before you invest.”

Investors who can afford to be more aggressive and take bigger risks, however, should take the initiative to do some legwork before handing over any assets, he said.

Find out who audits the firm, make sure the auditor is reputable and evaluate whether the operation is transparent and whether you understand how it works, Lasko recommended.

An investor might also consider asking to see underlying account statements from the funds' brokers or clearing firms, Lasko said.

Radvany suggested investors research the qualifications of the person they are investing in and get documentation of any deposits they make.

Even so, there is no foolproof recipe to avoid getting caught up in a Ponzi scheme.

“There is no way to avoid it, even if you are very cautious and only invest in blue chip-type things,”deStefano said. “Our system is set up as such that you have to take some risk, no matter what you invest in.”

The bottom line? According to attorneys, when judging investments, don't lose sight of the old adage, “If it looks too good to be true, than it probably is.”