Why Ponzi Schemes Work: An In-Depth Look At The Allen Stanford Fraud

Dec 21 2014 | 11:30am ET

Texan Allen Stanford first appeared on the radars of financial regulators in 1997. Julie Preuitt, then a branch chief in the SEC’s Fort Worth Broker-Dealer Examination group, was becoming “very concerned” about the “extraordinary revenue” Stanford claimed to me making in his investment fund. It took authorities more than 12 years until Stanford was charged with a crime.

H. David Kotz, who served as the inspector general of the Securities and Exchange Commission for over four years, takes us inside the investigation—or lackthereof—and explains why Stanford got away with it for so long.

The following excerpt is reprinted from Kotz's recently released book, Why Ponzi Schemes Work and How to Protect Yourself from Being Defrauded, with permission of Thomson Reuters. Copyright © 2014.

By H. David Kotz

More “Too Good to be True” Returns

After the Madoff investigation, there was a great deal of fallout from Congress and in the media about our findings and concerns about the SEC and its inability to uncover Madoff’s Ponzi scheme. One of the comments made by SEC officials at that time was that the Madoff case was “a perfect storm” of circumstances that led to the commission’s failure. The sense was that this lapse was a once-in-a-lifetime event that could and would never be replicated.

However, not long after the Madoff investigation, I kept hearing about another Ponzi scheme that had been perpetrated by a Texan named Allen Stanford that had just come to light, and there were worries that perhaps the SEC was derelict in uncovering this fraud, as well. When I learned more about Stanford’s fraud, and that the SEC had examined his operations on multiple occasions, I became concerned.

My understanding was that Stanford had been registered as both an investment advisor and a broker-dealer in Texas and was affiliated with an offshore investment bank in Antigua. The Antiguan bank evidently offered Stanford’s customers certificate of deposit (CD) accounts with relatively high and very steady interest rates. This sounded much like Madoff in that returns being given were simply “too good to be true” and required scrutiny by the SEC. Eventually, my office conducted two investigations of the circumstances surrounding the Stanford Ponzi scheme and found that although the SEC did, in the end, uncover the fraud, SEC officials had been aware of concerns about Stanford’s actions for many years before they took action in court to try to stop the Ponzi scheme.

Building Stats: Complex versus Slam-Dunk Cases

My investigation found that the SEC’s Fort Worth office had been aware since 1997 that Stanford was likely operating a Ponzi scheme, having come to that conclusion a mere two years after Stanford Group Company, Stanford’s investment advisor, registered with the SEC in 1995. We found that over the next eight years, the SEC’s Fort Worth Examination group conducted four examinations of Stanford’s operations, finding in each examination that the CDs could not have been “legitimate,” and that it was “highly unlikely” that the returns Stanford claimed to generate could have been achieved with the purported conservative investment approach. Fort Worth examiners dutifully conducted examinations of Stanford in 1997, 1998, 2002, and 2004, concluding in each case that Stanford’s CDs were likely a Ponzi scheme or a similar fraudulent scheme.

The problem we found was not with the SEC’s Examination group, but with the Enforcement group in the SEC’s Fort Worth office. The Examination group had tried for years to get the Enforcement unit to investigate Stanford but was, for the most part, unsuccessful. In 1998, Enforcement opened a brief inquiry, but then closed it after only three months, when Stanford failed to produce documents evidencing the fraud in response to a voluntary document request the unit had made. In 2002, no investigation was opened even after the examiners specifically identified multiple violations of securities laws by Stanford in an examination report. In 2003, after receiving three separate complaint letters about Stanford’s operations, Enforcement decided not to open an investigation or even an inquiry, and did not follow up to obtain more information about the complaints.

Even though the SEC examiners had been concerned since 1997 about Stanford operating a fraud, it was not until 2005, when there was a change of leadership in Fort Worth’s Enforcement office, that Enforcement finally agreed to formally open an investigation against Stanford. I found that the reasons were primarily related to larger institutional influences operating within the SEC at that time. I discovered that Fort Worth Enforcement officials perceived that they were being judged on the number of cases they brought—so-called stats—and communicated to the Enforcement staff that novel or complex cases were disfavored. As a result, cases like Stanford, which were not considered “quick-hit” or “slam-dunk” cases, were not encouraged.

I also found that the former head of Enforcement in Fort Worth, an attorney named Spencer Barasch, who played a significant role in multiple decisions over the years to quash investigations of Stanford, sought to represent Stanford on three separate occasions after he left the Commission. He did, in fact, represent Stanford briefly in 2006, before he was informed by the SEC Ethics Office that it was improper to do so.

I further found that even in 2005, after Enforcement finally commenced a formal investigation, the case dragged on for years, and it was not until after Bernie Madoff confessed that the SEC finally went into court to challenge Stanford and caused his Ponzi scheme to collapse.

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