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

Dec 21 2014 | 11:30am ET

Differences in Stanford and Madoff Cases

This case was a little different from the Madoff one. In the Madoff situation, essentially all of the SEC personnel, whether examiners or investigators, were fooled into thinking that Madoff was conducting a legitimate operation. At no point did any SEC officials conclude that Madoff was operating a fraud. In the Stanford case, SEC examiners from Fort Worth were extremely skeptical about Stanford’s operations and made those suspicions known both in examination reports and in communications within the SEC.

In the first SEC examination of Stanford that occurred in 1997, Julie Preuitt, then a branch chief in the SEC’s Fort Worth Broker-Dealer Examination group, said that simply based on her review of Stanford’s investment advisor’s financial statements, she was becoming “very concerned” about the “extraordinary revenue” from the CDs that Stanford was issuing and immediately suspected the CD sales were fraudulent. After only six days of fieldwork in the examination of Stanford, the examiners concluded that the statements promoting the CDs appeared to be misrepresentations. The SEC examiners believed that the CD annual rates of between 11 percent and 13.75 percent were simply too high to be achieved through the purported low-risk investments Stanford was claiming to be making.

Similarly, Mary Lou Felsman, the former assistant district administrator for the Fort Worth Examination program, said she saw “red flags” about Stanford’s operations that caused her to believe it was a Ponzi scheme, specifically the fact that the “interest that they were purportedly paying on these CDs was significantly higher than what you could get on a CD in the United States.” She further concluded that it was “highly unlikely” that the returns Stanford claimed to generate could be achieved with the purported conservative investment approach.

A second examination that was conducted in 1998 came to the same conclusions as the 1997 exam, finding Stanford’s extremely high interest rates to be suspicious.

In November 2002, the SEC’s Exam group conducted yet another examination of Stanford’s investment advisor. In this exam, the SEC examiners found that Stanford’s operations had grown significantly in the four years since the 1998 exam, from $250 million in investments in the purported fraudulent CDs in 1998 to $1.1 billion in 2002. In 2002, these examiners identified the same red flags that had been noted in the previous two examinations: “the consistent, above-market reported returns,” which were “very unlikely” to be able to be achieved with “legitimate” investments.

After the examiners began this third examination of Stanford, the SEC received multiple complaints from outside entities reinforcing and bolstering their suspicions about Stanford’s operations. However, I found that the SEC failed to follow up on these complaints or take any action to investigate them.

In October 2004, the SEC exam team conducted a fourth exam of Stanford’s investment advisor. Again, they saw that the suspected fraud had grown significantly. As of October 2004, Stanford customers held approximately $1.5 billion of CDs with approximately $227 million of these CDs being held by US investors. The 2004 examination specifically concluded that the Stanford customers were part of a “very large Ponzi scheme.”

At that time, the examiners prepared a formal referral to Enforcement to specify in detail all of the reasons that a formal investigation should be opened. The Enforcement referral characterized the Stanford CD returns as “too good to be true,” noting that from 2000 through 2002, Stanford reported earnings on investments of between approximately 12.4 percent and 13.3 percent, while the market indices reviewed were down by an average of 11.05 percent in 2000, 15.22 percent in 2001, and 25.87 percent in 2002.

Later that year, the Enforcement staff sent Stanford another voluntary request for documents, which Stanford essentially ignored. After no documents were received, SEC Enforcement officials were poised to close the Stanford investigation until continuous pushing from the examiners and a change in leadership in Enforcement finally led to the new head of Fort Worth Enforcement deciding to open a formal investigation in November 2005.

However, in 2005, the Enforcement staff rejected the possibility of filing an “emergency action” against Stanford because they felt they had only circumstantial evidence that it was a Ponzi scheme. Over the next several years, the SEC continued investigating Stanford, but bureaucratic issues slowed them down. At one point, the Department of Justice (DOJ) asked the Fort Worth Enforcement staff not to pursue further investigative action while it considered how to launch its own investigation of possible wire fraud and/or money laundering activity. The SEC officials would routinely go back to DOJ officials seeking to continue their investigation, but DOJ kept asking them to continue to wait. After December 11, 2008, when Madoff confessed to perpetrating his Ponzi scheme, the SEC staff felt an increased sense of urgency regarding any ongoing investigations of possible Ponzi schemes. They contacted the Federal Bureau of Investigation (FBI) again and learned that the DOJ’s investigation was still in its early stages. At that point, the SEC contacted DOJ and expressed its concern about deferring the SEC investigation any longer, and it was decided that, in light of the revelations about Madoff’s Ponzi scheme, the SEC could pursue its investigation.

Finally, Charges of Fraud

The SEC quickly finished its investigation and on February 16, 2009, filed a complaint in court against Stanford alleging that representations he made to investors regarding the safety of their CD investments were “fraudulent” and sought emergency relief. Based on the SEC’s request, the court immediately issued a temporary restraining order, froze Stanford’s assets, and appointed a receiver to marshal those assets. The SEC gathered additional evidence and filed an amended complaint on February 27, 2009, adding allegations of a Ponzi scheme. On June 19, 2009, Allen Stanford was charged with fraud, conspiracy, and obstruction in a twenty-one-count indictment handed down by DOJ. Facing a maximum sentence of 250 years, he surrendered to the FBI.

Once again, I struggled for answers as to how it was possible that the SEC, which had issued these numerous exam reports documenting Stanford’s potential fraud, could not have commenced an investigation and brought an action at an earlier date. I found the answer in the SEC-wide incentives in place at the SEC at this particular period. I found that the Fort Worth Enforcement program’s decisions not to undertake a full and thorough investigation of Stanford were due, at least in part, to Enforcement’s perception that the Stanford case was difficult, novel, and not the type favored by the SEC. The former head of the Fort Worth office, Hal Degenhardt, told me that SEC regional offices were “heavily judged” by the number of cases they brought and that it was very important for the Fort Worth office to bring a high number of cases. A Fort Worth assistant director named Jeffrey Cohen, who worked on the Stanford matter, said that everyone in Fort Worth “was mindful of stats” since they “were recorded internally by the SEC in Washington,” and there was heavy pressure to bring a high volume of cases.

Spencer Barasch, the former head of the Examination program in Fort Worth, told me that the Enforcement leadership in Fort Worth “was pretty up front” with the Enforcement staff about the pressure to produce numbers, and this pressure for numbers incentivized the Enforcement staff to focus on “easier cases”—“quick hits.” As a result, he said, anything that did not appear likely to produce a number in a very short period got pretty short shrift.

I found that Fort Worth Enforcement believed that Stanford “was not going to be a quick hit” for a variety of reasons, relating to the fact that Stanford’s CDs were issued by an Antiguan-based entity, complex legal issues relating to whether Stanford’s CD’s were actually a “security” under US statutes, and the deep pockets of Stanford and his many lawyers.

I also found indications during the investigation that the early lack of US investors in Stanford’s CDs led to some reluctance on the part of the SEC to prioritize bringing a case against Stanford. SEC examiner Julie Preuitt recalled that in 1998, the lack of US investors was an issue that caused some folks in Enforcement to not want to conduct an investigation, although she did not understand why this issue mattered if there was evidence that a US broker-dealer has engaged in fraud. Mary Lou Felsman, the former assistant district administrator for the exam program, also recalled that in 1998, the staff believed that no US citizens had purchased Stanford CDs and that the SEC itself was not interested then in entertaining cases not involving US citizens.

Ironically, had the SEC filed an action earlier, significant US investor losses could potentially have been avoided. In 1998, the SEC estimated Stanford brokerage and advisory clients may have invested as much as $250 million in the CDs. In 2002, the estimate increased to investments of $1.1 billion. In 2002, the SEC estimated that of the $1.5 billion of outstanding CDs, $227 million were now held by US citizens. In the 2009 complaint, the SEC said that Stanford had sold more than $1 billion in CDs per year between 2005 and 2007, including sales to US investors, noting that the bank’s deposits increased from $3.8 billion in 2005 to $5 billion in 2006, and to $6.7 billion in 2007.

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