You Can't Cheat an Honest Man

by James Walsh

  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.

  A group of investors sued Chrysler First, arguing that the loans were part of the fraudulent scheme and, therefore, not enforceable.

  Delaware courts didn’t show much sympathy to the investors. In a March 1991 decision, James M. Burns, et al., v. John J. Ferro, et al., and Chrysler First, a trial court ruled that Chrysler First was not responsible for the fact that its borrowers spent their money in a Ponzi scheme. It agreed with Chrysler First that the borrowers knew they were getting into an illegal scheme and did so willingly:

  It would be far easier to turn straw into gold than to turn $5,000 into $40,000 legally under this scheme. The fact that [investors] had knowledge of the pyramid scheme is not in dispute. The promotional materials made it plain that the investment idea was a pyramid scheme from the beginning. They participated in promoting the “airplane” by recruiting new members to perpetuate the scheme. [They], therefore, may not seek relief.

  “Commonality” and “Efforts of Others”

  In the 1974 federal court decision SEC v. Koscot Interplanetary, Inc., the Fifth Circuit Court of Appeals defined some basic issues and terms. Koscot was a subsidiary of Glenn W. Turner Enterprises (an umbrella organization that owned a number of Ponzi and pyramid operations). Through Koscot, investors could make money both by selling cosmetics and by recruiting them as “supervisors” and “distributors” to sell cosmetics and recruit others.

  To obtain the right to make money through the recruitment of others required an investment of at least $1,000. That investment qualified a person as a “supervisor” who could then recruit other supervisors. For every supervisor recruited, the recruiting supervisor received $600 of the $1,000 paid by the new supervisor. For $5,000, an investor could become a “distributor” who could then recruit both supervisors and distributors in return for a share of their investments.

  The details of the scheme were fairly standard. But the court decided that it was important to distinguish whether the Koscot distributorships counted as a security—like a stock, bond or promissory note— and, therefore, whether Ponzi scheme precedents could be applied.

  In order to be a security, an investment needs to be made in a common enterprise in which investors give over control of assets to another entity. In discussing the common enterprise element of the scheme, the court recognized that “[t]he critical factor is not the similitude or coincidence of investor input, but rather the uniformity of impact of the promoter’s efforts.”

  It quoted an earlier appeals court decision which held:

  A common enterprise managed by...third parties with adequate personnel and equipment is therefore essential if the investors are to achieve their paramount aim of a return on their investments.

  This may sound like a pretty generic description of any investment vehicle—but, in the context of a Ponzi scheme, it’s what distinguishes an elegant con from simply sticking a gun in someone’s face and taking his money.

  Using this analysis, the Fifth Circuit ruled that “the requisite commonality is evidenced by the fact that the fortunes of all investors are inextricably tied to the efficacy of the Koscot meetings and guidelines on recruiting prospects and consummating a sale.” These meetings and guidelines were very much like those of most pyramid schemes— they were almost evangelical in their intensity and they focused more on getting paid than on the substance of the investment.

  This left one other key pyramid scheme issue for the Koscot court to consider. Ponzi perps often argue that an investor’s losses are the result of investors not working hard enough to keep the scheme going. In other words, the reason that Grandma lost the $20,000 she pumped into her cosmetics distributorship is that she didn’t do enough to sell lipstick or recruit salespeople. She deserved to lose the money. And, technically, the fact that she had to do some work to keep the scheme afloat means that the cosmetics distributorships didn’t count as securities in the first place.

  In this narrow sense, the perps might have a point. The Securities and Exchange Acts of 1933 and 1934 defined securities in part as investments whose success or failure came “solely from the efforts of others.” But some courts had allowed broader interpretations of that phrase.

  The Koscot court agreed that “solely from the efforts of others” wasn’t meant to be a tool for protecting Ponzi perps. It ruled that a literal interpretation of the requirement would frustrate the original intent of the law. Instead, “the critical inquiry is whether the efforts made by those other than the investor are the undeniably significant ones, those ess
ential managerial efforts which affect the failure or success of the enterprise.”

  Since, in most Ponzi schemes, the answer to that question is Yes, the court concluded that the perps don’t have a right to Grandma’s $20,000.

  Case Study: Elliott Enterprises

  From 1980 to 1987, Charles Elliott managed a collection of investment companies that included Elliott Real Estate, Inc., Elliott Securities, Elliott Mortgage Company, Inc., and Elliott Group, Inc.

  Elliott Securities was a stock brokerage. The other companies marketed investment vehicles created and managed by Elliott. The brokerage operated primarily as what one former employee called “a fish pond.” Clients with the money to buy and sell large amounts of stock were invited to meet Elliott. The sales pitch was simple: “We can get you 7 percent down here but if you want 18, you’ll have to go upstairs to see [Elliott].”

  Most of Elliott’s 1,400 investors were retirees who believed they were gaining a high-yield tax haven for their life savings.

  In fact, they were being sucked into a Ponzi scheme. Like many smart Ponzi perps, Elliott made a big show of religious devotion. In his newsletters, he often quoted the scriptures. “Every letter we got from him made me think this is one of the most religious men I’ve ever dealt with,” recalled one investor.

  In his first newsletter of 1987, Elliott wrote floridly:

  I am reminded of my strong commitment and relationship with God. I believe that spiritual strength is the only strength because it is capable of infinite renewal....I personally approach 1987 inspired to be honest, humble, courageous, clean-hearted, patient and noble.

  In the meantime, he was using gullible investors’ money to collect conspicuous signs of God’s favor—flashy things like rare jewelry, vintage cars and trendy art. He threw lots of parties, including a big Christmas party every year for employees and investors.

  Less piously, Elliott decorated his offices with photographs of himself with politicians and celebrities. He’d boast especially about his ties to Republican power-brokers. Some potential investors were told that Elliott was one of Ronald Reagan’s “personal financial advisers.”

  The political boasts weren’t Elliott’s idea. He’d grown up in rural North Carolina and still saw most things—including confidence schemes— from a farm boy’s earnest perspective. William Melhorn, chief executive officer for Elliott Enterprises, was the man who saw the obvious connection between power and money.

  Melhorn had begun as a special assistant to Elliott and quickly worked his way up to chief executive officer. The two men had met in the mid-1970s. Melhorn was out of a job, following the collapse of an earlier enterprise, and Elliott needed people with...particular...experience.

  In public, Elliott said his special expertise was municipal bonds and other tax-advantaged investments—and that investments with his firms were insured by the Securities Investor Protection Corp. In private, though, the most common investments he peddled were socalled “repurchase agreements.” Essentially, these agreements were loans made by investors to Elliott (and, therefore, not insurable by SIPC). The loans may have been collateralized by municipal bonds— but investors never actually participated directly in the investments.

  The SEC would later charge that most of the loans weren’t really collateralized at all. (Elliott kept a small portfolio of muni bonds, which he pledged dozens...and possibly hundreds...of times as collateral.)

  Free to use investment proceeds any way he chose, Elliott tended toward speculative start-ups and boneheaded real estate deals. But he was disciplined about keeping payments current with investors. “Elliott paid like a slot machine,” said one associate. “He lulled everyone to sleep.”

  He had to borrow extensively to maintain the appearance of a thriving business, though. And his precarious circumstances always pressured him to chase new investors to pay off old ones. All the while, Elliott used investor funds to pay for his personal living expenses— including medical expenses and mortgage payments on his various houses. His sole employment during the lifespan of the scheme was as president of Elliott Enterprises—for which he never received a salary. Instead, he compensated himself by commingling investors’ money with his own.

  There was no legal mechanism to prevent him from doing this. Because Elliott Enterprises was an unincorporated business, Elliott could draw upon company bank accounts as though they were his personal funds. He kept a separate personal account on the books of Elliott Enterprises and moved money into this account whenever he needed it. At several points during the scheme, his account had a balance of more than $1 million.

  The SEC was first alerted to Elliott in 1986. During the summer of that year, Elliott Realty employee James Gersonde convinced his mother to invest about $400,000 with Elliott. Gersonde’s brother John, who lived in Michigan, felt the deal was too good to be true. John asked questions but didn’t like the answers he heard. His mother and brother claimed that they were earning a guaranteed 10 percent on money placed with Elliott—and that this income was tax-free. John rightly suspected a tax-free investment which paid as much as 10 percent—let alone a “guaranteed” 10 percent. So, he contacted the SEC office in Miami. (Though his mother was later happy she’d been able to get her money out of Elliott Enterprises, John Gersonde said at the time “she was furious with me for ruining her tax-free investment. Livid.”)

  The Feds called Elliott to their Miami office for questioning. He showed up at their offices but refused to explain his operations in any detail. Surprised by Elliott’s brashness, the SEC agents let him go. But Elliott Enterprises was in their investigative sights.

  In the early part of 1987, which was the peak of its success, Elliott Enterprises owed approximately 940 investors about $60 million in repurchase agreements and other loans. However, word was spreading fast through south Florida that the Feds were after Elliott. And interest checks started coming less reliably. Through this all, Elliott maintained a kind of crazy impetuousness. One worried investor who telephoned the company was told by an Elliott Enterprises employee that Elliott had been called to Washington by President Reagan for emergency financial advice.

  There’s no question that personal charisma was one of Elliott’s keenest tools. “He would make decisions that weren’t logical at all,” one former associate said. “You’d wonder. Then you’d look around at the office, and all he had put together, and you’d say ‘This guy must know what he’s doing. Maybe he sees a bigger picture than I do.’”

  Like many persuasive Ponzi perps, Elliott was able to convince some investors that the Feds were the villains. “I don’t think the SEC is being very nice to Mr. Elliott,” one investor told a local newspaper. “We honestly feel he hasn’t done anything all that wrong.”

  Nice or not, the SEC filed a civil suit against Elliott and his firms in early 1987. The SEC suit was the final blow for Elliott Enterprises. The Ponzi scheme collapsed and interest payments ceased.

  In the immediate aftermath of a court-ordered receivership, Elliott’s investors and creditors stood to recover a little more than 10 cents on the dollar. For any more, they would have to sue someone. Within a few months, Elliott and Melhorn were facing a major criminal indictment—which included 22 counts of fraud under the Investment Advisers Act, six counts of securities fraud under the Securities Act, 10 counts of mail fraud, and one count of conspiracy.

  “I’m not sure that apart from market forces and unwise investments that he has an explanation for what happened,” said David Pollack, Elliott’s lawyer. “I think [it was] just a series of investments that didn’t work out the way he thought they would.”

  But one former Elliott employee offered a more likely explanation: “His ego told him he could stay ahead of the game and it would all pay off. I don’t think he had any criminal intent. He really thought he could give them what he promised.”

  The legal proceedings didn’t go well for Elliott. In August 1988, a federal judge ordered him to “disgorge” $1 million for the receive
r’s benefit. Elliott was not able to comply because he didn’t have any money. In January 1989, he was ordered in a civil suit to turn over his personal jewelry and household effects to the SEC. In March 1990, a federal trial jury returned a verdict of guilty on all but two of the criminal charges Elliott and Melhorne faced. Elliott was sentenced to three consecutive five-year prison terms. Melhorn received three consecutive four-year prison terms.

  In April 1994, a federal appeals court considered Elliott’s last gasp at arguing his innocence. Elliott claimed that the trial court should have listened to testimony from his satisfied customers when considering his intent to defraud. The appeals court didn’t agree:

  No amount of testimony from satisfied customers could “average out” Elliott and Melhorn’s intent to defraud when they continued to solicit new investments and reassure old investors while concealing millions of dollars in losses per year with fictitious audits and phantom collateral....

  But Elliott remained free on bail while he filed other appeals. “Last time I heard, he was living up in Tallahassee,” one burned investor said. “They just keep appealing and appealing. He’s never served a day. I hope he winds up in jail, though. He should serve some time.”

  CHAPTER 2

  Chapter 2: Location, Location, Location...Then the Money’s Gone

  Real estate seems to beg Ponzi schemes.

  Historically, Ponzi perpetrators have focused on commercial real estate development programs. They’d often use the so-called “four-fromthree” formula—which is often used by legitimate developers.

  In this kind of deal, the developer finds a good property, lines up potential tenants and may even arrange partial financing. To find the money he needs to complete the project, he looks for three investors (the number can, of course, vary) who will each put in a set amount of money in exchange for an equal ownership interest. In the case of three investors, each one gets a 25 percent interest and the developer gets an equal 25 percent interest for the time and effort that went into setting up the project.