You Can't Cheat an Honest Man

by James Walsh

  Gordon and Boula’s attorneys said they would appeal Duff’s sentence. They contended that he had exceeded federal sentencing guidelines, which would call for a prison term ranging from 30 to 46 months for each man.

  A federal appeals court later held that sentences for crimes arising out of a Ponzi scheme were not subject to enhancement on the grounds the defendants specifically targeted elderly investors. So, it asked Duff to reconsider his sentence. He did—and found stronger legal grounds for keeping the same, harsh sentences. Specifically, he wrote:

  In this court’s view, the crime is more heinous if, as in this case, there are 3,300 [investors] and the total loss is $7 million as opposed to if there were 10 [investors] with the same loss....

  CHAPTER 3

  Chapter 3: A Better Mousetrap Makes a Good Scam

  New technologies have a rich history of fraudulent promotion. Over the last hundred years, crooks have promoted perpetual motion machines, water engines and magic elixirs. In the last 20 years, real technological advances have made outlandish promises seem a little more plausible.

  As recently as the early 1980s, few people would have guessed that hundreds of millions of dollars would be made in stock offerings for companies that make Internet web browsers. A few years before that, no one would have known what to think of recombinant DNA drugs. And these issues say nothing of more modest tech advances, like cellular phones and satellite TV.

  Like predators sensing a kill, Ponzi scheme perpetrators are drawn to this high tech confusion. “Whenever a new technology comes over the horizon, we see the same types of scams,” says Paul Huey-Burns, assistant enforcement director at the SEC. Though this remark could apply to any high tech issue, Huey-Burns was talking specifically about a favorite Ponzi scheme premise of the early 1990s—wireless cable.

  The wireless cable television business centered on a new technology that transmitted television programming signals through microwave relay systems, rather than through wire cables. This eliminated the capital-intense process of connecting homes to cable networks. It removed the cable from cable TV. It also made it possible—at least theoretically—for small, scrappy start-up companies to compete with giant cable companies. And the actual product is virtually unregulated. Ponzi perps didn’t miss the chance to exploit this opportunity. They promise outlandish returns—as much as several hundred percent—in a few months. The pitch will usually have something to do with acquiring licenses for transmission access cheaply and then selling them to an established cable player. It has nothing to do with the truth. The perp takes a big chunk of money out immediately, never puts anything into the cable system and runs the pyramid long enough to blur his tracks.

  Other wireless cable deals will have some basis in truth. The perp will actually acquire a license and will use at least some of the investment proceeds to build a system. The rest of the money goes in the perp’s pocket. Then, he’ll operate the company for a while or sell it to a larger company for less than the amount he raised in investments— hoping no one loses enough to sue.

  As far-fetched as they may be, these schemes were a booming business in the mid-1990s. In 1997, the SEC was prosecuting more than 20 wireless cable fraud cases, involving more than 20,000 investors and $250 million. In a single 1996 civil lawsuit, the SEC sued four companies and 14 stock promoters who pitched nearly $19 million in investments in wireless cable systems from 1992 through 1994.

  Wireless cable is another example of an idea that makes more sense to investors than it should. Many people think they know the cable industry because they watch a lot of ESPN and HBO. “It was the largest mix of people I’ve ever seen,” says a southern California perp who sold bogus wireless cable securities in the early 1990s. “When you’re selling gold or real estate, you get wealthier people who think they know what they’re doing. In wireless cable, you get all kinds. Doctors and dentists, sure. But also truck drivers and people working retail. They’re greedy. They might have heard Peter Lynch or somebody say ‘invest in things you understand.’ And they think they understand TV.”

  The State of the Crooked Art: Pre-paid Telephone Cards

  As the 1990s wore on, consumer complaints and SEC investigations chased many Ponzi perps out of the wireless cable business. Many moved into a field in which the technology issues were much more basic—but popular demand was much greater: long distance telephone service.

  The deregulation of AT&T was a shining moment of 1980s smallgovernment ideology. It allowed companies like MCI and Sprint to become billion-dollar giants and drove down the cost of most long distance telephone service. It also created dozens of small long distance companies that focus on finding cheap, aggressive ways of marketing their services. In short, the long distance telephone business became a commodity market, in which price drove market share.

  While investment-oriented Ponzi schemes do best in industries with big mark-ups and profit margins, sales-oriented pyramid programs do well in fields with thinner margins. This is one of the most important distinctions between the two. And it’s the reason that some of the most devoted Ponzi perps have experience running either kind of scheme. They size up a market, a company and a population—then start an investment- or sales-oriented scheme based on which will work best, accordingly.

  When an industry transforms from a regulated monopoly (or near monopoly) to a price-driven commodity market, legitimate multilevel marketing mechanisms will flourish. They’re cheap and relatively effective1. Where legitimate multilevel marketing schemes flourish, illegal pyramid schemes—their black sheep relatives—will follow.

  In early 1995, the Better Business Bureau of San Diego County warned that southern California residents were being exploited by a multilevel marketing operation that was engaged in the long-distance phone business.

  The company was Irvine-based National Telephone & Communications (NTC). Its corporate parent was Incomnet, a publicly-traded company also based in southern California. NTC sold long-distance telephone service and prepaid cards which allow people to make calls from public telephones. It also sold distributorships for selling the service and cards. Critics claimed that it cared more about selling distributorships than signing up actual long-distance customers.

  1 For more detail on multi-level marketing and its uneasy relationship with Ponzi schemes, see Chapter 14.

  For $95, a person could become an NTC distributor. But distributors were strongly encouraged to pay $495 to attend Long Distance University, a “leadership course.” (According to an NTC newsletter, the course was “a requirement for becoming an area marketing manager.”) Finally, for another $700, a distributor could become a “certified trainer”—and sell distributorships to other people.

  The BBB was concerned that Incomnet made its money from a pyramid scheme—not from selling long-distance service. About 24 percent of Incomnet’s 1994 revenue came from fees paid by distributors and trainers. “Based on our investigation, we believe the average sales rep for NTC can expect to make less than $100 a year,” said Lisa Curtis, president of the San Diego BBB. Curtis went on to say that ethnic groups—primarily Hispanics—were being recruited with particular intensity by NTC.

  Beginning in the summer of 1994, NTC and Incomnet started having some severe problems. A number of sales representatives were leaving NTC—and many of these were complaining that it hadn’t paid them earned commissions. The Better Business Bureau noted: “Our complaint history shows a failure to eliminate the basic cause of complaints alleging problems with billing for long-distance service.”

  Incomnet insisted the approach was legitimate and that it wasn’t the pyramid critics alleged. But, as the BBB group was making its announcement, word was circulating that NTC and Incomnet were being investigated by the SEC for operating an illegal pyramid scheme.

  A January 1995 Incomnet press release said that rumors that it was under SEC investigation were “categorically false.” But the next day, a company spokesman sheepishly said Incomnet wasn’t under a “major
” investigation. Two weeks later, the company issued a “clarification” conceding that it had indeed been under an SEC investigation since August 1994.

  The SEC wasn’t the only group looking into the companies. The California Attorney General’s office was probing whether Incomnet complied with the state’s “business opportunities” law. (The law requires marketers to register with the state if, among other things, sales representatives must pay $500 or more to join.)

  As much as anything, critics of NTC were concerned about some of the people running it. The long-distance operation was designed by two people who were involved with Kansas-based Culture Farms, Inc.2—an infamous pyramid scheme in which some principles went to jail.

  Jerry Ballah, NTC’s marketing director, had settled a civil lawsuit over his role as a consultant to Culture Farms. (Ballah was also involved with another multilevel marketer of long-distance phone service, Arizona-based NCN Communications.) Chris Mancuso, NTC’s director of product development for a brief time, had served nine months in prison for his role in Culture Farms.

  NTC and Incomnet weathered the regulatory storms of 1995. By early 1997, NTC was still in business. But it had turned its focus more sharply on ethnic groups and selling pre-paid phone cards, rather than traditional long-distance service.

  “Pre-paid phone cards are the perfect product for a Ponzi scheme trying to pass as legitimate multilevel marketing,” says one former Ponzi perp. “They have the gloss of high tech...but they’re actually inexpensive and need to be replaced constantly.”

  Even the most grizzled Ponzi perp can’t predict where the next hightech schemes will emerge. But a number of people who know how the schemes work guess the premise will be genetically-engineered cosmetics and dietary supplements. “You started to see hints of this when the FDA was holding back on approving new AIDS drugs,” says a federal law enforcement official who’s helped prosecute dozens of Ponzi schemes. “The combination of biotech sizzle with the triedand-true appeal of make-up and vitamins is a great pitch for Ponzi scammers.”

  Case Study: United Energy Corporation California-based United Energy Corporation operated at the intersection of technology, tax havens and larceny.

  2 In the Culture Farms scam, some 28,000 investors lost about $50 million buying kits that would grow milky “cultures” in a glass, supposedly to be processed into cosmetics. Most of the cultures grown were simply recycled into new kits and resold to investors.

  UEC President Ernest Lampert, who claimed to have made a fortune in construction and other business ventures in Alaska and Hawaii, had a fairly utopian plan. His company would generate electricity from high-tech solar modules suspended in pools of water—and sell the juice to local utilities. It would then use the hot water produced by solar electricity to raise warm-water fish and produce ethanol and high protein cattle feed as byproducts.

  UEC installed a network of 3,000 photovoltaic solar-cell collectors on man-made, acre-sized ponds in the rural California towns of Borrego Springs, Barstow and Davis. From the air, the “solar farms” looked like huge checkerboards. The 20-by-20 foot photovoltaic modules were shallow boxes with concave surfaces that focused sunlight on solar cells. They were mounted on islands about 208 feet in diameter, with aluminum frames packed with Styrofoam. These islands floated in a few feet of water.

  Water was piped through the modules to cool them; this would then heat the ponds for fish breeding. The whole process was part of what Lampert called an “integrated life system.”

  Better still: Lampert claimed that UEC’s solar energy cash flow would be heavily tax-advantaged. The average module, over its 30-year life span, would produce net cash flow of $243,775, all for an out-ofpocket investment of only about $15,000.

  The promised tax benefits proved to be grossly exaggerated. Still, UEC sold 5,323 aluminum and silicon solar energy devices to 4,500 investors for $30,000 to $40,000 each. That was a total take of more than $200 million—though only about $83 million was collected. “Ernie was a consummate salesman,” says Patrick Jordan, a lawyer who bought a solar module from Lampert.

  UEC recruited life insurance agents and financial planners to sell modules on a commission basis. The contracts for the modules usually provided for down payments ranging from 36 percent to 43 percent of the purchase price, with the remainder financed by long-term, generally nonrecourse, promissory notes which were payable in semiannual or annual installments and secured by the modules themselves. In a typical United Energy sales agreement, a person bought a $40,000 module with a $14,500 down payment and signed a 30-year promissory note for $25,500 in monthly payments. There was some truth to the tax-advantage claims. Federal and state tax credits created in 1982 to spur investment in renewable-energy programs allowed a UEC investor in the 50 percent tax bracket who put down only $14,500 on a module to reap tax benefits of $23,235 in the first year.

  So, for UEC’s investors, many of them lawyers, accountants or engineers, the company’s sales pitch offered a chance to invest in a socially beneficial program and a lucrative tax shelter at the same time.

  Early investors were paid for power their modules never produced. In typical Ponzi scheme fashion, UEC made it appear that the business venture was a success. It fabricated kilowatt hours of production for each module and paid owners more than $4 million for this phony productivity.

  The truth: UEC solar farms produced a negligible amount of power. The farms actually sold a total of less than $3,500 of electricity, in part because about 1,200 of the modules bought by investors were either not built or not installed.

  Almost half of those that were installed didn’t have a critical element, the solar cells that chemically convert sunlight to electricity. Lampert said that problems with solar-cell suppliers forced him to install many of the modules without cells in order to meet IRS requirements that the devices be “placed in service” to qualify for tax benefits. Because the modules were capable of producing thermal energy—that is, heating the water—they technically functioned.

  This kind of slippery logic was typical of Lampert’s business ethic. He was also a virtuoso of self-dealing. Among his transactions:

  • Renewable Power Corp., owned by Lampert’s wife Delphine, actually owned the hardware and real estate at the three solar farms. It rented the integrated life systems to UEC.

  • United Financial Corp., owned by Lampert himself, and operated as a financing unit whose sole income was a 1 percent interest markup on investors’ money as it flowed from UEC to Renewable Power.

  • Lampert executed an agreement with himself, as “exclusive designer” of various renewable-energy equipment, to receive a 4 percent commission on UEC’s gross sales. Besides his $75,000 annual salary, the arrangement brought him about $2.7 million.

  By early 1984, word was circulating among UEC investors that the company was being investigated by the IRS and California state regulators. In April 1984, eleven southern California investors who put a total of almost $400,000 in UEC filed a lawsuit claiming fraud.

  John Bisnar, an attorney for the group, said that his clients intended to use the investments as a means of lessening tax liabilities. Instead, they learned that the devices were “never purchased and never installed,” Bisnar said. “In the beginning, everything seemed to be all right. Perhaps [UEC] got too successful and got more investors than they could handle.”

  Bisnar said the investors would be pleased if they could recover their investments and attorney’s fees. “If Lampert called tomorrow and said ‘I’ll give them their money back,’ I’d be willing to drop the whole thing,” Bisnar said. The call never came. But more trouble did.

  In October 1984, UEC and Renewable Power were named in a civil lawsuit filed by the California Corporations Commission, which alleged violations of state securities laws. The state tried to get an injunction to put the companies out of business—but the court refused, insisting the case go to trial.

  By early 1985, well before any of the 30-year benefits were seen, UEC
filed for protection from creditors under Chapter 11 of the federal Bankruptcy Code. By the bankruptcy trustee’s accounting, more than $40 million of the $83 million received by UEC went to manufacturing and construction of solar modules, the ponds and manufacturing equipment. About $7.3 million was spent on research and development, $12 million for operating and marketing costs, $12 million for sales commissions and $4.7 million in payments to module owners for “purported but fictional power sales” to public utilities. The payments made UEC a Ponzi scheme.

  The trustee alleged that $20 million in UEC assets, including three condominiums valued at more than $600,000, four airplanes, two cars and nearly $2.7 million in “royalties” were “fraudulently or otherwise improperly transferred” to Lampert and Lampert-controlled entities.

  In March 1987, a federal court ruled that the Lamperts had operated an abusive tax shelter that “perpetrated a massive fraud upon the public and the government.” The ruling, by Magistrate Claudia Wilken, enjoined the Lamperts from selling tax-shelter-related investments without prior Internal Revenue Service approval. Wilken concluded that Lampert had “diverted money from UEC for the purpose of hindering the Internal Revenue Service. He has engaged in extensive deceptive and fraudulent practices and made it clear that he intends to continue these practices.”

  Wilken also ruled that Lampert had diverted $4.5 million from UEC into his own bank account. Finally, she wrote:

  No buyer with reasonable knowledge of the relevant facts would buy a UEC module at any price....Such a buyer would have realized that UEC’s modules had no chance of producing any significant income and that tax credits would never become available because the modules would never be placed in service and because the...operation was a sham.... The best evidence of the modules’ value is the Trustee’s sale of them for scrap, which will bring at most several hundred dollars.

  One of Lamperts attorneys said the findings “[weren]’t supported by the evidence” and he intended to appeal the ruling. He said that Lampert already had been assessed more than $9.5 million in abusivetax-shelter fines by the IRS even though the judge who had presided over the state actions had “found absolutely no evidence of any type of Ponzi scheme.”