You Can't Cheat an Honest Man

by James Walsh

  Of course, the basic fee was only the beginning. ILN encouraged inverstors to join one of its select clubs. For an additional fee of $100, $500 or $1,000, an investor could become one of the cream of ILN’s sucker crop.

  Club membership entitled a person to the benefits provided to basic investors plus newsletters and seminars on money management. As a member of the $500 or $1,000 Club, a person could participate in ILN’s Property Rights Acquisition program (PRA), which offered real estate investment training courses. And, finally, there were the bonus programs.

  By recruiting friends and family to join, ILN investors could participate in the Capital Fund Bonus System and the Maximum Consideration program. These programs directed portions of new investors’ fees to the people who’d recruited them.

  For each new investor recruited, an Independent Representative received 50 percent of the new member’s fee for whichever club he or she joined. The Independent Representative also received a descending percentage of the club membership fees paid by new investors recruited “downline” through recruits (and recruits of recruits) to the fifth level of recruitment.

  ILN summed the recruitment process up in a slogan often repeated in its literature and at its meetings: “First you join. Then you bring your wife and kids.” Investors would invite potential recruits to so-called “President’s Nights.” These were the meetings that looked and felt like revivals.

  Ford was always the featured speaker. He’d enter a crowded hotel ballroom to the soundtrack from the movie Flashdance. Then, he’d deliver a lengthy presentation—part motivational speech and part financial evangelism—rousing the crowd with chants like “I will not accept defeat” and “I’m the captain of my ship.”

  In a complaint it filed during the peak of Ford’s activity, the SEC summed up his appeal with typical understatement: “He is both engaging and persuasive.” The engaging and persuasive man called ILN’s Capital Fund Bonus System “the most powerful financial system since banking.” And a disturbingly large number of his listeners agreed.

  If Ford had stuck close to the original structure of his scheme, ILN would probably have continued on even longer than it did. Although ILN was pretty plainly a Ponzi scheme, Ford was cautious enough—at first—to avoid flagrant violations of investment and securities law. But, as time went on, he expanded his operation into an investment operation that would prove his undoing.

  Offering Investments Instead of Advice

  Ford had experimented with mechanisms for convincing ILN’s winners to keep pouring their money back into his schemes. Beginning in 1990, he expanded these efforts into what he called the Property Rights Assignment Program.

  According to promotional materials, the PRA program offered investors “an opportunity to acquire property below market value.” Still part of ILN, the PRA program would assign tax lien sale certificates or rights to property acquired through foreclosures or government-assisted programs.

  According to the PRA material, purchasers of $1,000 PRAs would be assigned property rights assessed at $10,000; purchasers of $5,000 PRAs would be assigned property rights assessed at $50,000; and purchasers of $10,000 PRAs would be assigned property rights assessed at $100,000. The property transfers would be made within 180 days of the purchase of the PRA investment units. If this weren’t tempting enough, ILN salespeople added a cash kicker. They promised potential investors the option of cash payment of five times the initial investment.

  In other words, 180 days after making a $1,000 PRA investment, you could choose between $10,000 worth of real estate or $5,000 in cash.

  Many of the ILN investors lucky enough to get money out of the recruitment scheme jumped at the chance to parlay their profits. Few cared much about property rights assignments—most wanted five times their money in cash. During the entire two-years-plus lifespan of ILN and the PRA programs, only one property selection list was ever distributed.

  But Ford had stretched his persuasiveness too far. ILN declared bankruptcy in the summer of 1991, after the SEC filed a lawsuit charging that it was a giant Ponzi scheme. Of $110 million invested with Ford, only $1 million was recovered.

  Much of the SEC’s complaint focused on the PRA programs. The Feds claimed that promises made in the programs amounted to guarantees, which meant the investment units were securities. Investors, most black and elderly, packed a Washington D.C. federal courtroom in June 1991 to hear the SEC make its case against Ford and ILN. They were there in support of the man who had taken their money. In this way, the trial felt like a replay of Carlo Ponzi’s trials in the 1920s.

  After three days of live testimony and one day of argument, the court was still unclear about the mechanics of the ILN operation:

  Programs as described in testimony and in written material are frequently incomprehensible.... As the Court understands Ford’s explanation, a person who purchases a $1,000 PRA, a $5,000 PRA, and a $10,000 PRA, for a total of $16,000, is eligible for...up to $80,000 because...“the velocity of money increases to such a point, the ability to create wealth expands to such a degree, that we could come back and give somebody an award for up to $80,000.”

  Despite this gibberish explanation, the court found that the PRA programs fit relatively neatly into the framework established by the Supreme Court’s Howey decision. It concluded:

  Clearly, each involved an investment of money. Similarly, each involved a common enterprise in the sense that the fortunes of investors were inextricably tied to the efforts of ILN management....

  Ford insisted the investments weren’t securities. In his presentations, he had been careful not to make guarantees. He emphasized that ILN bonuses were awards and not commissions. However, he urged people to participate by saying “the system does work.... No, we can’t guarantee you any money, but we sure have got a system that can produce some.”

  The court didn’t find these evasions convincing. It concluded that the PRA programs constituted an investment contract. Sarcastically, it added:

  The Court continues to be puzzled about why neither defense counsel nor any of defendants’ witnesses has been able to explain how the velocity of money creates wealth. The Court regrets that Melvin Ford did not take the stand to more fully explain his novel theory.

  Most Ponzi perps are immune to judicial irony, though. In June 1996, Ford—who ended up serving no jail time for the ILN debacle—was offering get-rich-quick seminars at a resort hotel in Antigua. He invited investors to make a fortune using some vague off-shore banking techniques.

  Things You Can Do to Avoid Being Cheated

  Many people think of investments and the investment community as a secret society with a language and rules of its own. Of course, it’s not. Ponzi perps simply take advantage of investor hesitation—and sell their shady investments against better judgment.

  There are a number of things any investor can do to avoid being taken by a Ponzi perp peddling worthless investments. Before you put any money in an investment, do the following:

  1) Get a prospectus and read it. A prospectus should contain details on where the money is going, who will be responsible for it, and—most important—what the risks are.

  2) Understand that all investments entail some degree of risk. Ponzi perps like to say investments are guaranteed or government backed. But, in most cases, these terms don’t really mean much.

  3) Don’t invest because a promoter is a member of your church, country club or ethnic group. Affinity groups are a big mechanism for promoting Ponzi schemes and various other shady investments.

  4) Investigate the salesperson or broker—and the firm. Get the salesperson’s disciplinary history from state attorney general’s office or National Association of Securities Dealers (NASD).

  5) Don’t put all your eggs in one basket. Scammers try to get victims to cash in their savings or retirement money, saying it’d be easier to have it all in one place. That’s usually not the case.

  6) If you’ve already invested and are having trouble cashin
g out, watch out. Beware of brokers who cajole you into “rolling over” your money into a larger position.

  And, perhaps most importantly, law enforcement officials always remind investors not to let shame or fear stop them from reporting fraud or abuse.

  Case Study: Hedged Investments

  In terms of capitalizing on geek chic, James Donahue was 20 years ahead of his time. In terms of getting prosecuted for Ponzi scheme larceny, his timing was perfect.

  In 1974, shortly after the Chicago Board of Trade opened its Options Exchange, Donahue set to applying statistical theory and computer techniques to tracking and measuring trends in options. He was on the cutting edge of mathematics and finance; he wrote Options Strategies, one of the first textbooks on the subject, as well as a related newsletter during the mid-1970s.

  In 1977, Donahue formed Hedged-Investments Associates, Inc. for the purpose of operating an investment fund known generally as Hedged Investments. Donahue attracted investors to the fund by claiming he had developed a sophisticated, computer-based strategy for trading in hedged securities options. He boasted reliable, annual returns of between 15 percent and 22 percent.

  Donahue appealed to wealthy investors in the Denver area. He had an advanced degree in mathematics from Stanford. And he looked like an academic—tall, overweight and owlish. He wore business suits awkwardly but spoke in a calm, deliberate voice. His lifestyle spoke to reliability. He was an elder in his Presbyterian Church. He’d been married for 33 years. He lived in a nice, but unassuming, house in an upper-middle-class neighborhood.

  In the late 1970s and early 1980s, Donahue’s reputation spread quietly around the Rocky Mountain states.

  However, there was a dark side to the professorial analyst. Some investors said they suspected Donahue because of his reluctance to share information about the stock option trades. He didn’t offer audited statements. “He complained about how dumb the auditors were.... Not many CPAs understand hedging,” said one former colleague.

  Donahue dealt with hesitant investors in a disarming way. Rather than working hard to persuade, he simply told people to take their money elsewhere. “he used to say, ‘Look, I could just as well take your money and throw it in the ocean. If you are not comfortable with the way I do things, don’t participate,’” said one Denver-area financial advisor.

  What Donahue did do was guarantee investors a 25 percent annual return on their investments. He said his options investment program always produced returns of at least 19.7 percent. These numbers were compelling enough to make many investors forget their skepticism. When a person invested in Hedged Investments, Donahue would sell him or her shares in one of three limited partnerships. Donahue’s strategy was to combine buying or short-selling a stock with investing in call (sell) or put (buy) options in that stock. Whether the stock went up or down didn’t matter; Donauhue’s goal was to exploit inconsistencies in the small niches of the financial markets. (Theoretically, the price of a stock corresponds consistently to the price of its options; but markets sometimes make mistakes. When they did, Hedged Investments would make money.)

  Buying stocks and selling call options is considered a conservative investment strategy. But Donahue sometimes varied his positions so that he was investing more heavily in options—a far more speculative move. But, by using complex statistical models, Donahue seemed to make it work profitably. “There was always the possibility a stock would jump outside the range and cause a loss,” says Gregory McNichol, a money manager who helped Donahue establish his system. “But if he had 20 positions, it’s hard to imagine any one being bad enough to wipe out profits on the other 19. He used to preach the discipline of this thing.”

  But he practiced something far looser. Donahue failed to maintain separate accounting records for the Debtor Partnerships and commingled investors’ funds into a single checking account. In other words, he treated the investors as if they were direct participants in a single investment pool instead of investors in discreet limited partnerships.

  Donahue made money his first three years of operation, from 1978 to 1980, when he managed less than $2 million in assets for a small group of investors. But for the rest of the decade, he lost money routinely. After a few years, the program was insolvent— in that its cumulative losses exceeded its cumulative gains. The true source of funds paid to the investors as earnings were the funds obtained from the sale of partnership interests to new investors.

  Beginning in 1981, Donahue lost $2.1 million, then $1.7 million the following year, $2.6 million in 1983, slightly under $1 million in 1984 and slightly over that in 1985. In 1987, the year the stock market crashed, Hedged Investments lost $6.5 million. Far from admitting his losses, Donahue told clients and potential investors that Hedged Investments not only survived the Crash, but had achieved a 26 percent annual gain.

  His losses nearly quintupled in 1988, when he dumped $29 million into the market. There was some relief the next year when he made $5.7 million, but it was short-lived. And then, in 1990, he gambled on a heavy investment in United Airlines for his financial salvation. And lost.

  In the course of a few weeks, Donahue lost $90 million trading United Airlines options. There had been talk of a takeover at United; he believed it would come. As Wall Street concluded there’d be no takeover, the value of United options dropped—and Donahue kept buying. “There’s an old saying in investment circles: The trend is your friend. Don’t fight the trend,” says one West Coast money manager who knew Donahue. “He knew this. He just lost his mind.”

  Normally, Donahue pooled all of his investors’ money in to a handful of accounts. But, late in his scheme, he made one exception. This hastened his demise. In September 1987, Weyerhaeuser Corp.’s employee pension fund had made an initial investment as a limited partner in Hedged Investments. By February 1988, it had committed $17 million. Like most big pension funds, Weyerhaeuser allocates a portion of its assets to “non-traditional investments,” such as short-selling, commodities and options. Donahue had come recommended by several money managers in the Pacific Northwest.

  At the end of each quarter, Weyerhaeuser received a short statement showing its investment and its gains. Like most Hedged Investments investors, Weyerhauser staff didn’t question the temperamental genius down in Denver. In the spring of 1988, Weyerhaeuser gave Donahue another $5 million. But this time, it made a request. It split the money into two brokerage accounts handled by Kidder, Peabody and Morgan Stanley—but available to be traded by Donahue as he saw fit.

  This was a smart move. By looking at the monthly brokerage accounts, Weyerhaeuser could check for itself how Donahue was doing. This was the first time anyone had managed to audit Donahue’s performance.

  As it turned out, the timing was good for the temperamental genius. Donahue managed to make money steadily for about a year. In November 1989, though, he had to do some explaining. The brokerage reports showed huge losses from a large number of call options on United Airlines stock—which had dropped sharply in November. Even more disturbing: the reports showed no offsetting investments to act as a hedge against the United Airlines options.

  Donahue reassured Weyerhaeuser. He said the calls had been fully hedged by puts in the main Hedged Investments portfolios, where Weyerhaeuser still had most of its money. To prove his point, he transferred money into Weyerhaeuser’s separate accounts. He allowed Weyerhaeuser to assume that this money was its share of profits on the UAL puts. This is a typical tactic used by Ponzi perps trying to buy time.

  Weyerhaeuser money managers were calm for a few months. But the monthly reports continued to show a large number of UAL calls; and there were still no hedges in Weyerhaeuser’s separate accounts.

  In February 1990, Weyerhaeuser contacted Donahue again. They were worried. In April, the company’s money managers flew to Denver for a face-to-face meeting. Donahue was able to convince them that he was sticking to his model.

  In June and July, as the price of UAL common stock—and related call options
—fell, the Weyerhaeuser people called Donahue several times a week. Finally, they couldn’t take his word any more. In August, they demanded an accounting of the company’s funds in the pooled account.

  This demand broke Donahue. He admitted to Weyerhaeuser money managers that he couldn’t provide an accounting—and that there was no hedge in Hedged Investments.

  On August 30, Hedged Investments filed for voluntary bankruptcy pursuant to Chapter 11 of the U.S. Bankruptcy Code. On September 7, the case was converted to a Chapter 7 liquidation and the bankruptcy court appointed a trustee. In a videotaped message, Donahue tearfully told investors that he had lost all of their money. Specifically, he said:

  It is with deep remorse that I inform you that the Limited Partnerships in which you are a member have incurred a very significant financial loss.... At the request of many individual investors to keep the extent of their participation confidential, the total dollar amount of loss will be disclosed to you through correspondence and after a final accounting, and not at this semi-public meeting. The loss is extensive and involves almost all of the total assets of the fund.... My words at this point cannot possibly alleviate the emotion or financial impact on each person involved nor can they express the deep sorrow I have over this incident.

  He blamed the collapse on a general stock market decline caused by Iraq’s invasion of Kuwait, which presaged the Gulf War.

  However, after the initial panic over the losses subsided, two former employees said Donahue had told them as early as September that he had been “miscalculating” the returns on his limited partnerships for five or six years. In all, Donahue had lost $129 million in the stock market.

  In the end, only Donahue knows the path the money took. He kept no financial books, all of the accounts were commingled and only he saw the records of investment transactions.