Wednesday, March 30, 2011

Ponzi Schemes and Sophisticated Investors

So when you read about a small, $50 million dollar, Ponzi scheme coming to light, you almost always read about some gullible investors who had no idea they couldn't make 50% returns in a legitimate business deal. The list of victims was recruited from friends or family in an affinity fraud and almost always includes a bunch of doctors and dentists who have too much money and think they need a bunch more but don't understand risk and return. It is very rare that the so-called sophisticated investors who understand risk and return get duped. The following story was sent to me by a former student, Robert Madsen, who pointed out that this is what makes this story incredible...

Only rarely do we hear of sophisticated investors falling for a Ponzi scheme but normally the scheme doesn't carry the unmistakeable red flag of "a 40% return is too good to be true!" In fact, Bernie Madoff is the only real Ponzi schemer that I know of who duped the "sophisticated investors" as he promised much more reasonable returns of about 10-15% but claimed to have a strategy that made his returns bullet proof even in market downturns.

The really sophisticated among Madoff's victims, such as the many hedge fund managers, may have concluded that he had some magic formula that made his outrageous claim possible.  Or maybe they thought he was doing something shady through his brokerage business but they were willing to let him do whatever it took to get a steady return since they were making tons off of him. Ultimately, these "sophisticated investors" were willing to take a calculated risk that sounded somewhat plausible and Bernie duped them big time. Until then, the hedge fund managers and the likes were the ones scoffing at anyone caught in a Ponzi scheme. Until a guy named John "Scott" Clark from the Logan, Utah was able to dupe some of these guys again.

Clark was charged by the SEC two days ago for running a Ponzi scheme that took in almost $50 million in what was supposed to be a payday lender operation that would generate 55-80% returns to investors. According to several sources, the amazing thing about this relatively little scheme is that Clark was able to get $15 million from three hedge fund managers! "What," you say, "these are supposedly the sophisticated investors." Yes, and Clark duped them.

How he duped them is also pretty amazing. You'd think that a sophisticated investor would also know that next to an outrageous promise of return, the thing to watch for is a shiny, smooth talking, manager who can build others' confidence but you won't be conned by him. Not so this time. Several sources are quoting a spokesman from the SEC as saying that Clark was a shiny salesman type who you might buy a snowmobile from.

Some other notable characteristics of this case that put it in the "another small Ponzi scheme, just like the other Ponzi scheme" category is that Clark spent almost all the $50 million on himself by buying multiple fancy cars and other "things." The guy was a small town, unsophisticated, greedy, materialistic, run of the mill Ponzi schemer and three hedge fund managers couldn't see it.

That case definitely says something about hedge fund managers. Madoff showed us they are often greedy and willing to take large sums of money without doing any research while taking their millions (like Ezra Merkin). Clark is showing us that some of them are all those things and aren't very sophisticated either. Maybe the combination of these things is why the SEC has recently announced they will be looking carefully at any hedge fund that beats the market by 3% or more.

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