Chapter 6Individual Factors: Moral Philosophies

and Values

Frauds of the Century

Ponzi vs. Pyramid Schemes

Ponzi scheme:

A type of white-collar crime that occurs when a criminal—often of high repute—takes money from new investors to pay earnings for existing investors.

The money is never actually invested and, when the scheme finally collapses, newer investors usually lose their investments.

Ponzi vs. Pyramid SchemesPonzi scheme:

This type of fraud is highly detrimental to society

Huge financial impact

Displaces consumer trust in business.

Despite the high-profile cases like Bernard Madoff, Tom Petters, and R. Allen Stanford, Ponzi schemes continue to be used in any industry that includes investing.

Ponzi vs. Pyramid Schemes

Pyramid scheme:

Offers an opportunity for an individual to make money that requires effort.

Usually this is in the form of an investment, business, or product opportunity This type of fraud is highly detrimental to society.

The first person recruited then sells or recruits more people, and a type of financial reward is given to those who recruit the next participant.

Ponzi vs. Pyramid SchemesPyramid scheme: The key aspect of a pyramid scheme is that

people pay for getting involved. Each new individual or investor joins in what

is believed to be a legitimate opportunity to get a return, which is how the fraudster gets money.

Unlike a legitimate organization, pyramid schemes either do not sell a product, or the investment is almost worthless. All income comes from new people enrolling.

Ponzi vs. Pyramid Schemes

Pyramid scheme:

Direct selling businesses that employ a multilevel marketing compensation system are often accused of being pyramid schemes because of similarities in business structure, although multilevel marketing is a compensation method that involves selling a legitimate product.

Charles Ponzi

The original Ponzi schemer

Saw way to profit from international reply coupons

International reply coupon: guarantee of return postage in response to an international letter

Lived a fairly opulent life outside Boston

Charles Ponzi

Success came from personal charisma and ability to con

People trusted him because he created an image of power, trust, and responsibility

Fraud exposed in 1920

Scheme was self-destructed after one year

In order to give earlier investors their returns, he had to continually draw people in

Tom Petters Operated the third largest Ponzi scheme in U.S.

history at 3.65 billion dollars

Petters Company, Inc. (PCI), Petters Group Worldwide’s wholesale brokerage firm operated the Ponzi scheme

Scheme was believed to have lasted for over a decade

Petters was eventually sentenced to 50 years in prison without appeal He continues to maintain his innocence, saying

he did not find out about the scheme until shortly before his arrest

Bernard Madoff Most notorious Ponzi scheme conductor

Scheme lasted a very long time and was of great magnitude

Madoff’s fraud lasted because of his respectability and reputation as a market genius

Used his legitimate success and high visibility to start a second money managing business

Promised consistent returns of 10-12 percent

Attracted billions of dollars

Appeal to invest created through exclusivity

Bernard Madoff Stated strategy: buy stocks while also trading

options on those stocks as a way to limit the potential losses “Split-strike conversion”

Used intermediaries known as “feeders” to continuously draw new clients Feeders profited by receiving fees

Money was never invested Money was deposited in banks and was moved

between Chase Manhattan Bank in New York and Madoff Securities International Ltd., a U.K. corporation

Bernard Madoff 2008: economy collapsed

Clients requested deposits back

Turned himself in to his sons

He was arrested on December 11, 2008 Charged with criminal securities fraud

Still had approximately $200-300 million left in the company

Sentenced to 150 years in prison

Fraud billed as a $65 billion Ponzi scheme Actual amount may be below $10 billion

Securities and Exchange Commission (SEC) highly criticized for the fraud

Insider Trading at the Galleon Group

Company Overview

The Galleon Group was a privately owned hedge fund firm

Provided services and information about investments (stocks, bonds, etc.)

Made money for itself and others by picking stocks and managing portfolios and hedge funds for investors

Founded in 1997

Company Overview Company’s philosophy: it is possible to deliver

superior returns to investors without employing leverage or timing tactics

The company held monthly meetings

Executives explained the status and strategy of each fund to investors

Investors were told that no Galleon employee would be personally trading in any stock or fund the investors held

Company Overview The federal investigation and prosecution of members

of the Galleon Group is the largest insider trading case in U.S. history.

Over two dozen people were implicated, and Raj Rajaratnam, an eccentric millionaire and head of Galleon, was convicted of 14 counts of securities fraud and conspiracy.

Rajat Gupta, a man of high influence as Director of McKinsey & Co., was convicted for participating in the scheme and was sentenced to two years in prison.

The investigation ushered in a new era in white-collar crime prosecution because wire taps and other techniques were used to secure convictions.

Insider Trading Cases are incredibly difficult to prove because:

Prosecutors must demonstrate that the defendant not only acquired insider information but also that he or she used that information to trade stock in a way that damaged a company.

While regulators have passed more legislation to discourage insider trading, prosecutors are becoming more aggressive and are using strategies previously only seen against drug and organized crime rings.

Hedge Funds Hedge funds

A combination of assets bundled together with various strategies that minimize risk.

Created as an unregistered investment management company and is meant to maximize returns while minimizing risk or exposure.

Invest in a broad range of assets, including equities, bonds, and commodities.

Only investors who meet criteria set by regulators can participate in hedge funds.

Are not sold to the general public

At its peak, the Galleon Group invested $7 billion.

Hedge Funds Hedge fund managers typically invest their own money in the funds they

manage

Management fee Investors typically pay this fee Fee goes towards the operational costs of the fund Usually ranges from 1 to 2 percent of an investor's assets in the fund

Performance fee

Fee investors pay when the fund’s net asset value is higher than that of the previous year

Fee is typically 20 percent of the fund's gains in a given yearExample: if a client invested $100,000 and the fund earned 40 percent in one year, the additional fee would be $8,000, or 20 percent of the investor's $40,000 gain

The performance fee was Galleon’s main source of revenue. The fees associated with hedge funds can generate massive wealth for

hedge fund managers.

Securities Fraud

Because hedge funds are not sold to the general public, hedge fund managers have not been subject to the same restrictions as other investment fund advisers.

After the recent financial crisis, new regulations were passed to increase government oversight and eliminate regulatory gaps between different kinds of investment funds.

Securities Fraud

The Dodd-Frank Wall Street Reform and Consumer Protection Act of July 2010Require hedge fund managers holding more than $150 million

to register with the SEC as investment advisers.

Hedge fund managers with less than $100 million in assets are subject to state regulations.

Requires hedge funds to provide information about trades and portfolios so that the Financial Stability Oversight Council can monitor and regulate systemic risk.

Securities Fraud Securities fraud occurs when a person or company

misrepresents or misuses information that investors utilize to make their financial decisions.

The types of misrepresentation involved in securities fraud include:

Providing false information

Withholding key information

Offering bad advice

Offering or acting on inside information. In Galleon’s case, it was found to be engaging in insider

trading.

Other Unethical Practices Aside from insider trading, Rajaratnam and his colleagues at the

Galleon Group engaged in other unethical practices

Tax shelter

A kind of investment that allows investors to reduce their taxable income, such as pension plans and real estate.

Not all tax shelters are legal.

In the Galleon case, Rajaratnam was accused of having a fraudulent tax shelter, because he hid taxable money in foreign bank accounts.

Shell corporation

A company that has legal status but provides no products and has few, if any, assets.

Shell companies are illegal if they are used for income tax evasion or are formed to attract funding.

Player and Employer Shared insider information about

Charges/Convictions

Raj RajaratnamGalleon

At the center of the insider trading network; pled not guilty to 14 charges of insider trading and fraud; sentenced to 11 years in prison and ordered to pay over $66 million in penalties

Danielle ChiesiNew Castle/ Bear Stearns

IBM, Sun Microsystems, and AMD

Pled guilty to charges of securities fraud; sentenced to 30 months in prison, two years of supervised release, and 250 hours of community service

Roomy KhanIntel, Galleon

Intel, Hilton, Google, Kronos

Pled guilty to charges of securities fraud, conspiracy to commit securities fraud, obstruction of justice, and agreed to the government’s request to use wiretaps; sentenced to one year in prison and ordered to forfeit $1.5 million

Central Players

Copied from page 519 in Business Ethics: Ethical Decision Making and Cases

Player and Employer Shared insider information about

Charges/Convictions

Anil KumarMcKinsey & Co.

AMD Pled guilty to passing inside information to Rajaratnam in exchange for $1.75 million; sentenced to two years probation

Rajiv GoelIntel

Intel Pled guilty to passing inside information; sentenced to two years probation

Rajat K. GuptaGoldman Sachs

Goldman Sachs, Proctor &Gamble, McKinsey

Accused by the SEC of passing insider tips to Rajaratnam; sentenced to two years in prison and a $5 million fine

Adam SmithGalleon

Galleon, ATI, AMD Pled guilty to giving inside information directly toRajaratnam over a six-year period; sentenced to two years probation

Copied from page 519 in Business Ethics: Ethical Decision Making and Cases

Central Players

Player and Employer Shared insider information about

Charges/Convictions

Micheal CardilloGalleon

Axcan Pharma, Proctor & Gamble

Pled guilty receiving tips indirectly from Rajaratnam; allegedly has evidence about Rajaratnam’s trades based on insider information; sentenced to three years probation

Zvi Goffer a.k.a. the “Octopussy” Schottenfeld Group, Galleon

Hilton, several others Had a reputation for having multiple sources of insider information; allegedly paid others and gave them prepaid mobile phones to avoid detection; pled not guilty to 14 counts of conspiracy and securities fraud; convicted on all 14 counts and sentenced to 10 years in prison

Copied from page 519 in Business Ethics: Ethical Decision Making and Cases

Central Players

The Impact The Galleon case is the largest investigation into insider trading

within hedge funds

Twenty-six people were charged with fraud and conspiracy

Galleon closed in 2009 after investors quickly withdrew over $4 billion in investments from the company

Over a dozen companies’ stocks were traded based on allegedly nonpublic information. These trades could have affected the financial status of the companies, their stock prices, and their shareholders

Federal authorities hope that the Galleon convictions deter other powerful investment managers from engaging in insider trading

The Impact

The Galleon insider trading investigation was the first to use wiretaps, which are usually used to convict people involved in terrorism, drugs, and organized crime

This set a precedent for insider trading cases

Electronic surveillance will likely become the technique of choice for white-collar crime investigations

Most investment firms rely on email, phone calls, and other digital information