Introduction

Investors have very short memories.

Roman Abramovich, Russian billionaire

In the days before electronic point-of-sale tills, when you spent an evening in a bar with some friends you could try the following experiment: check the total cost of the drinks each time your group bought a round to see if the prices were consistent. Very often they were not, even though the drinks bought didn’t vary. Why did this happen and who was to blame? Perhaps it was because the bar staff weren’t very good at maths, and we should blame the State for allowing so many individuals to leave school without adequate numeracy skills. Perhaps the place was understaffed, and the bartenders were hopelessly overworked, leading to errors – in which case, presumably, we should blame the management and, if we are so inclined, the evil effects of alcohol on the customers who tended to become more and more demanding as the evening progressed. Let’s go out on a limb here: perhaps it was because some of the bar staff were overcharging for some rounds of drinks and pocketing the difference. Old-fashioned people would call that theft.

There are some similarities here with the financial services industry, which has come under attack in recent years, particularly since the banking crisis of 2008, for a whole range of shortcomings. Around the world it has expanded hugely since the 1980s, leading to a kind of consumerised capitalism in which armies of poorly trained staff have often missold and misdescribed investment products. Deregulation forced sleepy institutions to become aggressively competitive just to survive in the new environment. Also, customers, who were always quite greedy, seem to be becoming more so; for example, in some senses we, the public, ‘deserved’ the 2008 banking crisis because we took advantage of all the easy credit and we didn’t throw out the politicians who should and could have prevented the crisis.

This book isn’t really about those shortcomings, although they often come into the story. It’s about outright financial fraud, committed by individuals on a grand scale. This is where the bar analogy starts to break down. A barman is stealing from both you and his employers when he overcharges you, but he can only pocket the difference between what he charges you and the real price. In financial services it is sometimes possible to take much, much more, and it’s not only the workers at the bottom of the food chain who sometimes steal. In financial services, the people who can steal the most are often the bosses of the business.

For example, in 2009 Bernard Madoff, a former chairman of the NASDAQ stock exchange, well-known for his philanthropy and much admired for the success of his long-established stock brokerage firm, was convicted of defrauding his clients of almost $65 billion. In the same year, Sir Robert Allen Stanford, a Texan, was stripped of his Antiguan knighthood as US regulators began proceedings against him alleging his involvement in an $8 billion fraud of clients of his Stanford International Bank. In 2006, Kenneth Lay, CEO of Enron, the giant US energy company, was convicted on 19 counts of fraud, including false accounting and insider trading. Investors in Enron’s corporate bonds were outraged that the firm continued to be rated as AAA until only four days before its bankruptcy. In 2003, Parmalat, the Italian food conglomerate, collapsed owing $20 billion; its founder, the millionaire art-lover Calisto Tanzi, is currently serving a prison sentence for embezzlement and false accounting. In 2002, Worldcom, a US telecoms company, filed for bankruptcy, losing investors an estimated $100 billion; its former CEO, Bernie Ebbers, is serving 25 years for securities fraud and false accounting. In short, large-scale frauds occur frequently – they are not as rare as shocked media reports about the latest scandal can make them seem.

Investors who are victimised in large frauds rarely get all their money back; in fact, they often don’t get any of their money back. This book is primarily intended for investors who are interested in avoiding being abused in this way, but it will also be of interest to people who don’t invest in the stock market at all, because, as we will see, fraud and other financial misdeeds are sometimes so severe that they end up affecting the whole economy, not only of a particular country but also the whole world. For example, at the time of writing it is very hard in the UK to get a mortgage, even though a few years ago it was very easy; fraudulent practices in the sub-prime lending boom in the US in 2007 was a major factor in the series of events that led to this situation, where ordinary people in the UK are suffering. And we can spare a thought for the people of Greece, whose economy is currently in dire straits, in part because of long-term fraudulent accounting by their own government.

Sadly, governments don’t usually go to jail for fraud; the worst that can happen in a Western democracy is that the politicians get voted out. And as the excellent documentary film Inside Job, winner of the 2010 Academy Award for best documentary, has demonstrated, dishonest practices in financial services can be systemic, running like a fungus through government, government agencies, regulatory bodies, boards of directors, banks, corporations and even into academia. One of the most interesting aspects of the film was that it showed for the first time just how some senior academic economists (who in America can flit between university, boardrooms and government) had helped to provide a phoney intellectual justification for the financial excesses that were occurring, and they were in the pockets of the banks and corporations, which were profiting the most from the excesses. These academics knew better; they should have called for it to stop. Instead, they backed up a reckless free-for-all that they knew had to end in disaster. And before you assume that Inside Job was made by a bunch of fuzzy-minded political extremists, you should know that the director, Charles Ferguson, has a PhD in political science from MIT, started a software company he sold to Microsoft for $130 million, and says of himself, ‘I don’t think I’m an anti-capitalist or anti-business at all. I am, however, against large-scale criminality and if being against gigantic frauds makes me left wing, then so be it.’ Ferguson is hardly a bomb-throwing anarchist!

This book can offer no solutions to these grander socio-political problems. What it can do, however, is to show how big-time fraudsters – the ones who actually do go to jail – take advantage of opportunities to commit fraud on a large scale, and to suggest ways in which you might be able to spot a fraud and avoid it before it’s too late. The twelve chapters of the book are organised into four parts. The first part introduces some of the major frauds that have occurred during the last few decades to provide insight into the ways in which specific types of fraud tend to run in fashions, depending on the economic and political circumstances. The second part deals in more detail with the mechanics of particular frauds, and the third part takes a closer look at the ways in which investors, and the financial industry itself, can become vulnerable to fraud. In the final part, the focus is on the ways in which we, ordinary private investors, can protect ourselves against being victimised by fraudsters.

So, in Chapter 1, let’s look first at two of the most recent villains whose activities should and could have been stopped before they got so wildly out of hand: Bernie Madoff and Allen Stanford.