Abstract
Thomas Petters successfully ran a $3 billion show over 13 years. His illegitimate "asset based lending" scheme seems to be very simple and the promised returns were too good to be true. Then, why did so many investors miss his misconduct for such a long time? A golden rule to avoid a potential fraud is: there is no free lunch. But, there are three other critical steps investors could have taken to avoid the massive losses they suffered.
Case Profile
Background
From as early as 1995 through September 2008, Thomas Petters (“Petters”), a prominent businessman in Minnesota, perpetrated a massive Ponzi scheme through the sale of promissory notes to investors. While Petters’ $3.65 billion fraud dwarfs Bernie Madoff’s $65 billion, it is still the third-largest hedge fund fraud case as of today (Jan 2012).
After failing several retail businesses, Petters started a wholesale brokerage business, which later became Petters Co, Inc., (“Petters Co”) in 1988, and traded closeout, overstock, and bankrupt company merchandise, which were usually traded with a huge discount. Petters Co and its affiliates bought those merchandises and sold them to “Big Box” retailers such as Wal-Mart and Costco, but such transactions usually took up to 180 days to complete and that the sellers or manufacturers demanded payment upfront while the retailers did not pay until the merchandise was delivered. In order to finance this 180-day period (“purchase order inventory financing”), Petters issued a short-term (up to 180-day) promissory note with a large coupon payment (from 10 to 18% p.a.) to at least 20 investors.
There were at least four fund operators of feeder funds, which are set up primarily to purchase secured notes from Petters Co and its affiliates. Shortly after the arrest of Petters, SEC accused all four operators, including their principals, for knowingly supporting the fraud scheme. According to various court documents, these feeder funds raised more than $4 billion from their investors, including a well-known fund of hedge funds operators.
Source: various court documents; figures are rounded
Many feeder funds are structured to purchase the notes from subsidiaries or affiliates of Petters Co. In order to show legitimacy of the scheme, Petters Co. established bank lock box accounts, or “Escrow” account, over which Petters Co has no control. All payments from the Big Box retailers shall be paid into the accounts. Each feeder fund had a slightly different scheme, but the fundamentals are basically the same. The following diagram is the scheme used by Stewardship.
Source: SEC vs. Stewardship (2009)
Doug Kelly, a personal lawyer of Petters, became a court-appointed receiver in the Petters’ bankruptcy and filed about 200 lawsuits, seeking to recover about $2 billion. As of Dec 2010, he had collected about $200 million.
Problems
Petters fabricated purchase orders from retailers and used them as collaterals to borrow money through hedge funds. In reality, paying 10-18% interest on highly secured paper sounds too good to be true and the scheme crafted by Petters was relatively simple compared to other Ponzi schemes. So, why did many investors, who directly purchased the Petters paper or indirectly invested in the feeder funds, fail to detect his misconduct?
The reason he could run this $3 billion Ponzi scheme over so many years was largely due to the negligence of investors and lack of operational due diligence. The stable return stream of the feeder funds (1.0-1.5% a month with almost no fluctuation) was, if true, attractive not only for individual investors but also institutional investors who obsessively sought “low volatility, low correlation” opportunities.
The payment scheme with the lockbox accounts described above should have worked well if it were operated and monitored properly by the direct holders of the notes (i.e., feeder funds). But, it was a sham as the feeder fund operators never conducted due diligence as promised.
Petters and his affiliates indeed knew very well how to manipulate investors’ psychology and many investors thought they were invested with a legitimate lending practice:
By being informed that all promissory notes were secured by purchase orders from the Big Box retailers, investors made themselves believe that Petters should have not made such obvious lies
Multi-layered schemes, including subsidiaries/affiliates of Petters Co and feeder funds
The lockbox account scheme gave a false sense of security
Payments were made on time for over 13 years of its existence until the very late stage of the scheme
No audit was legally required at the level of borrowers (Petters Co and its affiliates), even though annual audit for the feeder funds were conducted by reputable audit firms (they might have missed several key issues during the audits)
Recommendations
Conduct extensive background checks on all related parties
This is one of many cases in which background checks should have helped investors to avoid investing in the scheme. But, it was important for investors to conduct all related parties since investors tend to conduct background checks on principals of feeder funds for various reasons (mainly due to the high cost to execute background checks).
For example, on May 22, 2005, a potential investor emailed one of the feeder fund operators, stating that a third party “report indicated that Mr. Petters’s background includes a criminal history (fraud or forgery convictions, possibly with prison time served), along with significant civil litigation, including a recent $5 million fraud suit.” In fact, Petters had been convicted of several felonies, including a 1983 conviction for writing a bad check, a 1989 conviction for forgery (for which he served time in prison), and a 1990 conviction for theft by check.
New York hedge fund manager Richard Bookbinder of Bookbinder Capital Management passed on an investment after he learned that Petters had lied on a Dun & Bradstreet questionnaire about earning a degree from St. Cloud State University.
Mr. Bookbinder late said, "Things popped up and we didn't feel comfortable. When people gave money [to Petters] they didn't ask, 'Who's this guy? What's his background?' The question is: This information was out there in 2002. We looked at it and we're a small firm; why didn't other people look at it?"
Confirmation on the Big Box retailers and their payments to the lockbox accounts
In 2005, AG Deutsche Zentral-Genossenschaftsbank Frankfurt Am Main (“DZ Bank”), a German lender, discovered that the lock box account did not function as Stewardship represented in its offering materials. DZ Bank made this discovery in the course of performing due diligence for a line of credit to Stewardship’s operating company called Acorn Capital Group, LLC.
In 2008, Acorn sought a loan from Fortress Investment Group LLC (“Fortress”), but Fortress decided not to loan Acorn money after it learned that the Big Box retailers did not make payments directly into the lock box accounts as explained by Acorn.
For an investor of a feeder fund, it could be difficult to obtain transaction details of the lock box accounts. However, it is possible to conduct due diligence by calling some of the Big Box retailers whether they recognize Petters Co and its affiliates as counterparties of the transactions and whether they recognize purchase orders, which many feeder fund operators claimed as collaterals for the notes they purchased.
Confirmation of registration as a Registered Investment Advisor
Arrowhead Capital Management LLC (“Arrowhead LLC”), and Arrowhead Finance told their investors and potential investors that Arrowhead Corp. (predecessor of Arrowhead LLC) and, later, Arrowhead LLC were registered with the SEC as investment commission. While Arrowhead Corp did registered with the SEC on November 27, 1995, but terminated its registration on July 7, 1997 before Arrowhead raised any capital for its funds. A quick online check at the SEC website should have revealed that it was not true and investors should have considered it as a red flag.
Resources
U.S. Securities and Exchange Commission (2009). Litigation Release No. 21124 / July 10, 2009. SEC Website
U.S. Securities and Exchange Commission v. Thomas J. Petters, Gregory M. Bell, and Lancelot Investment Management LLC, and Inna Goldman, Inna Goldman (2009). U.S. District Court for the District of Minnesota.
U.S. Securities and Exchange Commission v. Marlon Quan, Acorn Capital Group, LLC and Stewardship Investment Advisors, LLC, et al (2009). U.S. District Court for the District of Minnesota
U.S. Securities and Exchange Commission v. Marlon Quan, Acorn Capital Group, LLC and Stewardship Investment Advisors, LLC, et al (2009). U.S. District Court for the District of Minnesota
Ellerbrock Family Trust, LLC; Belmont Strategic Income Fund, LP, on behalf of themselves and all other similarly situated v. McGladrey & Pullen, LLP (2009). U.S. District Court for the District of Minnesota
Lancelot Investors Fund, LP, Lancelot Investment Management, LP v. Thomas Joseph Petters, Thousand Lakes, LLC, Petters Company, Inc., Nationwide International Resources, Inc., Enchanted Family Buying Company, Larry Reynolds, Michael Catain, Deanna Coleman, & Robert White (2009). U.S. District Court for the District of Minnesota
Moylan, Martin. “J. P. Morga Chase sued to recover Petters fraud funds”, Minnesota Public Radio website, December 30, 2010