State of Fraud

This is a good article that appeared in the April 2010 edition of Utah Business.  It looks into why Utah has so much securities fraud and echos many of the same conclusions discussed elsewhere in this blog.

State of Fraud

Why is Utah Rife with Fraudulent Investment Schemes?

by Gaylen Webb

It’s been about four years since Val Southwick, the Bernie Madoff of Utah con artists, received his ticket to the state penitentiary for the biggest fraud scheme in Utah history. Today, Southwick sits quietly in a cell in Gunnison, serving out his nine consecutive sentences. Although he pled guilty and expressed remorse at his sentencing, he routinely declines media interviews and is mum about his fraud conviction and the tactics that supported his grand deception.

Despite the imprisonment of Southwick and other con men like him, much has remained the same—Utah is still fertile soil for all sorts of white-collar crimes and, especially, for affinity fraud.

“We haven’t learned our lesson,” says Utah Division of Securities Director Keith Woodwell. “The message hasn’t sunk in deep enough.” This is apparent, as the case volume at the Utah Division of Securities, along with the number of complaints and enforcement actions, went up significantly in 2009 and 2010 and are still “stubbornly high.”

Many fraudulent investment deals fly under the radar when the economy is good and investors are plentiful, only to collapse when the economy turns sour. Such was the case in Utah from 2008 to 2010, when numerous Ponzi schemes couldn’t support their own weight in the bad economy and the stream of new investors dried up. But what has surprised Woodwell is the number of new enforcement actions and complaints that have emerged since the economy began to improve.

“We thought maybe the numbers would drop back down and we would see fewer complaints and fewer enforcement actions that we were filing. That has not been the case. We have no shortage of new cases coming in the door,” he says.

Meanwhile, the FBI says Salt Lake City ranks among the top five Ponzi scheme hot spots in the nation, rubbing shoulders with the likes of Los Angeles, New York, Dallas and San Francisco. And the $1.4 billion in fraud losses the Salt Lake City FBI office reported in 2010 has since grown closer to $2 billion, according Special Agent Jim Malpede.

“That’s huge. By comparison, our cases in San Francisco were much smaller. The point is, given our small population, the dollar volume of losses from con men in Utah, comparing apples to apples, is worse on a per capita basis than in San Francisco,” Malpede says.

Gullibility, Greed and Trust
What makes Utah such fertile soil for financial fraud? The propensity for Utahns to fall victim to fraud, and especially affinity fraud, is often due to a trifecta of gullibility, greed and trust. Both Woodwell and Malpede say con artists prey on all three, but especially on a relationship of trust, where victims have some type of “affinity” or common ground with the con artist that elevates the level of trust, such as membership in the same church, club or professional circle.

“In Utah, we tend to know who our neighbors are. It is a very different community dynamic with a lot of inherent trust,” Malpede says. “It makes Utah a great place to live but also makes us vulnerable to this type of activity.” Indeed, most Utahns don’t presume that the neighbor bringing them lasagna or offering to help them move in is also scheming to steal their life savings.

Other con men, like Madoff, have proven that the trust problem isn’t unique to Utah. For example, Madoff’s empire swindled wealthy Jews, Europeans and country-club types. But Utah’s culture of tight social networks, close-knit church congregations, friendly neighbor-hoods and communities does make for easy pickings by con men.

Woodwell describes one con artist who defrauded a woman in his Church of Jesus Christ of Latter-day Saints (LDS) church congregation by saying he had come from the LDS temple, that he had been very blessed in his life and that he had prayed about what he should be doing now. “He told her, point blank, he had received a revelation that his mission in life now was to help people like her with their finances. Essentially, he said ‘I have been sent by God to help you.’ That’s a powerful argument. If you feel like this is a good person, and you share the same faith, you can understand why that kind of strategy sometimes succeeds. The guy ended up just flat out stealing her money.”

Analogous to Child Abuse
The penchant to prey upon people’s trust infuriates State Senator Ben McAdams, who is also a securities attorney.

“It enrages me,” says McAdams. “In Utah, we are quick to make friends. We are a genuinely friendly state, but the people of Utah shouldn’t have to trust less. That’s who we are, but there are people in our communities that take advantage of our greatest qualities and turn them against us.”

McAdams says affinity fraud is analogous to child abuse: a person in a position of trust victimizes another individual who has trusted them in good faith. Hence, McAdams has pushed bills through the State Legislature to bolster the state’s ability to crack down on fraud, especially affinity fraud. “My legislation creates a private remedy, saying victims can go after the assets of third-party individuals surrounding the perpetrator,” he says.

For example, in Val Southwick’s case, there were alleged third-party promoters out soliciting investments for Southwick’s company, Vescor. “What happens to them?” McAdams asks. “Did they know the investment they were promoting was a fraud? Under current law, a victim of a financial fraud may only recover treble damages (actual damages multiplied by three) against a participant in a fraud—but only if it can be shown that the individual had actual knowledge, or was reckless as to whether the investment was a fraud. This is a high burden to meet.”

Through his latest legisla-tion, an individual may now recover treble damages against a third-party promoter of a fraud if it can be shown that the promoter exercised undue influence by using a relationship of trust or position of authority, and the promoter was negligent about the fraudulent nature of the underlying investment.

“Negligence is a much easier burden to satisfy than actual knowledge or recklessness,” he explains. “This opens up an avenue to go after third-party promoters. They have a higher burden of responsibility and can’t be negligent as to whether the investment is real or a fraud. Third parties are in the best position to ascertain if the investment is real. It also opens the door to help victims recover losses.”

Such measures are noteworthy and move Utah forward in its fight against fraud, especially since understaffed enforcement offices often have a difficult time keeping up the caseload. Malpede admits that the FBI just doesn’t have the resources to go after many of the down-line, third-party promoters of fraud schemes.

McAdams addressed that problem at the state level this year by sponsoring a bill that appropriates $2 million in onetime money to create a fraud prosecution unit in the Utah Attorney General’s Office. The money, which comes from a recent mortgage settlement with major banks, will allow the AG’s office to hire as many as five additional people, including a financial analyst, two investigators, a paralegal and a fraud prosecutor.

We Con Ourselves
One of the reasons affinity frauds are often successful is because standard rules of investing generally don’t get applied. Woodwell says the good con artists out there help us con ourselves.

“The best scammers don’t give you a high-pressure sales pitch. In fact, what they do expertly is make the appearance that they are doing extremely well. They talk about how great things are for them, and you then approach them. It is somebody you know—it’s your friend, it’s your neighbor, it’s somebody you go to church with—and so you ask, ‘What is it you are doing? I see you
just bought a new Porsche. Where are you getting all this money?’ And they talk a little bit about it and of course dangle in your face what a great business opportunity they have going on,” he explains.

“They will dangle the investment in such a way that you feel like it was your idea to invest with them; they are doing you a favor by letting you in to this fantastic opportunity. And so in that sense, people feel like they are not being conned into something. And of course, we all want to believe at some point our ship is going to come in and we will have the opportunity to get rich. So if somebody does a good job of dangling that out there and making us think this investment is it, this is our chance, we’ll jump on it, without asking all of the questions we should, or maybe being as skeptical as we should.”

It would be nice if people would just pick up the phone and check out the investment before they part with their money, Woodwell says. “It is very different investing with Charles Schwab verses a neighbor or friend. If they will just call the Utah Division of Securities or the FBI and explain what they are looking at investing in, we will check it out for them.”

Vetting an Investment
The key to safe investing is to do your research first. Check the investment out, Woodwell says, and “make sure you know what you are getting into before you put your money in.”

Woodwell’s office can determine if the investment and its offeror are licensed in the state and if there have been any complaints filed. Further, a significant amount of information concerning scams and how to avoid them is published online by both the Utah Division of Securities and the FBI.

Woodwell also advises that investors remember the basic rules of investing, one of which is never put all of your money into one investment. Another is never investing more than you can afford to lose.

Of course, not all Ponzi schemes start out as such. Legitimate investments can turn fraudulent when a business’ financial situation turns sour and its owners use new investments to pay returns to previous investors. “At least half of the Ponzi schemes that we are looking at probably fit into that category. They didn’t start out fraudulent, but turned into fraud later on, when the owners were not honest with their new investors,” says Woodwell. Hence, it is also important to stay active and involved with your investments.

In terms of fraud prevention and prosecution, there is only so much the government can do. Malpede believes the only thing that will make a real difference is education.

Brent Baker, shareholder and director at the law firm of Clyde Snow, agrees. “Education is the key component,” he says. That’s why Baker organized the Fraud College, which held its annual event in February. After working for the Securities and Exchange Commission as a fraud buster for many years, Baker was tired of seeing businesses ruined and lives destroyed. He started talking to his friends in law enforcement and the regulatory agencies about putting on an annual educational event and received overwhelming support.

Approximately 400 people attended this year’s Fraud College, which included Gov. Gary R. Herbert and LDS Church Public Affairs Director Michael Otterson as host speakers. The event brought together enforcement officials, victims and even former fraudsters to offer Utahns a crash course in how to detect bad investments and affinity fraud schemes.

The Utah Division of Securities and the FBI have also engaged in public service campaigns to educate investors about financial fraud. Woodwell’s office ran a series of TV spots and billboards a year and a half ago based upon the “I am a con man theme” to create public awareness, and just launched a new TV/billboard campaign based upon its new “Red Flags” theme, trying to educate people about what the red flags are with regard to investment offers.

A Black Eye
Sadly, the state’s fraud climate has given Utah a black eye.

“Nationwide, Utah has a reputation for fraud, and that is unacceptable to me. When you get a billion and a half dollars lost in a year due to fraud, Utah’s fraud industry essentially negates the economic impact of our beautiful ski industry. And not only are individuals being victimized, but legitimate businesses that need to raise capital—they’re being hurt as well,” says Baker.

The message Woodwell’s office is trying to get out is that fraud is a serious problem in Utah, but the good news is that it is usually preventable…if people will take the steps to do some checking, to do their due diligence before they invest. “It doesn’t hurt to do that extra check and get that extra opinion. It can prevent a lot of heartache and loss down the road,” he says.

Copyright © 2010 by Mark W. Pugsley. All Rights Reserved.

6 thoughts on “State of Fraud

  1. The rapport described is also a factor where unregistered individuals and firms raise capital (debt or equity). These firms claim connections and expertise. In addition, they describe state and federal security laws and regulations as burdensome or intrusive. The outright disregarded for the regulations and laws exposes these fraudsters to potential civil and criminal penalties and also pose serious problems for these individuals or firms that unwittingly retain them.

    Fraud is possible here also because those perpetrating it know that the targets are unlikely to undertake a minimal amount of due diligence. The trust engendered is also possible, to a lesser extent, because trusted advisors either do not understand the regulatory maze, inclusing registration exemptions, or they are kept out of the process to save money or resources.

    The UT Bar and other groups (financial planners, etc.) can take a more active role educating their members in an attempt to identify the problem areas and firms and individuals that operate illegally.

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