Business Columns & Blogs

New scam involves old financial practices

Perhaps people are particularly naive, but once again I am shaking my head and asking, “How could anyone be so stupid?” while reading of yet another Ponzi scheme.

This one involves only $64 million and a few hundred victims, so it’s not in the league with Bernie Madoff or Tom Petters. Yet there have been many such scams in only a few years. One wonders what has happened to common sense.

First, the basics: The Securities and Exchange Commission has just acted to shut down brokers selling promissory notes issued by a Miami-based investment firm, purportedly to buy accounts receivable from businesses in Brazil. The notes supposedly guaranteed returns of 12 to 13 percent a year.

The notes are not registered with the SEC, nor is the local broker pushing them. Providence Financial Investments reportedly holds Brazilian receivables equaling only a sixth of investor funds. It is having a hard time collecting on the ones it does have. And the underlying economic fundamentals, including the state of the Brazilian economy and the value of its currency relative to the U.S. dollar, are moving against the scheme, even if it were completely legit. It obviously is not.

All the technical terms are confusing. What are “registered securities,” “accounts receivable” or “factoring?” Can one blame investors for being confused? The technical terms are real, though also perhaps used to obfuscate the risks. The money also is real — which leads one to ask whether confusion should lead to gullibility.

Start with the purported use of the investors’ money — short-term financing of Brazilian businesses. I saw this personally on a semester in Brazil in 1972. Apart from my studies I bopped around with friends. One was an engineer-contractor who built small factories, retail-office buildings and schools.

One of his clients ran a for-profit high school in Rio. He contracted my friend to add six classrooms. The contract specified payment of $35,000 at three stages of work. So it was both a construction agreement and a promissory note.

That contract was an “account receivable” for my friend Jaime. If he did the work, he had a legal right to money when specified. But, operating on a shoestring, he needed money for workers and material. So he went to a bank. But banks require collateral. Other than tools, the only asset Jaime had was the contract to construct school rooms. So this contract was pledged as security for the loan.

A contract is not money in the bank, however. Many things could happen, and the job took time. So the contracts were “discounted,” and Jaime got only $30,000 cash. As the payment dates fell due, the bank itself would collect from the owner. The difference of $5,000 was the bank’s fees and interest.

Jaime dealt with Bradesco, the “Brazilian Bank of Discounts,” now a huge multinational. Bradesco held onto the client’s IOU. But other banks might pass these on to others in a secondary “rediscount” market. For some, such “discounting” of accounts receivable was their only business. Such firms, called “factors,” exist here too. In U.S. practice, resorting to “factoring” is often seen as the last step above a mob loan shark for businesses with bad credit. But in many countries, borrowing on the basis of another person’s IOUs is a common practice, even for healthy businesses.

That brings us back to the SEC’s intervention. The brokers the SEC is shutting down took money to be put into large blocks, exchanged into Brazilian cruzeiros and used to buy business promissory notes in that country’s “discount” and “rediscount” markets. The larger the discount, the greater the return on a given IOU when collected. Interest rates in Brazil are high. Providence Financial in Miami promised investors 12 percent or more — in dollars.

However, risks in lending to small businesses in another country and currency are enormous. An expanded school or a store with new stock must actually enroll students or sell dresses to pay bills when due. Any financial intermediaries, banks, factors or whatever, have to be solvent and pass the funds along.

Moreover, the IOUs are all in Brazilian currency. As money works back to the U.S. lender, it must be exchanged into dollars. Even when every IOU is paid, if the value of the cruzeiro falls more than expected in comparison to the dollar, there won’t be as many dollars to repay some U.S. investors as promised.

“What could possibly go wrong?” A scammer sold these “investments,” at “Social Security seminars.” He was not a registered broker. The notes were not SEC-registered. Providence and the broker “guaranteed” an interest rate several times greater than what could be earned on other investments. All of this not only screams scam — it flashes fraud in blinking neon lights.

Add Brazil’s political and economic problems that would jinx an investment model like this, even if carried out honestly, and it becomes clear that the poor folks who bit are not likely to get much back.

Looking at the positive side, only 420 people allegedly were duped. The scheme allegedly breaks the law. The SEC is taking action. Some people could get at least nominal jail time. News of the affair may prompt other potential investors to be more wary.

On the pessimistic side, look at some of the “crowd funding” initiatives that are sprouting on the internet. Fascination with this new medium lulls people into ignoring risk in many ways, not just in appeals for working capital.

Regulation always lags technological innovation. Expect more scams, and new variations on an age-old theme, to emerge.

St. Paul economist and writer Edward Lotterman can be reached at boise@edlotterman.com.

  Comments