Why We Trust Fraudsters!
Today’s video is sponsored by the Daily Upside, a totally free, high quality daily business and finance newsletter. Visit the link in the description to learn more. In 1925, Victor Lustig was staying in Paris and noticed a newspaper article discussing the expense associated with maintaining the Eiffel Tower. The tower had originally been built as the centerpiece of the 1889 World's Fair and Eiffel originally only had a permit for it to stand for 20 years. It was supposed to have been dismantled in 1909 (in fact it was designed so that it could be quickly taken apart), but the tower had been allowed to remain after the permits expiration.
By 1925 the monument had fallen into disrepair, and the city was finding it increasingly expensive to maintain. The news article that Lustig read suggested that public opinion on the monument would move towards calls for its removal. This sparked the idea in Lustig’s mind that he could use the Eiffel tower for his greatest con. Lustig set to work first hiring a forger to produce fake government stationery for him and then invited a group of scrap metal dealers to a secret meeting. He introduced himself as the Deputy Director-General of the French Ministry of Posts and Telegraphs.
He explained to the men that due to the high maintenance costs, the French government were selling the tower for scrap, but that the deal had to be kept quiet to prevent public outcry. Lustig explained that he was in charge of selecting the scrap metal dealer who would buy and dismantle the structure and that the group had been selected carefully because of their reputations as "honest businessmen". The government had made this decision, he explained after careful consideration of the costs and due to the simple fact that the structure performed no function and didn’t fit in with the city's other great monuments.
Lustig found his mark in André Poisson—who he identified as an insecure man who hoped to rise in the Parisian business community. Lustig arranged a private second meeting separately with Poisson, explaining that because of his low government salary, he might chose Poison if he was paid a suitable bribe. Poisson paid the bribe and Lustig fled to Austria. Lustig wasn’t quite yet done though, as he suspected that Poisson would be too embarrassed to notify the authorities of what had happened and so he kept an eye on the French on newspapers from Austria.
When the story didn’t turn up in the press, he returned to Paris later that year to repeat the con. On the second attempt, with a new group of dealers one of them got suspicious and called the police. Lustig fled to the U.S. to avoid being arrested.
In the US Lustig continued with his career as a con man and even managed to con the notoriously violent mobster Al Capone. Lustig asked Capone to invest $50,000 in a crooked scheme, he put the money in the bank for two months and then returned it to Capone, claiming the deal had fallen through. Capone decided that he was dealing with an honest man.
When Lustig explained that the deal falling through meant that he was penniless and unable to support himself. Capone gave him $5,000 to "tide himself over", which had been Lustig’s plan all along. Lustig is alleged to have written a list of the ten commandments for conmen which we will get to shortly, but in a nutshell con artists like Charles Ponzi, Bernie Madoff and fraudulent businesses like Wirecard, Theranos and FTX exploit the fact that we go through life assuming that the people and businesses we deal with are real and honest and that there are institutions and processes in place to make sure that we are treated fairly.
In the book Lying for money, Dan Davies explains that trust is necessary in society as it means that we don’t have to spend all of our time on pointless checks. He points out that most deceptions could be caught quickly with basic due diligence, but nobody actually wants to spend all of their time confirming the facts, there are simply too many facts. It might appear to make as much sense for a banker to visit every office of a company applying for a loan as it does for the buyer of a bottle of milk to inquire after the health of the cow before each purchase.
Big frauds work because they exploit our beliefs in institutions, our faith that people will do things the right way. A big difference is that big frauds often take one large lump sum of money from investors, while a farmer who sells bad milk is in a business of repeated transactions. If he sells a bad product to a customer once, that customer likely won’t come back to buy from him the next day. Elizabeth Holmes was held up as an example of hard work and grit when she was named by Forbes as the youngest self-made female billionaire in America. Holmes, through her company Theranos, promised to revolutionize the field of blood testing, but it turned out that Holmes was just another start-up scammer who used blustery talk to sell investors on an idea that experts in the field of blood testing knew could not work. Phyllis Gardner, a professor of medicine at Stanford who worked with Holmes during her freshman year of college described how Elizabeth came to her and described her idea.
Gardner said, 'Elizabeth, that's a fun idea, but it's not going to work. She says that Elizabeth didn't really want scientific input. She instead aligned herself with very powerful older men who seemed to succumb to her charm. Those powerful men could influence people in the business world, the government and the department of defense.
Instead of studying the scientific literature on blood testing, Holmes allegedly studied research on human behavior that showed how body language, eye contact and vocal tone could command respect and approval. Her uniform of a black turtleneck evoked the memory of Steve Jobs, while conveying a sense of authority and eccentricity. She modeled herself on Steve Jobs, studied his body language and practiced pulling the blood nanotainer out of her pocket the same way Jobs did with the iPhone. Holmes lied about her machine working and exaggerated the firm's performance to secure millions of dollars of investment in Theranos between 2010 and 2015. This included falsely claiming the tests had been vetted by Pfizer and that the technology was being used by the US military.
Many patients will have been harmed by her actions as they received false or inaccurate blood test results upon which medical decisions were made. Part of what made Theranos stand out to investors was the list of names Elizabeth brought on for the board of directors. They had notable figures from the worlds of both business and government, but no one with expertise in science, medicine or blood testing.
Elizabeth’s story played well in Silicon Valley where the idea of a college dropout with a vision of changing the world doesn’t sound as unlikely as it might amongst medical professionals or scientists. So, a big part of her trick was crafting a story and a persona that worked well with her target investor audience. Now, before our next example, let me tell you quickly about today’s video sponsor – The Daily Upside. If you find yourself sifting through multiple news sources trying to find unbiased and insightful news, the Daily Upside might be the solution to your problem.
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The FT journalist Dan McCrum who uncovered the fraud at Wirecard points out that it was an unusual example of investment fraud in that there were many attempts to check the actual facts of the business. In 2015 an investigator tried to visit a number of Wirecards remotest locations around the world. In Laos she found nothing at all, in Vietnam the businesses reception area looked like a school lunchroom; furnished with a picnic table. She says that she went half mad looking for non-existent addresses down Southeast Asian dirt roads, as it became increasingly obvious that something was really wrong about the business. When her report was presented to Wirecard investors – including photos of the empty offices, the investors rejected the report. It couldn’t be true! Wirecard was run by reputable people, audited by a reputable firm, why would they all be lying? A French fund manager at the event asked his secretary to call Wirecard’s Singapore head office, he reported back that all was well as someone in Singapore had answered the phone.
McCrum describes in his book Money Men that the shareholders reacted at an emotional level. They didn’t want to believe that they had been fooled. Things like social proof and deference to authority, like having well-known investors and a well-known accounting firm, turned out to be powerful forces. Wirecard is “a technology company with a bank as a daughter”, The CEO Markus Braun told investors, one using artificial intelligence and cutting-edge security. He waved a wand of innovation to describe a fairly dull credit card processing business as something truly extraordinary. As the share price rose, so did Braun’s star as a technologist with a vision of a future cashless society.
Who were these investigators to suggest that the results of all this innovation, with operations in 40 countries, were too good to be true? Wirecard was even able to convince the German financial market regulator BaFin to publicly investigate critics of the company on three different occasions, which was taken by observers as a signal of support. BaFin even suspended short selling of the stock to “protect the integrity of financial markets.” It is possibly always a red flag when company management starts complaining about short sellers. Wirecard was one of the best performing German stocks for quite a while.
Those who had invested early and made a lot of money were recognized for their skills. Who would dare to claim that these leading investors were being taken in by a fraudulent CEO. The kind of person who was driving around taking photos of empty offices was more likely to be a fraud and was just spreading FUD. In lying for money, Dan Davies describes what he calls “The Canadian Paradox”.
Canada is a high-trust society and Canadians mostly assume that the businesses they deal with are honest, that laws are fair, that contracts will be honored, and debts repaid. They believe that the strangers they meet are trustworthy. However, Canada is infamous for financial fraud, the Vancouver stock exchange was described as the “scam capital of the world” by Forbes in 1989. Surprisingly, in low-trust societies, there is less financial fraud and people often do business deals on a handshake – but only with people they already know well. So why does Canada have so much financial fraud despite having robust institutions to deal with it? And why do Canadians still trust each other, given all the financial fraud? The answer appears to be that Canada has financial fraud because it is a high-trust society (trusting people - attract fraudsters).
But the fact that it is a high trust society also means that businesses and individuals can thrive in Canada because Canadians are mostly honest, and businesses are not slowed down by only dealing with people that they have a strong personal connection to like happens in low trust societies. A person who always thinks they are being scammed will never go into business, and never invest in anything. The take-away from the “Canadian Paradox” is that there is possibly an optimum level of fraud in a society, and it’s not zero, or at least that there is more value gained from doing business in a trusting way (even if you occasionally get ripped off) than refusing to engage in any business dealings as you are always sure that you will be conned.
Nonetheless, be careful in Canada… When you look at enough examples you can see that con artists and fraudulent businesses take advantage of situations where people begin taking shortcuts as they are in a situation where they feel that it’s reasonable to trust those around them. With a big fraud like the Chinese forestry company Sino Forest, by the time John Paulson, one of the world’s shrewdest hedge fund managers had become its largest shareholder, its shares had already been trading for 15 years in Canada. It had all the appearances of respectability and not many investors felt it was necessary to travel to China to see if its woodlands really existed.
They mostly didn’t… So, why do people fall for scams? Well, self-confidence is often a big factor that causes people to fall for scams. People who believe they are too smart or too well-informed to be tricked are often likely to become victims. People also make bad decisions when they become emotional, and the analytical parts of their brains shut down. Innovative businesses that investors fall in love with are maybe more likely to have overlooked problems than businesses in duller looking industries. Strong feelings of fear, anger, and greed can cause people to make decisions that they wouldn’t make at other times. Con artists and frauds excel in using social engineering to stimulate strong emotions.
If you are investing in a business because the CEO has stirred up emotions in you of how it will change the world, maybe it is a good idea to calm down and do some careful analysis. The world watched in awe a few weeks ago as the floor fell out from under Sam Bankman-Fried and his cryptocurrency exchange FTX. Over a few days, SBF went from one of the richest people in the world to the poster boy of the biggest crypto collapse to date. On the surface, FTX appeared to be thriving — in the past year, it made several high-profile acquisitions and bailed out other failing crypto companies. SBF was on billboards around the world, and A list celebrities (plus Kevin O’Leary) told you what a great firm it was. In reality, it was drowning in debt and hidden losses.
One negative tweet from a competitor was enough to cause billions of dollars of investor and customer funds to vaporise. Bankman-Fried was everywhere you looked over the last year. He was the subject of countless profiles; he was on the cover of Fortune and Forbes. He was the New Warren Buffett and the millennial JP Morgan. The media portrayed him as an unassuming, nerdy savant, frequently noting his down-to-earth ways, his messy hair, his sloppy T-shirts and shorts and of course his Toyota Corolla.
Investors loved that he wasn’t a buttoned-up entrepreneur; he played computer games during pitch meetings, and like other modern-day founders, his eccentricities were taken as proof of his distinct genius. Temasek, not the most exciting VC investor, released a statement after losing $275 million with FTX. They mention how their exposure was a small percentage of AUM and that they did extensive due diligence which took approximately 8 months, they said they didn’t engage with the board because their stake was so small. Sequoia, when it lost $214 million, also mentioned that they had done “extensive research and thorough due diligence”. A week later they apologized to their investors on a call and said they'll do better, by maybe using the Big 4 accounting firms to audit all startups going forward.
Sure Temasek didn’t request a Board seat, but during their eight months of research did they notice that there was no Board at all at FTX? Or did they work out how exactly Alameda, FTX and the 130 other entities were intertwined. Sequoia seemed to be aware of a number of the red flags at FTX, as they wrote them up on their own website with a positive spin. They figured the fact that SBF played videogames while pitching to them just showed that he was good at multitasking. Buying up huge swathes of luxury real estate in the Bahamas with corporate funds for the partners and their families to live in isn’t exactly under the radar, and running a financial institution worth over $30 billion dollars without an accountant seems like something that would have showed up in eight months of research.
Using an auditor with an office in the metaverse… well… I don’t know what to tell you... The problems with FTX were not just fraud, there was gross incompetence and hubris that should have stood out to investors too. Perhaps the investors felt that because Sam didn’t appear to care about money (he was driving a budget car and dressed like an unruly toddler) he would have no interest in ripping them off. Perhaps his claims to be saving the world with effective altruism made them feel safe.
A guy who cares so much about humanity wouldn’t be a con man, right?? Sam, just like Victor Lustig, Elizabeth Holmes Bernie Madoff and Markus Braun knew how to present himself such that he would be trusted. It is not even obvious today that he feels bad about the harm he has caused. He keeps saying how embarrassed he feels, but there is no mention of feeling any shame. So what were Victor Lustigs Ten Commandments for conmen. Maybe they will help us to spot frauds. 1 Be a patient listener. 2 Never look bored.
3 Wait for the other person to reveal political opinions, then agree with them. 4 Let the other person reveal religious views and have the same ones. 5 Hint at sex talk, but don't follow it up unless the other person shows a strong interest.
6 Never discuss illness, unless some special concern is shown. 7 Never pry into a person's personal circumstances (they'll tell you everything eventually). 8 Never boast – just let your importance be quietly obvious. 9 Never be untidy. Well I guess Sam got to break that one… 10 Never get drunk.
I’m not sure that looking out for those things will keep you safe from con men. Most of them are just ways of blending in and making yourself likeable. Maybe for businesses you should look out for firms that seem more exciting than they naturally should be - like Wirecard.
A dull business in something like manufacturing that tries to pass as a tech firm using buzzy ideas like AI. Maybe a celebrity CEO like Elizabeth Holmes is a red flag. Or maybe a CEO Like SBF who claims to care more about humanity than his own personal interests, or a leader who feels that the rules don’t apply to them. I’d love to hear your suggestions of red flags to look out for in the comments section below. If you’re looking for a good finance book for either yourself or as a Christmas gift for someone else, you should check out my top ten finance books video next.
Don’t forget to check out our sponsor The Daily Upside, by clicking on the link in the video description, it’s a great newsletter that I can firmly recommend. Talk to you soon, bye.
2022-12-11 03:48
