Ponzi Strikes Again

Case History Anatomy

The Fraud: Tom Petters, the CEO and chairman of Petters Company Inc. (PCI), an international holding company, is charged with 20 counts of conspiracy, money laundering, and mail and wire fraud.

The Method: PCI allegedly created fictitious documents and then provided them to current and potential investors as evidence that it was buying and selling substantial goods and merchandise that it would resell. However, prosecutors suspect that PCI never purchased any merchandise nor resold it to the company's big-box clients. PCI allegedly still received payment for merchandise that never existed and was never received.

The Fraud Examination: A PCI whistle-blower who was involved in the intricate Ponzi scheme came forward. FBI special agents later discovered fictitious companies and documents that supported the whistle-blower's accounts. The exact dollar amount of fraudulent activity isn't known, but prosecutors suspect at least $11 billion was stolen.

Charles Ponzi is back in the news with the alleged $50 billion Bernard Madoff scheme. But here's another Ponzi crime that might not be so prominently on your radar: entrepreneur Tom Petters has been charged with selling billions in merchandise that never existed. Learn how this happened and how frauds like this can be prevented.

Tom Petters, CEO and chairman of Petters Group Worldwide, was a high-flying entrepreneur with major holdings in Sun Country Airlines, Fingerhut, and Polaroid among others. A son of a modest St. Cloud, Minn., family, he had built his one-man trading company into a conglomerate with thousands of employees around the world.

He was a huge success and renowned for his generosity; Petters gave millions to universities and charities. At a local area business meeting held Sept. 12, 2008, he was even lauded for his "innovative thinking," which had helped "connect and create quality businesses that now span the globe," according to StarTribune.com.

But two weeks later, on Sept. 24, federal agents seized potential evidence from Petters' headquarters in Minnetonka, Minn., and his home in Wayzata, Minn. On Dec. 1, a federal grand jury indicted Petters on 20 counts of conspiracy, money laundering, and mail and wire fraud.

INCRIMINATING EVIDENCE 

Petters maintains his innocence, but earlier on Oct. 8, 2008, three cooperating witnesses, all Petters Group former executives, pleaded guilty in U.S. District Court of being active participants in a giant interstate Ponzi scheme involving the use of false purchase orders, fictitious bank statements, and fraudulent sales invoices.

Each of the witnesses admitted to receiving millions of dollars while being involved in the scheme, according to an article in the Oct. 9 print edition of the Minneapolis-St. Paul Star Tribune. The lawyer of a fourth individual had said his client was negotiating a plea agreement in return for testimony, according to an Oct. 17 Star Tribune article.

The alleged fraud scheme involved creating fictitious documents and then providing these documents to current and potential investors as evidence that Petters Company Inc. (PCI) was buying and selling substantial goods and merchandise that PCI would then resell, according to FBI Special Agent Timothy Bisswurm's affidavit in the Minnesota County of Hennepin.

Prosecutors don't yet know the exact dollar amount of fraudulent activity because the alleged scheme is so extensive. However, according to Bisswurm's affidavit, the bank reported $11.6 billion of incoming and outgoing wire transfers from January 2003 through March 2006. 

HOW WAS IT PERPETRATED? 

The alleged scheme primarily involved three companies: PCI, Nationwide International Resources, Inc. (NIR), and Enchanted Family Buying Company (EFBC). Deanna Coleman, PCI's vice president of operations, reported the case to federal agents and confessed her role in the scheme. She subsequently was indicted for creating fictitious purchase orders related to the purchasing of large amounts of electronic goods from NIR and EFBC.

Prosecutors have found false documentation alleging the sale of these electronic goods to multiple big-box retailers such as Sam's Club (a subsidiary corporation of Wal-Mart). The Bisswurm affidavit alleges that in one six-month time period in 2008, PCI purchased more than $23 million in merchandise from EFBC and then resold all of it to Sam's Club. However, the affidavit alleges that PCI neither purchased nor sold the merchandise.

The alleged fictitious transactions and phony documents were used to convince investors that PCI, NIR, and EFBC were legitimate, profitable companies, Bisswurm reports. Investors in PCI were told that funds loaned to PCI would be used to finance the purchase of inventory that would be resold to the big-box retailers. Typically, investors would then wire funds directly to NIR or EFBC.

As part of the alleged money laundering scheme, the funds, less a commission, would then be forwarded to PCI. The amount of the commission was typically .05 percent. A significant percentage of the loans was secured by promissory notes. According to Coleman's U.S. District Court of Minnesota documents, these notes pledged as collateral either: (a) the merchandise PCI purportedly had purchased from NIR and EFBC; and/or (b) accounts receivable for the fictitious purchase orders between PCI and the big-box retailers.

Bisswurm's affidavit indicates the merchandise and accounts receivable were created entirely from fictitious transactions. At times, the funds received were used to repay loans that previously had been acquired based on fictitious source documents, he said. However, according to the Coleman court documents, the vast majority of the fraud proceeds went to PCI and Petters, and was then used to fund the operations of other companies owned by Petters, to pay others who assisted in the fraud scheme, and for Petters' extravagant lifestyle.

If potential or current investors in PCI needed questions answered about PCI's business, the investors would be directed to talk with NIR's owner, who would verify that PCI's purchase orders were legitimate. Also, NIR's owner would arrange for representatives of insurance companies (insuring fictitious goods) to tour warehouses of electronic goods owned by other companies, while representing that the goods were those sold to PCI, according to FBI Special Agent Eileen Rice's affidavit in the Minnesota County of Hennepin.

In those instances in which auditors wanted to verify warehouse inventory counts, NIR's owner would assert that the goods were in warehouses that weren't accessible, according to Bisswurm's affidavit.

FBI INVESTIGATION OF THE SCENE 

On Sept. 8, 2008, Coleman voluntarily discussed with the FBI the details involving an alleged scheme to defraud investors out of billions of dollars. Coleman provided the FBI with documents supporting the allegations of fraud. This documentation included an itemized list of investors who are owed money by PCI and copies of promissory notes and other lending documents that pertained to the scheme, according to Bisswurm's affidavit.

Approximately two weeks before her plea agreement was signed, Coleman agreed to wear recording devices to provide audio evidence from the alleged participants in the fraud scheme.

She identified the names and voices of the individuals involved in conversations concerning the alleged scheme. Petters allegedly discussed the need to keep preparing false documents on the tape. He is said to have also talked about fleeing the country and creating fabricated defenses if the fraud scheme was discovered, according to the agents.

The FBI found that PCI existed at its given business address. However, the EFBC address was a paint store, and the NIR address was an older two-story building with boarded-up windows.

A consolidated balance sheet for PCI and subsidiaries listed total current liabilities of $3.5 billion with net accounts receivable of $1.9 billion. Coleman told investigators the accounts receivable were based on phony documentation and that the actual market value of accounts receivable was considerably less than $1.9 billion. Thus, the collateral used to securitize the promissory notes issued by PCI was, at best, insufficient and most likely nonexistent.

Based on the documentation provided by Coleman, the FBI investigated various transactions alleged to be fraudulent. The results of FBI agents Bisswurm and Rice's investigation of a specific transaction found that:

• PCI has eight outstanding notes with the Fidelis Foundation reflecting an investment totaling $27.6 million.
• Fidelis Foundation will have a security interest in the [certain] purchase orders that the corroborating witness indicated were fictitious.

The agents presented one purchase order, believed to be bogus, to a Sam's Club representative. According to Bisswurm's affidavit, the representative "reported that PCI's purported vendor number on the Sam's Club purchase order was fictitious." The agents found that vendors wanting to do business with Sam's Club must use an Electronic Data Exchange system for delivering purchase orders. However, the PCI purchase orders didn't meet Electronic Data Exchange standards. They appeared to be manually prepared purchase orders, according to Bisswurm's affidavit. Thus, not only were the accounts receivable not sufficient collateral for borrowing, the inventory for collateralizing investor funds didn't exist.

The FBI's analysis of EFBC's bank records supported Coleman's allegations that fees totaling more than $3 million were paid to Michael Catain, EFBC's owner, for participating in the cover-up of the fraud scheme by rewiring funds from EFBC to PCI. Consequently, on Sept. 25, 2008, the FBI executed multiple search warrants on the individuals and businesses identified by Coleman as being involved in the alleged fraud and confiscated a considerable amount of paper records, computers, and electronic storage media. If the business model used by PCI, NIR, and EFBC was legitimate, the FBI expected to find documentation supporting the actual purchase, transfer, and sale of inventory. If no bills of lading, freight records, inventory records, etc. were found, this would be evidence of fraud, according to Bisswurm's affidavit.

HOW TO PREVENT FALLING FOR A SIMILAR SCHEME 

Petters' alleged fraud scheme is an example of a situation in which due diligence isn't always sufficient to mitigate the risks involved with lending money to a third party. The defendants went so far as to show agents for the lenders inventory for which the borrowers didn't have titles. However, Randy Shain, vice president of First Advantage Investigative Services, provided due diligence services for several clients with respect to PCI. Each client was provided evidence that "the amount of litigation involving Petters was pretty startling," said Shain in an Oct. 26 Star Tribune article. In each instance, the client relied on PCI's reputation, and ignored the litigation evidence, and subsequently loaned money to PCI.

The appendix to the Statement on Auditing Standards No. 99, "Fraud Risk Factors," identifies several risk factors that might indicate the presence of fraud. The factors that relate to the PCI fraud case include:

• Significant related-party transactions with related entities not audited
• Inadequate segregation of duties or independent checks of supporting documentation
• Domination of management by a single person or small group
• Large amounts of cash on hand or processed
• Known history of violations of securities laws or other laws and regulations  

Each of these conditions existed at PCI. The related party transactions between PCI, NIR, and EFBC weren't properly audited. When an attempt was made to audit inventory, PCI representatives allegedly misrepresented inventory of other companies as being inventory owned by PCI.

The prosecution's evidence against PCI indicates a maximum of seven people involved in the alleged Ponzi scheme. When a small number of individuals are involved in collusion, it becomes extremely difficult to identify fraud specifics. In this case, if Coleman hadn't voluntarily confessed and reported the alleged scheme, the fraud would still be undiscovered.

The evidence gathered by the FBI indicates routine wire transfers in and out of bank accounts in the millions of dollars. Transactions of that magnitude and frequency should have been a red-light alert. Also, Shain said Petters had a history of litigation issues.

One method of protecting a financial interest in a company is for a lender to file a priority lien by properly filing a "financing statement" with the secretary of state. This financing statement notifies third-party lenders that the lender has a previous claim on inventory, machines, vehicles, equipment, or other assets listed in the financing statement. Therefore, lenders should consider doing a Uniform Commercial Code filing for a purchase money security interest. This filing will alert new lenders that the assets offered as security are previously encumbered by liens from other lenders.

Before filing the financing statement, the lender should inspect and document ownership of assets to ensure the assets are in the possession of the borrower. It's in the self interest of the lender to make sure the financing statement is accurate or it might be invalid and not be able to protect the secured loan with the stated collateral. This results in a perfected purchase money security interest that defeats any other claim including a bankruptcy trustee who would otherwise seize the assets for distribution to general creditors. However, as in this case, if the borrower doesn't have legal title to the assets proposed as security, then the lender ends up being a secured general creditor in bankruptcy.

CASE IN PROGRESS 

On Oct. 14, the U.S. District Court for Minnesota ordered an asset freeze for all defendants, agents, affiliates, employees, officers, or any other persons related to the defendants' affairs. As a result of the asset freeze, the defendants are enjoined "from transferring, converting, encumbering, selling, concealing, dissipating, disbursing, assigning, spending, withdrawing, or otherwise disposing of, in any manner, assets ... up to and including $3 billion, unless specifically authorized by Order of this Court."

As of Oct. 24, four of the five individuals implicated in the scheme had signed plea agreements in U.S. District Court. Federal authorities contend the dollar amount of the fraud will exceed the $400 million threshold in the sentencing guidelines, according to an article in the Oct. 23 issue of the Star Tribune.

As mentioned earlier, Coleman agreed to plead guilty to conspiracy to commit mail fraud. She faces a prison term of up to five years, and a criminal fine of more than $250,000 or twice the amount of gain or loss. As a cooperating witness in the case, her sentence will be reduced only if she continues to cooperate in the case. Coleman has also admitted to preparing false documentation that was used by PCI to acquire billions of dollars in third-party loans, according to a U.S. Department of Justice (DOJ) news release.

Robert White, employee and consultant to Petters, pleaded guilty to one count of mail fraud and one count of money laundering and faces up to 30 years in prison: 20 years for mail fraud and 10 years for money laundering.

Michael Catain, EFBC's owner, pleaded guilty to one count of conspiracy to commit money laundering and faces up to 20 years in prison.

On Oct. 23, Larry Reynolds, owner of Nationwide International Resources, pleaded guilty in U.S. District Court to one count of money laundering conspiracy. Reynolds faces up to 20 years in prison, according to an Oct. 24 article in the Star Tribune.

On Oct. 31, Petters was denied bail pending trial for his alleged participation. The government is concerned that Petters is a flight risk and has procured false identification that he has planned to use to flee the country, according to a Nov. 1 article in the Star Tribune. Also, the government believes that the advisory guideline range for the defendant's offenses is life in prison, according to Petters' court documents.

Two individuals identified by court documents as "alleged scheme participants" haven't yet been charged with any civil or criminal complaint. Petters still contends he's innocent of all charges, according to an Oct. 24 article in the Star Tribune.

On Oct. 6, 2008, the U.S. District Court for Minnesota appointed Doug Kelly as receiver for the alleged participants in the PCI fraud scheme. The court order gave Kelly the authority to take immediate, exclusive, and complete control and custody of all the alleged participants' property, assets, and estates. This control includes both private assets and all ongoing business operations. As part of this control, Kelly has power to, but isn't limited to (according to 2008 U.S. Dist. LEXIS 81913, pp. 5 and 6):

• Take all the steps necessary to secure the business premises of the defendants.
• Obtain pertinent information from all employees and agents.
• Videotape the entire business premises of the defendants.
• Secure the business premises by changing the locks.
• Disconnect all access to computers and other records maintained at the locations.
• Employ attorneys, accountants, appraisers, and other professionals.
• Defend or settle legal actions related to the businesses owned by the defendants.

On Oct. 22, U.S. Bankruptcy Judge Gregory Kishel decided to consolidate 10 existing bankruptcy filings related to Petters under one case number. An attorney for Petters anticipates the filing of additional bankruptcy filings as attorneys untangle Petters' portfolio of more than 150 worldwide business entities. Kishel called the complicated case "a record," according to an Oct. 23 Star Tribune article. One company wired $50 million directly to PCI as a loan. Preliminary evidence suggests the dollar amount of assets available to satisfy such claims are limited, according to a Nov. 26 Star Tribune article. Therefore, in addition to Petters' entities' bankruptcies, probably numerous entities outside the Petters' portfolio will be filing for bankruptcy.

BENEFITS OF DUE DILLIGENCE 

As with the alleged Madoff Ponzi scheme, the Petters' case illustrates that investors constantly need to protect themselves from becoming fraud victims. Of course, investors should take the time and spend the money to methodically investigate investment opportunities.

Fraud schemes are successful when investors only rely on individuals' word-of-mouth reputations. The promise of high returns is always an alluring enticement, too. Ponzi scheme artists have found the bigger the lie, the more likely people are to believe it because passion tends to overrule reason. However, the benefits of performing due diligence easily outweigh the costs.

Steven J. Carlson, Ph.D., is a professor of accountancy at University of North Dakota.  

Kenneth A. Hansen, LLM, is a professor of accountancy at the University of North Dakota. 

Robert J. Dosch, Ph.D., is an associate professor of accountancy at the University of North Dakota. 

Sources  

StarTribune.com. Sept. 24, 2008. Liz Fedor, Dave Phelps, Jenna Ross. "Feds raid Petter's Minnetonka HQ."

Star Tribune. Oct. 9, 2008. "Petters' cronies plead guilty." A1 and A13.

Star Tribune. Oct. 23, 2008. "Judge applies brakes to slew of Petters suits." A1 and A9.

Star Tribune. Oct. 24, 2008. "Petters aide pleads guilty to money laundering," D1 and D5.

Star Tribune. Oct. 26, 2008. "Closeout: The Collapse of the Petters Empire," A1, A20, and A21.

Star Tribune. Nov. 21, 2008. "Past Trips Up Petters Bail Bid." A1.

Star Tribune. Nov. 26, 2008. "And just where did all those Bentleys go?" A1 and A10.

StarTribune.com. Dec. 21, 2008. Nick Coleman. "Why did Petters stay out of jail for so long? He bought silence."

State of Minnesota County of Hennepin ss. Affidavit of Eileen Rice. Civil No. 08-5348.

State of Minnesota County of Hennepin ss. Affidavit of Timothy Bisswurm, Civil No. 08-5348.

Statement on Auditing Standards No. 99. "Consideration of Fraud in a Financial Statement Audit." Appendix.

United States of America, v. Deanna Lynn Coleman. Criminal No. 08-304, Plea Agreement and Sentencing Stipulations. U.S. District Court for the District of Minnesota.

United States of America, v. 1. Thomas Joseph Petters et al., Civil No. 08-5348, United States District Court for the District of Minnesota. 2008 U.S. Dist. LEXIS 81913.

United States of America v. Thomas Joseph Petters et al. Criminal No. 08-364 Indictment filed Dec. 1, 2008. U.S. District Court for the District of Minnesota.

United States of America, v. Thomas Joseph Petters. Criminal No. 08-MJ-364. Motion of United States for Detention Without Bail Pending Trial and Continuance of Detention Hearing. U.S. District Court for the District of Minnesota.

U.S. Department of Justice. U.S. Attorney's Office. District of Minnesota, News Release, Oct. 28, 2008.

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