Investment advice is a complex, highly-regulated industry. Many of those in the industry, particularly brokers, complain about over-regulation and long nostalgically for “simpler times.” At the same time, most investors are not aware of how many regulatory hurdles their advisers must jump through to provide their services. While the days of lax regulation of investment advice may have been simpler, they were not better. The swashbuckling tale of Charles Ponzi shows both the impetus and purpose for the regulatory scheme in place today.
A Smug Little Man
Charles Ponzi was born in Italy but immigrated to America in 1903 in pursuit of fame and fortune. A “smug little man, just over five feet, Ponzi was good-looking, slim, dapper, self-assured and quick-witted.”[i] For his first 20 years in America, he worked various odd jobs, including fruit peddler, smuggler, and waiter. He also served two jail stints during that time, one for fraud and another for human smuggling. Despite his name now being synonymous with investment fraud, Ponzi did not enter the field of finance and investments until age 42.
Ponzi’s scheme began in 1920 when he found what he believed to be an arbitrage opportunity in International Postal Union reply coupons. These coupons could be purchased in one country and then redeemed for stamps in another. Because of inflation in post-World War I Italy, stamps there were significantly cheaper than in the United States. Thus, a person could buy coupons in Italy, redeem them for stamps in the U.S., and then sell the stamps at a profit. Using this purported scheme, Ponzi promised to pay a 50% return in 45 days and a 100% return in 90 days. The money came in slowly at first, but at his peak, investors sent Ponzi approximately $1 million ($12.5 million in 2018 dollars) per week. The money came in so fast that it was piled ankle-deep in Ponzi’s office. He literally waded through money to get to his desk.
But in reality, Ponzi was just taking money from new investors and using it to pay fabricated returns to his old investors. There simply were not enough reply coupons in print to generate the returns Ponzi touted, and there was little evidence that he actually invested any of the money he received. He was eventually discovered as a fraud when the Boston Post did a series of investigations on the reply coupons, Ponzi’s assets and liabilities, and his criminal past. Ponzi spent 12 years in prison for his scam and afterward was deported to Italy. He eventually found a job with an Italian airline in Brazil and lived his last years there in relative poverty. He died in 1949 in a Brazilian charity hospital with $75 in his pocket.
The Need for Regulation
In the same year that Ponzi was released from prison, Congress passed the Securities Exchange Act of 1934, which created the U.S. Securities and Exchange Commission (SEC) and gave that agency authority to enforce federal securities laws. Congress created this agency because it believed financial fraud (like Ponzi’s) was a problem of national scale that required a national solution. Just five years after its creation, the SEC began an investigation into the field of investment advice and “investment counselors,” the predecessor to modern-day investment advisers.
The SEC issued a 1939 report on the results of its investigation which revealed, among other things, that those who “indulged in exaggerated claims constituted a menace not only to the investor” but also to bona fide advisers. Further, the SEC noted that the nation’s current laws imposed “no limitations, restrictions, or conditions” on the qualifications of a person soliciting public funds for investment advice. The SEC concluded that the current method of self-policing amongst the profession was ineffective. As a direct result of this report, Congress passed the Investment Advisers Act of 1940 (the 40 Act), which became the cornerstone of regulation of investment advisers.
Example of Regulation and How It Might Have Stopped Ponzi
The 40 Act gave the SEC authority to create rules and regulations for the investment advice industry. One of the regulations the SEC created pursuant to this authority is the so-called “Books and Records” rule (17 C.F.R. § 275.204-2), which requires advisers to maintain certain records pertaining to their business. For example, subsection (a)(16) of the rule requires advisers to maintain records of the calculation of published investment performance.
Had such a rule been in place in Ponzi’s day, his fraud would have been discovered much quicker. First, Ponzi’s only records were client’s names that he scribbled on an index card, so his failure to follow the Books and Records rule would have aroused suspicion. Second, Ponzi would have been unable to demonstrate to investors how he was calculating his published performance numbers, because there were no returns. He simply robbed from Peter to pay Paul.
Obviously, however, no system of regulation is fool-proof. In a Ponzi scheme that would make Charles look like a charity operation, Bernie Madoff fleeced his investors of approximately $18 billion. Though, in Madoff’s case the fraud resulted primarily from a failure of authorities to properly investigate and enforce regulations, not the regulations themselves.
Black Cypress supports sensible regulation of our industry, and we believe our compliance program sets us apart from our peers. Unfortunately, as with any industry, there are bad apples in the field of investment advice that create the need for policing and enforcement. And as these bad actors increase the sophistication of their schemes, so must the regulatory scheme grow in complexity. We feel that our navigation of this complex regulatory environment separates us from the pack in two areas.
First, like our investment research, we handle our compliance in-house. Our compliance program is tailored to our business because we created it rather than farming it out to a third party. This approach lets us stay on the leading edge of developments in regulations and have greater conviction in our compliance program.
Second, we strive to promote trust with our clients by having an independent third-party verify our performance numbers. We also report our performance using the Global Investment Performance Standards (GIPS), an objective, international standard of performance measurement and reporting. We understand that it is often difficult for retail and institutional investors to find and trust an adviser. By utilizing objective standards and third-party examination, our clients and prospective clients do not have to just “take our word for it.” Rather, clients can look to the reports of our third-party examiner to confirm our performance. These reports are available on our website and upon request.
At Black Cypress, our commitment to excellence extends beyond our investment advice to even our compliance program. We believe our culture of compliance leads to greater trust from clients, which is why so many of them continue to grow their relationships with us. For more information on Black Cypress’s compliance program, you may contact the firm’s Chief Compliance Officer, Jordan M. Roberts, at firstname.lastname@example.org.
[i] Ken Fisher, 100 Minds that Made the Market, (2007).