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Lying for Money
How Legendary Frauds Reveal the Workings of the World
Table of Contents
About The Book
The way most white-collar crime works is by manipulating institutional psychology. That means creating something that looks as much as possible like a normal set of transactions. The drama comes later, when it all unwinds.
Financial crime seems horribly complicated, but there are only so many ways you can con someone out of what’s theirs. In Lying for Money, veteran regulatory economist and market analyst Dan Davies tells the story of fraud through a genealogy of financial malfeasance, including: the Great Salad Oil swindle, the Pigeon King International fraud, the fictional British colony of Poyais in South America, the Boston Ladies’ Deposit Company, the Portuguese Banknote Affair, Theranos, and the Bre-X scam. Davies brings new insights into these schemes and shows how all frauds, current and historical, belong to one of four categories (“long firm,” counterfeiting, control fraud, and market crimes) and operate on the same basic principles. The only elements that change are the victims, the scammers, and the terminology.
Revealing some of the most famous frauds of the modern age, Davies explains how fraud has shaped the entire development of the modern world economy. For those “who like their true-crime stories laced with economics will enjoy these forays into the dark side” (Kirkus Reviews) this is a gripping and vivid look at modern market societies.
I am sorry guys but I have scammed you. I am not going to try to justify it with my reasons, I am just a terrible person. I am sorry for each and every person affected. I am ashamed about the way I have deceived so many people for my own personal gain. For what it is worth, the money is not going to stupid lifestyle enriching purposes. Even though I could likely go on for a few more days making fake promises and feedback I have reached my goal and will lock myself out of my account.
For anyone interested. This started on 19–22 December. After that I have not had a single gram of weed or hash in stock. That is all I had to say.
That was the message received by customers of 9THWONDER, an online drug dealer on a marketplace known as “Evolution” when they logged on in January 2015 to check why their merchandise hadn’t arrived. The apology and confession were unusual but the scam wasn’t. The unlisted websites where contraband is bought and sold over confidential web browsers (known as “dark markets,” because online criminals are addicted to science-fiction language) have been absolutely rife with frauds from the start.
On the one hand, this might be seen as predictable—if you are looking for ideal targets to steal from, participants in illegal drug markets have the attractive property that they can’t report you to the police without raising lots of awkward questions about themselves. On the other hand, this obvious fact was not lost on the original designers of the Silk Road (the first such site to get real traction) and its competitors, and the aim of these entrepreneurs was to build fraud protection into the architecture of the system. Many of them produced long and windy political manifestos on this very point, claiming that their virtual online realm was a techno-libertarian paradise that did not need conventional laws.
So how did they all get ripped off?
Pleased to meet you
Actually, at this point I should probably explain why I’m so interested in these things. And maybe reassure you that I’m not a criminal and this book isn’t going to end with a superficially plausible invitation to join in with a pyramid scheme. About half a dozen friends forwarded the news stories about 9THWONDER to me when they came out, and as soon as I read the opening lines, I could guess what had happened, because I’m extremely familiar with the pattern. This particular fraud has been around since the Ancient Greeks, in fact, although I’m personally most familiar with it from autobiographies of gangsters in Swinging London of the 1960s. I collect fraud stories, because they fascinate me. And they fascinate me because they’re a sort of counter-template. All the things that you miss out on by studying normal economics come sharply back into focus if you take a moment to think about its criminal counterpart.
I made my living for twenty years on the fringes of bank regulation. Early on, while I was young and innocent (and broke), I was a junior economist for the Bank of England, helping to analyze the loopholes and unintended consequences of the ferociously complicated international banking rulebook. Later on, I was older, considerably less innocent, and a lot better paid to help investors make money out of exactly those loopholes. But early on in my career, I noticed that although you might expect something like bank regulation to be one of those gray areas where economics and criminology meet each other, there’s actually no overlap at all.
If you’ve ever had the misfortune to read a lot of bank regulation, you’ll see that it’s made of numbers—measures of capital, measures of risk, probability distributions, and ratios. On the other hand, if you’ve ever had the misfortune to be involved with a bank going spectacularly bust, you’ll probably notice that the reasons why everything went wrong usually have very little to do with those numbers—they tend to be very human in nature and made up of varying proportions of incompetence, dishonesty, and bad luck. The reasons for this disconnect took me years to understand—they’re very deep in both psychological and economic terms. Unfortunately, while I wasn’t able to understand the problem, nor was I able to keep my mouth shut about it, and before long, me and the Bank of England decided to seek our fortunes separately.
As soon as I got another job, I quickly grew to realize that I would never be all that good at forecasting stock prices or calculating probabilities. So I decided that if I was going to have a career in the competitive world of stock market trading, it would have to be based on things which were impossible to forecast and which weren’t part of any probability distribution. Luckily for me, shortly after I made that decision Russia defaulted on its debt, the internet bubble popped, and Enron went bankrupt. Also, Nassim Taleb started publishing books that gave a sort of intellectual respectability to the whole project of looking at the implications of unpredictable events.
For my part, and with the support of a couple of far-sighted bosses, I spent the next decade gathering details and stories and trying to build a mental toolkit for living through those strange historical episodes when everything you thought you knew turns out to be untrue. It involved a lot of digging through out-of-print books and reading up on unfashionable management theorists, looking for the gaps between theories and the awkward things that people didn’t like to talk about.
Did any of this help, when 2007 arrived and it turned out that the previous decade’s prosperity had been built on a mountain of lies? Yes and no. Later in the book I’ll discuss some of the big frauds where I had front-row tickets. I think my record in spotting them was better than random chance, but maybe not much better. But anyway, back to 9THWONDER and the online drugs fraud.
Money for nothing
The mechanics of the dark market scam are almost so simple as to need no explanation: you take money (in this case, electronic money such as bitcoin) on the basis of a promise to send someone illegal drugs, and then you don’t send the drugs. The interesting bit is that the controls that were put into the system to rule out this absurdly obvious possibility didn’t work.
The way that things were meant to happen is that payments were meant to go through “escrow.” You sent your bitcoins to a central address associated with the marketplace itself, so that the vendor could see that you had paid. Then, when your goods arrived, you sent a confirmation message and “released” the payment, allowing it to be sent on to the vendor. Or, if your goods didn’t arrive, you submitted a complaint to the marketplace, which, via its (surprisingly efficient) dispute arbitration service, took evidence from you and the vendor about who was likely to be lying, and if it thought you were in the right, gave you your money back. All of this signing and acknowledgment was carried out on an anonymous basis via clever cryptographic protocols that don’t need to be discussed here because for the most part they worked—there was no technical weakness worth speaking of.
The escrow system would seem to be a pretty solid protection against fraud, and it was available even for quite small deals, whereas normal trading companies only use the comparatively expensive services provided by lawyers and banks when the size of the transaction warrants doing so. And for the most part, the escrow service worked. The vulnerability came in because people didn’t use it.
Why didn’t they use it? That’s the best kind of question—it’s relatively easy to answer, and the answer not only tells us something useful, but sets us off on a train of thought that ends up with a much deeper understanding of fraud in general, and of its relation to the honest economy of which it is the mirror image. The simple answer here is that the failure of the Silk Road escrow system was a specific instance of a general problem in computer security—that if something is a pain in the ass, it will not provide any protection because people will not use it.
It turns out that there was not (and is not yet) a technological solution powerful enough to overcome an elementary fact of business—that the conventions of who pays cash and who gets credit reflect the relative power of buyers and suppliers in the market. The escrow system was highly inconvenient for vendors. They had the normal cash-flow problems associated with extending trade credit, in that they had to finance their inventories before getting paid. Against this, they had a degree of protection from deadbeat customers through the escrow system. But they could still be made the victim of fraudulent or frivolous customer disputes; it was not uncommon for unscrupulous dealers to send in dozens of orders to a rival and then dispute them all, to drive one of their enemies out of business.
The biggest problem for the vendors, though, was that the online payments were all made in bitcoin and its equivalents. The ways in which the financial system has been recruited as a tool of law enforcement are interesting in themselves (we talk about them at length in Chapter 11), but for the time being it’s just important to note that bank accounts are always linked to named people, and their transactions are monitored and can be subpoenaed by the cops. So if you do business with a variety of drug dealers using cash transferred to and from a bank account (or a PayPal account, or any other legitimate means), you’ve effectively started the clock ticking for when one of them gets busted and the narcs start following all the trails of banking data, one of which will lead to you.
That’s why street drug dealers use cash, and why the online markets didn’t take off until an electronic equivalent of cash was invented. Bitcoin, to oversimplify mightily, is a technology that creates magic numbers that can be sent back and forth, via a computer program that keeps checking that they aren’t forgeries and they are only associated with one particular bitcoin account. Unlike bank accounts, bitcoin accounts don’t have to be associated with an identifiable person; a bitcoin account is effectively not much more than a magic number itself. There’s a load of clever cryptography in the background making sure it all works and nobody’s anonymity is compromised,1 but the overall effect is that the supply of magic numbers can be used as if they were coins, so long as people are prepared to exchange them for valuable goods like drugs.
So bitcoin was used as the currency for the drug market, with the dealers converting their bitcoin proceeds into US dollars in whatever way they chose. This meant that they were faced with a typical small-business dilemma—revenues in one currency (bitcoin) and costs in another (mainly US dollars). Since the market was competitive and transparent, markups on the drugs were somewhat less than those available to street dealers, and could easily be wiped out by weekly fluctuations in the bitcoin/dollar “exchange rate.” Various means of allowing the vendors to hedge these currency movements were attempted, but they were all quite expensive and none of them worked very well.
The escrow system made the problem significantly worse for the drug dealers, because it imposed a delay during which the currency movements could be substantial. So they used their market power to get around it. Large dealers, with a reputation for reliability, would ask to be paid via “finalize early” (or “fast execution,” in either case usually abbreviated to FE), a feature of the Silk Road market that allowed the customer to forgo the protection of the escrow system. If you wanted to get the best quality and the most competitive prices, you paid via FE, effectively allowing the market to determine an implicit price that the customers were willing to pay to be certain that they were protected against being ripped off.
That “implicit price” is pretty important; it’s the basis of fraud considered as an economic phenomenon. The trade-off is always there, whether or not the victims realize that they’re making it. The optimum level of fraud in a system is rarely zero, and as we’ll see later, can often be surprisingly high. And in many cases, the level of fraud seems to be determined by the market. If the overall level of dishonesty is high, people take more precautions and bring down the level of fraud (if it’s really high, the market itself might disappear as nobody is willing to do business). In an environment where nearly everyone is trustworthy, the implicit value of fraud protection is low, so fewer people pay it.
In the case of Silk Road, the implicit price was indeed low. There was significant honor among thieves, and the Silk Road marketplace had an elaborate feedback system (not unlike that of eBay) that allowed consumers to carry out their own credit analysis. As in the normal economy, vendors were able to build up a trading name, and to establish that they were good credit risks, encouraging buyers to deal with them without using escrow. So although the technology was there to do without it, the dark market ended up reinventing most of the apparatus of conventional small-business credit.
A key difference between the online drug trade and the normal economy, though, is that not all that many people are interested in building a career in online drug dealing and passing the firm down to their children. People grow up, leave college, or have the kind of short interaction with the legal system that suggests to them that a lifestyle change is in order. Businesses often tended to close down.
And having built up valuable goodwill on a dark market, it seems like a shame to just throw it all away when you disappear. The “ethical” thing to do would be to simply decline to take new orders, but when people are literally emailing you untraceable money, this would require quite a bit of moral fiber. And so the “exit scam” began to become a feature of Silk Road. A large vendor would start taking lots of FE payments (perhaps suggesting that this had been made necessary because he was being attacked by rival dealers using the escrow scam described above). There might even be a big “sale” to attract the maximum possible volume of orders. And then… disappear with the money. The bitcoins that had been sent to the defaulting vendor could not be reclaimed—that’s not the way the system works. The disappointed customers tended not to have any details or address for the vendor, just an online screen name that wasn’t being used anymore. The exit scammer would even be free to set up a brand-new business, building up goodwill from the ground floor, and there would be no easy way of finding out that this was being done.
By the time Silk Road was shut down by the law authorities and its market share taken by a number of smaller competitors, exit scams had become enough of a problem to materially affect the economics of the online marketplace, and to be a subject of lurid warnings to newcomers to the darknet economy. However, the suggested remedy of paying the price premium and dealing only via escrow turned out to have its own problems. The customers of 9THWONDER might have avoided his exit scam by using the Evolution market’s escrow service, but this would not have protected them against the fact that Evolution turned out to be run by scammers itself. One day it disappeared, taking roughly $12 million of bitcoin that had been deposited in its escrow accounts.
This was a somewhat extreme example of darknet fraud, and in principle there is a technological solution to it—an extension to the bitcoin protocol to allow “multisignature escrow,” so that bitcoins can’t be spent by someone who is only holding them on behalf of another. Darknet researchers,2 however, seem to more or less despair of this technology ever catching on—it’s too inconvenient for users, most of whom can’t even be convinced to pass up the price discounts you get for dealing via FE.
The lesson from the darknet frauds is that you can build technical controls into the system, but fraud will work around them. Precautions are expensive, or inconvenient, or both, and trust is free. This means that people will substitute trust for precautions up until the point at which the “shadow cost of trust”—the expected fraud loss—begins to exceed the direct cost of precautions. Since this trade-off is likely to involve a mixture of both, there will always be trust and therefore there will always be scams. When the same features of a system keep appearing without anyone designing them, you can usually be pretty sure that the cause is economic.
And they do keep reappearing. There are always blind spots; in many ways there have to be. From the beginnings of modern capitalism, there have been people engaged in the business of stealing by lying. Seeing the forest for the trees is a difficult thing to do. People have failed to do it much more spectacularly than the online drug buyers.
The Cazique of Poyais
It is common for young men in a hurry to make rash career decisions. Few of us, though, have screwed it up quite as badly as a London banker by the name of Gauger. In 1822, he was making a career in the City. A good chap from a good family though he was, nevertheless promotion was arriving slowly in the house of Thomas, Jenkins & Co., and so Gauger decided to do what bankers have done for generations: jump a few rungs up the ladder by taking a higher-risk opportunity in an emerging market. The job in question was the role of general manager of the Bank of Poyais, a new British colony in Central America being established by Sir Gregor MacGregor, the war hero and minor Scottish nobleman. Gauger paid a considerable sum of his family’s money to purchase this commission. His trust seemed to have been reciprocated when he took delivery of a chest full of $5,000 worth of newly printed Poyais dollars to transport to the colony’s capital, the fair city of St. Joseph.
Several weeks later, up to his knees in a foreign swamp, Mr. Gauger must have been having second, if not third thoughts. He would never be the man to run the central bank of Poyais, for there was no such country as Poyais. Despite the engraved pictures of it that had decorated all of MacGregor’s marketing material, there was no city of St. Joseph. There wasn’t even a trading post. The Poyais dollars in his chest weren’t completely worthless: the local Miskito children quite liked the pretty pictures on them. But that wouldn’t have been much comfort to Gauger, who had encouraged many other colonists to exchange this absurd scrip for their valuable English and Scottish currency. He had been made the victim of, and party to, one of early capitalism’s first and most audacious investment frauds.
Similar disappointments were felt by the other passengers of the Honduras Packet and Kennersley Castle, which between them had carried around 250 families from Britain to the mouth of the Black River, located in modern Honduras. The voyagers included cobblers (who were never going to be official shoemakers to the Princess of Poyais), musicians (never going to direct the national opera of Poyais), and soldiers (never going to take up their officers’ commissions in the army of Poyais). In an even worse plight were the unskilled and agricultural colonists, who quickly realized that their dreams of an idyllic retirement running sugar plantations farmed by Native American labor were unlikely to be realized without significant unplanned work on a patch of land known as the Mosquito Coast. There was real land, but Poyais was not a real country—no capital city, no fertile plains, not much of anything except swamp and thick local rain forest.
The colonists did not take the revelation well. Those who could hitched lifts to Belize. Mr. Gauger headed off to seek his fortune in the USA, where he disappears from the records; it is not known what subsequently happened to him, but if he stayed in America, he did not live long enough to appear in the 1850 census. Many of the other colonists just died from heat, malnutrition, bad rum, and suicide.
In London, meanwhile, the self-styled Cazique (from a local native American word meaning “chief”) of Poyais was hard at work, hustling with his bankers for a bond issue on behalf of the government of Poyais. “Sir” Gregor MacGregor was in fact preparing for the second London flotation of an issue of Poyais bonds, the proceeds of a previous issue already having been largely wasted. The Cazique was a descendant of Rob Roy who had, like many ambitious officers after the Napoleonic Wars, joined in the independence struggles of Spain’s South American colonies and failed to gain either fortune or honor. He returned to London with a fake knighthood, a highly embellished account of his service, and the claim that he had been asked by the Poyais tribe of Native Americans to become their king. On this basis, he appointed brokers to raise sovereign debt and started selling parcels of land and passages on the Kennersley Castle and Honduras Packet.3 We haven’t heard the last of him. For now, though, we need to ask the question: How did this fantasist manage to take anyone in?
The shallow answer explains the Poyais fraud historically. In fact, there were plenty of countries raising money on the London market, which didn’t, in the modern sense, exist. It was the early 1800s and the Spanish possessions in the Americas (which, at the time, still included modern Florida) were going through a series of independence struggles. The revolutionary governments of New Granada and Venezuela, among others, had not been recognized by the British Crown. Their loans were sold at significant discounts to speculators who could expect a windfall if the state lasted long enough to redeem the principal. These were high-risk, high-return investments, generally bought by gamblers who knew what they were getting into.
So much for the financial backers. But even the colonists deserve some slack, incredible as their naïveté sounds at first. If they had checked in the library, they would have found a book called Sketch of the Mosquito Shore in which the fertile plains of Poyais and its bustling capital were described—MacGregor had faked it, under the pseudonym “Thomas Strangeways,” copying out all the most favorable bits from almanacs of the West Indies and Latin America and then exaggerating them. He claimed that the soil was so fertile that three or four plantings of rattan would have to be made before it was sufficiently impoverished to be good for sugarcane, and that the Miskito tribe wanted nothing more in the world than to work for British settlers, preferring to be paid in cheap textiles rather than cash. Presumably in order to sound credible, he restricted himself to saying that the Black River was full of golden nuggets, rather than claiming they grew from the trees.
If they had gone to the Court of Chancery, they would have found official documents certifying the ownership of the land—MacGregor had sworn false affidavits to have the claim “inrolled” there, based on a much more limited letter of intent (which did not include the granting of any titles of nobility like “Cazique,” by the way) that he had extracted from the tribal leader of all the Mosquito Coast peoples including the Poyais, “King George Frederick,” whom he had treated to copious amounts of whiskey one night while on the run from a previous adventure.4 The Poyais bonds were sold and traded on the London Stock Exchange and quoted in the newspapers alongside those of the Bank of England.
Even the usual protection against scams—that if something seems too good to be true, it is—would not necessarily have protected anyone. The small territories of Latin America were at the time often giving substantial incentives to attract settlers, particularly Europeans with capital and skills. If it seems fanciful that you could buy valuable land for a pittance and then commandeer nearly costless labor to get incredibly rich developing it, bear in mind that this is exactly what the plantation fortunes of Jamaica and the United States were based on. So it wasn’t as easy to see through this mirage as one might think. It was just more difficult to find things out in those days.
That, in my view, is the shallow explanation of how it happened. And the reason I think it’s shallow is that with all the advantages of the internet era, the exact same scam is being carried out today.
ICOs and cryptocurrency
As we mentioned when talking about the Silk Road payment system, bitcoin is a system of “magic numbers” plus a system for keeping track of them so that you can use the magic numbers as if they were a currency. But, of course, there’s nothing intrinsically special about the strings of digits that constitute bitcoins; they’re only made to be magic numbers because the bitcoin algorithm identifies them so. A different algorithm—or even the bitcoin algorithm itself with the parameters tweaked—would identify a different set of ordinary numbers as being magic. And the thing about numbers, of course, is that there are lots of them.
So, if you were to make up your own magic number system along the lines of the bitcoin one, you could create your own personal cryptocurrency. Lots of people have actually done this; there are even platforms that will make one for you automatically. Once you have your set of magic numbers, you have a potential currency, and the question then becomes one of whether you’re going to be able to exchange it for something valuable. How do you do that?
The answer lies in the bit of bitcoin that isn’t the magic numbers themselves. A cryptocurrency delivers on its promise of anonymity because there is no centralized repository of information; the record of transactions is kept in a distributed fashion, with every user keeping a record of all the transactions, and clever communication among the various ledgers to allow them to check up on each other and prevent someone from defrauding the system.5 Effectively, every time you create a cryptocurrency, you’re creating a network of computers running a database.
And you might want to use that database to do something useful. Like, for example, keep a record of predictions that people have made about the future, and reward them for getting it right (Gnosis). Or register internet domain names so they can be traded more easily (Domraider). Or trace the copyright ownership of digital photographs, while also making use of some vintage intellectual property you picked up cheaply (KODAKCoin6). Or, somewhat less comprehensibly, store customer surveys and a loyalty card scheme for dentists (Dentacoin). The point is that participating in your shared database can only be done by people who have the magic numbers, and the only person who can generate the magic numbers is you, and so you might be able to get people to send you US dollars in return for your magic numbers.
This process is the “Initial Coin Offering” (ICO), where you sell “tokens” (magic numbers) for cash. The done thing is to market the tokens with a white paper describing the technology you plan to use and the case for believing that your database will be useful. The promise to people buying the tokens is that you will use the money raised to build the technology thing, and that at some future date everyone will want to use it and need to buy magic numbers in order to do so. The people who bought tokens in the ICO will then either be able to use the system themselves, at a cheaper price than johnny-come-latelies, or sell their tokens at a profit to the users.
One might expect that the majority of people buying into any given ICO would therefore be prospective users of the system, or technologists who were attracted by the detail of the white paper. One would surely be wrong in this expectation. In fact, the majority of cryptocurrency buyers have been speculators, hoping to make a quick percentage return on their cash by selling their coins on. In general, cryptocurrency investors are not well placed to have opinions on whether a technical solution is viable or whether the business case for any given “blockchain” database system is genuine. Their expertise is in spotting which ICOs look hot or well marketed, and which are therefore likely to rise in value. If it looks a bit like a wholly unregulated7 securities market, that’s because it is one.
And, well, what happens in an unregulated securities market? Yep. Doing tech things on a blockchain is difficult (particularly if you want them to be quick or efficient, as the processing overhead associated with keeping all the distributed copies consistent is considerable). It’s also difficult and uncertain work to establish a new product with enough people to justify the costs of setting up the network. But just writing a white paper full of technobabble and wishful thinking is comparatively easy and cheap, and if most of the potential investor base are credulous speculators with no long-term interest in the project beyond the quick turn they hope to make, it’s roughly as effective.
Some ICOs have been proven to be definitely fraudulent, in the sense that there was never any intention to build the promised technology. “Benebit,” for example, promised that it would use a distributed database to keep track of frequent flier miles, and spent a marketing budget of at least $500,000 on assembling a team of nine thousand promoters and followers. It was surprisingly late in the day, after around $3 million had been raised by selling tokens to the public, that it was noticed that the portrait of “John Laverty, co-founder and CEO” on the Benebit website was in fact the deputy headmaster of Tower House Boys’ School in East Sheen, a suburb of London. The other key employees of Benebit were also stolen from the school’s staff photo page; as far as anyone can work out, the true controllers of the Benebit scam were based in Mumbai.
This is structurally a similar fraud to that of Gregor MacGregor. We have a group of promoters who are unconstrained by the normal protections of securities regulation, and who are able to spin fantasy visions of new possibilities without being held down by having to make concrete and auditable financial statements. There is an investment community, like the traders in Latin American bonds of the 1820s, who are largely uninterested in the reality of the things they trade, except insofar as it affects their value as gambling chips. And there are a few true believers, who are prepared to put their trust in a prospectus full of confusing but optimistic hype. All of these things come together in an environment where misinformation is easy to find and aggressively promoted while skepticism is rare and hard to find.
And the near-term feedback is all in exactly the wrong direction; just as the Poyais colonists were led to believe in the possibility of free land and labor by the experience of the Caribbean plantation fortunes, the ICO community has the example of the “bitcoin millionaires” to mislead them. If we think that modern financial markets are much too sophisticated to allow the large-scale misdirection of investment capital into a laughable fiction, we’re wrong.
So the shallow explanation of what went wrong in Poyais—that the world was different then and it was more reasonable to be fooled by a fictional country—seems wrong. The deeper explanation is that Poyais only looks ridiculous to us because we have different blind spots today than the ones that people had at the start of the nineteenth century. And the troubling corollary of that is: there are always blind spots.
The Canadian Paradox
Some places in the world are what they call “low-trust societies.” The political institutions are fragile and corrupt, business practices are dodgy, debts are rarely repaid, and people, rightly, fear being ripped off on any transaction. In the “high-trust societies,” conversely, businesses are honest, laws are fair and consistently enforced, and the majority of people can go about their day in the knowledge that the overall level of integrity in economic life is very high. With that in mind, given what we know about the following two countries, why is it that the Canadian financial sector is so fraud-ridden that Joe Queenan, writing in Forbes magazine in 1985, nicknamed Vancouver the “Scam Capital of the World,” while shipowners in Greece will regularly do multimillion-dollar deals on a handshake?
We might call this the “Canadian Paradox.”8 There are different kinds of dishonesty in the world. The most profitable kind is commercial fraud, and commercial fraud is parasitical on the overall health of the business sector on which it preys. It is much more difficult to be a fraudster in a society in which people do business only with relatives or where commerce is based on family networks going back for centuries. It is much easier to carry out a securities fraud in a market where dishonesty is the rare exception rather than the everyday rule.
The existence of the Canadian Paradox suggests that there is a specifically economic dimension to a certain kind of crime of dishonesty. Trust—particularly between complete strangers, with no interactions besides relatively anonymous market transactions—is the basis of the modern industrial economy. And the story of the development of the modern economy is in large part the story of the invention and improvement of technologies and institutions for managing that trust. In other words, many things about the way the business world is organized make a lot more sense when you realize that they exist because of the constant drive for countries to become less like Greece and more like Canada.
And as industrial society develops, it becomes easier to be a victim. In The Wealth of Nations, Adam Smith described how prosperity derived from the division of labor—the eighteen distinct operations that went into the manufacture of a pin, for example. While this was going on, the modern world also saw a growing division of trust. In previous eras, when people set out across continents to discover new worlds, they had known that they were stepping out into the unknown, but Mr. Gauger was at the cutting edge of a new reality. Already, he belonged to a class of people whose natural assumption was to take things on trust, to assume that the fact that an offer was extended publicly meant that it was probably legitimate. Nearly two hundred years later, his equivalents in the ICO craze were no more likely to expend personal effort on checking things for fraud than to throw their own pots and sew their own trousers. The more a society benefits from the division of labor in checking up on things, the further you can go into a financial fever swamp before you realize that you’re in one.
Trust and its abuses
The thread that links all these frauds together across space and time is that the blind spots are built into the system, and only become glaringly apparent once the whole thing has collapsed and people are watching the sun set over a pestilent swamp where a capital city ought to be. The problem is that whenever you’re creating an economic institution like Silk Road or the colonial system of the nineteenth century, you have to make decisions about what checks and balances you need to put into the system. And every decision about what you’re going to check up on is also a decision about what you’re not going to check up on. And when you’ve decided what you’re not going to check up on, then those are the things you’re going to have to take on trust.
We can see now that one of the truisms about corporate crime—that white-collar executives are given the benefit of the doubt—is not necessarily something we should regret or regard as an invidious fact about social class. It’s pretty much the definition of what it is to be a high-trust society. If you want to be like Canada, you more or less have to accept that you’re going to be the kind of place where people assume that a guy in a suit is probably honest. If you’re going to build the kind of society that Britain grew into in the nineteenth century, you might have to accept that every now and then you’re going to send hundreds of colonists and investors to a country that doesn’t exist.
The way we might describe this is to go back to the lesson about trade-offs that we learned from the online drug market, and say that fraud is an equilibrium quantity. We can’t check up on everything, and we can’t check up on nothing, so one of the key decisions that an economy has to make is how much effort to spend on checking. This choice will determine the amount of fraud.9 And since checking costs money and trust is really productive, the optimal level of fraud is unlikely to be zero.
This, then, is a book about trust and betrayal. But not all kinds of trust and not all kinds of betrayal. In popular culture, the fraudster is the “confidence man,” somewhere between a stage magician and the trickster gods of mythology. In films like The Sting and Dirty Rotten Scoundrels, they are master psychologists, exploiting the greed and myopia of their victims, and creating a world of illusion. People like this do exist (albeit rarely), and we will meet some of them later on. But they are not typical of white-collar crime.
The interesting questions are never about individual psychology. There are plenty of larger-than-life characters. But there are also plenty of people like Enron’s Jeff Skilling and Barings’ Nick Leeson: aggressively dull clerks and managers whose only interest derives from the disasters they caused. And even for the real craftsmen the actual work is, of necessity, incredibly prosaic. Even a master fantasist like Sir Gregor spent a lot of his time calculating agricultural yield tables and dealing with land claim documentation. The way in which most white-collar crime works is by manipulating institutional psychology. That means creating something that looks as much as possible like a normal set of transactions. The drama comes later, when it all unwinds.
Fraudsters don’t play on moral weaknesses, greed, or fear; they play on weaknesses in the system of checks and balances, the audit processes that are meant to supplement an overall environment of trust. One point that will come up again and again as we look at famous and large-scale frauds is that in many cases, everything could have been brought to a halt at a very early stage if anyone had taken care to confirm all the facts.10
But nobody does confirm all the facts. There are just too bloody many of them. Even after the financial rubble has settled and the arrests have been made, this is a huge problem. It is a commonplace of law enforcement that commercial frauds are difficult to prosecute. In many countries, proposals have been made, and sometimes passed into law, to remove juries from “complex fraud trials,” or to move the task of dealing with them out of the criminal justice system and into regulatory or other nonjudicial processes. Such moves are understandable. There is a need to be seen to get prosecutions and to maintain confidence in the whole system. However, taking the opinions of the general public out of the question seems to me to be a counsel of despair.
When analyzed properly, there isn’t much that is truly difficult about the proverbial “complex fraud trial.” The underlying crime is often surprisingly crude; someone did something dishonest and enriched themselves at the expense of others. What makes white-collar trials so arduous for jurors is really their length, and the amount of detail that needs to be brought for a successful conviction. Such trials are not long and detailed because there is anything difficult to understand. They are long and difficult because so many liars are involved. And when a case has a lot of liars, it takes time and evidence to establish that they are lying.
This state of affairs is actually quite uncommon in the criminal justice system. Most trials only have a couple of liars in the witness box. The question is a simple one; when a vault is blown, it’s obvious what happened and the mystery is who did it. When a bank goes bust, though, it’s the other way round. There’s only the CEO who could possibly have been responsible—the difficult question is to find out if a crime happened.
In order to promote an innocent explanation, a crooked businessman might employ the services of crooked lawyers, crooked accountants, even crooked bankers. Crucial documents will turn out to be ambiguously worded or lost altogether. And the question of guilt may turn on having to judge what was in the businessman’s mind at the time—was this an unfortunate series of deals, or an attempt to steal? The goal of the prosecution in a fraud case is to construct a straightforward framework, fitting all the disputed deals into a pattern. The goal of the defense is usually to insist on looking at every piece of evidence individually and burying the pattern in a mass of contradictory detail.
Not everyone accused of fraud is guilty. But if you want to understand how white-collar crime works—to protect yourself, enrich yourself, or just to understand the way of the world—you need to think like a prosecutor. Financial frauds might be presented as masses of overlapping documents and witnesses, but they are created from simple plans following basic principles. Stick to the broad sweep. Don’t get bogged down in the detail.11 Under the blizzard of paperwork, the chances are that you’re dealing with one of four basic maneuvers.
The four types of white-collar crime
The most basic kind of fraud is simply to borrow some money and not pay it back, or alternatively buy some goods and not pay for them. In a modern economy, businesspeople are forced to trust each other to pay invoices and deliver goods as promised. This feature of real-world commerce is surprisingly absent from economics textbooks, but it is absolutely fundamental. Most industries would be very different—almost unrecognizable, and certainly unable to operate at their actual scale—if all transactions had to take place on a cash-on-delivery basis. Every single stage in the production of this book, from the author’s advance to the printers’ payment terms to the retailers’ sale-or-return, depends on the fact that businesses extend credit to each other to let payment be made when the money has arrived to make it.
Strangely, the credit extended between businesses, from suppliers to their customers and vice versa, is not systematically measured in official statistics. Yet any sensible estimate of it would dwarf the size of the banking system—probably less than 10 percent of commercial credit is directly financed by a bank loan. And it is the practice of intentionally running up a lot of credit, and then defaulting on it (as in the 9THWONDER case), that is the basis of the fraud known as a “long firm.” This is our first lesson in commercial crime. It also introduces the key problem of detecting and prosecuting frauds. Even after it has been completed and the money stolen, a long firm often looks just like an honest business that went bust. Unlike most other kinds of criminal, white-collar fraudsters do exactly the same basic stuff as their honest counterparts. What makes the crime is the intent to deceive.
Another way of stealing money through commercial fraud is to abuse people’s trust in the ways by which ownership and value are verified. Again, the fraudster exploits the fact that a world in which every single document was checked, every claim of ownership verified, and every certificate of quality audited would be a world in which a huge proportion of the business world’s time and effort was wasted by checking up on each other. The only practical way to do many types of business is to trust that, for the most part, documents are what they appear to be, and that they prove what they claim to prove. Abusing this trust by creating false documents to verify false claims is “counterfeiting.” We can see at this stage that, just as different types of trust relationships reinforce each other to make commerce profitable, different types of fraud can also reinforce each other. In order to carry out a long-firm fraud, for example, you might want to counterfeit a document that shows you to be more financially sound than you actually are.
As an economy gets more sophisticated, it tends to separate the function of providing capital to a business from the activity of managing one. In such an economy, it is usually impossible (or at least highly inefficient) for the ultimate owners and creditors of a company to monitor everything that is done by the managers they have employed. Like everyone else, they have to rely on trust. And this trust opens up the possibility of a “control fraud.” A control fraud differs from the simpler kind because the means by which the value is extracted to the criminal is generally legitimate—high salaries, bonuses, stock options, and dividends, but the legitimate payments are made on the basis of fictitious profits and unreal assets, and the manager tends to take vastly higher risks than those that would be taken by an honest businessman.
It is also unique in that it is, at least potentially, a “subjunctive” crime—if things turn out well for the underlying business, and the wild risks that the control fraudster takes pay off, the victims never know they have been had and the crime never exists. It is even possible to create a “distributed control fraud,” in which the mechanism of fake profits, high risk, and value extraction arises without the necessary involvement of a single legally culpable actor, by assembling a set of perverse, “criminogenic” incentives that make the distortions happen independently.
Finally, we reach the highest level of abstraction. These frauds exploit the general web of trust that makes up a modern economy, rather than a single relationship. There are plenty of actions that are not even really crimes at all in the traditional sense—they are not obviously or intrinsically dishonest activities. Nevertheless, experience has shown us that a market economy works better if people are able to assume that they won’t be done. Cartels, for example, or insider dealing rings, might be examples of “market crimes,” where the victim is the market itself rather than a particular person who has lost an identifiable sum of money. Market crimes can be very lucrative, but they make other users of the market more reluctant to extend the trust that makes the system work. More than any other, this kind of crime is a matter of judgment, local convention, and practice, rather than one of cut-and-dried criminality. A blatant market crime in one jurisdiction could be considered aggressive but legal practice in another and the definition of good business somewhere else. A long firm clearly falls under “Thou shalt not steal,” and a counterfeit under “Thou shalt not bear false witness,” but where’s the commandment “Thou shalt not trade securities while in possession of material nonpublic information”? The investigation of market crimes takes us into some profound questions about the workings of the modern economy itself. It also takes us to some of the biggest frauds: because market crimes can only arise in a market big and important enough to need its own legal framework, the sums of money are often eye-watering.
Don’t get too hung up on the terminology in any of these cases—in particular, don’t expect it to match up too closely to the criminology literature. We’re less interested at this stage in the details than in the broad structure and the type of breach of trust that’s involved. This gets more abstract at every stage. A long firm makes you question whether you can trust anyone. A counterfeit makes you question the evidence of your eyes. A control fraud makes you question your trust in the institutions of society, and a market crime makes you question society itself. Since it’s impossible to run a modern economy without all four levels of trust, fraud is an insidious crime.
So how does this book work? We will alternate stories of famous frauds (with digressions into the underlying structures that they exploited) and examinations of the trust mechanisms that underpin the modern world (with digressions into how some famous fraudsters exploited them). Commercial fraud is the evil twin of the modern economy. Understanding one gives us powerful insights into the other.
By the end of this journey into corruption, you will be better placed to understand how frauds work, and even to manage—one can never quite eliminate—the risks to your own business or employer. You will also get a useful glimpse into the way that the honest commercial system works. Like the human brain, the market economy is an information processing system. Like the human brain, we get our best looks at its hidden mechanisms when it breaks down. Just as neurologists study the consequences of head injuries, we can learn about the economy by looking at currency forgers and pyramid schemes.
You might, of course, choose to use this book instead as an instruction manual. There are enough case studies and schematics for you to work out how to do one. But bear this in mind. Almost all of the fraudsters discussed in this book got caught. Some of them enjoyed a high lifestyle before they did. But many of them greeted their inevitable discovery with tears of joy that the whole wretched, stressful business had come to an end. The time, effort, and commercial acumen that goes into almost any fraud would nearly always have been better spent on doing something productive.
1. Or at least, not compromised very much. If you don’t take care with the way you manage your bitcoin account (and nobody does, because to do so would be a massive pain in the ass), then you can probably be linked to some of your transactions. But to do so would take more time and effort than the average overworked drug cop is prepared to expend, so the protection was good enough for the users of Silk Road.
2. Oh yes, they exist, albeit pseudonymously. Bloggers, mainly, but performing the recognizable functions of banking consultants and money brokers, writing research either for payment via bitcoin, or to promote their own markets and escrow services.
3. It is more complicated than this. In fact, as far as anyone can tell, MacGregor provided so many assisted places to colonists and advances against their wages in the nonexistent thriving Poyaisian economy that he probably lost money on sales to colonists, which was partly what the funds raised by the sovereign loans were meant to cover. It was not wholly clear, either to his contemporaries or to us with the benefit of hindsight, what he thought he was playing at.
4. This also was not necessarily as weird as it seems. Tribal societies did make land deals, and these sometimes involved the granting of royal or equivalent status in the tribal society to foreign land promoters. The ability to sell one’s land is an important benefit of owning it, and in the absence of a developed society with land registries and law courts, strange things sometimes have to be done. This sort of consideration was a major part of the motivation for the Treaty of Waitangi, for example, as agreed between colonists and the Maori of New Zealand. By establishing that property rights in land were assigned to chiefs, and that transactions between Maori and colonists would be governed by statute law (at the time, that of New South Wales), the treaty aimed to tackle what was becoming a fairly serious problem whereby small Maori family groups would draw up “sale” agreements for huge tracts of land with passing opportunistic explorers, who would then demand that the colonial administration enforce their claims.
5. That is, to prevent anyone from defrauding the system by making fake entries in the database. As with Silk Road, all the technical fraud protections seem to work pretty well. The trouble is that the kind of frauds you can protect against with technology aren’t always the important kind.
6. A trusted brand is a useful thing to have. The KODAK name was, at the time of writing, last seen attached to a stock that went up by more than 2,000 percent on the news that it would be given a federal loan to develop a COVID-19 vaccine. Both the loan and the stock price move are under investigation.
7. “Unregulated” here is a statement of fact rather than law. In actual fact, it’s quite likely that most of these ICOs are illegal, but the SEC hasn’t at the time of writing really gotten around to enforcing the law on their issuers. The more cautious and savvy ICO promoters try to emphasize that the tokens they are selling are for the future purchase of technological services and to disavow the speculative motive, but the law on what constitutes “issuing securities” is widely drafted.
8. Am I being unfair to the Canadians? Is this kind of fraud really more prevalent in Canada than in other countries? Criminological and statistical issues with respect to defining, detecting, and categorizing fraud as a crime more or less guarantee that a proper answer to this question is impossible. But Canada, and particularly its regional stock exchanges, does have a reputation. While writing this book, I got scammed precisely once, and it was by a fake website selling Canadian business visas for ten times their true price.
9. Although probably not in any particularly predictable way. Antifraud protections aren’t like sausage machines or steam looms with a straightforward relationship between input and output, and fraudsters have their own decisions to make, too. But all we really need is for there to be a broad relationship that more control most likely means less fraud, and a broad assumption that people will make decisions that work for them and ensure the long-term stability and viability of the overall system.
10. Another thing that will come up again and again is that it is really quite rare to find a major commercial fraud that was the fraudster’s first attempt. An astonishingly high proportion of the villains of this book have been found out and even served prison time, then been placed in positions of trust once again. “Sir” Gregor MacGregor had tried a version of his land and currency scam in Amelia Island, previously a Spanish possession off the coast of Florida.
11. I will occasionally admit “it’s more complicated than that” in a footnote when I’m doing something really horrific in terms of skating over detail.
- Publisher: Scribner (March 9, 2021)
- Length: 304 pages
- ISBN13: 9781982114930
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Raves and Reviews
“If you want to learn to fend [off] fraud, read this. And if you want to commit fraud ... don't. But if you absolutely must, first read this.” —Nassim Nicholas Taleb
“An engaging and indispensable guide for novice fraudsters - and for those who want to keep out of their clutches.” —John Kay, author of Other People’s Money
“Swindling is never a black and white business, and Davies is good on the shades of grey in fraud-land.”—Financial Times
“Readers who like their true-crime stories laced with economics will enjoy these forays into the dark side.” —Kirkus Reviews
“Dan Davies tells all these stories with verve and wit ... Much of the book is a romp through the crimes of scoundrels - Ponzi, Madoff, Keating, the Krays ... Yet what takes it from absorbing to excellent is the author's insight. Read Lying for Money and you will look at fraud in a whole new way. Actually, you will look at every market transaction you take part in in a whole new way.” —Sunday Times (UK)
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