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Twisting trust: social networks, due diligence, and loss of capital in a Ponzi scheme

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Abstract

This paper examines a pre-planned fraud which ran undetected for more than five years and deceived 2285 investors for $240 million. We seek to uncover the effects of trust in social ties and conducting due diligence on 1) an investor’s initial amount of investment and 2) their overall loss of capital. Using data from a survey of 559 victims, we conduct two linear regression models to test for effects on investors’ amount of initial investments and their total net loss. By using two dependent variables, we examine effects of social ties and performing due diligence at the beginning stage and end stage of a Ponzi scheme. Performing due diligence and relying on information provided by industry professionals increased initial investments, while having performed due diligence also increased investors’ loss of capital at the end of the fraud, suggesting both social ties and due diligence contributed to fraud victimization. The findings are interpreted within the context of a particularly sophisticated fraud where document falsification was almost impossible to detect, contributing to a false sense of security among victims.

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Notes

  1. It was legally determined by the British Columbia Supreme Court to be a pre-planned fraud. Evidence of Eron’s actions also provide evidence of a pre-planned fraud: 1) Eron did not adequately investigate projects before funding them and, 2) Slobogian and Biller continued to advance funds to projects that they knew were losing money and exceeded their worth during the time Eron was formed, These actions should take place before securing money from investors for any legitimate mortgage brokering business.

  2. The Santa investment fraud was a Ponzi scheme that lasted over ten years and targeted military officers in Greenland from 1986 to 1999.

  3. Specific charges include: 1) overstating the value of mortgaged properties, 2) overstating extent to which mortgaged properties had been developed, 3) understated the degree of risk in the mortgages, 4) promised investors unrealistic rates of return (15 to 20%), 5) promised investors repayment in 6 to 12 months which could not be met without raising more funds, 6) did not fulfill guarantees to investors of repayment, 7) put investors into mortgages with lower priority and/or higher principal amounts than which the investors were told, 8) raised funds from investors for mortgages that exceeded the face value of said mortgages, 9) spent investors funds in ways that were different from their intended purpose, without advising the investors, 10) used the funds of subsequent investors to make interest and principal payments to existing investors without their knowledge and, 11) failed to keep proper records of the funds raised from investors [30].

  4. Seven respondents from our network sample were removed from the study because they chose themselves as the person who influenced them to invest in Eron.

  5. A control variable for how respondents first heard about Eron was created. Respondents were asked “How did you first hear about Eron?” Respondents could select all that applied to their situation from eleven different options including: 1. Eron employee, 2. Financial broker, 3. Family or friend, 4. Business associate, 5. Hockey connection, 6. Eron seminar, 7. Newspaper advertisement, 8. Newspaper article or column, 9. Mail solicitation, 10. Television advertisement and 11. Other These 11 options were indexed into two distinct variables, first heard about Eron through Personal sources, coded as an index of respondents who selected options 1–5, (M = .9733, range = 0–4) and first heard about Eron through impersonal sources, coded as an index of respondents who selected choices 6–10 (M = .6089, range = 0–4). Both variables were not significant in either model. Initial Investment model (R2 = .198; F = 3.835; p < .001); personal sources: B = .119, p = .206; impersonal sources: B = .011, p = .894. Net Loss model (R2 = .447; F = 16.469; p < .001); personal sources: B = .036, p = .702; impersonal sources: B = .037, p = .667.

  6. We ran the same model (R 2 = .162, F = 2.273, p < .05) on our non-network sample (n = 222) with the exception of including the social tie indicators and found no significant effects on initial investment from due diligence, B =

    −.002, p = .734; Personal sources, B = −.019, p = .081; Impersonal sources, B = −.004, p = .699..

  7. We ran the same model (R 2 = .454, F = 10.569, p < .001) on our non-network sample (n = 222) with the exception of including the social tie indicators and found no significant effects on net loss from due diligence, B =

    .008, p = .104; Personal sources, B = .002, p = .837; Impersonal sources, B = .003, p = .814.

  8. An important distinction must be made between our study and that of Baker and Faulkner’s [1]. The Fountain, Oil and Gas fraud examined by Baker and Faulkner is an intermediate fraud – a fraud that started off as a legitimate business but turned to fraudulent activity to sustain itself. Our study examines a pre-planned fraud which starts on the premise of fraudulent activity from the beginning of its existence. In the pre-planned fraud conducted by Eron, two factors may automatically be working against investors: (1) falsified documentation provided by Eron, contributing to the malfeasant effect of conducting due diligence, and (2) an overreliance on industry professionals, contributing to the negative effects of trust in making financial decisions.

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Authors and Affiliations

  1. California State University, Long Beach, 1250 Bellflower Blvd, Long Beach, CA, 90840, USA

    Rebecca Nash & Aili Malm

  2. School of Criminology, Simon Fraser University, 8888 University Drive, Burnaby, B.C., V5A 1S6, Canada

    Martin Bouchard

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  1. Rebecca Nash
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Correspondence to Rebecca Nash.

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Table 5 Correlation Matrix
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Nash, R., Bouchard, M. & Malm, A. Twisting trust: social networks, due diligence, and loss of capital in a Ponzi scheme. Crime Law Soc Change 69, 67–89 (2018). https://doi.org/10.1007/s10611-017-9706-2

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