Thomas Petters successfully ran a $3 billion show for over 13 years. In hindsight, his illegitimate “asset based lending” scheme was far from complex and the promised returns were simply too good to be true. Why then did so many investors miss his misconduct for such a long time? A golden rule to avoid a potential fraud is to remember: there is no such thing as a free lunch. In this case are three critical steps investors could have taken to avoid the massive losses they suffered.
|Fund Name||Arrowhead (Arrowhead Capital Finance Ltd, et al)
Lancelot (Lancelot Investors Fund, L.P., et al)
Palm Beach (Palm Beach Finance Partners, LP, et al)
Stewardship (Stewardship Credit Arbitrage Fund, LLC, et al)
|Investment Manager||Petters Company, Inc.
Petters Group Worldwide, LLC.
Arrowhead Capital Management, LLC, et al
Lancelot Investment Management LLC
Palm Beach Capital Management LP, et al.
Stewardship Investment Advisors, LLC
Acorn Capital Group LLC
|Portfolio Manager||Thomas Petters
James Fry and Michele Palm (Arrowhead)
Gregory Bell (Lancelot)
Bruce Prevost and David Harrold (Palm Beach)
Marlon Quan (Stewardship)
|Other Notable Parties||PC Funding, LLC; Thousand Lakes, LLC, et al|
|Investment Strategy||Asset-based lending; Purchase-Order inventory financing|
|Estimated Losses||Over $3 billion|
|Fraud Causal Factors||- Theft and Misappropriation
- Existence of Assets
- Misvaluation of Fund Assets
- Concealment of Trading Losses
- Conflict of Interest
From as early as 1995 through September 2008, Thomas Petters (“Petters”), a prominent businessman in Minnesota, perpetrated a massive Ponzi scheme through the sale of promissory notes to investors. While Petters’ $3.65 billion fraud is dwarfed by Bernie Madoff’s $65 billion whale, it remains the third largest hedge fund fraud case in history.
After failing in several retail ventures, Petters started a wholesale brokerage business, which later became Petters Co, Inc., (“Petters Co”) in 1988, trading closeout, overstock, and bankrupt merchandise. Petters Co and its affiliates bought the goods at a huge discount and sold them to “Big Box” retailers such as Wal-Mart and Costco. Such transactions usually took up to 180 days to complete. While the sellers or manufacturers demanded payment up front, the buyers/retailers did not pay until the merchandise was delivered. In order to finance this 180-day period (“purchase order inventory financing”), Petters issued a short-term (less than 180-day) promissory note with a large coupon payment (from 10 to 18% p.a.) to at least 20 investors.
There were at least four fund operators of external feeder funds, set up primarily to purchase secured notes from Petters Co and its affiliates (Exhibit 3.1). Shortly after the arrest of Petters, SEC accused all four operators, including their principals, of knowingly supporting the fraud scheme. According to various court documents, these feeder funds raised more than $4 billion from their investors, including well-known fund of funds operators.
Exhibit 3.1: List of Feeder Funds for Petters
Source: various court documents; figures are rounded
Many feeder funds were structured to continuously purchase the notes from subsidiaries or affiliates of Petters Co. In order to show legitimacy of the scheme, Petters Co. established escrow accounts, over which it had no control. All payments from the Big Box retailers were to be paid into the accounts. Each feeder fund had a slightly different scheme, but the fundamentals were the same. The following diagram is the scheme used by Stewardship.
Exhibit 3.2: Flow Chart of Purported Investment Scheme
Doug Kelly, a personal lawyer of Petters, became the court-appointed receiver in the Petters’ bankruptcy and filed about 200 lawsuits, seeking to recover some $2 billion of investor capital. As of Dec 2010, he had collected about a tenth of the losses.
Petters fabricated purchase orders from retailers and used them as collateral to borrow money through hedge funds. In reality, paying 10-18% interest on highly secured paper was simply too good to be true. In fact, the scheme crafted by Petters was relatively simple compared to other Ponzi schemes. So, why did many investors, who directly purchased the Petters paper or indirectly invested in the feeder funds, fail to detect his misconduct?
The reason Petters could run a $3 billion Ponzi scheme over so many years was largely due to the negligence of investors and a lack of operational due diligence. The stable return stream of the feeder funds (1.0-1.5% a month with almost no fluctuation) would have been highly attractive not only for individual investors, but also institutional investors who obsessively sought “low volatility, low correlation” opportunities.
The payment scheme with the escrow/lock box accounts described above should have worked well if it were operated and monitored diligently by the direct holders of the notes (i.e., feeder funds). But, it was a sham as the feeder fund operators never conducted due diligence as promised.
Petters and his affiliates knew very well how to manipulate investors’ psychology and were able to mislead them via a variety of false guarantees and obfuscations:
- All promissory notes were secured by purchase orders from the well-respected retail names, enhancing the reputation of the fraudulent notes
- Multi-layered schemes and entities, including subsidiaries/affiliates of Petters Co and feeder funds
- The escrow account misdirected investors’ sense of security
- Payments were made on time for over 13 years of its existence until the last stages of the scheme
- No audit was legally required at the level of borrowers (Petters Co and its affiliates), even though annual audit for the feeder funds were conducted by reputable audit firms (lack of area expertise, lack of interest, or laziness being the top culprits at the audit level)
Conduct extensive background checks on all related parties
- This is one of many cases in which background checks could have helped investors avoid stepping on a landmine. With due respect to the cost of running such checks, in this case, it was important for investors to check on both the manager and all related parties.
- For example, in May 2005, a potential investor emailed one of the feeder fund operators, stating that a third party report indicated that “Mr. Petters’s background includes a criminal history (fraud or forgery convictions, possibly with prison time served), along with significant civil litigation, including a recent $5 million fraud suit.” In fact, Petters had been convicted of several felonies, including a 1983 conviction for writing bad checks, a 1989 conviction for forgery (for which he served time in prison), and a 1990 conviction for theft by check.
- New York hedge fund manager Richard Bookbinder of Bookbinder Capital Management passed on an investment after he learned that Petters had lied on a Dun & Bradstreet questionnaire about earning a degree from St. Cloud State University.
Mr. Bookbinder: “Things popped up and we didn’t feel comfortable. When people gave money [to Petters] they didn’t ask, ‘Who’s this guy? What’s his background?’ The question is: This information was out there in 2002. We looked at it and we’re a small firm; why didn’t other people look at it?”
Confirmation on the Big Box retailers and their payments to the lock box accounts
- In 2005, AG Deutsche Zentral-Genossenschaftsbank Frankfurt Am Main (“DZ Bank”), a German lender, discovered that the lock box account did not function as Stewardship represented in its offering materials. DZ Bank made this discovery in the course of performing due diligence for a line of credit to Stewardship’s operating company, Acorn Capital Group, LLC.
- In 2008, Acorn sought a loan from Fortress Investment Group LLC (“Fortress”), but Fortress decided not to loan Acorn money after it learned that the Big Box retailers did not make payments directly into the lock box accounts as explained by Acorn.
- For an investor of a feeder fund, it could be difficult to obtain transaction details of the lock box accounts. However, it may still have been possible to conduct due diligence by calling some of the Big Box retailers outright and asking if they recognize Petters Co or its affiliates as actual counterparties of the purchase orders, or if they recognize the purchase orders at all.
Confirmation of registration as a Registered Investment Advisor
- Arrowhead Capital Management LLC (“Arrowhead LLC”), and Arrowhead Finance marketed their affiliate entity Arrowhead Corp. (predecessor of Arrowhead LLC) and later Arrowhead LLC as registered with the SEC as investment advisor. While Arrowhead Corp was previously registered with the SEC on November 27, 1995, it subsequently terminated its registration on July 7, 1997 before Arrowhead raised any capital for its funds. A quick online check at the SEC website should have led to serious questions being asked surrounding this issue alone
U.S. Securities and Exchange Commission (2009). Litigation Release No. 21124 / July 10, 2009. SEC Website
U.S. Securities and Exchange Commission v. Thomas J. Petters, Gregory M. Bell, and Lancelot Investment Management LLC, and Inna Goldman, Inna Goldman (2009). U.S. District Court for the District of Minnesota.
U.S. Securities and Exchange Commission v. Marlon Quan, Acorn Capital Group, LLC and Stewardship Investment Advisors (2009). U.S. District Court for the District of Minnesota
U.S. Securities and Exchange Commission v. Marlon Quan, Acorn Capital Group, LLC and Stewardship Investment Advisors, LLC (2009). U.S. District Court for the District of Minnesota
Ellerbrock Family Trust, LLC; Belmont Strategic Income Fund, LP, on behalf of themselves and all other similarly situated v. McGladrey & Pullen, LLP (2009). U.S. District Court for the District of Minnesota
Lancelot Investors Fund, LP, Lancelot Investment Management, LP v. Thomas Joseph Petters, Thousand Lakes, LLC, Petters Company, Inc., Nationwide International Resources, Inc., Enchanted Family Buying Company, Larry Reynolds, Michael Catain, Deanna Coleman, & Robert White (2009). U.S. District Court for the District of Minnesota
Moylan, Martin. “J. P. Morga Chase sued to recover Petters fraud funds”, Minnesota Public Radio website, December 30, 2010