One Financial Frauds and Their Causes

On Financial Frauds and Their Causes:

Investor Overconfidence

By STEVEN PRESSMAN*

ABSTRACT. This paper examines two possible explanations for why inves-tors are so often and so easily taken by the likes of Robert Bennett and hisNew Era fraud or Nick Leeson's sinking of the esteemed Barings Bank. Imle out the traditional explanations offered by neoclassical economicssuch as asymmetric information in a world of calculable risk. I argue thatthe literature on empirical psychology, which emphasizes how peoplemake choices in a world characterized by uncertainty provides a moreplausible explanation for why financial fraud is so prevelant. The paperemphasizes the interdi.sciplinary aspeas of financial frauds and concludeswith some policy prescriptions for preventing financial fraud.

Introduction

EVERY FEW MONTHS another case of financial fraud seems to make it to thefront pages of the daily newspapers. On a somewhat small scale, companyheads such as Barry Minkow (Akst, 1990; Domanick, 1989) and "CrazyEddie" Antar, the New York electronics king who ran commercials thatconcluded with the memorable line "Our prices are insaaaaaaaaaaaane"(Queenan, 1988), receive jail sentences after embezzling large sums ofmoney from the firms they started. In search of much larger sums of money,Michael Milken deceived investors about the risks involved when investingin junk bonds (Stewart, 1991; Sobel, 1993), while Bankers Trust deceivesits clients about the dangers of financial derivatives (Holland, Himmelstein,and Schiller, 1995; Loomis 1995). And in one of the greatest frauds of this

* (Steven Pressman, Department of Economics and Finance, Monmouth University,West long Branch, NJ 07764. E-mail [email protected]).l ProfessorPressman's interests include macroeconomic policy, poverty and income distribution, andthe history of economic thought. His publications include Economics and Its Discontents(edited with Richard Holt, Elgar. 1998) and Quesnay's Tableau Economique: A Critiqueand Recotistmction (Kelley. 1994)American Journal of Ecimomics and Sociology. Vol. SI, No. 4 (October, 1998).® 1998 American Journal of Economics and Sociology'. Inc.

American foumal of Economics and Sociology

century or any other century, Nick Lee.son (Leeson, 1996; Pre.ssman, 1997)brings down Barings Bank, one of the oldest and most conservative finan-cial institutions in the world, through his illicit and risky trading in foreignexchange options. Barings had financed the American purchase of the Lou-isiana Territories from France in 1803, and by the early nineteenth centuryhad become banker to the British royal family.

Instances of financial fraud have not been limited to the private seaor.Frances Cox, the Treasurer of Fairfax County', Virginia used her position toembezzle more than half a million dollars during the 1960s and the 1970s(Coughlan, 1983). And Orange County, encouraged by Merrill Lynch, wentbankrupt after wildly speculating in financial derivatives 0orion, 1995).

Why do such financial frauds continually recur? What are the causes ofthese fiascos? What can traditional economic theory tell us about the causesof financial frauds and their po.ssible cures? These are the questions thatwill be addressed in the remainder of this paper. The next .section looks atone particular case of financial fraud—New Era Philanthropy. This casestudy Ls useful for two reasons. First, it contains many characteristics ofother financial frauds. Thus, it is a good case to use if we want to drawsome lessons or morals. Second, because many colleges and universitieswere duped by New Era, New Era is likely to be of greater interest to theacademic readers of this journal than the collapse of a large financial insti-tution or some egregious case of embezzlement.

11

New Era Philanthropy—A Case Study

IT IS HARD TO BELIEVE THAT A CfL\RnT WOULD RUN A PoNzi SCHEME; but this

is exactly what the Foundation for New Era Philanthropy did, making itpart of the biggest financial .scandal in the history of philanthropy.

John G. Bennett, Jr., was the founder and driving force of New Era Phi-lanthropy. He was born in 1938 and grew up in a working-class Philadel-phia neighborhood. In 1963, Bennett graduated from Temple Universityand began work as an administrator for a drug and alcohol abuse program. _Then in 1982 he began a company called the "Center for New Era Philan-thropy." This firm advised corporations about which nonprofit organiza-tions should receive their money (Stecklow, 1995).

In 1989, Bennett began the Foundation for New Era Philanthropy. At

On Financial Frauds 407

first. New Era provided free investment advice and assistance to nonprofitorganizations. Nonprofits were instruaed where and how to best investtheir endowments. These services earned Bennett considerable recognitionand respect in the nonprofit community. They also earned Bennett a po-sition on the Boards of Directors of numerous Philadelphia nonprofit or-ganizations, including the Philadelphia Orchestra. - -' ̂ . = ':>^^5..

New Era Philanthropy then went into the business of helping nonprofitsraise money. But it attempted to do so in a manner that was unique andunorthodox. Bennett promised that in six months time he would doublethe investment of any nonprofit organization that gave him money. Suchreturns, Bennett claimed, were made possible by wealthy philanthropistswho wanted to make anonymous donations to charity through New Era.

While it is unusual for charitable organizations to have to ttim over moneyto receive additional contributions. New Era had a ready answer for anyonewho questioned this practice. Bennett claimed that New Era needed the in-terest on this money to cover their operating casts (Knecht & Taylor, 1995).Despite their unconventional request that nonprofit organizations tum moneyover to them. New Era thrived and prospered in the early 1990s.

Numerous factors contributed to the success of New Era Philanthropy.First, Bennett had close ties to established and well-known Christian phil-anthropic groups. This gave him and New Era an aura of respectability andtrustworthiness. Second, Bennett had an infectious optimism that madepeople trust him. Third, Bennett paid substantial "finder's fees" to any in-termediaries directing charitable donations to New Era. Fourth, over thecourse of several years. New Era did pay enormous returns on the moneythat philanthropists and charities deposited into special accounts. For themany nonprofit organizations that were hard hit by cuts in Federal spend-ing during the 1980s and early 1990s, the lure of an annual rate of returnof 300 percent was just too hard to pass up.

Finally, and perhaps most important, charitable organizations felt thatthe money they gave to New Era was secure. Bennett told donors that theirmoney would be put into escrow or custodial accounts at Prudential Se-curities. These accounts would make it easier for each donor to keep trackof its money and the returns it was making. Tlie accounts also reduced therisk that something might go wrong and the charity or philanthropic or-ganization would lose the money it gave to New Era.

In the early 1990s, hundreds of nonprofits gave large sums of money to

408 American Journal of Economics and Sociology

Bennett, Some were prominent nonprofit organizations such as the Amer-ican Red Cross, the Salvation Army, and elite academic institutions such asHarvard, Princeton, and Brown Universities. When New Era folded, theseinstitutions all lost the money they had on deposit. John Brown Universityin Siloan Springs, AK, lost $2 million, close to 4 percent of its endowment.The big loser, however, appears to be Lancaster Bible College in Lancaster,PA, which had Sl6,9 million deposited with New Era, *

Even cautious charities that carefully checked out New Era fell victimto John Bennett s philanthropy scam. Nature Conservancy is a nonprofitorganization that works to preserve threatened wildlife habitats. It is oneof the most respected and most conservative charities in the United States.After one of its major donors made a $15,0(K) gift through New Era, NewEra approached Nature Conservancy and discussed their program of dou-bling deposits in six months. Being skeptical by nature. Nature Conser-vancy called other nonprofit organizations that had relationships withNew Era and asked for references. They also called Prudential Securities,which held New Era s funds, the IRS, and the Pennsylvania Bureau ofCharitable Organizations, Then they performed an extensive search ofnewspaper articles looking for any negative information about New Era.In all cases New Era checked out as legitimate and problem-free (Knecht& Taylor, 1995),

However, New Era was not what it seemed, and Bennett defrauded allof these organizations. In fact, there were few wealthy philanthropists con-tributing to New Era. Rather, Bennett took a substantial fraaion of themoney he received for his own personal benefit, and he used the depositshe made with Prudential as collateral on a personal loan. When it cametime to pay off early investors, Bennett u,sed the funds he obtained fromlater investors. In essence, he was running a huge pyramid or Ponzischeme.

It took nearly six years for all the facts to be discovered and for New Erato collapse. Two separate incidents in 1995 led to the downfall of New Era.Albert Meyer, an accounting profes,sor at Spring Arbor College in ruralMichigan, became concerned about the endowment money his school wasgiving to New Era. He contacted the Securities and Exchange Commission(SEC) and the Wall Street Journal, and he wrote to the IRS for informationabout New Era's tax returns. This information was all very slow in coming.Finally, at the end of March 1995, Meyer received a copy of New Era's 1993


tax return. The key number, the proverbial smoking gun for Meyer, wasthe $34,000 in interest that New Era claimed it had earned during the year.If New Era had invested millions of dollars, as it claimed. New Era shouldhave received close to $1 million in interest. The $34,000 in reported in-terest was clear evidence that something was wrong at New Era (Demery,1995; Michelmore, 1996).

At about the same time. New Era failed to repay a loan to PrudentialSecurities. As a result. Prudential took control of New Era's funds and de-manded to see its financial records. These records showed that New Erahad virtually no assets and virtually no income, yet at the same time theyhad more than $135 million in liabilities, which were primarily the depositsthat nonprofit organizations made to New Era.

On May 15, 1995, New Era filed for protection under Chapter 11 bank-ruptcy laws after the Wall Street Journal published an article about the NewEra fraud (Knecht & Taylor, 1995). When lawyers for New Era admittedthat there was no chance the organization could be saved through a reor-ganization, the case was moved into Chapter 7 liquidation.

Soon the indictments and lawsuits began. Bennett was charged with 82counts of fraud, money laundering, and tax evasion. Furthermore, the SECsued Bennett and New Era, charging them with violating U.S. securitieslaws. They claimed that the matching fund program of New Era was reallyan unregistered public offering of securities. The SEC also charged thatBennett moved $4.2 million from New Era into several companies that hepersonally owned and then used the money for the benefit of himself andhis family.

In January 1996, Bennett agreed to tum over $1.2 million in personalproperty, cash, and securities to a Federal bankruptcy judge. This includedhis $620,0(X) home in suburban Pennsylvania, his Lexus automobile, andthe $249,000 home he bought for his daughter (Stecklow, 1996). Thesefunds were added to the assets of New Era for distribution to the charitableorganizations to which New Era owed money.

A 19% bankruptcy court settlement returned nearly two-thirds of themoney that nonprofit organizations had on deposit with New Era. In anattempt to recoup the remaining money, 30 nonprofits sued PrudentialSecurities for $90 million, charging that the brokerage firm was a co-conspirator in the New Era fraud. Specifically, they charged that Prudentialassured them that their funds were being held in escrow accounts, when


in fact Prudential knew that all New Era funds were held in a single, generalaccount and were being used to repay loans to Prudential (Bulkeley, 1996),This lawsuit was settled out of court in November of 1996,

On March 26, 1997, Bennett pleaded no contest to charges of fraudand money laundering. He was sentenced in late 1997 to 12 years inprison,

mThe Causes of Financial Frauds—The Neoclassical Story

THE NEW ERA CASE PROVIDES A CLEAR EXAMPLE of how easily investors can bedefrauded by a simple Ponzi scheme. In most instances, the investors JohnBennett duped were sophisticated nonprofit organizations with extensive ex-perience investing large sums of their money. Most of these organizationschecked out New Era (although not thoroughly), and they believed theirmoney was safe and that New Era Philanthropy was a legitimate endeavor.

The case of New Era raises two questions. First, how can something likethis happen to sophisticated investors? Second, what can be done to keepless knowledgeable and experienced investors from falling prey to financialfrauds on a regular basis? Neoclassical economic analysis provides onepossible explanation for the recurrence of financial frauds; but, as this sec-tion argues, the neoclassical explanation is rather limited and unconvinc-ing. The next seaion relies on the findings of empirical psychology topresent a more convincing explanation for why financial frauds like NewEra occur with great regularity.

The main reason standard economic theory provides little help in un-derstanding the prevalence of financial frauds is that neoclassical econom-ics pretty much rules financial frauds out of existence by assumption. Thekey assumptions leading to this result are that people are knowledgeableand that they are rational. Rationality implies that people want to maximizetheir returns on investment (given a known degree of risk). This meansthat when a great deal of money is at stake, investors will seek a great dealof information about where they invest their money. There is no denyingthat individual inve,stors know that cases of fraud exist (sufficient evidenceof this appears in magazines and newspapers). Individual investors alsoknow that there is a nonzero probability that they will be defrauded. Whenlarge sums of money are at .stake, neoclassical theory holds that rational


investors should weigh their potential gains against their potential lossesand that they should seek out large amounts of information about whothey are giving their money to.

But once it is assumed that people are rational in the sense just described,and that they know what they are doing before they invest, it is hard toexplain why people should frequently be duped or why financial fraudssuch as New Era Philanthropy exist. ' '

It is at this point that neoclassical theory brings in the notion of asym-metric information. In cases of investment, the investor must always know-less than the person or institution that receives their money. The individualwho gives his or her money to someone to invest does not know that themoney will really be used as part of some Ponzi scheme, or to establishthe facade of a legitimate business whose proceeds then get used for per-sonal consumption. Investors are thus at a disadvantage, and this disad-vantage leads to Ponzi schemes, embezzlements, and so on.

But falling back to the notion of asymmetric information really does littleto explain financial frauds. First, there are internal problems with this ap-proach—even within the neoclassical paradigm it does not provide a goodexplanation for the existence of financial frauds. Despite asymmetric in-formation, any rational individual giving up money has great incentives tomake sure that the monies are actually being employed as promised. Inmany cases, potential losses can run into the millions of dollars. So whydon't individuals take better care and try to obtain the additional informa-tion that would reveal the existence of a fraud? Neoclassical theory and thenotion of asymmetric information provide no answer to this question. Inaddition, why don't individuals stop investing or not invest until they havesufficient information to make sure that they are not being defrauded? Ra-tional and knowledgeable investors (in the neoclassical sense) should re-alize that extremely high gains are unlikely, and promises or payments oflarge returns should be a red flag indicating the possibility of a Ponzischeme. It should signal to investors that "more information is necessary"rather than "this is a good place to invest money,"

Moreover, the basic facts in the New Era case do not support neoclassicaltheory. Many investors did no? check New Era's financial records carefullybefore they gave New Era millions of dollars. In addition, everyone tookat face value assurances from Prudential Securities that the money theygave to New Era was being held in individual escrow accounts. Not one


nonprofit organization demanded to see an account statement from Pru-dential bearing solely its name and containing exactly the amount of moneyit deposited with New Era. Albert Meyer, the mild-mannered accountingprofessor who pressed Spring Arbor College to get this information and tohave other questions answered, was met with indifference and hostility bythe senior administrators at his school. He even felt that he was putting hisjob as an untenured professor at risk by merely asking such questions(Michelmore, 1996).

Most financial frauds follow this pattem. Investors do not thoroughly checkout who they are giving their money to, and even if they do this, swindlersare able to cover their tracks. Oscar Hartzell's Drake Estate swindle providesanother good example of how and why the asymmetric information and neo-classical theory do not get to the root causes of financial frauds. In thLs case,the defrauded investors were not large nonprofit organizations with substantialinvestment experience; they were midwestem families, primarily in Iowa, thatknew little about investing their hard-earned money.

The Drake swindle involved the supposed estate of the British admiraland explorer Sir Francis Drake. Hartzell convinced hundreds of familiesthat they were descendants of the great explorer, and that Drake hadleft an estate valued in the hundreds of millions of dollars or even more.Hartzell also convinced them that he was trying to get the Drake Estatedistributed to its rightful heirs and that all he needed was "expensemoney." Those who contributed to this enterprise, he claimed, wouldreceive a portion of the Drake Estate. Using this sales pitch, Hartzellconned 70,000 American families out of more than $2 million (in 1920sand 1930s money). Many farmers in Iowa and other midwestern stateswent into debt and heavily mortgaged their farms to meet Hartzell'scontinual requests for expense money. Eventually, many of these farmswent into foreclosure.

Yet, no one asked the simple questions that would have revealed Hart-zell to be a con artist. For example, Drake died childless, so his heirs couldnot inherit his fortune, no matter how massive it was. In addition, the statuteof limitations on wills in England is thirty years. So even if Drake did hideaway billions worth of gold, and even if he did have an heir, that heirwould not be legally entitled to any of the Drake Estate in the twentiethcentury (Brannon, 1995; Nash, 1976, pp. 77-93). Again, the problem is notasymmetric information in the neoclassical sense of investors trying their


best to get information and being thwarted by scam artists. Rather, theproblem is that investors themselves do not ask the appropriate questionsand naively believe what they are told and apparently what they want tobelieve. They are not rational in the neoclassical sense of the term, nor forthat matter, in any other sense of the term,

A final problem with the traditional economic view of financial fraudsis that in cases of financial investment, individuals are not facing risk, butuncertaint>'. Traditional theory attempts to convert situations of uncer-tainty into cases of risk by assuming that people form subjective proba-bility assessments for the situation based on the laws of probability. Butit is unlikely that any investor can come up with probabilities for thelikelihood that they are being defrauded. One reason for this is the lackof information about the number of fraudulent investments. Many fraud-ulent investments never become known to the public because the greatrisks undertaken by some individuals eventually get paid off. Others re-main unknown because the victims are too embarrassed to come forward.So it becomes a matter of faith rather than a matter of probability that aninvestment is legitimate. In the next section we will see that having aparticular psychological makeup increases the likelihood that an individ-ual will take this leap of faith.

IV

Causes of Financial Frauds—^The Other Story

THE NEOCLASSICAL EXPLANATION OF RNANCIAL FRAUDS viewed investment de-cisions as primarily matters of risk. They are cases in which people makeprobability assessments of future events and then make rational decisionsthat maximize the expected utility they will receive from their investmentopportunities.

However, it is not clear that investment decisions involve choices inwhich people know the risks of different possible investments. Nor is itdear that investment decisions involve forming probability assessments ofpossible fijture outcomes. Rather, most investment decisions are choicesmade when facing some degree of uncertainty. In cases of uncertainty,people typically resort to some kind of focal point for making their decisionor coordinating their actions (see Schelling, I960, chap, 3). If uncertainabout whether to refinance one's mortgage, one looks at what one's neigh-

414 American foumal of Economics and Sociology

bors and acquaintances are doing. When a large number refinance, thatprovides a signal for others to refinance. Likewise, when uncertain whetherto invest money in a certain mutual fund or business, one looks at whatone's friends and acquaintances are doing. If they are giving their moneyto firm X or individual Y, then one does not look like a loner if he or shedoes so as well. Conversely, a person may look foolish if he or she did notget in on a good thing. Thus, when many people invest in a certain way,there is a tendency for others to do so as well.

But if investment decisions are based on focal points, the situation is ripefor financial frauds. As we saw earlier, the typical financial scam beginswith a few investors who receive extremely large rates of return. It is thesegreat returns that attract more investors and that make a certain investmentseem legitimate or become a focal point.

Empirical psychology provides a good deal of evidence that people arepsychologically constituted to make the very sorts of errors that lead tocases of massive financial fraud. One result from the empirical psychologyliterature is that judgments about potential risk are frequently mistaken,and human fallibility tends to be greatest when people hold their faultyjudgments with great confidence (Slovic, Fischhoff, & Lichtenstein, 1982).Moreover, people are psychologically predisposed to be optimistic when-ever they are individually involved and have had no bad personal expe-riences from their past to counter this innate optimi,sm. For example, a largemajority of people think that they will live past 80 (Weinstein, 1980) andthat they, personally, are unlikely to be harmed by products they buy anduse (Rethans, 1979). Psychologically, people tend to live in the world ofLake Wobegon, where all children are smarter than average and betterbehaved than average.

People also tend to believe that good things will happen to them. Theyoverestimate their chances of winning the lottery and think that they willnot suffer serious injury if they are involved in a car accident but do notwear their seat belt (Slovic, Fischhoff, & Lichtenstein, 1978). It appears thenthat people are psychologically predisposed to believe perpetrators of fi-nancial frauds and to believe that they themselves will not be the victimsof such frauds.

Another relevant result from the empirical psychology literature is thatpeople are overconfident in their judgments. People believe that they areright more often, and to a much larger degree, than they actually are right


in their assessments (Oskamp, 1965). What is true of laypeople is also trueof "experts" in a particular area. It is this overconfidence that leads to suchdisasters of human error such as Three Mile Island and the collapse of theTeton Dam, and such ecological and biological disasters such as acid rainand ozone depletion (Slovic et al., 1982). Overconfidence by investors alsoexplains why investors do not raise obvious questions and why perpetra-tors of fraud seem to have such an ezsy time duping even sophisticatedinvestors. From the perspective of human psychology, it is no wonder thatindividuals like John Bennett and organizations like New Era Philanthropyare not rigorously scrtJtinized and pass inspection even when they arechecked out carefully.

Moreover, the human disposition toward overconfidence gets rewardedand reinforced by the typical format of a financial fraud. Normally, largegains are paid to initial investors to generate overconfidence. There is agreat deal of psychological evidence that people frequently make misjudg-ments when looking at events that occur purely by chance. Instead of at-tributing these events to chance, people develop some rationalization forthese events. One rationalization is a belief that they are better than othersor luckier than others. Thus is bom the belief in the "hot hand" amongbasketball players, even though good statistical analysis and argumentspoint to the conclusion that the hot hand is not a real phenomenon andthat the chance of a basketball player's making a given shot is the samewhether he or she made or missed the last few shots (Gilovich, 1991, chap.2; Gilovich, Vallone, & Tversky, 1985). By paying out large retums initially,fraudulent entrepreneurs create overconfidence in the public and a beliefthat high returns will continue into the indefinite fijture because they havea "hot hand." Adding further credence to these beliefs is the fact that mostmutual funds advertise their retums and attempt to attract new investorswith their claims of having "beaten the market." Given their psychologicalmakeup, investors stand little chance against financial frauds.

Further compounding this problem are the phenomena of framing ef-fects, recency effects, and halo effects. Framing effects, or anchoring, oc-curs when people make judgments based upon a given initial value orstarting point. Tversky and Kahneman (1974, p. 1124) note that in cases ofuncertainty people rely on heuristics to make decisions. For example, de-cisions about purchasing insurance are known to be affected by the waythe decision is presented to people. Decision choices frequently get re-

416 American foumal of Economics and Sociology

versed when the decision is portrayed as accepting a small financial lossinstead of making a gamble on future events or vice versa (Fischhoff, Slovic,& Lichtenstein, 1980; Hershey & Shoemaker, 1980). In financial matters,past returns or promised returns (or some combination of the two) becomeanchors, and people come to expect such returns in the future (despite therequired disclaimers about past returns and future returns).

Recency effects occur when the most recent information we are givengreatly influences our judgments. Halo effects occur when one positive traitinfluences our evaluations to a large degree. Entrepreneurs or flimflamartists with upbeat and outgoing personalities immediately develop haloeffects. We tend to like them and believe them. If these individuals are ableto provide above average returns during any recent time period, recencyeffects lead others to believe that these j^eople will always generate aboveaverage rates of return and that these people are trustworthy individualsto whom it is safe to give your money.

Many cases of financial fraud have involved individuals with charming andconvincing personalities who were able to develop Ponzi schemes of sortsbased on recency effects. Nick Leeson's (1996) superiors did not questionmany of his activities because during the year he spent at the Jakarta, Indo-nesia, branch of Barings Bank he cleaned up an office in shambles and col-lected large amounts of money that Barings Bank was not even aware that itwas owed. Leeson was rewarded with the assignment of starting up and run-ning the Barings operation in Singapore; but because of the halo effect andthe recency effect, he was not monitored carefully and his future actions werenot questioned. Recent experience led the senior management at Barings Bankto assume that Leeson would tum the Singapore office into a highly profitableendeavor Problems began when a trader bought shares when she shouldhave sold them. Leeson hid this mistake in an error account and sought tomake up the loss by using this account to speculate in foreign currency. Thenumbers that Leeson reported to London, however, showed that all his foreignexchange trading was eaming Barings Bank a great deal of money. Leeson ssuperiors were happy to see the firm making large profits and to cash theirlarge bonus checks. With no one questioning him, and with no one checkinghis financial reports, Leeson was allowed to speculate in foreign currenciesusing Barings Bank deposits. His speculatioas became increasingly risky overtime because winning a risky gamble was the only hope Leeson had of re-versing his losses.

On Financial Frauds ill

John Betuiett of New Era Philanthropy also had the upbeat and outgoingpersonality that caused people to immediately trust him. His long associ-ation with Christian philanthropic groups and his association with charitiesthrough years of giving them advice helped to anchor people's beliefsabout Bennett, It was thus relatively easy for him to get money and refer-ences from those people he had dealt with for many years. .'5.

Added to this anchor was the halo effect and the recency effect. Wheninvestors seek above average returns on the belief that such returns willcontinue to be paid in the future, there will always be Ponzi schemeswaiting to occur. As we saw. New Era Philanthropy paid investors morethan 100 percent interest during its first few years of operation. Becauseof these high returns, investors came to expect large returns and becamereluctant to question New Era for fear of being asked to put their moneyelsewhere.

Further reinforcing anchoring, halo effects, and recency effects, peoplebelieve that someone is monitoring things and that frauds cannot happen.But this is not the case in the real world, Eirms that seek to evade regulatorsusually are able to do so with little difficulty. Regulators have too few re-sources and too little time relative to the number of firms that need mon-itoring. Regulators can also at times be bought off or stalled through prom-ises of compliance with regulations in the future or complaints about in-trusive govemment interference with the free market. Even seeminglyindependent and objective parties might be paid "finder's fees" as in thecase of New Era Philanthropy,

This section has argued that financial frauds arise not because of as>Tn-metric information, but because of the psychological dispositions of humanbeings and the fact that human decision making involves employing someheuristic or focal point in the face of uncertainty regarding future events.The next section examines the policy implications of this view,

V

Preventing Financial Frauds

JUST AS NEOCLASSICAL ECONOMIC THEORY IS RELATIVELY USELESS when it comesto explaining financial frauds, so too is it relatively useless for devisingsolutions to this problem. As we saw earlier, neoclassical theor>' sees theproblem in terms of asymmetric information. Only one ,solution follows


from this—to increase the amount of information available to potentialinvestors so that they can rationally and intelligently invest their hard-eamed money.

But in the real world, this solution will not likely work. Again, the liter-ature from empirical psychology can help us understand why more infor-mation is not the solution. Greater information is only helpful if it is re-ceived correctly, without any biases, and interpreted and used intelligently.But many psychological studies have found that judgments do not improvewith more information (see Janis & Mann, 1977, chap. 8; Rabin, 1998, pp.26-32). Just as damning of the neoclassical perspective is the work of Kah-neman and Tversky (1972; Tversky & Kahneman, 1982), which finds thatincreasing the knowledge of statistics does not eliminate or reduce biasesin judgment.

Most financial frauds contain waming signs that should have been ob-vious to tho,se who were taken in or deceived; yet most investors fail to beswayed by the evidence staring them in the face. This is true of the SirFrancis Drake Estate scam to a very large extent, but it is also true of New-Era Philanthropy.

If all that neoclassical theory can recommend is that investors should beprovided with more information, neoclassical theory becomes a recom-mendation for playing a game of financial survival of the fittest, in whichthose who are smart enough or lucky enough to avoid frauds thrive andthe average person gets duped with some degree of regularity. But thisoutcome is not acceptable; in the long run it will lead to dissatisfaction withthe current system and, when the frauds become too numerous and egre-gious, a reluctance to invest that will hinder the ability of the capitalistsystem to run well.

Ju,st because neoclassical economics is of no help in understanding andcuring financial frauds does not mean that economics cannot help. One ofthe mo,st important lessons to be leamed from economics is that incentivesare important. With respect to financial frauds, potential gains are alwaysenormous. If I take someone's money, gamble with it, and win, I wind upmaking a large sum of money and my actions will not likely be discovered.On the other hand, if I do not succeed, I can still live extremely well. Aswe saw, Robert Bennett prospered for many years on the monies given tohim by various nonprofit organizations; he was also able to use this moneyas collateral for personal loans. Even when caught, the penalties for finan-


dal fraud are generally small relative to the potential gains. Although Mi-chael Milken spent a few years in jail, he was still able to accumulate greatwealth. Similarly, although Robert Bennett had to tum over $1,2 million tothe state for distribution to charitable organizations owed money by NewEra, if the SEC estimates are correct, Bennett should have at least $3 millionhidden somewhere. Unless penalties are substantially increased relative torewards, there will be little change on the supply side of frauds.

But the demand side is even more important than the supply side. Andaction on the demand side is even more difficult because here we have tocontend with human nature and the tendencies to be overly optimistic, andto hope for and expect large gains. The psychological literature, however,does offer some hope. One lesson from this literature is that informingpeople of the risks in concrete terms makes people judge risks to be greaterand makes them perceive risks to be much closer to the actual risks (Slovicet al,, 1982, p. 484), In many instances, concrete examples of somethingbad happening will cause people to overstate the risk of something badhappening to them.

This leads to the following important conclusion. Rather than assuminginvestors are knowledgeable about investment opportunities, and ratherthan providing investors with more information about particular invest-ments, providing investors with more information about investments goneawry is necessary. The best solution to the problem of financial fraud is tokeep reminding investors about the Charles Ponzis, the Nick Leesons, theCrazy Eddies, and the John Bennetts.

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One Financial Frauds and Their Causes

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