Ponzi schemes abound failed income trusts trusts should be under consideration

Ponzi schemes abound
From Canadian Business magazine, February 20, 2009

By Al Rosen Al Rosen is a forensic accountant and principal of Rosen & Associates in Toronto. He writes frequently for Canadian Business magazine. More stories by this author >>

Several sources have credited Bernie Madoff with orchestrating the biggest Ponzi scheme of all time (US$50 billion). But that record probably deserves an asterisk: not one of the Barry Bonds variety (for cheating while amassing his record), but maybe a Roger Maris footnote (for breaking Babe Ruth’s home-run record, but taking more games to do it).

Simply put, the Madoff record is questionable, not because of its size, but because of its nature. Judging whether something is a Ponzi scheme really comes down to a matter of perspective and timing. And while Madoff clearly engaged in a Ponzi scheme, the real issue is that he has much more competition than most people are willing to admit.

Many corporate pension plans, for instance, have been called Ponzi schemes. Several surely are, but the problem is no $50-billion funds have collapsed yet. We should probably exclude those from the running, for now.

On another front, several failed income trusts should be under serious consideration for Ponzi recognition. Some trusts were simply borrowing money or selling more units to new investors in order to pay cash distributions to old ones. And that’s the basic nature of a Ponzi scheme. The unseemly part is when cash distributions exceed the amount of income made by the company. As such, Ponzi schemes tend to be unsustainable over the longer term.

The differences between an investment Ponzi (like a bad income trust) and a Madoff Ponzi are fewer than one might think. In fact, the major difference comes down to legal disclosure. People can get away with financial murder by barely disclosing the inner workings of a scheme.

Every Ponzi-like income trust at some point revealed somewhere that it was paying out more cash than it was earning, and that the difference had to be funded by contributions from new investors. Some of the sales literature on income trusts was clearly deceptive, and essentially misstated the nature (origin) of the cash distributions. But, the legal prospectus was still on file with the crucial facts buried deep inside. That seems to have been enough to hold off Canadian regulators from delving into the issue. It makes you wonder where the legal line exists.

Many income trust cash yields were too good to be true, and should not have passed the smell test, just like Madoff’s overly smooth investment returns should not have, either. Both shared the same unsustainable structure, but it seems the only mistake Madoff made was to not intentionally bury the truth in plain sight.

That same veil of quasi-legitimacy also surrounds certain accounting rules that end up impacting all companies, not just income trusts. Accrual accounting can produce Ponzi-like effects simply through inconsistent recognition of the time value of money. Expenses like depreciation are not indexed to inflation; they are a function of historical cost figures. So, even in a straightforward case, income can become inflated over time. And whether it’s inflated income or phony income, the Ponzi-like effect is the same.

Likewise, inventory costing can be just as misleading when amounts are not adjusted for time value. And these are just some of the mandated impacts. On top is an additional layer of seemingly endless management choices that can overstate income.

This is where the numbers easily start to reach into record territory. Add up all the accounting chicanery that overstates income in this country, and we far surpass Madoff’s relatively puny US$50 billion.

What with income trusts, pro forma financial metrics, pension plans and deficient accounting, almost everyone is a victim of one Ponzi scheme or another. It’s a matter of whether we want to admit it or not.