Finding Recourse When Investors Are Cheated

Russell Wasendorf Sr., chief of the Peregrine Financial Group, admitted to stealing millions of dollars from his customers. Rick Chase/Waterloo Courier, via ReutersRussell Wasendorf Sr., chief of the Peregrine Financial Group, admitted to stealing millions of dollars from his customers.

The financial scandals of recent weeks seem to involve the simple act of cheating.

Whether it’s falsifying documents or fudging an interest rate quote, many of the actors of these schemes knowingly cheated in some form or another. But the federal government may need to find new ways of providing some recourse for investors who are victims of brazen fraud.

The dictionary defines “cheating” as “to violate rules dishonestly.” It is a rather benign term. Who hasn’t fudged a bit on their taxes, or ignored the speed limit?

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Yet, it is investors who pay the cost when someone decides it would be all right to cut a few corners. As some recent scandals have demonstrated, the acts can spiral quickly into a significant fraud, costing firms and investors millions or billions of dollars.

The controversy over false reporting of interest rates used to set the London interbank offered rate, or Libor, by Barclays and other banks usually involved only modest misstatements of a few basis points. And it appears the false reports were not viewed as particularly wrongful because they were made to counteract the cheating of others – or the “everyone else was doing it” defense.

Another defense offered by Barclays was that the government knew what it was doing – therefore, it was not really cheating because its misstatements were somehow approved. So if the umpire did not object, then it must not have been wrong.

Meanwhile, JPMorgan Chase has recorded nearly $6 billion in losses on derivatives trades, saying that its traders may have intentionally tried to obscure the full extent of the losses on the disastrous bet.

As with any subjective valuation, the judgment may have been in favor of an “optimistic” view in the hope that the market would recover and no one would ever be the wiser – so the traders may have viewed their actions as not really cheating so much as an “aggressive” position.

While the JPMorgan derivatives and the Libor scandal have led to much hand-wringing over what regulators should have done, it is Russell R. Wasendorf Sr. and the now-bankrupt futures firm Peregrine Financial Group who probably employed the most blatant forms of cheating. Mr. Wasendorf said in a letter that seeing losses starting to mount at his firm posed to him the dilemma: “Should I go out of business or cheat?” Faced with that choice, he wrote in a statement that “I guess my ego was too big to admit failure. So I cheated.”

Mr. Wasendorf went well beyond just a few modest rule violations. He became an expert at deception. He falsified bank documents to make it appear that his firm held more than $200 million in segregated customer money when its account had only a few million dollars. And he admitted to lying for more than 20 years, so there will be no claim that this was merely aberrational conduct. What may have started as a short-term effort to keep his firm afloat grew into a large-scale fraud.

Prosecutors charged him with making a false statement to the federal government, and additional charges for fraud are likely to follow if he does not work out a plea agreement. If he is convicted of defrauding customers, the federal sentencing guidelines call for a sentence of as much as life in prison based on a loss of more than $200 million and the number of victims.

For the clients of Mr. Wasendorf’s firm, however, the government provides no real protection from his decision to cheat. For them, this is not just a matter of a little bit of cheating, but a crime that will leave them with little recourse. They may even have to repay some of the money they withdrew from PFGBest, as Mr. Wasendorf’s firm was commonly known.

While the firm is in bankruptcy, the trustee can try to recover money withdrawn by customers through clawback suits, similar to those filed by Irving H. Picard, the trustee for Bernard L. Madoff‘s advisory firm. The goal is to gather assets for the benefit of all creditors of PFGBest, which means that some investors may be sued despite having lost money when the firm collapsed.

Even worse, customers of a “futures commission merchant” like PFGBest do not have the protections afforded to those who invest through a securities broker. The Securities Investor Protection Corporation returns an investor’s stock and other securities, and up to $250,000 in cash, held in the account of a failed brokerage firm.

Although the PFGBest customers can pursue a claim in the bankruptcy proceeding, they are considered to be unsecured creditors. Therefore, they will have to wait until the end of the process to receive any money. Any payment is likely to be pennies on the dollar because Mr. Wasendorf admitted that he embezzled customer money and spent it on a variety of ventures along with financing his own lifestyle, so it is unlikely there will be much of anything left after the liquidation.

The customers will be in the same position as those who lost money when MF Global collapsed last year with approximately $1.6 billion in customer money missing. There were even some investors who did business with both firms, and watched their accounts frozen twice and waited for a drawn-out bankruptcy process to determine what they might be able to recover.

The collapse of PFGBest, coming on the heels of MF Global’s bankruptcy, may nudge Congress to take steps to protect investors in futures firms. But as Mr. Madoff’s Ponzi scheme showed, the Securities Investor Protection Corporation provides only limited protection to securities investors when there is fraud, falling far short of what the Federal Deposit Insurance Corporation provides to bank accounts up to $250,000.

Any proposal to adopt comprehensive insurance for futures and securities investors is sure to meet significant resistance from investment firms that would have to pay for the programs. Insurance is not free, and those who do not engage in misconduct will have to put up the money to protect against losses caused by those who undertake risky, or even fraudulent, behavior.

Mr. Wasendorf’s decision to cheat, as he called it, may well send him to jail for the rest of his life while costing his customers millions of dollars. Whether that’s enough to finally push Congress to provide some form of safety net for investors to protect them from fraud remains to be seen.


United States v. Russell Wasendorf Sr.