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Haskel Hawkins Jr. took the stand.

Before him, at the defendant's table, sat B. Don James--"Donny," to Hawkins, who knew him as the gregarious insurance broker with the office on the square in Smithville. Donny James, who had been writing policies for folks in DeKalb County since 1966. Donny James, the man Hawkins had trusted so fully that he had turned over his life savings, $2 million, when James told him of a can't-miss investment opportunity that would multiply the funds he was saving to put his grandchildren through college.

"A kid needs a college education," Hawkins told the federal court in Nashville. "I didn't get one. I only got an eighth-grade education, and I went to work at the daylight of a morning and worked 'til dark to make money, to save money, to help my family.

"And he has took it all," Hawkins said. "He has totally destroyed my life."

By the time Hawkins faced down Donny James in court on May 25, 2007, Brentwood-based venture capitalist Fred Goad probably knew something was wrong with his own investment. Others who had entrusted money to Murfreesboro investment advisor Robert W. McLean had already filed suit after he failed to make good when they tried to cash out.

Goad's money, anyone in Nashville would tell you, was smart money. A pioneer in the electronic payment processing industry, he had built up, taken public and then sold Nashville-based Envoy Corp. in the 1980s and '90s. He was a partner in a venture capital firm. He sat on the boards of a half-dozen or more companies, public and private.

And, as he would reveal in an involuntary Chapter 7 bankruptcy petition filed seven weeks later, Goad was into McLean's investment funds for $3 million.

By the autumn of 2007, Donny James would be in a federal prison, serving the eight-year sentence for fraud handed down just after Hawkins addressed the court. His lawyer said that for the 65-year-old James, who suffered from chronic medical problems, the prison term was likely a life sentence.

Bob McLean was scheduled to face his victims in bankruptcy court on Sept. 26, 2007. But none would ever be able to speak to him as Hawkins did to James. The day before, he traveled from Murfreesboro to his hometown of Shelbyville, where his father had been a prominent business owner. On a hill behind a church, McLean put a .38 caliber pistol to his head and pulled the trigger.

Myriad mini-Madoffs

The James case, in which investors lost at least $8 million, and the McLean case, with a price tag estimated at $40 million, were episodes in a rash of alleged Ponzi schemes that have come to light across Tennessee in the past few years. Like mega-fraudster Bernard Madoff, and like 1920s namesake Charles Ponzi, several Tennesseans stand accused in criminal, civil or bankruptcy court of engineering scams that took in money with the promise of high investment returns, which turned out to be derived solely by paying off early investors with money from later investors.

Besides James and McLean, other recent cases labeled as Ponzi schemes by aggrieved investors, and sometimes prosecutors, have turned up across the state. A few examples:

In Gatlinburg, Dennis Bolze ran a scheme that collected some $20 million from about 100 investors in a fraudulent commodities trading operation before it imploded late in 2008, according to a complaint filed against Bolze by the Commodity Futures Trading Commission. After more than two months as a fugitive, Bolze was arrested March 12 on charges of wire fraud and money laundering.

In Chattanooga, prosecutors claim Luis Rivas bilked $31 million out of hundreds of people who thought they were buying foreign-exchange contracts through him. He disappeared in May 2008 and was arrested the following month while driving through Kansas, carrying more than $100,000 in cash and gold coins. Indicted on 19 counts of wire fraud, money laundering and bankruptcy fraud, Rivas faces trial in July.

In Nashville, investors have lost virtually all of the $21 million they paid Hanover Corp. in exchange for promissory notes that paid a guaranteed interest rate of 2% per month. The company and its founder, Terry L. Kretz, have both been in bankruptcy for more than two years, and a judge in those proceedings has ruled that Hanover was a Ponzi scheme. As of early March, however, no criminal charges had been brought in the case.

In Memphis, two key executives with the Stanford Financial Group--which the Securities and Exchange Commission has labeled as an $8 billion fraud--had their base of operations. James M. Davis, as chief financial officer, and his protege Laura Pendergest-Holt, as chief investment officer, allegedly helped Texas billionaire R. Allen Stanford orchestrate a massive scheme to report inflated investment returns that would back up the extremely high rates the Stanford group was paying on certificates of deposit. At press time, Pendergest-Holt was facing criminal charges, while Stanford and Davis were refusing to talk with the SEC, citing their constitutional protection against self-incrimination.

The impact of these cases extends well beyond the localities where each enterprise was based. A Haskel Hawkins or a Fred Goad can be found in cities and towns across Tennessee. In Crossville, a dozen residents have lost more than $2 million between them in Hanover's promissory notes. McLean's downfall led to similar losses in Shelbyville. Among those who accuse Bolze of scamming them are residents of Jefferson City, Morristown and Sevierville.

The causes of credulity

More than most crimes, Ponzi fraud tends to elicit a blame-the-victim reaction from outside observers. Even members of the public who don't accuse the soaked investors of succumbing to their own greed and stupidity still keep asking each other the question: How could people who did well enough in life to have significant financial assets fall for such a time-tested scam?

The answer, to hear Steve Pressman tell it, is that humans are wired to be suckers. Pressman, a professor of economics and finance at Monmouth University in West Long Branch, N.J., has written about what makes Ponzi schemes keep happening, generation after generation, even after the investing public has seen ample proof that promises of unrealistically high returns inevitably lead to losses. "I have never believed that people are as rational as economists say they are," Pressman said in an interview. And so he relies on psychological literature to gain insights into mankind's uncanny propensity to fall for flim-flam artists.

Pressman has written that people are "psychologically constituted to make the very sorts of errors that lead to cases of massive financial fraud." He notes that psychologists have found that individuals typically do a poor job of judging the risks they face and are predisposed, absent any experience to the contrary, to believe that the things they do will have good results for them. They tend to be much more confident in their judgments than the evidence would indicate they should be. "Overconfidence by investors," Pressman writes, "explains why investors do not raise obvious questions and why perpetrators of fraud seem to have such an easy time duping even sophisticated investors."

The way such scams operate only serves to aggravate our inherent vulnerability, according to Pressman. Ponzi operators normally make sure their earliest investors reap handsome returns, just as promised. Those people go out and tell their friends what a great investment they have discovered, and the next round of investors is psychologically conditioned to be trusting. The investment promoter may seek to further this cognitive bias, known as the "halo effect," by making a show of other virtues such as religious devotion and philanthropy.

Tennessee's recent Ponzis have almost always involved personalities who actively promoted an image of goodness. In the Hanover case, for instance, securities regulators posed as investment prospects to meet with Kretz during an undercover investigation. He told them all about the supposed success of Hanover's various business ventures, concluding:

"If you were around us a couple of weeks, you would say 'God's hand is on you guys.' It's very, very obvious."

Later, in a deposition, Kretz said he had created Hanover to help people who had lost money in prior investments. "That was our premise," he said. "And then alongside of that is--we're believers in Jesus Christ and religious people, and our thing was to fund the Kingdom of God, and that is where we stand with it."

Stanford's top personnel also frequently displayed their Christian piety, and the company became known for its generosity in Memphis. Stanford sponsored a PGA golf tournament that generated $4.5 million in donations to St. Jude Children's Research Hospital in 2007 and 2008.

Rivas took the display of philanthropy to the extreme. At Christmastime in 2007, he invited five foster families over for lunch at a Chattanooga bed-and-breakfast he had purchased. In the course of the meal, he gave each child a $100 bill and a $100 Toys "R" Us gift card. He gave the parents each a check for $5,000. And then he promised to buy each family a new home. Tearful family members hugged him in gratitude.

Another characteristic commonly found in Ponzi schemes is the pretension of genius. As Pressman notes, Ponzi artists like to deal in "arcane mathematics and finance that most people canÕt understand." Thus we find that Bolze and Rivas, running separate enterprises, each claimed to derive special investing wisdom from Fibonacci numbers--mathematical sequences that some investors believe can help predict market behavior. And we learn that Allen Stanford carefully guarded the secret to the success of his "Tier 3" investment portfolio, to which not even top officers in his company were privy. The real secret, according to the feds, was that he had made up the performance figures.

The secret-formula claim can have a particularly insidious effect on 21st-century investors. Legitimate mutual funds often also imply that their managers have special stock-picking talents, and, like Ponzi artists, funds market themselves on the basis of past performance--albeit with the standard disclaimer that past performance is no guarantee of what the future may hold, and with regulatory measures in place to discourage false reporting. And then there are hedge funds, the object of much public attention in recent years. A completely honest hedge fund is likely to operate with just as much public opacity as the typical Ponzi.

Small wonder, then, that even an experienced investor can be fooled. Pressman cites a classic case of such deception. In the early 1990s, the Philadelphia-based Foundation for New Era Philanthropy convinced numerous nonprofits that it would double their money within six months. All the school or charity had to do was hand over the cash. You can guess what eventually happened: The losses ran to the tens of millions.

"Most people don't ask the difficult questions," Pressman says. In the case of New Era, college endowments were involved. "These guys hire the best investment counselors in the world, and they don't even do their homework."

Scurrying from the light

Discovering financial fraud became a lot easier when the economy began to crater last year. Edward M. Yarbrough, U.S. Attorney for Middle Tennessee, credits the cockroach effect. "If you want to know how many roaches you've got, go into the kitchen at 3 a.m. and turn on the light," Yarbrough says. "If you want to know how many Ponzi schemes you have, let the stock market go to half. You'll find out, pretty quickly."

Yarbrough, who has held his current post since October 2007, says his staff has prosecuted "more complex white-collar cases in the past two years than in the previous five." Department of Justice rules prevent him from discussing any case in which criminal charges have not yet been brought, but he says he can understand why scam victims and the public wonder about the lengthy intervals that sometimes pass between the exposure of a Ponzi in civil or bankruptcy court and the filing of criminal charges. After the B. Don James scam became known early in 2005, for instance, more than a year passed before James was indicted.

"There are so many things weÕre doing that we can't talk about," Yarbrough says. "With a financial crime, unlike, say, a murder or kidnapping, the devil's in the details. If you don't go into the records carefully and do a proper examination of them, you'll live to regret it in court later on." His prosecutors delve into banker's boxes, hard drives, bank records and the like in cooperation with an alphabet soup of federal investigative entities--the FBI, the IRS and myriad OIGs (Offices of Inspector General within federal agencies, such as the Department of Labor, and entities such as the Troubled Asset Relief Program), as well as the Secret Service, the Postal Inspection Service and others.

"The fact that we have so many guilty pleas in these cases is good evidence that these investigations are done right," Yarbrough says. "Typically, when we make a charging decision, we expect to get a guilty plea, or at least to win at trial."

Collateral damage

Putting scam artists in jail does not undo the harm their machinations have inflicted--not just on those who lost money to the racket, but often on people and entities that were innocently involved in it, or even not involved at all.

Ponzi artists spread around their ill-gotten gains for the strategic purposes of winning over investors and making themselves look saintly. In the eyes of the law, recipients of such largess are not entitled to keep it. Bankruptcy trustees unraveling Ponzi schemes have a duty to pursue claims against those recipients. In Tennessee's recent cases, that duty has led to the sorry spectacle of lawsuits against a church, a charity, a university and a little old lady.

The trustee in the Hanover case filed suit against Cornerstone Church, a large Assemblies of God congregation in the Nashville suburb of Madison, after finding that Hanover honcho and Cornerstone member Terry Kretz had directed more than $180,000 in donations from the company to the church in the years preceding Hanover's downfall. Cornerstone ultimately paid $50,000 to settle the claim.

The McLean case has resulted in more widespread damage. That trustee sued Nashville's Country Music Hall of Fame, McLean's 88-year-old aunt and Middle Tennessee State University, among others, invoking the principle that Ponzi-tainted assets must be returned to the bankruptcy estate. In 2004, amid great publicity, McLean presented the museum with funding to acquire a treasure trove of musical instruments: Bill Monroe's mandolin, Mother Maybelle Carter's guitar and two of Johnny Cash's guitars. The trustee sought $1.5 million from the Hall of Fame but eventually settled for half that amount. Still, the settlement forced the museum to mount a fundraising drive at the beginning of 2009 amid daunting economic conditions. Meanwhile, the trustee has claimed that Elizabeth Carlen McLean of Shelbyville reaped millions in gains while her nephew was managing her account--money that actually came from other investors.

McLean had endowed MTSU with pledges of more than $2.5 million to support student scholarships, the athletic department and the music department. The trustee eventually cut a deal in which the Murfreesboro university would hand over $750,000 from the money it had received. That financial blow, combined with the loss of ongoing funding meant to support students making their way through college, hit MTSU just before the 2008-09 recession placed it in truly dire financial circumstances. Last March, a committee studying the need for cost-cutting at the university targeted 44 undergraduate majors and four graduate programs for possible elimination.

In other schemes across the state, the damage done is both monetary and psychic. The Stanford implosion has left the PGA and St. Jude Hospital without a lead sponsor for the golf tournament set to begin June 8 at the Southwind course in Memphis. Landing a new lead sponsor on short notice in the current economy cannot be easy, and nobody knows what the bottom-line impact will be for St. Jude. The hospital has relied on the golf tournament since 1970 to help support its research and treatment of pediatric cancer.

As for those homes that Chattanooga's Luis Rivas promised to the foster families he summoned for a Christmas lunch--well, they had not materialized by the time investors put Rivas into involuntary bankruptcy five months later. The foster parents can count themselves lucky: If Rivas had made good on his pledge, it's likely that his trustee would have been obliged to force them to give the properties back.

Sidebar

By Joseph Woodruff and Wynne James
Waller Lansden Dortch & Davis

Signs of Trouble
Investors in the post-Madoff era have good reason to be on their guards

Just like the flags staked out on the beach warning swimmers to avoid the undertow, there are signs that should warn investors of the possibility that their securities accounts are at risk of being pulled under by fraudulent managers or promoters.

In the past year, we have seen the exposure of massive frauds that have swallowed up billions of investor dollars worldwide--and the ones that have happened in Tennessee are no less damaging to victims who have lost "only" tens of millions.

What could investors have looked for that might have been warning signs that their portfolios were exposed to risks other than general market conditions? Below are three red flags that ought to warn an investor either to stay out of the water to begin with or to make an immediate exit:

1. A promised return too good to be true

Fraudulent securities deals frequently promise the investor a return that "beats the market" or carries with it "no way to lose your money." B. Don James, for instance, made both promises. He was selling promissory notes that guaranteed a 10% return. The principal amount contributed by the investor was supposedly going to be pooled with money from other investors and used to finance insurance premiums on policies purchased by James' insurance customers. James promised the investors that, if a customer defaulted on the premium finance repayment, the insurance policy would be cancelled and the unearned premium refunded, thereby making the investor whole.

His victims testified that James told them, "The only way you can lose your money is if I steal it." At least that statement was proven to be true.

2. The money manager wants a loan

Frequently, the perpetrators of a securities fraud manage to avoid detection because the investors receive periodic distributions of money. These distributions are often made possible because, in classic Ponzi style, the perpetrator is using the cash contributed by new investors to make payments to old investors. Because there is no genuine value in the investment, whenever an investor wants to liquidate his or her position, the perpetrator needs to raise cash quickly.

We have seen instances in which the perpetrator, often in an effort to raise funds quickly, asks unwary investors for personal loans. It is highly irregular and inappropriate for an investment manager to borrow money from his clients, and such a request is a warning of fundamental problems with the manager and the investment account.

3. Generic account statements

Publicly traded investment securities are purchased and sold through exchanges such as the New York Stock Exchange, the NASDAQ, the Chicago Board of Trade and other similar markets, both in the United States and abroad. A stock broker or investment fund manager is not physically going to take an investor's cash, go to the floor of the NYSE, purchase shares of a company and hold them for the investor's account.

Instead, a legitimate broker will place orders for stock trades through a registered broker/dealer who is a member of the Financial Industry Regulatory Authority (FINRA). This registered broker/dealer will close the actual stock purchase and sale transactions either directly or through intermediary entities that are members of the various stock exchanges. A legitimate broker will furnish his or her customers with periodic account statements that disclose all of the activity in their accounts. These statements will usually be on a form generated by the registered broker/dealer and will contain certain disclosures required by securities laws and regulations.

An investor should immediately question the bona fides of a document purporting to be an account statement of transactions in publicly traded securities that does not disclose the registered broker/dealer through which the trades were processed. The simplest explanation for such a document is that it is a complete fabrication intended to conceal from the investor the fact that his "investment manager" has stolen the money instead of investing it.