Last Friday, Stephen Walsh, a former minority owner of the New York Islanders NHL team pleaded guilty to securities fraud and operating a Ponzi scheme, which he had done along with his already convicted partner, Paul Greenwood during the years between 1996 and 2010. Walsh and Greenwood described their investment strategy to the institutional investors they targeted as being a stock index arbitrage strategy that they claimed was both low risk and high return. Many investors including Carnegie Mellon University, the University of Pittsburgh and the 3M Company Pension Plans fell for the lies of Walsh and Greenwood and as a result lost as much as 554 million dollars. In truth, the complicated investment strategy of Walsh and Greenwood which also incorporated promissory notes as a part of the investment strategy was a failure with both Walsh and Greenwood siphoning off funds to support lavish lifestyles that included mansions, a horse farm and an expensive collection of 1,300 rare stuffed animals.
Not to blame the victims of this scam, but they did violate a cardinal rule of investing, which is to not invest in anything you do not understand. Another cardinal rule that they violated was when anything sounds too good to be true, it usually isn’t true. In this case, an investigation into the strategy used, particularly involving promissory notes as part of the strategy would have exposed it for the fraud that it was. In addition, the investment was not monitored by an independent third party. In the Bernie Madoff scam, Madoff served both as the investment adviser and the custodian of the investments, which is a recipe for disaster. Walsh and Greenwood acted similarly. You should always have a separate custodian of your investments who is independent of your particular investment adviser.