Excuse me sir, could I interest you in a fa$t million?

Everyone wants to make easy money, which is why so many people fall prey to international fraud. Luiza Karim investigates the medium term note market and discovers that an advance fee is a warning bell. Technical consultant Denis Chambers.

Many cases of international fraudsters offering investors huge annual returns on capital for a fee have been reported in recent years. One famous scam, originating from a Pacific island known as the Dominion of Melchizedek, involves the notorious convicted fraudster Mark Pedley, who also goes under the bizarre name of Branch Vinedresser.

The scam involves Pedley and bogus insurance companies and banks, allegedly based in Melchizedek, which have extracted millions of dollars from victims around the world, more recently in Britain, promising huge returns on initial investments.

"Melchizedek has certainly given a new meaning to the word ‘offshore’. Although their operations have been closed down for the present in Britain, there is always the risk they could return in another form, such as an offshore reinsurance company,” said Trevor Jones, a UK-based private detective.

Fraudsters are usually career fraudsters, according to a Bank of England spokesman.

“Once a person thinks of a fraud, they often think of a second. They do not go from being a blue-chip banker one week to a fraudster the next,” he said.

The quoted returns are often in excess of 100 per cent per year, which are generally unobtainable anywhere, unless the investor is privy to insider information in a monopoly situation.

The fraudster, who will usually claim to have such knowledge about major bank debt instrument issuance, offers to share the potentially huge profits with the unsuspecting investor after he or she has paid a fee.

Elaborate

Covered by an elaborate private legal agreement or contract forbidding the investors from contacting any bank, it often specifies a substantial capital investment for a minimum of one year.

In order to repay the capital sum a so-called 108 per cent guarantee is suggested, to be issued by a major international bank, via an escrow or trust account, into which the investor’s funds disappear under the guise of funds management.

This guarantee is almost certainly non-existant since no first-class bank will ever issue such an instrument with interest in excess of dollar market rates unless a third party pays the interest differential to the bank first.

The fraudster disappears with the fee and sometimes some of the capital, perpetrating the same fraud several times in different countries. Unfortunately victims are either too embarassed to report the matter to the police or unable to take action because of the legal wording of the contract, which often allows the fraudster to keep the fee to cover his ‘expenses’.

Fees typically range from $10,000 to $250,000 for false ‘master commitment letters’, which are supposed to give the investor access to huge amounts of heavily discounted and non-existant bank debt instruments on a monthly basis.

The reason people fall for this kind of scam in the first place is that it is similar to a legitimate method of investment known as a medium term note (MTN) programme.

Legitimate agents with access to private placements which are usually unlisted and untraded on the secondary market can obtain better returns for investors than major investment banks do using listed offerings. It is possible to obtain risk-free profit on a monthly basis of 2 to 3 per cent from the closed-end forfaiting of bank instruments, usually called ‘bank notes’, issued under a medium term note programme.

The difference from the fraudster operation is that the investor’s capital is at all times secure and there are no advance fees payable. Agent and investor pre-agree a profit sharing agreement as the basis of any contract and provided the investor is not using borrowed funds, this approach should be entirely risk-free.

Using borrowed funds can create risks as the investment situation is market driven and therefore there can be no absolute guarantee of income.

UAE

IN the UAE, the MTN market has not been developed although there are a few private and corporate ‘end’ investors who buy for their own portfolio through investment bankers, such as Merrill Lynch. For the first nine months of 1997, Merrill Lynch dominated the public US domestic market with 23.9 per cent, worth $18 billion, while Bear Stearns and Lehman Brothers held second and third place with $16 billion and 21.45 per cent between them.

That figure only relects 60 per cent of the market.

“There is limited financial fraud in the UAE as it is not a very experienced market and MTNs are not widely available or even known about,” said Denis Chambers, a UAE based private investment banking advisor.

In November last year British Bank Dubai issued a Certificate of Deposit (CD) programme which was actually an MTN with Certificate of Deposit features. It was issued directly to major local investors and corporations for a minimum of Dhs 5 million (US$1.3 million) on a confidential electronic transfer register basis. A spokesman at HSBC Financial Services confirmed it was an MTN but said: “We could not tell the investors because they are not yet familiar with MTNs.”

No actual MTN certificates were issued for this programme, merely an account custodial receipt, as the UAE Central Bank must give approval before a bank or financial institution can issue a full MTN.

“The beauty of an MTN programme is its swiftness, safety and secrecy. It can be tailor made to suit an investor’s demands,” said Chambers.

Given the size of the MTN market in Europe and its continuing explosive growth, the chances of any investor losses from non-trades is probably limited to any very short-term differential between bank bid and offer interest rates, plus leveraging costs, if any.

This assumes that at all times a pre-arranged closed-end forfaiting deal is in place without the investor physically purchasing financial instruments to hold to maturity.

The risk is virtually nil while profits are maximised. The end purchaser is often a large institution where a certain yield to maturity is required or else the deal suits shorter-term treasury operations. Over the last fifteen years, MTNs have emerged as a major source of funding for US and European corporations and banks, government agencies, supra-national institutions and sovereign states.

Pionereed in the US in the early 1970s by General Motors Acceptance Corporation as an alternative to short-term financing through commercial paper and long-term borrowing in the bond market, they and other auto companies needed to match maturing debt with loans to auto dealers and customers.

But the market was hindered by a lack of liquidity and securities regulations at that time so issuers would often seek private placements.

It was not until the mid 1980s that the market expanded into a major source of debt financing, initially by means of major US automobile companies using MTNs to finance dealer floor stocking, leasing, consumer credit and credit card operations.

In the 1990s, the market has seen a dramatic increase in size and there is now somewhere in excess of $2,000 billion of outstanding MTNs. The European market holds $1,000 billion of these from barely $100 million in 1993.

Most MTNs are uncallable, unsecured senior debt securities with fixed coupon rates and investment grade ratings, similar to bonds.

Bonds

However, unlike bonds, they may be sold on a best efforts basis by investment banks or brokers acting as agents.

And unlike bonds, the agent does not have to underwrite the issue, although as the markets have developed most issues are underwritten. Another difference to bonds is that whereas bonds are usually sold in large discreet stand-alone offerings, MTNs may be sold on either a continuous or intermittent basis.

Offerings of MTNs may be issued with great flexibility to include zero coupons, floating interest rates or rates computed to unusual formulas tied to equity or commodity prices and other options. This makes MTNs highly flexible debt instruments instead of the narrow stand-alone bond issue.

The MTN market allows issuers to match more closely the maturities of assets and liabilities through continuous offerings. This way a company can average out its cost of funds over a period of time rather than a single day bond offering.

Once an MTN programme is in place an issuer can place a sizeable amount of debt in a short time.

Bonds on the other hand, usually require the prior arrangement of a syndicate and negotiation of an underwiritng agreement plus further time for a pre-selling to investors.

A bond issue may also require board of directors prior approval whereas often a corporate treasurer can issue MTNs without delay within discretionary limits.

The MTN market provides the opportunity to raise funds discreetly because the issuer, the agent and the investor are the only parties that need to know about a primary transaction.

In contrast, the investment market obtains detailed information regarding underwritten bond offerings.

In times of economic uncertainty, issuers often avoid the bond market as an issue could signal financial distress.

In the early 1990s, many commercial banks used the MTN market to raise funds quietly rather than risk possible negative publicity in the bond market.

Also, because of the discreet nature of the MTN market, many issues and trades now stem from reverse enquiry, where investors approach potential issuers with specific investment criteria. This reduces borrowing costs to the issuer and gives the investor much flexibility.