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[video] Why 'Sophisticated' Investors Fall for Ponzi Schemes

NEW YORK (TheStreet) -- Bernard Madoff is back in the news, but the $1.4 billion Scott Rothstein Ponzi scheme sheds plenty of light onto the thought process of otherwise sophisticated investors as they get swindled.

With JPMorgan Chase (JPM - Get Report) about to cough up over $2 billion for its role in enabling Madoff to run a long-term Ponzi scheme through his asset management business, this is a good time for investors to consider how they make their investment decisions, and whether or not it is possible for them to be approached by someone seeking to sell them bad paper.

Madoff's Ponzi scheme went on for 20 years, as he promised and delivered consistent returns to his asset management clients.  These annual returns were in the low double digits -- high enough to please the investors, but low enough for the Ponzi scheme to survive, as long as Madoff brought in new clients.  There were relatively early signs that Madoff's asset management skills were too good to be true, including the submission of evidence to the Securities and Exchange Commission by Harry Markopolos, a financial analyst. 

But Madoff had little difficulty in skating by multiple SEC investigations and continuing to operate his scheme until the financial crisis caused clients to request redemptions in such great amounts that the Ponzi scheme collapsed.  Madoff pleaded guilty to numerous federal charges and was sentenced to cool off for 150 years in prison. He hasn't cooperated with the government.

Rothstein's Ponzi scheme was different from Madoff's scheme in many respects.  For starters, Rothstein was the lead partner in Rothstein Rosenfeldt Adler (RRA), a Fort Lauderdale, Fla., law firm.  For roughly five years, through October 2009, Rothstein cultivated a colorful, even outrageous, "new money" persona, making huge donations to various local charities, expanding his law firm to such a degree that lawyers with competing firms couldn't understand how RRA could afford the expenses, and showing as much flash as possible by wearing expensive suits, amassing a collection of expensive cars and showing up to many high-profile local events.

Through his largesse, Rothstein made many "friends" among local politicians, law enforcement, and even former Florida governor Charles Crist.

Such a high profile, as described in great detail in the fascinating book, The Ultimate Ponzi, by Chuck Malkus, served Rothstein well in attracting clients to his investment scheme, which involved the sale of investments that didn't really exist.

There were plenty of news reports saying Rothstein was selling "structured settlements" to investors.  He wasn't.  Investments in structured settlements are legitimate investments, where the investor buys the settlement -- for example, an insurance annuity paying out over 20 years -- at a discount, so the seller can get most of their cash immediately.  The investor buys the settlement at a discount sufficient enough to make the deal worthwhile, resulting in a winning scenario for both parties. 

What Rothstein was doing was offering investors the opportunity to "prefund" litigation settlements at a discount.  Rothstein specialized in employment litigation.  If an employer was ready to settle a lawsuit by an employee alleging discrimination or abuse for, say, $3.5 million, Rothstein would offer to pay the plaintiff $3 million, funded by the investor.  Once the settlement was made, there would be an instant $500,000 profit.  One major part of the scheme was that most the lawsuits in question didn't actually exist.  There were few real settlements coming. 

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