You Won’t Find a Rat By Looking For Cats

”Only when you realize how powerfully that theory skews how you perceive the evidence can you throw it off and search instead for the thing that you are trying to avoid, a fraud.”

Last week the SEC filed an emergency enforcement action to halt what it claims was an ongoing Ponzi scheme that promised investors attractive returns on investment in water-filtering natural stone pavers imported from Australia. Specifically, the SEC charged Eric Aronson, Vincent Buonauro, Jr., Robert Kondratick, Fredric Aaron, and the PermaPave Companies (PermaPave Industries, LLC, PermaPave USA Corp., PermaPave Distributions, Inc., Permeable Solutions, Inc., Verigreen, LLC) with bilking roughly 140 investors out of more than $26 million beginning in 2006. According to the SEC’s press release:

”The SEC’s complaint, filed in U.S. District Court for the Southern District of New York, alleges that convicted felon Aronson and others defrauded investors in PermaPave Companies, a group of firms based on Long Island, N.Y., and controlled by Aronson. About 140 individuals, many working in the construction or landscaping business, invested in the scheme between 2006 and 2010, the SEC alleged. Investors were told that PermaPave Companies had a tremendous backlog of orders for pavers imported from Australia, which could be sold in the U.S. at a substantial mark-up, yielding monthly returns to investors of 7.8% to 33%. In reality, the complaint states that there was little demand for the product, and the cost of the pavers far exceeded the revenue from sales.

Lacking the profits promised to investors, Aronson and two other PermaPave Companies executives, Buonauro and Kondratick, used new investments to make payments to earlier investors and then siphoned off much of the rest for themselves, buying luxury cars, gambling trips to Las Vegas, and jewelry. In addition, the complaint alleges that Aronson used investors’ money to make court-ordered restitution payments to victims of a previous scheme to which he pleaded guilty to conducting in 2000.

According to the SEC’s complaint, when investors began demanding money owed to them, Aronson accused them of committing a felony by lending the PermaPave Companies money at the interest rates he promised them, which he suddenly claimed were usurious. Aronson and his attorney, Aaron, then allegedly made false statements to persuade investors to convert their securities into ones that deferred payments owed them for several years.”

Forget for a minute that you know about the SEC’s allegations in this case, and try to put yourself in the shoes of people who were pitched this opportunity. What investigation would you have done? Most of us would have investigated to confirm the company’s representations. We’d have done some research on this type of stone paver. Perhaps we’d have asked to see documents that proved the cost of the pavers. We may have looked in landscaping magazine to judge just how popular this type of paver was. We’d have laid eyes on the pavers in a finished garden setting, and we’d certainly have met face-to-face with the people responsible for making the venture profitable. That sounds like quite a bit of investigation, doesn’t it? It sounds like an investigation sure to confirm whether the investment opportunity was legitimate. But, assuming that the SEC’s allegations are true, that investigation would have done nothing more than set the alleged scam artists’ hooks deeper.

Why? Because the investigators took the wrong mental approach to the investigation. Looking for legitimacy is a recipe for disaster and humiliation, but it’s the investigative theory that most naturally occurs to us. Only when you realize how powerfully that theory skews how you perceive the evidence can you throw it off and search instead for the thing you are trying to avoid, a fraud.

So, what would a vigilant investor have done differently? She’d have looked for evidence of fraud. She’d have looked at PACER.gov for criminal prosecutions and civil lawsuits against the people involved. She’d have searched PACER for bankruptcy filings. The Vigilant Investor would have tapped many other unique sources of information, but she would not have had to go beyond those already mentioned to find strong evidence of a fraud — Aronson’s criminal record and obligation to make restitution to victims in a previous scam.  The Vigilant Investor looks for fraud, because an absence of cats doesn’t mean that there aren’t any rats.