Do You Sincerely Want To Be Rich? (11 page)
Read Do You Sincerely Want To Be Rich? Online
Authors: Charles Raw,Bruce Page,Godfrey Hodgson
Tags: #Non Fiction
The outline of the IOS Stock Option Plan was simple enough. All associates were graded, according to the quantities of mutual fund shares that they had managed to sell. The system was similar to that used by Cornfeld's first mentors, Walter and Ruth Benedick, although the IOS grades eventually became a good deal more complicated.
Promotion carried, at each level, an option to buy a certain number of new shares in IOS Ltd (sa).
The price at which you could buy shares in the company was determined by a formula based on the growth of IOS, and of its sales force and its sales. Naturally, the formula price was expected to rise, and indeed it mostly did. So it would appeal to a salesman to take up his full option, contracting in effect to pay for shares in the future, at the price reigning
now.
Consider the case of a man reaching the grade of Regional Manager in early 1964. He becomes entitled to an option for 1,000 shares. At the formula price of early 1964, he would be contracting to pay $21,430. Even saving all his commission, he would have to sell $300,ooo-worth of mutual fund shares to pay it off. Taking realistic account of expenses, he would have to sell another $1,000,000 mutual fund shares. At that point, he could step up to General Manager and contract for another 1,300 shares.
now.
Consider the case of a man reaching the grade of Regional Manager in early 1964. He becomes entitled to an option for 1,000 shares. At the formula price of early 1964, he would be contracting to pay $21,430. Even saving all his commission, he would have to sell $300,ooo-worth of mutual fund shares to pay it off. Taking realistic account of expenses, he would have to sell another $1,000,000 mutual fund shares. At that point, he could step up to General Manager and contract for another 1,300 shares.
So long as the sales force expanded - and the system goaded each 'managerial' salesman to recruit more associates - then the formula price of shares bought under the Stock Option Plan would continue to rise. But their owners could not take their gains and get out, because the only
1
Dreyfus Corporation: Prospectus 1965.
shares in IOS Ltd (sa) that could in practice be sold on the open market were those owned by Bernard Cornfeld himself. The shares his salesmen and executives bought could only be sold back to the company at the formula price. Their loyalty was bound; and it was further inspired by a great vision.
This was Cornfeld's promise that the company would eventually be reorganized so that its shares could be sold off on the open market. 'We can all cash in,' the salesmen used to say, 'when Bernie cashes in.' Or, as Roy Kirkdorffer, boss of the British sales force, put it, 'When you sign on with Bernie, it's for keepsville.'
Loyalty and diligence were assured by the Stock Option Plan. But there was more than this. Indeed, there had to be more, because a company that merely deals in mutual funds, as IOS did when it began, is not an especially profitable animal. In 1959, IOS sold nearly $58,000,000 worth of the shares of the Dreyfus Fund and other funds, but it made a profit of only $75,187. A company which sells shares in funds run by other people profits only on the margin between the fee it gets from the fund organizers and the large commissions it has to pay out to its salesmen. To make more sales requires more salesmen, and squeezes the margin further.
Real profits come not from selling funds, but from managing them. If a fund expands, the managers' fee increases, but not their expenses: it costs little more to make investment decisions about a billion dollars than a million dollars. So Jack Dreyfus and his colleagues were sitting pretty when Cornfeld and other dealers sold for them. In 1961, Dreyfus' management costs were only 39% of the $1.2 million fees they took on the fund,
and
their stockbroking firm was getting brokerage on the fund's investments,
and
as the fund expanded the costs of running it dropped to about a quarter of the fees.
1
and
their stockbroking firm was getting brokerage on the fund's investments,
and
as the fund expanded the costs of running it dropped to about a quarter of the fees.
1
The solution for Cornfeld was to start his own funds, but starting a fund organization needs capital. He persuaded the Dreyfus Corporation to lend him $26,000 in 1961. He could hardly expect them to go further.
The beauty of the Stock Option Plan was that it generated the necessary capital. It got the salesmen to put a big slice of their commission back into the company. That money was then available to help to start up operations which would really make profits: fund management companies, investment banks, insurance companies, real estate concerns.
In the accounting of IOS Ltd (sa) the salesmen were listed as part of the assets of the company. Indeed, at the start, they were half of all the assets of the company. In early 1961, each salesman was reckoned to be worth about $2,000. Each salesman, when he bought shares under the stock option plan, was then agreeing to buy back the part of himself that he had given to Cornfeld. They were sufficiently in love with the dream of 'cashing in' that they didn't, on the whole, see it that way: until, with the collapse of 1970, shares in IOS became virtually worthless.
The ultimate expression of this system was reached in Germany, after the crash. Numerous salesmen had bought their shares with borrowed money. Many of them found that their shares were actually worth less than the amounts they had borrowed. Such men were thus ruined. In a number of cases, men were 'terminated' specifically on the grounds that persons in such poor financial condition could hardly expect to impress the customers.
With supplies of capital thus assured, Cornfeld and Cowett
1
Dreyfus Corporation: Prospectus 1965.
were ready to turn themselves into financiers. In December 1960, eight months after its own formation in Panama City, the IOS parent company sponsored its first mutual fund. This was given the resounding title of 'IIT, an International Investment Trust', and eventually it became the largest of all the IOS investment vehicles, controlling $700 million. The corporate existence of IIT, which was rather fuzzily defined, resided in the Grand Duchy of Luxembourg.
The launch of IIT had its haphazard aspects, especially when it came to finding a bank to perform the important-soundng role of Custodian of Securities. Obviously, IIT needed to be able to assure prospective customers that stocks and shares bought with their money would be kept in respectable and independent hands, and it was with this in mind that Victor Herbert, onetime dealer in rare musical manuscripts, journeyed from Geneva to Brussels late in 1960. Herbert had been taken off the IOS sales force for executive duty, and he had with him the draft prospectus of 'IIT, an International Investment Trust', which he was to show to Banque Lambert of Brussels, an organization of vast respectability founded by a section of the Rothschild family. The draft said that Banque Lambert had agreed to be Custodian of Securities for IIT
This caused amazement at the Banque Lambert's headquarters. No-one there had heard of IIT or IOS. Neither did they seem anxious to repair the omission. (Later, it emerged that someone from IOS had vaguely mentioned the idea to Banque Lambert's New York office.) Politely and firmly, Herbert was told that Banque Lambert declined the honour, and this created an awkward gap in the organization. In fact, the sales force had been unleashed and money was actually pouring into IIT before a proper Custodian of Securities was found.
IOS was helped out of this predicament by Credit Suisse (the Swiss Credit Bank) of Zurich. Bernard Cornfeld had been introduced to Credit Suisse, one of the 'Big Three' Swiss Banks by Dr Bruno Hugi, who he had hired to be investment adviser for the new fund.
Dr Hugi himself was an ex-manager for the Union Bank, another of the Big Three. And when IIT needed a bank to act as Depository of Cash, Hugi at first took his new colleagues along to the Union Bank. But Union already had some funds of their own and felt that they could not take the business. So Hugi introduced Cornfeld to Credit Suisse - who first agreed to be Depository of Cash and then, when IOS could not find a Custodian of Securities, Credit Suisse helped again. They persuaded a respectable affiliate of theirs, Bank H. Albert de Bary, of Amsterdam, to accept the job. But until that could be done, IIT had to make temporary expedients. The story suggests a rather light-hearted attitude to the organizing of a new international investment trust. More important, it illustrates the attitudes of European banks towards IOS. Cornfeld successfully persuaded almost every journalist who wrote about him that IOS was locked in combat with something called 'the European financial establishment'. This enabled him to represent legitimate criticism of his methods as mere Old World resentment of brisk American competition, and to claim in the end that his downfall was caused by a banker's plot. The fact is that large sections of the European financial establishment were delighted to work with Cornfeld, and to take his money, while other sections were not. It would be hard to say which section was the larger, but it is quite certain that IOS depended, from the start, upon the co-operation of established, old-line European finance houses. In this instance, Banque Lambert of Brussels declined to help IOS, but Credit Suisse and Albert de Bary were ready to do so. Neither of them had any lack of successors.
Even when decked out with a Custodian of Securities and a Depository of Cash, Bernie Cornfeld's creation was a very curious animal. It would have been a stillborn one in the harsh legal climate of America or Britain.
It is fair to say that there are two general approaches to the problem of protecting investors and inhibiting speculation. The British law tends to assume that the majority of investors are idiots, and in effect tries to take some ultimate decisions about their money out of their hands. The American law tends to assume that investors are reasonably sensible provided that they are told exactly what is going on.
But both approaches depend entirely upon there being two clearly separate legal entities in an investment operation: the
fund,
into which the customers put their money to be invested, and the
management company,
through which the organizers of the operation are entitled to earn fees for putting the fund to work. Much hard experience has shown that the crux of investment company regulation consists in keeping this division hard and fast. As the Senate Committee of Banking and Currency put it:
fund,
into which the customers put their money to be invested, and the
management company,
through which the organizers of the operation are entitled to earn fees for putting the fund to work. Much hard experience has shown that the crux of investment company regulation consists in keeping this division hard and fast. As the Senate Committee of Banking and Currency put it:
Basically the problems flow from the very nature of the assets of investment companies. The assets of such companies invariably consist of cash and securities, assets which are completely liquid, mobile and readily negotiable. Because of these characteristics, control of such funds offers
1
Senate Report 1775, 76th Congress, third session, 1940.
manifold opportunities for exploitation by the unscrupulous managements of some companies. These assets can and have been easily misappropriated and diverted by such types of managements, and have been employed to foster their personal interests rather than the interests of public security holders.
1
1
In Britain, the law requires that the assets of a unit trust (mutual fund) must be placed under the control of an entirely separate trustee, whose powers are clearly defined by a trust deed drawn up under the strict legal provisions of the Prevention of Fraud (Investments) Act, 1958. The trustee is empowered to dismiss the managers in the last resort, and the aims of investment policy cannot be altered without his approval. In America, it is not required that mutual fund assets must actually be placed in the hands of a trustee, but they are usually placed with custodian banks. The whole process is closely supervised by the Securities and Exchange Commission, which requires full public disclosure of all transactions.
Possibly the fact that Cornfeld called IIT 'an International Investment Trust' led people to think it actually
was
a trust. There was, however, no trust deed and no trustee, nor has there ever been. In smaller print, the prospectus called IIT 'a unit trust organized under the laws of Luxembourg' but what that amounts to is not easy to say. The Grand Duchy, an eighty-by-forty mile piece of well-timbered hill country between France and Germany, is rich in iron ore, deer and wild boar, but not in
was
a trust. There was, however, no trust deed and no trustee, nor has there ever been. In smaller print, the prospectus called IIT 'a unit trust organized under the laws of Luxembourg' but what that amounts to is not easy to say. The Grand Duchy, an eighty-by-forty mile piece of well-timbered hill country between France and Germany, is rich in iron ore, deer and wild boar, but not in
1
Senate Report 1775, 76th Congress, third session, 1940.
securities law. An open-end investment fund has no legally defined qualities in Luxembourg. Insofar as any law applies it would be ancient common law relating to co-ownership of property. The Luxembourg Banking Commission merely requires mutual fund organizations to register a management company and a set of rules.
All that IOS set up in Luxembourg was a company called 'IIT Management Company', whose purpose was defined as the managing of something called 'IIT, an International Investment Trust'. This must be one of the most diaphanous structures ever employed to hold $700 million of other peoples' money. In theory at least, the rules of IIT would give a shareholder some recourse against misbehaviour by IIT Management, but the fact that they were not filed until February 14, 1961, a couple of months after the fund began operating, is not encouraging. And after the original filing, IIT do not seem to gave bothered keeping them up to date. For instance they still gave in 1970, the Bank H. Albert de Bary as Custodian, although that arrangement ceased in 1964.
The skeletal nature of IIT was not easily apparent to the customers. The Banque Internationale a Luxembourg, the Duchy's largest bank, completed a mechanism which sounded highly reassuring, by becoming Transfer Agent and Registrar. Money was inserted into IIT by the customers, and was placed on account with the Credit Suisse, the Depository of Cash. Shares of the fund, to correspond with the inflow, were registered and sent out by the Banque Internationale. The cash of the fund was employed to purchase securities in a number of countries, and these were placed on account with the Bank H. Albert de Bary i
n Amsterdam. Investment policy was decided by the Bruno A. Hugi Banque Privee of Zurich. Few people realized that none of the eminent international concerns whose names appeared on the sales literature bore any responsibility to check up on the securities bought by IIT, and that the Bruno A. Hugi Banque Privee was Dr Hugi operating out of his suburban house in Zurich. It was virtually inevitable that some of the money going into IIT would be misapplied - and so indeed it was.
Chapter Six
Other books
Burnout by Teresa Trent
Corporate Daddy by Arlene James
Soul Whisperer by Jenna Kernan
False Memory by Dean Koontz
A Series of Unfortunate Events: The Penultimate Peril by Lemony Snicket
The Fox in the Forest by Gregson, J. M.
Not My Mother's Footsteps by Cherish Amore
An Invisible Thread by Laura Schroff and Alex Tresniowski
Down River by John Hart
Fated: An Alex Verus Novel by Jacka, Benedict
