The habit does not make the monk

François Rabelais

The Portuguese Banknote Affair

When contemplating counterfeiting, banknotes usually come to mind as the prime target, with designer jeans perhaps trailing as a distant second. But what truly constitutes deception when counterfeit money is forged and circulated? The crucial aspect isn’t replicating a physical item; it’s the assertion that it’s an “authentic” product. Even an exact replica of a van Gogh painting would still be deemed fake if claimed to be an original van Gogh. Similarly, a pair of Lacoste jeans would be considered “counterfeit” even if produced from identical cloth and patterns by the same factory workers as the authentic ones.

Likewise, a flawless forgery of a banknote manufactured on the monetary authority’s own presses would remain counterfeit if produced without the central bank’s authorization. This scenario unfolded in a historic and economically significant fraud, known as the Portuguese Banknote Affair of 1925, a culmination of the brief yet ambitiously audacious career of Artur Virgílio Alves dos Reis.

At the onset of the Roaring Twenties, both Alves dos Reis and Portugal were grappling with severe economic challenges. Portugal had resorted to printing money to address its government deficit post-World War I. Meanwhile, the Bank of Portugal, lacking modern anti-counterfeiting technology like serial numbers, had outsourced its note printing to the English firm Waterlow & Sons. Alves dos Reis, having ventured to seek his fortune in Angola after his family’s financial downfall, resorted to fabricating a Portuguese university diploma, attributing it to the “Oxford University Polytechnic School of Engineering.” This credential adorned him with qualifications across various disciplines, facilitating his employment as the chief engineer of Angola’s railway system. Despite the forged degree, Alves dos Reis managed to acquire practical engineering knowledge on the job, earning a decent reputation upon his return to Portugal in 1923.

However, his fortunes soon dwindled. As he aimed to venture into high finance through a hostile takeover of a company named Ambaca, his approach led him straight to incarceration. During his time in jail, he focused on studying—not religious or literary texts, but the statutes governing the Bank of Portugal.

Several elements of the Portuguese monetary system during the 1920s coincided, laying the groundwork for the ensuing events. Firstly, despite holding the monopoly on printing escudo banknotes, the Bank of Portugal was a private entity with shareholders. Secondly, the currency used in Angola, the Angolan escudo, held a tenth of the value of a Portuguese escudo. Moreover, the Angolan escudo banknotes were essentially Portuguese escudo notes with an “Angola” stamp overlaid. Furthermore, there was no systematic scrutiny of escudo note serial numbers, and occasionally, the Portuguese government and the Bank of Portugal authorized “secret” issues of banknotes for potentially contentious purposes.

These factors, coupled with the propensity of Portuguese notaries of the time to validate nearly anything, provided the groundwork for a scheme. Alves dos Reis concocted a fraudulent contract, seemingly on government letterhead, notarized multiple times. This document essentially deputized him, purportedly at the behest of the Bank of Portugal’s governor, to form an investor consortium for extending a loan to Angola. In return, the investors were to be rewarded with the privilege of printing the equivalent of $5 million in Angolan escudos. Presenting this counterfeit contract to the Portuguese minister in the Netherlands, Alves dos Reis convinced the minister, perhaps influenced by the promise of commissions or possibly his inherent crookedness, to assemble a consortium.

Approaching Sir William Waterlow, suspicions were raised, requiring personal authorization from the Bank of Portugal’s governor for such a transaction. Strangely, instead of directly contacting the Bank of Portugal, Waterlow sought a personal letter from the consortium. Unsurprisingly, the letter returned—a further forgery by Alves dos Reis. The issue of serial numbers arose.

Alves dos Reis convinced his backers to provide a substantial cash advance, allowing him to analyze numerous 500-escudo notes and decipher the format of Portuguese banknote serial numbers. Although adept, he lacked a copy of Waterlow & Sons’ master list of serial numbers, resulting in some requested numbers already being in circulation. Swiftly devising an excuse that these notes would solely circulate in Angola, he managed to persuade Waterlow to proceed with printing. Alves dos Reis had no intention of stamping the notes, relying on the absence of systematic checks to evade detection of duplicates.

As the notes circulated and were introduced into the system, chaos ensued. The counterfeit money amounted to slightly less than 1 percent of Portuguese GDP, sparking a mini economic boom. Alves dos Reis’s syndicate members, oblivious to the failed Angola loan, eagerly divided the counterfeit banknotes amongst themselves. Meanwhile, Alves dos Reis continued to concoct even grander schemes.

Given that the Bank of Portugal was the sole entity capable of scrutinizing the counterfeit banknotes and being a private company with shareholders, Alves dos Reis, now a man with his own bank founded on fake money and substantial riches, schemed to seize control of the Bank of Portugal’s shares and assume its governance, thus ensuring the perpetuation of the fraud.

Predictably, rumors circulated, causing distress. While the Bank of Portugal aimed to suppress rumors, heightened drone activity led to concerns that the country was inundated with forged notes, potentially due to foreign aggression. Seeking to maintain currency confidence, the Bank of Portugal inspected notes for authenticity, discovering that those in circulation in Lisbon were genuine—printed in England by Waterlow & Sons.

The fraud’s exposure was purely accidental. Disparaging rumors regarding the Bank of Angola and Metropole, fearing its ascent to the central bank, triggered media scrutiny, compelling authorities to scrutinize notes in Alves dos Reis’s vaults. Confirming their authenticity, the inspector stumbled upon two notes with identical serial numbers—a genuine note stacked next to its counterfeit twin. Subsequent investigations unearthed more pairs, leading to Alves dos Reis’s imprisonment, where this time, he devoted himself to reading the Bible.

As confidence in the currency plummeted, inflation soared. The Bank of Portugal recalled all 500-escudo notes, replacing them with 1,000-escudo notes. The ensuing upheaval led to a military coup and established the “Estado Novo” dictatorship, governing Portugal until 1974. During this period, an economics professor named António Salazar helmed the country, pondering the series of events that catapulted him to power.

The Portuguese Banknote Affair stands as a tragic testament where a weak link in a high-trust society—the notaries—ultimately eroded the entire structure of trust. In 1955, Alves dos Reis received an obituary in the Economist applauding his scheme for benefiting Portugal on Keynesian principles, a perplexing statement by the newspaper.

Banknotes, distinct in that they only certify themselves, create a closed loop in counterfeiting; once the paper is created, the crime is consummated. Typically, such frauds involve exploiting a broader trust system where papers or delegated authorities certify something else, such as the value of a gold deposit in the ground.

The Bre-X Mining Fraud

The mining industry, particularly in precious metals, seems to attract dishonest individuals. The allure of striking literal gold can lead investors to turn a blind eye to caution. Even an otherwise honest miner can easily convince themselves that the jackpot is just a few meters of drilling away. This optimism can sometimes slide into telling white lies to backers to secure funds for further exploration. There used to be a joke on the Vancouver Stock Exchange that defined a mine as “a hole in the ground with a liar at the top of it.”

Mining stands as a sector with fluctuating honesty standards but a considerable need for capital. It allows for prolonged fundraising without immediate results, making it an ideal hub for individuals who, whether initially sincere or deluded, end up resorting to fraudulent practices on stock exchanges.

In the past, a common practice involved taking a shotgun cartridge, emptying it of shot, filling it with gold dust, firing it at rocks on the mine site, and sending these rocks for crushing and assaying. This “salting” of a mine manipulated assay reports, presenting false evidence of gold in the rock samples to attract investors. The modern-era method isn’t remarkably more sophisticated. It still relies on manipulating assay reports and geologists’ studies, often involving the introduction of gold from elsewhere into underground samples. A minuscule amount of gold in a sample can generate an assay report indicating a commercially viable concentration, making it as simple as altering a wedding ring with a file.

While there have been advancements in sampling procedures, sealing methods, and professional regulations within the mining industry, finding a corrupt geologist and operating a remote fake mine can still evade inspections. A prime example occurred in 1997 when Canadian investors valued an almost worthless Indonesian excavation site at $12 billion, believing it to be the largest gold discovery globally.

The case of the Busang mine in Borneo and Bre-X, the company claiming its discovery, remains the most significant mining fraud recorded. Michael de Guzman, a struggling geologist, was employed by David Walsh, a near-bankrupt stock promoter. They raised funds to drill deep holes in the Borneo jungle. Under Guzman’s supervision, the drill cores were sealed and sent for assay.

There indeed was gold in the ground, acknowledged by all. Local villagers occasionally panned for gold in nearby rivers. Yet, other mining firms exploring Kalimantan concluded that there wasn’t enough gold in the rock to sustain a mine commercially. Consequently, the rights to the Busang region were cheaply acquired by a financially distressed Canadian promoter.

De Guzman, an expert in “diatremes,” believed fervently that the Busang claim was such a formation, despite conflicting conclusions by other geologists. The market for Bre-X stock soared when assay data from Guzman’s drill cores revealed high gold percentages in the rock, backed by microscope photos showing smooth metallic-gold micronuggets.

Geology aficionados would recognize that gold found in rock doesn’t typically appear as smooth nuggets. Such smooth gold nuggets occur through erosion by running water (“alluvial” gold). Bre-X’s critical error was fabricating microscope photographs of smooth gold nuggets, indicating fraudulent intervention.

The weak link in the fraud was the initial sealing of the drill cores, conducted in a remote Indonesian mining camp where only laborers or junior geologists hired by Guzman were present. Once the samples were tampered with, further detection became implausible. Analysts and investors in Canada believed that three independent consultants had analyzed the Bre-X data, unaware that none had access to anything but fraudulent information prepared by Bre-X.

Such gaps between verifiable facts and assumed credibility create the ideal ground for counterfeiting fraud. Having obtained a certification, the fraudster readily markets their operation as validated. This strategy propelled Bre-X’s success for a while; the share price soared from pennies to over $264 on a split-adjusted basis, enriching numerous Canadian stockbrokers and investors.

However, revelation was inevitable. The Indonesian government demanded that Bre-X develop the mine rather than solely drilling for assay holes and issuing stock-market releases. Inept at this, Bre-X formed a joint venture with an established mining company. When this company (Freeport-McMoRan) drilled their own holes and found no gold, Michael de Guzman mysteriously fell from a helicopter en route to a meeting discussing Freeport’s findings. His body was later discovered by wild pigs before investigators arrived. Bre-X stock certificates remain available as souvenirs in novelty shops in Toronto, remnants of a frenzy that caused losses for many middle-class Canadian households caught in the mania.

Mining for investors

The concept of mining fraud can be extended to various industries because at its core, the act involves delving deep into someone else’s funds. The essence of the scam lies in targeting industries requiring substantial initial investments, promising future rewards—a temporal aspect distinguishing commercial fraud from other forms of theft. The strategy involves attracting external investors to contribute funds that are redirected for personal gain rather than towards the intended project. The counterfeit serves as the linchpin, justifying victims’ cash transfers.

Consider the recent case of Theranos, resembling a mining fraud but executed in the healthcare sector. As detailed in Chapter 3, healthcare frauds often yield substantial revenues through insurance payments, with minimal actual costs due to fictional treatments. However, Theranos differed; while it provided some fraudulent treatment, its primary focus was acquiring cash from investors.

The company’s proposition was straightforward: Elizabeth Holmes envisioned a device conducting diagnostic tests on a single drop of blood. This technology, used in clinics housing Theranos machines, offered quick test results with minimal blood, revolutionizing healthcare and promising substantial profits for its inventors.

However, the concept was inherently flawed. Simple calculations revealed that a single drop of blood lacked the volume necessary for an accurate sample. Moreover, testing marker chemicals in minute concentrations required larger samples to ascertain medically relevant variations, preventing Theranos’s success. Patients visiting trial clinics were erroneously diagnosed with potential heart issues due to amplified variations in small blood samples.

Theranos confronted an insurmountable statistical hurdle before a fluid dynamics issue. The core “lab-on-a-chip” concept relied on blood flowing through microscopic channels with various chemical sensors, which contradicted blood’s natural flow. To work around this, the “Edison” machine required normal syringe-sized blood samples, manipulated by a robot arm onto commercially available blood test chips. These samples were too small for the chips, rendering inaccurate results. Yet, Theranos was evaluated at $10 billion based on this prototype—a valuation absurdly disproportionate to a contraption reliant on an eyedropper-equipped toy robot.

Silicon Valley maintains a complex relationship with “fake demos.” Detecting deception is challenging, as even major tech successes have involved demo fabrication. Microsoft, for instance, demoed its “Interface Manager” software in 1983, showcasing overlapping applications without a functional underlying code. This tactic recurs frequently among tech giants, akin to salting a gold assay. However, Theranos erred by operating at the intersection of a culture embracing “faking it until you make it” for rapid progress and a tightly regulated medical industry where higher standards of quality and transparency are essential, particularly when health is at stake.

Typically, biotech fraud exploits regulations themselves. Biotech firms, distinct from pharmaceuticals, focus on unapproved drugs, necessitating continuous fundraising for research and testing. Investors, often doctors, are drawn to these companies, anticipating a surge in stock value upon favorable test results. However, early-stage test outcomes seldom offer unequivocal results, leading companies to blur the line between spin and dishonesty when communicating test results to the stock market, especially when further stock issuance is required.

Exemplifying the complexity, British Biotech, testing marimastat as an anticancer drug, faced FDA objections regarding their trial methodology. The company overstated positive-sounding results derived from antigen-level trials, ignoring their lack of significance in drug approval. Similarly, AVEO Pharmaceuticals Inc. skewed press releases on tivozanib, downplaying FDA concerns about patient death rates in a trial period while capitalizing on public stock offerings. These actions led to legal repercussions despite eventual European drug approval based on the same inconclusive evidence.

However, misrepresenting drug approval test results to investors pales in comparison to fraud against the approval system itself. We’ll soon explore this aspect in depth. But first, let’s delve deeper into the essence of “counterfeiting” fraud.

Circles of trust

Consider the hedge-fund frauds discussed earlier. A crooked auditor’s significance lies in signing off on fraudulent accounts. While accountants, like Bernie Madoff’s associate Frank DiPascali, offer technical advice on concealing theft by creating intricate receivables to mask withdrawals, an adept fraudster can often devise such tactics independently. Yet, the challenge lies in producing valid audited accounts for investors, creditors, and the public.

Professionals—lawyers, doctors, accountants, actuaries—hold a distinct status in the business realm. Specific documents hold weight solely with an accountant’s seal of approval, regarded as “audited accounts,” subject to less scrutiny. Similarly, documents drafted by qualified lawyers and notarized carry greater presumed validity compared to layman-drafted papers, even in factual checks unrelated to intricate legal aspects, like verifying property ownership.

These professions operate as circles of trust. Their extensive training aims to instill values of trustworthiness, weeding out those lacking such qualities. Moreover, professional status, a valuable asset, can be revoked by disciplinary bodies with severe repercussions. Thus, corrupting a professional demands a significantly higher sum than corrupting a layperson. Considering the earning potential of a qualified professional over a career span, the incentive for involvement in a fraud, even for morally deficient individuals, typically starts at about a million dollars to offset the risk of losing professional standing and future earnings.

Another entry into this trust circle occurs through affinity groups, as seen in pyramid schemes. The economic logic supports this approach: stronger social connections imply higher shared interests, making exploitation costlier. The Greek side of the “Canadian Paradox” thrives on strong personal ties among Greek shipowners. However, the risk arises when people identify with groups despite weak commonalities. Boston’s Italians had no real reason to trust Charles Ponzi based on his surname, while the connection between widows and Sarah Howe was merely their marital status and gender.

Californian venture capitalists’ tolerance of fake demos stems from a filtering mechanism akin to an affinity network. These investors interconnect, fostering relationships, and swiftly integrating start-ups associated with one member into the trust circle of others. This method operates in an environment focused on substantial gains rather than minor losses. Yet, instances like Theranos reveal limited controls once a deceitful entity enters the loop, with prominent Silicon Valley figures publicly supporting Elizabeth Holmes despite critical exposés by individuals like John Carreyrou of the Wall Street Journal.

The core of all types of counterfeits, including banknote forgery, targets certification systems, presenting items as having specific origins when produced through cheaper or dishonest means. The pharmaceutical and medical industry, dedicated to certification, monitoring, and authenticity, faces significant fraud due to the industry’s potential for malpractice. The medical fraud spectrum includes frauds against and by the industry, each posing unique challenges.

Certification in these sectors is often a one-time process, akin to a professional’s assurance, minimizing the need for duplicated checks. Social norms discourage questioning professionals’ judgments, forming a robust collective mental block, especially concerning health issues. This trust extends beyond doctors to all providers in the medical system. While medical professionals adhere to stringent ethical codes, other providers lack such obligations. Medicare, embracing a deferential culture, faced challenges in implementing fraud controls without disrupting the doctor-patient relationship. This leniency extended to all providers, leading to rampant fraud and significant losses in program spending.

Drug counterfeiting

Upon the tragic passing of pop icon Prince, among the items discovered near him was a bottle of generic Vicodin painkiller tablets. Shockingly, these tablets were counterfeits containing fentanyl, an exponentially stronger synthetic opioid than morphine. At its core, pharmaceutical counterfeiting becomes an act of violence where susceptible patients are duped into ingesting substances without informed consent regarding the risks.

This criminal activity stems from the pharmaceutical industry’s emphasis on certification. Manufacturing pharmaceuticals is arduous and highly competitive, constantly pressuring profitability. The crux of profitability lies in the final stage, where significant markups occur over manufacturing costs, often through robust brand recognition or patent protection. Hence, individuals capable of manufacturing pills without their brands or patents are tempted to produce counterfeits.

It’s crucial to recognize that drug counterfeiting fundamentally challenges the certification system. Even if the counterfeit mirrors the chemical composition of the “genuine” drug, profits deviate from the patent’s intended purpose, rendering the fake drug, well, fake. Moreover, the pharmaceutical certification system inherently ensures safety. Counterfeit manufacturers evade audits and scrutiny on manufacturing processes and ingredient purity, eroding the safety measures integral to the patent system. This criminal behavior escalates to the point where individuals might adulterate a pill intended to contain hydrocodone with fentanyl due to apathy and malice.

The fight against counterfeit drugs epitomizes the struggle to establish a zero-fraud system. The pharmaceutical industry has invested considerable resources in tracking products from inception to delivery, often inconveniencing itself. Previously, medical wholesalers managed drug inventories via a “gray market,” essential given drugs’ perishable nature. However, rampant circulation of fake drugs compelled stringent regulations, drastically reducing the gray market’s scope.

Despite these efforts, fraud resurfaces. Mandated “track and trace” systems implemented globally utilize randomized serial numbers on pill packets, documenting every transaction within the supply chain. In theory, this setup should prevent counterfeit drugs from entering the market. However, it’s observed that as the audited chain becomes more burdensome, its efficacy diminishes. Notably, the majority of counterfeit pharmaceuticals in developed nations are now retailed through unlicensed internet pharmacies, illustrating the complexity of fraud within these networks.

Even the track-and-trace system fails to thwart counterfeiting within the circle of trust. Ranbaxy Laboratories, for instance, pleaded guilty to multiple criminal charges in 2013 concerning the generic drugs it produced for global distribution, admitting to employing subpar ingredients and falsifying quality-control tests using competitors’ branded products.

Vioxx

Ranbaxy’s fraudulent actions, while extreme, didn’t entirely exclude it from the circle of trust; under new management, the company remains operational and continues drug production. However, pharmaceutical fraud isn’t confined to peripheral entities; it has infiltrated even the highest echelons involving individuals and corporations previously untarnished. Consider Merck’s drug Vioxx, approved by the US Food and Drug Administration as a painkiller.

Initially sanctioned in May 1999 for osteoarthritis and severe menstrual pain, Merck conducted ongoing research, exploring broader applications. One study targeted Alzheimer’s patients, while another extensive trial aimed to exhibit reduced gastrointestinal side effects compared to naproxen, a competing rheumatoid arthritis drug. The Vioxx Gastrointestinal Outcomes Research study (VIGOR) involved eight thousand patients, split between Vioxx and the alternate medication.

Early analysis during the study disclosed pivotal findings—Vioxx patients experienced fewer ulcers but suffered serious, including fatal, heart issues at twice the rate. This posed a scientific and ethical quandary, leading to a decision to continue the trial while disproportionately analyzing heart data until February’s end while considering gastrointestinal symptoms until a month later. Consequently, the published paper in the New England Journal of Medicine exaggerated Vioxx’s benefits and downplayed its risks, aligning with Merck’s prevailing practices.

Merck aggressively marketed Vioxx as a groundbreaking arthritis solution, with an adept sales team trained to counter concerns about cardiac side effects. Despite FDA reprimands and mounting evidence of cardiac issues from external analyses, the drug persisted in the market. Merck expanded Vioxx’s prescribed conditions, inadvertently accumulating evidence of its association with heart attacks. The company continued to downplay controversies in discussions with doctors while emphasizing the drug’s intestinal benefits and emphasizing its “unknown” cardiological risks.

In 2004, studies regarding Vioxx’s treatment of colon polyps and Alzheimer’s disease prompted action. Management shifted focus from retaining market presence to mitigating legal liabilities caused by Vioxx. Consequently, the drug was withdrawn, triggering litigation. An estimate suggested that Vioxx’s lucrative sales over five years potentially caused around eighty thousand heart attacks, with approximately forty thousand resulting in fatalities.

Post-2004, stricter practices emerged, especially in disclosing conflicts of interest among medical researchers consulting for pharmaceutical companies. The Vioxx saga emphasizes a breach in the broader trust system rather than a solitary assault on an individual. Patients anticipated pharmaceuticals as outputs of clinical and scientific processes rather than commercial interests. Vioxx’s debacle raised questions about Merck’s understanding of risks and their commitment to communicating impartially with prescribing doctors. The breakdown of checks and balances resulted in scientifically untenable claims.

This case highlights the tension between pharmaceutical production by commercial entities and managing ethical considerations. The “counterfeit” aspect in Vioxx wasn’t merely a drug or a label; it counterfeited the perception of business operations within the industry.

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Fraud: The Art of Stealing Wealth and Trust - Counterfeits (Ch. 5)

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