Tom Petters Goes To Trial In History's Second-Largest Hedge Fund Ponzi Scheme

Ed's Note: An earlier version of this article incorrectly stated that Fingerhut had filed for bankruptcy protection. That correction has been made.

In Minnesota this week, a trial is quietly getting underway to prosecute the alleged mastermind behind the second largest Ponzi scheme in history.

In the aftermath of the collapse of Bernie Madoff's breathtaking fraud, there has been little fanfare over Tom Petters' $3.5 billion wholesale broker scheme, which took in major U.S. hedge funds looking to earn a quick buck on an investment that bore no correlation to the stock market. Still, that doesn't mean the story is without its own extraordinary details.

After going broke with no formal education in the late 1980's, at one point even having to move in with his brother, Petters rapidly engineered a stunning about-turn in his unremarkable business career. By the end of the next decade, the entrepreneur's firm bearing his name would own Polaroid, catalog retailer Fingerhut, and even an airline (Sun Country Airlines).

If these names strike you as the types of companies which seem more likely to have reached a point of saturation in terms of market share rather than as likely windfall earners, then you're right. According to court filings, the bulk of Petters' legitimate businesses were money-losers. (Polaroid has filed for bankruptcy protection this year.) Tom Petters Group's cashflow was instead all derived from a scheme which purported to buy electronic goods (mainly flat-screen TVs) at cut-down prices and re-sell them to large retailers such as Wal Mart.

"These companies provided Petters with the appearance of a corporate tycoon, which made it easier for him to lure in new investors," Bloomberg reports.

It was during the time that this scheme was at its apex that I first heard of Petters, via a small Midwestern business owner I met through an open business forum. At the time, the Midwestern chap was trying to build his own catalog merchandizing empire. After a frustrating year attempting in vain to raise a sufficient amount of money to finance his venture, he told me, the business owner turned to an aggressive high-commission capital raiser, who raised a cool quarter of a million dollars from Petters for the start-up. (Unfortunately, the broker also got commitments from the former directors of a public company who ended up resigning their positions when it briefly got entangled in a securities fraud lawsuit. I never met the broker, so one can only speculate as to the true merits of her ethical credentials.)

The owner of the start-up tried to explain to me briefly how Petters' flat-screen trading operation worked. Hard as I tried, I couldn't figure it out; neither could he, nor could a friend of mine who works on Wall Street, with whom I later discussed the subject in passing conversation. "He's very well respected," the Midwestern business owner had concluded in defense. Looking back on that brief encounter, I realize what a great example it makes for the generally lax culture of due diligence at the time.

Petters claims that the enterprise was always entirely legitimate to his knowledge; any wrongdoing was the result of the actions of his associates which took place behind his back. According to the defendant, one of those colleagues was disbarred attorney and one-time mob informer Larry Reynolds, who claims that he acted as a fake supplier for Petters, cashing more than $12 billion through his current account from January 2003 to September 2008 for a "commission" agreed upon with Petters.

It doesn't help Petters' case that Gregory Bell, a former Chicago-area hedge fund manager, has admitted to covering for the defendant by falsely claiming to have cashed returns from the venture though his fund Lancelot Investment Management. Bell now faces up to 20 years in jail.

In the advent of the trial, it is surprising how little media reports have mentioned the details of Petters' colorful though tragic life. Petters has constantly battled a fractured personal existence: He spent time in rehab for cocaine addiction, divorced his wife, and has been sued by his former business partner and other associates. In 2004, just before Petters was about to remarry, his son John Thomas Petters was stabbed to death at 21 while on holiday with friends in Florence, Italy. (Petters later donated $10 million to his son's former college, Ohio-based Miami University, as well as to a string of other educational institutions.)

By late 2007, Petters was finding it increasingly hard to raise money to perpetuate the wholesale trading scheme, according to prosecutors. The fund collapsed shortly after the FBI raided his offices on September 24, 2008.

Petters' brother claims that the former billionaire has already been tried by the local media, and that as such the trial is somewhat of sham. Legal experts are less compassionate, however.

"This case is a Ponzi scheme and an out-and-out fraud," Peter Henning, a professor at Wayne State University Law School who has been following the case, said in an interview with Bloomberg. "It's the Hail Mary defense. When you've got nothing else left, you say 'I didn't know anything.'"

The trial is due to start tomorrow. Keep your eyes open for the details, for it promises to be one of the more interesting chapters in the history of hedge fund related frauds.