Nearly six months ago, I asked, "What happens when a pyramid scheme's mania turns south?" We've just found out.
Spanish authorities have raided Forum Filatelico and Afinsa Bienes Tangibles, the parent of U.S.-based Escala (Nasdaq: ESCL ) , a coin and stamp trading house, and nine people suspected of possible criminal offenses have been arrested. It seems Spanish police concluded that the stamp investments the companies were offering were indeed nothing more than glorified Ponzi schemes. Escala, which is 67% owned by Afinsa, suffered a 62% drop in its stock price on the news.
In addition to offering apparently legitimate stamp and coin auctions, both Afinsa and Forum Filatelico sold investments offering guaranteed rates of return of up to 10%, backed by the value of the stamps in their collection. In these investments, a postdated check is given to the investor, and after a year, the houses either find a buyer for the stamps or buy them back themselves. The investor has the option of taking the money or investing in more stamps. Until today, investors had been opting for the latter.
Filatelico had more than 200,000 Spanish clients, while Afinsa, the world's largest stamp dealer, had 143,000 clients in Spain. Afinsa is also the third-largest auction house in the world behind Sotheby's (NYSE: BID ) and Christie's.
To determine the value of the stamps in its collection, the houses use stamp catalogs, which critics contend is an exceptionally poor way to judge value, since the catalogs are simply a guide -- the actual prices paid for stamps tend to be much lower. Lloyds of London had dropped both companies as clients, based on concerns over their stamps' value. Though Afinsa had brushed off Lloyds' departure and contended that it still had 150 other insurers, it's been said that at least one other insurer would agree to insure the collections only -- at much lower valuations.
The Spanish government, meanwhile, said the companies were suspected of "fraud, criminal insolvency, money laundering, tax evasion, and embezzlement." The government raided 21 homes and offices and found some 10 million euros in cash during one of the searches. It also froze the companies' Spanish businesses until a court-appointed administrator could step in to run them. Needless to say, the trial-lawyer lobby has already filed a class action lawsuit.
In any mania, whether it's stamps, tulips, or tech stocks, the euphoria associated with the wager often outweighs the due caution an investor ought to bring to the transaction. The potential for guaranteed 10% returns was based not on the stamps, really, but on Afinsa's 25-year history of making payments. It takes just one crack in the dam, however, before the trickle of doubt becomes a torrent of fleeing investors. That's what we saw with Escala's stock: As news of the raid spread, the price crashed through the floor.
Almost parenthetically, Escala also released its third-quarter earnings Wednesday. It said profits grew 28%, along with a 40% increase in collectibles revenue. However, most of the growth in sales and earnings was attributable to its acquisition of A-Mark Precious Metals, a precious-metals dealer undoubtedly benefiting from the soaring price of gold, silver, and platinum. Considering the mania forming around the rise in prices of those metals, investors there might begin to wonder how long their good fortune will last.
In November, when I questioned whether Afinsa was a pyramid scheme, I had said I believed its operations were legitimate. My concerns at the time, as an investor in its U.S. subsidiary Escala, were the relationship between the two companies. Any misfortune that befell Afinsa, I felt, would ultimately fall back on Escala. That has happened today, and it should stamp indelibly on investors' minds the notion that any deal that seems too good to be true probably is.
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Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
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