The Very, Very Rich and How They Got That Way (9 page)

Cornfeld wrote to the Dreyfus Fund, offered some juicy statistics about the market he had uncovered in Europe and asked to be appointed Dreyfus’s European dealer on a commission basis. Dreyfus, having no full-time European operative and having nothing to lose, said OK.

Cornfeld gave his new firm the grandiose name of Investors Overseas Service (IOS). He started by selling Dreyfus Fund shares himself – a one-man dealership. Then he began recruiting other salesmen one by one to work under him. The setup was the standard one of fund hierarchies: Cornfeld kept about a fifth of each salesman’s commission on each sale.

At first the IOS sales force was small enough so that the whole crew – including Cornfeld – could pile into Cornfeld’s car. They would drive to some likely city, put up at its medium-priced hotel if it had one, sell Dreyfus at the local U.S. Air Force base by day and sample the local booze and girls by night. Gradually the force grew too big for this omnibus wandering technique, and in any case Cornfeld was earning enough from the dealership commission cuts so that he no longer needed to sell in person. He established a combination pad-office in Paris and concentrated on recruiting new salesmen, opening up new territories and building the dealership. When the French government grumped that he was illegally selling to French citizens and began making trouble for him, he moved the operation to Switzerland.

By the late 1950s IOS had nearly 100 salesmen wandering about the earth on its behalf. They were not only in Europe but were beginning to spread into other parts of the world where there were concentrations of Americans with money: Africa, India, South America. The sales force was growing too big for Bernie Cornfeld to manage alone; so he established new, intermediate levels in the hierarchy. Some of the original salesmen moved up to become supervisors, with authority to recruit and train their own stables of salesmen in various countries and regions – plus, of course, authority to extract cuts from those salesmen’s commissions. In time each of these supervisors built a stable big enough so that he had to set up subsupervisory levels below himself, and some of the supervisors eventually appointed sub-subsupervisors.

Each level took its bite from the money that the share buyers believed themselves to be investing in the stock market. The final bite, of course, went into the capacious pocket of Bernard Cornfeld. By 1960 at the age of 33, without having invested any important amounts of his own money, he had made himself a millionaire.

And now he was ready to take the final breathtaking step in his climb upward through the mutual-fund business. He was ready to organize his own fund.

“It was very easy to set up a mutual fund back then,” says a Zurich banker, now in New York, who began dealing with IOS at about this time. “You couldn’t do it easily in America, Switzerland or any country with strict laws for protection of investors. But if you chose some other country whose laws were more easygoing, all you really needed was a mailing address, the names of a few important-sounding banks and directors to put on your prospectus and a good printer who could turn out expensive-looking share certificates. You then went out, sold shares, collected money and invested in practically any stock that caught your eye.”

Cornfeld’s first mutual fund was named International Investment Trust (IIT). It was incorporated in Luxembourg, a tiny country that stresses the
free
in free enterprise. The fund’s mailing address and actual operating headquarters, however, remained in Switzerland with the rest of IOS. Cornfeld’s seasoned and aggressive salesmen were able to give prospective investors the impression that this new IIT was a large, rock-solid, Swiss-based outfit. The shares sold like glamour stocks to a bull market. At the end of 12 months IIT had some three and a half million dollars of other people’s money to invest, and the size of the fund kept growing until it finally reached nearly three-quarters of a billion dollars.

Cornfeld had long been irritated by the restriction of selling only to American citizens. Several foreign governments had complained in the late 1950s that IOS salesmen (perhaps without Cornfeld’s blessing) were secretly evading this restriction – were in fact selling Dreyfus shares in volume to non-Americans through various banking and currency-changing subterfuges. Cornfeld now set about the task of getting the restriction lifted, country by country. He went to each country’s monetary authorities and said, in effect, “You’re worried about capital flowing out of the country, right? OK, I’ll tell you what I’ll do. My new fund, IIT, will invest some of its money in your country’s stocks. In return, you must let me sell shares to your citizens.”

As this deal was concluded in one nation after another, ITT’s stock portfolio became highly diverse, to put it kindly. The stocks held ranged from solid Swiss and Dutch and American blue chips to obscure little companies and speculative ventures scattered all over the world – ventures that no regulated U.S. fund would have been allowed to touch. Not all these investments proved sound. IITs shares, originally offered at five dollars, lost about 25% of their market value in the first two years of operation and didn’t struggle back to five dollars until the fourth year. But Cornfeld’s salesmen obviously didn’t stress this fact when discussing IIT with new prospects and the prospects continued to buy new shares, and the raw size of the fund continued to grow without letup.

Cornfeld thus phased himself from supersalesman to fund manager. His personal income no longer flowed mainly from sales commissions but from much richer sources. He now commanded management fees (calculated as percentages of the fund’s total value), performance fees (calculated on the quarterly growth in per-share value, if any) and sundry brokerage and other bites that an alert fund operator could extract from the vast sums under his control.

If operating one fund was nice, Cornfeld and his top lieutenants figured, operating more than one would probably be still nicer. In 1962 they generated what may have been the most brilliant of all their ideas. This was the Fund of Funds.

The sonorous, faintly biblical name was without doubt a stroke of genius. The idea behind FOF was also highly salable, though it didn’t make a great deal of sense when you analyzed it in sober quiet after the salesman had left. FOF was set up and promoted as a mutual fund that would invest mainly in other mutual funds.

“Look at it this way,” the salesman would say. “You invest in a mutual fund to get diversity and professional management, check? So if you invest in the Fund of Funds, you get both
double
. You can’t lose!”

You could, in fact, lose easily. In the first place, you paid two sets of fees – one directly to the Fund of Funds, the other indirectly to the funds invested in. In the second place, the sales pitch was based on two entirely unwarranted assumptions.

First assumption: that the professional management and diversity offered by a mutual fund will automatically protect investors against loss when the market turns sour. As was demonstrated with poignant clarity in the late 1960s, this simply is not true. Mutual funds went down the drain in 1969 and 1970 along with everything else.

Second assumption: that a master fund or fund-of-funds setup can be counted on to pick those funds that will fare best in a market downturn – or at least, through its diversity, to pick a cluster of funds in which the majority will stay afloat in foul weather. This had already been shown up as mere wishful thinking in 1929, when layers of investment companies, built one on top of the other in fund-of-funds style, all came tumbling down together in a single mighty crash. As a Securities and Exchange Commission official put it in 1971, “If a single mutual fund can’t guarantee to pick the right stocks, why should anyone suppose a superfund can guarantee to pick the right funds?”

Yet the somewhat leaky logic behind the Fund of Funds made sense to thousands upon thousands of people, and IOS salesmen rapidly grew rich. And Bernard Cornfeld grew richer.

The Fund of Funds was incorporated in Canada as subsidiary of the parent company, IOS. Why Canada? Because Canadian securities laws were friendly to this type of enterprise. United States law specifically bars any publicly owned investment company such as a mutual fund from owning more than a small percentage of any other public investment company’s shares. The law was written to prevent a repetition of the disastrous 1929 chain-reaction effect in which the first layer of funds buckles under the second layer, which in turn buckles under the third layer. Canadian law in the 1960s, however, had no prohibitions against the fund-of-funds approach. One fund was allowed to own a sizeable portion of another.

There was nothing to prevent FOF from buying shares of U.S. mutual funds on the open international markets. And so the Fund of Funds, in the first phase of its notable career, concentrated on investing in hot Wall Street funds that were known and admired by investors all over the world.

The second phase came when Cornfeld and his aides were struck by an intriguing idea: Suppose IOS were to set up some new funds of its own, and suppose the Fund of Funds were then to buy their shares. This way IOS could collect two sets of management and performance fees – one for the first layer of funds, the other for FOF.

This led to a still more intriguing notion. The U.S. law against multilayered funds applied only to publicly owned companies – that is, companies whose shares were sold to the public. But a privately owned company could behave in this respect as it wished. If IOS were to set up a fund with just one shareholder, namely FOF, that would fulfil the definition of
private company
. Such a privately owned fund could operate without legal interference in the U.S. – indeed, could set up shop right on Wall Street, the center of the big action. To IOS, long denied direct access to Wall Street and the rest of the U.S., the notion was hugely attractive.

And so, one by one, privately owned IOS funds came into existence. They invested in all kind of stocks from blue chips to hair-raising speculations; they invested in real estate (an investment area in which heavy restrictions are imposed on public open-end funds in the U.S.) and in Arctic oil exploration and sundry other ventures, some more prudent than others. Gradually FOF ceased to be what it had set out to be – a superfund investing in other mutual funds. It became, instead, a kind of holding company operating a string of ventures that were all ultimately managed by one central group of wheeler-dealers.

Bernard Cornfeld was now, in the middle and late 1960s, enjoying the fullest flowering of his brief summer. “The IOS structure had become so huge and complicated,” says one of Cornfeld’s Zurich banker friends, “that almost nobody could sort it out. Every time I thought I had it figured out, a new piece would turn up and I’d have to take the puzzle apart again to fit the new piece in.” But though few men knew exactly where all Cornfeld’s wealth lay or exactly how it was pieced together, almost every newspaper reader in the Western world knew the round-faced social worker from Brooklyn had become improbably rich.

Cornfeld would turn up at such jet-set watering spots as Acapulco, Mexico, and make headlines simply by arriving. Photographers would scramble to take leggy pictures of the famous miniskirt platoon with which he traveled. He threw enormous parties and seemed delighted when
Life
or the
New Yorker
sent reporters around to cover the festivities. “He sometimes acted like a college boy bragging about all the girlfriends he had collected,” says the Zurich banker.

Warren Avis, the millionaire who founded the Avis Rent-A-Car System, owns a boat in Acapulco and was occasionally invited to Cornfeld’s parties. Avis is a serious-minded man with no great interest in such affairs, but he strolled over to Cornfeld’s place one night out of curiosity. When he saw that the party was degenerating into an orgy and that reporters were present, he turned around and went back home. “I told Bernie,” he recalls, “that he should cool it. He had set himself up as an international financier, handling millions of other people’s dollars. It seemed to me he was projecting altogether the wrong image. People expect a financier to be quiet, sober, prudent. . .”

Bernie Cornfeld’s public image as an international swinger may indeed have contributed to his summer’s abrupt end. The image certainly didn’t help him.

Trouble began in the late 1960s when some of the less prudent fund speculations turned sour. It wasn’t serious trouble at first, but it was aggravated by some internal management and cost problems – by sheer mismanagement, unhappy shareholders later charged. The result was a painful cash shortage.

Partly to raise cash, IOS decided to go public in 1969. The parent company’s stock, until then privately held by Cornfeld and his aides and salesmen, was offered to the public at ten dollars per share. This not only raised cash for the company; it also enabled Cornfeld and his colleagues to cash out of the business in varying degrees. Previously they had been private stockholders in a company whose shares weren’t traded on any public market. They could cash out only by finding private buyers – which might have been difficult. But now the shares were publicly traded, and Cornfeld and his men could sell as many shares as the market cared to absorb – and could come out with cash.

Those who sold their shares right away fared well. Those who hung on hoping the market price would rise far above ten dollars soon regretted it. For shortly after IOS stock was publicly floated, the world’s stock markets faltered, slumped, recovered briefly and then crashed.

Ah, woe! The whole structure of IOS collapsed beneath the horrified shareholders’ feet. The market value of the funds’ dizzy speculations plummeted one by one. Some investments were wiped out completely, reduced to flat zero.

A decade back, buyers of the various IOS mutual funds had been assured by salesmen that their money was going to grow by something like 20% compounded yearly. It now turned out that these promises had been, to put it gently, exaggerated. People who in 1960 had bought the first IOS fund, IIT, discovered by the end of 1970 that their money had grown by somewhat less than 3% per year over the decade. They would have been far better off putting their money in savings banks. People who had bought FOF shares when the superfund was launched would have been far better off keeping their money under a mattress. The shares were issued at ten dollars apiece in 1962. Eight years later they were worth less than eight dollars.