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Testimony of Herbert A. Biern
Deputy Associate Director, Division of Banking Supervision and Regulation
"Prime bank" schemes
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
July 17, 1996

I am pleased to appear before the Committee on Banking, Housing, and Urban Affairs to discuss actions that the Federal Reserve has taken over the past several years to address the problem of "prime bank" financial instruments and related illegal financial schemes. The Federal Reserve has taken an active role in alerting the banking industry and the public about the illicit activities of individuals trying to peddle nonexistent financial instruments here in the United States and abroad, and we have worked closely with the law enforcement community to assist their efforts to investigate and prosecute these wrongdoers.

"Prime Bank" Schemes and Advisories
In late 1993, Federal Reserve staff was alerted by domestic and foreign banking organizations that their names were being used for apparently unlawful purposes in connection with the attempted sale of questionable financial instruments. We were also contacted by individuals who had been approached to purchase questionable, highly complex investment-type instruments.

The transactions that were brought to our attention involved notes, guarantees, letters of credit, debentures, or other seemingly legitimate types of financial instruments being issued by an unidentified "prime bank," or by a domestic or foreign banking organization that was said to be keeping the issuance of the instruments secret. The various proposals that involved "prime bank"-related financial instruments had similar characteristics:

(1) the investor could realize extremely high rates of return on an instrument described as risk free;

(2) the investor was buying a part of a large tranche of securities or financial instruments that was almost fully subscribed by other investors or was part of a "roll program" that automatically put the investor into an investor group of some sort;

(3) the financial instrument that was being purchased was traded on a worldwide secret exchange;

(4) the documentation related to a "prime bank" investment was extremely complex and difficult to comprehend;

(5) a secure escrow account maintained at a "prime bank" or by an attorney would be used to hold the investors' funds and payments into this account would be made by some sort of "key tested telex" message;

(6) the financial instruments being issued were in formats purportedly approved by the International Chamber of Commerce or fully sanctioned by the Federal Reserve, the World Bank, or some other known international organization.

Some "prime bank" schemes appeared to be targeted to individuals and companies who needed loans. These potential borrowers were advised that their loans would be funded by a "prime bank" provided they paid a large, up-front fee to secure the funding. Board staff believed that the proposed payment of unrealistic rates of return was indicative of a fraudulent scheme and contacted several banks to make sure that legitimate banking organizations were not referring to themselves as "prime banks" or using financial instruments that in any manner referred to "prime banks." Once assured that there was no legitimate use of the term "prime bank" or lawful use of a "prime bank" instrument, we drafted an interagency advisory on "prime bank" schemes and began to work through the Department of Justice's Interagency Bank Fraud Working Group in order to issue the pronouncement. Coordination efforts to address the problem were also initiated with some of the other 12 agencies participating in the Working Group, including the Securities and Exchange Commission, as well as with international law enforcement authorities, including Britain's Scotland Yard and Department of Trade and Industry.

On October 21, 1993, the Federal Reserve and the other federal banking agencies issued the first interagency advisory entitled "Warning Concerning Prime Bank Notes, Guarantees, and Letters of Credit and Similar Financial Instruments." The advisory, which is attached to my prepared statement, informed banking organizations and the public that the Federal Reserve and the other regulators know of no legitimate use of any "prime bank"-related financial instrument. The advisory also asked the public to contact agency representatives if approached to invest in a "prime bank" instrument or pay an advance fee to secure a loan funded by a "prime bank" note, letter of credit, or other type of questionable financial instrument. The banking agencies committed to refer cases of potential illegal conduct associated with supposed "prime bank" documents to a senior official in the Washington, D.C., office of the SEC and to the local offices of the FBI because almost all "prime bank" schemes appeared to involve fraud, including securities fraud.

The advisory prompted numerous calls and letters about "prime bank" matters. Between late 1993 and mid-1995, hundreds of inquiries were received from individuals who had been solicited to purchase "prime bank" financial instruments, from investment advisors considering potential investments on behalf of clients, and from banking organizations that had received faxed solicitations. Calls and letters came from as far as South Africa, Germany, Australia, France, and Singapore. The correspondents were highly suspicious of the proposed schemes and many indicated they wanted to check with the government "to be sure" that their suspicions were justified. During this period, Board staff assisted federal prosecutors in New Jersey, Oklahoma, Virginia and in other districts to investigate and eventually convict individuals for "prime bank"-associated federal criminal law violations.

Calls and letters to the Federal Reserve regarding "prime bank" scams began to slow in late 1995 and early 1996 but, unfortunately, began again in recent months. The new inquiries have focused on the role of the Federal Reserve itself, with callers asking whether the Federal Reserve registers agents in certain European countries, licenses traders on secret "prime bank" exchanges, clears the transfers of "prime bank" securities, or oversees investment plans comprised of "prime bank" instruments.

The Federal Reserve responded with a new advisory, released on June 11, 1996, to dispel any misconceptions that the Federal Reserve plays a role in "prime bank"-related investments. The recent advisory is also included with my statement.

The Effect of "Prime Bank" Schemes
The Federal Reserve is not aware that banking organizations supervised by the Board or any other federal banking agency have engaged, or otherwise knowingly participated in, any illegal "prime bank"-related conduct. We know of no domestic bank that has suffered losses from "investments" in "prime bank" financial instruments or from any other enterprise involving such instruments. Most "prime bank" scams entail multi-million dollar investments, and as such we are not aware of losses to individual, as opposed to institutional, investors. Some well- known organizations, however, have suffered large losses because of their investments in phony "prime bank" financial instruments.

In criminal matters involving "prime bank" schemes, U.S. Attorney's Offices have prosecuted and won cases under existing criminal statutes, and the SEC has been able to freeze accounts of wrongdoers and obtain other injunctive relief.

The Committee has asked the Federal Reserve to comment on the need for additional legislation addressing misconduct by fraudsters selling these instruments. The Board generally defers to the law enforcement community and to the securities regulators regarding legislative proposals such as S. 1009, the "Financial Instruments Anti-Fraud Act of 1995" proposed by Senator D'Amato. It is our view, however, that continuing successful prosecution of these cases is crucial in sending a message to potential "prime bank" fraudsters. Thus, new statutory authority enhancing law enforcement's ability to prosecute wrongdoers may prove useful.

I am happy to address any questions you may have about the Federal Reserve's efforts to address the problems associated with these illegal financial schemes.

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1996 Testimony