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A very strange scandal

November 21, 2013, 12:18 PM UTC
Illustration: BRIAN STAUFFER

In mid-September the Securities and Exchange Commission said it had foiled what sounded like the most heinous financial crime since Bernie Madoff’s. A father and son in Lexington, S.C., had run a scheme that, according to the SEC, targeted the financially strapped terminally ill, netting the pair $6.5 million from 44 individuals, milking them all the way to the grave. On the day the charges were announced, Kenneth Israel, a regional director at the SEC, said the Stapleses, both named Ben, “turned the misfortune of others into a profit-making enterprise for themselves.” But, bizarrely, others were benefiting from the Stapleses’ scheme — the very people the SEC alleges the pair were ripping off: the terminally ill and their heirs.

The reason the Stapleses could pull off a scheme that seemingly benefits everyone begins with corporate bond offerings and a little-known provision called a survivor’s option. If you buy a bond and die, your heirs are allowed to cash in the bond at face value immediately rather than having to wait until it matures. The survivor’s option is meant for estate planning purposes. On Wall Street some call it a death put. Issuers have used the provision to attract elderly couples — a key debt-buying demographic.

Starting in the mid-2000s, a small group of investors saw another use for death puts: Fissures that would eventually lead to the financial crisis were starting to form, causing the price of some normally safe corporate bonds to trade at steep discounts, and the investors began recruiting terminally ill people to buy up the discounted bonds in joint accounts. When the terminally ill died, the investors were able to cash in the bonds and turn a quick profit.

Among this group of investors who saw an opportunity in death puts was Ben S. Staples, an accountant. Brenda Eason, 51, said she heard of Staples from a co-worker of hers when her sister, Patricia, 41, was dying of breast cancer in 2011. Eason’s mother had died, and she had to scrape together money to pay for the funeral. Eason’s co-worker said she knew someone who could help people like her sister, who didn’t have health insurance. Eason and Patricia met Staples and signed up. A few months later another one of Eason’s sisters, Cheryl, 43, was diagnosed with colon cancer. Cheryl signed up with Staples as well. When Patricia and Cheryl died, Eason says that each time she received the $5,000 Staples promised, which she used to pay for the funerals. She says she doesn’t see herself or her sisters as victims. “He gave money to people who had nothing at a time we needed it most,” Eason says.

The Staples case isn’t the first that the government has brought related to the survivor’s option clause. In 2011 the Justice Department indicted a Rhode Island financial planner named Joseph Caramadre in part for cashing in death puts. Caramadre led his terminally ill clients to believe that the payments were coming from a philanthropist. The Staples story is different: Eason says she and her sisters were aware that the father and son were opening joint accounts and that Staples wasn’t helping out of the goodness of his heart. “I didn’t care that he was making money,” she says.

The SEC sees it differently. It appears from the complaint that the SEC’s main beef is that the Stapleses defrauded corporate issuers by saying these were joint accounts, while the SEC claims the terminally ill had no real control over the accounts. (The Stapleses, through their lawyer, declined to comment for this piece.) In the end, it’s difficult to pin down just who was defrauded. Not the families of the terminally ill. They got money they otherwise wouldn’t have, at no risk. The people who lost money on the bonds that Staples bought would have lost it anyway. When you do the math, the Stapleses didn’t even benefit much. According to the suit, they invested $26.5 million from 2008 through mid-2012, and made $6.5 million. If the Stapleses had instead bought an S&P 500 index fund in late 2008 and sold at the same time, they would have netted nearly $10 million. So you know who really lost money in this scheme? The Stapleses. They should sue the dead people. But that would be silly.

This story is from the December 09, 2013 issue of Fortune.