Caveat Emptor

Part 2 of the 3 part series, “Diamonds Are Not Forever”

In 1977, in Los Angeles, a film producer, who had just closed his account with his stockbroker, received an unexpected call from a stranger with a distinct English accent. The caller, identifying himself as a representative of “De Beers Diamond Investments, Ltd.,” began by commending the producer on his acumen in withdrawing from the stock market. “You obviously are aware of the fact that stocks and bonds can’t keep pace with inflation,” he continued in a soft voice, “but have you considered diamonds as an alternative?” He explained that diamonds had appreciated “700 percent over the last ten years,” and that they were the “most prudent investment available, since the supply is tightly controlled by a private monopoly.” Without further ado, the caller offered to sell the film producer a selection of “investment diamonds” for $5,000.

“But how can I buy diamonds over the phone,” the producer asked incredulously.

“All the diamonds are sealed in plastic with a certificate guaranteeing their quality,” the caller responded. “And of course you have heard of De Beers.” The more hesitant the producer became, the more determined the caller became. “We can register these diamonds under your wife’s name, which might be helpful for your taxes,” the caller went on.

“Think of how surprised she will be when the diamonds arrive … and you are buying them below wholesale.”

The caller, it turned out, was one of dozens of salesmen seated around a bank of telephones in Scottsdale, Arizona. Like the rest of the men in this boiler room, as it was called, he was making a pitch to sell diamonds and had been supplied with a list of names of individuals around the country who had recently closed brokerage accounts. For every order he sold, he received a commission of up 20 percent. Since the prices were in reality far above wholesale prices, the company could afford to pay its salesmen, most of them “telephone pros,” large commissions. And despite the similarity of its name, De Beers Diamond Investments, Ltd., was in no way connected with De Beers Consolidated Mines. Like a host of other recently formed diamond boiler rooms, with names like Diamond Selection, Ltd., Kimberlite Diamond Resource Company, and Tel-Aviv Diamond Investments, Ltd., this firm was formed to promote “investment diamonds.”

When the mail-order diamonds finally arrive at the purchaser’s home, they are sealed in plastic with the certificate guaranteeing their quality. The customer is then advised of what amounts to a catch-22 situation: The quality of the diamond is only guaranteed as long as it remains sealed in plastic; if the customer takes it out of the plastic to have it independently appraised, the certificate is no longer valid. When customers broke the seal, many found diamonds of inferior or even worthless quality. Complaints to the authorities proliferated at such a rate in New York that the attorney general was forced to mobilize a “Diamond Task Force” to process the hundreds of allegations of fraud.

“It is incredible,” William R. Ralkin, the assistant attorney general said in the New York Times in 1979. “These crooks will get outwardly rational people to buy a sealed bag containing supposed gems. . . . And they have the nerve to tell their victims not to unseal the packet for two to three years, after which they promise to buy back the stones it much higher prices.” He added, “It never falls to amaze mc me how . . . professional people like lawyers [and] medical practitioners will send checks for thousands of dollars to people they never met or heard of after being contacted by these boiler room operators.”

Aside from selling tens of thousands of diamonds a month over the telephone, many of these newly created firms hold “diamond investment seminars” in expensive resort hotels. At such events, they present impressive graphs and data, and typically assisted by a few well-rehearsed shills in the audience, they proceed to sell sealed packets of diamonds to the audience. (Not uncommonly, in dealing with elderly investors, diamond salesmen play on the fear that their relatives might try to seize their cash assets and have them committed to nursing homes. They suggest that the investors can stymie such attempts by putting their money in diamonds and hiding them.

Some of these entrepreneurs were relative newcomers to the diamond business. Rayburne Martin, who went from De Beers Diamond Investments, Ltd., to Tel-Aviv Diamond Investments, Ltd., both domiciled in Scottsdale, Arizona, had a record of embezzlement and security law violations in Arkansas and was a fugitive from justice during most of his tenure in the diamond trade. Harold S. McClintock, also known as Harold Sager, had been convicted of stock fraud in Chicago, and he had been involved in a silver bullion caper in 1974 before he helped organize De Beers Diamond Investments, Ltd. Don Jay Shure, who arranged to set up another De Beers Diamond Investments, Ltd., in Irvine, California, had also formerly been convicted of fraud. Bernhard Dohrmann, the “marketing director” of the International Diamond Corporation, had served time in jail for security fraud in 1976. Donald Nixon, the nephew of President Richard M. Nixon, and Robert L. Vesco, the fugitive financier, were, according to the New York State attorney general, allegedly participating in a high-pressure telephone campaign to sell “over-valued or worthless diamonds” by employing “a battery of silken-voiced radio and television announcers.” Among the diamond salesmen were also a wide array of former commodity and stock brokers who specialized in attempting to sell sealed diamonds to pension funds and retirement plans.

Meanwhile, in London, the real De Beers, unable to stifle all the bogus entrepreneurs in Arizona and California using its name, decided to explore the potential market for investment gems. It announced in March of 1978 a highly unusual sort of “diamond fellowship” for selected retail jewelers. Each jeweler who participated would pay a $2,000 fellowship fee. In return, he would receive a set of certificates for investment-grade diamonds, contractual forms for “buyback” guarantees, promotion material, and training in how to sell these unmounted diamonds to an entirely new category of customers. The target was defined by De Beers as “men aged 55 and over with inherited or self-made wealth to spend.” Rather than sell fine jewels, as they were accustomed to, these selected retailers would sell loose stones with a certificate for $4,000 to $6,000.

De Beers’ modest move into the investment diamond business caused a tremor of concern in the trade. De Beers had strongly opposed retailers selling “investment” diamonds on the grounds that because there was no sentimental attachment to such diamonds customers would eventually attempt to resell them and thereby cause sharp price fluctuations. Indeed, De Beers executives expressed concern that retailers would not be able to cope with the thousands of distressed investors who tried to resell their loose diamonds back to them. In response to this new “diamond fellowship” scheme, the authoritative trade journal, jewelers’ Circular Keystone, observed: “Besides giving De Beers an unusually direct role in retail diamond sales, the program marks a softening of its previous hard-line stand against gem investing. Eric Bruton, the publisher of Retail Jeweler in London, added, “De Beers is standing on the edge of a very slippery slope…. They say it is unwise to sell diamonds directly as an investment, then [they] go ahead with this diamond investment scheme.”

If De Beers had changed its policy toward investment diamonds, it was not because it wanted to encourage the speculative fever that was sweeping America and Europe. Its marketing executives in London realized that speculators could panic at any moment, and by precipitously flooding the market with diamonds they had hoarded, burst the price structure for diamonds. They had, however, “little choice but to get involved,” as one De Beers executive explained. Even though the “De Beers Diamond Investments” in Arizona, which had pioneered in selling diamonds over the telephone, had gone bankrupt, ‘ more than 200 firms had by then entered the business of selling sealed packets of diamonds to the American public over the phone. And aside from these proliferating boiler rooms, many established diamond dealers rushed into the field to sell diamonds to financial institutions, pension plans and serious investors. It soon became apparent in the Diamond Exchange in New York that selling unmounted diamonds to investors was far more profitable than selling them to jewelry shops. By early 1980, David Birnbaum, a leading dealers in New York, estimated that in terms of dollar value, nearly one third of all diamond sales in the United States were for investment diamonds. “Only five years earlier, investment diamonds were only an insignificant part of the business,” he added.

Even if De Beers did not approve of this new market in diamonds, it could hardly ignore one-third of the American diamond trade. It had to take some action.

Mass-marketed investment diamonds was made possible in the 1970s by the invention of the diamond certificate. Diamonds themselves cannot be valued by any single measure, such as weight, and the factors involved in such an assessment-clarity, color, and cut-cannot be made by an individual investor or financial institution. Moreover, since diamonds are not fungible in the sense that one diamond can be exchanged for another diamond of the same weight, some means had to be found of standardizing the quality of diamonds. Certificates, which guaranteed the color, clarity and cut of individual diamonds, provided this medium.

The Gemological Institute of America, a privately owned company established to service jewelers, developed a convenient system for certifying the quality of diamonds. For ascertaining the “cut” of the diamond, the Gemological Institute devised in 1967 a “proportion scope.” This contraption casts a magnified shadow of the stone in question over a diagram that represents the ideal proportions for a diamond of that size. By comparing the overlap between the image of the diamond and the diagram, the deviation from the ideal can be easily measured-and recorded on the certificate. For determining the “clarity” of the diamond, the Gemological Institute developed a “Gemolite” microscope, which has an attachment for rotating a diamond under ten power magnification against a dark background. If no blemishes can be seen in the diamond under this magnification, it is graded “flawless”; if there are blemishes, but they are very difficult to find with this lens, it is graded “VVS,” and with imperfections visible at lower magnifications, it is further downgraded. Finally, to establish the exact color of the diamond, the Gemological Institute introduced the “Diamondlite”: a boxlike machine with a window in it which allows a diamond to be compared with a set of sample stones that span all the color gradations from pure white to yellow. The purest white on this scale is classified as “D”; the next grade of white is classified as “E.” Gradually, by grade “l,” the white is tinted with yellow; and by grade K,” the color is considered to be yellow and of much lower value.

By 1978, diamonds were being routinely certified through these methods, not only by the Gemological Institute of America, but also by other Gemological laboratories in Antwerp, Paris, London and Los Angeles. Since dealers needed certificates for selling investment diamonds, and customers were usually willing to pay a hefty premium for such a document attached to the diamond, the laboratories found it difficult to keep up with the demand. Long lines of diamond dealers usually formed in front of the laboratories, and in many cases, stand-ins were hired to wait in line for impatient dealers.

The certification mechanism, despite all the Rube Goldberg sorts of inventions employed, did not entirely remove the subjective element from diamond evaluation. Not uncommonly, dealers would resubmit the same diamond to the Gemological Institute and receive a different rating for it. It did, however, facilitate the trading of rare diamonds. A diamond certified as D, flawless, was an extreme rarity, and since very few such stones existed, or would ever be extracted from mines, they could be bought and sold on the basis that they were in short supply. The price of these near-perfect diamonds rose from $4,000 a carat in 1967 to $22,000 to $50,000 in 1980. Even though such extravagant prices for D, flawless, diamonds are frequently cited by the press in stories about the appreciation of diamonds, they are atypical of diamond prices. In all the world, there are probably less than one hundred diamonds mined that can be cut into one carat, D, flawless, stones, and only a small proportion of these ever are certified and sold to investors. Moreover, very few diamonds are ever sold for the prices reported in the news stories. “No dealer I know has ever sold a one-carat investment diamond for $50,000,” a New York dealer commented.

The high prices quoted for the few available D, flawless, stones do not necessarily hold for diamonds of an even slightly inferior grade. For example, in 1978, when D, flawless, diamonds were quoted at $22,000 a carat, an H grade white diamond, without any visible imperfections, was valued at only $2,750- Once mounted in a ring or piece of jewelry, it would be extremely difficult for the untrained eye to differentiate between a D and H color (especially since the setting reflects through the diamond). But while this subtle difference makes little difference in the sale of jewelry, it creates nearly 90 percent of the value in an investment diamond. For what is measured by this grading system is not beauty, but the comparative rarity of a given class of diamonds.

Most investors have no choice but to rely on the piece of paper that comes attached to the diamond to specify the grade, and hence the value, of their investment. Not all the certificates, however, emanate from the Gemological Ins Institute of America. Many certificates have been issued by less reputable-or even nonexistent-laboratories, and the diamonds might be of a much lower grade than that certified.

Even if the certificate comes from a bona fide laboratory, its evaluation of the diamond may later be disputed by another assessor. Robert Crowningshield, the New York director of the Gemological Institute, observed, “. . . I’ve never seen two experts agree on the quality of a particular diamond.”

The extent to which the value of diamonds is determined by the eye of the beholder was demonstrated in 1981 by an experiment conducted under the sponsorship of Goldsmith magazine. In this test, four leading diamond evaluators were handed 145 diamonds that had previously been graded by the Gemological Institute of America, the European Gemological Laboratories and the International Gemological Institute. The team of experts was not told how each of the diamonds previously had been graded. After the team had reached its own consensus on the grade of each stone, the results were compared with those of the Gemological institutes. In 92 Out Of 145 cases, the team of evaluators disagreed with the grades previously given on the certificates. Despite all the scientific paraphernalia surrounding the process of certification, diamond grading remained, according to this test, an extraordinarily subjective business.

To make a profit, investors at some point must find buyers who are willing to pay more for their diamonds than they did. Here, however, investors face the same problem as those attempting to sell their jewelry: there is no unified market on which to sell diamonds. Although dealers will quote the prices for which they are willing to sell investment-grade diamonds, they seldom give a set price at which they are willing to buy the same grade diamonds. In 1977, for example, Jewelers’ Circular Keystone polled a large number of retail dealers and found a difference of 100 percent between different offers for the same quality investment grade diamonds. Moreover, even though most investors buy their diamonds at or near retail price, they are forced to sell at wholesale prices. As Forbes magazine pointed out in 1977, “Average investors, unfortunately, have little access to the wholesale market. Ask a jeweler to buy back a stone, and he’ll often begin by quoting a price 30% or more below wholesale.” Since the difference between wholesale and retail tends to be at least 100 percent in investment diamonds, any gain from the appreciation of the diamonds will probably be lost in the act of selling them.

Many New York dealers feared that despite the high pressure telephone techniques, the diamond bubble could suddenly burst. “There’s going to come a day when all those doctors, lawyers and other fools who bought diamonds over the phone take them out of their strong boxes, or wherever, and try to sell them,” one dealer predicted. The principal ingredient in the Diamond boom is expectations that may not be fulfilled.

by Edward Jay Epstein