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Fraud squad

High-profile investment scams offer lessons for all

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Bernie Madoff, Earl Jones, Allen Stanford and Andrew Lech are all famous for one thing. They were all jailed in the last few years for defrauding investors of millions and in some cases billions of dollars.

But these fraudsters also share other similarities. Their scams raised a number of red flags that would have had well-informed investors running away like they were being chased by mordacious monkeys infected with the Ebola virus.

To help vaccinate investors from future ill-advised dealings, the CFA Institute -- the professional body governing investment analysts -- issued a Top 10 list of investment scam tips as part of the "festivities" for Fraud Awareness Month in March.

One of the institute's resident experts on the topic, Stephen Horan, says each one of the scams perpetrated by the above-mentioned money-minded deviants illustrates at least a few -- if not all -- of the following tips.

The director of private wealth management education at the institute and former forensic economist says no one tip is a "silver bullet" to ferret out a fraudulent investment. But investors who find a potential venture raises one or two red flags should consider taking a page from Nancy Reagan's drug-abuse prevention playbook, and simply just say no.


1. Clearly understand the investment strategy

Many investors in these high-profile scams didn't really know how they were earning consistent, risk-free and higher-than-normal annual returns. Madoff is often considered to have used a "black box" strategy to produce one to two per cent monthly returns for clients. But he claimed to use a variation of a common yet complex strategy involving options.

"His basic strategy was to buy blue-chip stocks and create what's called a collar," Horan says. "It is somewhat complicated, and he even chose to put a complicated label on it: 'a split-strike conversion strategy.' " But those who knew how the strategy worked were skeptical, because Madoff's fund made money regardless of market conditions.


2. Match the investment strategy to the reported performance

Like all other investment frauds, Madoff's hedge-fund returns didn't add up as they should.

Investment analyst, trader and independent fraud investigator Harry Markopolos worked for an investment firm in the late '90s that worked with another firm dealing with Madoff's hedge fund. He looked at the strategy and couldn't figure out how Madoff's company -- Bernard L. Madoff Investment Securities LLC -- made money.

"So he took Madoff's data to another guy in Boston by the name of Dan DiBartolomeo, who is a real bright guy."

In about half an hour, the financial mathematician also concluded something wasn't right. Either Madoff was manipulating the market, which would be illegal, or he wasn't investing the money at all.

Of course, the latter turned out to be true. Madoff -- like Jones, Stanford and Lech -- was running a Ponzi scheme. He paid investors returns using money coming into the firm from new investments.

"It's sustainable as long as you can bring in fresh money," Horan says. And when the financial crisis hit in 2008 and several clients needed a lot of their money back, the $65-billion jig was up.

3. Find out about independent audits

Investment firms need independent auditors to verify their financial reporting is accurate. Horan says all of these high-profile frauds had poor auditing practices -- if any at all. Madoff's hedge fund claimed to manage billions. He even prepared fake documents to make the ruse seem legit. "But the auditor was out of proportion with the scale of the operation," Horan says. "It wasn't like a PWC or KPMG or anything like that." It was one guy in a strip mall in a small town north of New York City.


4. An affinity for friends and family

All four fraudsters used their connections with friends, family and the community to find investors in their swindles. "What they did was to prey on what's called an affinity group," Horan says. "They have some sort of common identification with each other and the fraudster, and it builds a level of trust." Jones worked for aging anglophone Quebecers. Many of the investors Lech defrauded of $100 million before he was caught in 2006 were members of his church in Ontario. Madoff used his influence in the Jewish community to bilk people with their guard down -- even institutional and high-net-worth investors. Director Steven Spielberg's charity Wunderkinder Foundation, for example, invested 70 per cent of its assets in Madoff's management firm, the Wall Street Journal reported.


5. Be aware of those offering "sure things," quick returns, and special access

Horan says almost every investment fraud scheme claims to provide high returns with little risk. Texas-born swindler Stanford's fraud may not have offered exceedingly high returns, but it still bore the hallmark of a fishy deal. His firm, Stanford Financial Group, sold certificate of deposits -- $8 billion worth -- to investors yielding three to five per cent more than what U.S. financial institutions offered. That is like finding a five-year GIC with an eight-per-cent annual return these days. Stanford, like the others, persuaded investors he was on to something special -- only available to those with affluent connections. "He was sponsoring cricket tournaments and rubbing elbows with the richest of the rich," Horan says. "What that allowed him and Madoff to do was to give their investors the impression that 'my investments are not really available to the ordinary person, but I can open it up to you and give you special access.' "

6. Understand what, if any, regulatory oversight exists

Jones, who persuaded elderly Quebecers to invest about $50 million, operated in the exempt market space. For that matter, so did the others. In other words, they sold investments that weren't highly regulated, and they weren't traded on open markets such as exchanges. Jones wasn't registered with the Quebec regulator, either. And Lech wasn't registered with the Ontario Securities Commission. If they had been, it would have been difficult for them to carry out their schemes, which boiled down to taking people's money and not investing a single cent -- except in themselves. But they could do what they did because investors took their word for it the phantom investments existed.


7. Assess the operational risk and infrastructure

Obviously, fraudulent firms are going to have major gaps in business operations. Investors who asked the right questions, however, likely would have realized something's amiss. "Among what you can ask advisers are, 'What are your operational controls?' or 'Does your firm subscribe to the asset manager code of conduct?' " Horan says. "That is kind of like the ISO 9000 of investment management." Well-defined internal regulations keep shady money managers from all sorts of unethical activities, such as 'self-trading' -- something investment firm K.W. Brown and Co. did in the early 2000s. "They would purchase securities for clients, but they wouldn't immediately assign those securities to accounts," Horan says. "At the end of the day, the profitable trades were allocated to Brown's accounts while the unprofitable ones were allocated to the clients' accounts." When the misdoings were uncovered in 2006, the three-person firm had earned $4.5 million off client trades while their clients had lost $9 million.


8. Assess the personnel

Madoff may have headed up the Nasdaq at one time, but he had no professional designations or official training in finance. Neither did Jones, Stanford or Lech. Horan says investors should look for advisers and money managers with professional designations, like chartered financial analyst (CFA), chartered investment manager (CIM), chartered accountant (CA), financial management adviser (FMA) or certified financial planner (CFP). "Anybody who has on their mind 'I want to defraud investors' isn't going to take the time to do years of investment training to do it," Horan says. Designations show commitment. Of course, being able to verify credentials is helpful. You can contact professional organizations to be certain. It's also prudent to check with the Manitoba Securities Commission, the Investment Industry Regulatory Organization of Canada (IIROC), the Mutual Fund Dealers Association of Canada (MFDA) or the Exempt Market Dealers Association of Canada to ensure a person is registered and licensed to sell the products being offered.


9. Limit your exposure

Even the most well-intentioned and legitimate investments go awry. It's why most experts preach diversification -- putting your eggs in multiple nests instead of just one. "The sad thing about the Earl Jones and the Madoff cases was people invested their life savings with these guys, and in the Andrew Lech case, a lot of his clients borrowed money," he says. Some took out second mortgages so they could invest more money with him. "That's certainly not limiting your exposure."


10. Perform a background check

The basic take-away here is to do your homework, and that really entails following all of the aforementioned tips. But Horan says it's also important to learn the history of the adviser or money manager. Just because someone is a licensed stock broker doesn't mean he or she doesn't have a long rap sheet with the provincial regulator or a governing professional body. "Those can be very good predictors of potential fraud -- even if it's not investment-related." Ask for references and follow up on them. As mentioned, referrals from friends and family shouldn't be the only basis for a green light to invest.

As Horan says, none of these red flags is a sure-fire indication an investment is fraudulent. But in most cases, a scam will have an "I have a bridge I want to sell you" kind of feel to it, he says. Only these days, it's often a little more polished -- like buying shares in a gold company promising a 35 per cent annual return. If it sounds too sweet to be real, it's more likely to turn out similar to what monkeys have been known to throw. And no one can retire on that.

Republished from the Winnipeg Free Press print edition March 31, 2012 B9

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