Spotting the Next Madoff

June 01, 2010

It’s been two years since the Ponzi scheme was heard ‘round the world. Our expert provides tips that can help spot a possible Ponzi scheme—and it starts with the old saying, “If it sounds too good to be true …”

By Wayne R. Borkowski, CPA

We’ve all heard the saying, “If it sounds too good to be true, it probably is.” Some people, however, forgot. In a 2008 Ponzi scheme, for example, three men were accused of promising individuals that if they invested $1,500 with them, they would receive a return of $50,000 in 18 months. Sounds too good to be true, right? Who would believe such a return was possible? Well, 7,000 individuals did and invested $80 million with the fraudsters.

In December 2008, Bernie Madoff, owner of Bernard L. Madoff Investment Securities, LLC, told his sons, Andrew and Mark, that he had been conducting a massive Ponzi scheme for years. On that same day, Dec. 10, his sons informed authorities of their father’s alleged criminal activity. The Madoff fraud represents the largest loss in history from a Ponzi scheme. Irving Picard, the court-appointed trustee, estimates that the losses to investors, including fabricated gains, was almost $65 billion. To date, no family member has been charged with a crime, although investigations into the fraud continue.

However, six individuals associated with Madoff’s firm have been charged with criminal activities and more indictments are expected.

Subsequent to Madoff’s arrest, in February 2009, Robert Stanford, the head of the Stanford Financial Group, was accused of conducting a $7 billion Ponzi scheme. The 49-year-old Stanford was arrested and is in prison awaiting his trial.

These are just two high-profile examples of the many Ponzi schemes that have occurred in recent years. (See Ponzi Tsunami sidebar.) In 2009, almost four times as many Ponzi schemes were uncovered than in 2008, thanks in part to the SEC’s stepped-up enforcement and investigation.

So, what can you do to avoid being victimized by a Ponzi scheme? The SEC offers the following red flags of potential schemes:
  • High investment returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any “guaranteed” investment opportunity.
  • Overly consistent returns. Investments tend to go up and down over time, especially those seeking high returns. Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions.
  • Unregistered investments. Ponzi schemes typically involve investments that have not been registered with the SEC or with state regulators. Registration is important, because it provides investors with access to key information about the company’s management, products, services and finances. 
  • Unlicensed sellers. Federal and state securities laws require investment professionals and their firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
  • Secretive or complex strategies. A good rule of thumb is to avoid investments you don’t understand or for which you can’t get complete information.
  • Issues with paperwork. Be wary of excuses regarding why you can’t review information about an investment in writing and always read an investment’s prospectus or disclosure statement carefully before you invest. Also, account statement errors may be a sign that funds are not being invested as promised. 
  • Difficulty receiving payments. Be suspicious if you don’t receive a payment or have difficulty cashing out your investment. Keep in mind that Ponzi scheme promoters sometimes encourage participants to “roll over” promised payments by offering even higher investment returns.
Some additional things to keep in mind:
  • Lack of transparency. Investment statements should be received on a timely—at least quarterly—basis and include all of the investments that comprise an investment category. Merely listing totals under an asset class is not appropriate.
  • Insurance. It’s important that the firm has Securities Investor Protection Corporation insurance or some other form of insurance should a defalcation occur. In smaller advisory firms, a copy of the insurance certificate should be requested.
  • Auditing. A firm should be audited by at least a mid-tier firm in the local community that is qualified to conduct SEC-related audits.
  • Always maintain your skepticism, and never forget the old saying, “If it sounds too good to be true, it probably is.” 
Ponzi Then and Now
Ponzi schemes got their name from Charles Ponzi, an Italian immigrant who duped thousands of New England residents into investing in a postage stamp speculation scheme in 1920. At a time when the annual interest rate for bank accounts was a mere 5 percent, Ponzi promised investors that he could provide a 50 percent to 100 percent return in just 90 days.
He initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds to pay off earlier investors and support his own personal lifestyle. Before engaging in the massive fraud, Ponzi spent time in prison in Canada for check fraud and in the United States for smuggling illegal immigrants into the country.

Ponzi Scheme Defined
The SEC defines a Ponzi scheme as an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.
In many schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity. This is what happened in the Madoff fraud.

Ponzi Tsunami
What follows are a handful of Ponzi and fraud schemes taking place in recent months. Take note of the mistakes made by victims in these cases ... and watch out!
Millions Taken by Arthur Sassman

$200M Bilked
Fraud at the California DMV
Saratoga Attorney Charged with Fraud
Visa Fraud in Fullerton
Fraud Scheme Targeting Homeowners
Bank Fraud Involving Stolen Identities
$61M Fraud
Information compiled by Leonard C. Wright, CPA/PFS

Wayne R. Borkowski, CPA, CMA, CFM, MBA, is president of Borkowski & Associates and is a frequent instructor for the California CPA Education Foundation.

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