Spotting Red Flags of Ponzi Schemes – Fraud Files Blog

Every time there is turmoil in the stock market, we hear about allegations of investment fraud. Are there more investment scams occurring, or do market conditions just lead to the discovery of more of these schemes? I’ll guess the latter, although no one really knows for sure.

The beauty of fraud is that so much of it goes undetected. Those involved in financial fraud actively conceal their schemes and their involvement, so it’s impossible for fraud investigators to know exactly how much fraud is happening. For example, perpetrators go so far as to pay others to participate in the scheme and cover up phony financials and non-existent promissory notes. This kind of concealment leads to more investors putting money in a scheme, and ultimately creates ever larger financial losses.

In the end, however, it doesn’t necessarily matter if we can put our finger on exactly how many of these investment schemes are out there. What really matters is being able to identify the hallmarks of such schemes so that investors can avoid them like the plague.

When considering any type of private investment, the potential investors should be researching who is selling the investment and exactly what they are selling. My book ‘“Expert Fraud Investigation: A Step-by-Step Guide”  details some of the most critical questions investors should ask about the investment vehicle they’re considering. Included in this list are:

• Does the business of the company make sense in light of market conditions and your general business knowledge?
• Does the company exist because of some secret, revolutionary new process or product? If so, what proof is there that the technology or process is legitimate?
• Does the company’s performance make sense when compared to other companies in the industry?
• What do objective third parties have to say about the company and its business? Are those things in line with what you are being told? Or are third parties suspiciously quiet about the company and its offerings?
• Is the business of the company so complicated that an ordinary person cannot really understand what it is selling or how it is operating?
• Are unusually high rates of return on the investments being marketed? Are such returns possible or probable? If such high rates of return are so easily obtainable, couldn’t other companies do the same?
• Are certain parts of the business unusually secret? Is there a general reluctance to disclose key facts?
• Have any of the principals been involved in scandals or bankruptcies? Do they have criminal records? Have they been accused of running any scams?

Look at the Bernie Madoff scheme as an example of how the above questions would have worked. We know relatively few details about how the scam worked. However, we do know that the entire Ponzi scheme depended on exclusivity and secrecy. New investors were told that Madoff’s investment fund was closed to new investors, but that if they did some strategic name-dropping, they might be allowed in. The scheme further relied on secrecy about the investment methods Madoff was using. The secrecy was supposedly necessary to protect methods so others couldn’t steal his idea.

Most telling, however, was the fact that Madoff’s investment fund touted unusually high returns for investors. We’re not talking about a guy who consistently produced modest returns for investors. This scheme boasted double digit returns year after year for an extended period. Anyone who knows the markets knows this just isn’t possible. Even professional money managers with successful track records can’t produce such outrageously high returns for 10 or 20 years running.

Is ferreting out an investment scheme really as easy as that? Unfortunately, it is. Take a look at the investment scams being reported in the news. Each and every one of them includes at least a handful of the above bullet points.

Just a bit of independent research (made much easier than in the past, thanks to the internet) can reveal unsettling things about the investments and those promoting them. Look for evidence of involvement in questionable investment opportunities in the past, a lack of a substantive background related to the investment being sold, and little to no real information available about the actual investment or fund.

If there are any warning signals going off, run away quickly. There are literally thousands of investment opportunities available, so there is no good reason to risk losing money in an “investment” that displays multiple red flags of fraud.