[IMGCAP(1)]Pyrite is a mineral that, unfortunately for some prospectors, was thought to be gold but turned out to be worthless.

Fool’s gold, it was called. Today, prospecting has left the hills for the cities, but there is no shortage of fool’s gold for 21st century prospectors. In fact, far too many people fall victim to scam artists every year, and it’s not just average investors.

As we learned from the Bernard Madoff scandal, even sophisticated investors are vulnerable to deception. Therefore, it is critical that the public and their advisors know the warning signs and complete due diligence on every opportunity before investing.

The number of frauds that have been exposed since the 2008 financial crisis is astounding. Many of these schemes operated under the radar of regulators and investors for years. Discovery of investment fraud tends to be cyclical in nature, so that in good times investors are willing to take more risks and are less prudent than usual, and in bad times investors often reduce risk by redeeming their investments, creating a liquidity crisis for scam artists.

According to the FBI’s most recent Financial Crimes Report (fiscal year 2009), the number of financial crime investigations increased 33 percent over the previous five years. The bureau directly attributes this increase to market declines experienced between October 2007 and March 2009. To make matters worse, fewer than 1 in 20 victims of fraud report their experience to the authorities, causing an untold number of crimes to go undiscovered.

After being whipsawed by volatile markets over the past three years, many investors are either looking for more consistent ways to grow their portfolios or to hit a home run to make up for losses. This latter mindset plays straight into the strategy of scam artists, and should highlight the fact that the scams will continue as the economy recovers. No group, it seems, is more vulnerable than the Baby Boomers, who began turning 65 this year. Many people assume it is the very old who are most likely to fall victim to financial fraud. While this is partly true, statistics paint a different picture.

Fraud Attributes
There are common themes among most fraud cases. The most common attribute is the promise of outsized returns with little or no risk. Regardless of the overall appearance on the front end of the scheme, the underlying mechanics are often the same on the back end: the Ponzi scheme.
Most people are familiar with the term “Ponzi scheme,” which is named after Charles Ponzi. In 1920, Ponzi promised to double investors’ money within 90 days, but in reality he was paying old investors with money from new victims. This is the foundation that underlies fraud.

Most frauds are cloaked in a facade of legitimacy. To avoid raising suspicions, perpetrators often find a way to weave kernels of truth into their approach to make it sound plausible, no matter how fantastic it may seem when analyzed dispassionately. These stories are usually elaborate, keeping potential victims aroused and fascinated with visions of dollar bills dancing in their heads or playing on the victims’ heartstrings.

In one recent inheritance scam, victims were told of a wealthy billionaire who had an illegitimate daughter. When he died, his will stated that this daughter would receive his vast fortune, but—and there is always a “but” —all of her debts had to be paid off before she received so much as a penny. The heiress in this story had been plagued by terrible health crises throughout her life and was left with numerous expensive medical bills. The hook was that if the victim gave her $10,000, she would repay that amount three times over when the estate was settled and she obtained her inheritance. Because the name of this famous man could not be revealed, everyone who helped the daughter had to sign a nondisclosure agreement and relinquish any gains if they told a soul about it. This scheme purportedly pulled in more than $1 million before it was halted by the FBI and U.S. Postal Inspectors.

High-yield investments are another come-on characterized by offers of outsized returns with little or no risk. These often come in the guise of prime bank notes, pyramid schemes or promissory notes. All are variants of the traditional Ponzi scheme.

The FBI reports that in prime bank schemes, victims are induced to invest in financial instruments allegedly issued by well-known institutions. These institutions supposedly offer risk-free opportunities for high rates of return, a benefit that is allegedly the result of the perpetrator’s access to a secret worldwide exchange ordinarily open only to the world’s largest financial institutions.

The pyramid scheme is similar in structure to multilevel marketing plans. The promoter sells the victim a product or service at a significantly inflated price, but, as an added value, if the victim wants to get the product for free, he or she can bring in two new people. Because these schemes grow geometrically, they collapse fast, leaving the last persons holding the bag.

Facade of Legitimacy
Most frauds are designed to operate outside the purview of securities regulators, but, in some cases, perpetrators will do their best to blend in with the regulated world. These include phony hedge funds, forex scams, and pump-and-dump schemes.

Phony hedge funds, or “Black Box” schemes, are becoming more popular. A promoter in this situation would have a “proprietary trading system” that allows investors to experience high returns with little or no risk. Madoff falls into this category. A common thread in these cases is consistently positive returns with no losses. Another clue is if there is no separation of duties between the asset manager and the clearing/custody firm. There are plenty of legitimate hedge funds for people to research and invest in, so make sure your clients do not buy into the fake ones.

With the expansion of global securities markets, there has been a lot of interest in foreign exchange, or forex, trading. This has created a burgeoning industry of software companies and “educators” who lure in unsuspecting victims with the “high returns with low risk” promise. The result is often excessive trading activity, which generates significant transaction fees for the marketer.

Market manipulation is a major concern for the FBI as more people enter the markets. Of particular concern is the pump-and-dump. Pump-and-dump scams usually involve the hyping of small, thinly traded securities through unsolicited spam, faxes and mailings to increase the volume of trading. As the price rises due to the hype, scammers sell their interest in the stock, leaving unsuspecting investors to ride down the stock when the buying dries up. The FBI is concerned that pump-and-dump may have gone electronic, with malware designed to execute trades on the victim’s computer through an online brokerage account.

Another area of increasing concern is private offerings. The Securities Act of 1933 regulates the process of offering securities to the public. This promulgates registration of the offering with the Securities and Exchange Commission, the use of a prospectus containing audited financial statements, and significant disclosures of risk. The SEC does not evaluate offerings based on their merits; it only confirms whether the registration complies with the law. Registration costs can be significant, making it feasible only for larger offerings.

Regulation D of this act, however, provides an exemption for smaller companies looking to raise limited amounts of money. These are known as private offerings, and they have a high degree of risk. Depending on the exemption (504, 505, or 506), the filer may be limited by the amount raised and potentially up to 35 nonaccredited investors. The number of accredited investors is often unlimited.

An accredited investor is usually an institution, but the definition also includes benefit plans, trusts and charitable foundations. The definition of an individual who is an accredited investor is as follows:

* A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or,

* A natural person with income exceeding $200,000 in each of the two most recent years, or joint income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.

This has created a netherworld for unscrupulous people who qualify under this exemption, as they are able to sell unregistered securities in all 50 states without individual state registration. Thus, the state securities commissions do not have jurisdiction over Regulation D offerings under rule 506. The only suitability standard required for all investors is that they be sophisticated investors—which is they must have “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”

As a result, countless people who felt they had sufficient knowledge to make informed decisions have purchased companies that were either mismanaged or the officers made off with significant salaries, bankrupting the company. This isn’t necessarily classic fraud since the risk of failure is high in small companies, but investors should pay close attention to companies doing Regulation D offerings. Get as much information as possible so clients can make truly informed decisions.

Marketing Mimics
Those who peddle investment fraud schemes use many of the same techniques that legitimate marketing firms use to get people to purchase their products. They try to elicit emotional responses that are deeply imbedded in the human psyche.

Affinity marketing is common among legitimate businesses, such as credit card companies and membership groups. Even professional societies arrange discounts for their members with major companies as a value-added benefit. Con artists know the appeal that goes along with being in a group dynamic, so they focus on people with similar profiles, such as religion or ethnic identity.

Once they have a group’s vocabulary down and the hot buttons identified, they can replicate the affinity process without having to build it from scratch. Social consensus is often used in affinity frauds because it creates peer pressure to accept. “Everyone else in the congregation has invested in this. You don’t want to be the only one to miss out on this, do you?”

Any product that is marketed has a benefit statement, and in investment fraud phantom riches is one of the strongest and most commonly used strategies to get victims to buy in. “If you invest today, you could double your money in three months!”

They also tap into the appeal of personalities. By dropping names of recognized people as existing investors, schemers rapidly gain credibility in the mind of the potential victim. This is known as source credibility.

Third-party validation has long been used in the marketing of legitimate products, but scammers have developed their own way to build credibility by having a “songbird.” This is someone who currently is receiving income and can sing the praises of the scheme with believable conviction. Often they are actually getting paid but don’t realize it’s a scam.

We are conditioned through our upbringing to return a favor when someone does one for us. Legitimate financial advisors market to the public using dinner seminars. Unfortunately, con artists have figured this out, too. In response, regulators have placed particular emphasis on this technique because it could be considered an inducement to buy.

Intuitively, people react to limited supply or scarcity. Scammers have become adroit at tapping into that insecurity that arises from scarcity. “There are only three units remaining in this offering. I would hate to see you miss out on this terrific opportunity. I have five other appointments today; and when the units are gone, they’re gone forever.”

Exclusivity is also a popular technique. Madoff was famous for telling people that they didn’t meet his minimum net worth requirement. The psychological response of his potential victims would be to beg him to let them in. He would then “make an exception” for the victim and take his or her money. Once invested, that person felt special—part of an exclusive group for which very few people qualified.

Clues of Deception
Once a perpetrator has a victim hooked, he or she will stop at nothing to reel that person in. That means repeated calls: at first to gain trust, but later to manipulate or intimidate the victim into giving up their money.

If your client is purchasing an investment, make sure it is done through someone with the appropriate registrations or licensing. If it’s an insurance product but the person is not licensed to sell insurance, or it’s a security and the seller doesn’t have the appropriate registration, it could indicate that there isn’t any supervision by a government agency or self-regulatory organization (SRO). Registration alone will not prevent fraud, but it can weed out many with bad intent.

Risk is inherent in any investment. The job of regulators is to make sure that investors receive sufficient facts, including the risks, so they can make educated decisions. If an investment doesn’t contain detailed disclosures, it isn’t worth considering.

One of the reasons people were sold on Madoff was because he would generate high-single-digit to low-double-digit returns, regardless of how the market was doing. An important analysis tool for investment professionals is performance attribution. The performance of the overall fund should mirror its underlying assets. If it doesn’t, something is going on that requires deeper review.

If you or your clients are concerned about a proposed investment, or they think they may have been a victim of investment fraud, there are many government watchdogs and SROs that can help depending on the nature of the offer.

Investment fraud causes a wide path of damage in its wake: from the personal level of the victims and their families to the much broader public perceptions of the markets and the investing industries. CPAs in all facets of personal planning have an obligation to their clients to make sure that they understand the warning signs of investment fraud, to counsel them appropriately, and to let them know where to turn for help.

Reprinted with permission from the Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of CPAs.

Douglas P. Hepburn, CPA, PFS, CFP, is an investment advisor representative of Multi-Financial Securities Corp. in Phoenixville and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at dhepburn@hepburnadvisors.com.

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