The trick to spotting a fraud

Bernie Madoff proved it's not only fools and their money who are easily parted but, writes CAROLINE MADDEN, proper checks can cut risks

PONZI SCHEME operator extraordinaire Bernie Madoff succeeded in duping some of the world’s biggest financial institutions and hedge funds, not to mention wealthy and influential investors such as Nobel laureate Elie Wiesel, New Jersey senator Frank Lautenberg and a charity of Steven Spielberg, to the tune of $50 billion.

Even the US government’s watchdog, the Securities and Exchange Commission (SEC), failed to detect the scam.

Closer to home, alleged pyramid-scheme orchestrator Breifne O’Brien persuaded close friends and relatives to hand over large sums of money to him, including €1.85 million from his brother-in-law, Bernard Lambilliotte, the managing director of London investment firm Ecofin.

If highly sophisticated professional investors can’t spot a Ponzi scheme, what chance does the ordinary, small investor stand? It’s easy with the benefit of hindsight to say that investors burned by Madoff, O’Brien and the like should have spotted warning signs, but it’s true that the right checks can help investors to spot red flags and avoid falling into the clutches of con artists.

Be suspicious of unrealistic returns

No two Ponzi schemes are exactly alike, but they all have one thing in common – they promise returns that are just too good to be true. To entice investors, fraudsters promise either suspiciously high short-term “guaranteed” profits, or unrealistically smooth, consistent returns over the long term.

In the 1920s, Charles Ponzi swindled thousands of New Englanders by promising a 40 per cent return on their investment in a postal stamp speculation scheme in just 90 days, compared with the prevailing interest rate on savings accounts of 5 per cent.

Madoff’s fund consistently produced returns of 10 to 12 per cent a year for over a decade, regardless of whether markets were up or down.

The latest alleged fraudster to be exposed is Texan billionaire and cricket aficionado Sir Allen Stanford. His Antiguan-based company Stanford International Bank (SIB), sold roughly $8 billion of so-called “certificates of deposit” to investors, promising what the SEC described as improbable and unsubstantiated high interest rates.

“These rates were supposedly earned through SIB’s unique investment strategy, which purportedly allowed the bank to achieve double-digit returns on its investments for the past 15 years,” the SEC said.

A rule of thumb recommended by the SEC is to compare promised yields with current returns on well-known stock indexes. “Any investment opportunity that claims you’ll get substantially more could be highly risky,” it warns. “And that means you might lose money.”

Carry out your own due diligence

Investors are often blinded by the charming facade and seemingly impressive credentials of con artists. As a former chairman of the Nasdaq stock market, Madoff was widely respected in the investing community.

O’Brien had all the attributes of a successful businessman, and was a well-known figure on the south Dublin social scene. This veneer of respectability helped him to persuade people he had the Midas touch.

Just because an investment adviser looks professional and above board, that doesn’t mean you should bypass some background checks. For example, if they claim to have certain qualifications, check these with the accrediting body.

Try to find out if their firm is registered with or authorised by a body such as the Financial Regulator. Also check the regulator’s warning list which names investment firms operating in Ireland without appropriate authorisation.

It’s also possible to check the credentials of an individual by paying to access a consumer credit database such as BusinessPro.

This will enable you to find out if the person is a disqualified director, is assuming the identity of a deceased person (a particularly common form of identity theft used in financial frauds in the US and Britain), has any court judgments against them or, if they’re a solicitor, whether they have been fined by or struck off by the Law Society.

It’s also worth checking to see if there’s anything strange lurking in their past that should arouse your suspicion.

For example, Stanford had claimed to be related to the founder of Stanford University, Leland Stanford. However, Stanford University filed a trademark infringement case against him last year on the ground that he was using the school’s name “in a way that creates public confusion”.

Don’t rely on auditors

Investors are sometimes advised to be wary of large investment firms that are audited by small unheard-of auditors. Given that Madoff’s firm was audited by Friehling Horowitz, a three-man operation, there may be some merit to this advice.

However, even if an investment firm is audited by a Big Four global accountancy firm, it doesn’t guarantee that everything in the firm is kosher. If a cleverly-concealed fraud is being perpetrated within the firm, it can be extremely difficult for auditors to detect.

Last month, two PricewaterhouseCooper audit partners were arrested by Indian police in connection with the fraud investigation at Satyam, which has been dubbed “India’s Enron”.

The moral of the story? Don’t be lulled into a false sense of security by a clean audit opinion.

Ask questions – and make sure to get answers

Don’t be afraid to ask questions about the firm’s modus operandi and its investment strategy.

According to reports, when Madoff was asked how he delivered his returns, he replied: “It’s a proprietary strategy. I can’t go into it in great detail.” Alarm bells should sound if the firm is reticent about disclosing such details. If you can’t understand a firm’s methodology, don’t assume that it’s because of your lack of investing knowhow.

Consider paying an independent fee-based adviser to assess it for you, and walk away if they can’t make sense of it either.

Also be particularly wary if a promoter or investment firm is using a “strong-arm” approach to get your to open your wallet. Allowing yourself to be pressured into making an investment is a recipe for disaster.

Don’t invest solely on the basis of a recommendation from a friend or family member, even if they consider themselves to be investing “experts”. Make sure that the proposition stands up on its own merits.

Spread the risk

Finally, consider spreading your risk by splitting your investments among different brokers or firms. It may seem time-consuming and impractical but at least if one of them turns out to be a fraudster, all your life savings won’t be wiped out.