Ponzi Scheme

How To Protect Yourself from Becoming the Next Victim of a Ponzi Scheme

Jonathan S. Dinkins, CPA/PFS, CIMA®, AIF® Personal Finance, Investing 1 Comment

ponzi scheme

Recent years have seen the emergence of financial fraud as a leading threat to investor confidence in the US financial system.

These frauds are complex and sophisticated and can go undetected for decades. The fraudsters include men such as Bernie Madoff, who made off with $64.8 billion and Allen Stanford, who accumulated $7 billion.1 Both men are serving substantial prison terms – Madoff received a life sentence, Stanford 110 years.

Common Elements of a Ponzi Scheme

As we study these events, we see common elements emerging.

Investors are promised huge returns that outpace the market or are too good to be true. As the fraud gains momentum, investors are encouraged to refer friends, creating an atmosphere of an elite and privileged membership.

These confidence men prey on the unsuspecting, and the relationship becomes a kind of status symbol ("My money is managed by you-know-who"). Their actions have been likened to economic homicide, destroying the lives of countless pensioners and negatively impacting the works of many charitable organizations.

Kevin Merrill's Recent Local Ponzi Scheme

In recent days we have seen the arrest and indictment of Kevin Merrill, a Baltimore County resident, Jay Ledford, of Texas and Nevada, and Cameron Jezierski, also of Texas, in an alleged $364 million Ponzi scheme.2

As the details of this alleged conspiracy become known, we are learning more about its elaborate nature and its resemblance to other schemes.

Merrill and Ledford are reported to have set up a network of shell companies and bank accounts to process investor funds and create an illusion of legitimacy.2

The Madoff And Stanford Ponzi Schemes

Madoff owned his own brokerage firm, which by design was directly connected to the financial system and able to process client transactions under the radar of federal regulators. Madoff never included an independent-third-party service provider in his equation, as this party might have uncovered the fraud.

Stanford set up and owned two international banks in Antigua and Venezuela. As was the case with Madoff, his connection to the financial system bypassed all the established checks and balances in client relationships that might have revealed the fraud at an earlier date. Regulators began to suspect fraudulent activity only after Stanford’s banks claimed abnormally high depository returns.

In all these instances, investor funds were purportedly deposited into corporate accounts rather than brokerage accounts secured by an independent-third-party custodian.

The funds were usually never invested and, even worse, were held in corporate bank accounts to fuel the fraudsters' lavish lifestyles.

Subsequently, brokerage statements reporting substantial growth of investments were fabricated by the fraudsters. Finally, liquidation requests were fulfilled by transferring new investors’ money to pay out the redemptions (a.k.a. robbing Peter to pay Paul).

Self-Protection Checklist

So, how can you protect yourself from a Ponzi scheme? We’ve created a short checklist of questions for assessing an investment opportunity.

  • Are your funds deposited with an independent-third-party custodian? Who is the payee of your investible funds?
    • In a Ponzi scheme, no independent custodial relationship exists.
    • Raise red flag #1 if the payee of your investable funds is not an independent custodian.
  • Is the custodian a well-known financial intermediary?
    • If not, research the custodian to learn about its history and relationships in the industry.  Public companies face far more oversight than private companies.
  • Are independent brokerage statements and trade confirmations issued by the custodian?
    • If the investment manager is the only issuer of these statements, raise red flag #2.
  • Is your custodian a publicly traded company?
    • If so, obtain a copy of the custodian’s year-end financial statements and independent audit report.
    • If not, you will need to do substantially more research.
  • If you are working with a registered investment advisor or independent broker-dealer, are your funds held by an independent-third-party custodian (such as Charles Schwab, Fidelity, LPL or National Financial Services)?
    • If not, custody may exist, and an audit of investor accounts should be required.  Request a copy of the audit report. If no audit report is available, raise red flag #3.
  • What is the background of the audit firm? Is it qualified and does it possess the resources to perform the audit?
    • Audit firms should be registered with the Public Companies Accounting Oversight Board (PCAOB), which oversees audits of public companies and broker-dealers in order to protect both investors and the public interest by promoting informative, accurate, and trustworthy audit reports.
    • If the auditor is not registered or is seemingly ill equipped to perform the audit, raise red flag #4.
  • Are the returns promised to be higher than current market returns?
    • If yes, raise red flag #5.
    • Consult with an independently registered investment advisor if you need help making this evaluation.

As you can see, we can learn a lot from previous Ponzi schemes. Asking the right questions and doing your due diligence will protect you from falling into the trap of a Ponzi scheme.

It’s a shame that we have to be on guard against such horrific and hateful attacks, but we do not have to live in fear!

A proper advisory relationship is built on structural checks and balances. Transparency and accountability are crucial to building the mutual trust and awareness that we all seek in our lives. Look for a fiduciary financial advisor who has these accountabilities in place.

Need help?

If you are concerned you might be a victim of a Ponzi scheme, or you would like to discuss our financial advisory services, click the button below to schedule a consultation.

About The Author

Jonathan S. Dinkins, CPA/PFS, CIMA®, AIF®

Shareholder, Managing Director, Investment Advisory Services Learn More>>

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