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The Best Interest » How to Avoid Frauds and Ponzi Schemes

How to Avoid Frauds and Ponzi Schemes

A short drive down the NY Thruway from my home in Rochester, a Ponzi scheme is unraveling.

Hamilton, NY is a cute upstate town best known as the home of Colgate University. But it’s also the long-time home of Miles Marshall – a tax preparer, insurance agent, and local landlord who is under investigation for owing $90 million to nearly 1000 individual investors.

Does Marshall have the money? Nope. He only has $21 million in assets. Where’s the money? Who knows?! His investors are screwed and will most likely only receive ~25% of their original investment back. It begs the question: why’d they invest with Marshall in the first place? The answer is because he promised them guaranteed (!!) 8% returns.

Scary stuff. But for now let’s drive northwest from Hamilton to another small upstate town: Hannibal, NY. I grew up 5 miles west of Hannibal (in Red Creek) and played baseball and basketball against them my entire childhood. Unfortunately, Hannibal is in the news for bad financial reasons too.

A recent state audit revealed that the former treasurer of the Hannibal Fire Department stole $850,000 from 2016 to 2022, and possibly significant funds before that period. That’s taxpayer money. As the truth unraveled around him, the treasurer walked into the woods and committed suicide. It’s nasty stuff all around.

But it begs an important question: how do you ensure you avoid Ponzi schemes and other frauds?!

3 Vital Tips to Avoid Ponzi Schemes and Frauds

Here are 3 tips that’ll help you avoid ponzi schemes, frauds, or other types of financial misconduct.

Independent Third Parties are Vital

In both the Hamilton Ponzi scheme and the Hannibal Fire Department fraud, a neutral 3rd party would have prevented the frauds in the first place.

In Hamilton, a 3rd-party custodian would have allowed the investors to see their account values without any interference from or interaction with Miles Marshall.

This is vital. Bernie Madoff, for example, did not use a 3rd-party custodian. The only way for investors to see their account data was to ask, “Hey Bernie…can you send me a statement?” That makes fraud way too easy! All Madoff – or Marshall in Hamilton – has to do is fudge the numbers and send the investors a lying document.

Courtesy Investopedia

As a counter-example, my employer (a fiduciary wealth management firm in Rochester) is required by Federal law to work with a 3rd-party custodian. We work with Schwab and Fidelity. As such, all of my clients receive statements from Schwab/Fidelity that are independent of any statements I give them. I cannot meddle with those Schwab/Fidelity statements. The clients don’t need to go through me to get those statements. That’s as it should be! If there’s ever a discrepancy between the statements, I hope/expect my clients to say, “Hey – what gives?!”

At the Hannibal Fire Department, the 3rd-party should have been an independent auditor. For years, the department treasurer was allowed singular access to the books. He reviewed things with the department’s accountant, but they were friends too, and thus the accountant “did not apply the same level of professional scrutiny as he did with his other clients.”

Another screaming red flag: “the fire department was also required to have an independent financial audit every year because its budget is over $400,000, but it never did so.”

Research and Understand

Before investing in any opportunity, conduct extensive research. An investment in knowledge pays the best interest!! Look for information online, check reviews, and verify the legitimacy of the business or investment opportunity.

Be cautious of deals that promise unusually high returns with little or no risk. There is an intrinsic relationship between risk and reward. Any investment that violates that relationship should be viewed cautiously.

Make sure you fully understand the investment or business model being offered. If the details seem vague or overly complicated, it’s time for caution.

Know What the Schemes Look Like…

Ponzi Schemes: if you’re not familiar, a Ponzi scheme is a fraudulent investment scam that promises high returns with little risk to investors. Instead of generating profits through legitimate business activities, the scheme uses funds from new investors to pay returns to earlier investors.

As long as early/old investors remain content – and don’t want to pull their money out – the scheme continues to grow. But eventually, an event occurs where too many investors want access to their money. But without sufficient new money entering the scheme, the whole fraud collapses.

Affinity Frauds: most Ponzi schemes grow as affinity frauds. Affinity fraud is a type of investment scam where fraudsters exploit trust within a specific group or community, such as religious, ethnic, or professional circles, to deceive individuals into investing money.

For example: “Look – everyone else in this cozy, cute town of Hamilton is trusting me…you should trust me too!”

Affinity frauds combine two powerful effects descibed in Robert Cialdini’s best-seller Influence:

  • Social Proof: if they’re all doing it, I should do it too.
  • Authority: this person is a well-liked, trust, smart member of the community…of course I should trust him!

Pyramid Scheme: pyramid schemes are similar to Ponzi schemes but rely on recruiting new members rather than investing new money. Be cautious if you’re asked to recruit others to earn money.

Guarantees: any investment with a “guarantee” should be eyed very suspiciously. Especially if it promises a large return. The Hamilton, NY scheme promised an 8% return when the risk-free rate (a.k.a. what U.S. government bonds yield, generally considered the safest investment in the world) was only at 2%.

4x the return of the U.S. government, with the same guarantee? I smell a rat!

Pressure Tactics: while high-pressure sales pitches aren’t illegal, fraudsters often use high-pressure tactics to rush you into making a decision without giving you time to think or do your due diligence. Be skeptical of anyone who insists you must act immediately.

What’s the rush?! Remember that genuine wealth-building takes time, effort, and consistent financial planning. Be wary of schemes that promise quick and easy riches.

“Are You a Fiduciary”: when Jason Zweig wrote “The 19 Questions You Should Ask a Financial Advisor,” his most important question is, “Are you a fiduciary, and will you state that in writing?”

A fiduciary is legally obligated to work in your best interests. Many financial professionals are not fiduciaries, and working with them means they might put their own financial interests above yours. Not good!

No More Frauds!

None of us want to be taken in by fraud. Hopefully, these tips on avoiding Ponzi schemes and frauds might helps a few of you out.

If you do come across a potential fraud or Ponzi scheme, report it to your local law enforcement or financial regulatory agency. Reporting such activities can help protect others from falling victim to the scam. Help each other out.

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