Protecting Your Money From Fraud


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On 29th June, Bernard Madoff was sentenced to 150 years in jail for his ?unprecedented? $65 billion fraud. In effect he stole billions of dollars from 13,500 investors around the world, duping th

On 29th June, Bernard Madoff was sentenced to 150 years in jail for his ?unprecedented? $65 billion fraud. In effect he stole billions of dollars from 13,500 investors around the world, duping thousands out of their life savings and leaving them devastated.

In passing the sentence, Judge Denny Chin described Madoff?s crime as ?extraordinary evil? and one that ?takes a staggering human toll?. He said the sentence was ?symbolic? to ?deter future crimes and as retribution?.

Madoff?s investment fraud was a massive Ponzi Scheme. He promised high investment returns but never invested the capital, instead paying existing investors out of money received from new investors enticed by his reputation and investment claims.

While the Madoff fraud ? possibly the largest in history carried out by a single person – and the alleged Allen Stamford investment fraud have been making headlines around the world, smaller frauds such as ?boiler room? scams unfortunately go on every day.

In April the City of London police, the leading force for fraud investigation, said that it was receiving 100 new calls a week from people who had lost sums ranging from ?3,000 to ?1 million. Victims of boiler room scams tend to be men in their fifties and sixties who have had experience in buying shares.

Nowadays boiler room frauds employ articulate graduates who are very convincing. The victims are told that they have an exclusive opportunity to buy shares that are about to be listed and will shoot up in price. In reality many of these shares either do not exist or prove worthless.

Is it possible to protect yourself from fraud?

Choosing an adviser

Unfortunately regulation alone does not necessarily prevent you from being caught up in a fraud like Madoff?s. Many respected and regulated financial institutions and fund managers had invested client money in his fund ? though others did have their suspicions and stayed away.

What you need is an advisory firm which will apply strict due diligence procedures before recommending any investment to their clients. It should examine every nook and cranny of the investment; look under the carpet, so to speak, and analyse the bare structure to ensure all is really as it seems. In Madoff?s case there were clues which should have rung alarm bells, but which somehow some people either overlooked or had not bothered to check out.

Is there a credible auditor? Madoff?s auditor was a retired accountant who was a sole practitioner operating out of tiny office and employing just one secretary and audit clerk. This is simply inconceivable for a fund of this size ? the largest hedge fund in the world! Allen Stamford?s auditor was also a sole practitioner operating out of a small office above a hair saloon in north London.

Is there a third party custodian holding the title deeds and checking the valuations to confirm they are correct? Madoff was his own custodian and his own broker; there was no third party to check that he was making the investments and returns he claimed he was, so the system was open to abuse.

Another clue was the claimed investment returns ? which were literally too good to be true. It is not so much that they were consistently so high, but that it was impossible to make such returns from what he said he was doing ? it was just not feasible.

My firm will always look into how the returns will be generated and if we cannot understand how it is possible to achieve the claimed returns we will not recommend the investment to our clients.

If it sounds too good to be true?.

At the risk of sounding clich?, if an investment sounds too good to be true, it probably is. Stop and ask yourself how it can possibly produce much higher returns than its peers ? there has to be a catch. The higher the promised returns, the higher the risk. It is simply not really possible to generate high returns from something that is low risk. You will either be taking on more risk than you realise or the promised returns will never materialise.

Don?t put all your eggs in one basket

Spreading your money across various ?regulated? funds and assets helps to lower investment risk in general through diversification, not only fraud risk.

While diversification helps to reduce risk, you should also diversify your capital across assets, companies, countries, currencies etc. In today?s world it is also sensible to diversify your cash holdings across more than one bank.

Protecting yourself from fraud is obviously important, but so is taking steps to protect your capital from market risk, inflation risk, interest-rate risk, currency risk etc. Your financial planning should be set up to take all these issues into account and designed to meet your personal investment objectives.

Don?t rely on one manager

Madoff was a former chairman of the Nasdaq stock exchange; he had other directorships and was a generous donor to charitable causes. The lesson here is not to trust all your money to just one manager based on his reputation or charisma.

While the manager may not purposely defraud you, he may become more careless with your money. It is also a fact that many of today?s top managers don?t remain top managers forever, in time they do tend to slip down the performance tables. It is possible that a manager was so successful because he took a high risk approach that worked well under certain conditions but could backfire under others.

Just as you should diversify your capital over companies etc, you can also diversify over managers to lower this risk. Either buy a few different funds managed by different teams or invest in multi manager funds where a range of managers, employing different styles, will manage the same fund.

Seek high investor protection

While this does not necessarily insulate you from fraud, you will still want to take any possible steps to protect your money, including from institutional failure.

Investor protection varies across countries, the type of financial institution and the type of investment. In Europe, if you invest via a Luxembourg insurance bond, you will be covered by a very high level of protection.

Luxembourg?s state controlled protection law is designed to provide maximum security without limit. If you invest via an insurance bond issued by a Luxembourg regulated company the government regulator selects a custodian bank to hold the assets of the insurance company. Furthermore, the custodian bank is required to ?ring-fence? clients? assets and is bound to protect the assets on behalf of policyholders. Your assets are completely protected should the insurance company fail.

Most of all, remember this is your hard earned money. However tempting an investment opportunity sounds, or however much you need to ?make a quick buck?, don?t hand over your money until you are satisfied with both the adviser and the investment company being recommended and you are confident you have taken all the possible steps to protect your money. Always seek advice from an authorised and experienced adviser like Blevins Franks Financial Management.

By David Franks, Chief Executive, Blevins Franks

6th July 2009

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.