Stanford Makes Two: How to Identify and Avoid Ponzi Schemes

Last night, major news networks announced that Texas billionaire R. Allen Stanford had surrendered to officials for charges related to a $7 billion “ponzi scheme.” Stanford, a chairman of Stanford Financial Group, and his associated had advised investors to purchase certificates of deposit from the Antigua-based Stanford International Bank. This activity caught the attention of the Securities and Exchange Commission who filed civil fraud charges earlier this year.

Since this follows so closely behind the Bernie Madoff scandal of 2008, it’s no surprise that investors may be casting a suspicious eye toward their own investment purchases. As such, we’ve pulled together some information to help explain what a ponzi scheme is, and how to avoid it.

How Ponzi Schemes Work

Mike Moffet at About.com explains ponzi schemes as having five key elements:

1. Benefit: The investment is promised to have a rate of return that is better than average, or most other investments. Oftentimes, a rate of return will be specifically noted.
2. Setup: Investors are given a believable explanation for why the rate of return will be so good. Oftentimes, this explanation includes the investor’s extensive skill, insider information or unique opportunities not available to the public.
3. Credibility: The person running the scheme may have exceptional credentials that make them easy to trust and believe.
4. Initial Pay-Off: Investors will reap the expected (high) rates of return for the first few periods, helping to substantiate the investment.
5. Ongoing Success: Other investors are told about the success in order to bring in new funding.

Step 5 is crucial to the ongoing success of the scheme, because the “investments” being sold are actually just empty purchases. The “return” is funded by new investors. Once new investors stop coming in, or current investors request liquidation of investments, the scheme collapses. Oftentimes, the leader will have stopped returning funds to investors and simply escaped with all of the money.

How to Avoid a Ponzi Scheme

There are five steps you can take to ensure that you are not investing in a Ponzi Scheme or similar fraudulent investment (Courtesy of USNews.com):

1. Verify Credibility with Second-Party Sources: Anyone can call themselves a financial planner,  so check with national organizations such as the National Association of Personal Financial Advisors to get the credentials of the person you are considering. It may also help to get referrals from trusted friends and family members. Also, check your state’s securities regulator for complaints filed against them.
2. Verify Credibility Directly: Ask your potential financial planner for their documentation of success and ethics by requesting to review ADV Form, Part II, which a planner files with the Securities and Exchange Commission. It contains information about the adviser’s background, services, and fees. A site visit can also be a good idea.
3. Manager v. Custodian: A custodian is in possession of your investment account and issues periodic statements of transactions (i.e., Charles Schwab). The manager of assets executes those transactions (i.e., broker). Beware anyone who offers to do both functions, and asks that checks, etc. be made out directly to them.
4. Understand the Playing Field: Banks, brokerages, and planners offer both domestic and exotic investments, and it helps to get to know some of the basic types or names of these. If you get a pitch for an obscure or exotic investment you’re not familiar with, make sure you understand how exactly you will receive returns, including the process and the sources.
5. Age Matters: Your age, that is. If you are close to retiring, be especially careful with whom you trust your financial investments. Ponzi schemers have been known to prey on those near retirement because they may have some substantial securities to liquidate and “invest” with them.

And, as always — if it sounds too good to be true, it probably is.

June 19th, 2009 by admin | Posted in Debt Management, Saving Money | (0)