Money & You – October 2013

Financial Fraud

By Brett Newberry

Ponzi schemes are a form of financial fraud that refer to illegal operations that use financial instruments of some sort to extract money from victims. A Ponzi scheme is generally defined as an illegal business practice in which new investors’ money is used to make payments to earlier investors. In a Ponzi scheme, there are few or no actual investments being made, just funds passing up a ladder.

The term Ponzi scheme is named after Charles Ponzi who, in the early 1920s, persuaded tens of thousands of Bostonians to invest over $10 million. He created an entity, aptly named the Securities and Exchange Company, and issued investors a promissory note guaranteeing a 50% return in 90 days on every $1,000 invested.

Pyramid Gallup JourneyThere were two main problems, however, with Ponzi’s investment. First, although Ponzi claimed to be trading over $10 million worth of postal reply coupons, only a few hundred thousand dollars worth actually existed. Second, his scheme relied on new investor funds to pay returns to earlier investors. In August 1920, after the inevitable collapse of his scheme, Ponzi was arrested for mail fraud and larceny. Ponzi served jail time and was later deported to his native Italy.

An illegal pyramid is a scheme in which a buyer or participant is promised a payment for each additional buyer or participant he or she recruits. Typically, these schemes involve a strategy whereby the fees or dues a member pays to join the organization are paid to another member, and in many cases, these schemes contain a provision for increasing membership through a process of new members bringing in other new members.

In these schemes, the members make money not by commission on the bona fide retail sale of a legitimate product, but by signing up new people. An organizational structure that, like the Ponzi scheme, relies on bringing in new people, must eventually collapse.

According to the Association of Certified Fraud Examiners’ manual, financial service providers are subject to certain standards of conduct. There are several reliable and long-established rules of thumb that can be used to determine if an advisor has violated his or her professional standard of conduct. Some examples are:

• For most accounts, a financial advisor’s annual commissions and fees in relation to the assets should be between one and three percent.
• Portfolio turnover (or the value of the assets bought and sold) in excess of 300% justifies close examination.
• Advisors should maintain due-diligence files, records related to client recommendations, and portfolio analyses.
• Regardless of complexity, advisors should be able to articulate the primary features of any recommendation and should have evidence that they have communicated that to their clients.
• Firm-sponsored technology, such as client-contact programs, should be regularly used.
• Advisors should demonstrate an effort to revise client profiles to match any lifestyle changes.

Until next time,
The Business Doctor

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