Recognizing and Avoiding Investment Scams

The evening news reports stories about financial investment scams with disturbing frequency. People get caught in fraudulent schemes because they forget to use reasoning and logic when evaluating financial decisions. Individuals who make wise decisions in other areas of life can fall prey to financial scams. Wise investors will learn to identify and avoid the typical approach scammers use to embezzle funds from people. Any financial opportunity that appears to be “too good to be true” probably is a scam. Objective evaluation of an investment includes self-examination to determine if the investor has certain behavioral traits and characteristics that create particular vulnerabilities to common types of investment fraud.

Common Fraudulent Investment Schemes

Frequent use of scam terminology has deadened the sensitivity of the public when important indicators are reported about each investment scam. As details of the latest scandal unfold, the public learns that the core of each investment fraud resembles one of these schemes:

• Pyramid Scheme – The name of this common method of fraud is derived from the shape of the organization. Each participant must recruit multiple new people who pay fees to enter the program. The idea is to generate desire to participate through efforts to market a “get rich quick scheme.” People at the top of the pyramid make money from the new fees paid by new recruits. Breakdown of the scheme occurs when new participants can no longer be found.

• Ponzi Scheme – Named after Charles Ponzi, a criminal con man from the 1920s, who persuaded thousands of people to participate in a complex scheme that involved postage stamps. The central character in the scheme will collect money that is never used to invest or pay returns to investors. Funds from new members are used to pay false dividends to earlier investors. Ponzi schemes collapse when the fraudster is unable to attract additional investors, or too many existing investors request to permission to withdraw funds.

• Pump-and-Dump Scheme – Just as the name implies, the fraudster selects a low-priced share of stock from an unknown company and then creates a false run on the stock shares. Once the shares increase in price because of the high demand, the fraudster dumps his shares, makes an enormous profit and disappears. Word of mouth causes interest in the stock shares so that the price climbs incrementally. Cold calls are made using faxes or e-newsletters to find people who are willing to buy the stock. Today, text messages and spam emails are sent to thousands of people in hopes of finding a few interested parties.

• Fraudulent Advance Fee Scheme – An investor with worthless stock in his portfolio is vulnerable to this scheme. The fraudster plays on the hopes of the investor to reduce the losses incurred on that stock. The offer is made to pay a high price for the shares of worthless stock. The investor must pay an advance fee to receive the payment. Anyone who pays the advance fee will lose that money and never see the payment from the fraudster.

• Offshore Schemes – Similar scams exist in foreign countries and U.S. investors are targets for participation. Most fraudulent offshore investments involve fake stock shares of a company because “Regulation S” exempts U.S. companies from registering their securities with the SEC. These shares are sold only outside the U.S. A fraudster will violate the regulation and sell the unregistered stock to U.S. investors. American law enforcement agencies have a difficult time investigating these schemes.

Scam Psychology

Fraudsters know that most people have a risk tolerance threshold. Investors are vulnerable to the common types of fraud if the crook can decipher the level at which a good deal becomes too good to be true. Lies must be packaged in a believable way that is almost true.

A masterful fraudster begins the conversation with an investor by asking seemingly innocent questions about the family, political positions, health, personal interests or former employers. Most people will continue the conversation and unknowingly offer valuable information that defines the existing vulnerabilities. The fraudster uses the information to tailor the approach that will lure the investor into one of many scams.

Each tactic has been assigned a descriptive name:

• Phantom Riches Tactic – The investor is told about remarkable wealth that is just out of reach. A significant monthly income is projected for the “right person.”

• Source Credibility Tactic – The fraudster associates himself with a famous firm or claims to have a respected credential. Catch phrases create an illusion that is meant to create trust.

• Social Consensus Tactic – A rumor that savvy investors would never pass up the opportunity creates a feeling of being left out for the investor. The desire to be part of the crowd drives the investor to pursue an opportunity that would be dismissed otherwise.

• Reciprocity Tactic – The fraudster will offer a token discount if the investor will jump at the chance at the moment the opportunity is offered. A sense of urgency is produced when the fraudster sets a short deadline.

• Scarcity Tactic – Instead of short deadlines, the fraudster will tell the potential investor that a limited supply exists. To seize the opportunity, the investor must act before someone else snaps up the last one.

Consumers are approached with the same tactics used by legitimate marketers because each method is effective with a different group of people. A desire to win and be part of the group is powerful enough to cause anyone to act on the subliminal messages. Savvy investors are aware of the tactics before opportunities are presented. Awareness prevents being caught in one of the common scams.

Frauds Offer Red Flags

Every investor must be cognizant of the obvious signs that a scam is being offered in place of a legitimate investment. One of the red flags listed below is sufficient grounds to dismiss the opportunity.

• Guarantees – All investments carry risks. Anyone who offers a guarantee that the investment has predictable returns or timeframes is perpetrating a fraud.

• Unregistered products – Investors must take bold steps to ensure that the securities and advisor are registered with the proper organizations. Fraudulent opportunities will not exist in the registries where legitimate investment instruments reside.

• Obviously consistent returns – Any investment instrument that gains value every month regardless of the market conditions is suspect. The absence of one misstep in the investment’s history over a long period is a red flag.

• Complex investment strategies – Fraudsters devise complex schemes that cannot be tracked. Part of the sales technique is to ask the investor to trust the investment managers to take care of the details.

• Omitted documentation – Valid investment instruments must be accompanied by proper documentation. Unregistered securities are fabricated and sold to unsuspecting investors who are unwilling to demand that sufficient documentation is provided.

• Obvious account discrepancies – Investors must accept an active role in verifying the account statements that are provided. Missing funds or unauthorized trades can indicate fraudulent activity against the account. The advisor should never occupy the roles of keeper of the accounts and custodian of the assets.

• Pushy sales tactics – Reputable financial advisors will not create false urgency to manipulate investors to make quick decisions. Wise investors will avoid any advice that imposes false deadlines.

Victims Have Similar Traits

All investors must realize that careful evaluation of past fraudulent schemes and the victims provides insight for everyone. Savvy investors will reduce their personal level of vulnerability if the common characteristics are outlined in simple terms. Fraud risk factors have been identified, including:

1. Investors with high-risk investments in the portfolio are considered more willing to participate in fraudulent schemes.

2. Embracing advice from amateurs is an indication that the investor is easy to mislead.

3. Openness to investment information from unique sources, such as a free investment seminar, creates an opportunity to mislead many people at once.

4. Failure to investigate the investment professional allows fraudsters to perpetrate their schemes.

5. A naïve approach to the persuasion tactics that are used by fraudsters will leave the investor vulnerable to any scheme.

Investors Can Learn to Avoid Scams

Careful attention must be paid to the current, and past, investment schemes and how they were developed and carried out on the victims. All investors learn from the mistakes that other people make. Anyone with investments is vulnerable to scams if a void of knowledge develops over time.

Certain actions must be taken to avoid the common scams.

• Investigate investment professionals – Reputable financial advisors will provide proof of current licenses. Registration with FINRA, the SEC and the state securities regulator must be maintained at all times. Avoidance of the request for proof of licensure is grounds to terminate the conversation.

• Validate investments – Proper registration of the securities and investment instruments will require sufficient documentation. Deflection of the requests for proof of registration is an indication of fraudulent instruments.

Fraud Requires Action

An investor who is concerned that an investment is not legitimate should contact FINRA at the first opportunity. Proper steps must be taken to report the fraud and alert the proper authorities. Written complaints are taken seriously.

Mark Fryman is an attorney at the law firm of Starr Austen & Miller, where they specialize in investment and securities fraud cases.  When he’s not researching potential cases of investment and securities fraud, he enjoys running, playing cards and watching the Indianapolis Colts win on Sundays.

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