5 ways to avoid financial fraud

Dec 2010 // Reuters

Allan Ehrlich, like many successful entrepreneurs, looked to friends for advice on where to invest his disposable and retirement income. So on the advice of a good friend, but not much else, Ehrlich invested some $650,000 with Bernie Madoff more than 20 years ago.

“The hardest thing was to get in,” says Ehrlich, 72. He used the same strategy of asking friends when he decided to invest $1 million in International Management Associates in January 2006, one month before he found out that it too, was a Ponzi scheme.

His annual investment income has fallen from an annual $200,000 to $50,000.

“I grew up in a world where everyone was honest,” says Ehrlich. “A lot of this falls on me for not being a sophisticated investor,” he says. But even sophisticated investors get scammed, too.

While the Madoff scam may have been the biggest financial fraud to date, it is unfortunately only one of many that have been discovered. Still, with the increasingly complicated investment platforms and volatility of the markets, many people need financial advice and money management services more than ever before. Yet the fear and mistrust of turning one’s money over to someone else is never far away.

No doubt, there will always be fraudsters. But there are actions investors can take to at least minimize the chance of becoming the next victim of a financial fraud. Often those who have been defrauded failed to follow through with one of these five important steps.

Check, check and then check again

Of course, this advice could be attributed to any aspect of hiring a financial professional, but, in this case, we’re referring to an adviser’s background and credentials. We all want to trust what people say as the truth, and it is easy enough to be lulled into thinking that you don’t really have to check credentials. Not so.

There are several ways to do a background check. First, enter the financial professional’s name into a search engine. By doing a very basic background check we have found that there have been lawsuits or brokers banned from the industry, says Tom Ajamie, an attorney and co-author of Financial Serial Killers. “Stockbrokers have been banned but then they become insurance brokers,” he says.

For brokers, go to FINRA.org and click on BrokerCheck. Make sure the broker is licensed and look at complaints filed with regulatory agencies. “You may find former employers who have posted information about them,” says Ajamie. For financial advisers, go to the Securities and Exchange Commission’s website to make sure they’re licensed and that they haven’t been barred or suspended. “These are excellent tools that 99 percent of the people don’t know exist,” he says.

Seek qualified professionals

It isn’t enough to just do a background check. “The qualifications to become licensed as a financial adviser are very loose,” says Mitchell Franklin, an assistant professor at Syracuse University’s Martin J. Whitman School of Management.

Other than a National Association of Securities Dealers exam, no formal higher education, degree or experience is required, he says. To that end, investigate a financial professional’s experience, educational background, and certifications. Look for the Chartered Financial Analyst (CFA) or Certified Financial Planner (CFP) and call the governing bodies to make sure the person has really gone through the required process.

Make sure the person who will potentially handle your money can easily explain his or her investment strategy. “They should be able to explain what they do and how they do it in plain language, even a complicated derivative strategy,” says Tom Robinson, director of CFA Institute’s educational division. “Always have a sense of skepticism and ask questions,” says Robinson. “Just because a person has a fancy office doesn’t mean they can’t defraud you.”

Insist on custodial accounts, independent audits and oversight

This step should not be overlooked. Investors should have a separate custodial account with their name on it at a bank. “Separating custody and investment adviser functions provide the client with better control over their assets and better defends against the ability of the investment adviser to commit fraud,” says Michael Spindler, an executive director at Capstone Advisory Group LLC, where he performs forensic accounting investigations.

Other safeguards may include ensuring that each trade or transaction requires approval by the investor, the investor doesn’t provide power of attorney to the adviser or allow the adviser to have ownership of any of the investor assets, third-party statements go directly to the investor and are promptly reviewed and there is transparency regarding any income received by the adviser, recommends Spindler.

Don’t give all your money to one person

The old adage to diversify should be used among managers and not just among investments. You may get overloaded with reports from many managers, but you’ll be protected from losing all your money as many Madoff victims experienced.

Pay attention to red flags

Red flags are easy to ignore, but when properly addressed, can be an investor’s saving grace. Some warning signs might include financial statements that are delayed, incomplete or have unusual items and evasive answers to specific questions. Ideally, investors should get separate paperwork from an independent source and place them side by side with the adviser’s report and make sure they agree with each other, says Robinson.

Finally, look for “promises of high rates of return or returns consistently exceeding the market,” says Spindler. “Benchmark rates of return should be selected with care to ensure a meaningful comparison. Returns below or in excess of these market rates should be clearly explained and understood by the investor,” he says.

In some cases, such as the Madoff case, it’s hard to see where someone might have avoided being defrauded. In that case, consider this: if an investment seems too good to be true, it probably is.