Don’t be fooled by the next Madoff

Bernie Madoff may not have been a New York Mets fan; but the Mets owners’ were huge fans of his. So much so that they had 483 accounts with him. The problem was Bernie Madoff ran the biggest Ponzi scheme in history, with $65 billion in investments. And the Mets’ owners may have to give up the team—not because they lost money, but because they unfairly benefited at the expense of others. Now they’re being asked to pay back.

As an entrepreneur, you’ve achieved success through hard work, savvy investments in your business, and a devoted customer base. So did many of Madoff’s investors. In fact, the very qualities that make business owners successful may make them vulnerable when it comes to financial investments.

Read: Fraud slipping past Canadian regulators

It’s easy to get scammed. But if you watch for these eight telltale signs and put in the legwork, you can protect yourself from the Bernie Madoffs of the world.

Step 1: Admit you don’t know everything

Entrepreneurs know the numbers needed to make the business math work and they expect the same of their financial counterparts. While you may know your business—and those of your competitors—don’t assume you know how a completely different line of business works.

Here’s an example from the 1990s. A mutual fund salesperson in Ontario used high-powered seminar speakers to attract investors to his events where he also offered a private placement, a security not listed on the stock exchange, in a business venture called a “bovine limited partnership.” The partnership itself offered favourable tax terms, but to maximize tax advantages and returns, investors were advised to borrow from a bank to increase their investment leverage. The partnership went bust and, in the end, investors lost their capital as well as the tax advantage they’d been counting on to justify the borrowing.

LESSON: You probably don’t know an investment venture inside and out. Before sitting through a seminar, check whether the principals holding them are registered with a regulatory body, and see if they’ve ever been subject to any regulatory actions. To check for registration, go to your provincial securities commission’s website. You can also perform a search for regulatory actions. (See “Do your Homework,”) Always seek further advice from a trusted professional before handing over your money.

Step 2: Work with money managers who understand private investments

Fraud can occur in publicly regulated investments—consider YBM-Magnex, a Russian magnets producer listed on the Toronto Stock Exchange whose board of directors included a former Ontario premier. YBM had failed to disclose that the company’s founder had links to Russian organized crime and was intentionally bilking investors out of $150 million.

Such public frauds are infrequent. They’re much more common in the private investment market.

Private investments come in many forms: hedge funds, real estate limited partnerships, and private equity vehicles. Most are aimed at the institutional market (i.e., pension funds), and some at high-net-worth individuals. They generally depend on a small investor base requiring high minimums to opt in. What’s called the limited or exempt market allows accredited investors to participate in non-advertised ventures, providing they have above average incomes ($200,000 a year) or financial assets of $1 million.

Read: 7 tips to fight fraud

But unlike a mutual fund, which has to go through the costly and rigorous process of filing a prospectus, these investments file only their offering documents, which aren’t required to be exhaustive. And, clients signing up for an exempt offering are required to acknowledge they could lose all of their money—which puts considerable onus on the investor.

LESSON: Private offerings are very intricately structured, so make sure the person handling your financial affairs is familiar with them. Determine if the person you’re dealing with is registered to sell securities, and if he or she has the necessary licensing and experience to handle private investments. Insist he or she informs you about the performance of the investment. If you’re really interested in exempt market investments, most brokerages and mutual fund dealerships have a subsidiary that deals with them. They sell off an approved list of products deemed appropriate for clients. If a product has been offered to you that’s not on the list, that’s a sign the rep you’re dealing with is not on the up and up.

Step 3: Beware of appearances

It gets more complex when someone operating with a reputable firm goes “rogue.” Sometimes a broker or mutual fund salesperson is able to hide illegal activities within a well-regulated structure.

A prominent Victoria financial advisor—who attracted headlines for organizing campaigns for charities as well as for his high-flying helicopter business—sold off-book investments. He was only registered to sell mutual funds, and had no authorization to sell shares of individual securities; but he did so without his employer’s knowledge.

The rep required investors to make cheques out in his name and provided a brokerage statement that was separate from those covering clients’ other investments. What rubs the salt deeper in the wound is he was selling shares in a bank owned by his ultimate employer; and let on to investors that he had an inside connection.

Read: Fraudsters buy credit card numbers online

LESSON: There were warning signs. Never make out a cheque directly to an investment rep. It should always be made out to his firm, which holds the money in trust. Don’t be afraid to call that firm to see if he or she is authorized to sell the investment you’re considering buying.

Step 4: Don’t be dazzled by reputation

Let’s take it a step further. Yes, there are carnival barkers with seminars; there are schemes promoted by unscrupulous operators who don’t much care about the law; and there are rogues who go behind their firms’ backs.

But sometimes, despite well-designed appearances, a whole firm is a fraud.

Case in point, the mother of all Ponzi schemes, run by Bernard Madoff. Instead of producing a steady 12% a year, Madoff simply falsified investment returns. When people cashed in their investments, they were effectively getting their own capital back, plus someone else’s money to pay for the faked investment gains.

As the former chairman of NASDAQ, the trading arm of the National Association of Securities Dealers, which itself held regulatory responsibility for brokers and securities markets, Madoff stood at the pinnacle of the investment world. His brokerage business was one of the heaviest traders on the exchanges. But that veneer of respectability conveniently covered a fraud.

While Madoff’s registered brokerage business was legit, his hedge fund operation—offered so exclusively that it wasn’t even named—was not. And it was kept separate from Bernard Madoff Investment Securities. It shared a good reputation by association with Madoff’s trading firm. And that reputation was used to defraud.

Read: Investors wary of scandal

LESSON: Don’t avoid doing necessary research because the firm or players seem reputable. Look at the company structure, who is managing your trades, and if they are a real businesses.

Step 5: Beware when key service providers are located far away

According to Frank Casey, principal at Vintage Investment Partners, and one of the people who helped tip off U.S. authorities about the scheme, Madoff claimed to have an accountant vetting the hedge funds books. He said this accountant was his brother-in-law, and that only he could review the accounting because he didn’t want the fund’s investment secrets exposed.

It turned out the accountant wasn’t even Madoff’s brother-in-law, but just a guy who shared an office in an upstate New York strip mall with his dog. “Not the type of entity that would be normally used to do accounting operations on a monstrous business,” Casey says.

LESSON: Check the credentials of service providers, and determine if they’re qualified and of a size commensurate with the investment being offered. Further, find out who the auditors are, as well as who serves as custodian of the stocks purportedly being traded. All stock trades generate paper trails and provide checks and balances—except when they are subverted or compromised, or bought off.

Step 6: Beware the oath of silence

It’s especially important to be wary of requirements that investors pledge secrecy—as Madoff’s were.

Such calls for quiet are usually coupled with promises to beat the market, which means those agreeing not to talk should be getting some information about the firm’s strategy. Even a manager who doesn’t want to tell you “how it’s done” should be revealing some elements of the strategy to put you at ease. Learning about the structure of the markets, and what returns are actually realistic, is a due diligence step that will give insights about what’s plausible.

LESSON: A request for silence usually means someone has something to hide, especially if they’re asking you to refer friends in the same breath. And, a promise to achieve returns well beyond what the markets are doing is a sign something is wrong. For example, Casey based one of his whistleblowing points with regulators on Madoff’s claim that he was trading $65 billion on the options markets. In reality, those markets were not even large enough to support $7 billion in trading every day.

Read: Victims in Madoff fraud to get $405 million

Step 7: Look at the firm’s internal controls

Is there a separation between the guy who’s making the investment calls and the guy who’s tracking the profit and loss statement? If not, the fund manager could manipulate the reporting on his trading profits.

Or, as happened at one Canadian hedge fund, a trader was making unauthorized bets on interest rates but the compliance system was so defective that the trades weren’t detected until he had blown up the fund and forced it into liquidation.

LESSON: Dig down into an investment company’s structure to find out who’s pricing the portfolio. Ask questions such as, is the pricing being done daily, weekly, or at some other interval? Where are the trades taking place? Are the trading people separated from the accounting people inside the firm? They’re supposed to be. If something looks odd, ask.

Step 8: Don’t rely on the regulators

When it comes to protection against fraud, don’t expect much help from securities regulators. They’re lawyers, not traders or asset managers. They’re not experts on investment techniques—nor on what is a plausible return. They focus on best business practices, and making sure the books are in order. Despite their constant surveillance, they come to the defense of investors only after the horses have left the barn.

Read: Fraudsters are ahead of regulators

Sometimes it’s very long after. The Bre-X gold scandal took over a decade to litigate. Even then, there was no conviction—and no money for investors. Even in cases when there is some money left for investors, it can take years for court-appointed receivers to unwind complex investment structures.

LESSON: Do your own due diligence on an “extraordinary investment opportunity”—or hire someone to do it for you—before laying money down. Sometimes regulators can pull off successful litigation, but the process is lengthy and you can be out of pocket a long time before getting reimbursed. Worse, if a firm goes bankrupt and the principals are broke, there’s no cash to put back in your pocket. Scot Blythe has been writing about investments for a decade and is based in Toronto. This article was originally published on capitalmagazine.ca.