Don't Fall For Investment Scams - Part 1

Phone Scam, fraud or phishing concept.

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Co-produced with Philip Mause

It was often said that the early part of this century was the "golden age" of fraudulent schemes capped off by the enormous Madoff catastrophe, which is still the subject of media attention. Madoff was one of the main characters in the financial crisis of 2008. He swindled millions of dollars from a lot of people, including famous actor Kevin Bacon and his wife, who were two of his most high-profile clients. While the couple didn’t reveal how much they lost, it was clear most of their savings were for trusting a fraudulent man. However, they must have felt better when Madoff was sentenced to 150 years in prison.

The latest variation is the collapse of FTX, the second-largest crypto brokerage in the world. Apparently, FTX was funneling investor capital into its sister company, Alameda, which was then making leveraged bets on the crypto space. FTX was popular among many crypto investors thanks to massive advertising, celebrity endorsements, and its size. These provided the perception of safety, even though it was unregulated. Investors knew they were taking on the risk of investing in crypto, but many likely did not consider that the brokerage itself was smoke and mirrors.

It shouldn't surprise anyone that such a thing happened in crypto. When massive sums of money are involved, fraud becomes very tempting and sometimes honest incompetence can lead to massive losses. The significant number of regulations in the financial industry came about because the problems with FTX have historically been seen with banks, insurance companies, and brokerages.

The problem of investor fraud has become so serious that a television series - "American Greed" (on CNBC) - is entirely devoted to such scams, and it never seems to run out of subject matter material. In fact, there have been numerous such schemes - one of which is the Stanford Financial scheme - which we will discuss in this part.

It's unclear exactly why many of these schemes flourished more in the early 2000s, but it may have to do with a decline in interest rates. As interest rates on safe investments (bank deposits, government bonds, etc.) declined, there is an almost inevitable investor migration up the risk curve. Furthermore, the expansion of the Internet provided a means to reach out to millions with relatively little expense and no oversight. Some investors have little experience with riskier assets and cannot distinguish or appreciate degrees or types of risk. A seemingly legitimate website advertising above-average gains can appeal to a person's greed.

Another important factor that may feed money into these schemes is the sudden receipt of substantial funds by investors who are simply inexperienced with handling large sums of investible money. We all read stories about athletes and lottery winners who get enormous amounts of money and wind up broke several years later. This is largely because they simply have no experience investing and protecting their funds.

On a lesser scale, the coming decades will see many, many households experiencing a significant inheritance, a lump sum termination payout, an opportunity to transfer a corporate 401k to an IRA, or a large cash payment for a residence sold as part of a downsizing plan. Individuals with little or no investment experience will be hounded with "cold calls" and plastered with confusing literature.

This series of articles will explain why most investors should stick to regulated markets like publicly traded stocks or bonds registered with the SEC and traded on established markets or insured bank deposits. In fact, there is a whole other "world" of investments, including private "deals", private limited partnerships, and other vehicles which are often marketed very aggressively.

In general, investors should avoid these unless they are very confident in the integrity and stability of the sponsor. Even then, the amount put at risk should be limited to a relatively small part of one's portfolio. The further you stray from regulated investments, the easier it is for someone to commit fraud.

This series of articles will try to explain some of the pitfalls such investors face and some of the ways they can protect themselves. This first part will deal with certain relatively "safe" investments and explain exactly why they are safe. Although some of this material will seem overly rudimentary to some investors, a reflection upon it can help structure one's thinking and sharpen one's ability to analyze other types of risks. One problem is that it is often the case that a fraudulent or highly speculative investment can "masquerade" as a very safe investment.

1. Bank Deposits

Anyone who has watched Jimmy Stewart in "It's a Wonderful Life" around Christmas time knows at least a little bit about the terrifying dynamics of a "bank run." While very naive investors may think that a bank "deposit" is similar to placing assets in a safe deposit box and that the bank actually holds your specific funds ready for you the way an airport storage locker does – in fact, bank deposits simply make the depositor a creditor of the bank.

After the deposit, the bank mixes the funds with its other funds and now owes the depositor the amount deposited plus accrued interest. Because banks are leveraged, there's always a solvency risk that the bank's assets will not cover its obligations. There is also a more urgent liquidity risk that the bank will simply not have liquid funds available to satisfy all depositors seeking immediate withdrawal, even if its assets are theoretically enough to cover all withdrawals in time.

These risks materialized during the Great Depression and then during the Panic of 2008. The big difference between these two episodes was the existence of Federal Deposit Insurance and much more strict regulations. The federal government wisely created the FDIC to insure deposits at member banks. Thus, if an investor deposits funds at a bank with FDIC insurance, that deposit is covered up to a limit of $250,000 so that even if the bank fails, the depositor will get his money back from the FDIC. There are rules about multiple deposits and joint deposits that are readily available, and it's pretty easy for a household to protect substantially more than the $250,000 maximum with multiple accounts at different institutions. It's also important to realize that in the process of resolving failing bank assets, the FDIC has been careful to protect even those deposits above the limit in the case of very large institutions such as Washington Mutual and Continental Bank of Illinois.

In understanding this situation, it's important to consider the concept of "counterparty risk." When you invest or take other action which creates an obligation of another party in your favor, that party is often called a counterparty. Counterparty risk is essentially the risk that due to bankruptcy, becoming judgment proof, absconding, etc., the counterparty cannot effectively be sued for the amount that it owes you. Thus, a depositor at a bank that fails has a valid claim against the bank for his deposit. The problem is that a lawsuit against the counterparty (the bank) will not yield effective relief because the counterparty does not have sufficient funds. What deposit insurance does is effectively substitute the FDIC for the bank as a counterparty so that counterparty risk is removed.

It is very important to understand the limits of this protection. There is no protection for bank bonds, money market funds, or other bank products other than deposits. The only deposits that are protected are deposits in banks with FDIC insurance. A very ingenious fraudulent scheme - Stanford Financial - induced many large investors to put enormous amounts of money into certificates of deposit in a Bank chartered on the Island of Antigua. Investors doubtlessly had come to think of bank deposits as "safe" and, having been lulled into a sense of false security, opened the financial spigots as funds gushed into the uninsured offshore bank. Of course, the FDIC does not insure deposits in Antigua banks, and some $7 billion was lost. The scam did not get enormous attention because the story broke around the time of the Madoff disaster.

Another recent fraudulent scheme in Michigan accepted investor funds with the assurance that they would be invested in bank certificates of deposit but then made other use of the funds. These investors probably thought that they were protected by the FDIC, but they were not.

2. Brokerage Accounts

Subscribers to Seeking Alpha and even casual readers are familiar with volatility in the stock market and realize that there is really no protection from market loss. But there are other risks associated with delivering funds to a person or entity who is a self-identified stockbroker, and there is some protection from these risks. Brokerages are generally required to keep investor accounts segregated from the funds of the brokerage itself and to follow certain rules designed to protect investors. Of course, there are instances in which these rules are not followed.

As a general matter, investors who are victimized by individual brokers or brokerages can seek relief from the brokerage itself by filing an arbitration with the Financial Industry Regulatory Authority (FINRA). A brokerage house is generally responsible for the misbehavior of its brokers - including embezzlement of funds and churning (excessive trading motivated by a desire to maximize commission income). If you're dealing with a large and stable brokerage house, there will be a strong counterparty able to compensate you for any liability you are able to establish.

A problem arises when funds are missing from an account, and the brokerage itself has become insolvent or has gone bankrupt, leaving the investor with no useful counterparty against which to make a claim. The Securities Investor Protection Act protects investors in failing brokerage firms. In these situations, the firm may have taken an investor's account funds, and an investor's remedies may be limited because the firm has failed and cannot satisfy a judgment against it. SIPC protects investors up to a limit of $500,000 in this kind of situation. It is important to note this limit applies to the account as a whole, but the protection limit of cash (or non-invested funds) is capped at only $250,000. You can, however, get more than $500,000 worth of SIPC protection at the same brokerage firm by having different categories of accounts there. For example, an individual account, joint account, individual retirement account, and Roth IRA each get up to $500,000 worth of protection. So having a second joint account with your spouse, or an account with a separate brokerage firm will increase your insured investments.

However, four things are not covered:

  1. There is no insurance against market losses.
  2. There is no insurance due to losses resulting from account hacking unless the brokerage firm was forced into liquidation due to the hack. It is important that you keep your online trading account secure with a strong password. A 2-step login (Two-factor Authentication) will significantly reduce hacking risk.
  3. There is no protection in the situation in which an individual or a firm fraudulently represents that it is an insured brokerage when it is actually no such thing. Thus, investors should be careful in dealing with smaller firms or individual brokers and be sure to know exactly to who it is they are giving their money. There have also been cases of fraud artists creating websites and other materials which appear similar or identical to materials from legitimate brokerages and inducing investors to forward funds to them under the misimpression that they are dealing with a real brokerage.
  4. There is another unprotected risk. Many scam artists create a bewildering network of companies with similar names. In one notorious case, one of the companies in the network was actually a legitimately licensed brokerage. The network's literature highlighted the fact that it was represented by a reputable law firm and accounting firm (these reputable firms actually represented only the legitimate licensed brokerage). Investors were induced to invest in other fraudulent entities in the network which had names that were confusingly similar to the name of the legitimate brokerage. Only $100 million was lost in this Ponzi but it occurred before the "Golden Age" described above.

Investors should also take care to review account statements for any items which appear unusual, unauthorized, or abusive. If something seems amiss, an investor should immediately make inquiries and demand answers. This may minimize losses, and it will also negate a defense of implied consent.

3. Insurance Products

Many insurance industry products are sometimes viewed as investment alternatives. Thus, whole life insurance and annuities can both be viewed as a part of an investment portfolio. In addition, investors may buy long-term care insurance as an alternative to saving enough money to provide for this eventuality.

The insurance industry has generally avoided federal regulation, and thus, there is no federal entity comparable to the FDIC covering the insurance industry. However, the insurance industry is regulated at the state level, and most states have state insurance guarantee associations. These have varying provisions for policyholders of failing insurance companies. Some typical coverage limits are - $100,000 for the cash surrender value of a life insurance policy, $250,000 for the present value of annuity benefits, and $300,000 for long-term care benefits. These limits vary by state, and investors considering a very large insurance product should conduct due diligence. Most risks can be avoided by buying a policy with a highly-rated insurance company. A very risk-averse investor may want to consider multiple policies with different insurers to minimize risk and increase total guarantee benefits.

Generally, the insurance industry is relatively low risk, and there is not a great deal of losses imposed on policyholders in the insurance industry. But it seems that not a year goes by when NOLHGA doesn’t report one or more insurance companies that have experienced impairments and insolvencies. Most of the failures are smaller companies, and policyholders usually get coverage from backup systems at the state level and from funds recovered in the aftermath of the failure. Even so, when you’re counting on insurance protection, surprises are unwelcome and take time to resolve. Of course, in addition to the risk that an insurance company will fail, there is always the risk that a fraudster will try to sell a "policy" with a non-existent insurance company or an insurance company that has not authorized the fraudster to issue policies for it.

There have been some highly publicized insurance frauds. A notable one covered on American Greed and reported by the GAO involved small life insurance policies issued by companies in several Southern states designed primarily to pay for funeral expenses. Another larger fraud was perpetrated by Sholam Weiss and led to the failure of National Heritage Life Insurance. This may have been the biggest single insurance failure caused by fraud. Coverage of the case indicates that backup insurance covered up to certain amounts per policy and that amounts above those limits were ultimately recovered through assets of National Heritage, but only after policyholders waited a number of years.

4. Conclusion

In each of the three situations discussed above, an investor enjoys certain important protections from certain kinds of risk. But it is important to understand the terms and limits of those protections because fraud operators will always try to masquerade their products to create a false impression of security.

A properly structured brokerage account at a solid firm is actually a key component of any investment portfolio today. But the reality is that there is no way to completely avoid risk.

While there is always risk in the securities market, the risks other than market loss have been limited by protective policies. Market volatility risks should be accepted for at least a substantial portion of one's portfolio, given the alternatives. Finally, if you have a substantial amount of money with a single brokerage firm, it may be advisable to split this money into two or more brokerage firms to maximize the protection available for your nest egg.

At High Dividend Opportunities, we like to focus on publicly traded high-dividend stocks that are liquid and provide a high and recurrent income for investors through a model portfolio that is easy to follow.

A diversified portfolio of dividend stocks, preferred stocks, high-yield bonds, certain closed-end fund products, Property and Mortgage REITs, BDCs, and utility stocks can provide you with a large yield. They help investors get recurrent income whether the markets are up or down. Importantly, they have great liquidity that investors and retirees can sell in case they need cash, and they are regulated by the SEC.

Part 2 of this article will address Fraud, Pyramid Schemes, and "business opportunity" scams that investors should be aware of. These often tout the ability to provide above-average returns but frequently rely on illiquidity and opaque finances.

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