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The Ponzi Trap

Even sophisticated investors have gotten hit by sticky Ponzi schemes—Here’s how to avoid the snares in the future.

By Elizabeth Millard

Although Bernie Madoff's name should be infamous for some time, he's certainly not the only Ponzi operator who's taken investors down in the past few years. Locally, Tom Petters owes a large chunk of change to numerous people, and the SEC recently went after self-proclaimed money manager Trevor Cook and his conservative radio talk show host partner, Patrick Kiley, for allegedly running a scheme that defrauded over 1,000 people. Earlier in 2009, charges were filed against local company Crossfire Trading and its owner, Charles Hays, with accusations that Hays bilked a charitable foundation out of funds so he could buy a lavish yacht.

Some of the victims may have been new to the marketplace, but they weren't all green-even experienced investors were sucked into Ponzi schemes that promised strong returns and resulted in depleted bank accounts instead.

"Nobody is that good every year, the way Ponzi artists claim to be," says Bruce Langer, portfolio manager at Minneapolis-based Tealwood Asset Management. "In the next couple years, people will be very careful, but as greed comes back in, there's a danger that some investors won't be asking the tough questions."

So, how can an investor separate the tricksters from the tried-and-true? Here are a few tips on staying out of the Ponzi traps:

Use an independent custodian:

Madoff's investment advisory firm used his own business as the custodian for all managed clients' assets, but it wasn't the only one attempting that shady trick, notes Gregg Sainsbury, financial advisor at Wayzata-based BlueChip Advisors, a financial and advisory services firm.

"This is perhaps the most common red flag," he says. "It relates to who's holding your money, and who's watching out for you. Ask your advisor about whether there's an independent custodian, and then get information on that firm as well. The more transparency you can get, the better."

Although some investment managers do act as custodians of a client's assets, it's a better idea for a firm to employ a separate, unaffiliated custodial company, since that firm's compliance policies and procedures can safeguard against fraud.

Don't settle for a handshake, ever:

Another Madoff specialty was the handshake deal, Sainsbury says, and some firms still try to evoke that "casual deal-making" vibe, putting the investor at risk.

He notes: "Look closely when a firm doesn't require any paperwork, claiming that they're trying to streamline the process. Some ask for money to be wired to them, and they'll call back to let the investor know how things are going. Just remember that if there's no paper trail, there's probably no oversight."

Question antiquated systems:

In these uber-connected times, a professional website is crucial for any kind of business, but investors need to look beyond the graphics to what financial firms are actually using, Sainsbury advises.

Madoff was keeping records on handwritten ledgers and a financial program that was woefully outdated. Also, lack of online access to accounts is another red flag, Sainsbury adds: "If someone has antiquated account statements or lack of online access, it doesn't mean they're running a Ponzi scheme, but it's worth examining."

Be realistic:

Wealth building doesn't happen overnight, despite the promises of Ponzi operators, notes Kim Brown, president of JNBA Financial Advisors in Minneapolis. It might be tempting to look for quick, high returns, but in general, she advises that investors think long term.

"Some of these Ponzi schemes worked because people didn't have a solid plan that was realistic," she says. "Sometimes people think they've found the Holy Grail, but you have to be smart enough to ask why an advisor seems to be succeeding at such a surprising rate."

Do some homework:

Some advisors claim that certain investments are "limited time only" deals, and although this is sometimes the case, it shouldn't prevent an investor from thoroughly researching an advisor, says John Foster, JNBA's Senior Investment Strategist. Investors can look up an advisor through the Financial Industry Regulatory Authority (finra.org) to see whether there have been any compliance issues or other black marks. He says, "Don't rely on testimonials from other clients without checking them out, either. They could be complete strangers. Instead, check with FINRA, find out if they're licensed with the SEC, really look into this individual."

Another area to check is insurance, Foster adds. All JNBA clients have fraud insurance, and other advisory firms also offer this type of insurance. These policies don't protect against market declines, but they do protect against theft of securities in the case of fraudulent transactions.

Trust your gut:

The bad news is that there's no such thing as easy money. If the markets are down across the board, and someone comes along promising consistently high returns, there's a reason an investor might feel at least a twinge of suspicion.

Langer says, "If you start asking questions and don't like the answers, run away. Make sure your advisor is willing to educate you, and if the performance seems very good, have them explain why it's so good." If an advisor seems to be bobbing and weaving instead of speaking intelligently, he notes, don't be afraid to keep asking for more information. After all, that's a huge part of an advisor's job-to articulate how assets are being used, where they're located, and why they might be lower or higher than the last statement.

"There will always be bad guys," adds Brown. "If people ask the right questions and set realistic goals, they should be fine. They just need to understand there are no shortcuts. If something seems too good to be true, then chances are that it is."

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