How to Avoid a Ponzi Scheme

Financial fraud seems to have proliferated in recent years as volatility has increased and as markets go down. In fact, when the market drops and assets levels fall, clients seek to redeem their investments and those redemption notices put schemers on the ropes because they have to come up with the money to return.

That's how Madoff was caught. It wasn't from a whistle-blower, but it should have been.

Now with MF Global under the gun for misusing $1.2 billion in client funds, it's apparent that you not only have to be aware of fraud, but incompetence as well. That's hard to handicap especially in the MF Global situation since Jon Corzine was a former chairman of Goldman Sachs as well as the former governor of New Jersey. MF Global has roots that go back to the 1860s. Another firm, Britain's oldest merchant bank Barings PLC, collapsed in 1995 due to fraudulent trading. The bank was chartered in 1762.

But having Corzine in jail or banned from the securities industry for Failure to Supervise is the door prize when you're a farmer whose missing all his allocated capital for hedging or an emerging fund manager who had a promising career as a Commodity Trading Advisor or Hedge Fund manager.

There has been plenty of testimony regarding MF Global, but no charges have been filed against anyone yet. That may change soon as the prosecutors consider immunity for several key witnesses, especially Edith O'Brien, the firm's former assistant treasurer.

Investors who are victims of crime or financial fraud might have an easier time dong background search in trying to avoid Ponzi schemes before making investments than guessing which bank, Future Commission Merchant, or broker/dealer goes bankrupt.

Kathy Phelps, Esq., co-author of The Ponzi Book with the Hon. Steven Rhodes, is an expert in financial fraud and Ponzi schemes. "Obviously, the best thing to do would be to avoid a Ponzi scheme in the first place, so I advocate completing a great deal of due diligence prior to handing over any funds," she told me during a recent interview. "You'd be surprised how much is actually available to the public."

Phelps represents trustees in such cases and estates when there are funds to recoup from financial fraud.

Surprising or not, there are a great many resources an investor can use to comprise their due diligence before making an investment.

Phelps suggests the following checklist before making an investment:

  • Do a background check or a Google search by the individual's name
  • A simple Google search on James Davis Risher of Sanibel Island, Fla., would have turned up a treasure chest of information. He plead guilty last year of making off with $22 million in investor funds before getting caught while he was boarding a plane to Bermuda. His accomplice in the scheme, Daniel Joseph Sebastian, was found dead April 4 days ago of an apparent suicide. Risher, 61, has since been sentenced to 19 years and 7 months.

    Both men targeted retired teachers and boasted of 14 to 24 percent annual returns possible through their fraudulent investment vehicle. Had any of his victims done a basic background check of his name "James Risher," prior to making an investment, they would have seen that he'd been incarcerated for 11 of the last 19 years.

    There not always that easy to spot, but as you can see, there are plenty of resources to get some basic information before you invest so that you can ask better questions about the managers who are seeking your investment dollars.