Despite numerous high-profile examples of investment fraud, it seems the scam is always with us. Therefore, CPAs must make sure they know which red flags to look out for when giving a client advice.

The Boys in the Bust

In 2008, two men — one American, one Canadian — catapulted investment fraud into headlines around the world.

The American was 70-year-old Bernie Madoff, who for years had operated a massive Ponzi scheme that cost his many investors billions of dollars when it collapsed. In 2009, Madoff pleaded guilty to 11 felony charges, including fraud, and was sentenced to the maximum punishment — 150 years in prison.

The Canadian was 67-year-old Earl Jones (see Humanizing the Victims of Fraud), a Montreal native who bilked 158 investors, including his cancer-stricken brother, his own daughter and other family members, out of $50 million. Like Madoff, Jones had managed to get away with his Ponzi-type schemes for a long period of time, about 30 years in his case.

Both men were by all accounts charming and seemingly trustworthy. Their intricate financial webs, which they kept going for so long, became undone by something beyond their control — a sudden downturn in the economy. When many of their clients decided to cash out their investments, the financial house of cards the fraudsters had so carefully built could no longer remain standing.

Investment fraudsters are by no means all cut from the same smooth cloth. They come in every size and shape imaginable. And they are far more prevalent than the average person likely imagines.

For every Madoff or Jones, there are thousands of fraudsters trying to separate gullible, and often greedy, individuals from their savings. This was made patently obvious by the results of Operation Broken Trust, a U.S. federal investigation organized by President Barack Obama’s Financial Fraud Enforcement Task Force in 2010.

Operation Broken Trust, the first U.S. nationwide initiative to combat investment fraud, was established in the wake of the financial crisis of the time. The objective was to nab fraudsters who preyed on the general public. The results of the Justice Department’s undertaking, which spanned only three-and-a-half months, shocked the investigators.

In early December 2010, U.S. Attorney General Eric Holder announced that criminal and civil charges had been brought against more than 500 people. The schemes exposed by the investigation had defrauded thousands of investors out of $10.5 billion. “These are staggering, staggering numbers,” Holder said. Prior to his news conference, 87 people had already received prison sentences; several were given more than 20 years. One defendant received 85 years in prison.

The investigation looked at more than 120,000 cases of fraud, including Ponzi schemes, foreign currency fraud, investment scams and market-manipulation. Holder noted that the fraudsters targeted communities, churches, immigrants, the elderly and the disabled.

The Justice Department said that in some cases church members exploited their fellow worshippers. One man in Texas offered his congregation lucrative foreign exchange rates he said were a “blessing from God.” Fraudsters often targeted friends and coworkers. In one example, a police officer lured other members of his force into a Ponzi scheme.

Operation Broken Trust was a joint effort among Justice, the U.S. Postal Service, the Commodity Futures Trading Commission and the Securities and Exchange Commission. Robert Khuzami, director of the SEC’s enforcement division, said that while Wall Street banks have received the biggest fraud headlines, hundreds of other scams devastated working families and retirees. Indeed, investment scams ensnare victims of all stripes, and their losses can range from small amounts to many millions of dollars.

Telltale Signs

Although it’s impossible to prevent all potential victims from being scammed, there are many telltale signs an investment opportunity might not be legitimate. If advisers are aware of what to look for, they should be able to help clients avoid losing money unnecessarily.

Large-scale investment frauds typically promise investors unrealistic returns. One example featured a slick-talking con man — most investment fraudsters are male and many have the gift of the gab — who somehow convinced a large number of Toronto-area residents that he could get them returns of 20% or higher in a scheme involving the sale of high-technology components to countries in the developing world.

He met his prey at several business networking events, where he casually mentioned the investment opportunity. When some showed an interest, he first feigned reluctance to share his good fortune but gradually relented. Professing a dislike for office meetings, he suggested they have breakfast gatherings at a local, low-scale diner. At the breakfasts, the impeccably dressed con man slowly spun a tale of incredible sales and amazing profits.

To be eligible for such a windfall, he said, they all had to pay a nonrefundable enrollment fee of $2,500. Once they anted up, he played them like a cult leader, making them believe they were a specially chosen and elite club, one that was about to become incredibly wealthy.

Then he announced the deal was happening faster than scheduled. If they wanted in, they had to invest immediately. A couple of the group members balked, saying they needed time to conduct due diligence. Some mentioned they had been cautioned by advisers and friends that the opportunity sounded too good to be true. No adviser, however, had aggressively warned them to walk away from the deal.

The con man quietly agreed with the dissenters. He urged them to leave the group. He said there were many others waiting to replace them. He even offered to return their enrollment fee. His gambit worked. No one left. Within days the con man received $7 million in total from the investors. Within a week he had disappeared with their money.

Although some of the advisers had voiced concerns about the deal, they had not done more than offer a few words of caution. However, this scheme had so many red flags they should have considered an intervention to protect their clients.

In addition to the promise of unreasonably high returns, the breakfast meetings were an indication that something was wrong. Although the con man had cards and letterhead for an office in a downtown high rise, it was no more than a mail drop-off box. And who would invest large sums of money with someone who only held meetings at a greasy spoon?

The man’s background was dubious. He had a website that glowed with his accomplishments and recommendations from previous investors. But apart from the website, there was nothing about him in the main Internet search engines. That was a result, he explained, of his penchant for privacy and his policy of offering opportunities only to small and exclusive groups.

In truth, he had no real track record or credible financial credentials. Any meaningful due diligence would have unmasked him as a fraud.

The other major red flag was the ticking clock. Like many a movie plot, a con man’s story often includes an impending deadline. Whenever an investor is told it’s now or never — leaving no time for effective due diligence — the investor should immediately step away from the deal.

It’s possible, however, that investors would not have listened to anyone who challenged the legitimacy of the deal. Greed can be blinding. But none was directly told that this sounded like a scam. And none was confronted with any evidence that might have shaken their faith in the con man. However, a visit to the purported office, which was a short walk from where some of the advisers worked, likely would have provided enough cold water to throw on an investor’s raging desire.

Friends with Your Benefits

As one forensic accountant likes to say, when it comes to family and friends, keep your checkbook separate.

That’s because not all individuals spinning scams are strangers to their victims. Many, like Earl Jones, are trusted friends and even, at times, family. Understandably, it might seem awkward or uncomfortable conducting effective due diligence on a close acquaintance for fear of offending him. “Are you saying you don’t trust me?” the acquaintance might respond. But if the deal is legitimate and the person presenting it is professional, the response should be to welcome the scrutiny. Any attempt to dissuade meaningful inquiry should be taken as a bad sign and an incentive to dig into the person’s background and claims even more diligently.

Jones ingratiated himself into the lives of his victims. He was someone people easily liked. He was also not qualified to invest their money. A quick check of his background would have revealed that he was not a certified financial planner, contrary to what he claimed.

Fraudsters tend to be expert at reading human nature and know how to take advantage of a person’s weaknesses. One such trait they like to exploit is vanity. When touting a scam, one approach is to couch it in difficult-to-follow language that makes it sound incredibly impressive. “Unlike a lot of people, you understand how this all works,” they will say, or words to that effect. As soon as the victim nods in agreement, the bait has been taken.

As an adviser, make sure you and your client are completely clear as to what a potential investment entails. If not, warn your client to stay away from it. No legitimate investment should be unclear in any way. All risks should be understood and closely assessed.

If the client is being offered exceptional returns and has been told the individual or firm making such claims has a history of similar achievements, do not take the assertions at face value. A red flag in the Madoff case was that his reported performance was too good to be true.

If the returns are far above industry norms, follow the advice of the CFA Institute: “Find out if the firm has its reported performance numbers independently audited, who audits them, and whether these figures comply with Global Investment Performance Standards, a set of ethical principles for calculating and reporting investment results.”

While a client should not automatically avoid investing with an individual or a small firm, the risk, understandably, is greater than when doing business with a large entity that is subject to oversight. For that reason, thorough due diligence is even more critical when considering a deal when there are no safeguards if the deal turns out to be fraudulent.

A transaction involving a broker or a financial institution affords some degree of protection. The institution might make restitution or the victim could seek recourse from bodies such as the Investment Industry Regulatory Organization of Canada or the Canadian Investor Protection Fund, which provides insurance for investors who lose money in a transaction involving a CIPF member.

Doing business with a seemingly respected broker does not guarantee that investment fraud won’t occur. There are too many cases of brokers misusing clients’ money to dispel that notion. In many instances of broker fraud, the evidence shows that the clients paid scant attention to what was happening with their account.

One red flag to watch out for is if the broker, and not the firm, is sending out the account statements. A client should also be careful not to sign any papers sent by the broker without obtaining professional advice on what the papers state. This is especially true if the client is elderly. And, needless to say, a broker should not be allowed to make transactions without a client’s authorization. If such a relationship exists, especially if a bond of trust has developed between a broker and client over the years, it needs to be curtailed. Sometimes, an outside adviser can help such a change take place by presenting it as a matter of business practice and not as a personal slight to the broker.

Too often the lure of easy and quick money trumps common sense. That’s where an adviser can play an essential role by pointing out the red flags, providing, of course, that the adviser doesn’t also fall for the pitch.

From Uncovering Fraud: True Stories About Fraud, Fraudsters & How They Got Caught by David Malamed, edited by Paul McLaughlin. This column was first published in June/July 2011.