The Securities and Exchange Commission defines a Ponzi scheme as “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.”
The best way to avoid being taken by a Ponzi scheme is to make an effort to understand how the system is supposed to work.
The North American Securities Administrators Association recommends the following precautions:
- Contact your state or provincial securities regulator to see if the investment vehicle and the person selling it are registered.
- Contact your local Better Business Bureau to see if any complaints have been filed against the venture’s promoters or principals.
- Deal only with financial advisers, broker-dealers or financial institutions having a proven track record.
- Ask for written information on the investment product and the business. Such information, including financial data on the company and the risks involved in the investment, is contained in a prospectus.
- Don’t take everything you hear or read at face value. Ask questions if you don’t understand, and do some sleuthing for yourself.
- Steer clear of investments touted with no downside or risk.
But these tips wouldn’t be enough to prevent someone like Bernie Madoff from making a convincing play for your money.
To prevent yourself from falling for a more sophisticated scam, you need to understand the concept of “custody,” which refers to where the funds are housed. Make sure your funds are under the custody of a reputable investment firm such as a Charles Schwab, Fidelity, or Merrill Lynch. You should be able to see your accounts when logging into their website. Financial advisers may be employed by a custodial firm or may be independent brokers. Your funds should be with a large, well-known firm, not in the custody of a broker.
Bernie Madoff was a financial adviser who got away with his fraud because he controlled his clients’ assets and falsified the documentation. If you invest with a financial advisor that generates his own statements, you are at risk.
A financial adviser or broker should only have access to your funds in order to manage them, not to control them. They shouldn’t be able to withdraw funds without your consent. And they should never have the ability to move funds without your awareness.
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