On a summer afternoon in Boston in 1919, a middle-aged businessman opened a letter. What he found inside would lead to one of the largest financial frauds of all time. His exploits are so (in)famous that his name lives on today when we come across similar “Ponzi” schemes.
Fast forward 100 years. Michael Carter, a Morgan Stanley financial advisor, pleads guilty to federal charges of wire fraud. Over the course of 12 years he funneled $6 million of client funds into his own accounts.
While the two men defrauded investors differently, they both abused their positions of trust for personal gain. 100 years after one of the greatest financial scams of all time, investors can still fall prey to unscrupulous financial advisors.
How did Charles Ponzi and Michael Carter take advantage of their clients? How can you reduce the risk of becoming a victim of financial fraud? I’ll attempt to answer both questions in this article. Full disclosure: I have been a Registered Investment Advisor since 2012. Prior to that time, I worked briefly as a broker at Morgan Stanley Smith Barney.
Ponzi’s Scheme
The most famous investment swindle of all time began with a stamp. Charles Ponzi, the eponymous creator of the crime, devised a brilliant idea while opening his mail in the summer of 1919. A Spanish businessman had written a letter to Ponzi and enclosed an international postal reply coupon. He hoped Ponzi would exchange the Spanish coupon for a U.S. postage stamp to make it easier for him to send a return letter. Due to a lack of regulations and differences in foreign exchange rates, consumers could purchase the coupon in Spain and exchange it in the U.S. for a more valuable stamp. Ponzi discovered what finance professionals call an arbitrage opportunity – buying an asset in one currency and selling it for a profit in another.
The profit was riskless and fairly substantial – estimated at about 10% at the time. But Ponzi was unsatisfied with this investment return and set his sights on a more lucrative plan. He would sell the idea of a risk-free, high-profit investment to other investors. He created his own company, the Securities Exchange Company, and lured investors with promises of outrageous returns. The idea made him rich practically overnight. He bought a mansion in Lexington, Massachusetts and earned an estimated $250,000 per day!
In reality, Ponzi was not investing client funds at all. He simply took money from new investors and paid it out to earlier ones. This is the hallmark of a Ponzi scheme.
But Securities Exchange Company’s days were numbered. On August 12, 1920, just a year after concocting his scheme – Ponzi was arrested following investigations by The Boston Post. He went to prison for 14 years and died penniless in Rio de Janeiro, Brazil in 1949 – but not before writing a tell-all autobiography.
Following in the footsteps of a crook
Ponzi’s scheme was bound to fail eventually, as all Ponzi schemes are. The racket can only continue as long as there is a steady flow of new customers to pay existing ones. Once new cashflows dry up, the scheme collapses. In some cases, Ponzi schemes can go on for a long time. For example, Bernie Madoff perpetrated the largest Ponzi scheme in history. It survived for at least 17 years and resulted in losses of $65 billion.
But advisors can defraud their clients in other ways. In July, 2020 Michael Carter pleaded guilty to stealing over $6 million from clients. In 12 years, he made some 50 unauthorized transfers in client accounts by forging client signatures and falsifying financial statements. Like Ponzi, he used the misappropriated funds to enrich himself and fund a lavish lifestyle.
Carter’s scheme might have continued for many more years had it not been uncovered by chance. While applying for a short-term loan to cover relocation costs to an assisted living facility, an elderly client discovered Carter had taken out an $800,000 loan under her name without her knowledge.
How to protect yourself from financial fraud
Cases like Carter’s remind us that investment schemes continue today. And while it may be impossible to safeguard against all possible financial fraud, there are steps you can take to substantially reduce the risk. The suggestions below can help you make smarter decisions when working with a financial advisor. The Consumer Financial Protection Bureau’s website covers a wide range of fraud and scams and provides some very useful advice.
Insist on an independent custodian
A major function of custodians like Fidelity or Charles Schwab is to safeguard client securities. A custodian is independent when the company is separate from your financial advisor, making it difficult for your advisor to conceal transactions. Your financial advisor also monitors the custodian, ensuring clients are paying reasonable fees. When your financial advisor and independent custodian are different firms, they each prepare their own statements and reports, essentially checking each other’s work.
Review statements regularly
Make it a point to periodically review your statements. Fraudsters operate in the dark and succeed more easily when nobody checks the numbers.
If you have an independent custodian, you should either receive statements in the mail or be able to easily log in to the custodian’s website to view them. Compare your custodian’s statements against those from your financial advisor. If there are material discrepancies, hire an outside expert to review the numbers.
If you do not have an independent custodian, at the very least make sure you can log in to the custodian’s website and review online transactions, which are generally more difficult to manipulate than paper statements.
Check your advisor’s background
Both the Securities and Exchange Commission (SEC), the federal regulatory agency responsible for protecting investors, and the Financial industry Regulatory Authority (FINRA), have online search tools you can use to confirm whether an advisor is registered and to review their record. Use the SEC’s Investment Advisor Search if your advisor is a fiduciary or FINRA’s BrokerCheck if you work with a broker.
While a background check wouldn’t have caught someone like Michael Carter or Bernie Madoff, a history of client complaints or disciplinary action should raise red flags.
Understand your fees
Knowing what you pay your advisor not only makes you a more educated investor, but also reduces the likelihood of becoming a victim of fraud. When you know how your advisor is compensated you know what to expect on your statements and you are more likely to spot an anomalous transaction.
Understanding your fees, however, can be complicated. First, there are numerous types of fees and they are not always explicit. While an invoice for a financial plan or ten hours of analysis is probably easy to understand, things like commissions or sales loads are more difficult. You have a right as a consumer to know what you are paying. Thoroughly understand whether your advisor will earn a commission (and how much) if they recommend a financial product like life insurance or an annuity. Ask the advisor for a detailed breakdown, signed and in writing, especially if the product is complex. If your advisor will not do this, it’s probably a good idea to avoid the recommendation.
Second, understanding fees is further complicated by the fact that financial advisors are compensated in many different ways. Registered Investment Advisors (RIAs), who are regulated by the SEC or state securities regulators and are held to a fiduciary standard, are frequently “fee-only”. They are compensated exclusively by fees paid to them from their clients. By contrast, brokers are regulated differently and are subject to a best interest (formerly, suitability) standard. Many brokers are “fee-based” or work on commission. That means investment and insurance companies pay for some or all their compensation for selling their products. Working with “fee-based” or commissioned advisors will likely make understanding your fees more difficult. Regardless of what type of advisor you work with, you should ask (at least annually) for a fee summary, in writing, which outlines all fees that your advisor receives from working with you.
Freeze your credit and/or monitor your credit
A credit freeze restricts access to your credit report(s). This means that even someone with access to your personal information would not be able to open a new account in your name, such as a bank account or a line of credit. Many professionals recommend freezing your credit if you do not plan to open any new accounts or apply for credit in the near term. The FTC’s Credit Freeze FAQs website contains very useful information, including how to place a credit freeze at the three major credit bureaus and how to lift a freeze in the future. I wrote about freezing credit previously in the Sensible blog.
An alternative to a credit freeze is credit monitoring. Services such as Privacy Guard and Credit Karma notify you of changes to your credit reports as they occur. While a credit monitoring service cannot prevent fraud before it happens, it may give you the tools to react before it’s too late.
Finally, everyone should review their credit reports at least annually for suspicious activity. You can do so for free through the official website https://www.annualcreditreport.com/.
Be wary of investments that sound too good to be true
A good rule of thumb is If it sounds too good to be true, it probably is. Ponzi and Madoff lured investors with promises of huge returns with little or no risk. In the real world, if you want higher return you have to take more risk. If you want a low-risk investment, you must accept a lower return.
Unfortunately, financial fraud will be with us so long as people want to get something for nothing. Fortunately, you can take a few relatively simple steps to significantly reduce your risk of being scammed.