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Due Diligence Checklist To Prevent Investment Fraud

Investigators and prosecutors cannot protect you from investment fraud. Even with secured, regulated investments you should always assume that fraud is a possibility. The front-line of defense against investment fraud is an educated and skeptical consumer. You must protect yourself. That is why due diligence is necessary.

The reason investment fraud succeeds is because people are lured into emotional decisions by the con artist without first completing their due diligence. Due diligence is what forces you to look behind the façade, uncover the facts, and make a well reasoned decision; however, due diligence takes time and effort. The sad reality is most people spend more time planning their vacation than they spend on investigating their investments.

“Let the fear of danger be a spur to prevent it; he that fears not, gives advantage to the danger.”

Francis Quarles

Con artists are different. They do their homework first. They learn persuasion techniques designed to convince you to buy on faith without investigating. They study the characteristics of affinity groups to create a sense of trust and common bond. They have well-rehearsed answers to common questions. In short, they are professionals out to get you.

If it’s worthwhile for the con artist to spend so much time and energy preparing a strategy to scam you out of your money wouldn’t it make sense for you to spend a little effort to prevent his success? Below is a step-by-step due diligence process to help protect your portfolio from investment fraud. Each step in the process becomes increasingly difficulty for the investment to pass and increasingly more cumbersome for you to apply. For that reason, start at the beginning because few investment frauds can pass even the most basic tests. This will keep things simple and only require you to implement the more detailed due diligence questions on rare occasions.

Investment Fraud Prevention – The Business Common Sense Test

The first thing to notice about investment fraud is it’s usually promoted by promising a high return on your investment. Easy money, get-rich-quick returns are almost universally appealing to less experienced investors. It is a powerful sales tool. But do returns in excess of market rates pass the business common sense test – our first test for investment fraud?

The reality is investing is nothing more than the application of capital to business. As a result, the return on your capital must be consistent with the laws of a competitive business environment. The high returns must make business sense.

“Nature never deceives us; it is we who deceive ourselves.”

Jean-Jacques Rousseau

Above market returns only make business sense if a competitive advantage exists that you can exploit but other potential competitors cannot. The reason is because excess return on capital (above market rates) will always attract sufficient new capital to lower those returns back in line with the expected risk. It’s called competition, and the only time it doesn’t hold true is when artificial barriers limit capital inflows or a proprietary investment edge exists that can’t be exploited by competitors.

Below are two questions to help you address the business common sense test for any investment:

(1)   How exactly does this investment strategy create above market returns? What is the competitive advantage?

Ask yourself if the answer you are given is complete, thorough, and makes business sense. Is the answer is glib, laced with jargon and techno-babble, or is it simple and straightforward? Do you understand the competitive advantage well enough to explain exactly how it works to someone else? If you can’t explain it then you don’t understand it.

(2)      What are the barriers that will lock out competitors so that additional capital and supply doesn’t force returns down to market level?

There must be a legitimate business reason that returns will remain excessive. Again, does the answer pass the common sense test or does the explanation sound like something from the Top 24 Warning Signs of Investment Fraud? Can you explain the reason why to a friend in every day language?

Fully exploring these two questions should help prevent investment fraud right from the beginning. In order for an investment to pay you above market rates of return it must have a competitive advantage and barriers to competition. If it doesn’t then it can’t pass the business common sense test for legitimately offering above market rates of return.

How The Sales Person Reacts To Your Due Diligence Questions Is An Important Clue

As you begin asking due diligence questions it is important to notice the quality and tone of the sales person’s response. This can provide you with vital clues to the quality of the investment he is peddling.

Serious questions are a symptom of a serious buyer and honest salespeople know it, welcome it, and respect it. They have nothing to hide so they will attempt to simplify their answers so you can understand the investment and make an informed decision. Buying investments should be a professional, businesslike experience – not warm and fuzzy like a trusted friend nor too cold and abrasive like a distant competitor – but just right like a professional you respect.

“Never value the valueless. The trick is to know how to recognize it.”

Sidney Madwed

Watch out for the “Friendly Fred” fraud sales tactic where you feel too guilty to ask pointed questions because he’s such a nice guy. After all, how could you not trust such a charming person? Alternatively, the salesperson might become cold and use intimidation tactics to make you feel stupid and derail you from getting the answers you deserve. Excessively warm and excessively cold sales tactics are designed to bring emotion into the sales decision and derail common sense. That is a key point.

Another tactic sometimes used by investment fraud promoters is to respond to your questions with techno-babble terminology so that you become too confused or intimidated to ask more questions. They might claim the investment is too technical to understand or get irritated with your questions.  The purpose is to keep you from looking behind the façade and finding the truth.

What you want is a professional sales environment where a rational, fully informed decision can be made. You want to ask your questions and get straightforward answers. Never allow trust, friendship or emotion to get in the way of that task. It’s your money and investing is serious business.

When you don’t understand an investment it doesn’t mean you are dumb: it just means the investment doesn’t make sense. If they make you feel dumb, then go ahead and be dumb and get your questions answered anyway. Be like “Columbo” from the TV series and be dumb like a fox.

“Blinding ignorance does mislead us. O! Wretched mortals, open your eyes!

Leonardo Da Vinci

Never be intimidated or allow the con man to sidetrack you with flippant answers that lack substance. Con-artists are second only to politicians in evasion and double-speak. Don’t allow their manipulative tactics to derail you from getting behind their façade. Never settle for anything less than a complete and detailed understanding that allows you to make a fully informed investment decision. Drill them until you get the answers you deserve.

It’s your money. You’re taking the risk. You deserve to know what you are getting involved in. Accept nothing less.

Investment Fraud Protection: How Can I Lose Money?

If the proposed investment passes the business common sense test and your sales person is providing reasonable answers to your questions, then the next step in due diligence is to understand all the ways you can lose money with the investment.

Why? Because you can’t understand an investment until you know the risks. Investment fraud is often sold on the basis of high returns with little or no risk, but this sales appeal is pure nonsense.

“Approach each new problem not with a view of finding what you hope will be there, but to get the truth, the realities that must be grappled with. You may not like what you find. In that case you are entitled to try to change it. But do not deceive yourself as to what you do find to be the facts of the situation.”

Bernard M. Baruch

Every investment includes risk of loss and anyone who tells you otherwise is either a liar or self-deceived. There is no such thing as a perfect investment. The investment business is a constant battle between risk and reward. You can’t have one without the other.

I’ve detected investment fraud in hedge funds just by noting track records that were too good to be true. Later discoveries by regulatory authorities verified my suspicions.  I’ve researched thousands of investment strategies and never found an exception to the rule that every investment has risk either in terms of purchasing power loss, opportunity cost, or outright capital loss. There are no exceptions. All investments have risk.

To discover the risk of loss ask the promoter the following questions and don’t be surprised if you have to press hard to get a thorough answer:

(1)      What are all the conditions under which this investment will lose money?

(2)      What is the worst market environment for this investment strategy?

(3)      What assumptions or correlations must remain valid for profits to continue?

(4)      What crazy, impossible to imagine situations would result in losses if they actually occurred no matter how remote the possibility of their occurence?

Until you uncover the risk inherent in the investment strategy then you don’t understand the deal. If the risk doesn’t appear, then the investment is probably not legitimate or you don’t understand it.

Additionally, be wary of guarantees. The more an investment is touted with a guarantee the more I want to know what I am being guaranteed against. Guarantees are frequently marketing tactics designed to make you accept claims at face value, invoke

trust, and make your decision easy so that you don’t look deeper into the issues. Don’t fall for it. There is no free lunch in the investing game.

Because investment fraud is often sold as low or no risk, one of the primary tasks in due diligence is to uncover all the ways you can lose money on the deal. You must know the risk because your objective as an investor is to balance risk with reward. The only way to do this is by fully understanding the risk before ever committing a dime.

Investment Fraud Prevention: Selling To Individual Investors

As a former money manager, I can tell you that selling to many small investors is the most difficult way to gather capital. If you are an individual investor being sold on the next great investment then ask the promoter why he is trying to attract capital from “the little guy” rather than large institutions?

Underlying this question is the logic that it doesn’t make business sense for a legitimately great investment organization to bother with all the marketing costs and headaches of many small investors when they can attract all the capital needed with a lot less hassle by doing business with institutional investors.

“Integrity is the recognition of the fact that you cannot fake your consciousness, just as honesty is the recognition of the fact that you cannot fake existence.”

Ayn Rand

This may not sound nice, but it is the business reality of money management and investing. Great investments will be marketed to large investors because it is the most cost efficient way to raise capital. The little guy is left with the retail level stuff.

The primary reason investment fraud is marketed to individual investors instead of institutions is because individual investors rarely do their due diligence; whereas, institutions nearly always do their due diligence. That makes small investors easier prey.

For that reason, be extra careful when sophisticated or non-traditional investments are marketed to individual, non-accredited, investors in denominations under $100,000. It is another warning sign that should prompt you into even more detailed due diligence as shown below.

Due Diligence Checklist for the Promoter

If an investment made it this far in the due diligence process then it probably merits investigating the background of the promoter as follows…

(1)      Verify that the person and company offering the investment are registered with your state’s securities regulator. You can contact the North American Securities Administrators Association ( http://www.nasaa.org 202-737-0900 ) for local securities regulator’s contact information. Request a copy of the offering from the regulator and determine if there are any complaints or actions recorded.

(2)      Contact the NASDR ( the regulatory branch of the National Association of Securities Dealers http://www.nasdr.com 800-289-9999 ) and the Securities and Exchange Commission ( http://www.sec.gov 800-732-0330 or 202-942-8090) to determine if the company and promoter are registered. Request a copy of their offering and check for complaints and actions filed.

(3)      Determine the state in which the company is incorporated and use the National Association of Secretaries of State http://www.nass.org to find the contact information for the appropriate Secretary of State. Some state’s information may be limited to officers and directors lists, and other states may offer more complete information such as annual financial statement filings or business plans.

“There is danger in both belief and unbelief.”


(4)      Check with the Better Business Bureau http://www.bbb.org  and state attorney general to see if there are any complaints filed against the company.

(5)      Verify all claims of patents, trademarks, and large contracts. Large contract claims can be verified with the counterparty and intellectual property claims can be verified whether completed or pending at http://www.uspto.gov U.S. Patent and Trademark Office.

(6)      Search the internet using your favorite search engine by trying keywords such as the company name, promoter name, investment name and anything else you can think of. What is the buzz? Your goal is to find negative or contrary postings that might refute the promoter’s claims or make you aware of previously unforeseen problems.

(7)      What are the track records, backgrounds, and histories of the person and company soliciting the investment?

(8)      How long has the company been in business?

(9)      Verify the company offices and address by physically inspecting for existence. Prestigious addresses can turn out to be little more than a mail drop location.

(10)  What background information can you obtain about the officers, directors and other key personnel for the investment?

(11)  Review recent financial statements for the company. Have they been independently audited by a reputable accounting firm or are the statements self-prepared?

(12)  Can you obtain a contact list of other investors for further due diligence? Be wary of handpicked reference lists. Determine the credibility of the references by discussing their background, knowledge, and level of due diligence. Just because they are happy investors doesn’t make the investment legitimate: they could be self-deceived.

(13)  Are there any current or pending lawsuits or bankruptcies against the company or any of its officers or directors?

(14)  Determine exactly how the promoter will be compensated by the company if you purchase the investment. How does this compensation compare to competing investments? Above market sales compensation is a symptom of potential fraud.

(15)  Your local library can provide many other resources for researching companies and investments. For example, you can learn about the company, credit reports, lawsuits, judgments, liens and much more. Resources vary widely depending on your library so check with your local librarian.

Due Diligence Checklist for the Investment

Very few fraudulent investments should make it this far in the due diligence process. Most should be weeded out by now. However, here are a few more actions to add to your checklist to flush out the remaining few bad apples…

(1)      Verify that the investment offering is registered with your state securities regulator and/or the Securities and Exchange Commission. Depending on capital and shareholder requirements it may be exempt from SEC registration but should still be required to register with the state. Get a copy of the offering document and read it.

(2)      Beware if the only written material you receive is a glossy brochure. Demand a prospectus and/or other legal disclosure documents as required by law.

(3)      Make sure you will receive regular, written reports updating the investment. Review past issues of investor reporting for completeness, accuracy, and disclosure.

(4)      Determine how the funds solicited for investment will be used? Will the funds be segregated from other accounts available to the business?

(5)      What is the basis for the purchase price of the investment? Does it represent fair value?

(6)      What does it cost to own this investment? Are there any annual fees, holding charges, custodial fees, or hidden charges? Let the promoter know you want a complete disclosure of every last penny required to own this investment.

(7)      What is the liquidity of the investment? Can you sell it whenever you want to? Is there a ready market of buyers? What are the expected transaction costs when selling? What are the restrictions to selling?

(8)      If you’re not confident or lack experience in a particular investment then consider consulting with a third party such as your attorney, accountant or registered investment advisor for a second opinion before investing.

(9)      Maintain a file with all correspondence and notes from conversations. Print a hard copy of all on-line solicitations noting the internet address (URL), time and date. Get all claims, guarantees, and terms of the deal in writing. If it’s not in writing then it’s not real.

Due Diligence Checklist Summary

The con artist’s biggest fear is an informed investor. He doesn’t want you to ask detailed questions; therefore, asking questions is exactly what you should do. Be a cautious and skeptical investor by investigating before you put money at risk.

And if all of this sounds overwhelming don’t despair. Rarely will you have to complete the entire due diligence checklist to flush out an investment fraud. Most frauds won’t make it past the first couple of tests. However, if you are suspicious then this checklist will help you find the information that the con-artist doesn’t want you to uncover.

“We are never deceived; we deceive ourselves.”

Johann Wolfgang von Goethe

When asking your questions never allow a salesperson to rush you into a decision. Don’t be influenced by the charisma, kindness, or enthusiasm of the salesperson. Additionally, don’t take everything you read and hear at face value. The wise investor goes slow enough to ask their questions, reflects on the answers, and gets written confirmation of verbal statements. Don’t be afraid to sleep on your decision for added perspective.

Remember, an ounce of prevention is worth a pound of cure. Due diligence may be a pain in the neck but it is also necessary. It is simply a part of investing. Accept it or pay the price.

Remember, once a con man gets your money then it’s gone forever. The only solution is to do your homework up front so that the con-man never gets the money in the first place.

This article may not be uplifting, but the unfortunate reality of investing is you must be skeptical because fraud does exist. People get cheated every day.

“You may be deceived if you trust too much, but you will live in torment of you do not trust enough.”

Frank Crane

Likewise, there is no value in paranoia because most regulated investments and dealers are honest. It won’t serve you to walk through life believing there’s a con man lurking around every corner ready to steal your money, but it is necessary to be cautious enough to realize that eventually you will turn the corner and stand face to face with a con man.

You must be prepared when that day occurs, and this due diligence checklist should provides the answers you need.

Category: Advisor

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