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June 2009

Recognizing the Red Flags of a Ponzi Scheme

Will You Be Blamed for Not Heeding the Warning Signs?

It was a simple, one-paragraph, unsecured demand promissory note with a guaranteed rate of return. I was preparing the estate tax return after my client's spouse died in Georgia in 1992. This simple note was the supporting documentation of his wife's “stock market investment.” When I raised my eyebrows, my client described this as his favorite investment. The guaranteed return was several percentage points above market and the regular income provided support and peace of mind. I was concerned that my client believed he owned an investment in the stock market when, in fact, he simply held an unsecured promissory note that depended on the solvency and honesty of the creditor to repay. I called the investment advisor and asked these basic questions: Where were the funds invested? Was there a detailed statement listing the financial assets? What was his investment strategy? In response, the advisor claimed the funds were “pooled” so he would have the flexibility to invest when and where he needed, and his clients could demand his money at any time. The advisor's tone clearly indicated his reluctance to respond to reasonable inquiries. His assertion that my client could demand his money at any time was no reassurance, given the advisor's conflict of interest in simultaneously holding the roles of custodian of the funds, sole record-keeper, investment advisor, and creditor. My antennae went up. A tour of the advisor's small office (with one employee) was unimpressive, and did not reassure me about the operation. In summary, the deal appeared to be too good to be true. I advised my client to demand his money and get out. Unfortunately, my client had only partially retrieved funds when the scheme collapsed. The elderly widower lost all of the principal remaining with the schemer (nearly $500,000), with no ability to replace it. Then things got worse: When creditors filed bankruptcy, the widower had to return both principal and interest for several years, totaling nearly $150,000, to the bankrupt estate of the investment advisor. An odd peculiarity in the federal Bankruptcy Code allows the bankruptcy trustee to seek avoidance (as a “preference” or “fraudulent conveyance”) of any transfers made by the schemer and demand repayment of interest and principal paid to the investors who were duped into “investing” in the scheme. The client then came back to me and demanded to know why I had not made him get all of his money out! (Author's note: Identifying facts above were changed to protect confidentiality).

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