How to Spot an Investment Fraud

Excerpted from John F. Wasik, Morningstar

There's rarely a siren going off when you're about to write the check for a fraudulent investment. The scammer may be someone you know, even a clergyman. Like mystery novel characters, they often are the people you least expect.

Yet there are ways to vet an investment before you sign on the dotted line. Some investors are intuitive enough to have a decent "smell test" that they use while others just stay away from things that seem too good to be true.

As people, though, we're hard-wired to trust our advisors (medical, financial, and otherwise), because we can't know everything. But if you don't have the expertise, you can at least arm yourself with a rigorous checklist before you hand over a check.

The first calling card of a scammer is unrealistically high returns. If insured certificates of deposit are only yielding 1.5%, you can be pretty sure that a promised return of 20% is either highly risky, bogus, or front-end loaded with high expenses. Most swindlers make their money upfront, then move on to other investors.

If the investment program offers low-risk, double-digit yields, well above historical averages, then you need to be wary. Remember, traditional stocks and bonds have returned around 8% and 4%, respectively, over the past 80 years. Those are pretty reliable benchmarks.

The pitches for frauds are almost always laced with secrecy and the necessity to act quickly. Documentation such as prospectuses and offering sheets with meaningful details are rare when a scammer is peddling something illegitimate. They thrive because investors don't demand transparency. Their marks don't know what they're buying because they aren't skeptical enough to ask the pertinent questions. Con artists thrive on opaque transactions.

You can usually stop scam promoters in their tracks by finding out whether they are licensed to sell securities. Many aren't. They must be registered with state or federal agencies. You can easily check their status by locating your state securities regulator at the North American Securities Administrators Association. A phone call would take only a few minutes. There's also a broker background check that will show you any disciplinary actions or lawsuits against them. This information can be found on Finra's BrokerCheck. Look to see if they have bounced around from state to state or firm to firm. Have there been any complaints lodged against them?

But even if you get past the smell test and the registration check, and everything looks fine on the front end, investors should remain vigilant. For example, pay attention to the performance reporting on your investments. Do you receive regular statements? Do the statements come at odd intervals (other than monthly, quarterly or annually)? One troubling sign is if the proof of ownership and account activity is provided on a low-quality client statement that arrives irregularly, is incomplete, or fails to match your understanding of the investment.

Ultimately, though, the unwillingness of a broker to answer basic questions might be the biggest giveaway. If they are evasive, won't redeem your money, or simply stop returning your calls, that's the time to call your state securities regulator.

What if you get stuck and can't get your money back? Call your state attorney general and file for arbitration, which every broker offers to resolve disputes. It's often brutally difficult to get any money back once it's gotten tangled in the web of a scam, so your best defense is to avoid them altogether.

Samples of Recent Scams
Here's a summary of some recent scams, many of which play upon headlines and market activity:

• Real-Estate Turnarounds. Scammers have pitched "distressed real estate" as a way to buy undervalued properties. Con artists have seized upon this theme as a way to swindle investors. In February 2011, for example, a Florida man pleaded guilty to fraud after he took $2.3 million from investors in a scheme to buy and refurbish homes. Instead of being given ownership in the properties, the man sold worthless promissory notes at 12% interest. It was a Ponzi scam.
• Energy and Metals Schemes. When the price of any commodity goes up, there are always schemes tied into them. Oil, gas, gold, silver, and other resources are offered through fake "stakes" in mines or wells. One scheme solicited nearly $30 million through a Florida Gold Bullion Exchange. The operator used telemarketing to find his 1,400 victims.
• Life Settlement Contracts. Although there are legitimate ways of investing in the death benefits of other people's life insurance policies, some schemes sell securities in these vehicles. They usually involve bogus promissory notes. Earlier this year, two executives of National Life Settlements, LLC, of Houston were indicted for fraud for selling $30 million in unlicensed notes.