Investors in a US $260 million Ponzi scheme run by former boy-band promoter Lou Pearlman will soon get a little of their money back, the Orlando Sentinel reports. The bankruptcy trustee in the case will distribute $10.4 million to hundreds of investors duped by Pearlman's scheme — which amounts to about 4 cents on the dollar. Pearlman was convicted of fraud in 2007 for luring individuals and banks to invest in Trans Continental Airlines Travel Services Inc. and Trans Continental Airlines Inc., both of which existed only on paper. He used falsified U.S. Federal Deposit Insurance Corp., AIG, and Lloyd's of London documents to win investors' confidence in his "Employee Investment Savings Account" program and faked financial statements created by a fictitious accounting firm, Cohen and Siegel, to secure bank loans. Pearlman is serving a 25-year prison sentence.
Not surprisingly, Ponzi schemes such as the one operated by Pearlman continue to persist in a "post-Madoff" world. Impoverished investors typically only recover pennies on the dollars they gave to fraudsters — on average 10 cents to 12 cents on the dollar, says Joe Borg, former president of the North American Securities Administrators Association, in the Orlando Sentinel report.
Internal auditors already may be familiar with many of the tell-tale flags of a Ponzi scheme. These include: promised high investment returns with little or no risk, overly consistent returns, secretive or complex investment strategies that are not easily understood, "conspicuous consumption" by fraudsters, issues with paperwork, and difficulty receiving payments.
But what can be done to detect or deter such schemes sooner? Above all, businesses and individuals should use all of today's investigative due diligence resources — including audit and fraud investigation techniques — to avoid becoming another statistic tomorrow. One way is to conduct quantitative due diligence on a potential investment and investment adviser/broker/hedge fund manager (e.g., reviewing financial statements and understanding the investment scheme).
Here are some additional tips on how to detect an investment-related fraud from a due diligence investigation perspective:
"Googling" is not due diligence.
A typical search engine accounts for less than 1 percent of what is actually on the Internet. The next time they are searching online for a particular person or company with few results, auditors should consider that the more successful and more complicated the particular scheme has become, the more likely the fraudsters will "bury" any derogatory or damaging information about themselves.
Value references, but check them anyway. Professional attestations used to create the aura of respectability, but those referred to you by a respected member of your community should be treated with the same scepticism as anyone else. Affinity frauds — investment frauds that prey on an identifiable group, such as in the Madoff case — have increased in recent years. Former investors, employees, and business associates can provide critical details that may not be found anywhere else. A fraudulent promoter may claim that the government or an industry guardian has reviewed the program and approved it or found nothing wrong with it, or state that it has been endorsed by industry professionals. They also may provide other attestations, including legal opinions — such as stating that the investment product is not a security — and accounting opinions, such as a "clean" audited financial statement.
Look for unregistered investments and unlicensed sellers. Ponzi schemes typically involve investments that have not been registered with the U.S. Securities and Exchange Commission or state regulators. Registration is important because it provides investors with access to key information about the company's management, products, services, and finances. Similarly, federal and state securities laws require investment professionals and their firms to be licensed or registered — many Ponzi schemes involve unlicensed individuals.
Review litigation. Historical civil complaints filed by current or former investors often are the first warning sign of trouble. Federal and state litigation searches also can identify potential red flags such as divorce petitions and harassment lawsuits concerning conflicts with former employees, employers, suppliers, or business partners.
Research criminal and Department of Motor Vehicle records.
Fraudsters can have criminal records or a history of alcohol abuse, which could be easily identified during a routine background check.
Confirm service providers.
Outside accounting firms and fund administrators, who are "independent" third-party providers, provide an important buffer between the investment managers and their victims. But these independent providers may not be so independent after all and actually can be aiding in the scheme. For example, Bernie Madoff used an unusually small two-person accounting firm to manage his billion-dollar hedge fund; the firm later was implicated in fraudulent activities.