Fraudbook: The Utah Legislature’s Well-Intended but Feckless Ponzi-Prevention Site

Ponzi schemers usually don't hide behind computers, unlike the guys in this line up. Photo By John Lund and Sam Diephus/Getty Images.

Utah state legislators want to make it easier for you to identify fraudsters before you become their next victim. How? Technology! Lawmakers plan to launch a new website featuring a description of every convicted fraudster in the state along with a recent photograph to help you identify them. Now, this Facebook of white collar criminals-which we have dubbed, "Fraudbook"-is no doubt well intended. But we are quite skeptical it will prevent many folks from falling prey to Ponzi schemers. For just one teensy issue, fraudsters likely won't willingly sign up for this (free!) service before they get caught, which is probably when you need this information. That'll happen after they are caught, sentenced and released.^[i] Which brings us to some good news and some bad news.

• Here is the bad news: Fraudsters and Ponzi schemers still exist in America, and the good times-like the present big bull market-are when they make most of their hay.
• Here is the good news: It isn't difficult to make yourself an extremely difficult dupe.^[ii] You don't need Fraudbook^TM.

To understand why it's fairly easy to protect yourself, understand how these crooks generally operate. Here is a simple, four-step explanation of how most Ponzis "work":

1. Identify person/people with money.
2. Get person's trust and access to their money. Steal it.
3. Confuse them so they don't see what's going on.
4. Ensure there are more people with money to prey upon to be able to cover earlier victims' withdrawals and keep the Ponzi afloat. Lather, rinse, repeat.

Yes, in real life, the details are frequently more complicated. Shell corporations, fake investment products, big promises and complicated, jargon-packed, flashy-sounding strategies abound. But you needn't know much, or even any, of that to protect yourself.

First, the would-be Ponzi schemer must identify a pocket of people with deep pockets, preferably one he or she can easily curry favor with. This is why so many Ponzis are perpetrated against family, friends, affinity groups the criminal belongs to, church and religious organizations and more. This is the Ponzi schemer targeting an audience of people they believe have money. Now, we aren't saying you should never invest with someone in your religious organization-but you shouldn't suspend skepticism or due diligence because of that. The connection should be irrelevant to your hiring decision.

Second, the Ponzi schemer must win your trust and get access-usually accomplished by taking direct custody of your money in a pooled account they have access to. A large part of this is related to step one. After all, if you are familiar with someone on a personal level or if they have a commonality with you, it's easier for them to build confidence and trust. In addition, some behavioral research suggests merely knowing a person does business with family or well-known charitable organizations will build trust in strangers. But acting on this presumption basically lets these other people do your due diligence for you-a poor idea, as "feeder funds" clearly show.

Third, the Ponzi schemer must confuse you, usually employing a bit of rhetorical magic involving jargon and flashy-seeming strategies. For Madoff, it was Split-Strike Conversion-a strategy involving hedging he claimed yielded consistently, impossibly positive and above-market returns. The fraudster's practice attempts to stoke your greed, quell market-related fears and turn off your skepticism by blinding you with jargon and tricks.

Finally, since Ponzis operate by stealing from new investors to replace funds already stolen, a fraudster must find a consistent stream of new money. This is why so many Ponzis were uncovered after 2008-why Madoff and Stanford couldn't keep up their decades-long ruses. Amid the financial panic, investors' skepticism of the financial world was high and many were frozen in place. The allure of higher returns and complex strategies wears off when panic-driven sentiment values return of money over return on money. Hence, the flow of cash to these frauds dried up. The bear market brought these conmen to justice after bull market returns facilitated their fraud for years. Today, the fact Ponzis largely aren't front-page news doesn't mean they don't exist. (Here is a list.) Most schemes are probably still able to find victims.

So how to protect yourself? Simple! Start by eliminating step two. If you do not give an adviser custody of your assets-instead keeping the funds segregated at a major brokerage house-they have few opportunities to dip into your money. Second, make sure you have reasonable expectations. High returns come with high volatility and a risk of loss! Risk and return are married at the hip, and no amount of adviser wizardry and flashy tactics are going to undo that. High returns must have risk, and if the adviser has been in business for more than a few years, they likely have some periods of negativity. Similarly, your adviser should be able to explain their strategy to you in terms you understand. Last, remember: Do not cease due diligence because of a personal relationship.

We are all for plans like the Utah legislature's, which may help some folks. But realistically, most of these efforts are likely too backward-looking to protect you. Ultimately, you are the only person who can successfully ward off a Ponzi schemer. Heck, even Fraudbook^TM requires you to look .

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