Patricia Foster, BridgeTower Media Newswires
Schemes, scams and swindles have continued throughout history. A recent example of investment fraud with a local nexus underscores the importance of a rigorous due diligence process when selecting a financial services professional or when evaluating products and services offered by one. This column considers ways that you can sidestep bogus “investment opportunities” presented by scammers.
Last month, Perry Santillo, 39, of Rochester pleaded guilty in Federal District Court for the Western District of New York to conspiracy to commit mail fraud, mail fraud, and conspiracy to launder money, in connection with his role in masterminding a nationwide, multimillion-dollar investment fraud. Santillo is a named defendant in at least two other federal court proceedings, including one brought by the United States Securities and Exchange Commission.
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SEC allegations of investment fraud
The SEC alleges that, over a period of eight years, Santillo and his co-defendants raised more than $102 million from at least 637 investors across the United States. According to the SEC’s complaint, Santillo and one of the co-defendants purchased books of business from retiring investment professionals. The scam allegedly got under way when they persuaded their newly acquired clients to withdraw their savings from traditional investments and invest the proceeds in companies that they controlled, falsely claiming that investors’ money would be used to operate businesses in various fields such as financial services, insurance, real estate, and medical laboratories.
The scheme, as outlined by the SEC, involved the co-mingling of funds by investors in various offerings, and the transfer of those funds through multiple bank accounts controlled by the defendants. The complaint alleges that, of the $102 million raised by the defendants, most of funds provided by investors were either misappropriated by the defendants to fund lavish lifestyles or were paid to early investors in an effort to create the illusion that their investments were legitimate.
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Classic Ponzi scheme
The investment fraud alleged here is customarily referred to as a Ponzi scheme. Charles Ponzi, an early perpetrator of this type of scam, was a charismatic charmer who, in the summer of 1920, offered Bostonians 50 percent interest for the use of their money for short periods of time — between 45 and 90 days. This extraordinary return was supposedly made possible by “arbitrage” in an obscure financial instrument, international postal reply coupons. The funds obtained from investors were never actually invested. Early investors were paid by funds provided by new investors. The scam collapsed when the influx of new funds could no longer meet maturing obligations owed to existing investors.
Ponzi scheme organizers often promise to invest money in instruments that will generate high returns that are not available through traditional investments and will involve little or no risk. The risk/return profile of these investments never favors the investor because the so-called “investments” involve an extraordinarily high degree of risk and may not provide investment returns at all. That’s because, in many instances, the fraudsters do not actually invest the funds obtained from investors. Instead, they use funds obtained from new investors to pay those who invested earlier, and they may misappropriate substantial portions of the funds. The SEC claims that Santillo misappropriated at least $13.4 million to fund a jet-setting lifestyle which included commissioning a song about himself to be played at a party in Las Vegas. Because there are no investment earnings, Ponzi schemes require a constant flow of funds from new investors to survive, and eventually collapse.
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How to spot a scammer
There is much that you can do to screen out individuals and firms that do not deserve your trust.
Look beyond the business card. Check the background of the individual and the firm with which he or she is associated. Investigate the background of a registered representative (of a retail securities brokerage firm) on FINRA’s Broker Check website. Investigate the background of an investment adviser representative (of a registered investment adviser) on the SEC’s website. If the individual provides investment advice, ask for the advisory firm’s Brochure and his or her Brochure Supplement. The Brochure Supplement will provide the name and telephone number of the individual’s supervisor. Ask for referrals, and check any referral sources provided.
Consider the circumstances under which you are approached by an individual who seeks to garner your trust and sell you a product. Members of ethnic and religious groups can be vulnerable to frauds perpetrated by individuals who share the same ethnicity or religious affiliation. Scams perpetrated by those who exploit common demographic characteristics come within the “affinity fraud” category. For example, Bernie Madoff cultivated Jewish investors for his fake hedge fund.
Consider whether you are being offered an investment product or an investment service. Ask the individual to explain the product or service thoroughly, and to provide detailed information. If you don’t understand the product or service, stop! If investment returns are guaranteed, stop! If responses to your questions are evasive, stop!
Ask the individual who seeks to sell you a product to provide a thorough explanation of the custody arrangements. Is the custodian an independent and credible institution? Ask who will provide account statements and at what intervals they will be delivered. Ask whether you will receive audited financial statements.
Recognize that scammers typically sell interests in companies that they control. Generally, these companies are not sufficiently capitalized and may not be engaged in any legitimate business. Whether the instruments offered consist of debt (promissory notes) or equity (stock), these instruments are typically not registered securities that can be traded in the marketplace. Securities sold in private placements (i.e. in reliance on an exemption from the registration requirements of the federal securities laws) involve a high degree of risk and have restrictions on resale. The issuer’s exit strategy, if there is one, may never be implemented, and, if you invest, you may have to hold a worthless, unregistered security indefinitely.
Recognize that Ponzi scheme organizers typically operate outside the traditional, mainstream financial services industry. Scammers may not even be affiliated with a firm that is registered as an investment adviser or broker-dealer. Moreover, individuals who have been barred from the industry may continue to operate without the requisite registrations and licenses.
Once you have established a relationship with a financial services professional, it is important to understand what types of accounts have been established, how the accounts are invested, how the accounts are performing, and where account assets are held by a qualified custodian. If you are approached by an individual who appears to be operating outside the mainstream, be sure to discuss the “investment opportunity” with your financial advisor. Remember that a single investment product does not constitute a complete investment program. These questionable “investment opportunities” are well beyond the scope of a typical retail investor’s risk tolerance.
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New investor protection initiatives
Beginning on July 1, 2020, financial services professionals associated with registered broker-dealers and registered investment advisers will be required to provide retail clients and prospective retail clients with a Client Relationship Summary (Form CRS). Adopted earlier this year as part of the SEC’s new standards for investor protection, Form CRS is a disclosure document that is intended to reduce investor confusion about fees, conflicts of interest and the required standard of conduct for the particular firm. Caveat emptor!
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Patricia Foster is a securities law attorney who represents clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. The information in this article is provided for educational purposes and does not constitute legal or investment advice.
