There are many ways to lose money in the financial markets. While some are more pernicious than others, when all is said and done, "A loss is still a loss." But lest we succumb to the truism and merely fade away, we want to discuss one of the most egregious forms of financial loss — fraud.
In the early years of the 21st century, fraud, an offshoot of the third deadliest sin, greed, is alive and thriving. In fact, Wikipedia lists two dozen types of criminal fraud.
Rooted in English Common Law and depending on the jurisdiction, modern jurisprudence requires that nine elements be present to prove that fraud has been committed (see "It is fraud if:"). Quite simply, a fraudster misrepresents a material fact with the intent that the defrauded relies upon that misrepresented fact. When the misrepresented fact is relied upon, damages are caused. Whether fraud is committed or not boils down to "intent." Large or small, all fraudulent financial schemes have one thing in common — there is a victim. Think of the Bernard Madoff Ponzi scheme.
Large and small scale fraud
On June 9, 2009 Bernard Lawrence Madoff was sentenced to 150 years in prison, the maximum allowable after Madoff pleaded guilty in March 2009 to 11 federal felonies following his admission that he had turned his "wealth management" investment advisory firm into a giant Ponzi scheme. Investors ultimately were defrauded of $65 billion in paper assets, the largest fraud in history, with eventual losses estimated at $18 billion.
In early 2011, 12 investors discovered that they may have lost their physical gold and silver investments that were supposedly being held "in trust" by Lawrence Heim, the owner of U.S. Gold and Silver Investments, Inc. a firm located in Portland, Ore. Heim’s legal counsel at that time, Martin Meyers of Sussman Shank LLC, said in early March that "Mr. Heim is claiming business assets of $2000 and is close to bankruptcy."
Also In early March the Portland office of the FBI via a warrant executed a search and seizure at Heim’s residence after FBI representatives suspected "… probable cause that Lawrence Heim devised and executed a scheme to defraud individuals…." It remains to been seen how assets disappeared because the FBI’s investigation was not complete as of this writing and Heim has chosen to make no statements.
As with the Madoff case, some of the U.S. Gold and Silver Investments investors filed civil suits against Heim and his company hoping to retrieve assets.
Losses for the Heim investors to date total several million dollars, hardly on the scale of the Madoff fraud, but still painful for those affected.
While it’s now evident how Madoff was caught and how his investors lost money, some folks would like to know how Heim, supposedly a seasoned gold and silver dealer, could have failed in a bull market in which gold and silver rallied 500% to 700% over a decade. Madoff admitted to fraud. It remains to be seen if Heim committed fraud, but regardless of the intent, the result for investors was the same.
Who to turn to?
What could an investor have done to protect himself against Madoff or Heim?
For about 8,000 Madoff investors who invested directly with Madoff Investment Securities, a broker/dealer, they were protected by SIPC (Securities Investor Protection Corporation), "a special reserve fund mandated by Congress to protect the customers of insolvent brokerage firms," for up to $500,000 per account. But 30% to 50% of Madoff investors, the so-called "feeder-accounts," were not covered by SIPC and never knew they had lost money with Madoff until the firm they had originally invested with notified them. One such firm was The Fairfield Greenwich Group, which poured billions into Madoff’s Ponzi scheme. As a consequence of the Madoff failure, Fairfield’s investors suffered huge losses.
With U.S. Gold and Silver, Heim was not required to register with SIPC or any regulatory agency, just the State of Oregon via a standard business license. The only recourse Heim’s investors could have taken was to have insured their hard assets via a private insurance company the same way they might have insured jewelry or valuable paintings. Investors also could have taken possession of the coins early during a period in which Heim was solvent.
Because some of the Heim investors believed their "contracts" with Heim might have been "securitized," because the contracts were issued serially, they filed complaints with the Securities and Exchange Commission (SEC) hoping to open a path to restitution. But the primary responsibility of the SEC is "enforcement," not asset retrieval. In addition, the agency is highly secretive and is not in the information-sharing business. In fact, if a small investor files a complaint with the SEC, the securities "watchdog" will not contact the investor to reveal how an investigation might be progressing.
We similarly were underwhelmed after calls to the Federal Trade Commission (FTC), whose "principal mission is the promotion of consumer protection." We were left with the distinct impression that the FTC was not interested in investigating such acts as the transporting of gold and silver coins across state lines.
Of the federal agencies we contacted, the FBI and the U.S. Attorney’s Office in Portland proved to be the most helpful.
The Financial Industry Regulatory Authority (Finra) has put together a profile of an "average" fraud victim (see "If you can’t spot the sucker…"). It also provided links to white papers on fraud named: "Psychology of a scam" and "How to protect yourself through asking and checking".
The National Futures Association (NFA) booklet "Scams and swindles," is a guide on avoiding investment fraud. Also, any futures broker commodity trading advisor or commodity pool operator is required (with few exemptions that must be noted) to be registered with the NFA. You can look them up on the NFA’s Background Affiliation Status Information Center (BASIC). BASIC is a web-based system that allows individuals to check the registration status and disciplinary history of every firm and individual registered to conduct futures trading business with the investing public. NFA also puts out "investor alerts" that highlights changes in regulation, potential types of fraud and best practices that your broker/investment advisor should be carrying out. It also provides a list of the resources provided by other regulators (links to these due diligence tools are provided at futuresmag.com/duediligence).
These preventative measures are very important because it is difficult to catch fraudsters and gain restitution once you are separated from your money. In addition, even if an agency provides some help, investor and agency objectives eventually could be in conflict. For example, while it is the objective of the FBI to gain evidence that could result in a criminal indictment via the U.S. Attorney, possible jail time and perhaps a large financial penalty for a defendant, it is not the primary responsibility of the FBI to disburse discovered assets.
In a nutshell, small investors need to do their own due diligence.
Only certain asset classes, like stocks and bonds, offer protection while providing investors some recourse, like arbitration or SIPC. Other classes like physical precious metals have little or no protection.
Also, while a small investor can seek redress through civil action in court, the choice can prove costly, even if assets are discovered and recovered. Federal agencies ultimately took notice of Madoff because his crime was too large to ignore. There also was a very large agency "embarrassment" factor in play that some might say has yet to be erased. For the Heim investors, it remains to be seen what, if any, assets will be discovered during the investigation and if investors ever will recoup lost funds through legal channels.
While there are numerous types of fraud and they continue to grow, there are some best practices that will help you not only avoid fraud, but also the merely unscrupulous or incompetent in the investment world.
Rules for investment protection
1) Do business with reputable investment professionals and reputable investment firms: Someone once wrote that some investors spend less time choosing their investments than they do ordering lunch at a restaurant. Such an investor would be an excellent candidate for market loss or fraud.
As an investor exercises due diligence in the pursuit of the best and safest possible investments, it’s important to seek out professionals and firms with proven track records, with added emphasis on proven. This is where the tools noted above can come into play. Check out the history of your broker or investment advisor.
It also is important to make sure a prospective firm has a history of settling claims equitably. Investors with brokerage accounts at reputable firms are usually covered for up to $500,000 per account through SIPC. When an investor deals with a brokerage firm like UBS or Morgan Stanley, those companies require a new investor to sign an agreement at the outset that would require arbitration of all future disputes. For example, if an account representative makes a representation that is materially untrue, "churns" an account or engages in unauthorized trading, the client can seek restitution through arbitration.
Unfortunately, those investors in Portland who bought gold and silver coins from U.S. Gold and Silver probably will have no such recourse through SIPC or any other agency because most agencies do not want to create what they might perceive as "new law."
2) Diversify: Diversification is a form of portfolio insurance. Selecting only small- mid- and large-cap stocks is not being diversified. True diversification means being invested in multiple asset classes that can offer positive returns in different economic environments.
3) Know your risk tolerance: One trader we talked with recently revealed that he treats the markets as "cash cows." Trading exposure never constitutes more than 10% of the entire value of his portfolio. Of that 10% he will only risk a small percentage on each trade. The other 90% he puts into Treasury bills.
When T-Bill rates were in the 4% to 5% range, the trader knew that if he doubled his 10% through aggressive trading each year his annual return would be somewhere around 14% to 15%. If he lost his 10%, his losses would be minimal. Point is he never risked more than 10% annually.
This may not be the best investment plan, but it is critically important to know your risk tolerance and invest accordingly. Some investors in higher leveraged managed futures programs compound losses further by getting out after a loss because of the shock of a drawdown.
This trader knows what levels of risk he is willing to assume to receive a reasonable annual return and advises all astute investors to make similar assumptions. That way you don’t compound losses by making rash decisions.
4) Exercise discipline: It is one of the sad facts of Wall Street that for decades investors have been told that all they have to do to make money is to "buy good stocks and hold them for the long-term." First, how long is "the long-term?" Second, when you get to the end of a given period of time what do you do next?
One aspect of exercising discipline is to re-evaluate your investment positions frequently. Some even suggest every day. "Is my reason for buying this investment still legitimate and have I protected myself against surprises?" One veteran money manager revealed that despite any reason he may have acquired a position, "If that investment declines 20%, I’m out."
This is sound advice particularly for those trading on fundamentals and whose ego may be involved. Traders should have a definitive price/dollar-based exit level where they get out. Otherwise you can become victim of adding to a loser by thinking if xyz stock was a good buy at $50, it must be an even better buy at $40.
The essential point here is that an investor must have a precise and disciplined exit strategy that he is willing to implement no matter what happens.
5) Don’t get caught up in the story: That’s another way of saying don’t follow conventional wisdom. There’s lots of it out there and most of it’s wrong. Only the market is never wrong. Unbiased and intelligent investment analysis is valuable in direct proportion to its rarity.
6) If it’s too good to be true, it probably is: In Madoff’s case there were early warnings signs that suggested the risk-adjusted rates of return Madoff was claiming were highly unlikely. In one strategy, Madoff claimed to be making big profits trading listed options, but the volume of contracts he was buying in the market in which he claimed to be executing trades could not have supported his results.
Despite early warning signs, in testimony in 2009 Madoff said he told SEC investigators, that "I was astonished. They (the SEC investigators) never even looked at my stock records…. If you’re looking at a Ponzi scheme, it’s the first thing you do."
In Heim’s U.S. Gold and Silver situation, investors should have asked themselves what surety they had that a small coin dealer could deliver on his long-term promises and should have asked themselves how they could protect their assets at the outset.
The primary mandate of a regulatory agency should be to protect the public. But given the profound failure of the SEC to detect and prevent the largest fraud in U.S. history after being handed a blue print of the fraud 10 years prior to its exposition, we wonder how safe the small investor should feel in 2011.
The extent to which Bernard Madoff intentionally defrauded investors may provide interesting footnotes in future financial texts and law journals. Unfortunately such knowledge and the ineptitude of some federal agencies to protect investors will do little to help the defrauded recover lost assets unless they are willing to engage in costly legal actions in civil court aimed at retrieval. This will likely be the same in the Heim situation regardless of the outcome of the investigation.
As a consequence, what is important is what an investor does before investing to the extent he is able to avoid what could be fraud or merely a bad investment that declines in value. Keeping in mind that ultimately there are only two things in the financial markets that count — where you buy and where you sell — given human failings, it’s critical for a small investor’s financial survival that he always asks himself an important question before making any new investment — "What if?"
The author of this article is one of the investors of U.S. Gold and Silver Investments, Inc. still awaiting the outcome of the investigation.
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Robert McCurtain is a technical analyst, market timer and private investor based in New York City. He is a member of the Market Technicians Association and can be reached at firstname.lastname@example.org.