The Vigilant Investor: A Former SEC Enforcer Reveals How to Fraud-Proof Your Investments

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Introduction

In July 2006, I closed the door of my law office after saying good-bye

to a 70-year-old man who had lost his life savings to a Ponzi scheme.

This retiree—a family patriarch who had saved for decades in hopes

of paying for his grandchildren’s college educations—had come to me

because he knew that I had been an Enforcement Branch Chief at the

U.S. Securities and Exchange Commission (SEC). He wanted me to

help him get his nest egg back, but I couldn’t. The confidence man

who had taken it had no liability insurance, and he had never worked

for a brokerage firm that could have detected and prevented the scam.

The con man had spent this senior citizen’s nest egg, and many others’,

on homes, cars, expensive vacations, and phony ‘‘distribution’’

payments to earlier investors. I could have won this prospective client

a multimillion-dollar civil judgment—including punitive damages and

attorney’s fees—but we would never have collected a dime.

In more than two decades of protecting investors, both as an SEC

enforcer and as an attorney for investors, I’d had conversations like

this one with hundreds of investors, from institutions to blue-collar

retirees. It’s never fun, especially with seniors, who cannot rebuild

their nest eggs through several more decades of work. Usually they try

to remain stoic, but you can see them deflate and their minds wander

to the painful practical implications of the bad news. The blood drains

from their faces as they try to reconcile their image of themselves as

smart and competent with the reality that a stranger has already spent

the money that it took them decades to earn and save. Sometimes

they shed tears of shame and humiliation, feeling more guilt in that

moment than the people who defrauded them will feel in their entire

lives.

I expected nothing more from the rest of the afternoon than I’d

experienced all of the other times I’d given this kind of bad news: a

lingering sadness. But this day was different. As I turned away from

the door, a thought exploded into my head with lightning-strike

power; I actually felt a physical impact. How long are you going to keep

having these conversations before you do something to protect these people?

In that moment, Investor’s Watchdog, LLC, was born.

We began by building a database to hold information on stockbrokers,

investment advisers, and scam artists nationwide. We added

thousands of customer complaints that had been expunged from

stockbrokers’ official regulatory rap sheets—not because the brokers

were exonerated, but because the brokers made this a condition of

settlement with their victims. We gathered information on actions

against the horde of unregistered salespeople who operate off the regulatory

grid. We put it all in the IW database.

Within days of launching Investor’sWatchdog, we saved a church

in Arizona from losing its entire building fund to a con man who was

operating under an assumed name. Since 2006, Investor’s Watchdog

has investigated unregistered investments on three continents, including

supposed luxury resorts on the Red Sea; investments in renovated

hotels in the United Kingdom; private banks in Geneva, Switzerland;

and oil and gas projects in Texas.We’ve also investigated stockbrokers

that the Financial Industry Regulatory Authority (FINRA) rates as

perfectly clean but who have been the subject of so many customer

complaints that no investor would ever use them if he knew the truth.

Shortly after opening Investor’s Watchdog, I received my first

assignment as a court-appointed receiver in an SEC fraud case, cleaning

up the mess from the collapse of an investment scam in South

Carolina. I’ve cleaned up that kind of mess in three SEC cases as of

this writing (one involving an international hedge fund fraud), and

two more for the Federal Trade Commission. That work has taken

me all over the United States and beyond, closing down fraudulent

operations, recovering assets from overseas, and pursuing litigation

(against people who received investors’ funds or who contributed to

the scam) to generate a fund from which to repay investors. Sometimes

we’ve been able to pay back more than half of what was lost.

Other times, we’ve been able to return only nickels on the dollar.

Although our receivership work always produces far more for investors

than it costs, we cannot make the victims whole. We can neither

unscramble their nest eggs nor fully assuage the feelings of humiliation

and misplaced guilt that grip them in the wake of their financial

loss.

In 2008, hoping to reach more investors, I launched invest

orswatchblog.com, where we cover the hundreds of financial scams

that come to light every year. I write a new post every weekday, linking

to a news story about the case and drawing lessons from it that

can help others avoid a similar fate. Most days I have to choose from

among several scams that have come to light in the previous 24 hours.

The FBI estimates that Americans lose $40 billion annually to

investment fraud. That’s the equivalent of one Madoff-sized megafraud

every single year. And the problem is only getting worse.

Despite access to innumerable resources published by regulators and

consumer reporters on how to avoid scams, we are falling for them

in record numbers. Why? There are three reasons. First, the pool of

attractive victims is bigger. If there was ever a time to get into the

investment fraud business, this is it. The first baby boomers began

turning 65 in May 2011 and will turn 65 at the rate of 10,000 per day

until 2030. As they retire, those boomers will move $2.5 trillion in

assets from the relative safety of company-sponsored 401(k) accounts

into self-directed accounts at brokerage firms, where they will be as

vulnerable as a wounded rabbit in the forest.

Second, the world is getting smaller. Technology allows con men

in Russia and Dubai to rob pension plans, business owners, baby

boomers, and senior citizens in America, while American scamsters

can return the favor, swindling investors wherever people speak

English.

Finally, the advice we get from regulators and well-meaning consumer

reporters is always dangerously incomplete. It fails to address

key information that is emerging from those who study the science

of decision making. That information explains why, despite all the

warnings, we are so prone to fall victim to investment fraud and

unethical brokers.

Contrary to almost universal belief, neither gullibility nor low

intelligence is the problem. U.S. presidents, rocket scientists, Ph.D.s,

MBAs, CPAs, FBI special agents, lawyers, experts on gullibility, and

more members of the American Medical Association than you could

fit in the nearest major league stadium have been victimized by investment

fraud. The real culprit behind the worsening epidemic is the

human brain—specifically, the cognitive biases that come as default

settings in every healthy mind. While they are helpful in other contexts,

those biases skew how we view information in the investment

context, leading us to trust people who have every intention of breaching

that trust and leading us into shallow inquiries that we mistake for

in-depth investigations. An investor who memorizes a complete list

of helpful ‘‘dos and don’ts’’ without first appreciating the power of

cognitive biases is like an NHL All-Star without his skates; he has

impressive knowledge and talent without having the ability to put it

to practical use.

And it isn’t only individual investors who fall victim to scamsters.

Underfunded pension plans, desperate for a rate of return that will

bring them back into the black, fall prey to world-class con artists, as

do endowments, school districts, and family offices. People who make

decisions for institutional investors are more popular with scam artists

than sweet tea at a barbecue.

The securities industry is as dirty as a plumber’s boots. Multimillion-

dollar advertising budgets and the charisma and salesmanship of

individual brokers keep most investors in an anesthetic fog, through

which they cannot perceive a landscape that is strewn with mines and

traps. The Vigilant Investor burns away that fog.We’ll tour an industry

that is indifferent, at best, to the welfare of investors. This journey

will equip you to protect yourself from characters who are determined

to take as much of your money for themselves as possible.

Sir Arthur Conan Doyle understood that the ability to uncover

carefully crafted and expertly concealed misconduct has everything to

do with experience. In A Study in Scarlet, Sherlock Holmes explains,

‘‘There is a strong family resemblance about misdeeds, and if you have

all the details of a thousand at your finger ends, it is odd if you cannot

unravel the thousand and first.’’ What investors lack, and what they

desperately need, are the details of the thousand misdeeds to which

Holmes refers. This book puts the details of many misdeeds at your

finger ends to better enable you to unravel the many scams and unethical

advisers that will target you over a lifetime of investing.

Because experience is the best teacher, those who have seen hundreds

of scams and reckless brokers are best equipped to uncover a

well-disguised ongoing scam or a broker who intends to feast on your

savings. I’ve spoken to every type of investment criminal imaginable,

from professional con artists to fund managers who began with good

intentions, from highly functioning sociopaths to ineffectual bunglers,

from those who flee the country when the jig is up to those who

attempt to fake their own death. I’ve seen scams and unethical financial

advisers up close from a unique combination of perspectives: SEC

enforcer, court-appointed receiver, attorney for investors, blogger on

breaking scams, and founder and CEO of a professional due diligence

company. I know how scams and unethical advisers begin, how they

operate, what contributes to their longevity, and what tactics they use

to ensnare individual and institutional investors alike. I know how to

recognize scams and bad advisers that other investigators miss. This

book is my way of equipping you to do likewise.

We’ve organized the book in two parts. Part 1 explores the wide

world of investment fraud. It begins with an examination of cognitive

biases and explains how to defuse them. We then look at several categories

of scam artist, some of their favorite con games, and the

advanced tactics that they use to pull off these games. Along the way,

we give you advice that will protect you from getting conned. We

close Part 1 with a look into the future of investment fraud, where

scams will be bigger, last longer, and be harder to spot.

Part 2 narrows the focus to the U.S. securities industry. We begin

by introducing the investment cops and the limits of their power. We

then perform a harsh light-of-day examination of the usual suspects

(stockbrokers, registered investment advisers, and insurance agents),

the duties they owe to investors, and how they often use investors as

tools for their own enrichment. We also look at brokers who target

the most vulnerable of investors, the elderly, and provide advice on

how adult children can protect their elderly parents. We close the

book with a vision of how vigilant investors can band together to

cleanse the investing landscape as no investment cop ever can.

Each chapter uses actual examples of scamsters and brokers who

swindled very bright, but not-yet-vigilant, investors.We provide guid-

ance on how a vigilant investor should approach an investigation of

those scams. We conclude each chapter with a section entitled ‘‘Due

Diligence for the Vigilant,’’ which sums up, in bulleted list form, the

action items that will keep the vigilant investor clear of the characters

and tricks that have cost so many so much.

As hard as they work and as dedicated as they are, regulators cannot

keep you safe. Because it has more lobbying dollars than investors

can ever contribute, the securities industry has been—and will always

be—successful in keeping the investment cops severely understaffed

and underfunded. Even causing a once-in-a-century financial crisis

has not diminished the securities industry’s influence. The successful

solution, therefore, to an epidemic that will rob institutional investors,

baby boomers, and the elderly of more than $1 trillion over the coming

generation cannot involve Congress and must be immune to the

influence of lobbyists.

Where can we find such a solution? In your mirror. Using the

tools you’ll find in here, you can do what no Congress or investment

cop ever will. You can close down professional scams before they get

off the ground. You can run unethical brokers out of the business. You

can protect not only yourself and those you love, but countless others.

There is a path through the well-disguised traps and pitfalls that

litter the investing landscape to a retirement full of the blessings that

hard work and savings make possible. This book maps that path for

all who are wise enough to follow it. Let’s go.