The Great Recession flushed out many Ponzi schemes and other fraudulent investment vehicles, bringing to light their prevalence and devastating effects. As the economy begins to rebound, new investment mechanisms and other financing opportunities may present themselves; however, during your organization's investment evaluation process, it is important to put in place a checklist and due diligence process to help avoid entering into a fraudulent financial arrangement.
Historically, banks have inadvertently become an instrument for the misdeeds of fraudsters, making themselves susceptible to subsequent claims from bankruptcy and SIPA trustees. Likewise, investors wishing to obtain higher rates of return have been dragged into preference and fraudulent transfer lawsuits, often forced to return principal and interest payments received, and suffer costs of defense.
When lawsuits occur, courts will frequently look to whether investors and banks were aware, or should have been aware, of "red flags" surrounding the investment. The following due diligence considerations provide guidance to investors and banks based on these "red flags":i
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Does a nationwide litigation search on the investment and its principals bring any aspect of the investment into question, including prior crimes involving dishonesty, theft, or prior bankruptcies?
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If applicable, will the investment be documented with appropriate legal instruments? Do the documents contain usual legal provisions?
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Does the investment actually have a need for investor funds, based on the investment theory and the investment's financial statements?
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Are there audited financial statements made available to the investment's investors, potential investors, and banks in a timely manner? Are they complete, and show no signs of inaccuracies on their face? If audited financial statements are not available, is there a reasonable explanation?
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Are interest payments, dividend payments, payments to a lockbox or the like coming from the investment, or a different entity?
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Is the investment's reporting customary and in accordance with industry standards?
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Is the performance of the investment in conformance with actual market performance?
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Does a statistical analysis indicate that the investment's returns are improbable? Does common sense dictate that returns are plausible?
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Based on the investment's theory, should the volume of the investment impact the market, and can this impact be independently verified?
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Are investors able to perform their own due diligence, or are they forced to rely on the due diligence of others or take the "trust me" approach?
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If the investment in turn invests in another investment vehicle or vehicles, is access granted to the downstream investment? Is the multi-tier concept transparent and easily understood? Is there a viable method to recover directly from the downstream investment should the need arise?
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Do funds flow through the investment as they are designed to, or as they were promised to flow?
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When due diligence questions arise, are investors able to approach principals of the investment and receive reasonable answers to questions?
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Is the investment audited? Are there any unusual ties between the auditor and the investment or its principals? Does the size of the audit shop match the size of the investment?
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Does the investment utilize many bank accounts (either with the same or different banks), and do funds flow in and out of the accounts frequently?
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Does the investment experience a significant amount of overdrafts?
If you observe one or more of these red flags in a potential or existing investment or banking relationship, you should consider all of your options, including seeking additional due diligence, passing on the investment, and working with counsel to understand your rights and responsibilities.
This list should not be deemed to constitute an all-inclusive due diligence checklist when considering an investment, or when monitoring banking customers. These observations follow from involvement in numerous cases involving fraud, and from reviewing numerous recorded cases—Ponzi scheme related or otherwise.
