Personal finance: Local investment loss shows need for diligence

Personal finance: Local investment loss shows need for diligence

November 21st, 2012 by Christopher A. Hopkins CFA in Business Diary

It's not exactly a Madoff-sized swindle, but for the Soddy-Daisy investors who lost their savings, the pain is just as real.

In a court filing last week, nearly 40 former clients of Brown's Tax Service alleged investment fraud against the proprietor, Jack E. Brown. While the total losses are still unknown, at least one group of eight customers lost nearly $1.3 million according to court documents.

Sadly, this scenario is reprised with surprising regularity, despite the best efforts of regulators and the admonitions of reputable advisers. The outcome is especially unfortunate since it could easily have been avoided with a little healthy skepticism and a couple of key questions.

Investment scams involving securities almost always depend upon the lack of an independent custodian responsible for safeguarding the investments. In the classic Ponzi scheme, new investors' capital is merely funneled to other investors (after a generous cut to support the extravagant lifestyle of the organizer). Such schemes inevitably collapse once the inflow of new dollars falls behind, but can continue for some time and are only possible if the ringleader has possession of the assets.

Individual investors should never hand over their funds directly to an investment adviser or manager. Insist upon verifying the size and stability of the independent third-party custodian. This will typically be a large regional or national brokerage firm, bank, mutual fund or

insurance company broker-dealer. Be certain that the custodian is a member of SIPC (Securities Investor Protection Corp.), a nonprofit self-regulatory agency created by the U.S. government that provides up to $500,000 in insurance protection against the possible insolvency of the custodial firm. Most firms also acquire additional coverage from private insurance cooperatives like Lloyds of London for many millions more.

Another hallmark of securities swindles is lack of liquidity. Investment scammers often profess a "secret sauce," some kind of proprietary process or strategy that is not transparent and often undisclosed, but usually require that investors agree to lock up funds for some period of time with limited ability to withdraw. Furthermore, to the extent that victims receive accounting statements at all, they are frequently falsified.

For most individual investors, this should be a bright red flag. Nontraded or private partnerships, hedge funds or unlisted pools are usually legitimate and may be appropriate for sophisticated investors. But such investments should be assiduously avoided by most individuals seeking to build or protect a retirement nest egg.

Before you invest, ensure that the specific securities are registered with the SEC and trade on public markets. Any reticence on the part of the manager to fully disclose potential positions should be considered a warning. Run away.

Remember the adage: if something seems too good to be true, it most likely is. Any legitimate adviser or money manager will gladly provide verifiable information on the custodian, the securities under consideration and their own compliance track record with regulators. Just a few pointed questions and a little homework can drastically reduce the odds of becoming the next target.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at