How to Protect Yourself From Ponzi Scheme

Ponzi schemes are nothing new in the marketplace. Unscrupulous fund managers have always sought to dream up new ways of playing shell games with investor's money. Bernard Madoff's massive fraud exposed last year is simply the latest in a long history, though perhaps most shocking due to its sheer scale. The cost associated with this scheme is estimated to be somewhere in the neighborhood of 50 billion dollars. That's enough money to prop up a failing auto industry.

Who can forget the Ponzi scheme cooked up by Samuel Israel that was uncovered in 2004? Israel's company, Bayou Investments, bilked investors of over 450 million dollars. In the end, his fund was nothing but another elaborately concocted scheme. How can we avoid falling prey to the these Ponzi schemes?

Two words: Due Diligence.

It takes a back seat to the bad news, but some investors managed to escape getting bilked by the likes of Israel. Prudent investors decided to hire an investigator before parting with their nest eggs. The investigator recently spoke on NBC's Dateline regarding his detective work. He uncovered false educational credentials for Israel and a history of drug and alcohol abuse. Further research revealed an illegitimate accounting firm underpinning the fund.

A closer inspection of Madoff's scheme would have revealed similar tell-tale clues. A little due diligence could have saved untold investors. What should you be looking for when doing your own fact checking and how can it save you from a sophisticated scheme like Madoffs?

1) Any investment that offers amazingly consistent "too good to be true" yields is suspect. Madoff's fund relied on historically volatile trading practices but produced rock solid results. Don't just let people sell you a fund, make them prove it's worth. If you don't understand their explanation, find a neutral, knowledgeable party to evaluate it.

2) Be aware of the hard sell. If fund managers are courting you for your retirement dollars with free lunches, fancy gifts, or slick sales pitches be skeptical. Madoff frequently enticed clients by telling them the fund was "closed" but he could manage to "get them in".

3) Be sure to dig, dig and dig some more. Is the person approaching you properly licensed? Ask for their credentials; contact the issuer of those credentials whether it is the American Institute of Certified Accountants, the National Association of Personal Financial Advisers or other legitimate organization. Find out who employs them and where your funds go once in the hands of their company. Madoff buried his Ponzi scheme behind layers of "feeder funds". Follow the trail all the way to the top and start asking your questions there.

4) Finally, take a good look at the people who are supposed to be monitoring the company. Contact the SEC (Securities Exchange Commission) and ask for any information regarding the fund. By 2005 Madoff's fund already had a letter on file from a concerned financial advisor that the fund was a "Ponzi scheme". Further, Madoff's comptroller for the phony firm was based off-shore - most legitmate operations take care of this accounting in-house.