We want to share with you a disturbing tale we heard recently from an investor in a private investment fund. We share this to alert you to “red flags” that signal the high likelihood of investor fraud. If you can spot them, you can better protect yourself from financial predators.
The enactment of the Dodd-Frank Act ushered in a new era of investment adviser regulation. Depending on size, investment advisers now come under the oversight of either the Securities and Exchange Commission or the securities regulator of the state where they have a place of business. To protect investors from Ponzi schemes, federal and state securities laws now impose strict audit requirements and rules for maintaining custody of client assets.
Our investor entrusted their money to scammers who blatantly ignored these laws. The investment adviser orchestrated a fraudulent scheme not only to fool investors as to the true value of their investments, but to inflate the valuations of securities held in the fund. The investment adviser then collected, and concealed its receipt of, excessive fees based on the fund’s falsely inflated net asset value.
Here is a description of the “red flags” that occurred and those that you should be on the look-out for:
- The fund did not send investors quarterly statements. These statements identify the fund’s investment holdings and their market values and any changes from the previous quarter, the investor’s value, and the fees earned by the investment adviser for the period.
- The fund did not send investors audited financial statements. These annual statements are supposed to assure investors that the holdings represented are correct and valuations have been done consistently with generally accepted accounting principles.
- The fund did not entrust the securities and funds to a qualified custodian bank. This prevents the investment adviser from stealing, misplacing or losing investments.
- The investment adviser was not registered with any state or federal regulator. This requirement ensures that some regulatory body is monitoring investment advisers for compliance with investor protection rules and fraudulent conduct. The absence of regulatory oversight frees the investment adviser to defraud investors with impunity.
- The fund’s newsletter was sporadic and filled with poor grammar and typographical errors. This is not a regulatory violation but indicates a lack of professionalism that is characteristic of many fraudsters.
Keeping investors in the dark gives the investment adviser a big advantage in the investment fraud game. The biggest is that the investment adviser can assign whatever value they wish to the fund’s holdings. Because adviser’s fees are based on the value of the assets under management, the higher the assigned value given to the holdings, the higher the fees are for the investment adviser. Equally important, the higher the assigned values, the happier the investors are. Happy investors typically stay invested; unhappy investors typically withdraw their money. The longer investors remain, the longer the investment adviser conceals their fraud until the money vanishes.
The temptation to commit securities fraud with inflated valuations is tremendous. Here, the investment adviser placed a $2 per share valuation on a stock that was trading at 10 cents. Using their valuation method, the investment adviser fooled investors with inflated investment values that it listed on investors’ annual K-1 tax reports. The investment adviser then proceeded to drain fees that were twenty times higher than that which it was entitled. Without audited financial statements to present the true picture, the investors were none the wiser.
The truth came to light when our investor sought to redeem funds. The redemption request garnered a response that disheartened our investor: We have insufficient funds to honor your request. This prompted the investor to call the investment lawyers at Sanford Heisler Sharp.
We are taking steps that we are confident will remedy the situation. What happened here can happen to anybody who allows trust to blind them to the “red flags.” Stay vigilant. If you spot or suspect any one of these “red flags,” call one of our investment lawyers in San Diego or New York. With decades of experience spotting investment fraud, we can help you assess your legal options.