Ways to detect fraud in ‘perfect’ investment deal

The allure of reaping high returns or making a quick buck has often snared people straight into the merciless hands of fraudsters. In the last few years, a number of Kenyans have been left licking their wounds after being conned of their life savings by Ponzi scheme architects and other “get rich quick” schemes.

The US Securities and Exchange Commission (SEC) holds that Ponzi schemes are investment frauds promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors from proceeds of acquiring new investors.

Notable examples of such schemes in Kenya include DECI founded by the late George Donde which defrauded investors of approximately Sh2.5 billion and Clip Investment Sacco Limited run by Peter Ndakwe which went under with an estimated Sh1.9 billion of investors’ money.

VIP Portal, yet another “investment” scheme, went off the radar in 2014 after collecting over Sh1 billion from several Kenyans looking for an easy way out of poverty.

Between 2006 and 2007, for instance, 140,000 Kenyans had invested over Sh8 billion in Ponzi schemes as per Central Bank of Kenya (CBK) records.

The pertinent question becomes: how do you safeguard your hard-earned money from potential swindlers?

Benjamin Graham defines investment as an undertaking that upon thorough analysis promises the safety of the initial sum of money invested (“principal”) while offering a reasonable rate of return.

Any scheme that does not promise safety of principal, therefore, does not fit the bill of an investment, but is mere speculation at best.

It gets more interesting when defining “reasonable rate of return”.

Granted, we all have different risk appetites which will determine whether we are aggressive or risk averse in our investing. While seeking returns commensurate to your risk is advisable, it behoves you to undertake proper due diligence on the potential investment.

Due diligence is defined as the care and attention that would reasonably be expected of a prudent investor before making any investment.

Big time investors often incur millions of dollars in due diligence fees paid to financial advisers, lawyers and industry experts.

Since not all of us are investors of this scale or can afford to hire these due diligence experts, we are sometimes called upon to conduct the due diligence ourselves.

So how do we go about it? Thorough due diligence entails looking at the scheme’s history and background, its management and the basis or rationale of its investment returns.

A careful look at the history and background of a scheme could reveal red flags such as litigation in certain countries, lack of a track record, peculiar ownership structures, questionable tax standing with various authorities among other key legitimacy measuring sticks.

You can do a simple company search through the Registrar of Companies to know about the owners and directors of a scheme.

For those whose services or products are regulated, check whether they are duly registered with regulatory bodies such as the CBK, Sacco Societies Regulatory Authority (Sasra) and the Capital Markets Authority (CMA).

The integrity and quality of a scheme’s management will say a lot about whether or not a scheme is fraudulent.

American business mogul Warren Buffett’s mantra is that he invests in companies with first-rate managers whose interests are aligned to his interests.

Fraudulent schemes are often led by individuals with questionable integrity or inexperience in running the business they promote.

Other red flags include unrealistic but guaranteed returns, and dubious business activities or business models.

Unfortunately, unlike what is expected and prescribed, most “due diligence” practised is often a confirmation of herd mentality, with people investing in a scheme because person A or company B has invested in it or is promoting it.

Passive investors will often buy shares of a certain company because there is increased demand for the stock. Fraudsters often capitalise on this mentality by advertising through or partnering with big brands which give the investment schemes an aura of legitimacy.

Other more sophisticated swindlers, such as Bernie Madoff who was sentenced to 150 years in prison for defrauding investors of $50 billion (Sh5.2 trillion), use tactics such as the elite club illusion of pretending to turn down investors.

The “start small then invest more if you’re happy” marketing and offering modest annual returns of eight per cent to 12 per cent targeting conservative rich people.

The most basic way to ascertain whether returns are unrealistic would be simply to compare the promised (and sometimes guaranteed) returns with the prevailing cost of obtaining credit financing.

Ask yourself why would that entity pay you a high cost to finance the scheme than pay a bank charging lower financing costs.

You should be in a position to state in simple words why you think the scheme is making above market returns taking into account overall economic state of the country, industry specific factors such as the level of competition, demand and supply and the competitive advantage of the scheme.

While it is necessary for you to take on risk to realise returns, exercising caution on all deals is priceless. So the next time you hear of a deal that is too good to be true, exercise due diligence commensurate to the risk inherent in that deal.