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Friday, January 2, 2009

Closed End Managed Buy/Sell Program Is A Scam

Question: Are closed end managed buy/sell programs legitimate? I've made introductions to parties claiming they can produce 30% gains per trade as the buyer is under contract to perform. I think it could be a scam.


It is a scam of the type known as a pyramid scheme. The term buy/sell programs is a term often used by scam artists to try to impress investors into thinking they are putting money into a sophisticated hedge fund (many and possibly most hedge funds are scams in our opinion, but that's another matter entirely), where the fund can generate big returns without any risk of loss.

In fact, the risk-reward correlation is as absolute as the earth-gravity correlation: You just can't get away from it. You cannot have big returns without big risks. Nobody can promise 30% gains per trade without extraordinary risk. But this is just a pyramid scheme where old investors are being paid with new investors' money, but no traders are actually occurring. Like the Bernie Madoff scam, they are just making up statements showing trades out of thin air. Run!

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Saturday, December 27, 2008

Madoff Scheme Investors Will Have To Give Back Even If Less Than Original Investment

Some of the victims of the Madoff pyramid scheme are about to receive more bad news -- If they received any money back from Madoff, the Receiver will want it back.

When a pyramid scheme collapses, the Court appoints a Receiver to husband and sequester all the assets of the scheme for the benefit of all investors. The Receiver will create a Victim's Fund, and all victims will receive a percentage of the Victim's Fund based on the size of their original investment.

The assets of the scheme include payments that the scheme made to others, including payments back to investors. If a Madoff investor received anything back from Madoff -- even if it was less than their original investment -- they will have to give that amount of money back to the Receiver, to be pooled with any other money and assets that the Receiver can find, and then these investors will get their percentage of the Victim's Fund.

If a Madoff investor refuses to pay the Receiver back, the Receiver can sue the investor and make the investor pay the costs and attorney fees of recovery, in addition to getting the money back. In some situations, the Court may also issue order to hold a recalcitrant investor in jail for contempt. "Resistance," as one might hear in a sci-fi B-movie, "is futile." It can also be very costly.

Charities are not exempt from disgorgement. If a charity received money from Madoff, it had better be prepared to give the money back. Charities may have exemption from income taxes from the IRS, but charities have no special exemption at all from Receiver-ordered disgorgement of what amounts to criminal proceeds. This will hit a lot of charities hard at this time when the economy is sharply down and charitable inflows have slowed from a mighty river to a miserly trickle.

Receivers and disgorgement are one of the more unpleasant things about pyramid schemes, and have the effect of re-victimizing the victims, sort of like having a rape victim testify at trial. But it is necessary to protect the rights of all investors, and not just those who received redemptions from Madoff.

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Friday, December 26, 2008

The Madoff Scheme Isn't New -- Just Bigger

So people lost $50-plus billion to Bernie Madoff, so what? The only difference this time is that a few institutional investors, charities, and celebrities were caught up in this particular pyramid scheme.

Every year, pyramid schemes divest literally thousands of people of their life savings and put seniors on the street. Whether the victims are attracted through internet chat rooms or because the scam artist hoodwinked the local pastor into arranging investments for the benefit of the church, at any given time there are probably hundreds of pyramid schemes running somewhere in the U.S., and thousands more throughout the world.

Here at Quatloos! we have see and tracked many of these scams. For years, we tracked the Omega Trust & Trading scam, where people sent in $100 to buy "units" that were initially promised to give a $2,500 return, which eventually grew to where each unit was alleged to be worth $100,000. Indeed, even when the Omega scammers weren't paying off on the original scam, they ran a subsequent scam to sell "refund units", i.e., the units from other investors who had obtained refunds (although there were not any of these in actuality), and fleeced even more money out of their already-jilted investors.

Perhaps what makes the Madoff scam is the reputation of the main crook. Most pyramid schemes are run by those with no real financial education, background, or experience. Clyde Hood, who ran the Omega scam by contrast, was simply a retired electrician in Mattoon, Illinois. Madoff was the chairman of the NASDAQ from 1990 to 1993 -- no pyramid schemer has ever had such stellar credentials.

All the signs of a scam were there. The high but steady returns, the lack of transparency in how money was being made, and obscure auditors all raised red flags to those interested in knowing. And, indeed, it has since come out that there were at least one significant whistleblower, and maybe several.

But at the end of the day, the investors who lost everything have their own stupidity to blame. Sure, it is always easy to "blame the victim" for not discovering a scam, but this isn't why these investors were stupid. The reason the Madoff investors who lost everything were stupid is that they did not diversify their investments. There is simply no reason why any sane person -- or charity -- would have more than a small part of their investment with an obscure hedge fund like Madoff's. By following even minimal diversification rules, there is absolutely no reason why any Madoff investor should have lost more than 10% of their portfolio.

So why did investors throw caution to the wind and put everything with Madoff: Some combination of laziness and greed. These investors were getting a higher (albeit, paper) return with Madoff than on anything else they were investing in. So, instead of putting in the hard work to find other good investments, or accepting a lower return on their other investments for the sake of diversity, they instead put all their money with Madoff.

Mark Twain once wrote, "put all your eggs into one basket, and then watch it mightily." It's that second part that the Madoff investors missed, and if they weren't going to watch their investments like a hawk, they should have put them into one basket.

The way to avoid being scammed out of your portfolio is the same that it has always been: Diversify, diversify, and diversify. Decide how much is the most that you can lose on any particular investment, and then limit the investment to that percentage. It should be very rare that any particular investment, other than cash or government-backed bonds, should be more than 10% of a portfolio.

And that's not any sophisticated financial strategy; that's just common sense.

Talk about the Madoff scam on our new Madoff Scam discussion forum at http://quatloos.com/Q-Forum/viewforum.php?f=36

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