Fraud in the Financial Industry

We need to apply a rigorous “sanity check” to opportunities and relationships to limit risk.

Andrew Duvenage CFP®

Andrew Duvenage CFP®

Managing Director and Private Wealth Manager

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Fraud in the Financial Industry

The unfortunate reality is that such events have happened with alarming regularity, both locally and abroad. Fidentia, Masterbond, the Tanenbaum saga, Bernie Madoff, Enron, Steinhoff - the list goes on and on. Despite increased compliance, regulation and technology, greed continues to drive unethical people to find ways to exploit trust and rules, and to defy morality. 

The tragedy of these events has a far-reaching impact. Honest people have been financially compromised - sometimes irreparably. Many people will inadvertently be impacted by such events, with careers, families and lives ruined. And very sadly, trust is shattered.

While the issue of human greed, and the many manifestations it may take, is an oddly tangible concept that may be too large to truly fathom, the issue of fraud in the financial services industry is definitely something worth considering. Trust is one of the fundamentals of the industry, especially in the context of advisory service. The nature of providing meaningful, holistic financial advice often requires deep, personal relationships. In many cases, people trust their advisors with their financial wellbeing - often blindly so, which is another article entirely. 

Worryingly, occurrences of fraud manage to creep by unseen, even though investors have received valuable tools to have their proverbial ducks in a row and validating the information they receive for their portfolios, through things like regulation, higher levels of disclosure and improved line of sight into investments and their respective performances. A question that we often get asked - and indeed that we ask ourselves - is what is it that investors should be doing to try and mitigate the risks of fraud?

There are a couple of factors that are worth raising in relation to this topic.

Risk and reward are inextricably linked. One of the common threads that runs through many (if not all) of the fraud issues that we see relates to promises of unrealistic outcomes. High returns come with high risk. While it is entirely possible to find investments and opportunities that provide high levels of return, what is impossible is to deny the fact that the higher the level of return, the higher the risk implicit in the investment. Time and time again, we see instances of promises of the market (and reality) defying returns – guaranteed! 

The question that we should all ask is why these investments are “offering” this outcome, and who is guaranteeing it? If there is no risk, why do these opportunities require our capital? If the outcome was such a “slam dunk”, why is this windfall being shared with us? Why wouldn’t the proprietors of this opportunity not simply go to the banks and raise the funds themselves and keep the benefit? The reality is that the higher that the promise of return, the higher the risk involved in the investment. While such high-risk investments may play a role in one’s portfolio, we cannot divorce ourselves from the reality of risk and return, and in many cases, this is where investors go wrong. The promise and allure of sublime outcomes (especially in the context of a struggling market with benign returns) makes one ignore a simple question: “Is this too good to be true”?

The second issue is around “betting the farm”. Time and time again, we see investors overcommitting to opportunities. If one adequately deals with the theme of risk and reward, the next question one should be asking revolves around the issue of how much is appropriate to commit to high-risk opportunities. In many instances, fraud is perpetuated through the following mechanism: 

  • An opportunity which seems too good to be true is presented. 

  • Investors commit a small amount of capital to it (testing the water). 

  • The opportunity delivers on its promise (either yield or capital is returned as promised) – all looks good, roll on the good times! 

  • The investor now has proof of concept, and starts to ignore the “risk-return” paradigm, and jumps in boots and all.

Sadly, we know how this story ends. If one reflects on this all-too-common occurrence, the lesson is that investors should not commit more than they can afford to lose to speculative opportunities.

The next issue is around the nature of investments. The most recent instance of (alleged) fraud, which is playing out in the financial services industry is a case study on this issue. From what we can see, a trusted advisor convinced clients to exit highly regulated investments (unit trusts) and put the funds into unlisted, unregulated investments. These unlisted investments were positioned as offering sublime “guaranteed” returns. Once again, there are simple lessons or warning signs here: Does the investor understand the risk implicit in unregulated investments, and is it appropriate for investors to move into this environment? Who is guaranteeing this sublime outcome, and why are they sharing this windfall with anyone willing to invest? In the worst-case scenario (implosion), what can be committed to such an opportunity without compromising ones financial wellbeing? This is not to say that all unlisted investments are bad. Many investors have made their fortunes from such opportunities. The point is that the lack of regulation increases risk, irrespective of how “safe” the investment is purported to be. Investors need to fully understand this and question whether it is appropriate for their specific circumstances. The level of diligence with unlisted investments in respect of legal contracts, shareholders agreements and the like, far exceeds what is required for regulated investments, where checks and balances are built into the process.

The final issue to touch on is around trust. Strong advisory relationships are built on deep interpersonal relationships and high levels of trust. While this trust should be earned, it is not something that should be unquestioned. Blind trust is often at the core of many of the issues that we see. While investors may choose to trust and delegate many administrative matters to trusted confidants and advisors, they should never forget that the ultimate responsibility is theirs. At times, uncomfortable questions need to be asked. Information needs to be validated. Explanations need to be provided. Warning signs should start flashing when an advisor is offended or defensive around reasonable questions or is unwilling or unable to verify requested information.

Unfortunately, the recent instances of unethical behaviour that we have seen will not be the last. As investors and advisors alike, we need to apply a rigorous “sanity check” to opportunities and relationships to limit such risks.

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