Low-risk, high-return investing - a good idea?
Many will be tempted to answer such a question in the affirmative. But if you choose the wrong borrower, and invest in a Ponzi scheme, there is a risk of losing the loan and of having to give up the return received. In addition, there is a risk of significant legal costs in court.
From time to time, investments with very high returns are offered where the risk is stated to be small. The question is whether such offers can be credible at all.
The loan scandal in Stavanger
A recent example is the loan scandal in Stavanger, where a lawyer allegedly brokered private secured loans at high interest rates. Until the bubble burst and it turned out that the loan scheme was a so-called Ponzi scheme, where the lawyer did not mediate loans to other borrowers, but kept the loan amounts himself. He then "brokered" new loans from new lenders that he used to pay the high interest and installments on previous loans to previous lenders, as well as transfer a nice share to the lawyer himself for his own investments and consumption.
Ponze schemes
A Ponzi scheme is an arrangement in which the fraudster does not invest the capital received and therefore does not receive any return on the capital. The high returns he has promised investors pay the fraudster out of capital he receives from new investors. A Ponzi scheme can therefore only continue as long as the fraudster is able to attract new investors who inject enough capital to allow the fraud to continue. But in the long run, the fraud will require a larger and larger injection of capital and eventually collapse. In most cases, the fraudster will be insolvent early in the fraud process, because the promised return quickly exceeds the fraudster's equity.
When the bubble bursts
When the fraudulent event cracks and the money is gone, the actors will see if it is possible to recover the lost money in whole or in part. In the Stavanger case, the lawyer and his companies have been declared bankrupt and the lenders must file their claims against the lawyer's and the companies' estates. The administrator's task is to realise an estate's assets and ultimately distribute assets according to the order of priority in the Coverage Act, and so that creditors within each group receive equal dividends.
Annulment and recovery of amounts paid
A special aspect of the Ponzi scheme in Stavanger is that those who were lenders early in the fraud may have received interest on the loan and may also have received the principal amount back. Lenders late in the course lose the entire loan and are unlikely to receive much return. In other words, you can have net winners and net losers in such a scam.
When the estate's task is to realise assets and distribute these in equal parts within each priority creditor group, it will have to be considered whether there is a basis for reversing payments made by the lawyer to net winners and demanding loans and interest payments back to the estate for equal distribution to all creditors. Payments made within the three-month deadline for objective reversal of payments are short, normally within three months before the opening of bankruptcy. It will therefore be natural for payments to lenders to be assessed according to the rules on subjective avoidance in the Coverage Act, where you can go back 10 years. Such assessments must be based on the facts surrounding each individual payment, and may be very complex in some cases.
Subjective anullment
In order to reverse a payment on a subjective basis, an alternative is that the estate must demonstrate that a payment has unduly favoured a lender at the expense of the others, that the debtor's financial position was weak or was seriously weakened by the payment, and that the lender who received payment knew or should have known about the debtor's difficult financial position and the circumstances that made the payment undue.
The assessment of impropriety is based on the content of the outline, and can in some cases be very extensive. One issue may be whether payments to former lenders (net winners) with funds obtained from later lenders (net losers) can in themselves be regarded as an improper disposition as a beneficiary of a lender at the expense of the others.
There is hardly any doubt that the lawyer's (debtor's) financial position, at least a little out in the chronology of the Ponzi scheme, was weak. Whether a lender who received payment of interest and/or principal knew or should have known about the lawyer's difficult financial position must be assessed on the basis of the facts of each individual case, and such an assessment can be complex. Among other things, it may be of importance whether, and if so, why, a lender exercised active pressure to obtain payment.
A lender that has received a settlement may therefore, even after several years, risk having to compensate the bankruptcy estate for the loss it was inflicted by the voidable disposition.
In addition, there is the risk of being involved in litigation over several years, with the associated risk of large legal costs.
So maybe the low-risk, high-return investment wasn't a good idea after all.
Red flags for fraud
In a warning to investors, the U.S. Securities and Exchange Commission (SEC) has listed some common red flags for Ponzi schemes:
- Every investment carries a certain degree of risk. Promises of guaranteed returns or promises of high returns with low risk should be met with healthy scepticism.
- Investments tend to go up and down, especially if they seek high returns. Be wary of investments that generate consistent returns regardless of market conditions.
- Ponzi schemes will typically involve investments that are not registered with the government.
- Securities legislation requires that investment firms have a licence or are registered. Many Ponzi schemes involve unregistered individuals or enterprises.
- Secretive and/or complex investment strategies and fee structures can be difficult to understand. It is a good rule of thumb to avoid investments that you do not understand or do not receive complete information about.
- Most private investment offerings require qualified investors. There is reason for scepticism if you are not asked about your income and wealth.
- Investment offers should be documented in writing. Carefully study prospectuses and other descriptions, and be skeptical of explanations about why you cannot get written material as a basis for an investment. Look for errors in financial statements that may indicate fraud attempts.
- Difficulties in receiving payment or in redeeming the investment can be a warning sign. Ponzi schemers may try to get participants to "roll over" promised payments in exchange for offers of higher returns.
Perhaps it can be sufficient to avoid misinvestments to remember the old rule that if something is too good to be true, it is exactly what it is.
But if you have been unlucky, we may help. Read more about financial fraud here.
