The “Red Flags” of Investment Fraud from a Former $3.8M Ponzi Scheme Manager

This story was originally published at BiggerPockets.com

Please be advised: this podcast episode contains discussions about sensitive topics, including suicide, which may be distressing for some listeners. If you are experiencing thoughts of suicide or emotional distress, help is available. You can contact the National Suicide Prevention Lifeline by dialing 988 to connect directly with trained counselors who can provide support and assistance 24/7.

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Could you be ensnared in an elaborate Ponzi scheme? According to today’s guest, cases of financial fraud are MUCH more common than the average investor suspects. Tune in to learn how to protect your nest egg rather than leave your financial future in the hands of untrustworthy people!

Welcome back to the BiggerPockets Money podcast! Today, we’re sitting down with investment fraudster turned anti-fraud advocate, James Brandolino. In 2003, James set out to start his own hedge fund, pooling over three million dollars from friends and family. But one “down” month was the catalyst for eight years of fraudulent activity—a Ponzi scheme that included lying to investors, mailing false statements, and pulling money from the fund to keep the lights on. When the guilt became too much to bear, James turned himself in and has since committed his life to warning investors about the real threat of fraud.

In this episode, James shares his whole story—from starting his fund to serving six years in prison. He talks about common “red flags” to look out for when investing and the importance of due diligence when something seems off. Of course, fraud is prevalent in the real estate investing space as well. Stick around for tips on avoiding real estate scams and how to vet a syndication partner before entrusting them with your money!

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Read the Transcript Here

Mindy:
Today’s episode is a bit different, and we wanted to give a warning that this episode deals with potentially distressing material dealing with suicide. This conversation may activate distressing feelings for you. If that’s the case, feel free to skip this one. Help is available at the Suicide and Crisis Lifeline by calling or texting 9 8 8. Today’s episode is about investment fraud and the steps you can take to ensure it doesn’t happen to you.

Scott:
Yeah, we’re going to talk to James Brand convicted investment, fraudster turned, anti-fraud advocate. James is going to tell us about his own story about how he found himself leading a fraud scheme and about the warning signs of fraudulent investment activity that you should be looking out for.

Mindy:
Hello, my dear listeners and welcome to the BiggerPockets Money podcast. My name is Mindy Jensen, and with me as always is my anti-fraud Advocate co-host, Scott Che.

Scott:
Thanks, Mindy. Great to be here with you. We’re going to have a serious intro today, and we’re going to tell everybody that we’re here to make financial independence less scary, less just for somebody else to introduce you to every money story because we truly believe financial freedom is attainable for everyone, no matter when or where you’re starting. And now let’s bring in James Brandolino,

Mindy:
James Brandolino. Welcome to the BiggerPockets Money Podcast. I’m so excited to talk to you today.

James:
Very excited as well. Thanks for inviting me, Scott Mitty.

Mindy:
James, on an early day in January, 2011, you walked into the Chicago Dirksen Federal Building and turned yourself in why?

James:
So for eight years, I ran a Ponzi scheme as a trader at the Chicago Board of Trade, running a hedge fund. And during that period, there was never more than a day or two that went by that I didn’t think I could make the money back. Well, after eight years and $3.8 million later, the realization came. I woke up one morning and said, I’m not going to make it back. So I sold my condo and I gave all my possessions away and found an attorney and walked into the US Attorney’s office like you said, and said, this is who I am, this is what I did. Please arrest me.

Scott:
Can you define what a Ponzi scheme is? Just for those who I think most people know it’s inappropriate activity, but they don’t know the actual definition of it.

James:
Okay, so technically a Ponzi scheme is everybody knows it is robbing Peter to pay Paul, where an operator will be running a seemingly legitimate business where the business plan is dictating profits that they’re making in a Ponzi scheme. There are no profits from legitimate trading or legitimate sales or legitimate business or maybe a small portion. The profits are coming from new investors who are investing money, and that money is used to either show a lav lifestyle show success and to pay investors dividends and returns on previous investments.

Scott:
So you’re taking the new money from investors and using that to spend on either your lifestyle or pay back the people who had invested earlier. And that’s illegal. And this has happened many times throughout history.

James:
It Happens every day.

Scott:
Okay, great. So we’ve defined Ponzi scheme. Let’s start from the beginning. How do we set the stage where we either got on the path to being into a Ponzi scheme?

James:
So I would say from the very beginning, I always wanted to be a trader on one of Chicago’s future exchanges, the Board of Trader, the Mercantile Exchange. And it really started when I was at the end of my freshman year in high school with the release of the movie Trading Places with Eddie Murphy and Dan Aykroyd and just that wild trading scene at the end when they’re trying to corner the frozen concentrator orange juice market. That really got me excited about trading, and that’s really all I ever wanted to do. I ended up running a trading desk at a now defunct firm called MF Global. And while I was there, I designed a trading program that traded treasury bonds, bond futures, mind you. And really the end of 99, I had been trading this for a few years and I decided that I wanted to go out on my own and basically started a fund and became a member of the Board of Trade, and I was going to trade money and do really, really well.
So in my case, it was really simple. When I became a member of the Board of Trade before I even started trading for the fund, I was on the floor waiting for the IT department at the Board of Trade to come in and put in my phone line and all my internet stuff at the desk. And I’m kind of walking around and I had more than a few positions on the floor, so I knew how it worked. And although I’m trading bonds, which is slightly less volatile than say the Dow Jones or the s and p indices, I was just mesmerized by how the orders coming in from big firms would move the Dow Jones Futures market. And I’m thinking to myself, boy, if I could just make a few adjustments to my trading models and I could raise my six and a half, 7% returns trading bonds to nine, 10, 11% trading s and Ps in Dow futures, I’ll be a hero. And really in a matter of probably a couple hours I decided to do that. I went to my models, I made some changes, I did some quick back testing, and within a week I started trading. So my first week of actually trading for the new fund, I was down about 3%.

Scott:
Well, let’s back up. Let’s back up just one second here in the story here. So you left your job and set this fund up. This was in what year?

James:
So in June of 99, I left MF Global and I started a small independent futures brokerage firm called Lloyd Lewis in which I would be able to solicit customers as a broker for this system. Kind of like the intermediate step between leaving the brokerage firm and starting the fund, I wanted to be able to kind of test it with real customers as a broker, which means I would only be able to charge commissions. I did that until the beginning of 2003, and then in February of 2003, that’s when I became a member of the board of Trade and start at the hedge fund. And during that three year period, I had a positive track record, which gave me the confidence to go out and start the fund.

Scott:
Awesome. So super helpful here. So you start a fund, who are your investors and what is your incentive structure in this fund?

James:
The incentive structure is standard 2%, two 20, so 2% management fee of all the assets every year, and then 20% of profits. And that’s really why someone would start a hedge fund is because they want a piece of the action. So the more profits that you make for clients, the more money that you can grab for yourself. My clients really were my brokerage firm clients that I had for three, four years, family, friends, friends of family. So everybody in my fund I knew personally,

Mindy:
We are taking a quick break and when we’re back, we’ll hear about how a career at a futures brokerage turned into a multimillion dollar fraud scheme.

Scott:
And we’re back. We’re talking to James Brandi about the worst decision he made and how it led to him running an investment fraud scheme for seven years. Awesome. And how much did you raise?

James:
$2 million.

Scott:
$2 million, okay. So 2% of 2 million is $40,000 per year. That’s kind of like a base salary, right? That’s what a lot of these private equity or whatever, it’s very standard commission model two in 20 for incentivizing folks who manage capital. And that would be, hey, that’s your salary, and then you get 20% of the profit. So if you grow the 2 million to 4 million, you would get 20% of the 2 million in profits, which is really what motivates folks in this type of model. Is that right?

James:
Absolutely. The management fees just kind of keep the lights on and maybe we’ll pay the rent in a few of the expenses, but where the big bonuses come in is on the incentive side when you can make a profit and grab 20% of that profit.

Scott:
Awesome. This is super helpful context setting because again, legitimate trading, making a good profit, track, records established were raising a fund and not even, I would say even in 2003, a particularly large fund, this is a very standard sized fund, probably happens every day with folks here, and it’s with folks you know who have grown to trust you over either a lifetime or over several years in the professional field. Is that all correct?

James:
Correct. Absolutely.

Scott:
Awesome. Well, let’s keep going. So what happens next?

James:
After the first week of trading, I’m down about 3% in my documents. I had a clause that if I was down 3% in any one in point of the month, I would stop trading and begin trading the next month. So I had about two and a half weeks before the statements would be prepared and mailed out by a CPA firm I had hired. And I’m thinking, what am I going to do? And yes, I know everybody and everybody likes me, but it’s my first month, I’m down 3%, A lot of people are going to pull their money out, and then what am I going to do now? And I was just kind of thinking of ways of how I’m going to address my initial set of investors, and I’m sitting in an office with a colleague of mine and he’s on the phone and I’m paging through maybe Institutional Investor magazine, and the light bulb goes off, I see an advertisement for hedge fund accounting software, and I’m thinking, here’s the answer.
Let me buy this software and put everybody’s name into it, send statements for a month or two. I’ll show a gain, I’ll get the money back. I mean, I’ve been trading for a long time, right? I had been trading since college, so I’ve been trading for a long time. I can make 3% back, no problem at all. And that’s what I did. I sent false statements out that first month thinking that I could make funds back and I didn’t. And so we’re looking at minus 3%, minus 5%, minus 10%, minus 20%, and so on. So that was really stage one of the fraud that lasted for about a year and a half. Stage two comes in when I’m running a little bit low on money and I’m thinking, well, I’m a sales introvert and I didn’t want to go to my clients and ask them for more money.
So what do I do? I liquidate my 401k, my insurance policy, get a home equity line of credit and throw my personal net worth into the fund. And that lasted probably almost another year and a half. So now we’re at the three-year mark, and up to this point, it’s civil crime, it’s making false statements, sending false statements in the mail, but I’ve not taken a penny. All of the trading was legitimate and all the trading, all the losses were legitimate. And it just happened to be, I’m really thinking of how am I going to get in front of everybody and let everybody know, and are they going to go to the authorities? And they probably will. And okay, it is what it is. And I get a phone call from a random individual who is a friend of one of my bigger clients and who wants to invest, and he decides to write a check for $500,000. And I’m thinking, well, here we go. Now I’ve got no money to live on. Now I can at least take a small illegitimately. Of course, I can take money from the fund and pay business expenses, and also I can hire other people to help me fix my models and make this work. And really from year three is really where the criminal side of the fraud began from year three to year eight.

Scott:
So let me just make sure I’ve got this right. So we start the fund in 2003. We immediately first month have a small loss, nothing that would’ve potentially set off any flags, although it’s a point of pride and ego. I started this thing off and couldn’t get there. And then that starts the first small lie, which compounds over the course of the next year, but the next three years, sorry, to this point where it’s about to hear the next stage in the story. And during that period, looking back, was it possible, would it have been possible for you to just have a big month that eliminated all of the problems? Would that have, do you think a lot of some portion of people who start down that path get saved by that miraculous month, or was it never going to happen?

James:
Absolutely. I mean, even I had losing months that were greater than 3%. When I was managing the money as a broker, we had four and 5% losing months, not many of them. And then the market would turn around and we’d have a couple decent months and then back to kind of normal, and we’d stay on track. So to answer your question, yes, I could have made it back. I was just so darn afraid, Scott, in terms of what’s everybody going to say? Are they going to pull their money out? Am I going to have to close the fund? I spent at that time probably 15, 20 grand just on legal expenses to get all the documents done, et cetera, et cetera. What am I going to do?

Scott:
Well, let’s pick it up. What happens in 2006 or thereabouts three years in?

James:
So that’s really the point when I started to embezzle money to live on and to pay for business expenses, and that’s where the criminal side started. And what’s interesting, and not just in my case, but in many cases of investment fraud, most cases of investment fraud don’t begin as investment fraud. Most people don’t wake up one day and say, you know what? I want to steal 5, 10, 20, a hundred million dollars. And they get paperwork and they start a website and they open up a bank account and they go and they raise all this money, and then as soon as the phone rings or somebody knocks on the door, they’ve got the corporate jet ready to go to Brazil or wherever they’re going to go to hide from the authorities.

Scott:
I think what’s really interesting psychologically is hey, the first 3% loss, it’s not acceptable, but you can empathize with, I can make it back and prove that out. And that lesson learned here is never go down that first step ever because everything else is a derivative of that first month’s decision really in the path that puts you on here. But you said at some point there was a clear movement into criminal with embezzlement. What’s psychologically kind of went through your head or what was the moment at that point? Did you realize it and know that you were crossing whatever the step was here, this was way beyond the line that anyone would find acceptable? What was going on in your head at that point?

James:
Well, at that point, I didn’t understand probably the definition of civil and criminal, but I knew that after I deposited that $500,000 check and probably took $10,000 and moved it over to my personal account, that was changing the game. Now, there was a loss, not just with trading, but there was a loss that I was actually using client funds for business and personal expenses.

Mindy:
How did you cope with it personally?

James:
I think myself personally, I compartmentalized what I was doing, and even though I absolutely knew what I was doing was wrong, I mean there’s no doubt about it at all. I just really tried to focus on, I’m making the money back, and that’s what I just kept telling myself, I could make this money back. I know I can make it back, and it never happened. But that was my mindset

Mindy:
Because we’re going into 2008, 2009, 2010, I remember that time period in the market, and the market just kept going down, down, down, down. So

James:
Well, it was getting crushed. And don’t forget, December of 2008 is when the Madoff scandal broke. And I can remember being sitting in series restaurant, which is inside the lobby of the Board of Trade, and Rick Santelli, who was the CNBC rockstar commentator from the bond pit at the Board of Trade. He was holding court with a bunch of traders and just kind of went on this rant, yeah, this is really serious and that this happened, and a lot of people lost a lot of money, but the only benefit that we’re going to see is that we’re going to learn what stops causes investment fraud, and the SEC and the media are going to kind of partner up and make sure this doesn’t happen again. Which of course, unfortunately couldn’t be further from the truth. But I had clients who probably got a little bit nervous, who would call a little bit more often, Hey, can we come down and see you?
Or, Hey, can you clarify this on your statements and all that kind of stuff. And it was a little bit more nerve wracking for me, but they just didn’t ask the right questions. And when they asked the right questions, they just didn’t know how to prove what I was saying if it was right or if it was wrong. And I would say that’s probably in terms of investors who are looking at investments, some can ask the right questions and some will get the documents and the marketing literature and they’ll read it, but they won’t quite understand what’s there or what’s missing and what they read it. They just have no way to kind of aligned with what should the company be doing versus are they doing what they say they’re doing? And that’s the key right there.

Scott:
What did most of your clients think was happening during this period?

James:
They thought we were doing one and a half to 2%, two and a half percent per month. Trading. Trading futures.

Scott:
Did you ever show them a loss?

James:
I think I had probably maybe six or seven losses in that one half percent, maybe one and a quarter percent, but nothing really major.

Mindy:
So 2008, Bernie Madoff happens. Essentially, you are doing the same thing, similar thing, but on a smaller scale, you waited three years to turn yourself in. What led to that decision?

James:
It’s interesting. I wake up one Sunday morning and I’m standing on the balcony. This is probably November of 2010, and I’m standing on my balcony looking downtown Chicago, and I’m never going to make this back. It’s only $3.8 million. That’s not a lot of money when looking at other types of fraud, but I’m not going to make it back. I’m just done. I could have raised more money, and I was just tired and just done with everything, tired of the lying and the charades and the whole thing, and said, you know what? I’m going to turn myself in.

Mindy:
Yeah. In terms of the Bernie Madoff scandal, that was 20 billion in cash losses and 65 billion in paper losses. So I can see from your point of view, oh, it’s only 3 million. It’s not nearly so bad,

Scott:
But yeah, it was 3.8 million that you raised in its entirety. What did investors think the pile had grown to

James:
That number? Probably a couple hundred million. And that’s what new money coming out as well, or new money being invested as well.

Scott:
So investors thought they had a couple hundred million dollars with you that you had grown over eight years.

James:
Correct.

Scott:
But you had really lost most of 3.8 million or all of 3.8 million, is that right?

James:
Correct.

Scott:
How much did you have left in the coffers by the time you turned yourself in

James:
25 grand.

Scott:
Wow. And so what happens next? You turn yourself in, you’re charged what judicial civil items come up and how does this progress from there?

James:
I had the slightest idea what to expect, and I went to an attorney and the attorney is like, don’t turn yourself in. You don’t want to do that. He really discouraged me from doing so, and I’m like, well, it’s only me. There’s no other conspirators to this crime. He goes, look there. There’s no benefit of what you’re going to do here. So he goes, why don’t you just go to California, learn how to surf, and we will watch the federal and the state internet filings, and if your name comes up, we’ll give you a call and you won’t have to even go to court for probably two, three years, maybe a little bit longer. And I’m thinking to myself, well, why the heck would I wait so long to do that? And he goes, well, he goes, do you know anybody who’s committing a crime on the floor?
I go, well, of course, all the floor traders and all the tricks that they do to steal money from customers, that’s really, really difficult to find. He goes, he goes, maybe we can go to the US attorney, and you could be a mold, you could wear a wire and you could try to, he didn’t use the word entrap. That’s basically kind of what it would be of others doing other crimes. And I’m like, no, let’s just do it. So he actually went on vacation for a couple weeks. This is getting closer to Christmas, and I really had a mental breakdown and I decided that I was going to end it. So what I did was I went to a firearm store outside of the city of Chicago and purchased a firearm and basically attempted suicide on January the fourth of 2011, and the firearm did not go off, and it locked on me. And that’s what saved my life. And then as I went back to my condo, I talked to my attorneys like, oh, I can see you’re serious. I’ll call the US attorney’s office and try to find the best of the worst. And two days later, I’m sitting with the US attorney and with the FBI, and I basically tell ’em, this is what I did, this is how I did it, and here’s all my clients, and where do we go from here?

Scott:
Wow, this is really, really a powerful story. Thank you for sharing all of this. What happens next? You talk to the attorneys, the attorney general, you talking all this, what are the mechanics of how things transpire from there?

James:
It was one count of mail fraud, sending fictitious financial statements in the mail with the federal system. It’s a little bit different than the state system. So in that charge, the number, the money, it’s like a point system. So besides your charge, because I had over 50 victims, there was extra points for that because I was, depending upon the loss amount, you get extra points for that. So I received a sentence, my range was eight to 10 years, and I received nine years, a nine year sentence. And then I am forced, not forced. I am obligated to pay restitution every month that goes into a victim fund.

Scott:
And then how much of that sentence, how much time did you actually spend in jail before being released?

James:
I served six and a half years,

Scott:
Six and a half years in prison before being released. And you got out at what point?

James:
I got out in the end of June of 2017.

Scott:
Okay, so June, 2017. And I understand that you decided to start studying other fraud cases and speaking to other fraudsters in prison. And you have then since made identifying, preventing prosecuting, some combination of those things, your profession starting in prison and then following prison. Can you tell us a little bit about that?

James:
Yeah, well, probably early on, I think everyone thinks that what am I going to do when I get out? And I had no other skillset. I didn’t know how to lay brick or pour concrete or drive a truck or anything like that. What am I going to do? And I really kind of decided, well, maybe there’s an avenue that I can take to help prevent fraud. And as I spoke to dozens and dozens of other financial fraudsters and my family spent a lot of money sending me forensic accounting textbooks and for our examination textbooks that I kind of devoured, and the more I studied the red flags, they’re all the same. And they were the same back in the forties, fifties and sixties as they were in the seventies and eighties as they were for my case in the two thousands. And nothing has really changed. So my whole mission became that I was going to tell my story, but really kind of share the dozens and dozens of red flags that are out there that fraudsters use that really hasn’t changed in a long, long time.

Scott:
All right. We’re taking a quick ad break, and when we’re back, James brand will break down the telltale warning signs of fraudulent investment activity.

Mindy:
Welcome back. We’re talking to James Brand about if and how you can prevent investment fraud from happening to you.

Scott:
What was the eureka moment where you kind of began settling on some of these, and then can you tell us what those red flags are?

James:
Sure. So I would say not sure if it was a eureka moment, so much as just as I was speaking to a lot of the financial frauds that I was incarcerated with. They’re saying all the same things. I would say probably some of the top ones are audits. So in my case, probably three months after I started my fund, three months into my fraud, so to speak, I get a phone call from one of my parents’, good friends who invested a hundred thousand dollars with me. Hey, Jimmy, a couple of us are looking for audited financials. Can you send, do you have those and can you send ’em over? It’s like, yeah, yeah, I’ll take care of it for you. Not a problem. And it was a matter of God, what am I going to do? So go to Google hedge fund audit PDF and try to find a hedge fund that was similar to mine and basically copied it almost word for word, and came up with a phony accounting firm, did a website for a phony accounting firm with a New York address that nobody ever mailed anything to or ever called the number that was listed on there.
There were so many mistakes in that audit that if my investors didn’t notice it, which they probably wouldn’t, their CPAs who I know looked at them should have easily recognized the red flags of the mistakes I made. I wasn’t a CPA, so that would be number one. Next, the three, four days after the beginning of the year, starting in 2004, I get a call from one of my investors, Hey, Jimmy, when is your accounting firm going to send the tax documents? We want to start doing our taxes. And I’m thinking, oh boy, this is it. I’m done. Right? I mean, what am I going to do? There’s no way I got this fraud going on and okay, we’re a year into it, maybe down 20%, 25%, whatever it was at that time. I could make it back, but there’s no way I’m going to commit tax fraud and what am I going to do?
So I kind of just came up with this lie that, well, with hedge funds, you don’t pay tax until you pull the money out. And not only did they believe it, but I had probably over the eight years, probably 12 to 15 conversations with their attorneys or CPAs talking about that. And nobody ever ever questioned it. I had to do a lot of dancing when I was explaining it to ’em, but nobody ever called one of their colleagues who worked with hedge funds to say, Hey, is this right? Is this true? And just never verified with what I was doing. Another thing. So I was always very open and transparent about people wanting to come and visit me on the trading floor, and I had a newer client who was with me three months come and he came with his CPA and he says, we’d like to see your trading for these first three months.
I’m like, okay, no problem. So I’m thinking, well, is he smart enough to know the future’s business? And I’ll give you an example of what happened. So I pulled the first three months from my file cabinet of all the trades that I did, and my office was inside of the brokerage room, my clearing firm at the Board of Trade. We walked to the back office and I said, Hey, this is a CPA. He’s with my client here. Pull the three trades or the three months of trading that I did that you got from the board of trade. And they pulled all three monthly statements and they all matched. And the CPA was like, oh yeah, this is fine. If the CPA had any knowledge of futures trading, he would’ve realized that the size that I was trading or the amount of contracts that I was trading was probably commensurate if I was trading a $10 million fund versus at that time, probably said I had a $50 million fund. So if I would’ve looked at it as a fraud examiner, I would’ve said, wow, you’re not really trading very much. You’re trading really very light. But him not being familiar with the futures market and how it operates, he had no idea to say that it’s amazing. And those are three of just bigger ones that are out there

Scott:
As a lay person coming into this. Things that from documentaries and other stuff that I’ve seen, like you think, okay, these guys, they show super smooth returns. That was one of the things in the Bernie Madoff Netflix documentary, the people were challenging him because it was like, wow, the level, the tightness of the return relative to the risk profile of these returns compounded over a really long period of time is just absolutely bonkers. And nobody ever will do that. It’s just almost mathematically impossible to get something that smooth. It sounds like your returns were similar to that, right? Always within a narrow band, only a few months showing losses for it and all that. Is that another red flag or common theme in a lot of these?

James:
So yeah. So my returns weren’t quite as streamlined as Madoff’s were, but they were overall, they were, yes, they were definitely outside of the ordinary. And in the red flag reports that I do, I’ll look at a time series of all the returns that are being projected and try to find other benchmarks and just try to show that there are certain mathematical rules that will show anomalies in numbers when they are construed. If I’m picking, so every month I picked out a rate of return. So let’s say this month we’re going to make 1.24%, and next month we’re going to make 1.63%, and the next month we’re going to be down 0.74%. So when you’re picking your monthly returns that way, there are certain mathematical clues that we can pull out that will show, won’t show fraud, but it’ll show that they were construed. And I’ve done those with my numbers and with madoff’s numbers, and it’s just amazing to see people who fudge numbers, how easy it is to see that.
But yet you’re right. Now there are big hedge funds out there, and I’m not going to mention names that have been around for a long time that are doing 20, 30, 40% a year and sometimes even more. But they’re going to have volatility. They’re going to have your 5%, 8% winners for the month, and then they’re going to have 5%, 8%, 10% losses, monthly losses, so it’s going to average out. But when you don’t have that downward volatility, and it’s really, like you just said, it’s risk adjusted returns for this return, how much risk am I taking? And when your risk that you’re taking on your numbers is so much less than which you can get anywhere else, something’s probably amiss.

Scott:
It also seems to me as a lay person that this, yeah, let me open my books to you. Here’s the statements, here’s all that stuff in real time is almost too much. And when someone is giving you that much openness and coming in with there that there’s a little bit of a red flag that should be going off to some degree, yeah, look, I’ll prove that I did this here around that. No one asked you for that from this, or if there’s something remarkable and then an over eagerness to share in the name of transparency, it’s almost like a red flag. It comes across as disingenuous in a few instances in my career where that’s happened, right? Let me prove I do all these things with that. The second is this total lack of transparency, like what I think Madoff did where there was just nothing that they really got besides the statements in there. I guess that wasn’t, maybe he was more in the first category, but are those two items to look for as well? Again, I’m not an expert on this, I’m just spewing things that I’ve picked up from documentaries and stuff.

James:
So with Madoff, it’s a little bit easier only because clients would ask for an audit and he would never show it to him. Well, I don’t want Goldman Sachs to find out what I’m doing and reverse engineer what I’m doing. But here’s the thing about an audit. An audit’s not going to give away any trade secrets. Having transparency in a back office and how you do things and how you process trades and how you do statements, that’s not giving any secrets away in terms of how you’re actually picking which stocks to buy or sell, right, or which properties to buy or sell. A back office is a back office. And really in terms of audits, what we’re really looking for is to verify if the assets exist, how the assets being valued, are the performance returns real, and are the assets being custody correctly? And that’s just so, so important to be able to do that, whether an investor is able to do it or they hire someone to do it.
But the second part of that, I can have an audit. So I would say part of my business, people call me and they’ll ask, they’ll say, I’ve invested in something, would you take a look at it? And I’ll have the paperwork. And they’ll usually say, well, don’t let the company know that I hired you. On the other side of it, which I much more prefer is somebody call me up and saying, Hey, I’ve got this investment. I’ve got all the documents, I’ve got all the paperwork. The manager knows you’re going to call him, he’s expecting a call from someone and everything is out in the, but even with that case, Scott, I could have that audit in my hand, and it’s going to say who the CPA firm is. If it’s a name that I don’t recognize, I’ve got to verify If the CPA, if he’s a real person, if he’s a real CPA, which is relatively easy, you can go to CPA verify.org. But also too, has that audit been misused? Meaning a lot of times people, if I’ll call up a CPA firm and they won’t even say whether they’ve done the audit, they won’t even confirm that. And it’s really difficult because you don’t know. Somebody could have done that audit and maybe the fraudster took a page or two and just added a couple zeros in a couple different places. And yes, they did the audit, but the audit’s fake. So it’s important once you’ve got the audit that you’re able to verify the authenticity of the audit.

Mindy:
So how do I know that I’m getting correct information when I’m asking my hedge fund manager questions and he’s giving me plausible sounding answers. Like with hedge funds, you don’t pay taxes until you pull the money out. I mean, that sounds, if I dunno anything about hedge funds, you just said that I don’t have to pay taxes, so how do I get this correct information?

James:
As an investor, it’d be probably a little bit tougher, but you would go to your attorney or your CPA and they should know the answer, and if they didn’t know the answer, that’s where the problem is. I’ll give you a great little story. I’m sitting with one of my larger clients, his son who I’ve known for years and years and years is A CPA has a small little firm down in Chicago, and we’re getting finished with lunch. And he says, okay, so have you asked Jimmy everything? He goes, yeah, but I just can’t understand how a hedge fund can be exempt from paying taxes unless it’s in an IRA. And of course I’m thinking, okay, well I’m done now. That’s it. He’s figured it out and why he didn’t call somebody one of his colleagues to ask that question because I mean, look, a hedge fund or a private equity or a real estate fund, all they are is either a limited partnership or an LLC and everybody’s K one at the end of the year. It’s nothing rocket science. So for him not to know that or ask me that, I’m just appalled. And every once in a while I think about it and how I got away with this for eight years and all of the other red flags that the CPAs and attorneys didn’t recognize. It never ceases to amaze me that I got away with it for as long as I did. And it’s not me, you guys. It happens every single day.

Scott:
So let’s tie this in with a really uncomfortable conversation here very quickly, and I’m going to use the real estate syndication space, which is right now, I think a lot of people raised a lot of capital to buy apartment complexes. You talked about two and 20 where you get 2% of the profits or 2% of the capital amount raised in assets and management fees, and then you get a 20% profit interest syndications make that look like a weak compensation model. These guys get paid 1% to two and a half percent just to buy the real estate. Then they get the 2% management fee, then they get a one to two and a half percent if they refinance the property and another one to two and a half percent. If they exit the property, then they get 20 to 30% carried interest. So incentives are right there.
A lot of investors have invested in these types of syndications over the last couple of years, and they’re losing right now. Asset values have gone down dramatically. Some of them have already been exposed as Ponzi schemes or frauds at this point, and you’re already seeing prosecutions and that as an investor, how can I protect myself in the real estate syndication space through all of this? And how do I, if I’m invested in something that’s losing, determine if it was fraud, bad luck, gross negligence, some other combination of that, how can I parse that out without complete information and without being a forensic accountant who studied this as a profession like you do?

James:
Yeah, the real estate field makes it a little bit more difficult sometimes to do it only because you have to go and verify if the assets are real and you have to see how they’re registered and you’ve got to go to the courthouse or wherever you can go and you can check how they’re ED and where they’re located. I think the big scheme I’m going to take, I have a step back here if you don’t mind, Scott. Besides crypto, I think real estate syndication real estate, whether they’re family homes or multifamily, is probably the largest sector of fraud that I’m seeing in terms of more fraud happening. I’m investing in a case right now in Colorado and X, an X Denver Bronco invested over half a million dollars in a multifamily, well, let’s just say snafu, right? And the money’s pretty much gone. So I’m not sure what’s going to happen there, but it’s a really bad situation.
So I think one of the reasons why we’re seeing a lot more fraud in the multifamily space especially, is because, and I don’t want to sound condescending at all, but you’ve got a lot of Joe Smiths in Kansas City who have bought 30, 40 doors and they’re experts in the multifamily space and want to raise money, and they raise money and the deal starts going bad, and they’re moving, say they’ve got three or four deals, capital raises they’ve had, and one or two of the deals is not doing well, and they’ve got a deal that’s doing extremely well. So they’re going to take money from one deal and put it to the other and not disclose that. And that’s where a lot of problems are taking place. But to go back and answer your question, so since most investment fraud does not start out as investment fraud, it’s really, really difficult to pinpoint it.
I mean, a lot of these, the syndications, many of them will have audited financials, and it’s a matter of going through them with a fine tooth comb and verifying everything that’s on there. And probably even having a forensic accountant go and look at it. And even some of the cases that I get hired for, I’ve got a forensic accountant that will, stuff that gets really intricate will help me with the procedures of the back office and how everything’s working because some of the stuff is just really, really in depth, but you’ve got to go through the financials and you’ve got to look at the books. And a lot of firms will, not even, especially the small ones, will not let you look at the books. And it’s a matter of if an investor’s on their own trying to do it themselves, they’ve got to say, look, either you let me look at ’em, or I’m going to hire somebody and we’re going to charge potential fraud and we’re going to see what’s going on here because something’s just not right.

Scott:
Well, James, this has been super helpful. Thank you for sharing all of this with us today. Where can people find out more about you?

James:
They can go to my website at the investment fraud guy.com, and anyone can send me an email at James at the investment fraud guy.com with any questions. I’d be happy to give my opinion and help you out.

Scott:
Well, I appreciate it, and thank you for sharing your story and for the work you’re doing now to prevent and find fraud.

Mindy:
Yeah, thank you, James. This was very interesting. I learned a lot.

James:
Thank you, Scott. Thank you, Mindy.

Mindy:
Wow, Scott. That was James brand, the investment fraud guy, and that was a very interesting episode. I don’t know how I would have reacted if I had been investing with him because he had an answer for everything. And I mean, it really feels plausible that you don’t pay taxes until you pull the money out with a hedge fund. If you’ve never invested in a hedge fund before, it also seems completely implausible that you don’t pay taxes. Spoiler alert, the government is always going to get theirs. So I’m glad he was able to share some bits at the end about talk to your network, talk to your friends, talk to other people, and ask them these questions if it still seems a little hinky.

Scott:
I think today’s lesson, today’s interview was a sobering one. It sounds like without being a forensic accountant who’s going to study this stuff for years, it’s really difficult in a practical sense to expect yourself to be able to spot fraud. I mean, you got to call out the audit inconsistencies on there, or go back and do the research for the audit firm. That’s great. Let’s have more people do those kinds of things and make it harder. But these fraudsters are going to be one step ahead. In many of these cases, some of the mistakes he made are probably ones that the next fraudster is going to be able to overcome in some of these things. It’s scary because these people don’t start out as fraudsters. I believe that. I believe that nobody starts out, or very few people start out with the intent to rob people of millions of dollars in this and that.
It’s more about I couldn’t deliver the returns, and so I’m going to fudge ’em and see if I can get back. And then it becomes out of hand and it spirals from there. How many people are legitimate who or seem legitimate today, who went down that path but won and had that good month that saved them, and were able to get back out of that spiral that led to James Ponzi scheme. How many people are in the process of that right now, pretending like they have that it took eight years for this thing to be exposed? I mean, it’s so scary, right? People thought they were with, there was a hundred million dollars more in the fund than there was in there. I think the lesson is you never know, and you can’t concentrate all your bets in one area in these kind of unregulated or private syndication or hedge fund opportunities, and you always got to have in the back of your mind that no matter who you’re working with, this is a possibility. And that you’re just acknowledging that if you’re going to get into any of these private investing spaces and try to make it as difficult as possible for someone to do that, especially if you’re with them for a long period of time and the returns seem great the entire time, maybe that’s the lesson.

Mindy:
Well, and you just said something, Scott, you said it took eight years for it to be exposed. It wasn’t even exposed. He turned himself in. Nobody caught onto this.

Scott:
Absolutely. Well, on that note, yeah,

Mindy:
I am very thankful that he came and shared this story with our listeners today so they can start to think about what’s going on in their investments if they have hired somebody to take care of them. So ask questions, and if you don’t like the answer, keep asking until you understand what they’re saying or until you uncover something. I hope you don’t uncover anything. Keep asking until you understand what they’re saying. That’s where I’ll stop. Alright, Scott, should we get out of here?

Scott:
Let’s do it.

Mindy:
That wraps up this episode of the BiggerPockets Money Podcast. He, of course is the Scott Trench, and I am Mindy Jensen saying Tutu Lou Yorkie Poo.

Scott:
If you enjoyed today’s episode, please give us a five star review on Spotify or Apple. And if you’re looking for even more money content, feel free to visit our YouTube channel at youtube.com/biggerpockets money.

Mindy:
BiggerPockets money was created by Mindy Jensen and Scott Trench, produced by Kaylin Bennett, editing by Exodus Media Copywriting by Nate Weintraub. Lastly, a big thank you to the BiggerPockets team for making this show possible.

Watch the Episode Here

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In This Episode We Cover

  • How this former fraudster built a $3.8 million Ponzi scheme
  • How to prevent investment fraud from happening to YOU
  • The most common fraud “red flags” to watch out for
  • How to properly vet someone before entrusting them with your money
  • Investment fraud in real estate syndications (and how to avoid scams!)
  • Using your own network to help uncover fraudulent activity
  • And So Much More!

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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