• Protecting yourself from fraud and mis-selling

Protecting yourself from fraud and mis-selling

26 January 2017

Helen Hatton, managing director of Sator Regulatory Consulting and chairman of KYC Worldwide, has advice on how to avoid the potential losses from the dramatic collapses of investment funds and products.

Yet again there seems to be a crop of fraudulent or mis-sold investment products. Is this just part of an investor's risk? Do investors simply have to accept that in addition to market risk – that the value of their investments might go down as well as up – they also need to take their chances that the product itself might be phoney, or that their so-called adviser might be recommending something wholly unsuitable for their needs?

Experience shows there is not one answer to these two fundamentally different questions. 

To take each of them in turn, let us examine how exposure to these two areas of risk can be reduced.

The risk that an investment is fraudulent

Clever, carefully thought out fraud is difficult to detect. This means it is difficult for regulators who authorise the sale of the products, difficult for the advisers who may well recommend a product they thought was sound and turns out not to be, and difficult for the investor (including professional investors such as trustees) who may be considering buying an interest in the investment. But there are checks that can be undertaken to reduce the likelihood of loss from fraudulent intent.

Start by checking whether the product and the person advising on it are regulated. Most investments have at least two layers of regulation before they ‘hit’ the consumer. This article looks at funds.

A collective investment scheme (a fund) will be regulated. Standards of regulation are set by the International Organisation of Securities Commissions (Iosco).  Iosco rates jurisdictions' compliance with their standards to ensure the locally-applied regulation meets the international benchmarks. So, first check is whether the jurisdictions involved meet Iosco standards. 

Regulatory regimes set out in law the standards against which the regulators themselves are permitted to approve the product as suitable for sale. This is done on the basis of checks on the principal persons behind the fund, the stature of the other parties involved with the fund – for example the fund administrator and custodian – checks on the constituent documents, including for example the prospectus and offer documentation. Part of such an approval will involve the regulator assessing the risk of the investment. Something which is in volatile or exotic assets, or which is highly leveraged, will score a higher risk rating than something investing in listed blue chip companies. The regulator will check that where more risk is contained within a product, the prospectus sets out those risks clearly and will limit the type of investor who can go into the fund to persons who can meet the criteria of ‘professional’ or ‘expert’ investors. 

Take care on this one. Are you genuinely a ‘professional investor’ – lots of regimes allow a self-certification of that status, but sadly many investors sign it while in fact being very retail in their knowledge and risk profile.

Once authorised, the regulatory regime has two safeguards – firstly that the fund must submit annual audited accounts, and second that the regulatory authority supervises the conduct of the fund on an ongoing basis to make sure it is investing in what it is supposed to invest in, and that records of who has invested, when they invested, how many units they were allocated for that investment and what those units are worth on an ongoing basis, are all checked from time to time. The administrator who generally keeps track of all these matters is also a regulated entity, and therefore should be competent and honest. 

So, the checks that a prospective investor or a person who is considering recommending a fund investment for sale should focus on are initially what jurisdiction a company issuing units is in, or what jurisdiction a unit trust has been established from, and from this establish whether that jurisdiction meets Iosco standards. Moving to local law, they should establish precisely what regulatory regime is in place in regard to this particular fund, what kind of permit has been issued to the fund, exactly what is in the prospectus, and its historically published results. 

At one end of the scale checks may confirm that the product is incorporated in a sensible jurisdiction with proper creditor protection enshrined within company law, approved by a respectable regulator as suitable for retail investors, is in assets which can be transparently valued by independent indexes, is audited, and has published sets of accounts and annual reports going back a number of years which demonstrate ‘track record’. Importantly the checks should also look out for independent administrators and, vitally, an independent and regulated custodian of stature.

At the other end of the scale of possible results this may well show a newly or relatively newly-established fund, run by people with no long-term regulated track record – perhaps they have come from a retail or property background – investing into assets whose value is set by the opinion of the manager of the fund. Worse, you might find no independence in the structure – in other words that the fund, fund manager, fund administrator and ‘promoter’ (the person who is the driving creative force for the fund) are all the same bunch of people.

The tricky thing is that this last paragraph does not describe fraud, it describes a niche fund dependent upon expertise in particular fields. These can be good investments and often are very profitable, however, the characteristics described also create an environment which is much higher risk and much more vulnerable to abuse by fraudsters. 

Regulators try to keep the fraudsters out and supervise the conduct of the fund to monitor that it is being managed and administered within the rules for that risk level fund, but investors and advisers need to understand they take on the structural risks as well as the risks of the asset class when they invest in expert and sophisticated funds.

The risk that an investment may be mis-sold

The next layer of regulation to be applied to a fund product is generally through the independent financial adviser who is the interface between the product provider and the investor.

The adviser will be authorised to advise on certain types of products and may or may not be permitted to hold client money. Similarly, as an investor, check out your adviser before you place your trust in him. What solvency does the regulatory regime require his firm to demonstrate? Is he required to carry professional indemnity insurance? How long has he held his licence? Will he share with you the firm's audited accounts? What are his qualifications? How is he paid? What are his connections with the product providers? 

Very importantly, does the jurisdiction you are dealing with have an investors' compensation scheme?

The adviser's responsibility is to understand your current financial position, understand your financial goals and to make recommendations that will help you use your money – from income or from savings – to achieve those goals within a risk framework which is acceptable to you. Discussions on whether your risk tolerances are low, medium or high might be a new concept to you, but they mean quite simply how much are you prepared to risk to gain the returns you want. Generally those discussions focus on the asset class risk – but including the structural risks outlined above, is well worth the time and may be insightful on the adviser’s approach to risk himself if he simply does not know those answers about the products he is recommending you put your savings into. The risks you are prepared to tolerate may also be affected – probably reduced – if you are in a jurisdiction without a compensation fund that covers mis-selling.

The next layer of checks you should undertake with regard to your adviser relate to the documentation. Make sure you read the documents. Do not invest if you do not understand. To put it bluntly, if you cannot understand the offer document and prospectus, why on earth are you signing that you are a sophisticated or expert investor?  

The last piece of protection you can ensure is in place is to keep your records carefully. Keep meeting notes, keep emails, keep business cards, keep application forms, keep copies of checks or bank statements showing transfers and valuation statements and correspondence or newsletters. 

If all goes wrong will your records evidence what you bought, who sold it to you, why you bought it, the advice you relied upon, and how your early concerns were dealt with. These are vital factors to demonstrate to investigators be they sent from the police or the regulator. Sadly, most investors do not keep these records.