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The Growth of Affinity Frauds


Peter Turecek

Whether due to increased investor skepticism, regulators’ need to demonstrate active enforcement, the financial media’s search for good copy, an increase in fraud in the current economy, or a combination of all of the above, investment frauds have been coming to light more and more frequently.

The scams, most of them classic Ponzi schemes, involve investment in diverse vehicles, including securities, hedge funds, real estate, investment clubs, and so on. Many, though, have one thing in common: the victims share some trait with the perpetrators of the fraud. This element in common with the fraudster lulls the victims and makes them more readily trusting of the con artist’s pitch. The perpetrator preys upon that inherent trust of a shared bond. After all, the fraudster is “one of us” and must be “looking out for me.” These are called “affinity frauds.”

In the past year, multiple scams have targeted specifically identifiable groups of victims. Targets have included those who are geographically connected, such as high net worth individuals resident in New York City or Palm Beach; investors from certain religious faiths, such as the Jewish or Mormon communities; members of ethnic groups, such as Haitian-, Chinese-, or Korean-Americans; and even the elderly or those with disabilities. Affinity fraud can be based on almost any common bond: victims in the past have come from groups of pilots, former professional football players, divorcees, and members of specific interest clubs.

In August of this year, the Securities and Exchange Commission (SEC) moved against at least three alleged investment frauds targeting specific communities of victims:

  • a man was charged with fraud after he raised over $1 million from parishioners of a Redding, California church community in a Ponzi scheme;
  • a complaint was filed against a Pomona, California-based individual running an investment fraud aimed at mobile home park community residents;
  • an enforcement action was initiated against an Orlando, Florida-based individual running a pyramid scheme aimed initially at Orlando and Puerto Rico-based investors.

Even where fraudsters do not share a common trait with their victims, they work to co-opt influential members of the target group. These leaders are typically duped into believing in the investment opportunity, which then spreads by word of mouth to the rest of the community: “If the pastor believes in this opportunity, who am I to disagree?”

Fortunately, most of these situations can be avoided relatively easily. All that is required is a combination of a little common sense and due diligence.

If an investment opportunity promises returns that sound too good to be true – such as incredibly high rates of return or overly consistent returns despite volatile market conditions – it most likely IS too good to be true;

If the investment opportunity cannot be explained to you in a way that readily makes sense, be suspicious. Keep asking questions until you feel comfortable that you understand the opportunity fully.

If the opportunity is a “secret” one, with very limited participation, run the other way;

  • Check with your state securities regulator, the Financial Industry Regulatory Authority, or the SEC to see whether the person offering the investment is registered or has a disciplinary history;
  • Listen to your instincts. You would be surprised how accurate that little voice can be.


EIU Survey

A bad year: It has been an annus horribilis for the financial services industry in many ways, and fraud is no exception.

  • The average loss per company over the last three years rose to $15.2 million, 173% of the survey average, and roughly one-sixth more than the 2008 survey figure ($12.9 million).
  • Over one-half of respondents (51%) reported that the global financial crisis had increased levels of fraud at their companies – the highest figure for any sector. Moreover, 35% said that they had seen an increase in fraud in general in the last year, compared with just 28% who saw a decline. This made the sector one of only two where the former outweighed the latter, and it did so by the biggest margin.
  • 87% of firms reported being victims of some kind of fraud in the last three years, up from 79% in the previous survey.
  • Finally, the sector had the second-highest proportion suffering from each of internal financial fraud (29%) and management conflict of interest (26%), as well as the highest rate of money laundering (10%).

Efforts to address the problem: The industry realizes it has a problem, and is devoting resources to it, but not always consistently.

  • For every type of fraud covered in the survey, the proportion of companies considering themselves highly vulnerable increased from last year. Moreover, the industry has the highest proportion of highly vulnerable companies for four out of ten types of fraud – regulatory or compliance breach (25%), financial mismanagement (23%), money laundering (17%) and management conflict of interest (16%).
  • Only 2% of financial services firms are not making anti-fraud investments in the coming year, and for nine out of the ten anti-fraud strategies listed in the survey, over one-third of respondents are boosting defenses – the most widespread spending of any sector. In four specific areas, investment will be more common in this sector than anywhere else: IT security (63%), management controls (50%), risk management systems (38%) and reputation monitoring (36%). The first of these is particularly important, as complex IT infrastructures are increasing fraud vulnerability at 46% of sector firms, the highest rate for any industry.
  • Unfortunately, however, over one in five companies (21%) saw their internal controls weakened as a result of cost cutting – a tie for the second-worst record of any sector.

As part of their rebuilding in the wake of the recent turmoil, financial services companies need to toughen their anti-fraud defenses. Many are doing so vigorously, but the best controls in the world will fail if, in any future crisis, they are sacrificed to save money.

Written by The Economist Intelligence Unit