In this blog, Carl Mifflin, Head of Restructuring and Insolvency at Howes Percival, examines how investment fraud has thrived in recent years, highlights how economic uncertainty provides a breeding ground for fraudsters and identifies some of the key ways to avoid falling victim to investment fraud.
The last thirteen years have seen an unprecedented level of financial turmoil, starting with the global banking crisis in the autumn of 2008 and culminating in the economic devastation caused by the COVID pandemic in 2020. The FSB predicted last month that 250,000 small businesses in the UK would fail in 2021, and the damage is not limited to small businesses as the collapse of many high street retailers has demonstrated. A particularly troubling consequence of the economic downturn, however, has been the substantial increase in investment fraud.
It is easy to understand how financial conditions have created the ideal breeding ground for fraudsters to thrive. In August 2007, the Bank of England base interest rate stood at 5.5%. Mainstream investments, such as ISAs, offered investment returns of 10% p.a. and property prices were increasing at a steady rate. In summary, people with cash to invest could generate substantial returns with minimal risk. Fast forward to 2021 and the Bank of England base interest rate stands at 0.1%, property prices have declined substantially across most of the country, and high-interest savings accounts seem like a distant memory, now offering less than 2% p.a.
Faced with an inability to generate comparable returns on investment from 2007, investors have been drawn to riskier investments, promising returns of 10% or more, despite the age-old adage that “if something looks too good to be true, it probably is”. In most cases, the investments are packaged to look like legitimate investment opportunities, sold by independent financial advisors who are paid exorbitant commissions (25-30%) for inducing inexperienced investors to transfer funds from traditionally safe investments such as pensions, and often containing promises of “guaranteed” returns on investment. In many cases, investors are provided with an “asset”, such as a 999-year lease of an individual room in a hotel or student accommodation block, which is intended to (a) retain the value of the capital investment; and (b) generate an income equivalent to a high percentage return on investment.
The investment opportunity is given an appearance of legitimacy by demonstrating how existing investors are already achieving the promised returns on their investment. In many cases, however, this is a smokescreen achieved by using new investor money to pay early investors (commonly known as a ‘Ponzi’ fraud). Inevitably, however, as the number of investors grows, and new investor money dries up, the interest payments to investors cease and the investor is left with an “asset” which generates negligible income, has little or no re-sale value and a “guarantee” as worthless as the paper it is written on.
It is important to note that not every investment scheme that fails is fraudulent. The current financial crisis has caused many legitimate investment schemes to fail simply due to the sector in which the investment operates. It is a fact, however, that investments of this nature are inherently risky and chasing high interest rates can result in you losing your hard-earned capital.
The most critical advice is to carry out proper due diligence. Do not simply rely on the information you are given by a promotor or sales agent but seek your own independent advice to scrutinise the investment fully. Consider your exit route from the investment. Is there a legitimate secondary resale market for the “asset” you are acquiring? For example, who is going to buy a lease of a hotel room or student apartment from you if it only generates a return of 2% instead of the promised 10%? Research the company thoroughly. For example, do the directors have a history of insolvent companies or failed investment schemes?
I cannot emphasise enough the importance of seeking legal advice as soon as your investment falls into default. Do not rely on excuses or repeated promises of payment which fail to materialise. Those investors who take action quickly to demand repayment of their investment following default have the greatest prospect of getting repaid. The harsh reality is that many of these investments resemble a game of Jenga … the structure can probably withstand the removal of a small number of blocks but, at some point, the entire structure will inevitably come crashing down leaving a debris of disgruntled investors wishing they had acted sooner to remove their “block”.
If you would like any further information or to discuss any issues relating to restructuring and insolvency, please contact 0116 247 3500.
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