Views on improving the integrity of global capital markets
05 August 2014

Buyer Beware: the Common Traits of Investment Product Scams


Industry: Trading of the gemstone jade

Geographic region: China (provinces of Yunnan, Sichuan, and Guangdong) and Myanmar

Suspected culprit: Zhong Xiong, a 33-year-old Chinese citizen.

Value of the scam: At least 1 billion RMB

Details: As reported by Chinese publications Dong Fang Daily and Tencent News, in the past five years Zhong consistently portrayed himself as “second-generation rich,” a common term to describe wealthy young people in China who were born with a silver spoon in their mouths. He was featured in a local magazine, where he showcased his collection of exotic watches, and frequently arrived at meetings in his Bentley or Maserati. On top of that, Zhong entertained business acquaintances with lavish dinners but seldom forked out any cash because he apparently owned the restaurant or clubhouse.

Against such a lavish background and seemingly tangible assets, jade dealers slowly dropped their guard and trusted Zhong as a key industry key player. Here is how the process played out:

On 11 March, Zhong asked a jade dealer to bring his inventory to Yunnan, where Zhong had managed to gather VIP clients from Beijing and Shanghai. Because this was the first time the dealer had conducted business with Zhong, he was naturally eager to leave behind a good impression, assembling 50 pieces of top-quality jade from both his personal inventory and external network. It is common practice among jade dealers to cross-sell each other products, and without offering a letter of credit or tangible collateral.

On 15 March, Zhong “purchased” 13 pieces of jade (worth 5.4 million RMB) from Yang’s inventory, supported by a hand-written credit note and a verbal promise to pay for the merchandise two days later.

However, when the dealer called Zhong on his mobile phone to expedite payment, Zhong lamented that he was preoccupied with work and requested a payment extension. Repeated excuses were offered until 26 April, when Zhong could no longer be reached by mobile phone.

The alleged fraud didn’t stop there. Another jade dealer, who was subjected to a similar ruse between 12 March and 26 April, lost 65 pieces of jade valued at 27.3 million RMB. By the end of April, 67 dealers had reported similar cases to local police, with the total net worth of missing inventory now standing at least 1 billion RMB, based on media accounts. On the surface, it might appear that the jade dealers were simply ignoring conventional wisdom in risk management by entrusting millions in jade inventory to Zhong without any proper letter of credits or documentation.

But look deeper. Put yourself in their shoes. If everyone in the industry relies on mutual trust to transact business, it may feel odd to question otherwise. But what can we learn from this saga?

As is the case with most frauds and Ponzi schemes, there often are a number of things they have in common.

  • Lavish Marketing: There is a common saying that consumers buy on impulse and justify the purchase later with “logic.” Consumers are used to associating Armani, Ferrari, and other high-end luxury brands as symbols of “too-rich-to-fail.” Just take a cursory look at how top-notch private bankers and insurance agents are dressed, and it does not take a rocket scientist to determine it is still very much an image-driven ecosystem within the consumer markets. Of course, not all well-dressed people are con men, but as the alleged jade-trading fraud reinforces, simply “looking the part” is far from a fool-proof method for detecting would-be fraudsters.
  • Following the pack: Secondly, most consumers and investors simply do not question the way systems work if everyone else is doing the same thing. And this is even more evident within the finance industry. There might be a handful of professionals who were baffled by how Madoff managed to generate a monthly return of more than 1% on his mega Ponzi schemes, but no one managed to drill deeply enough to pierce through his operation. Given Madoff’s level of experience and reputation within the finance industry at the time, it’s easy to understand why some failed to question the returns.

How can these lessons be applied to investors in the capital markets?

  1. Question the status quo. Start by attempting to understand the business model. Behind every bond (with the exception of sovereign) and equity issue, there is an underlying company. Examine its business model to check whether you are contented with its product or service quality, sustainability of profit margins, and other relevant characteristics. Never go with the flow; you must do your homework.
  2. Rely on logical analysis. If there are investment products that have low risk while generating a high return, you likely would never be on the receiving end of a marketing pitch. The more likely target: institutional investors, or even government. In short, investors should develop a natural sense of skepticism during the investment evaluation process. It is always better to miss an opportunity than to lose your life savings.
  3. Don’t rely on regulators to do the homework for you. Many investors mistakenly believe that, if the promoters come from a properly registered company, their products must be genuine and are regulated by some higher authority. In some cases this may be true, but in others it may not be so clear-cut.

For many years, commodity buy-back schemes and land banking have attracted the eyeballs of many retail investors. Promoters of such products have indirectly implied annual returns in the range of 20% to 50%, a feat that would make the returns of veteran investors like Warren Buffet seem mediocre. If it seems too good to be true, it probably is.

What Is the Role of the Regulator?

The next obvious question is where the regulators are when investment product scams are carried out. There are examples of regulators warning the investing public of potential scams; take for example, this warning from the Singapore government on investing in undeveloped land in a foreign country. Because of the absence of official statistics, however, we are not sure how many investors have read it. And among those who did read it, what percentage of would-be investors changed their investing decisions solely because of it?

The subsequent question is whether we should fault the regulator for not having taken a harder stance on enforcement or banning the sales of exotic financial products altogether. Regulatory overreach is a constant peril that can threaten the vitality and effective functioning of capital markets, and regulators constantly seek the right balance between preventing abuses and allowing business to function. Many businesses operate in a grey zone that is within legal parameters but with more questionable outcomes, where regulators find it difficult to prosecute fraud. It is a constant cat-and-mouse game in which each party gets better at the game.

In situations involving risk with potentially massive social impact, regulators are likely to act to intervene directly and put in place a stronger enforcement mechanism. As an example, a proposed new enforcement mechanism for exotic investment products in Singapore was recently proposed by the Monetary Authority of Singapore. And even when direct intervention does occur, it is typically achieved in a moderately slow and cautious manner to avoid any unnecessary disturbance within the free markets.  Investors and their advisers are not without their own responsibility to assess investments, given the very real limits on what regulators can do.

It will take years, if not decades, to rebuild trust among the Chinese jade industry participants. That because once basic trust is broken within an industry, transaction volume trickles down sharply and even honest participants will be adversely affected. On the brighter side, though, it is also during such unfortunate incidents that market participants are forced to come up with a more robust system to propel the industry forward.

Henceforth, the rebuilding of trust can be extremely painful. That is why it is so critical for industry stakeholders to continuously highlight loopholes and patch them before they spiral out of control and negatively affect market integrity. That is precisely what CFA Institute is trying to achieve for the finance industry.

Indeed, based on the 2013 CFA Institute and Edelman Investor Trust Survey, only 52% of the respondents said they trusted the financial services industry. It was the least trusted industry among a group of eight that included technology, food and beverage, pharmaceuticals, consumer-packaged goods, automotive, and telecommunications.

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About the Author(s)
Alan Lok, CFA

Alan Lok, CFA, was a director of capital markets policy at CFA Institute. He was responsible for conducting research projects in the area of market instruments and market structures in the Asia-Pacific region. Mr. Lok worked with regulators, institutional investors, academics, and various other stakeholders within the financial industry to uphold investor protection and market integrity.

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