The Moneyist: We plundered our 401(k) to invest in a friend’s business — now we fear it’s a Ponzi scheme

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Dear Moneyist,

We are in a sticky situation and need some advice on how we should proceed.

We had a friend who has had some success (and failure) in business. He was sent to federal prison for two years for signing off on falsified financial documents as an executive of a company. He claims he somewhat knew but was also sort of tricked into it, or at least was backed into a corner. Whatever…

But after his release he got himself back on his feet fairly swiftly. And when I say friend, this isn’t a casual acquaintance: My wife, 55, has been best friends with his wife since they were toddlers. My wife met him in high school and actually introduced them to one another, so that is definitely a complicating factor.

After two years in prison, he presented an ‘investment opportunity’

In August 2015, he approached us with an investment opportunity. Since his conviction he is no longer allowed to helm a publicly traded company, but he was running his own private company, a social media site for tweens. We even attended some high-level events like anti-bullying campaigns.

He wanted friends to buy preferred stock in his company, which he said could be sold at three times what we paid.

He said his company had a suitor and he wanted friends to buy preferred stock, which he said could be sold at three times what we paid. He said the deal would be done in a “couple of weeks” so we needed to get in on it now.

We scrambled to get the money. I borrowed $6,000 from my retired parents. The worst part: I took nearly $70,000 out of my 401(k) to invest in this. He confirmed several times that I would have the money back in less than two weeks, thereby avoiding an early withdrawal penalty.

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Their friend now pays them $800 a month to help with bills

Well, no deal has been completed. We have not seen any return on this supposed investment. Making matters FAR worse, not only did I get hit with the early withdrawal penalty, the $70,000 was treated by the Internal Revenue Service as income, which knocked us into the next tax bracket up. We now owe the IRS around $30,000 and the state franchise tax board $10,000.

Our entire household income is below $100,000 annually, and the income is solely employment-driven, not from investments.

To his credit, I guess, he found us $800 a month to help us pay our monthly expenses, but even this has been fraught with frustrations. The first few times his checks actually bounced and my bank charged me the returned item fee.

He found $800 a month to help us pay our monthly expenses, but even this has been fraught with frustrations.

Interestingly, we’ve discovered that he’s roped in numerous family friends for his deal, some of whom opened a civil suit against him to try and recoup some of their money. One person leading the suit informed me that he initially approached them in 2011, and gave him millions of dollars.

He offered them $56,000, but they must sign away their rights

My fear is this guy is operating a Ponzi scheme. Every month or so, we get news that the deal is closing, and distributions should happen soon.

Most recently, he told us we would get a payout of $56,000, but we would only get that if we signed a document to say we agreed to not pursue further funds through legal or other means.

A person involved with the class-action suit claims they saw us listed on a discovery document and said we were listed as providing a $70,000 loan, and not listed as investors. And yet we signed a contract saying we would be shareholders.

We may have been listed as providing a $70,000 loan. But we signed a contract indicating we would be shareholders.

I reached out to my local District Attorney’s office. It referred us to our local county Sheriff’s office to file a police report. My fear is that no matter what we do, it will result in him shutting off the monthly $800. We still really need that money so the IRS doesn’t come after us and take our house.

We’ve learned some hard financial lessons: Be immensely careful how/when/who/what you invest with friends, don’t invest what you can’t afford to lose and don’t ever use retirement funds. I’d be ecstatic to just have the tax problem off our backs. What should we do?

Scammed in California

Dear Scammed,

This was one of those letters where I hoped your question would land about one-third of the way in—somewhere between the part where he served two years in federal prison for fraud and where he offered you a slice of his new business with triple the return within two weeks. Given what you knew about your friend and the ludicrously lucrative return on your investment, surely this struck you as too good to be true? Instead, you raided your 401(k) to find money for this deal. Just because you know someone for many years and like him, doesn’t mean he won’t defraud you.

Even though so many parts of this deal seemed shady, you were dazzled by the prospect of such high returns. Or, to put it in your words when describing this guy’s explanations for past misdeeds: “Whatever…” In order for me to answer your question, we need to acknowledge that hard fact first. Every scam finds that sweet spot between tantalizing and tantamount to highway robbery—just enough for those heavenly returns to triumph over reality. Bottom line: He gave you an offer you couldn’t refuse. You do bear a certain amount of responsibility for that.

Even though so many parts of this deal seemed shady, you were dazzled by the prospect of such high returns.

The reason I bring this up now: Your lack of due diligence may come back to haunt you later if you decide to pursue legal action. Of course, most people work hard and, when presented with a “now or never” scenario, want to believe there’s one good deal that could get them over the finish line into a comfortable retirement. Whether it’s a cryptocurrency or a cryptic business proposition, it’s never a good idea to invest in something you don’t fully understand. As some members of the Moneyist Facebook Group pointed out, FOMO or “fear of missing out” is a strong motivator in situations such as this. But that’s not usually the best reason to make such a substantial investment.

So what next? Think twice before signing any document where you promise not to take action against him. That’s the advice of David Wall, CPA at the CliftonLarsonAllen accountancy firm in Los Angeles, who represented the District Attorney’s office in the Ryan Rude Ponzi scheme. “If his offer is genuine, you are now on inquiry notice that the source of this ‘hush money’ was likely stolen from others,” he says. You may be required to pay back all of those payments if you are part of a Ponzi scheme. The IRS provides tax relief for victims of Ponzi schemes. You can read more here.

Unfortunately, you walked into this financial mess with your eyes wide open. “To truly be a victim you need to demonstrate good faith,” Wall says. “To determine good faith the court will consider: (i) Did you have information putting you on inquiry notice of the culprit’s fraudulent purpose and (ii) if you were on inquiry notice, did you conduct a diligent investigation?” Inquiry notice is the legal concept that a reasonable person would ask for more information in situations such as these. As a creditor or a shareholder, given what you have told me, that would seem to apply here.

Bernie Madoff used an ‘affinity scam,’ tapping friends, acquaintances and people with money who trusted him.

Whether this is a Ponzi scheme or a pyramid scheme, or simply a guy who is trying to keep his business afloat with other people’s money and fancy cocktail parties with virtuous themes, you’re unlikely to see your full investment again. Bernie Madoff used an “affinity scam,” tapping friends, acquaintances and people with money within the Jewish community who trusted him. Scam artists also use the “halo effect” by hosting events in respectable places. Anti-bullying campaigns are a worthy cause. But this seems to have been a factor in convincing you this man was a reformed character.

Looking ahead, there is so much here that you need clarity on. You appear to be unsure whether you gave your friend a loan or whether you actually own shares in his business. This is something you should know after giving him $70,000. Find the documents you signed and hire a lawyer to help you to pursue any legal options. Being a shareholder is quite different from loaning the company money. When a business files for bankruptcy, for instance, creditors generally come ahead of stockholders in the line to receive payment. In the meantime, negotiate with the IRS on a payment plan.

And, please, don’t sign any more documents that you could regret later on.

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Hello there, MarketWatchers. Check out the Moneyist private Facebook group, where we look for answers to life’s thorniest money issues. Readers write in to me with all sorts of dilemmas: inheritance, wills, divorce, tipping, gifting. I often talk to lawyers, accountants, financial advisers and other experts, in addition to offering my own thoughts. I receive more letters than I could ever answer, so I’ll be bringing all of that guidance — including some you might not see in these columns — to this group. Post your questions, tell me what you want to know more about, or weigh in on the latest Moneyist columns.