TheMoneyGeek Unplugged

As you are probably aware, Bernard Madoff, former NASDAQ Stock Market chairman and founder of Bernard L. Madoff Investment Securities LLC, has recently pled guilty to all charges against him and will be in jail for a very long time.  Incredibly, I’ve recently spoken with several individuals and they seemed to not be aware of Madoff’s most egregious offenses.

What did he do?  Madoff collected money to invest from clients, made up false statements to show that they were doing well, and used new clients’ money to pay interest and withdrawals to existing clients.  This is known as a Ponzi scheme and is estimated to involve more than a $50 billion loss for his investors.

Bernard Madoff’s Ponzi Scheme stands as an example of how the financial services industry has failed to protect the best interests of consumers. It highlights the increased need for consumers to proceed cautiously when working with an advisor and the importance of asking pointed questions before hiring a professional.

His clients didn’t see this coming.  Could they have?  Let’s look at three key safety tips that would have prevented this from happening:

Know what you own.  Stay with traditional investment vehicles such as stocks, bonds, Exchange Traded Funds (ETFs) and mutual funds that are publicly traded and listed on major exchanges like the New York Stock Exchange.  They are valued independently at least daily, if not minute-by-minute, while the exchange is open.  With the exception of common trust funds, you should be able to access pricing and performance of your individual investments in the newspaper or the Internet.

Use an independent custodian.  Madoff held his clients’ assets, managed them, and priced them via internally generated investment statements.  Naturally the investment performance will look better if the prices reported to clients are manipulated, which is allegedly how Madoff showed winning year after winning year despite market turmoil.

For example, as a registered investment advisor, we have selected TD Ameritrade Institutional as the custodian for our client accounts.  TD Ameritrade Institutional, as an independent third party, prices the investments owned and provides monthly statements to clients.  We have no control or input on investment pricing.

Each money management client of ours signs a Limited Power of Attorney on their TD Ameritrade accounts.  This limited power of attorney only allows us to:

• Place trades in the account on clients’ behalf;
• Receive copies of monthly statements, tax documents and trade confirmations;
• Deduct our investment management and financial planning fees directly from the account.

While we can request a distribution on a client’s behalf (which must be mailed to their home address or transferred to another account in their name), our ability to withdraw funds from client accounts is limited to the payment of our financial planning and investment management fees.  Clients are always free to pay their fees by check and are never obligated to use direct deduction from their accounts.

Inquire about insurance.  Our clients benefit from fraud insurance.  Each client is insured with the Securities Investor Protection Corporation (SIPC) with coverage of $500,000 per account.  Keep in mind that fraud insurance does not protect against market declines; but it does protect against theft of securities or related fraudulent transactions.

Now as the post-Madoff era begins and the federal government and industry regulators decide the best course of action to protect consumers, people need to ask the right questions of an existing or potential advisor.

As a member of the National Association of Personal Financial Advisors (NAPFA), the country’s leading association of Fee-Only financial advisors, I encourage consumers to take the time to get to know an advisor and gauge his or her commitment to placing clients’ interests first.

Find out how the advisor and his or her firm are compensated.  Fee-Only compensation has the fewest conflicts of interest, but there are other acceptable methods as long as full disclosure takes place up front.  It’s important to know if an advisor will make additional money if you follow certain recommendations.

You should always know where your money and securities are actually held. As discussed above, most reputable advisors will use an unaffiliated custodian for the safe keeping of your assets.  This simple check and balance could have saved the Madoff investors millions by bringing the problem to the forefront earlier.

Legally, all clients are entitled to a copy of the firm’s Form ADV Part II or brochure.  It’s a compliance document that can be pretty dry reading, but it contains a lot of important information and ultimately shows that the firm is registered with the SEC or the state(s).  For an example, see our Form ADV Part II.

NAPFA and the Fee-Only advisor community are hopeful that the new administration, the SEC and other regulatory bodies will enact thoughtful regulations to protect consumers.

Consumers can access a Financial Advisor Checklist and Financial Advisor Diagnostic on the NAPFA website by visiting www.NAPFA.org and clicking on the Tips and Tools button in the Consumer Information section.  The Diagnostic tool includes an answer key to help consumers understand NAPFA’s recommendations for the most appropriate answers to the questions.

One final thought. One of the statements most widely used in basic investment course work is “if an investment sounds too good to be true, it probably is.”  Reportedly, Madoff claimed consistent annual returns of 10-12% with little volatility and no quarterly or annual losses.  I am not aware of any legitimate and reputable portfolio manager that can make that claim.  There simply is no investment available that doesn’t carry risk; certainly, any investment that pays those levels of return have inherently high risk.

Have you or anyone you know been a victim of Madoff? Please share your story and comments below.