Back in 2008, as the Madoff scandal first broke, we sent an urgent warning to clients alerting them to tell-tale signs of investment fraud and documenting steps they should always take to avoid being caught up in a similar scam.
Here we are in 2013, and it’s déjà vu all over again, to quote the inimitable Yogi Berra.
In yesterday’s Fort Lauderdale Sun-Sentinel, the headline story was “31 NFL players lose $40M, thanks to Broward adviser.” Our South Florida area has had more than its share of big, flashy investment fraud stories (can’t these people please go somewhere else?).
The lessons never seem to sink in. For that reason, we’ve updated our checklist of rules you should follow to avoid being the victim of investment fraud.
Rule #1: Use an independent custodian
Your custodian’s job is to hold and protect your assets, collect your dividends and interest, and process your securities transactions. Always make sure your assets are held with an independent custodian like Charles Schwab & Co., Fidelity, or a big-name brokerage firm. The key word here is independent. Your custodian and investment manager should be independent of each other, and your investment manager should not have the power to withdraw assets from your account.
For example, the client accounts we manage are held at a national brokerage firm. Clients give us authorization to access information about their accounts, handle administrative matters, and trade (buy and sell) investments. However, only the client is allowed to withdraw funds from the account.
Often in fraud cases, the same firm acts as the brokerage custodian and investment manager. There are no checks and balances. When the investment manager steals from the account, the same firm, acting as custodian, forges statements to hide the theft. This would not happen if the client assets were held by an independent custodian.
Your statement, documenting your holdings, should be issued at least monthly by a known independent custodian, and you should review account transactions regularly.
Rule #2: If it looks too good to be true….
When someone is claiming to have investment results that are far better than peers or the overall market, or performance that is amazingly consistent in an inconsistent world, don’t be impressed. Be skeptical and stay far, far away. Here’s how one journalist described his reaction on reviewing his wife’s 401(k) statement, managed by Madoff (italics are mine):
“Fast forward to October of 2008. Her 401(k) statement for the nine months ended September 2008 arrives and once again the account was up 6% or so — it’s hard to tell exactly. Now, I’m thinking that maybe her 401(k) plan provider is … the one guy who’s making money in a down market, he’s the guy on the other side of the trade. He’s the next Bill Miller or Peter Lynch. In fact, my wife and I even discussed upping her contribution to her 401(k) plan given what’s his name’s success.”
And let’s not forget the miraculous CDs sold by financier R. Allen Stanford. Those CDs, according to a skeptical BusinessWeek in 2009, offered “returns more than double the market average by investing the CD money largely in corporate stocks, real estate, hedge funds, and precious metals.” (Mr. Stanford is now serving 110 years in prison; his investors are out a lot of money).
Rule #3: Investors need to do their homework
One Madoff victim tried to find out more about the firm managing his wife’s 401(k) account:
“Curious, I tried to learn more about her employer’s 401(k) plan provider, the Bernard L. Madoff Investment Securities LLC. Unfortunately, I found little information about the firm on its Web site, nor on the Securities and Exchange Commission and Financial Industry Regulatory Authority (FINRA) Web sites. So, I dropped the matter, failing to take note of what, in retrospect, was one of the red flags.”
Legitimate firms leave a data trail. They have regulatory filings, tax filings, are registered as business entities with the state, and may employ accountants, auditors, and attorneys who can be interviewed. If you cannot locate sufficient information on a business and its officers, that is indeed a red flag.
In the past, we have been asked by clients to review information on their other advisers, proposed investments, or perhaps check out a retirement plan offered by an employer. On more than one occasion, we have uncovered enough questionable information that we have advised clients to not participate in sketchy investment or retirement plans, and not work with advisers whose regulatory filings raise more questions than they answer.
Rule #4: Don’t invest in what you do not understand
In the Sun-Sentinel story, former NFL players were asked to invest in an out-of-state casino. That’s not unusual. Many fraudulent investment pitches involve exotic or “glamorous” investments.
So-called investment experts may try to bamboozle you with their foolproof, can’t-lose strategies, many of which are so complex you can’t begin to understand them. Before you plunge in, just remember the story about the emperor who had no clothes. No one wants to be the first to appear unsophisticated and say they do not understand.
Be especially careful when the investment strategies involve exotic or alternative investments, hedge funds, or other complex schemes (this should certainly include convoluted, can’t-lose annuity products where absolutely no one really understands all the moving parts).
Investing in mutual funds, stocks and bonds can be very straightforward, and the marketplace is highly regulated and transparent. But most hedge funds and other “alternative” investments are reserved for high net-worth investors who are presumed experienced and sophisticated enough that they do not need the protection of government regulation. That means standard investor protection measures may not apply.
The takeaway: Don’t be the victim of investment fraud. Before you take the leap and commit to an unproven investment, ask someone you trust, and whose opinion you respect, for a second opinion. Here’s the real truth about bad investments – they’re really easy to get into, and impossible to get out of.