How to Avoid Madoff-type Scams
Bernard L. Madoff was well known on Wall Street as a financier.He was a chairman of the Nasdaq stock exchange, and owned a brokerage business, but he became world famous when he confessed to operating a $50 billion Ponzi scheme. Note this : he was not caught by any law enforcing agency, he turned himself in. Had he not done so, his crime may still be undetected. This is despite the fact that someone (Harry Markopolos for one) had been telling the US Securities and Exchange Commission for years that Madoff was running a scam. Many rich people, as well as investment advisors, are victims of the Madoff scam.
Some people claimed that they were invited to join the Madoff fund, but declined after seeing signs that made them suspicious of the Madoff operation. We can learn from these wiser investors if we are to avoid falling into a Madoff-type scam.
- Returns are too good to be true. Madoff’s fund reported annual returns in the 11% to 13% range year in year out, even during the tech bubble bursting period. The guy who reported on him was a competitor of Madoff’s style of investment, and he found that the investment approach claimed by Madoff could not have been able to produce the returns that Madoff claimed that he made. If someone promises you double the rate of market return with less risk, you should know what to do. Smile and turn your back.
- Actual operations not visible. Some of the Madoff victims are fund of funds managers. They are paid supposedly for screening out good managers. Apparently, they did not bother to see if Madoff has an office that is suitably staffed to do the type of work that he claims that his company is doing. His investment advisory company (not his brokerage company), which managed over $17 billion investors’ money, was reportedly staffed by his brother, an accountant, and a clerk.
- Relies on reputation only. For many people, this is the hardest come-on to resist, primarily because this approach to decision-making often works. One gets to save time in researching into the person and subject matter, and if the person making the recommendation is someone that has good social standing, we can benefit from the association also. Bernard Madoff was chairman of the Nasdaq exchange at some point. He runs a real and apparently successful brokerage business, and hence has been working in the financial sector for over forty years. He is well connected and wealthy. He was recommended to many of his victims by people with statue and wealth. This may be a major reason why the SEC investigations could not uncover the scam. The investigators, or their supervisors, took Madoff’s word for it, and did not dig deep enough.
- No (real) third party involvement. Madoff hired an obscure auditor to audit the financial statements of his investment advisory company. There was no custodian for the investment assets of his clients.
- Fishy statements. Each month, Madoff clients would receive elaborate reports on the transactions done by the company. However, it is now known that some trades recorded in the statements were not possible. For example, according to Reuters, his November statement showed he bought software maker Apple Inc's securities at $100.78 each on November 12, about a month before his arrest. But Apple's stock on that day never traded above $93.24.
Of course, after the exposure of the Madoff scam, future scam operators are likely to take steps to cover such cracks. For example, forex scam artists have been known to show victims grand offices before running off with the victims’ money. Investors have to take more care in selecting their investment advisors and diversify the destinations of their investment.
(Chiu-ying Wong, CFA, 17 Jan 2009)