Lessons From the Madoff Fraud, 10 Years later

Has it really been ten years? One of the low lights indelibly associated with the Great Recession of 2008 was the discovery and unraveling of Bernie Madoff’s massive Ponzi scheme. It feels like only yesterday that I wrote about that almost incomprehensible fiasco in real time.

But the journalist Erin Arvedlund wrote the book on Madoff.  And as early as 2001, she was one of the first to suspect Madoff’s hedge fund was a fraud. Those early warnings were ignored.

In the December 10 isssue of Barrons, Arvedlund succinctly recounts the sordid tale and reminds us of the lessons (hopefully) learned.

Giant Ponzi Scheme

Madoff created a phony options-based investment strategy. His minions simply created fake account statements, showing his investors and prospects steady false profits in their accounts. In classic Ponzi style, as new money came in he used it to distribute “profits” to existing investors.

At least 10,000 investors lost money with Madoff. Including, most tragically, charities and endowments which had Madoff aficionados on their boards. Much of the money was raised through so-called feeder funds, whom Madoff paid off to bring in tens of millions of dollars.

Astoundingly, the crime lasted 45 years. When the market precipitously fell in 2008 and investors began demanding their money, the jig was up. Madoff and others involved went to prison. And his family was destroyed.

Once and Forever

Since at least the middle of the 19th century there have been Ponzi schemes. And there always will be; as long as we have clever and brazen criminals – and naïve investors. Over the past year, the SEC broke up the $1.2 Billion Woodbridge Ponzi scheme, which claimed 4,400 (mostly seniors) victims, who were induced by some 18 fraudsters, including Jordan Goodman, “America’s Money Answer Man” into buying notes in a non-existent mortgage company.

The Cardinal Sin

The lynchpin of a Ponzi scheme is the ability of the wrongdoer to have custody and control over investors’ money so the false “profits” can be delivered to earlier investors as ongoing infusions arrive from current victims. As long as there is equilibrium between the flow of new money and demand for cash from existing investors the game will go on. Until it stops.

Most Ponzi schemers induce their victims to deliver funds directly to them via a check payable to the “advisor” personally – or to a shell company under his control.

Accordingly, as an investor, the absolute most important thing you can do to protect yourself from a Ponzi scheme is to direct the funds you are investing using a check made payable to a large, reputable, independent SEC registered brokerage firm to act as custodian. (Perhaps Madoff’s most devious trick was owning and controlling his own brokerage firm.)

A Close Second

The second most important thing you can do is to regularly monitor your accounts to make sure nothing is amiss. At least monthly, review your account statements or online records to determine that deposits, withdrawals and trades are as you expect them to occur.

This will not only protect you from a Ponzi scheme, but also from an unscrupulous advisor who may be executing needless or unauthorized trades or simply stealing from your account. This may also protect you from an unrelated third-party hacking into your account and misappropriating funds.

Getting Sound Advice

Once you have locked in safety from fraud and theft, what are some of the steps you can take to make sure you are receiving reasonably good advice from an investment professional? This is a more subtle question around which there is some debate. But a good place to start is to make sure your advisor is a fiduciary, legally obligated to act in your best interest.

A fiduciary investment advisor will adhere to these five core principles:

  • Put the client’s best interests first;
  • Act with prudence, that is, with the skill, care, diligence and good judgment of a professional;
  • Do not mislead clients–provide conspicuous, full and fair disclosure of all important facts;
  • Avoid conflicts of interest;
  • Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

You can find more information about the fiduciary standard in investment advice at The Committee for the Fiduciary Standard.


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