The first part of what I’m about to say you know. The rest you likely don’t. In December 2008, news hit of the world’s all-time largest financial scam. Bernard Madoff scammed investors out of as much as $65 billion. There was, effectively, nothing left in the coffers when authorities rushed in. All gone! You saw the stories splashed across newspaper headlines and the nightly news.
Though Madoff was the biggest scamming rat by far, news quickly followed about other similar scams. Had Madoff not been first, Texas-born Antiguan knight “Sir” R. Allen Stanford’s (alleged) Ponzi scheme would have been the biggest ever. His was merely $8 billion. The SEC charges it was a pyramid scheme—nothing more. Stanford had even been a repeat member of the Forbes 400 with what in reality was an illusory net worth. Unlike Madoff, who confessed, Stanford has denied all allegations, been charged, and awaits trial—but it doesn’t look good for him. The evidence against him appears beyond overwhelming.
Through 2009 and into 2010, more news about other, though smaller, scams broke—a seemingly endless stream. But for the victims, it doesn’t matter if the con artists scammed a big sum or small. If he stole from you, your loss was, in most cases, total.
Also endlessly, media, investors, and authorities asked, “How did this happen? How could this happen?” In Madoff’s and Stanford’s cases, they were two seemingly upstanding people. Employers with many employees. Known philanthropists! Respected by their communities. In fact, many of their victims were close to them. Friends. Associates. Madoff pillaged his own Jewish community particularly hard. And some of their investors were sophisticated—others were big hedge funds. If sophisticated, super-wealthy investors could fall prey, the fear was no one is ever safe from con artists.
And in one sense, that’s right. For some reason, folks think con artists only want big-money victims. Not so. Many of Madoff’s victims were smaller investors. Some invested just a few thousand with him—their life savings. Madoff took them all, big and small. A con artist doesn’t care if you’re super-rich or have just a small pile—all they want is your money and as much of it as they can get.

Heed These Five Signs

But the good news: It can be very, very easy to spot a potential fraudster. In the immediate wake of the Madoff scandal, I wrote How to Smell a Rat (John Wiley & Sons, 2009)—detailing five key signs of financial fraud. From all the fraud cases through time I researched, all of them had, if not all five of the signs, at least three—usually more. The signs are:
1. Your adviser also has custody of your assets—this is true in 100 percent of the cases.
2. Stated returns are consistently great—almost too good to be true. Also true in 100 percent of the cases.
3. The investing strategy is murky, flashy, or too complicated for the adviser to explain to you so you can understand it—almost always.
4. The adviser promotes himself (or herself, though rats are usually male) as an “exclusive” club, or otherwise distracts you with flash, bling, and connections—none of which have anything to do with investing.
5. You hired the adviser based on a recommendation or through an intermediary and didn’t do any real due diligence yourself. Con artists hate anyone who does any real due diligence and avoid them.
All the signs are important. The appearance of any one is a bit worrisome, though not necessarily an indictment. But the biggest, baddest, reddest flag of all is number 1. It is ever-present in these schemes and if you see number 1 plus any of the others, get your money back, now, if you can. Then, either do more of number 5 than you can possibly envision, twice over, or take your money and go.

Custody Is the Number One Sign

But what does it mean for the adviser to have custody? For example, Madoff’s clients hired Madoff to manage their money. They gave him full discretion to decide what to buy and sell and when. That’s a normal thing for a client to have an adviser do. It’s what my firm does for its clients and what many other fine registered investment advisers do for theirs. But Madoff’s clients deposited their money with Madoff Securities—a custodian that Madoff had direct control over. They gave him the money, and once he physically had it, it was tactically nothing for him to take the money out the back door and put it in his own personal account—which is exactly what he did.
Then he dummied up statements—for years—even decades maybe. And when clients wanted distributions, he just gave them funds from incoming money from new victims. His was a classic Ponzi scheme—and how most all of these scams operate. It’s what Stanford allegedly did. It’s what Charles Ponzi himself did when his name became synonymous with stealing-from-Peter-to-give-to-Paul-while-taking-most-of-it-for-yourself.
What did Madoff do with the money? I don’t know. It seems he spent a lot of it. He may have invested some, intending to return it to clients—but that went badly. But he couldn’t have done any of that if he didn’t have access to the money. Maybe he didn’t start out intending to steal—as he now claims. I think many Ponzi schemes start that way. You have a money manager with custody who gets into some personal problem requiring money. He’s got a bunch of money ready and handy in the form of his clients’ accounts—again, he has custody. He thinks, “I’ll just take a bit and cover my problem. Then, because I see this great opportunity over here, I’ll invest in it and make the money back. Then I’ll put the clients’ money back fast into their accounts, with no one the wiser and no one harmed.” Even if he did that successfully (though my guess is usually it blows up, but you never know), someone was harmed because the adviser had a fiduciary obligation to put his clients’ interests above his own. When he had that great “opportunity,” he should have let the clients have it, not him.
Here’s a parallel and in some ways a much bigger rub. Usually that first attempt to invest stolen client money in a hit-big attempt does blow up. Instead of hitting big, it splatters big. So he does it again, but this time trying an even bigger gamble (with probably bigger risk) to get the money back. He’s getting desperate. After several failed attempts, he knows he is in too far to get out. So he, in effect, gives up. Instead, he covers requests for redemptions (clients wanting their money back) by giving them money from new victims—effectively rolling the liability forward. Meanwhile, he must dummy up statements to keep everyone in the dark. It just gets bigger and bigger over time. Eventually, all he’s doing is bringing in new clients to pay off old ones to keep from getting caught—and avoid going to jail—a major motivator.
Usually, how it all finally blows up is when the market turns down big—as it did in 2008. Then, people everywhere become fearful and lots of clients want their money back, yet the scam artist can’t sign on new victims fast enough, and he doesn’t have enough new money coming in to keep the charade going. That’s 2008’s crop.
In Madoff’s case, he was lying about performance to keep his clients docile. But because of the bear market, far too many clients tried to redeem at one time and he couldn’t support the scam. That’s what usually happens. He was outed. From what I’ve seen, bear market bottoms tend to out more scam artists than anything else.
The remedy is simple. When you hire an adviser to make decisions for you, don’t give them access to the money. Separate custody from decision making. If you do that, you can avoid being the victim of this type of Ponzi scheme. Insist your money be deposited in a wholly unconnected, third-party, large, reputable, nationally known custodian—like Pershing, Bank of America, Morgan Stanley Smith Barney, Charles Schwab, Fidelity, UBS, etc. Then give your adviser—not associated with that entity—written authority to make decisions for the money and trade that account but not take money from it. The custodian holds the assets as a watchdog, and the separation of powers promotes integrity—and you don’t get Ponzied.
Even a large regional custodian is ok, as long as it’s established and well known. You want to wire money to an account in your name alone (or you and your spouse). Or maybe you write a check! But the check is written to you and your own account number. No commingling assets. That way, your adviser can’t have access to the money, and it’s close to impossible for him or them (or her—but financial scam artists have overwhelmingly been men) to be in cahoots with the custodian and steal that way. (Many custodians have insurance above and beyond normal Securities Investor Protection Corporation [SIPC] insurance, which also protects you from matters that involve their negligence.)
Fortunately, most advisers are already set up with a separate custodian or custodians. I originally set my business up this way myself, purposefully, to protect clients from any of my employees who might go rogue, but also from myself—to ensure that I could never turn myself into a Madoff no matter what I encounter or do! Now, there are myriad reasons some advisers might choose to hold assets themselves—for example, it might make accounting easier. But in my view, the safety and integrity benefits of having separate custody far outweigh any small conveniences. And the SEC tends to agree. Starting in 2009, they began taking a closer look at “dual-registered” advisers—those who make decisions and also hold the dough. As they should!
Protecting yourself is easy. Not every adviser who holds assets is a Ponzi schemer, but every Ponzi schemer I’ve ever seen has had direct access to the cookie jar. Don’t give it to them.
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