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When he passed away last week, Bernie Madoff still had 139 years left on his prison sentence. Anyone over the age of 30 remembers the story—Madoff swindled thousands of investors for billions of dollars, running one of the most elaborate Ponzi schemes in history.
In an ideal world, Madoff’s conviction would have been the ultimate deterrent for fraudsters, purging the investment world of swindlers and schemes. Then investors could easily trust advisors with intelligent strategies, good credentials, and a strong pitch.
But we don’t live in an ideal world. Fraud is still happening, and the schemes are getting more sophisticated.
In 2019, authorities uncovered 60 Ponzi schemes that stole $3.25 billion from investors—the highest sum in a decade and more than double the amount in 2018.
Over the last year, the number and size of the schemes has grown. The reason is simple: fraudsters love bull markets.
Investors love bull markets too, which is where the problems start. Investors get greedy. Fear of missing out (FOMO) on big returns leads to lapses in judgment. When it feels like money is being made everywhere by everyone, investors are more willing try out new asset classes and alternatives.
The media feeds the narrative with stories of triple and quadruple-digit returns in cryptocurrencies, SPACs, and stocks like GameStop
One recently arrested scammer pitched investors the exclusive ability to sell film rights to Netflix
Just last month, a woman in San Diego was found guilty of stealing $400 million from investors, claiming she could make high interest loans to restaurants for liquor licenses. She couldn’t.
More recently, a Nevada man was found guilty of stealing tens of millions from investors under the guise of being an expert cryptocurrency options trader. He wasn’t.
Fraud is unfortunately too commonplace, so investors need easy ways to identify who they can and cannot trust in the financial world. Two reliable screens that can help readers avoid financial fraud are the custody test and the fiduciary test.
The Custody Test
Every Ponzi scheme has one thing in common: investors are asked to give money directly to the fraudster or to an account they control. Don’t ever do this.
By giving a manager direct custody (control) of assets, an investor forfeits all mechanisms for oversight and accountability, which is precisely what you need to avoid fraud.
The custody workaround for fraudsters is to generate fake statements that include basic things like balances, returns, and trading activity. Maybe they add some sophisticated looking charts and data. When returns are good and balances are growing, investors don’t ask many questions.
Bernie Madoff ran the ‘custody’ part of his business on a separate floor from his brokerage business. His back-office used a computer program to manipulate account statements, so they could generate whatever returns they wanted. Madoff didn’t make a single investor trade in 10 years. Meanwhile, his investors’ money went into his personal JPMorgan Chase account.
The other previously mentioned scams generally followed a similar blueprint. In order for the fraud to work, the money has to be in an account the fraudster can control, whether it’s a personal account or an account in the investment company’s name. Every Ponzi scheme involves an inappropriate custody relationship.
For investors, applying the custody test means requiring two criteria of your money manager:
1) Your money should only be held at a major third party custodian, like Charles Schwab, Fidelity, Pershing, Morgan Stanley
2) You are listed as the account owner.
In this setup, the custodian—with your express written permission—will give advisors discretionary authority to manage the assets in an account, but not the ability to extract money for their own benefit (only clients can move funds, withdraw, etc.).
Custodians also provide other forms of oversight and accountability. For instance, they handle reporting of trade activity, returns, and balances, and they offer clients the ability to access accounts online 24/7. They also insure your money and flag suspicious activity.
Remember: a key goal for every fraudster is to gain control over your money. But if a trustworthy custodian holds the assets in your name, they never will.
The Fiduciary Test
The money management industry consists of many different types of advisors. There are registered investment advisors (RIAs), brokers, Certified Financial Planners, and the list goes on. Most investors don’t have time to sort through all the differences.
Apply the fiduciary test instead.
Specifically, you want to know if the person or entity you’re considering is bound by a fiduciary standard.
If the answer is yes, continue vetting them. If the answer is no, move on to the next.
A fiduciary standard requires an advisor to always act in a client’s best interests when making investment recommendations. Advisors who aren’t held to a fiduciary standard, such as brokers and insurance agents, can recommend whatever products or strategies they want, including ones with the highest commissions. If a financial product aligns with an investor’s goals and has the necessary disclosures, it’s fair game.
The difference between acting in a person’s “best interests” versus recommending products that “align with their goals” may not seem significant, but it is. If a broker can make more money selling products with a high commission, they have less incentive to find the best possible solution for your assets.
Like Charlie Munger says, “Incentives matter.”
A fiduciary’s incentives are aligned with their client. The best scenario is a fee structure that puts advisors and clients on the same side of the table. Meaning: if a client does well and their assets grow, then the advisor earns more. If the assets shrink, the advisor’s compensation shrinks in tandem.
A survey by Financial Engines found that 93% of Americans think advisors who provide retirement advice should be fiduciaries. More than half of respondents (mistakenly) thought all advisors already were fiduciaries, which is way off.
There are about 300,000 “financial advisors” currently. According to Fidelity Institutional Asset Management, 90% are brokers. What’s more, many RIAs are also dually registered as brokers, meaning they can switch hats to earn a commission in some cases.
Working with a fee-only fiduciary is most advantageous. The fiduciary test is an easy screen people can use to whittle down the field of potential advisors they may want to hire.
The SEC also has a resource called “Check Your Investment Professional,” which can help with due diligence.
Most things in business get better with time, but investment fraud isn’t one of them. Frauds are getting more sophisticated, easier to hide, and the amounts keep growing. Add a frothy bull market to the mix, and it’s prime time for schemers.
Make the custody and fiduciary tests your first lines of defense.