In mid-December, Bernard Madoff was arrested for operating a giant ponzi scheme. After his two sons reported him to regulators, Madoff admitted that losses could be as much as $50 billion. Bloomberg tallied around $37 billion that is currently invested with Madoff, but the total numbers will obviously include amounts not subject to Bloomberg’s review of public admissions.
In a ponzi scheme, investment returns achieved from earlier investors are funded, not by real gains, but by using later investments. The ponzi scheme can continue so long as new investments arrive in increasing amounts. Because gains being paid are not real, a ponzi scheme is destined to collapse.
Madoff reported consistent earnings of around ten to twelve percent annually, with practically never a down month. This occurred regardless of market conditions. Numerous commentators marveled that these market-trouncing returns hardly seem possible. It turns out they were not!
The SEC was responsible for Madoff’s regulation. The SEC closed an “investigation” of Madoff in 2007 that were based on tips and press reports that Madoff’s investment returns were too good to be true. Unlike hedge funds that are basically unregulated, Madoff registered as an investment advisor in 2006. Before that, Madoff operated as a broker-dealer, which is also regulated by both the SEC and FINRA (the security industry self- regulator, formerly known as the NASD). The SEC is now investigating itself to see how anyone as large as Madoff’s operations slipped through the cracks.
As a registered investment advisor, Madoff was either required to place his security holdings with an independent custodian, or (as Madoff did) provide client statements directly and submit to surprise annual securities inspections by an independent auditor. To comply with these rules, Madoff (i) manufactured false client statements, and (ii) employed a CPA firm that appears to have aided in the fraud. The required CPA inspections and audits were performed by Friehling & Horowitz, a firm operating out of a 13-by-18 foot office in a suburban retail plaza, and whose active employees consist of a single accountant and a clerical worker.
Avoiding a Ponzi Scheme Yourself
Here is how the Madoff’s victims could have avoided being duped. The same rules should be applied to all of your current and future investments:
- Fraudsters often tell you that their ideas are highly complex. Often the claimed complexity is the basis for why the investment is a great idea. Nevertheless, don’t invest in anything that you do not understand. If you don’t have the time to figure out a complex investment, then don’t make the investment.
- Fraudsters often claim that their ideas for earning higher-than-normal returns are secret or proprietary. Don’t invest in any such arrangement. Other a description of the investment approach is provided, but the additional returns are not sensible based on the descriptions provided. Despite the confidence expressed by the fraudster, and your own feelings that you may not smart enough to understand this great idea, don’t make any investment when above-normal returns are not explainable.
- Fraudsters often take advantage of trust earned in non-business environments. Be wary of investments offered through relationships developed at a church, country club, or other social function or other scenarios where the suggestion is that someone is involving you in a special deal as favor.
- Risk and return are always correlated. Don’t invest in anything where high returns are promised without a presentation of the risks that are allowing the higher-than-normal returns to be achieved.
- Leverage (debt) increases risk … a lot. Highly leveraged investments can make a lot of money when circumstances are lucky, but will lose money just as fast when things are not as desired. Since a primary investment objective is to get your investment principle returned to you, be exceptionally cautious when invested in a deal that depends upon borrowing for the desired results.
- When reliance is placed on an independent audit firm, investigate who the auditor is. Similarly, investigate custodians or other service providers who are supposed to be protecting your interests.
- Don’t rely on a regulator to protect you. Compliance with regulatory requirements may disclose important issues, but will not prevent problems or overcome failures involving the above rules.
None of these rules are new or difficult. Nevertheless, our firm rarely sees a fraud that would not have been avoided if these rules were followed. Madoff’s victims would not be involved in this scandal had they followed these simple tests.