Don't Get Burned by the Next Bernie Madoff
Follow these steps to avoid financial fraud.
Questions are swirling about how some of the world's most sophisticated investors could have been duped by Bernard Madoff, the New York City investment adviser who allegedly defrauded investors of $50 billion in a classic Ponzi scheme. But could they have known ahead of time that they were being taken for a ride? And can you take steps now to ensure that your financial adviser is on the up and up?
A few basic checks can go a long way. Most important, know where your money goes when you hand it over. Whoever manages your portfolio should use an independent financial institution, known as a custodian, to hold your assets. Get the name of the firm and its contact information. Instead of relying on your adviser's word, check out the custodian yourself. And if your adviser is producing his or her own statements, as Madoff apparently was, watch out. "The presence of a custodian ensures that money from new investors can't be used to pay off old investors," says John Coffee, a financial expert and law professor at Columbia Law School.
Once you've established the bona fides of the custodian, find out which auditor your adviser uses. Then check the auditor, too -- particularly if the auditor works at a firm you've never heard of. Make sure the auditor is licensed to work in your state. Each state has its own database you can check. For instance, New York's database is maintained by the Office of the Professions maintains. Having independent auditors is crucial because they verify the existence of the assets in your account and others your adviser manages.
Be particularly careful if your adviser has switched accounting firms recently. If it has, find out why. "When an adviser leaves an accounting firm, it might be because the accountants didn't feel comfortable with the adviser's financials," says Ken Springer, a former special agent of the FBI and now president of Corporate Resolutions, which investigates money managers on behalf of hedge funds.
Once the custodian and auditor pass muster, gather information on the advisers themselves. See if they have ever run into trouble. A good way to do that is to tap the Financial Industry Regulatory Authority, the industry's self-regulatory body.
Finra has an easy-to-use broker check in the "Investors" section of its Web site. Run the names through the system. You can get an employment history and records of exams passed -- and you can see whether an adviser has had any customer disputes or been the subject of regulatory actions. The National Futures Association has a similar tool on its site.
You also should make sure your adviser is registered with the proper regulatory agency. Advisers who manage more than $25 million must register with the Securities and Exchange Commission.
Those who oversee less than that have to register with their state. A state-by-state list of regulators can be found on the Web site of the North American Securities Administrators Association. "You want to make sure your adviser is complying with regulations and putting your interests first," says Diahann Lassus, the national chairwoman of the National Association of Personal Financial Advisors, the trade group for financial-planning professionals.
Given that many of Madoff's investors were Jewish, it's also a good idea to be on the lookout for what the SEC calls "affinity fraud," which occurs when an adviser targets members of a specific ethnic or religious group. The SEC issued a warning about this in 2006.
If, after all that, you decide to become a client, consider having your adviser sign a fiduciary oath, which requires the adviser to put your interests first. It also prevents the adviser from taking a referral fee for buying or selling an investment for you. NAPFA has a fiduciary oath you can download.
Before you make a final decision, be sure you understand an adviser's strategy and any products that he or she is recommending. Once you've decided on the adviser, be sure to touch base with him or her on a regular basis and read your statements. If your returns appear too good to be true, they probably are (always compare returns to an appropriate benchmark, such as Standard & Poor's 500-stock index for stocks of big U.S. companies, or MSCI EAFE for shares of developed foreign nations).
In fact, Madoff's supposed performance should have been a tip that something was amiss. His accounts delivered remarkably steady returns, year after year, no matter what the markets were doing. "Don't leave your common sense at the door," says Tim Kochis, chief executive of Aspiriant, an independent wealth-management firm.
Finally, if you try to withdraw your funds and your adviser says you can't, it might be too late. Nadia Papagiannis, hedge-fund analyst at Morningstar, says that Ponzi schemes always unravel when investors start to withdraw their money. According to the criminal complaint that federal prosecutors filed against Madoff, not having enough money to return to investors is exactly what put Madoff over the edge.