ABC Mini-Series: How to Avoid a Madoff Situation

SeanInsights

Last week, ABC ran its well-publicized Madoff mini-series. I generally don’t watch much TV, and missed that one (and, to be honest, had my fill of that story back 2008 and 2009), but I heard it was reasonably well done and that Richard Dreyfuss, as usual, put in an excellent performance. As you may recall, in the wake of the financial crisis, we saw several stories of such activities with Bernie Madoff, of course, being the largest of such schemers, although Alan Stanford also made big news, as did one local schemer, Sean Mueller. These types of schemes tend to come to light after large or protracted market downturns as there’s not enough money coming in from new investors to pay out obligations and redemptions to established investors. Warren Buffett’s famous line summed it up perfectly: when the tide goes out, you can see who’s been swimming naked. I wrote about this back in 2010, but in light of the ABC mini-series opening up old wounds, I thought it worth revisiting.

The natural tendency when one reads such a horrendous story – whether it be about a Ponzi schemer such as Mueller or Madoff or an act of school or workplace violence like Columbine – is to wonder, could that happen to me, or perhaps how could I prevent such a scenario if I ever had the misfortune to run across such a person?

Fortunately, in the investment world, there’s a fairly easy way to avoid such a situation, and it can be summed up in four words:

Independent Third Party Custodian

What this means is that the person managing client monies should NEVER be the person in possession or custody of those funds, nor should that person be the one doing the primary reporting on the account. In the three cases I mentioned above – Madoff, Stanford, and Mueller – not only were the investments being managed by the perpetrators, they were also being custodied by the perpetrators or their own personal firms. Madoff, in addition to being a hedge-fund manager, also owned the securities firm, Bernard L. Madoff Securities, which acted as the custodian for client funds. Alan Stanford’s misdeeds were conducted under the rubric of an offshore bank also owned and controlled by him, and it appears that Mueller, who was offering private placement deals and limited partnership interests, was almost certainly doing the primary reporting of account assets to clients due to the nature of those investments.

There are many such firms that engage in these activities (private placements and limited partnerships that are custodied in-house) that are completely legitimate. However, in the one-in-a-million case where you have a schemer, the absence of an independent third-party custodian makes the misdeeds possible, if not just much easier. These kinds of activities would be nearly impossible with an independent third-party custodian such as TD Ameritrade, LPL or Charles Schwab as there are cross checks and balances and because the account statements are coming directly from the custodian, not the ill-intentioned manager. The result is that it would be nearly impossible to run such a scheme with a large, well-known custodian providing custodial services and producing the monthly client statements.

This is one of the many reasons that The Retirement Planning Specialists does not provide custodial services, and instead uses TD Ameritrade to provide custody and produce statements for your accounts.

I thought you might like to know that (or just be reminded of it).

As always, please let me know if you have any questions or if there is anything we can do for you.