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Madoff and the red flags we ignored

18 December 2008 Jose D. Roncal www.financialspeculation.com

18 December 2008

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Jose D. Roncal

www.financialspeculation.com

Wall Street was rocked when news broke that high-profile Bernard Madoff, a trusted former Nasdaq chairman and a man admired for his philanthropy, had bilked investors out of $50 billion—the biggest Ponzi scheme on record. Banks, investment funds and insurance companies across the globe, high-rolling wealthy players and regular folks, had all gotten suckered into something that sounded too good to be true.

Could anyone have spotted the red flags if they’d known where to look? Could a little diligent research and a more careful strategy have prevented this fiasco? Maybe, but unfortunately herd mentality is not an investment strategy and hindsight is 20/20.  And when wealthy investors rely on advice from friends over country club cocktails with no questions asked, it’s a set up for disaster.

Madoff knew how to play the game, to charm his victims, foster relationships of trust, and then reel them in. In some circles, he was considered a rock star—able to sell himself to European investors by indulging them in his favorite hobby: snow skiing. He had the aura of running an exclusive club that frequently turned some away at the door.

What were the warning signs?

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There are certain basic due diligence practices which investors should follow before giving their money to any financial advisor or principle involved in publicly traded securities—practices like reviewing a company’s financial statements

and other regulatory filings, and knowing the right kinds of questions to ask about the management team, the underlying business practices and the integrity of their accounting firm.

But Madoff had a particularly complex structure that shielded him from such scrutiny. Most of his supposed transactions were related to hedge funds, which are not regulated by government agencies. To make matters even murkier, Madoff Investment Securities, the entity under which he operated, was both the broker dealer and investment advisor.

That meant he was trading in the same securities that he recommended to advisory clients, and on top of that he actually had custody of the assets. Large, credible accountants are supposed to ensure that a company’s books are clean, but Madoff was using of a small auditing firm, Friehling & Horowitz, which has only one active accountant.

In his non-hedge fund-related transactions, there were suspicions raised when Madoff’s company avoided filing disclosures of its holdings with the SEC by selling its holdings for cash at the end of each period.

Strategies to avoid

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When you can’t rely on the standard resources available for doing due diligence on publicly traded securities, here are a few common sense tips to keep in mind.

 •    Herd mentality: If it’s good enough for them, it must be good for me
If someone gives you a tip, never assume that they have asked all the right questions.  Ask all the questions yourself, and if you don’t even know what the questions are, let that be your first clue to go no further.

•    Trusting smoother talkers
Madoff was apparently a slick actor. He kept everything shrouded in secrecy thereby creating an aura of exclusivity. Never assume that what you see is what you’re going to get.

•    Foregoing personal responsibility
If you can’t assume responsibility for how your money is being invested, you have no business investing, or speculating. And if you invest with anyone who claims to never lose money, reports consistent earnings for 20 years despite exceedingly volatile markets, will not explain his strategy, refuses to disclose even the most basic information or discuss potential risks, you’re not investing, you’re not even speculating, you’re basically throwing your money away.

There were plenty of red flags, but they were all ignored. If you need further evidence, be sure and read theletter that Harry Markopolos sent to the SEC.

 
If there’s one thing we should take away from this scandal, it’s to take control of your own financial dealings, be wary of anything you don’t fully understand and, if you are asking financial advice, make sure you understand what motivates their advice. The so-called “experts” like financial advisors, brokers and accountants are not infallible. Neither are your well-meaning friends. Do your homework!

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About the author

José D. Roncal is a truly global executive with over 20 years of experience in international business and finance, having worked and travelled frequently in six continents

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