Almost three years after Bernard Madoff’s fraudulent investment scheme was discovered, the unprecedented crime still holds some key lessons for financial advisors, according to investigative journalist Diana B. Henriques.
Henriques is a senior financial writer at the New York Times and author of “The Wizard of Lies,” an investigative book on the Madoff scandal, including Henriques’ own interviews with Madoff from jail.
Madoff’s scheme is often compared to Charles Ponzi’s investment scheme in the 1940’s, which the name Ponzi scheme came from.
But there are some key differences, Henriques said, particularly in the style of each man’s approach. Ponzi eagerly worked to impress his targets in a get-rich-quick proposition. Madoff, instead, was impressed by his victims and promised investments with steady returns.
“[Madoff] wasn’t appealing to people’s greed, he was appealing to people’s fear,” Henriques said.
The Madoff story also holds some key lessons for financial advisors.
Future schemes will likely take a similar approach to Madoff’s, according to Henriques, perpetrated by someone who does not claim to be the smartest in the room and could also run a legitimate business like Madoff’s stock trading operations.
Both financial advisors and investors also need to be aware that it is human nature to overlook warning signs once they decide to trust someone.
Contrary to popular belief, a criminal like Madoff only needs as much trust as is normal in a functioning society to lure you in, Henriques said. That is evidenced by how Madoff could fool everyone, including regulators like the Securities and Exchange Commission.
At the same time, the new regulatory rules that really address a crime like Madoff’s are limited, and mostly address custody issues. While the SEC wanted to change the rules so that third-party custodians were required, they ultimately backed away from those rules because of the potential burden to the industry.
The SEC now shoulders more of the burden for policing the industry such as more audits, they also do not have more funds to work with. As a result, Henriques said, financial advisors and investors cannot expect regulators to catch every crime.
New programs from regulators including the SEC make it easier to give tips on crimes. Henriques said she was surprised in her investigations to find out how many people suspected Madoff’s crime and did not report it.
“Financial advisors are going to be the first eyes and ears out in the jungle,” Henriques said. “I think they should consider themselves deputized to be the next whistleblowers.”
Handling that new role could mean having more specific talks with clients, Henriques said. A financial advisor can point out the ways their business is run differently from Madoff’s scheme in terms of custody, oversight and transparency.
A financial advisor also needs to make sure the client knows they have to scrutinize their investments, Henriques said, and understand that all practices run the risk of having a rogue employee.
Financial advisors should also encourage investors to set their own rules for investments. Henriques’ investigations uncovered a New Jersey man who met with Madoff in his New York offices hoping to invest. The investor had a personal rule that he only invested $250,000 in any first investment, and would invest more if that did well. When Madoff demanded $5 million upfront, he stayed true to his personal rule. Ultimately, that saved him from becoming a victim in Madoff’s scheme.
In its aftermath, Madoff’s crime is unique in how much of the money has been recovered, Henriques said.
While the total paper wealth that was lost totals $64 billion, the actual cash contributed by investors that was lost actually totals between $17 billion to $20 billion. Because trustees have collected about $10.6 billion to date, that makes for a 50 cents on the dollar recovery when compared to $17 billion, Henriques said, and an unprecedented success in the history of white collar crime.
Henriques’ comments were part of a Thursday webinar hosted by ByAllAccounts, a Woburn, Mass.-based company providing account aggregation technology and services for the wealth management industry.