Lessons From the Madoff Scandal

You may wonder how Bernard Madoff was so successful in ripping off so many people, including some very sophisticated investors.  In the January 19 edition of Investment News, Blaine Aikin, who is president and CEO of Fiduciary 360 in Sewickley, Pennsylvania (and one of our vendor partners) offered the following observations:

1. Mr. Madoff did not use an independent custodian (such as T.D. Ameritrade Institutional, Fidelity Investments, etc.).  He both directed trades as a money manager and kept track of the funds as a custodian, so there was no third-party oversight on a daily basis.  Additionally, he did not provide his clients with on-line access to their accounts.
2. His firm was audited by a tiny, obscure accounting firm, who did not routinely conduct audits.
3. He produced his own performance reports and wouldn't allow independent performance audits.  
4. His investment results were extraordinary, and didn't match up with reasonable benchmarks.  Furthermore, the results couldn't be substantiated when subjected to fundamental testing of the trading strategy.  
5. The business structure of his fund made little economic sense.  Rather than operate as a hedge fund and charge a performance-based fee, Bernard L. Madoff Investment Securities LLC operated as a commission-based broker-dealer with distribution provided through hedge funds of funds.  By operating as three different types of investment entities, it appears that he fell through the regulatory cracks as a result of confusion.
6. He also showed abnormally high levels of bravado and ego by creating an air of exclusivity.  He rejected and fired clients for asking too many questions and acted above-the-fray when challenged.  His behavior was unusual even for the investment industry.

It's an amazing story, but filled with warning signs.  Caveat emptor.

Our thanks to Blaine Aikin and Investment News for writing a good summary of the Madoff scandal.