Confessions of a Money Manager: Lessons learned from the Madoff scandal

Ray Unger  —  1/06/2009 6:24 am

The December revelation that Bernard Madoff "made off" with billions from his trusting clients should prompt investors to make this their No. 1 resolution for 2009: Don't get flimflammed by a smooth-talking crook.

One of my favorite movies is "The Fortune Cookie," starring that loveable rogue Walter Matthau. He plays a scheming personal injury lawyer who tries to bilk an insurance company by claiming his brother-in-law, played by Jack Lemmon, is seriously and permanently injured when in reality he was only dazed in a fall.

Lemmon tells Matthau there are laws against such illicit tactics, to which Matthau replies: "When they invent better mousetraps, the mice get smarter." Matthau should have headed up the enforcement division of the Securities and Exchange Commission.

Yes, the SEC let us down, and yes, the state of New York, and Nasdaq failed in their due diligence on Madoff's investment business. But those failures are of little comfort to those who trusted Madoff and lost billions.

Is there a way to protect against such deceit? Of course. But it starts with the word "trust" itself.

Suppose your Uncle Harry has a knack for investing. So you deposit cash into his account at a brokerage firm, and you let him manage it. At the end of the year he tells you, "Yup, had a good year -- up 20 percent." You have to trust Harry because you don't see any statements; they're in his name. And you have no idea what went on in the account -- purchases, sales, contributions, distributions, fees, etc. -- because, again, you don't have access to the account.

Now suppose you introduce a close friend to this arrangement, and he decides to invest with Uncle Harry, but your friend wants a CPA to watch over the account and issue reports. "Fine," says Harry, "I know just the man -- my nephew Jerry. He runs an accounting firm."

Would you feel comfortable with this arrangement? Now, just to add a little more spice to this investment dish, suppose the brokerage firm that holds the assets of Uncle Harry's account is called Mary's Brokerage Company, and Mary is Harry's wife, and the aunt of Jerry, the CPA. Now isn't that cozy?

Despite the good reputations of all concerned, you should understand that such an arrangement allows Harry, Mary and Jerry to lie, cheat and steal. It wouldn't be difficult to issue false reports, conjure up phony performance numbers, and completely misrepresent the value of your investment.

Now you get the picture of Madoff's Ponzi scheme. He held all the cards: custody of assets, brokerage, CPA reports, everything. And somehow -- I guess because of his impeccable reputation -- he convinced the SEC that such irregularities were acceptable.

Again, the word is trust, or rather, how investors define the word "trust."

Since 1984, I've worked with registered investment advisory firms and have endured many audits by the Securities and Exchange Commission as well at the Securities Division of the State of Wisconsin Department of Financial Institutions. Now the SEC and state of Wisconsin are very "trusting" people, they just don't trust anyone who might abuse this trust.

Among the first questions they ask during their preliminary interview -- before they turn your office upside down, peer into every file drawer and computer registry, and harass you with a barrage of nitpicky questions -- is about your business with brokers and if you manage any omnibus accounts.

Brokerage relationships involve money (commissions on security transactions) so they want to verify that such transactions are done for the benefit of the client, not for the money manager.

The second big concern is the omnibus account. That's the kind of account Uncle Harry, and also Madoff, had. They're legal, but such accounts can be tempting cookie jars for unscrupulous managers, especially if performance expectations don't pan out.

That's what happened to Madoff. His arbitrage strategy wasn't working, so he fudged the numbers. The mousetraps laid by the auditors didn't catch him -- he just got smarter.

Suffice it to say, SEC and state audits are grueling to professional investment advisers. They should be. Likewise, investors should also be tough as nails when it comes to trust. The best defense against crooks like Madoff is really quite simple: Don't ever allow one entity to have complete control of all aspects (custody, record keeping, access to assets, investment management) of your investment portfolio.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400.

Ray Unger  —  1/06/2009 6:24 am