By: Frank Armstrong, III, CFP®, AIFA®
Not a week passes without a new Ponzi scheme or scam emerging. The numbers are staggering. Bernie Madoff set the gold standard with losses estimated over $50 billion, so losses of just $50 million don’t even make headlines, and with few exceptions, no one even remembers the names of the perps. Even “sophisticated” accredited investors were like so many sheep quietly being led to slaughter.
A good scam has a few common threads: a great “story”, an appeal to greed, a suspension of disbelief, a charismatic front man, and an exclusivity factor that makes the rube feel special.
Under the spell of this potent combination, the sucker invariably ignores the simplest of checks and balances. The siren song has fried their brains. What could they possibly have been thinking?
Each newly discovered Ponzi scheme is a wakeup call, and an opportunity to examine your relationships to make sure it can’t happen to you.
Follow these golden rules, and you can keep all your gold!
Independent Custody: None of these scams could happen if an independent custodian held the assets. Independent custodians are an essential check and balance which would have prevented every single major scam unearthed this year.
Your advisor should not have custody of your assets, and he shouldn’t be in a position where he could ever get custody. For instance, the advisor shouldn’t be able to change your address and disburse to that new address, or write checks from your account, or transfer from your account to an account that is not identically registered. If he has these powers he will now be subjected to a much higher level of scrutiny by regulators and annual surprise audits. But, in our opinion, investors should just avoid these situations entirely.
Custodians exist to hold, protect, and account for assets entrusted to them. It’s the duty of the custodian to protect the client from all potential mischievous transfers. But, the word independent is key. The custodian should be totally independent of the advisor and the product manufacturer. They should have no economic interest in the advisor’s or product manufacturer’s business. Bernie was able to perform his magic act in part because he was the advisor, held (or just stole) the assets, and cleared (or didn’t) the transactions. There was no way to tell what was going on, because he controlled all the information going to the client. This is a time honored recipe for disaster.
The custodian provides periodic reports on holdings and transactions. These should reconcile to the penny with the reports provided by the advisor. Ignore this at your peril.
The SEC has just expanded the definition of custody beyond their traditional interpretation in the interests of further limiting potential abuse. While some modifications to many advisor’s (including ours) business practices may be involved, the potential reduction in service should be insignificant. And, we all now understand that where the potential for abuse exists, someone will take advantage of it. So, we think this is a very good thing indeed.
Limited Power of Attorney: Closely related to the custody issue are the limitations on the power of attorney that the advisor holds. Normally, the advisor has discretion to make trades in the account, perhaps withdraw fees for service, and make distributions to identically titled accounts. The vast majority of investment advisors operate comfortably within these boundaries. Powers that go beyond this invite potential abuse and would generally trigger the assumption that the advisor had custody.
The custodian must enforce those limitations, and would be liable when they are breached.
Independent Auditing: An independent audit should confirm that the assets exist as described in the custodian’s and advisor’s reports. Madoff’s no-name, strip mall, captive accountant should have been the only red flag necessary to avoid the scheme. However, notwithstanding that any honest newly minted CPA could have figured out that the assets didn’t exist, his rubber stamp approval went unnoticed for 30 years! So much for due diligence by the feeder funds and other advisors.
The takeaway is that investors should insure that a reputable accounting firm is auditing the custodian and the funds whether they are mutual funds, ETFs, separate accounts, pooled assets, partnerships or any other vehicle.
Common Sense: Your mother must have told you that if it’s too good to be true, it probably isn’t true. As many celebrities are finding out to their sorrow, it’s also extremely unlikely that you are so special that you will be let into a deal that defies market logic. You can’t escape the risk-reward line, and if you think you can you are delusional. Temper your enthusiasm!
Conclusion: Requiring fundamental business checks and balances, reinforced by common sense and a strong dose of skepticism will prevent a number of totally avoidable tragedies. Govern yourself accordingly.
Golden Rules to Keep Your Gold!
By: Frank Armstrong, III, CFP®, AIFA®