The Bernie Madoff Fraud: Five Lessons for Investors from 'The Wizard of Lies'
HBO's Wizard of Lies, featuring Robert DeNiro as fraudster Bernie Madoff, premiered recently. It follows up Madoff, a 2016 mini-series that featured Richard Dreyfus. As background to Wizard, a series of follow-up articles reviewing Madoff's schemes and crimes have also appeared: The New York Post's “Bernie Madoff's Closest Prison Pal Is A Crime Boss,” The Atlantic's, “No Movie Could Capture The Crazy Details Of Bernie Madoff's Story,” and Town & Country's, “How Bernie Madoff Took His Family Down.”
It was not just naive individuals who were taken for about $65 billion (net fraud of $17.3 billion) by Madoff; it was countless professional investors, mutual fund and asset fund managers, bank executives, financial advisors and other professionals in the investment arena that should have known better. One would hope that from all of the financial crime coverage the average investor would learn some basics to protect him or herself. But none of the TV portrayals or the countless articles are talking about the real lessons that average Americans investing for profit and retirement need to learn to avoid the same fate.
Here are the top five red flags – and lessons – that more seasoned investors should have seen and that average investors should learn from the Bernie Madoff scandal:
- There was no independent custodian
Investors should rarely if ever give their money to the same person or firm that is investing it.
Reputable advisors or management firms will have their clients fund accounts at independent financial firms, brokers or banks that have relationships with the advisors as third parties that clients give permission to manage the funds. In other words, the client writes a check or wires money to a custody holder who then holds the money in account until a third-party advisor registers with that firm with the proper paperwork signed by the client, which states they are the advisor directing the funds. Some respected custody holders are Pershing, TD Ameritrade, Charles Schwab and Fidelity.
Custody holders offer several protections. They are independent, well-known entities within the financial community that are accountable to federal and state laws and regulations, and governing organizations like the Financial Industry Regulatory Authority (FINRA), the Securities Exchange Commission (SEC) or the like. They also provide independent, secondary verifications, through their own monthly or quarterly statements, of how the money is being invested and used (i.e. the expenses and the cash flow). They are also independent, professional verifiers of the authenticity and reputation of the advisors managing said funds.
In Madoff's case, there were two types of investors, those who invested directly with him and his firm, and feeder funds, like fund of funds companies. From various reports, it appears that investors sent money directly to a JP Morgan bank account that was not reflected on company records. Madoff, and his assistant, or assistants, who handled the investment arm's administrative affairs, knew funds being channeled through Bernard Madoff Investment Securities (BMIS), formed in 1960 as a broker-dealer, were deposited in a separate account.
His brokerage firm was engaged in real operations. But, the funds targeted for investment ended up in the JP Morgan and affiliate accounts, and were never invested. These funds were used for redemptions, operational expenses, and Madoff's own personal needs. There was no independent custody holder and financial statements and reporting only came from one source - Madoff's own firm.
- There was no independent auditor of the firm
FINRA-regulated firms, like Madoff's brokerage, are required to file an annual audited report not more than 60 calendar days after the date selected for their fiscal year end. Public companies are required to undergo periodic audits, particularly when submitting information to the SEC. According to the SEC, investment advisors that have the authority to access client funds or securities are required to undergo an annual surprise examination by an independent public accountant. Additionally the ADV form advisors are required to annually file with the SEC contains information on disciplinary action for potential investors.
Ideally, the above required audit should be conducted by a well-known firm in the accounting industry. Under no circumstances should the firm conducting the audit be related to, owned by or involved in any way financially with the firm it is auditing. This would be a major conflict of interest.
Of course, even an audit by a well-known professional firm does not always offer the protection for investors that it should. One example of this is the complicit behavior of Arthur Anderson and its employees in the Enron scandal years ago.
However, an independent auditor does offer some protection to clients in the event that government regulators or agencies that are supposed to be doing their job fail. In Madoff's case, for various reasons too complex for this article, the SEC – even though warned by industry whistleblowers, like Harry Markopolos – failed to do its job and uncover the Madoff fraud. Government and industry regulators offer the public some protection, but it is always the responsibility of investors to conduct due diligence and evaluate the risk of their own investment decisions.
One issue in Madoff's case was that he was not forced to register as an investment advisor until 2005-06. Regardless, the accounting firm (Friehling & Horowitz) hired to audit his firm was suspiciously too small for as large an operation as Madoff’s. It was not a well-known firm and the address of the "firm" was in a rural location that should have made it immediately suspect. Even after registering as an advisor, Madoff was able to continue to circumvent fraud detection because his audits were "rubber-stamped."