Madoff and Investing and Investing Column

Madoff's ruthless scheme a black eye for profession

January 12, 2009
After an extended investment boom, it isn't uncommon to discover during the following bust that a few spectacular frauds were perpetrated.

In the United States during recent times, major frauds were uncovered at Enron, Tyco and Worldcom. And just the other day, a large corporate accounting fraud was discovered in India.

Yet, the world has never seen anything like the Bernie Madoff scandal. In a virtual instant, the net worth of many investors vanished as fictitious values on brokerage statements were rendered worthless.

The actual ruse was a simple Ponzi scheme, in which early investors "earned their returns" with the funds provided by subsequent investors. Such operations eventually collapse when the requests for withdrawals exceed the perpetrator's ability to attract enough new investor funds.

What is truly astounding about this scam is the length of time it has been in existence (since the 1970s), the scale of the swindle (reported to be anywhere from $17 billion to $50 billion), and the failure of regulators to detect the fraud (even though they were alerted to it by the suspicions of some savvy observers).

A letter sent to the SEC in 2005, drafted by rival adviser Harry Markopolos, is chilling in its predictions about Madoff's business. Titled, "The World's Largest Hedge Fund is a Fraud," the memo cites 29 red flags that predicted Madoff was either running a Ponzi scheme or front-running investor trades (also against the law).

Yet, it wasn't as though regulators ignored Madoff. They had examined his firm's practice eight times over the past 16 years. This regulatory failure is sure to shake up the entire investment-oversight system and lead to new rules and regulations.

Also puzzling is that several professional investors were seduced by Madoff's firm, demonstrating a breakdown in their due-diligence process. In particular, the various "fund of fund" hedge funds that shoveled large percentages of their portfolios to Madoff are on the hot seat. Their whole existence is predicated on their expertise in conducting extensive research about money managers and then selecting the best candidates for their investors. The lawsuits against these entities are likely to expose some unwelcome truths about the hedge fund industry.

In the end, it took cunning skills to mastermind this deception and build the network of wealthy contacts to constantly feed him new clients. And while Madoff's fictitious performance claims of 12-percent annual rates of return were probably not that unbelievable to call into question his operation, there were a few obvious red flags.

One key issue that should have raised eyebrows was that his firm was its own custodian of his client's assets. Most money-management firms put custody of their client assets in third-party firms, thus maintaining a separation from physically handling client monies.

For those of us who are in professions where trust is an important quality, scandals such as these are disheartening. You feel for the victims who probably had no ability or reason to question the validity of their results. On the other hand, you are disgusted with your professional advisory peers who failed in their jobs of due diligence and protecting their clients' interests. Their failure reflects poorly on our industry.

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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