Bernard Madoff and Classic Frauds

Most investment frauds, especially Ponzi schemes, last five years or less and steal relatively modest sums. Two of the many remarkable aspects of the Ponzi scheme of Bernard Madoff are that the fraud apparently persisted for decades and cost investors billions of dollars. Yet, many aspects of the scheme are classic, unremarkable features of run-of-the-mill con jobs-though there also were a few unique twists to Madoff’s plan that perhaps made it more seductive to the victims.

Little did I know when I warned of the coming onslaught of financial frauds in last November’s visit that we soon would have such a robust example in the headlines. Let’s look at what we know of the Madoff scam and compare it to classic frauds.

? We know little specifics of the marketing pitches made for the fraud, and apparently different arguments were made by different marketers. But clearly Madoff enticed those who were looking for alternatives to regular stock and bond investments. As we said in November, this is a classic selling point of frauds.

? Like most cons, Madoff avoided regulated products and services. I suspect he was required to register with the SEC as an investment advisor, but he did not do so and avoided much reporting and scrutiny.

? One difference from classic scams is that Madoff did not claim to have a simple, understandable strategy. He essentially claimed to have a “black box” and a complicated proprietary strategy. Madoff refused to explain his strategy to anyone.

?  Another unique feature is that Madoff did not promise exceptionally high returns. Apparently he didn’t even promise minimum returns, presenting a history of steady returns in the 8% to 12% range. But the return pattern should have been considered too good to be true.

?  Madoff and his marketers sought classic targets: people in their 50s or older who have some money and are worried about maintaining retirement income. A prime subset of this group also was targeted by Madoff: entrepreneurs and successful professionals. These tend to be risk-takers, so they are more likely to be interested in an unconventional strategy.

Unconventional victims included charities, mostly small ones, institutions, wealthy individuals, and funds of hedge funds. Each of these investors should have known better, asked more questions, and avoided the fraud.

?  Madoff had a gift for affinity marketing, an element of many successful cons. Remember “con man” is derived from confidence man. People take the advice of someone in whom they have confidence without probing too much.

One form of affinity marketing is to attract a strong personality who likes to brag about successes. Most organizations and communities have such these opinion leaders. They can convince friends and acquaintances the scheme is legitimate, often without being compensated.

Madoff also was a big name in the Jewish community, inducing Jewish charities as well as individuals to invest with him. Frauds are especially fond of religious affiliations.

High society was another affinity group exploited by Madoff and the feeder firms. Palm Beach, the California entertainment community, Western Europe’s upper class, and Latin America’s wealthy all either had insiders pitching Madoff to their peers or received personal contact from Madoff.

? Big-name financial firms and professionals were caught in the scam, often putting their own money in along with clients’. A number did not do proper due diligence.

In a Wall Street Journal article some smaller funds of hedge funds managers said they relied on the fact that several larger, well-known firms were investing their funds with Madoff, another form of affinity marketing.

? Exclusivity is a powerful tool Madoff exploited to the maximum. Investors initially were told they could not invest with him. Then, many were told to invest only a small amount at first and invest more if they liked the performance. It was a mark of status in some circles to be allowed to invest with Madoff. The prominence of many of Madoff’s investors, in both the financial world and certain communities, gave less prominent individuals the feeling of being admitted to an exclusive group. Another exclusiveness tactic: Anyone who asked too many questions was denied access or had his money returned.

? Economist Len Fisher, author of Rock, Paper, Scissors: Game Theory in Everyday Life, believes many Madoff investors knew he was a con man. They invested because they believed he was cheating in a way that would benefit them while hurting other, anonymous people. They thought the worst that would happen was that after a few years of earning steady profits, Madoff would be uncovered and punished, the scheme shut down, and their money returned. As Mordecai Jones said in the movie The Flim Flam Man, “You can’t cheat an honest man.”

It is not always easy to avoid bad investments or losing money in the markets. But it is easy to avoid Ponzi schemes and other scams that wipe out all your money. Avoid the red flags listed above and in past visits. In addition, remember these tips.

Do not assume other investors did the leg work. You need to do it yourself.

Unless you are very good at due diligence, stick with registered investments or investment advisors who disclose the basics of their processes to you. An investment advisor might have a proprietary element to a process, but a great deal of information can be revealed without revealing proprietary information. In today’s world it is not easy to invest only in investments you fully understand. But you should have a basic understanding of the investment process and how the returns are achieved.

Do not be swayed by titles or the apparent credentials of an advisor. Learn details about what titles mean and a firm the person represents.

Always be wary of investment contacts initiated by others. Do not be unduly influenced by celebrities or associates at church, the club, or other communities to which you belong. Be grateful for any tips obtained from these sources, but use them as leads for you to research.

Likewise, don’t be overly influenced by testimonials and references or by the “quality” of people in an investment. Often people who should know better are caught in scams. Everyone assumes some one else checked out the details.

Diversify your investment portfolio. The saddest part of the Madoff scam is the number of people who invested all their money with Madoff, especially those who borrowed to invest more with him.

There also should be checks and balances. Madoff was the investment manager, custodian of assets, and trader for client accounts. All Ponzi schemes depend on the crook having full control of the money. When I invest money for clients through my affiliate, Carlson Wealth Advisors, the money is kept at an independent broker, usually TDAmeritrade. Clients receive statements from TDAmeritrade describing their holdings and transactions.

These investment markets are tough, and that makes fertile ground for con artists. Stick with the fundamentals and you won’t lose all your capital to a scam.