Is There a Madoff in Your Neighborhood?

Much has been written about how and why Bernie Madoff was so successful in fooling so many people for so long. Unfortunately, Madoff wasn’t the only one preying on trusting individuals, as Allen Stanford has notoriously demonstrated (allegedly).

There is no question that these cases have caused many investors to distrust Wall Street, but the general perception is likely that wealthy individuals were the victims in these cases, and they don’t have a lot to do with the average investor. Beyond those high-profile examples, though, lie some much more pedestrian cases that are no less devastating to their clients.

Case in point: a quick search of Google on the name James J. Buchanan will turn up many reports from early in 2008 – months before the Madoff scandal broke – as well as numerous websites of attorneys angling to assist investors in claiming damages against Buchanan and LPL Financial, the broker who employed him and was charged with overseeing his conduct. Recently Buchanan, a resident of the Ahwatukee neighborhood in Phoenix, was sentenced to serve 20 years in jail after pleading guilty to 15 counts of theft that totaled over $10 million.

Although the scale of their crimes was much different, Buchanan and Madoff operated in similar ways. They both employed affinity fraud to build their Ponzi schemes. In the case of Buchanan, it is said that he preyed on members of his Church as well as friends he met through his affiliation with Little League.

This may all sound pretty scary, but the number of victims of these Ponzi schemes and similar scams is still a very small percentage of all investors, although the volume of cases over the past couple of years has shown that it may be bigger than many of us thought. Although large-scale fraudulent activity is not the norm, it pays to revisit some of the actions investors can take to protect themselves against predatory individuals who call themselves advisors.

Look for an independent custodian

One act that Buchanan and Madoff shared was to manufacture trade confirmations and monthly statements that purported to show the performance of investors’ assets. As the sole conduits between investors and their money, this was reasonably easy for them to do. Madoff owned his own brokerage firm, whereas Buchanan was affiliated with large brokerage firms, the last of which allegedly took him on after ignoring red flags on his record dating from his time with a previous broker. Investors should at all times maintain the ability to view their assets online via a site maintained by an independent custodian, preferably one that does not employ their advisor. They should also receive statements that are generated by that custodian. They may receive statements from their advisor as well, but these should sync with what the custodian provides. This is probably the single most important thing that an investor can do to ensure that what their advisor is telling them is actually true.

Be realistic

One of the most remarkable things coming out of the Madoff scandal was the reported returns investors were seeing. Apparently every year they would “gain” 10%-11% on “100% safe” investments. For one thing, that kind of return in most years implies a risk premium that would contradict the 100% safe idea. More obvious, though, is the lack of volatility year-to-year. These were risky assets in which the funds were supposedly invested. As such, they were likely to have some big years and some down years. If they were invested in the stock market, an average 10-11% return over a number of years would not be outrageous, although it would have been very solid over the last decade. It definitely would not have been consistent, though. The old saying “if it seems too good to be true, it probably is” is never more true than in the world of financial services.

Seek a fiduciary relationship

What is a fiduciary? Simply put, as a fiduciary, the financial advisor is required to act with undivided loyalty to the client. That means the clients’ interests come before those of the advisor, legally and ethically. It should be noted that just because an advisor signed up to be a fiduciary doesn’t mean that he or she isn’t a crook. It would nice to say otherwise, but that would be nonsensical. Criminals come in all shapes and sizes.

However, depending on whose research you believe, somewhere north of 90% of all people who call themselves financial advisors are NOT required to act in a fiduciary capacity all of the time. The 5%-10% who are have generally chosen that path because they think that is the most appropriate way to serve their clients. It certainly is not the easiest way to make money in this business. It stands to reason that those who’ve chosen a fiduciary role would be less likely to fabricate an investing record on a massive scale.

Regardless, if you’re looking for an advisor, seek one who has chosen to be legally bound to act in your best interests. They’re relatively scarce, but worth the effort. Just because an advisor claims to be independent, it doesn’t mean they’re not beholden to a brokerage firm. If their marketing materials say “…securities offered through…”, you can bet that they’re being paid to sell products. Certainly, many good advisors operate under the commission-based model, but so do a lot of pure salespeople who are easily confused with fiduciary advisors.

Kevin Patrick O’Reilly is the founding principal of Foothills Financial Planning, Inc., a licensed Investment Advisory firm based in Phoenix, Arizona. He is a member of the Garrett Planning Network and is manager of the Camelback Fund. Visit the Foothills website at http://www.FoothillsPlanning.com.