How to avoid investment fraud

Written by Christopher Hanson

The doorbell has an eerie echo tonight, as if it’s vocalizing your disdain for what is happening next.  After years of procrastination you finally decided to meet with a financial planner. Retirement is on the horizon and you need to make the most of your savings.

As the clean-cut advisor crosses the threshold you notice his expensive designer clothing. With impeccable manners he makes eye contact as he firmly shakes your hand. Then, he even goes so far as to compliment the interior decorating of your humble home. That’s exactly the sing-song you expected and the rock in your stomach only grows.

You try not to let the vulnerability show and work to calm your nervousness. After all, this advisor was highly recommended by your somewhat savvy cousin Joe. How could he be dishonest? But your sense of unease persists, you feel vulnerable in your own home. What can assure you that you are not dealing with the next Bernie Madoff? 

For many Americans this fear is very real. After all, if a sophisticated movie star like Kevin Bacon can be bamboozled in a Ponzi scheme, what could happen to regular folks like us? This apprehension leads to procrastination and that may rob you of the opportunity to aggressively grow your savings. You may have to work more years because you put financial planning off for so long.

The good news is that avoiding another Madoff is easier than most people think. One of your best safeguards is an independent, third party custodian to hold your investment funds. Let’s explore how these institutions reduce your risk of becoming a victim of investment fraud.

The initial check restricts the flow of funds
When you write out the check to open an investment account, make sure the payee is an institution, not an individual. Checks made out to brokerage firms such as Charles Schwab or TD Ameritrade cannot be cashed; those funds must be deposited into an account. Bernie Madoff’s client’s made checks out to Bernard L Madoff Securities, which technically is not an individual but Bernie didn’t care….yikes.

Advisor lacks custody of the assets
Since your advisor cannot directly handle deposits and withdrawals, the chances for fraud are slim. If there are withdrawals from your account, the funds must be deposited to another account in your name or a check sent to your address of record. Any exceptions require your signature, and the custodian is liable for any losses due forged documents. Reputable firms carry insurance to cover such losses. Madoff controlled the custodian, and the safeguards attributed to a third party simply did not exist. The door was left wide open to fraud.

Behavioral Analytics and technology protect you.
Like credit card companies, independent custodians use advanced technologies to identify patterns in your behavior. If a transaction does not reflect your past behavior it is flagged for further investigation. For example, if you routinely take out $2,000 a month, but then a withdrawal request comes through for $10,000, that would generate a phone call for verification. Bernie Madoff would have no use for this technology, but he may have manufactured the appearance of anti-fraud measures.

Custodian Statements are a basis for comparison.
Each month or quarter, the independent custodian will send you a detailed accounting of your assets and activity on its own letterhead. Take note of the return address and match the amounts to statements sent by your advisor. Fraud becomes easy to detect, yet Madoff ‘s clients could not perform this test.  Since Madoff controlled the custodian he was able to print phony statements. The assets he reported on simply did not exist.

The safeguards afforded by a third party custodian are very effective, but I recommend you take this additional step. Visit the institution’s website, or call customer service to verify your account balance. Better yet, visit a branch office and verify your account in person. This should help you sleep at night, as it would be virtually impossible for an advisor to fabricate such a far reaching scam.

If you truly suspect investment fraud, rather than stock market fluctuations due to risk, contact the Massachusetts Secretary of State immediately. These complaints are easy to make on the Secretary’s website www.sec.state.ma.us.

Chris Hanson is a CPA that specializes in financial planning at Oaktree Capital Partners in Easton. He earned his BBA at the Isenberg School of Management University of Massachusetts and an MBA at Babson College’s F. W. Olin Graduate School of Business