10 Years After Madoff, Scoundrels Still Abound

On December 11, 2008, Wall Street legend Bernie Madoff was arrested for running a financial swindle that bilked some 4,800 investors out of roughly $19 billion—the largest Ponzi scheme on record.^[i] Years of litigation have since recovered $13.3 billion, which is way better than we thought they would do years ago.^[ii] However, this relatively high recovery rate is rare. That is key because even now, 10 years later, Ponzi schemes haven’t disappeared. That said, the steps you can take to avoid falling victim are timeless, in our view.

You might think such a high-profile bust would heighten awareness of swindlers, stopping investors from falling prey. Yet the SEC has busted dozens more Ponzis since. Among them: A Florida man^[iii] was charged with fraud in 2012 after promising risk-free returns of 6 – 18%, then incurring huge losses after his astrology-based “investment strategy” didn’t pan out. In a similar vein, a woman arrested last year allegedly used investments in her failing high-end sportswear startup to fund a lavish lifestyle—then turned to the dark arts when the SEC came calling, administering various curses aimed at warding off investigators.^[iv] Last fall, operators of a shady “bitcoin fund” promised imminent cryptocurrency riches with zero risk. And this summer, the SEC busted three men for purchasing the businesses of legitimate brokers and persuading clients to buy phony debt issued by organizations the nefarious trio controlled.

Funny thing: These capers didn’t involve novel strategies, aside from the dark magic. Most followed the old Madoff playbook, just decorated differently. We suspect most future schemes probably will, too. While seeing people fall for the same cons year after year is dispiriting, there is a silver lining. There are common threads you can look for. Here is a list.

1. Taking custody of your assets

Madoff deposited all his clients’ money in a retail checking account under the name of Bernard Madoff Investment Securities—one pool, with no divisions between client accounts. This allowed him to send out paper statements showing stellar returns without any external verification—unworkable if the funds were housed in accounts in clients’ names at third-party custodians. Custodians verify and report holdings and values directly to you, either on paper or electronically. Unscrupulous advisers would struggle to falsify account statements.

2. Unrealistic returns

Aspiring Ponzi artists are notorious for touting jaw-dropping returns with minimal risk of loss. This caters to those who see investing as a get-rich-quick opportunity—or those who can’t stomach the thought of even short-lived losses. Madoff preferred a different method—less flashy but equally unrealistic. Instead of “doubling” clients’ money in a week or month, his outfit churned out a dependable stream of market-beating returns. Nearly every month! In a November 2005 SEC complaint, whistleblower Harry Markopolos noted Madoff’s hedge fund reported just seven monthly losses between December 1990 and May 2005, a 96% frequency of positivity, more than 30 percentage points higher than US stocks’ over this span.^[v] This, despite that stretch’s including the 2000 – 2002 bear market. Additionally, Madoff claimed his worst month was a paltry -0.55%.^[vi] The S&P 500 fell -14.4% in August 1998, amid the Russian Ruble crisis-led correction.^[vii]

Reality check: While it is possible to avoid declines in a savings account—with the associated miniscule returns—the idea you can get long-term returns exceeding stocks’ with such little volatility is nonsensical. All assets have their good days/months/years.

3. Complicated strategies, impenetrable jargon and reluctance to explain

Madoff’s purported “secret sauce” was his “split/strike conversion” strategy, which involves buying and selling options on a portfolio’s stock holdings. Yet these tactics are unlikely to reap consistently above-market or even equity-like returns. Asked why no one could replicate his results, Madoff told a Barron’s reporter in 2001 the details were “proprietary,” and “whoever tried to reverse-engineer … didn't do a good job. If he did, these numbers would not be unusual.”^[viii]

A “very satisfied investor” in a Madoff fund also told Barron’s, “Even knowledgeable people can't really tell you what he's doing. People who have all the trade confirmations and statements still can't define it very well.” Said one investment manager, “he couldn't explain how they were up or down in a particular month.”^[ix] An inability to show how investments yielded returns should be cause for alarm. Advisers should be able to answer your questions and explain the goings-on in your account in simple English. They should also be able to explain their investment strategy and philosophy. Evasion and obfuscation are huge red flags.

4. Pitches based on personal trust or connections

At the time, Bernie Madoff appeared highly trustworthy. A Wall Street giant, he chaired the Nasdaq stock market’s board for a time—a position that screams “sterling reputation.” This helped him run in elite social circles, rubbing elbows with (and accepting money from) wealthy investors, sports players and celebrities. Playing six degrees of Kevin Bacon with Madoff ends at one degree—Mr. Bacon was, unfortunately, a client.

Madoff was also prominent in the Jewish community—and, not coincidentally, many of his clients were Jewish. This pattern persists across many types of scams, as common ethnicity, faith, occupation, political beliefs or any other shared experience/identity, real or faked, can be fertile ground for fraudsters. They know establishing emotional or social bonds encourages people to turn off critical thinking and forgo due diligence. This “affinity marketing” approach underpins innumerable Ponzis. It says, “You can trust me—no need to verify.” Relatedly, watch out for this trait:

5. An aversion to anyone who does good, old fashioned due diligence themselves

Sadly (but logically), scammers prey on the least informed and inquisitive. If they sense you will do your research and ask questions, you are probably a waste of their time—too risky. This is because Ponzi schemes are inherently implausible—they don’t withstand logic. Hence, the bane of the Ponzi practitioner is someone who asks a lot of questions, gets second opinions and does their research.

Here are a couple good places to start: Brokercheck, where you can look up brokers’ and advisers’ professional history, including any client disputes or sanctions for misconduct. The SEC’s Investor.gov provides a similar service. You can also request an adviser’s ADV II forms, which outline (in simple terms) all services provided, fees charged, conflicts of interest and disciplinary actions taken.

In concert, knowing these five flags—plus the old-fashioned wisdom that if something seems too good to be true, it probably is—can help keep you out of fraudsters’ clutches.