This is the time of year when most people think of gifts and holiday gatherings. I couldn’t help thinking of frauds past.
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| Three men accused of defrauding clients arriving at federal court. From left, Marc Dreier in Manhattan on May 11, 2009; Bernard Madoff in Manhattan on March 12, 2009; and R. Allen Stanford in Houston last Feb. 29 |
Four years ago this week, Marc S. Dreier, a high-flying lawyer, was arrested and later charged with defrauding his clients of $700 million. A few days later, Bernard L. Madoff’s fraud was uncovered. Totaling an estimated $65 billion, Mr. Madoff’s fraud was in a class by itself. And then, a short time afterward, some of the brokers who had been selling fraudulent certificates of deposit for R. Allen Stanford began to turn on him; he was arrested in February 2009 and later convicted of a $7 billion fraud.
These schemes collapsed with the economy in 2008. But on their anniversaries, it may be a good time to ask whether you have done all you can to lower your risk of being caught up in a similar fraud. Call it Madoff Day (celebrated on Dec. 11, the day of his arrest).
Protecting yourself against fraud, or simply bad advice, is easier said than done. The most common advice is to make sure your money is held by an independent custodian or firm whose job is to keep your money safe. That wasn’t the case with either the Madoff or Stanford fraud. But that is only one small step.
So what else can investors do to protect themselves, not only from unscrupulous advisers but also from rushing into an investment that is clearly too good to be true?
Marc H. Simon, a lawyer who lost two years of bonuses, his job and months of unreimbursed expenses when Mr. Dreier’s law firm collapsed, said he has thought a lot about what he could have done differently.
Mr. Simon said that six or seven years before the fraud was uncovered, he knew of inconsistencies in the firm’s 401(k) plans. But the big red flag should have been that Mr. Dreier had sole control over every major decision at the law firm. Still, that had been Mr. Dreier’s pitch: work for him and don’t worry about the irksome details partners typically face.
“People like Drier and Madoff were highly intelligent individuals, they were very charismatic and they were giving people what they wanted,” Mr. Simon said. “It is harder to bring into question those who are providing you something you want.”
Randall A. Pulman, a lawyer in San Antonio who represents many victims of Mr. Stanford’s fraud, agreed that the will to believe was what ensnared people.
“For you and me, it’s too good to be true,” he said. “For the guy who has been working in the oil fields, how is he supposed to know?”
Of course, fraud and just plain bad advice are not limited to the poor or unsophisticated. Robert P. Rittereiser, the former chief financial officer of Merrill Lynch and former chief executive of E. F. Hutton, is working as the receiver for two funds suing J. Ezra Merkin, a former money manager who steered money to Mr. Madoff. Mr. Rittereiser did not think investors in Mr. Merkin’s funds knew that their money was simply being passed on to Mr. Madoff. But even if they did, they may not have seen anything to be concerned about.
“They were investing money and getting appropriate returns for the kind of fund it was,” Mr. Rittereiser said. “Most of them had a relationship of some kind and confidence with Merkin and the people he was dealing with.”
So how do you protect yourself? The first step would seem to be picking an honest adviser. The good news is that only about 7 percent of advisers have disciplinary records, said Nicholas W. Stuller, president and chief executive of AdviceIQ, a company that evaluates advisers. The bad news is that those violations appear only after someone has filed a complaint.
Mr. Stuller’s company, which has now approved some 2,400 advisers, rejects anyone with any type of infraction — from a securities fine to a misdemeanor for getting into a fight. He said this policy might keep some good advisers off the site, but his goal is to search the records of federal and state regulators to find advisers he knows are clean.
“There are advisers who have significant negative disciplinary history with one regulator but appear to be pristine with another regulator,” Mr. Stuller said. “There was a guy in Minnesota who was stealing insurance premiums. In his enforcement record, it says, ‘We’re going to alert Finra,’ but his Finra record is clean,” he said, referring to the Financial Industry Regulatory Authority. “That’s where the regulators don’t talk to each other.”
AdviceIQ’s main competitor, BrightScope, takes a different approach. It notes disciplinary actions taken against advisers but leaves it up to the consumer to go to regulators to determine what the violations were.
“We want the consumer to go to the source data, because there is a lot of liability in publishing that,” said Mike Alfred, co-founder and chief executive of BrightScope. “Many of these folks are good advisers, and they’ll take care of you. But what if they had one crazy client who put all his money in Internet stocks in 2000 and then sued?”
Both services have obvious downsides. With AdviceIQ, a crooked adviser could be rejected from the site and no one would know about it, while BrightScope’s listing could hurt an otherwise honest adviser who had a frivolous suit brought against him.
Mr. Stuller said his site’s main goal was to match advisers with clients of similar needs, like a doctor with someone whose clients are mostly doctors. Mr. Alfred said his site left it to the individual to do more due diligence, though he pointed to an adviser with 55 violations and said she would have trouble explaining those away. (Both sites charge featured advisers an annual fee.)
Ross Gerber, president and chief executive of Gerber Kawasaki, a wealth manager, said clients with sizable wealth should not trust it to any single adviser, no matter how good the adviser seems to be.
He said one of his clients, with about $25 million, has $5 million with him, $10 million with a private bank, and $10 million with a trust company. Each month, Mr. Gerber sends her statement to the private banker, who acts as the point person to make sure the various portfolios aren’t all invested in Apple.
“I’m not threatened by other investment managers who work with my client,” he said. “My clients with a lot of money have a lot of private banking relationships, or lending relationships, or things we don’t provide.”
Mr. Gerber added that he would steer clear of advisers who didn’t want to share with other advisers what they had done for clients. “If Starbucks goes from $50 to $80, it’s easy to show them why it did well,” he said. “When you’re investing in these scams, they’re funds. You don’t see what’s in them. People don’t necessarily ask a lot of questions or they don’t care.”
In some cases, investors do not even know the questions to ask. Marc Odo, director of applied research at Zephyr Associates, a financial software firm, said he had been asked by a client whether a return could be so high or consistent for so long that it might signal a fraud.
Not knowing the answer, he applied sophisticated financial models to compare Mr. Madoff’s record, using a fund that fed money to Mr. Madoff, Fairfield Sentry, against the returns of Hedge Fund Research’s Equity Hedge index from 1990 to 2008.
He plotted the returns on a graph that measured the frequency of losses and the amount of time returns were positive. All but five equity hedge funds were grouped together at the left side of the graph, and four of those outliers were still close to the pack. The Madoff returns floated in the top right corner, like a distant planet.
“This is a more mathematical way to quantify the ‘too good to be true,’ ” Mr. Odo said. “This helps pick apart the numbers. It helps you understand the risks out there.”
He said this analysis was particularly important with investments in hedge funds or other vehicles that do not disclose their holdings: testing how believable the returns are over a long period of time may be the only way to know if they are achieved legitimately.
Still, Daylian Cain, an assistant professor of organizational behavior at the Yale School of Management whose research has looked into how advisers who disclose their conflicts can give people a false sense of comfort, said anyone, no matter how smart, could be duped if the situation were appealing enough.
He said the best advice would be for investors to ask themselves at the moment they are about to invest: What would happen if the investment is not what I think it is?
“Asking, ‘Could I be wrong?’ is psychologically completely different to the brain than, ‘Could I be right?’ ” he said. “It’s not ‘Could this be true,’ but ‘How could this investment be a bad idea?’ ”
The very act of asking that question, he said, might prompt a potentially positive response: procrastination. “If the opportunity is gone tomorrow,” he said, “it may mean that your money and your adviser is gone tomorrow, too.”
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