In investing at least, fraud is the hardest thing to defend yourself against.

The Wall Street code

Wall Street has a very strict informal code of conduct.  Most market participants in the US are at the same time highly cynical and scrupulously honest.  Multi-million dollar trading business is routinely conducted over the phone, with the understanding that both sides will keep their word.  There’s paperwork, of course, and all conversations are taped.  But even having to go to the tapes can be seen as the breaking down of an implicit bond of trust.  People who don’t tell the truth quickly acquire a reputation and are shunned.

As a result, someone like Bernie Madoff comes as a double shock to market professionals, as jaded as they may want to appear to the outside world:

first, that a fellow professional would engage in fraud; and,

second, that he could have gone undetected for so long.

Protecting against fraud

There are several levels of protection against fraud at the disposal of any investor.  They are:

1.  the regulators

2. accountants, who audit financial statements

3. the “due diligence” of sales intermediaries

4. your common sense

5. diversification.

In the Madoff case, only diversification would have worked.  What diversification means in this case is limiting position size.  This would not have avoided a Madoff loss, but it would have contained it–and prevented the devastating negative lifestyle consequences that total reliance on Madoff seems to have producted for many of his clients.

Details:

1.  The government regulators. These are the Federal and state agencies that set and enforce the rules for investment products.  I don’t think there’s a problem with rule setting.  The US is generally regarded as the best at this in the world (there’s a reason all those toxic derivative products were created–by US financial firms–in London, not here).

In the Madoff case, and in the Stanford case as well, the regulators failed in enforcement, in a way that stretches the boundaries of belief.  Yes, it’s true that the regulators may not have the training or experience to understand today’s complex derivative instruments.  But that’s not the issue with Madoff.  According to press reports, a whistleblower who exposed the fraud to the SEC years ago cited specific trades that could be shown to be fictitious by a check of counterparty records.  The SEC looked at the Madoff records but didn’t bother to check with couterparties to see if the trades actually happened.  This is the essence of an audit–to check with outside parties to ensure records are genuine.

2.  The auditors, and financial statements. At the conclusion of an audit, accountants issue what’s called an opinion, in which they describe the scope of the audit and state whether they think the accounts fairly and accurately represent the operations of the company in question.  This is typically done yearly.

It’s the first thing a professional looks at when reading an annual report or other financial document.  The two items of interest are–who is the auditor? and, is the opinion qualified in any way (i.e., are there any ifs, ands or buts that point to possible trouble)?

The accounting scandals at the turn of the century revolved around the conflict of interest between the management consulting and auditing arms of the big accounting firms.  In many cases, the fees paid by a company for consulting services were 3x or more the fees paid for the audit.  The threat of the loss of consulting business appears to have persuaded auditors to be more lenient than they should have been in examining the accounts and to issue unqualified opinions when qualified opinions were really in order.  Subsequent changes in the rules have addressed this issue.

The Madoff issue, and the Stanford issue as well, was who the auditor was.  In the Madoff case, the auditor appears to have been a three-person firm–only one of them an accountant–operating from a small office in a smaller town in New York.  The Stanford case is similar, with Stanford naming a small accounting firm in Antigua as his auditor, and the accounting firm subsequently denying being Stanford’s auditor or for that matter having any knowledge of Stanford at all.

A large firm having a small and unknown auditor is always a red flag.  Reporters’ efforts to research the accounting firms after the scandals broke suggest to me that even a simple phone call to either would have signaled very serious concerns about the validity of the financials of either investment group.

By the way, if a reporter could uncover this with a phone call, so too could any potential investor have!!

3.  The “due diligence” of intermediaries. Given how easily reporters seem to have uncovered the dubious nature of the company’s financial statements, it would appear that intermediaries didn’t do much investigation of Madoff, if any.  The fact that he paid huge fees to these intermediaries may well have influenced how carefully they looked.

4.  Your common sense. This is a hard one for anyone to evaluate.  I would say, though, that investing is a relatively boring activity whose purpose is to make money.  But many people make investments (mostly unsuccessfully) for any number of other reasons, like:

as a show of wealth or status;

to be the first one to discover a new thing;

to be the center of attention at a cocktail party;

for some other kind of emotional satisfaction.

Madoff seems to have been unusually good at bringing out these motives in potential investors.  In my experience, any strong emotional tie to an investment is a big red flag.

5.  Diversification. We all are entitled to the reasonable expectation that our investments will be protected by the work of regulators, auditors, the people who sell us investments, and by our own innate craftiness.  But as the large flow of jewelry and watches for sale from Palm Beach residents shows, sometimes all these potential safeguards fail.  That’s why diversification is important.

Diversification means, in all likelihood, lower returns than one would have in a more concentrated set of holdings.  That’s not the point.  Diversification means greater protection against the occurrence of a low probability event that carries with it disastrous consequences.

What can you do to check your portfolio

Several things:

1.  You can check to see who audits the reports you are receiving on your individual investments and whether the auditors have issued an unqualified opinion.

2.  You can now, and periodically after this, analyze your portfolio structure.  Look at your exposure to specific investments and to specific investment service providers.  Ask yourself what would happen to you if one of them turned into another Madoff.  Your conclusion will tell you if you have too much money tied up in whatever investment it is you are considering.

3.  Use your own common sense.  If an investment seems too good to be true, it probably is.  You might also ask how you have gotten lucky enough to get in on the ground floor.  Yes, we all have special qualities that endear us to the rest of the world–or at least we think we do.  But it’s equally likely that, as in the Madoff case, someone is playing on our ego to convince us to buy something we’ll regret soon after.