Madoff: Lessons Learned

While the Bernie Madoff Ponzi Scheme happened more than a decade ago, there are still lessons to be learned, writes Nick Bhargava.

Roughly 11 years ago, Dec.11, 2008, Bernie Madoff was arrested by federal authorities. His now-infamous Ponzi scheme rattled markets and cultural spheres when he financially crippled many well-known individuals, nonprofits and large pension funds.

In many ways, Madoff highlighted all that was wrong with Wall Street: investors pursuing profits over all else, a reliance on exclusivity, walled gardens and not nearly enough scrutiny by investors (and regulators) despite countless red flags. As is often the case with financial markets, basic human psychology can help explain mistakes made in hindsight. Madoff built his career, particularly from the 1980s onward, on the simple, foundational idea of all Ponzi schemes: Everyone loves a winner. This premise allowed Madoff to commit a $65 billion fraud against his 4,800 clients at the time of his arrest. It’s still shocking to think this could happen, even now.

More than a decade later, it’s worth asking: What have we learned? Doing so helps prevent this horrendous situation from ever happening again. And, as shocking as the extent of Madoff’s fraud was, the lessons we can glean are simple safeguards that all investors can benefit from.

Diversify Investments, Institutions & Asset Classes

We’ve all heard the mantra: Don’t put all your eggs in one basket. But to take the analogy a step further, don’t put all your eggs in only baskets, either. Spreading one’s wealth across asset classes is important. For example, building a portfolio that includes stocks, bonds, real estate and even some alternative investments will help mitigate dramatic losses.

Furthermore, investors should diversify not only the assets in which they invest but also who manages or invests those assets. This may seem counterintuitive at first, but a real-world example comes from the 2008 financial crisis. Then, a money market fund “broke the buck,” meaning that the fund had to price its net asset value (NAV) lower than the dollar money markets traditionally trade at. This was due to the fund writing off bad debt as the crisis began to unfold. Even though many investors treat money market funds as interchangeable, the individual asset allocation and management decisions make a difference.

In the Madoff scandal, nonprofits like the JEHT Foundation and the Picower Foundation were forced to close because Madoff’s firm managed the majority of their funds. The Picower Foundation even had to return $7.2 billion the organization withdrew from Madoff over the years to the government (these purported earnings were actually investments from newer victims of the scheme in typical Ponzi Scheme fashion). One does not need to diversify asset managers as one would stocks, but having one manager invest all of your funds exposes you to different kinds of risks, especially if you are not in a position to actively monitor, engage or audit the manager.

Ask questions before and during

Often, we wait to ask the right questions. Once an investment has matured, we wonder what to do with it next or what the tax implications may be. But afterward is too late for questioning the process.
It’s important to ask the right questions before and during the process. For individual investors, that means asking tough questions not just about your manager’s performance but its finances too. Even if investment returns are strong, an investor should always look at the audited financial statements for the asset managers they work with.

Asset managers must disclose how they are making their money, and there should be some correlation between the assets under management or investment performance and the reported revenue. If statements indicate that returns are coming from a different source or strategy than the one stated, that is a concern. Style drift is a red flag. Investors should not only be looking for return, but access to a specific strategy/asset class based on their entire portfolio.

Individual investors should also inquire about a company’s investment strategy, discuss any irregularities and ask about tax implications and how future growth will be managed in the event of a downturn. Above all, if something seems amiss, it’s worth asking. There’s no such thing as a stupid question when it comes to one’s financial health.

One easy question many investors should have considered in Madoff’s case was why a three-person auditing company was handling the financial statements instead of one of the big four firms. This is especially true for a fund as large as Madoff’s.

Don’t Rely Solely on Regulator, Due your own Due Diligence

While the U.S. Securities and Exchange Commission (SEC) has oversight jurisdiction, investors must also play a role.

One way for investors to be effective regulators is to speak up with their expectations. In Madoff’s case, he ran a portion of his asset management business as a Broker Dealer. Broker Dealers are presently subject to a suitability standard when it comes to investors. This means the Broker Dealer's only obligation is to make sure the investments it recommends or otherwise purchases on behalf of the investor are suitable for the investor’s stated risk tolerance, goals and time horizon. While this standard may change in the future, it is a weaker standard than that of Registered Investment Advisors, who are considered to have a fiduciary duty towards investors.

In scenarios like this, it is incumbent on investors to safeguard themselves from situations that may not seem improper on their face but which nevertheless may compromise the investor’s expectations. Investors cannot just allow such managers to run on autopilot. Some degree of oversight is prudent to protect oneself from surprises.

Speaking from the perspective of the real estate crowdfunding industry, where some platforms operate in an opaque manner, investors should be asking themselves to what standard their platforms of choice are held? Are these platforms required to disclose audited financials, investment performance or fee structure? What about the existence and terms of other investments or sidecar deals?
When investors ask questions like these, regardless of the asset class, they can better avoid a Madoff-style meltdown. Don’t assume a regulator is looking out for you, do your own due diligence!
If nothing else, I hope that the Madoff scandal continues to reverberate this one thought: If it seems too good to be true, it probably is!

Nick Bhargava

Nick Bhargava is Co-Founder and EVP of Groundfloor, a real estate investing and lending platform that is open to non-accredited investors.

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