How to Avoid a Ponzi Scheme Lessons from the Madoff Fraud

In the wake of Bernie Madoff’s $50 billion Ponzi scheme, many investors have grown more concerned about the safety and security of their investments. Despite the efforts of regulators, financial scams remain far too common. Do you know how to protect yourself from financial deception? 

A Ponzi scheme is a fraudulent investment vehicle that promises returns to participants that cannot be delivered. You should be aware that Ponzi schemes do not always involve stocks, and many allegations of real estate and insurance based Ponzi schemes have surfaced since the Madoff fraud was uncovered. These schemes typically use money from new investors to pay unachievable rates of return to existing investors. With new money always needed to pay existing investors, Ponzi schemes usually fall apart when there are not enough new investors to continue the fraudulent scheme.

Red Flag #1

The first “red flag” should be any claim or representation that an investment is risk free or offers consistent returns that always outperform market averages. Regulated investment companies are typically prohibited from making such claims. Most managers that achieve superior returns do not guarantee them, and many will even emphasize that their returns are not benchmarked to major market averages. 

You should ask yourself: If these returns are so steady and solid, why does this company need to pay such a high rate of return for my money when financial institutions regularly invest in businesses with steady returns at a much lower cost of money?

Red Flag #2

Beyond their claims of “riskless reward,” the criminals behind Ponzi schemes operate by avoiding the checks and balances that apply to most legitimate money managers. Money managers that maintain custody of client assets should always be viewed as a “red flag” by consumers. Without an independent, third party custodian to maintain custody of client assets, Ponzi scheme operators have no one standing between them and their investors’ money. It is much more difficult for financial scam artists to pillage your assets if a reliable custodian is safeguarding them. 

If a small firm that you are not familiar with is the custodian for a money manager that you are considering, you should find out why. Large, well recognized custodians are readily available to most professional money managers at competitive rates.

Red Flag #3

The same “recognition principle” that applies to custody also applies to auditing. One of the reasons that the Madoff fraud remained undetected for such a long period of time was the lack of a credible auditor. Madoff’s company was audited by a tiny accounting firm with only a few employees, which made the effective auditing of a $50 billion fund impossible. The fact that many professional investors failed to spot this potential for wrongdoing from an undersized auditing firm gets to the heart of what allows Ponzi schemes to exist in the first place — failure to conduct due diligence.

Red Flag #4

Ponzi schemes only exist because participants are not thorough in their due diligence and do not ask the right questions. This often stems from excessive reliance on the reputation of a famous investor and the reputation of clients. Experts in investment management analysis knew that the overly consistent returns from Madoff were not possible with his strategy over long periods of time. At the same time, however, many otherwise accomplished experts knew that Madoff was previously Chairman of the Board of Directors at the National Association of Securities Dealers (NASD) and that his clients included many members of New York’s most elite social circles. Early in my career, I declined an offer to participate in one of the funds that channeled its assets to Madoff’s operation. Despite the list of well-known and wealthy participants, I declined because my own due diligence indicated a fundamental lack of transparency. Yet many professional investors lost money in the fraud because they were willing to substitute the reputation of Madoff and his high profile investors for their own due diligence. 

If you are considering an unregulated investment vehicle, you do not have to know how to conduct your own due diligence. You do, however, need to recognize when a capable professional is needed to help you conduct the due diligence. When assessing an unregulated investment, you should consider finding a financial planner who is equipped with the tools and knowledge necessary to look out for your best interest.  

FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, Calif.  He serves as Director of Public Relations for the Financial Planning Association of Los Angeles chapter.