Madoff whistleblower Harry Markopolos on how to protect against investment fraud

bookWhen Bernie Madoff confessed in December 2008 that he had been running a Ponzi scheme for decades, everyone was surprised, but not Harry Markopolos and his team.

Markopolos, Frank Casey, Neil Chelo and Mike Ocrant had been tracking Madoff's boldface lies for 10 years. They had, in fact, reported Madoff five times to the Securities and Exchange Commission. Despite detailed complaints, no action was taken. No one was listening.

Well, everyone is listening now. Markopolos, a full time independent fraud investigator after years in the securities industry, took time out of his busy schedule promoting his riveting account of the whole sage, titled "No One Would Listen: A True Financial Thriller," to chat with WalletPop about what investors can do to avoid the next smooth talking charlatan.

It has been more than a year since Bernie Madoff confessed to his Ponzi scheme. Has anything changed on Wall Street? Have there been any changes that will benefit investors?

Harry MarkoloposNothing has changed on Wall Street. There has not been any financial reform package [passed]. I think there have been some positive things that have changed at the Securities and Exchange Commission (SEC). And those are that the SEC now prioritizes Ponzi schemes. They treat them with a new level of respect. They've learned a lot from the failures of the Madoff case and they are addressing those rapidly.

They know what to look for as far as unbelievable, too good to be true returns and they investigate managers that have returns that are too good to be true a lot more aggressively, more effectively. They go to third parties and check the trading records to make sure the trades actually did take place, because in a Ponzi scheme, there is no actual trading. In fact, there is no investing going on. They are just robbing Peter to pay Paul.

It is my expectation that the new financial reform package will bring hedge funds and over the counter derivatives into the regulatory framework and there will be oversight finally. And it has been long overdue and will help investors going forward, only if the regulators are smart enough to find and understand the frauds that are taking place in the over the counter derivatives market and hedge fund market. Right now, I would argue, you change the laws, but until you change the people at our regulatory agencies and bring in people who are sophisticated and well trained and well schooled enough from the industry in to inspect these entities, nothing will change. You will have stronger laws but you will not have stronger enforcement because the people in the regulatory agencies don't have a clue as to what is going on.

You mentioned that SEC is taking some of your recommendations to heart. What are those changes and what do they still need to do?

They've sent well over 400 of their examiner staff to become certified fraud examiners so they have been educated on to how to conduct a proper fraud investigation, how to question witnesses and how to obtain confessions. So they are finally training their staff to become fraud fighters, where before, they were just book and records inspectors. Before they were bureaucrats and now they are looking to fight fraud, to prevent fraud. Kudos to the SEC for that.

They are hiring more staff and more people from industry, people with trading backgrounds and money management backgrounds and hedge fund backgrounds and public accounting backgrounds onto the agency staff. But there are too little a number to make a meaningful difference.

They've reorganized their enforcement unit along functional lines. So now lawyers work cases along a certain area of fraud so they become specialists. They're becoming smarter. They've created some cross-functional teams in the enforcement unit so it's not all lawyers. So they are doing some good things.

They are not working at the speed of government. They are changing at a much more rapid pace than any other government agency that I can think of. They've finally gotten religion. They know how serious this Madoff case was and they don't want it to reoccur. Being shamed in public over this case has sent a message. That agency has woken up from a decade-long slumber.

That's the positive. The negative: the SEC is still run by lawyers. All five commissioners of the SEC are securities lawyers. I would argue that none of them should be. They should all be various walks of the industry, in the accounting ranks that understand the finance and math and understand the complex products and complex frauds of the 21st century. That's not securities lawyer.

The other thing they are doing wrong is they need move the agency out of Washington to New York where you can hire competent finance professionals to join the SEC staff. You are not going to get many finance professionals in Washington D.C. They jus don't exist down there. It makes sense. New York is the largest financial center. Why wouldn't you want to be in New York? There is no finance in Washington. That is the political center. Plenty of lawyers down there; not many finance people. Maybe that's why there are so many lawyers at the SEC running things as commissioners.

I was pretty shocked at how the powers that be were complicit in all this. How can everyday investors protect themselves then? What kinds of questions should they be asking?

First, what type of due diligence have you done on the manager? Have you asked them questions? And do you even know which questions to ask? It's very difficult for the individual investor because you have to make a choice between going with a big firm with deep pockets, that if they do something dishonest, they have to reimburse you. But the big firms all have conflicts of interest. Or do you go with a smaller firm without deep pockets? I think you can as long as you have an independent third party custodian. If you go with the smaller advisers, you can often avoid the conflicts of interest a big firm has. There is always tension there. You are always asking yourself if you made the right choice.

What's your definition of due diligence? What are the questions we need to ask?

If I am an investor, I only want to invest in the strategy that I understand. If I don't understand the strategy, if it involves options, futures, commodities and I don't understand them, then I don't want to be investing in them. If I understand stocks, then I want to invest in stocks. If I understand bonds, I want to invest in bonds.

Because that's how people get trapped into Ponzi schemes. They don't understand what's going on with the actual investment. They have no basis for understanding and they get involved with something they shouldn't be. That's what happened with the Madoff investors and it was tragic.

If you ever find yourself being lured in through word of mouth by someone who is explaining they've received great returns and are getting checks every month, 1%, 2%, 3% or more a month on some scheme, and you're tempted to put all of your savings into it, then that's the mark of a Ponzi scheme.

Because they are so alluring, because they really are too good to be true. If you don't believe in the Tooth Fairy, then you shouldn't believe in returns that are too good to be true. And they are so compelling. People went to Madoff like the moth to a flame because his portfolio, purported on the statements he was sending to clients, would have 30 to 50 blue chip stocks, well diversified. He owned protective put options so that you're protected from market crash risks.

So it looked like a fully diversified, fully protected portfolio earning 1% a month. That doesn't exist in finance. In finance, it's not a straight road up at a 45-degree angle, which was Madoff's return chart. It's a bumpy, curvy road with treacherous drops and steep climbs. It more resembles a roller coaster. Nothing resembles a 45-degree straight line up.

What about having that third party custodian. A lot of investors didn't even know they were investing in Madoff. They were sending their money to a bank, to a fund.

This is important. Hedge funds – the proper allocation as I was trained, hedge funds is allocation between 0% and 25%. For most investors, unless you're wealthy, it should be 0%. Too many of the little people got caught up in hedge funds, had no business being there because he was unregistered. I would say you have to diversify across strategies and managers. You can't put all your eggs in one basket, no matter how tempting it might be. There is no one superior investment vehicle. At various points in time, certain investment strategies will dominate others.

And you may end up in some losing strategies and some winning strategies at the same time, and that's OK. That proves a diversification works. So you can't be all in on one strategy or manager. They trusted the wrong manager. They trusted someone who was a dishonest swindler, who told boldface lies right to their faces. And that is unfortunate. You have to hope the government will catch them all and put them in prison, but that is not very likely.

You mentioned earlier to go with a reputable firm so that there is a Madoff situation, you stand a chance of being repaid. Is that's what is happening?

The second largest feeder fund was Tremont, owned by Oppenheimer, which is owned by Mass Mutual. Mass Mutual is saying they are not going to pay, that they will go to court. You and I know better. If they go into a courtroom before a jury, it'll be a tough set of facts for them. It is going to be an uphill battle. How can they claim Tremont did due diligence when in fact they didn't. So if you can have deep pockets there to sue – that's why I say most investors are probably safer in a mutual fund environment than any other environment if they are an individual retail investor.
I am just amazed there are so many people in Wall Street, in government complicit in all this. That there seems little individual investors can do protect themselves.

The deck is stacked against the individual investor because they don't have enough information so it is an uneven playing field. That is why I've always recommended that they go to a mutual fund because at least you have professional managers that have professional skepticism, they have advance finance degrees, they have professional certification and have data feeds and analysts on staff, they have ability to seek out the truth if they wish to. Not all do of course.

But at least they have the ability to level that playing field on behalf of investors. Unfortunately, you have to pay a fee. Only pay reasonable fees. If you're paying more than 1%, I consider that unreasonable in annual fees. That is just me personally. I may pay 1 1/2 % for exceptional performance and service but for the most part, even mutual funds tend to under perform indexes.

Active investing is a losers' game. I am a firm believer in the biggest decision you can make is in your asset allocation decision. I like to get into beaten down asset classes. Where everyone is fleeing, that is where I am looking to enter. But I am a very unusual investor.
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