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Markopolos on Madoff
Six Red Flags and Tips for Investment Risks

Harry Markopolos made a name for himself as the whistleblower who, for several years, had pointed out the Madoff Ponzi scheme to SEC investigators. On Nov. 7, 2005, Markopolos submitted 19 pages of written testimony to the SEC, enumerating what he considered to be 29 red flags. When SEC staff examined Bernard L. Madoff Investment Securities (BLM) in 2007, they found a lack of disclosure and misleading information but no evidence of fraud. The SEC reported its findings and closed the case on Nov. 21, 2007. Madoff was arrested on Dec. 11, 2008, and Markopolos testified before the House Committee on Financial Services on Feb. 4, 2009.

Following is a summary of six of the whistleblower's points, accompanied by risk management tips:

1. The numbers didn't add up and were too good to be true. Markopolos, a derivatives expert with experience in financial mathematics, found a high probability that the investment returns produced by BLM were the result of a scam. He then asked a consultant - also a financial mathematician - for a second opinion, and the consultant concurred with Markopolos. BLM's performance numbers made BLM appear to have perfect market-timing capabilities, and even best stock and options trading firms on Wall Street do not have perfect market-timing capabilities. Also, accurate investment-return lines on graphs move up and down, reflecting positive and negative returns, as shown on the following chart, "S&P 500 vs. Madoff feeder fund." The investment return line for a Madoff feeder fund - almost a straight line approaching at a 45-degree angle - reflected the fabricated returns produced by the scam.

Tips: If it looks too good to be true, it probably is. When investors are seeing steady returns year after year, even when the stock market has dropped, something is probably not right. Compare the returns with an appropriate benchmark, such as Standard & Poor's 500 stock index for stocks of big U.S. companies.

2. Lack of disclosure and transparency. Markopolos questioned the opaque manner in which BLM was organized and funded, as well as the fact that the commissions charged were not fully disclosed to investors. Nondisclosure was the one general complaint with which SEC staff concurred, though the SEC cited BLM for nondisclosure in other activities:
a. acting as an undisclosed investment adviser to several hedge funds,
b. not disclosing to investors that investment decisions for hedge-fund customers were made by BLM,
c. misleading the SEC about the nature of the strategy implemented in the fund accounts, and
d. withholding information about certain BLM accounts.

Tips: Advisers use a variety of compensation structures: they may get a commission on the securities they sell; charge fees, either flat or a percentage of the assets; work at an hourly rate; or a combination. Ask them to detail exactly how they work and the total compensation picture from managing the portfolio. Be wary of anyone who shies away from answering these questions in a transparent way.

3. Why the need for secrecy?  Why would such a large fund, with such great returns, want to be so secretive that the manager didn't want investors to know that he was managing their money? Most successful funds are publicly proud of the size of their assets under management. Hidden fees and secrecy usually indicate back-door marketing and financing. If the product is not marketed properly, there's a good chance that it isn't managed properly. Markopolos stated, "In my financial experience, I've found that wherever there's a cockroach in plain sight, many more are lurking behind the corner out of plain view."

Tips: Most professional advisers will put an investment plan in writing, including a statement of investment policy that clearly describes the approach being taken with the client's investments in terms of risk tolerance, asset allocation (with periodic rebalancing), investment objectives, time horizon, liquidity, securities, performance histories and expectations. If advisers cannot explain their plan in simple terms, a red flag should go up. Secret strategies are no longer tolerable.

Ask for a second opinion from another expert. Just as a patient would ask a specialist for a second opinion on a doctor's diagnosis, ask another financial professional for an opinion on individual strategies.

4. In order to protect its "proprietary trading strategy," BLM did not allow adequate outside audits. The result: inadequate audits. BLM used a three-person firm based out of a 13-by-18 foot storefront office to "audit" its financial statements. The firm, which had one active accountant, told a key industry accounting group that it didn't perform audit services.

Tips: Find out who is auditing the investment adviser. Is it a no-name accounting firm? If so, more due diligence is needed to avoid going out on a limb. Has your adviser recently switched accounting firms? If so, why? If investments are going through a feeder fund, who is auditing the feeder fund?  Does it switch auditors frequently? Is it "auditor shopping" in order to keep its auditors from seeing what its numbers look like year after year?

5. Promise lucrative returns, but do so in a relatively unregulated area of the capital markets. Compared to other financial instruments, such as mutual funds, hedge funds face little due diligence from regulators. It's therefore easier for such funds to operate underground and avoid scrutiny - all the more reason for investors and brokers to exercise thorough due diligence.

Tips: The more significant the engagement and the investment, the stricter the due diligence should be. CAMICO recommends background investigations for all significant engagements. Investigations should be conducted with respect to the investment as well as the client. Scherzer International ( provides such investigation services at discounted rates to CAMICO policyholders.

6. Customers were told that they were being given "special access" to BLM's capacity, despite the fact that several hundred people and organizations also had "special access" to BLM.

Tips: The investment should go to an independent custodial institution (e.g., Fidelity Investments, Morgan Stanley, Charles Schwab), which will ensure that money from new investors can't be used to pay off longtime investors.

Involvement with other professionals is a major risk factor. A good risk management technique is to refer clients to two or more investment advisers who have passed strict due diligence. Suggest that the client choose the one with whom they feel the most comfortable. Juries believe that clients are partly responsible for their own finances, and if the clients ultimately decide who will work best with them, it helps insulate the CPA from liability.

Beware of affinity fraud, which are investment scams that prey upon members of identifiable groups, such as ethnic or religious communities, the elderly or professional groups. Affinity fraudsters: 1) exploit the trust that exists in groups of people who have something in common; and 2) promote the scams by pretending to be legitimate members of the group. Religious groups and the elderly seem to be especially prone to affinity fraud. The U.S. Securities and Exchange Commission posted an investor alert about affinity fraud on its web site in 2006, located at:


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