Bernie Madoff is unfortunately one of many. Source: Bloomberg/Getty Images.
If the one of the wealthiest people in Congress can get duped by a fraudster to the tune of $18 million, how can there be any hope for the rest of us?
So asked headlines after court documents revealed Rep. Alan Grayson (D-FL) fell prey to a bogus investment scheme run by the now-convicted William Dean Chapman, a Virginia-based "financial advisor." Chapman promised 122 willing victims to sign their stocks over to him as collateral for a three-year cash loan worth 85% of the stocks' value. When the loans matured, Chapman was supposed to return the collateral. Instead, he sold the shares to pay earlier creditors and fund his lavish lifestyle, bilking clients out of $35 million total.
Ordinarily, the shenanigans of one shyster from Virginia wouldn't make national news. For fraud to hit the A-block, it typically must be of Madoffian proportions or hit Hollywood. But this scam whacked one of our richest Congressmen-a self-made multimillionaire who rose from his poor childhood in the Bronx to get a BA in economics from Harvard and a JD from Harvard Law, both with honors. He built a successful law practice representing whistleblowers in fraud cases, headed up a telecom firm and won his first House seat in 2008. In short, not the kind of guy you'd expect to get duped-hence, some say, if he's vulnerable, we all are!
But in my view, this isn't true. Money and status don't protect against fraud-awareness does. Knowing a few basic structural facts can make it exceedingly difficult for you to get duped. For one, keep greed in check and have realistic expectations. Second, be a discerning investor. Your advisor should be able to clearly articulate his or her strategy in a way you understand. Third, crucially, never give a manager custody of the assets. Ever! That is giving your advisor not only the reins over strategy, but access to the cash. Limit it!
The victims overlooked one or all these three factors. Had they not done so, it wouldn't have been hard for any of Chapman's victims to spot the scam. It had all the classic signs. One, it was too good to be true-instant cash today, all your investments back tomorrow!
Chapman's strategy also violates the third point: It was complex and shadowy, with his strategy drowning in sophisticated lingo that didn't really mean anything. A close examination of Chapman's alleged strategy would tell you there was no way he could ever live up to his commitments. Consider: If you pledged $1 million in stocks as collateral for a $850,000 loan-and over a hundred other clients were doing the same-where would the advisor get the cash? According to the SEC's filing, Chapman "assured borrowers that [he] would engage in 'hedging' strategies, would 'hedge,' or would enter into contracts with counterparties that would ensure the portfolios could be returned." But that isn't what hedges do! A true hedge is simply a position that moves in the opposite direction of a certain asset (or basket of assets). A hedge on the pledged collateral would simply be put options or short positions-they zig when stocks zag. Saying this guarantees return of the securities or their full value (including all gains during the contract period) in cash is like Bernie Madoff saying his split/strike option strategy would guarantee 10% a year. If you buy that, you'll buy oceanfront property in Arizona.
The biggest red flag, however, is the easiest for anyone to guard against: Chapman made all of his clients sign their stocks over to him. He took possession-essentially temporary ownership-of them. He couldn't have sold his clients' stocks and made off with the proceeds if they weren't in his possession. By convincing clients to give him custody, rather than keep their stocks in brokerage accounts in their own name, he removed all protection against fraud.
If any advisor encourages you to keep your money with them, and not in an account in your name (ideally at an unaffiliated third party), run. Even if you don't think you smell fraud! Even if he seems like a nice guy, even if you've known him for years! Think of it this way: Who would you trust with your money? If you handed someone a million bucks for safekeeping, who would you trust to do the right thing? Anyone? Your spouse, perhaps, but I'd imagine that's about it.
No advisor who puts investors first will make clients sign over their hard-earned money. Honorable advisors understand the importance of checks and balances-they recognize clients have already placed a great deal of faith in them by entrusting them to develop and manage a portfolio strategy that could make or break their financial future. To deserve that trust, they know they must be as transparent as possible. They know that if they took custody of your money, you'd lie awake at night worrying they could run off with it. Advisors with the right values-who want the best and only the best for each client-don't want to be the source of that worry.
To avoid being a statistic, look for advisors who put investors first, always and everywhere. Sure, this doesn't guarantee investment success-the advisor's overall values, expertise, investment philosophy, approach, resources and long-term track record are hugely important. But finding an advisor who takes their responsibility seriously-who keeps clients' assets separate and in their own name; who has incentives to help clients reach their goals, not sell a product-will help guard you against the Chapmans and Madoffs of the world.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.