From the February 01, 2009 issue of Futures Magazine • Subscribe!

What were they thinking?

The Bernard Madoff mess kind of makes me chuckle. Of course, I wouldn’t be laughing if I had invested with him, and many very wealthy people, and sadly some charitable organizations, are out billions of dollars. But it seems no one was actually checking to see if Bernie was doing what he said he was doing. And that, in itself, is such a breach of fiscal responsibility it makes me think all of Wall Street is built on a Ponzi scheme.

The Madoff fund had so many red flags at some major brokerage firms that insiders knew he was fudging performance, yet they didn’t blow the whistle on him.

It also pulls the cover off of fund of funds that seemed to have shrugged off their responsibility in making sure these funds were safe. What were these firms collecting fees for? And isn’t it just good business to make sure your money is in a fund that actually will perform and is safeguarded?

Yet some savvy people did get caught up in the Madoff mess, so here’s a list of rules that I have learned from being a journalist and covering the business of managed funds.

1) Check your sources. The journalistic adage, “if your mother says she loves you, double check,” applies in this instance. Just because another firm invested in the manager doesn’t mean you get a free pass on doing your own due diligence. One friend suggested a Saturday Night Live skit in which a banker goes into Madoff and wants to perform due diligence, and when Madoff refuses to comply, the banker gives him $100 million.

2) Diversify. We’ve heard tale after tale of people putting their life savings (or a huge chunk of wealth) with Madoff. Isn’t the first rule of investment to diversify?

3) Place your money with a third-party custodian. The most amazing thing is Madoff was the broker of his trades. Most fund managers know this isn’t the best, or safest, route to go to invest, but it seems it didn’t sway investors from giving him money.

4) Don’t trust the regulator, more specifically, the Securities and Exchange Commission. Just because someone is registered doesn’t mean they have been checked. Regulators have a lot on their plate and, in this era of deregulation, perhaps they haven’t been so rigorous in checking the details (see Managed Money Review), even when someone comes to them to blow the whistle. Although regulations may be a payday for attorneys, they don’t guarantee an investment.

Further, being under (house) arrest doesn’t necessarily mean the law or regulators have put an end to the ruse, as was shown when the prosecutor wanted Madoff to go to jail when it was found he was trying to “hide” money by sending jewelry, valuables and money to friends and family from his apartment, while he was under arrest. One of the biggest scandals on Wall Street and they aren’t sitting on top of the guy, checking his mail, searching his house?

In the end, Madoff held a mirror up to the investment industry and uncovered the laziness and massive breakdown of responsibility, which is the thread that holds the seam of the business together. If investment firms can’t be bothered to check on the credibility of a fund or don’t understand how to do so, they should have to sacrifice any fees they’ve collected over the years. It’s one thing to lose money in a strategy that goes bad — it happens to even the best traders. But to lose money because the firm didn’t bother to do nominal due diligence on a scam artist, that’s just as reckless as Bernie Madoff.

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