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Protecting Your Assets Against Fraud

I was Securities Licensed Series 7 and Series 63 for 19 years. Clients have been asking how to avoid making poor investment decisions in light of the Madoff scandal.

The recent news relating to Bernard Madoff should remind investors to ask basic questions regarding their account(s).

These are issues that will be faced time and time again in wealth management and family business affairs.

Wise investors ask questions and seek plausible answers.

Each generation will see new fraudulent schemes. The names and players change but the underlying causes are always the same. Fraud can only succeed when basic checks and balances are overlooked…

In the securities industry there are four major functions: the investment advisory role; the custodian’s role; the internal record keeping role; and the external Auditor’s role. Most investors incorrectly assume the focal point should be the investment advisor. Had the Madoff investors addressed the following issues they would have avoided future problems:

1. Who is making the investment decisions
2. Who holds the securities
3. Who creates the records; monthly statements; confirms etc.
4. Who verifies those records.

It is surprising that so many people failed to stand back and look at the most basic elements regarding their business relationships. Let’s take a moment to review how these pieces fit together.

The Investment Advisor:
The investment advisor is charged with making investment decisions based on the investment strategy. At the very least, clients should have a reasonable understanding of the advisor’s strategy and how they implement their strategy.

This means a client asks about specific types of investments, the overall strategy and the criteria for buying and selling securities.

What is the strategy for controlling losses?

Is leverage used?

What is the turnover rate?


If an advisor cannot clearly describe their strategy in layman terms and what rules they use for entering and exiting positions, the prospective client should take a pass. Common sense goes a long way.

Safe-keeping of securities:
While it is customary for firms to hold securities, there are a number of options for safekeeping and delivery. Securities can be held by a firm in street name or on behalf of the customer’s account. Securities in street name are accessible by the firm. Most commonly, this arises when a margin account is used.

If a customer does not sign margin papers, then the securities are held on behalf of a customer’s account and are required to be segregated by the firm. Regulators routinely audit brokerage firms to insure segregated securities are not accessible by firms.

There are at least two other formats that would have avoided problems. Sometimes, a third party custodial firm is used, rather than having the advisor hold securities.

Another option, is a DVP account. Delivery versus Payment is often used by institutional investors and/or Trust accounts where a Bank is involved in the administration of the Trust.

To summarize, a customer eliminates risk if they have the equities held by a third party/custodial firm; a Bank using DVP delivery; and when they do not use a margin account.

It is always a good idea to consider options for delivery and safekeeping when using a small or medium size firm. Small firms understand your concerns and will be happy to accommodate you. If not, think twice about your risk.

Another element of checks and balances involves the records.

Where a single firm controls all functions: investment advisory, safekeeping of securities, and recordkeeping, the risks rise dramatically. This may or may not be the determining factor when using a very large, national firm. At the very least, however, the investor should look at the statements, and monitor the account.

In retrospect, had Madoff investors looked at their positions, they would have noticed the volume of some months was so small, it indicated almost no investors were active in those options. A review of the statements reduces problems.

Specialized CPA firms do audits of stock brokerage firms.

The SEC and FINRA set forth precise guidelines for verification of security positions and the financial audits of brokerage firms. While the use of a large, national accounting firm may not eliminate all risks, the use of a small CPA firm would send up warning flags. Obviously, a small firm could collude with a small CPA firm to falsify records.

As we noted previously, a good steward of family assets will insure they review investment strategies and the safekeeping of family assets.

They should make sure their spouse and adult children understand the concept of checks and balances, and possible problem areas.

The security of the assets is the first consideration; then the performance. Consider both of these, and you will protect your family assets for future generations.

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