Testing the Trust 

Trust is the fundamental premise behind any meaningful personal or business relationship. Trust in business is the notion that you do not have to second-guess or examine every action of the other party because you have comfort that their actions will not violate your interests or expose you to harm. Trust is essential - without trust we are facing a world where the danger of doing business and the cost of examining the other party outweighs the benefits of being in business.
Unfortunately, in the Madoff scandal, someone who was trusted by many investors, advisors, regulators and industry insiders violated that trust in the worst possible manner. That violation of trust left many investors with the sense that we are in a world where we can't trust anyone if such a high profile, reputable figure can turn out to be the opposite of what we believed. If we cannot trust the largest and best known investment managers - who can we trust?

• Does the company use a third party custodian or clearing firm? Is the custodian a large and well-known company? The majority of investment management companies use a third party custodian who is responsible for maintaining the account records and safeguarding the assets. The lack of a third party custodian was the most blatant omission in the financial control used in the Madoff case. Registered Investment Advisory (RIA) firms typically use a third-party custodian. Broker-dealers use a clearing firm which serves a similar purpose. Hedge funds usually use a type of clearing firm service. All three arrangements ensure that a third unrelated party sees all the accounts and has the obligation to verify and maintain the account records. Fictitious transactions cannot be executed in such an environment.
   
  Madoff was using a "self-clearing" broker-dealer, meaning that there was no third party seeing or verifying the account record. This is not to suggest that self-clearing firms are problematic, however, they do not have the added protection of a third-party firm.
   
  Large custodian firms include Fidelity, Charles Schwab, Pershing, JP Morgan, Citibank and others. The large custodians tend to be large banks and are usually well known companies. Smaller custodians could potentially present higher risk or vulnerability that they may be influenced by the company they are meant to verify, especially if that company is their biggest client.
  
• Who has the money at the end of the day? The Madoff case showed how complex the industry can be with brokerage firms selling hedge funds that ultimately invested in Madoff. You as an investor or a CPA helping an investor need to know who is at the end of the line and how are they supervised and managed. There are three types of companies that investors are likely to work with. Registered Investment Advisors (RIA) are regulated by the SEC and register and file information annually and are periodically audited by the SEC. RIA firms are required to use a third party custodian and thus also meet the first criteria. Broker-dealers are investment companies regulated by FINRA and are supervised closely by that organization, including annual audits. Hedge Funds are unregulated investment partnerships that do not have to meet any of the above requirements.
  
• Who is the person you are working with? Who do they represent? Are they paid by the company managing your money? Your advisor may either be independent (meaning they own their own company) or an employee of another company such as a large Wall Street firm or insurance company. If your advisor is representing the same company that is managing the assets then they cannot be assumed to be objective in their due diligence of that company. Advisors who represent a company separate from the company managing the money will be more objective in their scrutiny and opinion of the company.
   
  If your advisor is receiving a commission from the company you are investing in, you should be more skeptical of their objectivity when the performance, stability or other characteristics are concerned. This does not mean that the advisor is biased or unethical. It simply means that you cannot assume them to be objective.
  
• Can you log into your account at any time and obtain up-to-date or real-time information that is marked to market? This is a very simple but effective test. After all it will be more difficult to counterfeit hundreds of accounts if clients can see them in real time and compare them to the statements they receive. This is especially true if the investments are marked to market - meaning that the value of the assets is updated periodically based on market results. Real estate and private equity investments are unable to give you such access. That does not mean that such investments are a fraud risk but it does imply that the level of due diligence on them has to be higher than other types of investments.
  
• Are there restrictions on withdrawing money from your accounts and what are they? By itself the liquidity of an investment (ease of getting out of it or liquidating) is not a protection against fraud. Still, the more liquid the investment is the more difficult it is for a fraudulent investment to flourish for a long time.
  
• Does your company have a third party auditor and who is the company? An auditor will not scrutinize the investments made by a company but will verify the revenue recorded by the company and therefore can catch irregularities in accounting. An auditor will also verify the financial controls inside the company certifying that the company has adequate controls over its cash and financial record. CPA firms that audit investment companies tend to be Big 4 companies or top 50 firms with specialized practices.
  
• Who is scrutinizing the investments that are recommended to you? Is that a professional team of due diligence experts? What is their process? If the investment has been approved by a due diligence team at a broker-dealer, the internal investment committee of the investment advisory firm you are working with, the trust company, etc. the probability of a rotten apple declines with each set of eyes that take a look at it.
   
  There is however a big difference between being "on the platform" - meaning available for sale and "approved." The mere availability of the investment on the platform of the broker-dealer or custodian simply means that company has passed some very basic criteria. It does not prevent against potential fraud.

 When should you be worried? If the answer to more than a couple of questions is either unclear or raises the red flag, then this investment deserves a lot of scrutiny and is potentially vulnerable to Madoff-type problems. The added scrutiny of your advisor or your CPA can be helpful in vetting your options. No list of questions can represent a perfect due-diligence process but these straightforward questions should at least ensure that the chain of custody and the separation of responsibilities that are fundamental to any prudent financial control are not broken. As much as the Madoff case shows that reputation alone should not be enough to trust someone with your money, it also proves that we should never stop asking the basic fundamental questions, no matter how sophisticated the matter at hand may be.
 
If you are unsure how to pose some of the questions to the companies you are using, we can certainly meet to elaborate on this list and provide you with more information on how the industry is meant to operate. As an example, we have supplied our own answers to these questions in the appendix. Again, this is not meant to be a self-serving list but rather a tool of protection for all of us. We have to trust each other and we have to restore trust in the financial system and we can only accomplish this together.
 
We can't say "Trust me!" - trust does not work like that. All we can do is tell you a lot about how we do business answer all your questions, be completely transparent about our actions and hope that the trust will develop over the years of a productive relationship.

• Do we use a third party custodian or clearing firm? Is the custodian a large and well-known company? Yes - we use Fidelity (through its clearing division National Financial Services - NFS) as the custodian of all our advisory accounts and the clearing firm for all our brokerage accounts.
   
• Who has the money at the end of the day? We use reputable investment companies such as OppenheimerFunds, Dimensional Fund Advisors (through Symmetry Partners), SEI Investments and other well known investment managers and mutual fund companies. We can always trace all of their holdings all the way to the exchange floor.
  
• Who is the person you are working with? Who do they represent? Are they paid by the company managing your money? We are an independent firm (I own the firm) and I work as an Investment Advisor Representative (RIA) and as a Registered Representative (RR) of NFP Securities Inc. who is our broker-dealer. NFP Securities, Inc. does not manage your money - that is done by a third party investment management company which we should discuss together.
  
• Can you log into your account at any time and obtain up-to-date or real-time information that is marked to market?
  Yes - a variety of methods are available directly through Fidelity/NFS and or through the companies that custody your investments.
  
• Are there restrictions on withdrawing money from your accounts and what are they? Most, if not all of the investments I recommend to my clients are completely liquid but may have fees, taxes or other charges associated with early liquidation or withdrawal.
  
• Does your company have a third party auditor and who is the company? The actual companies investing the money are all audited by a reputable auditor. Our broker-dealer is also audited by PriceWaterhouseCoopers - a Big 4 accounting firm.
  
• Who is scrutinizing the investments that are recommended to you? Is that a professional team of due diligence experts? What is their process? Our broker-dealer, NFP Securities, Inc. also performs extensive due-diligence on all investment vehicles used. The process starts with a cursory review of a set of minimum standards in order to determine specific hurdles are met before further due diligence is performed.  Those that pass initial screening are considered for a more in-depth analysis and vetting process that is rigorous and systematic.  The due diligence process is viewed as a holistic approach where both qualitative and quantitative factors are used to develop a comprehensive understanding of the investment opportunity. When performing a full due diligence review, examples of things considered may include but are not limited to issues such as manager tenure, employee turnover, AUM, track record, and performance attribution.  Transparency in operations is a key factor in helping to assess whether a product/manager/fund contains a prudent balance between risk/reward and is the basis for approval of any new offering.

Despite the most thorough efforts to evaluate and understand an offering, it is impossible to completely rule out and avoid the potential risk of loss.  Due Diligence is designed to verify and ensure that the information provided by the product/manager/fund in the PPM or Prospectus is accurate and provides full disclosure enabling the investor to make an informed investment decision.

Five Red Flags to Watch for

Here is the link to the article. It's worth reading when you have a minute.

http://articles.moneycentral.msn.com/learn-how-to-invest/is-your-money-manager-a-crook.aspx  

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