NEW YORK — The suicides of two foreign tycoons, the loss of atleast $50 billion in assets and a regulator catching heat forfailing to follow through on several red flags waved over a 10-yearspan.
These are just a few of the outcomes involving the largest Ponzischeme on record allegedly perpetrated by Bernard Madoff and hisfirm, Bernard L. Madoff Investment Securities LLC. As of Jan. 5,more than 120 charities, hedge funds, European and Asian banks andindividual investors are among the victims, according to The WallStreet Journal, which has been tracking the losses of Madoff'sformer clients.
The aftermath has been grim. German billionaire Adolf Merckle,whose conglomerate of companies brought in more than $40 billionlast year, was hit by a train on Jan. 5. His family members laterfound a suicide note. The family of Rene-Thierry Magon de laVillehuchet said the French investor killed himself on Dec. 23 byslashing his wrists and taking pills after losing $1.4 billionthrough Madoff.
Congressional leaders held a hearing on Jan. 5 with the Securitiesand Exchange Commission, and they questioned why the regulatorfailed to stop Madoff's Ponzi scheme sooner than it did. SECChairman Christopher Cox had previously said the agency learned ofpast “credible and specific allegations” going back at least adecade involving Madoff. A former National Association ofSecurities Dealers (now called the Financial Industry RegulatoryAuthority) vice chairman, Madoff remains out on bail even thoughprosecutors want to send him to jail for allegedly violating bailconditions. He is currently under house arrest. The trusteeoverseeing Madoff's asset liquidation recently mailed out more than8,000 claim forms to former clients.
While several nonprofits and everyday investors are still reelingfrom their losses, credit unions have been immune to Madoff'sinvestment pyramid. The hypothetical question is what would happenif credit unions and members had investments through Madoff. Likehis clients, they would naturally have to stand in line to recoverany of their losses. Experts say it helps that the NCUA hasguidelines in place to restrict the type of instruments creditunions can invest in.
“Credit unions are independent cooperatives that serve theirmembers, and as such have essentially the same legal rights againsta third party as any other corporation,” said John McKechnie, NCUAdirector of public and congressional affairs.
NCUA regulations allow FCUs to use a third-party entity to purchaseor sell investments, including certificates of deposit only if thethird party is registered with the SEC or is a depositoryinstitution whose broker-dealer activities are regulated by anotherfederal agency. As a result, guidelines are in place to essentiallyprotect credit unions from themselves.
It may sound like operations 101, but credit unions must “take thetime and the money to do on-site due diligence,” said Scott Powell,managing director of common stock and managed accounts at MEMBERSCapital Advisers, the registered investment adviser affiliate ofCUNA Mutual Group. “Don't delegate the due diligence. Even if itcosts more money on the front end, it will be worth it on the backend.”
Powell said the Madoff case is a “great showcase” of whyregulations are in place to make sure something like this does nothappen within the credit union industry. That's not to saywidespread fraud can't happen. In 2001, it was discovered that anumber of credit unions lost millions of dollars through thedefunct Bentley Financial Services, which sold bogus securities asinsured certificate of deposits. The firm served as a CD broker andEntrust Group acted as the custodian for the instruments. In all,investors, including CUs and banks, lost, but later recovered,nearly $340 million.
The bulk of Madoff's clients were considered “accreditedinvestors”-those ultra-high net worth people with $5 million ormore in assets, Powell said. While some members may not meet thatcriterion, it really doesn't matter because regardless of networth, credit unions have prided themselves on looking at eachperson's unique needs rather than pushing unnecessary products,Powell said.
“We're trying to serve each individual member, not just take theirbusiness. The concept of how credit unions separate themselves[from how other financial institutions operate] coupled withproactive and constructive regulations helps members feel goodabout their money.”
Credit unions also tout their methods in educating members oneverything from creating a budget to saving for retirement. Thismay be an ideal time to offer refresher seminars on the differencebetween private and public offerings, suggested Pete Snyder,principal and founder of Snyder Consulting Solutions, an investmentand insurance program integration firm.
“The reality is you buy a mutual fund, stock or bond and that isprobably the epitome of what people think is risk, but it's notfraud,” Snyder explained. “Whereas with a Ponzi scheme, someone issoliciting money from a little old lady for a deposit so someonecan get money from the United Kingdom later. That's the epitome ofa fraudulent scheme.”
Snyder said Madoff's expectations, a lack of a prospectus, what hepromised and then the reality along with private offerings were arecipe for disaster. Credit unions can go a long way in helpingmembers understand what is legitimate and illegitimate.
“We as an industry hate disclosure because it's so cumbersome. It'sintended to weed out the bad guys,” Snyder said. “Does aninvestment require licensing? What should a member's expectationsbe when they are solicited to make an investment? If someone istrying to sell you an investment, ask if they are registered, do asearch on [Financial Industry Regulatory Authority, which regulatessecurities firms].”
The emphasis on due diligence and constant follow-ups can not bestressed enough, said Brian Hague, president/CEO of CNBS LLC, abroker-dealer and registered investment adviser that serves thecredit union industry. The issue of discretionary versusnondiscretionary is a critical layer of protection, he added. TheNCUA has limits on discretionary accounts, which allows a broker oradviser to buy and sell securities without the client's priorknowledge or consent, Hague explained. A nondiscretionary accountrequires the broker to obtain authorization before it makes anyinvestment decisions. All of CNBS clients have beennondiscretionary, Hague noted.
“Obviously, you want an adviser that is registered with the SEC.There's an advantage if the firm has adopted a code of ethics andyou ask to see it,” Hague recommended. “Disclosures and any otherinformation of the firm are major things. You want to know how longthey've been in business.”
Hague said another area to watch for potential conflicts ofinterest is within an organization's ownership structure. If anadviser is wholly or partly owned by a single credit union, therecan be the tendency to load up on their certificates, forexample.
“If you see large concentrations, it might raise some eyebrows,”Hague said. “The broader the ownership, the better.”
Madoff launched his firm in 1960 and many of his clients had workedwith him for more than 20 years. A fact that has puzzled Powellfrom MEMBERS Capital, who has been involved in outside duediligence management.
“I find it hard to believe that something of this magnitude canhappen with one person,” Powell said, adding the concern is thatMadoff's aftermath will “domino to other respectable firms” andlead to a mistrust of advisers. There is the potential for creditunions to get swept up in wanting to bring what may look like abelievable product to their members. Powell used a quote fromformer President Ronald Reagan as a word of caution: “Trust butverify.”
“Be careful with the 'wink and nod' of working with an individualor a small investment boutique. I know in the credit union space,relationships are key drivers, but that's not always the case invendor selection.”
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