Can You Avoid a Madoff-Style Ripoff?

Dec. 16, 2008 — -- If your financial adviser tells you your portfolio is making money, it's time worry about your adviser.

That's the joke I told when friends and clients asked for my thoughts on this year's market collapse.

Little did I know how true the joke would turn out to be until last week's emergence of the massive fraud allegedly engineered by Bernard Madoff.

According to press reports, Madoff continued to report positive returns to his wealthy investors during the worst market cycle since 1929 when even the mighty Harvard University endowment lost money. That alone should have set off alarm bells in the minds of Madoff's clients.

Instead, it shows even the super rich can be duped. It's not just the desperate who fall for scams.

For good reason, this episode will lead many investors large and small to take a second look at their own advisers and ask whether they are on the up and up.

I expect a higher degree of scrutiny from my own clients even though I operate in a realm far removed from the one in which Madoff operated.

A healthy degree of skepticism is something every investor should possess. It would have gone a long way toward protecting members of the Palm Beach Country Club, where Madoff is alleged to have found many of his victims.

So what questions should skeptical investors ask about their current or prospective advisers? Here are a few every reputable adviser should be able to answer without hesitation. If not, that might be a warning sign.

Who's my custodian?

A custodian is the firm that is in possession of your investment accounts. It could be a large, well-known operation like Fidelity, Charles Schwab or Merrill Lynch, or a smaller, reputable firm unknown to most investors, such as Shareholder Services Group. Either way, you want to know who's in possession of your nest egg. Never hand over your funds directly to your financial adviser.

Also, make sure the custodian is a member of the Securities Investor Protection Corporation, which ensures client accounts in the event a firm becomes insolvent. Don't do business with a custodian that is not an SIPC member.

How do I check my accounts?

Even when relying on a reputable financial adviser, you should be able to check on your accounts at any time. Don't simply wait for a monthly statement to arrive. In between statements, call the custodian or log on to your accounts at the firm's Web site to check account balances and verify recent activity.

How are you registered?

Advisers can go by a number of different descriptions -- financial planner, investment adviser, broker, financial consultant, etc. From a legal point of view, however, most financial advisers fall into one of two categories. They are either a registered investment adviser or a registered representative.

Registered investment advisers agree to adhere to a fiduciary standard that puts a client's interests before their own. Depending on their size, RIAs may be registered either with the Securities and Exchange Commission or with the states where they do business. I operate as a RIA registered with the state of Massachusetts.

You can confirm a firm's registration as an RIA by visiting the SEC's Investment Adviser Public Disclosure Web site at www.adviserinfo.sec.gov.

If you're dealing with a registered investment adviser, ask to see his or her Form ADV Part II, a disclosure brochure that outlines the adviser's background and business operations, including fees.

Registered representatives are brokers who sell securities and insurance products and may be affiliated with a large Wall Street firm like Smith Barney, a local bank or an independent broker dealer you've never heard of. Registered representatives typically get paid by commission and may put their interests ahead of a client's provided the investments they recommend are deemed "suitable."

Brokers are registered with the Financial Industry Regulatory Authority, or FINRA, which maintains the BrokerCheck Web site at www.finra.org/brokercheck.

Do you exercise discretionary or nondiscretionary authority?

Discretionary authority gives an adviser blanket permission to buy or sell investments on your behalf without seeking your approval on each and every transaction. The adviser should be following guidelines agreed upon ahead of time, but otherwise he or she has authority to make changes as deemed appropriate.

Nondiscretionary authority means the adviser must seek prior approval before carrying out a recommended transaction.

Discretionary authority is a customary practice and perfectly appropriate for many investors. But make sure you understand what it means, and what type of authority you've granted to your adviser.

Asking the above questions, of course, does not guarantee you won't fall victim to a skilled scam artist like Bernard Madoff, but it will certainly make it much less likely. Healthy skepticism is your best defense.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.