Three Lessons from the Bernie Madoff Scandal

This summer, HBO released The Wizard of Lies, a film adaptation of Diana B. Enriques’s New York Times bestseller about Bernie Madoff. Good movie. Good book. But Madoff’s life has been well chronicled since 2008.

While watching the film, I was less interested in the insights into his character than the lessons for investors considering perfectly legitimate investments from perfectly legitimate organizations.

I found three.

1. Don’t mistake a sales pitch for due diligence.

Even today, there are lingering questions about Madoff’s feeder funds. Was their due diligence that bad? Or were they in on the take? I express no opinion. But last year, while I was researching a nonfiction book, “Sam” (not his real name) told me about his firm’s near miss with the wizard.

During the Madoff reign of plunder, Sam headed up wealth management at a prestigious boutique investment bank. However anecdotal, our conversation raises questions about the quality of manager selection throughout financial services.

“We did our due diligence on Madoff and didn’t offer his fund on our platform,” Sam said.

“Why, what did you discover?” I asked.

“Nothing,” Sam replied. “We wanted in. I think he was softening us up before making the call and saying he found a spot and could squeeze us in. But Madoff confessed first.”

During our conversation, Sam admitted that profit incentives blinded his firm to the warning signs of fraud. His company got lucky. As did its clients. They all missed the muck. But there’s a bigger takeaway here: It is impossible to compartmentalize bad due diligence. If our industry cannot spot fraud, how well can we detect issues like style drift? Or anticipate the exodus of gifted stock pickers who leave to set up their own shops?

These problems are not criminal. Nor are they hard to spot. Investment firms should notice them through monitoring and regular due diligence. But just as feeder funds missed Madoff’s treachery, I wonder whether investment firms that sanction pay-to-play arrangements — those that receive compensation for promoting outside money managers — will miss the leading indicators about future mediocrity while their clients pay the price.

Just sayin’.

2. Beware the “Exclusivity Pitch.”

Madoff used exclusivity as bait. Investors were begging to gain access to his Ponzi scheme. So were sophisticated wealth management firms, as my story about Sam illustrates.

Sure, Madoff’s steady, reliable, never-miss, double-digit returns might be the reason why investors ignored the early warning signs that his performance was fake. But that said, these “exclusivity pitches” prey on internal emotions that cause investors to drop their guards and sometimes make bad decisions.