Just in case you thought I was the only one harping on the skewed incentives that guide the actions of most purveyors of financial services to the public, I bring you another voice.  In Stewards vs. Salesman, Cale Smith of Islamorada Investment Management writes on this very topic.

Much has been written about how and why Bernie Madoff was so successful in fooling so many people for so long.  Unfortunately, Madoff wasn’t the only one preying on trusting individuals, as Allen Stanford has notoriously demonstrated.  Beyond those high profile examples lie some much more pedestrian cases that are no less devastating to their clients.  Today many of my neighbors learned about one that hit closer to home.

A quick search of Google on the name James J. Buchanan will turn up many reports from early in 2008 – months before the Madoff scandal broke – as well as numerous websites of attorneys angling to assist investors in claiming damages against Buchanan and LPL Financial, the broker who employed him and was charged with overseeing his conduct.  Yesterday Buchanan, a resident of Ahwatukee, was sentenced to serve 20 years in jail after pleading guilty to 15 counts of theft that totaled over $10 million.

Although the scale of their crimes was much different, Buchanan and Madoff operated in similar ways.  They both employed affinity fraud to build their Ponzi schemes. In the case of Buchanan, it is said that he preyed on members of his Church as well as friends he met through his affiliation with Little League.

The number of victims of these Ponzi schemes and similar scams is still a small percentage of all investors, although the volume of cases over the past couple of years has shown that it may be bigger than many of us thought.  I remain much more concerned about the stockbroker who is legally funneling customer dollars into ill-advised investments that generate high commissions than I am about large-scale fraudulent activity.  Nonetheless, I think it pays to revisit some of the actions investors can take to protect themselves against predatory individuals who call themselves advisors.

Look for an independent custodian

One act that Buchanan and Madoff shared was to manufacture trade confirmations and monthly statements that purported to show the performance of investors’ assets.  As the sole conduits between investors and their money, this was reasonably easy for them to do.  Madoff owned his own brokerage firm, whereas Buchanan was affiliated with Ameriprise and ultimately LPL Financial (who, incidentally, took him on after ignoring red flags on his record dating from his time with Ameriprise).  Investors should at all times maintain the ability to view their assets online via a site maintained by an independent custodian, preferably one that does not employ their advisor.  They should also receive statements that are generated by that custodian.  They may receive statements from their advisor as well, but these should sync with what the custodian provides.  This is probably the single most important thing that an investor can do to ensure that what their advisor is telling them is actually true.

Be realistic

One of the most remarkable things coming out of the Madoff scandal was the reported returns investors were seeing.  Apparently every year they would “gain” 10%-11% on “100% safe” investments.  For one thing, that kind of return in most years implies a significant risk premium that would contradict the 100% safe idea.  More obvious, though, is the lack of volatility year-to-year.  These were risky assets in which the funds were supposedly invested.  As such, they were likely to have some big years and some down years.  If they were invested in the stock market, an average 10-11% return over a number of years would not be outrageous, although it would have been pretty solid over the last decade.  It definitely would not have been consistent, though.  This isn’t the first time I’m saying this, but “if it seems too good to be true, it probably is” is never more true than in the world of financial services.

Seek a fiduciary relationship

Disclaimer 1:  my firm is a Registered Investment Advisor and as such I act in a fiduciary capacity in all of my relations with clients.  So I may be biased toward the fiduciary way of doing things.
What’s a fiduciary?  Simply put, as a Fiduciary, the financial advisor is required to act with undivided loyalty to the client.  That means the clients’ interests come before those of the advisor, legally and ethically.

Disclaimer 2:  just because an advisor signed up to be a fiduciary doesn’t mean that he or she isn’t a crook.  I’d like to say otherwise, but that would be nonsensical.  Criminals come in all shapes and sizes.  
However, depending on whose research you believe, somewhere north of 90% of all people who call themselves financial advisors are NOT required to act in a fiduciary capacity all of the time.  The 5%-10% who are have generally chosen that path because they think that is the most appropriate way to serve their clients.  It certainly is not the easiest way to make money in this business.  It stands to reason that those who’ve chosen a fiduciary role would be less likely to fabricate an investing record on a massive scale, at least to my way of thinking.

Regardless, if you’re looking for an advisor, seek one who has chosen to be legally bound to act in your best interests.  They’re relatively scarce, but worth the effort.  Just because an advisor claims to be independent, it doesn’t mean they’re not beholden to a brokerage firm.  If their marketing materials say “…securities offered through…”, you can bet that they’re being paid to sell products.  Certainly, many good advisors operate under the commission-based model, but so do a lot of pure salespeople who are easily confused with fiduciary advisors. 

By virtue of alphabetic superiority, Carol Loomis asked the first question of the meeting, and it pertained to the SEC's recent complaint against Goldman Sachs.  Every year the Berkshire meeting begins with a movie that is a kind of Berkshire collage, featuring unpaid cameos by famous people from all walks of life.  For instance, there was a Desperate Housewives skit this year that featured the stars of that show.  Loomis pointe out that every year the movie includes a clip from a 1991 Congressional hearing into Salomon Brothers (which Buffett was temporarily leading in the wake of a crisis) in which Buffett states that he admonished Salomon employees that if they "lose money...I will be understanding; lose one shred of our reputation and I will be ruthless".  Given that, and the fact that Goldman's reputation clearly has been tarnished, what advice would Buffett give Goldman management?

The paraphrased, summarized response:

The nature of the transaction has been generally misreported.  There were four losers in the Abacus transaction, and Buffett focused on two of them.  Goldman Sachs was an unintentional loser.  The main loser in terms of cash was ABN-AMRO.  They lost money because they guaranteed the credit of ACA - they fronted the transaction.  Berkshire does this alot, and lost money in the 70s in a case where they ran into dishonest people.  ABN guaranteed $900m of ACA at a price of $1.6m.  It's hard for Buffett to be sympathetic because ABN-AMRO made a dumb deal.

ACA was a bond insurer.  They started out as municipal bond insurer, but margins got squeezed in that space.  Instead of sticking to their knitting, they moved outside their realm of understanding.  As Mae West once stated, they started out "like Snow White, but drifted".  Not long ago, Berkshire entered the business of muni bond insurance, but always stayed away from things they didn't understand.

Buffett then went into an example of a portfolio of state bonds that Berkshire insured.  He showed a chart of the states involved.  Berkshire was paid $160m to insure $8.25b for ten years.  The deal was presented to them by Lehman Brothers.  Berkshire did not select the bonds...more specifically they did not "dream up this list".  In fact, Lehman Brothers did.  Buffett and his chief insurance guru Ajit Jain analyzed them and proposed the $160m price.  If any of the bonds defaulted, Berkshire was on the hook to make good on the commitments on behalf of the defaulting state.  They didn't know if the ultimate counterparty was Lehman, and what the counterparty's interest in proposing the trade was.  The counterparty could have owned the bonds and merely wanted some protection, or they could have been betting that there would be defaults.  Berkshire didn't care.  They did what ACA should have done: they evaluated the bonds and determined the proper premium.  ACA initially agreed to 50 bonds of 120 that were presented to them.  Through additional negotiation, they agreed to insure 30 more.  In the Berkshire/Lehman case, it was totally Lehman's list - they didn't throw any out.  It was Berkshire's problem to determine creditworthiness.  If they lose money, they're not going after the counterparty due to superior knowledge or anything.  The fact that John Paulson apparently selected specific bonds and asked Goldman to propose the deal (and probably knew more about those bonds) is irrelevant.

The central point of the SEC's complaint seems to be that Paulson had superior knowledge of the overall deal, and Goldman worked with him to structure it and sell it to counterparties, and the counterparties may or may not have known about Paulson's involvement.  The bonds underlying the deal blew up, and the counterparties lost a lot of money while Paulson got rich.

When Warren asked Charlie about his view on the matter, he pointed out that the SEC commissioners were split 3-2 on whether or not to sue, and it's very unusual to take action of this magnitude without a unanimous vote.  He seemed to feel that was unfortunate, and said he would have voted with the minority.

My view

I view this transaction from two angles, and I think it is helpful to have a tiny bit of background on one of the legal issues in question.  This point is central to my business, and I view it as the point on which the whole Goldman transaction turns.  It speaks to the fiduciary duty that Goldman held, in this case.  There is a significant difference between brokers and advisors, and Goldman was a broker in this case.

In layman's terms, I view a broker as being similar to a car salesman who sells cars "As Is - No Warranty".  The buyer in this case has the responsibility to evaluate the vehicle and determine if it is worthy of the price being asked.  The seller undoubtedly has more knowledge of the car than the buyer, and that gap must be bridged to make the deal worthwhile.  If the buyer doesn't have the requisite knowledge to evaluate the car, a mechanic should be hired to provide a recommendation.

An advisor, on the other hand, has a legal, fiduciary duty to act in the best interests of his client.  The advisor would be more like the mechanic.  If he advises the buyer that the car is in great shape, and the car breaks down three days after being purchased, they buyer has a legitimate complaint with the mechanic.

Given that background, the moment I heard about the SEC suit I was skeptical that there was a legitimate legal case there, and I remain skeptical.  To the general public, it likely sounds like Goldman hoodwinked their customer.  To Warren Buffett and to others that are more familiar with these types of transactions, I think it sounds like ACA, ABN-AMRO and others who ended up on the short end of this deal just didn't do their homework.

That's the legal view.  It is now sounding like Goldman Sachs is discussing a settlement, and I think that's unfortunate from the standpoint of proper administration of our legal process, but it's probably a smart move for them.

The ethical angle is far less clear to me.  A follow on to the initial question asked about Buffett's thoughts on the impact to Goldman's reputation.  He feels that the allegation and related press alone cause Goldman to hurt and it hurts morale, but he doesn't really see it as a loss of reputation.  He does believe that the approach now should be to "get it right, get it fast, get it out, get it over."  Standard reputation management in a crisis.  Charlie, on the other hand, added that the standard should be higher than what's legal and convenient.  He feels they shouldn't have dealt with "scuzzy securities", and that plenty has been wrong with Wall Street.  The bottom line is that Berkshire has had a 44 year relationship with Goldman Sachs, and they have bought more companies through them than anybody else.  They trade with them, and Goldman doesn't tell them what their position is, i.e. shorting or trading from own inventory.  They act in a non-fiduciary capacity when they trade with Berkshire.

<soapbox>I think there are a lot of distasteful things that take place on Wall Street every day.  However, the SEC is making a show of attacking Goldman Sachs on points of dubious legality when they were trading with institutions that are very sophisticated investors.  At the same time, individual investors are being duped on a daily basis because they are not even aware that a distinction exists between brokers and advisors, and that their "advisor" is actually acting in his or her own best interest.  I'd like to see the SEC let the professionals make their own mistakes, and spend a bit more energy on protecting the rights of individual investors from people like Bernie Madoff as well as the Wall Street firms.</soapbox>

Earlier this week, Kathleen Pender wrote an article titled "Dodd bill punts on strict rules for brokers" in the Net Worth column of the San Francisco Chronicle addressing the lack of a fiduciary standard for stockbrokers.  It's a quick read, and sums up the reality of why it is hard to be optimistic that there will be meaningful regulatory reform in this area.  If you're not familiar with this issue and are currently using or seeking financial advice from a professional, it makes a lot of sense to educate yourself on compensation arrangements for financial advisors.

The article concludes with a recommendation to ask a prospective advisor whether he or she is required to act in your best interests.  Good advice.  To that I would add:  "How are you being paid to provide me with advice, and by whom?  Please list all sources".

Read the article here:  http://tinyurl.com/SFGateFidArticle.