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Investors are somewhat safer after Madoff

Today, we're expected to get to say goodbye to Bernard Madoff, convicted Ponzi schemer extraordinaire.
/ Source: Business Week

Today, we're expected to get to say goodbye to Bernard Madoff, convicted Ponzi schemer extraordinaire. That's when he's due to be sentenced in U.S. District Court in Manhattan for running what's been called the largest investment fraud in U.S. history.

Madoff's lawyer is requesting leniency and a 12-year sentence — one year less than his life expectancy. His victims, not surprisingly, are demanding harsher punishment, since he could be sentenced to 150 years. And while the entire sorry Madoff episode — with its defraud-your-friends villain, prominent supporting players, and legions of the formerly wealthy — is dramatic, and a harsh sentence may quench our thirst for justice, one question lingers: Are investors any safer today than they were before Madoff gave himself up?

At first glance it appears the answer may be yes. For starters, the Securities & Exchange Commission has attacked its mission of investor safety as if its life depends on it (which it probably does). It's responding faster and more efficiently to problems, says Patrick Hunnius, a lawyer at White & Case and a former SEC attorney. The numbers would seem to bear that out. So far in 2009 the SEC has rooted out 15 Ponzi schemes — six more than in all of 2008.

Structural changes, too, are on the way, and those could have an even greater effect on the SEC's ability to catch fraudsters. For starters, the agency is considering dividing its attorneys into practice areas, with some agents specializing in complex subjects such as collateralized debt obligations and credit default swaps, making it more difficult for complex scams to fly under the radar. It's also contemplating removing a layer of management from its regional offices — an investigation must be approved by four managers before it goes to the national office — and reassigning those lawyers to investigations in order to have more boots on the ground. "The SEC is willing to learn, change, and experiment," says Hunnius. "They clearly want to kick-start the program."

Hedge fund regulations will also make investing safer for investors. These private pools of cash were allowed to operate without oversight because it was assumed that the wealthy were sophisticated enough to not need protection. If nothing else, Madoff proved that the wealthy are just as stupid as the rest of us. President Barack Obama's financial regulatory plan, announced earlier this month, calls for hedge funds to register with the SEC and be monitored for systemic risk. While it's unclear what final form the regulations will take, it's clear that a hedge fund like Madoff's should no longer be able to operate without oversight. While that won't necessarily prevent another massive fraud, it will make it more difficult. "There will be more tripwires," says Barry H. Genkin, chair of the business department at law firm Blank Rome.

Still, nearly everyone agrees that even with the SEC's renewed vigor, investors are not safe from Ponzi schemes and other frauds. In good times, Ponzis are difficult to detect. The SEC can't catch a Ponzi if it doesn't know it exists, even when there's a red flag, as in the case of Texas billionaire Allen Stanford's alleged fraud. (It's unclear when the SEC became aware of those Antigua bank certificates of deposit with 8 percent rates.) Indeed, in the early stages of a Ponzi, people don't complain, because the investment is doing exactly what the managers said it would do. "People are fat, dumb, and happy, so they don't look beyond what meets the eye," says Genkin. It's only when things fall apart that they call the SEC or the FBI.

Right now, fraud is at the forefront of everyone's mind, and many investors are taking due diligence seriously. But even so, some advisers notice their clients slipping back into the sort of habits that got Madoff investors in trouble in the first place. Peter Turecek, a senior managing director at risk-consulting firm Kroll, says people are desperate to make back the money they lost in the past 18 months. That makes them susceptible to Madoff-like scams. "It's almost a catch-22," Turecek says.

Jason Thomas, chief investment officer at wealth manager Aspiriant, says he already has clients coming to him with investments that appear too good to be true. When he asks them why they want in, the answer is inevitably the same: A smart friend is making a bundle in it. It's human nature, Thomas says. "We're greedy," he says. "We don't want to be riding the bus. We want to be in the town car."