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How to hold money managers accountable

Madoff case shows need for custodial accounts when working with advisers.

By Thomas WattersonCorrespondent of The Christian Science Monitor / December 29, 2008

Advice Inside? New Yorkers stroll by the offices of Bernard Madoff, who confessed to defrauding investors of some $50 billion.

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Who's holding your money?

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As the list of wealthy individuals, institutions, and charities that have lost millions, even billions of dollars in the Bernard Madoff fraud case continues to grow, other investors have been asking an important question: Why was there no independent custodian holding the securities and other assets Mr. Madoff's firm was said to be investing?

In a legitimate arrangement between an individual investor and a money management firm or financial planner, the money manager may buy and sell stocks, bonds, mutual funds, and other investments on behalf of the client. These trades are often, but not always, made after consulting with the client.

But the money manager does not – in fact, experts say, should not – have access to the client's money. Rather, it is held in a separate "custodial account." Several large firms, including Charles Schwab, Fidelity Investments, and T.D. Waterhouse, provide custodial services.

Checks from the client should be made out to one of these firms, not to the planner or adviser. Every month, both the client and the adviser receive a statement from the custodial firm showing the current value of the account, as well as a list of any trades. If the client wants, he can even go online every day to check his balance. This arrangement isn't much different from if an investor made trades through Schwab or Fidelity himself; he's just giving the adviser authority to use those firms to make trades on his behalf.

The importance of independent custodians is likely to grow as more investors turn to professionals to manage their money. Many recent retirees, for instance, may have several hundred thousand dollars or more in 401(k) or 403(b) plans that they want to roll over into IRAs, and they're looking for professional money management. In general, a planner's service costs about 1 to 1.5 percent of client assets per year.

In the Madoff case, there was no independent custodian. All client statements and checks came from his office. But, as long as clients could take out money when they wanted to, they apparently didn't ask questions. Of, course, this meant they didn't know that the money they were getting was coming from new investors, which made Madoff's operation a classic Ponzi scheme, and at some $50 billion, the nation's largest.

Another red flag, experts say, should have been the consistently positive returns his firm provided, even in the face of severe market turbulence. For instance, Madoff claimed an average return of more than 10 percent a year, with very little price volatility, in both up and down markets.

That may have been one reason investors didn't ask questions, says Michael Martin, a financial planner and president of Financial Advantage, a planning firm in Columbia, Md. "They may say 'I've got something here that other people don't know about, so I'll keep my mouth shut.' "