Investing in Evasion (2009 Jan)

by Barry A. Liebling

Honesty sets the stage for prosperity; without it disaster is inevitable. You and the people you deal with ought to act honestly – recognizing what is real, what is not real, and base your actions on reality. Nearly everyone knows that committing fraud – attempting to fool others – is a serious crime that deserves harsh penalties. And there is another kind of dishonesty that is equally contemptible: evasion – deliberate self-deception where a man or woman purposely looks away, ignores what is consequential, and willfully refuses to understand.

In December 2008 Bernard Madoff, a man who had achieved spectacular success as a long-time Wall Street trader, was arrested for what he described as “a giant Ponzi scheme.” For many years Madoff managed money for high net-worth clients and reported that the investments were growing at a better-than-average rate. Clients received statements showing how their holdings were increasing each year. In fact, the statements were fraudulent. Madoff’s investment strategy was not working, and when clients asked to redeem their shares Madoff paid them with money he received from new clients. The deception was revealed when the stock market declined, many clients asked for their cash, and Madoff was unable to pay them.

While Madoff’s fraud is the crime that is likely to put him in jail, his deliberate evasions are what enabled him to act criminally. Consider Madoff’s background. He spent decades in the world of investing and was famous for his expertise in financial markets. It is not possible that he lacked the information or the intellectual skills to grasp that it is wrong to deceive clients, that betraying their trust will eventually be discovered, and that the end result will be personal ruin. Madoff had to purposely ignore reality and abandon rationality. To maintain his phony investment business for so many years he had to tell himself that what he was doing was not so bad, that he would accomplish the impossible – get lucky and make up the money that he had lost, and that he would – against all reason – come out on top.

Much has been said about Madoff’s clients who made investments that now may be worthless. Some were innocent victims while others were culpably negligent. Consider the victims first. Many were affluent individuals who had no special expertise in investing. Madoff was a well-known star in the world of money management. Articles were written about him, famous people mingled with him, and he was active in several high-profile charities. Trusting a portion of your money to such an esteemed business man might not have seemed particularly risky. After all, most people select a bank on incomplete information – is it established? do I know other people who are satisfied with its services? is it convenient? The victims of Madoff’s fraud are probably kicking themselves for not being more careful, and they may be temporarily cured of financial naivete.

But many of Madoff’s investors are not blameless. Madoff accepted money from financial professionals who were paid by wealthy individuals and institutions to find sound investments. A professional who is compensated for investment advice has an obligation to investigate. It is not enough to tell a client that Madoff is a celebrity who delivers high returns. A professional has to go through the due diligence process to prove that his advice is based on verifiable facts and sound reasoning. This means being able to explain how Madoff invests and what the risks are. It is interesting that The Wall Street Journal (December 13, 2008) reported that Madoff described his investment methods as “too complicated for outsiders to understand.”

Investment professionals who recommended Madoff must have engaged in evasion. They had to tell themselves that it is not necessary to investigate – even though the first item of their job description is to scrutinize investments. Then they had to tell themselves that although they did not do their jobs they still deserved a fee from their client. The investment professionals probably felt comforted by knowing that they were not alone, that other financial planners were blindly going with Madoff.

Madoff’s investment business retained an “independent auditor” – a firm charged with studying the books and certifying to investors that the results reported by Madoff were essentially true. Several commentators have pointed out that the firm had a total of only three employees and did not have the capability to audit the large, complex investments in Madoff’s portfolio. But this misses the essential point. If only one conscientious auditor examined Madoff’s business records the entire fraud would have been revealed. Obviously the principals in the firm were not even attempting to do their job.

Again, it seems that the auditors were guilty of evasion. If they were getting paid to refrain from looking into Madoff’s business they would have to conclude that he was up to no good. They certainly had enough information to know that the malfeasance would someday be discovered and their reputation would be destroyed. The only way to stay with Madoff was to deliberately not think about the consequences of their inaction.

The world of business is always risky, and even your best efforts are no guarantee of success. But engaging in deliberate self-deception is a path to disaster.

*** See other entries at in “Monthly Columns.” ***

Comments are closed.