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FLASHBACK FRIDAY: Before the Fall

Flashback Friday sponsored by Instinet

Traders Magazine Online News, December 7, 2018

John D'Antona Jr.

Jingle Bells, jingle bells, jingle all the way…

December is usually festive and ushers in the holiday season of good cheer and good will towards men. But back in December 2008 there was a different type of jingle in the air – the sounds of handcuffs and chains as Bernard Madoff was arrested and eventually found guilty for conducting the largest Ponzi scheme in U.S history.

Madoff, now nearly 80 years old, plead guilty to fraud in December 2009 and is currently serving a 150-year sentence at a federal prison in North Carolina. Seven of his employees also plead guilty to associated crimes. Five former aides to Bernard Madoff who spent decades working for his firm were found guilty at the time on most counts in helping run the $17.5 billion fraud that was exposed by the 2008 financial crisis.

Hatched in the 1970s, Madoff’s fraud targeted thousands of wealthy investors, Jewish charities, celebrities and retirees. It unraveled in 2008 when the economic crisis led to more withdrawals than Madoff could afford to pay out. In addition to $17.5 billion in principal, it erased about $47 billion in fake profit that customers thought was being held in their accounts.

The multi-year dismantling of the Madoff event stretched into 2013 when the liquidation of Bernie  Madoff’s defunct brokerage reached a total cost of $774.8 million, including lawyers’ and consultants’ fees and expenses of $737.1 million, the trustee for the firm reported.

The prosecutions lasted until March of 2014 when an 11-person jury on March 24 found five former colleagues of Madoff guilty on all counts, including claims they conspired to create fake trade confirmations and false account statements for thousands of clients of Madoff’s investment advisory unit. No trading took place in the business.

So, what’s the takeaway?

In the wake of the Madoff affair, the so-called “custody rule” Rule 206(4)-2 of the Investment Advisers Act saw extensive revision. The following are the highlights of the new custody rule:

Expanded Definition of Custody. The SEC has clarified that an advisor has custody of client funds when it physically possesses the funds or has authority to obtain possession, as well as when a "related person" of the advisor has such authority.

Surprise Exams. RIAs with custody of their client's assets or whose client assets are held by an affiliated custodian that is not "operationally independent" now must undergo an annual surprise examination by an independent public accountant to verify that the money claimed to be in customer accounts actually exists. If funds are discovered to have gone astray, the auditors are required to notify the SEC. When an adviser, or a related person, acts as the qualified custodian ("self-custody"), the surprise examination must be performed by a PCAOB-registered accountant. An adviser that does not "self-custody" can use any independent public accountant.

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