Frustrated. Disgusted. Angry. Concerned. Fed up.
In the wake of multibillion dollar financial frauds, Ponzi schemes, and names like Bernie Madoff and Robert Allen Stanford, that is how many investors feel about the financial services industry.
And rightfully so.
With a reputation for greed (deserved or not), we aren’t necessarily surprised when we see big gains and losses reported by investment banks or corporate acquisitions gone bad.
However, most of us expect that when it comes to the investment accounts of individual investors like ourselves, such funds should be protected from fraud.
And they should be insulated from any trading or lending that the company who holds the account may be doing.
Unfortunately, far too few investors take even the most basic steps to protect themselves and their money from potentially fraudulent activity.
And with the stock market continuing to show gains, it’s easy to get distracted by the increasing value of our retirement accounts and forget that risk management should always take precedent over growth.
Today, let’s look at one of the most basic steps an investor can take to safeguard their hard-earned money: demand an independent custodian.
What you can do to reduce the risk of fraud
The single most important step that you can take to protect your money is to require that your investment account always be held with a different (and unaffiliated) company from the one your financial advisor is employed by.
Specifically, smart investors only open accounts with a type of company known as an independent third-party custodian.
If you work with a financial advisor, ask them if your account is held with the brokerage firm that employs the advisor or if it is held with an independent third-party custodian.
The answer might surprise you.
By placing your assets with an independent third-party custodian, you are creating a firewall between your money and your advisor.
The custodian serves as the gatekeeper and watchdog for your account.
The graphic below illustrates how this set up works, specifically for Wealth Engineers and the independent custodian we work with.
As the advisor, we only have access to our clients’ accounts to manage their portfolio and place trades on their behalf.
We cannot withdraw or transfer funds to an outside account (unless that account is in the client’s name and they authorize such a transfer in writing).
Furthermore, if an independent custodian suspects fraudulent activity of any kind, they will take action by contacting the account holder or reporting the advisor to the appropriate regulators.
The custodian also sends out a quarterly statement directly to each client that details all activity in their account, including deposits, withdrawals, trades, and any management fees that were deducted.
This provides the investor with full transparency regarding their money and an official record of their account.
The protection that this arrangement provides investors cannot be overstated.
Simply put, it would have been virtually impossible for Bernie Madoff to have pulled off his Ponzi scheme had his clients held their accounts with an independent third-party custodian.
Not only would the custodian likely have reported Mr. Madoff very early on, but he would have found it extremely difficult to cover his tracks if his clients were receiving complete and accurate statements from a custodian.
Lastly, it’s important to note that while fraud is always illegal, it’s in an investor’s best interest to have as many checks and balances in place as possible.
When you maintain an account with an independent custodian, it also means that there are at least two government regulators keeping an eye on things:
- Your advisor is regulated by the division of securities of one or more of the 50 states and/or the SEC.
- The custodian is regulated by one or more of the following: FINRA, the SEC, the FDIC, and/or a state division of banking.
In summary, while using an independent custodian may seem obvious, far too few investors demand such protection.
Although nothing can provide 100% protection from fraud, working with an independent custodian and a registered investment advisor (RIA) that puts your interests first as a fiduciary will greatly reduce your risk.