An Important Lesson From Madoff: Make Kickbacks Illegal
Jul. 06, 2009
Last Friday, the Wall Street Journal reported about massive kickbacks allegedly paid by the Madoff firm to the Austrian fund manager and bank founder Sonja Kohn. In its report the newspaper refers to investigations of US and Austrian authorities: “U.S., U.K. and Austrian prosecutors are investigating a former Austrian fund manager they believe was paid more than $40 million in kickbacks to funnel billions of dollars of investments to Bernard Madoff.”
We don’t know if the astronomical sum of USD 40 million is correct. But what we do know after months of revelations in the Madoff case is that the wealth managers of good and bad reputation, banks in the US, Europe, Asia, and advisors of small and big institutions have funnelled their rich clients’ money to the fraudulent funds of Madoff. These wealth managers, private banks, fund advisors, irrespective of their titles, have had a strong incentive to invest their customers’ money with a crook. These incentives have a name: Kickbacks. In other words: Commissions paid by Madoff to those banks and wealth advisors who brought them their clients’ money. But these same banks and wealth managers had little incentive to check and re-check the honesty, integrity and investment strategy of Mr. Madoff.
And here is the heart of the matter: The incentive rules of the game must change. It’s not that important to strengthen regulation of products like hedge funds, it is much more important to strengthen and tighten the way such products are sold and distributed to unsuspecting private clients.
For example, the European Union MIFID (Markets in Financial Instruments Directive) from 2004 details that if a financial firm receives kickbacks, then this has to be disclosed to the client.
This is well and good but not sufficient (in many other countries even this kind of transparency does not exist). It should be very simple: The trusted wealth advisor is working in the interest of the client. So, all potential conflicts of interest must be eliminated. If an advisor receives kickbacks – either open or hidden doesn’t really matter – his advice to the client becomes automatically tainted. Kickbacks must go or kickbacks should be automatically transferred to the client. In this way the incentive kickback would be replaced by the incentive performance. The wealth managers would then have all the reasons to look carefully for the best investments to keep their clients happy. This would also reinstate true market forces in the game between client and advisor. I bet this very simple measure would have prevented the largest part of the Madoff fraud.