From the February 2009 issue of Investment Advisor • Subscribe!

Restoration

After we finish blaming everyone else for this mess, here's how to take control of our businesses and begin to restore clients' trust in the industry.

With most of the "Seven Deadly Sins" committed during the Market Cataclysm of 2008, all that is left for the rest of us is Anger!

The meltdown's poster child, Bernie Madoff, had a much publicized affair with Greed, of course. But so too did the investors who Lusted after the opportunity for high "guaranteed" returns from the human T-bill, and those who jumped into this pool out of Envy of others already in the country club. Add to this the Gluttony of the fund-of-fund managers who couldn't seem to get enough of what Bernie was cooking up, and the Pride of the advisors who placed client money with the modern-day Ponzi, claiming their due diligence was superior if not infallible. Compounding the pain was the Sloth of the regulators who appeared more methodical in ignoring the signs of malfeasance than in performing their duties, even when hot tips were rolling in.

The bad taste of being duped once again is rising in our gullets. The collapses of the Dot.coms, Enrons, and WorldComs should have taught people that "if it sounds too good to be true, it probably is." But as long as there are "greater fools," there will be greater foolers.

So much pain and anger over so many things out of our control. An e-mail I recently received from a friend represents a shout for help from the collective masses who wonder how so many smart people could have done so wrong. His missive was filled with despair. "I am on vacation," he wrote. "It gives me time to listen to the news about the Madoff scandal. Along with everything else going on in the markets, this is causing me to lose all faith in Wall Street, the Securities and Exchange Commission, and the management of these firms who claim to be keeping the markets open and honest."

My friend went on to describe how controls seem to work in so many places except the area where people make decisions based on good faith. He continued, "The thought of sitting down with an advisor and imagining for a nanosecond that the person has my [best] interests in mind seems an exercise for fools." He painted a picture of how many so-called professionals packaged their message so neatly--but all he can see now is a conspiracy to separate him from his money. He concluded, "I'm so disillusioned that I will not be able to trust anyone offering financial advice--ever."

Trust No One Over a Year Old

While it's tempting to dismiss his screed as an irrational rant from an emotional man, no one who knows him would use any of these terms to describe him or his behavior. Put simply, he is disgusted--and as far as I can tell, he represents a very large group of individuals who have lost confidence in our securities markets and those who render financial advice. I heard the same contempt from a woman and her husband at the theater the other night, in a call from my brother, and in letters to the editor. These are not random expressions but the beginning of a giant problem for all advisors.

Our first instinct is to separate ourselves from all those rotten apples, but this assumes the general public is able to discern what makes a good advisor. Think about it. Many of us are asked by new acquaintances, relatives, and friends: "What do you do?" Because of the way the nomenclature in financial services has evolved, most in the business have a hard time answering the question succinctly. "I'm a financial planner. A financial consultant. A financial advisor. A money manager. A wealth manager." Is there a difference? (Try telling them that you're a custodian as I now must do, and see the curious looks you'll get.)

In the 1960s, the mantra was "trust no one over 30," meaning one should always question authority. Now with esteemed individuals including priests, doctors, governors, senators, and CEOs finding ways to exploit others, perhaps the new mantra should be "trust no one." When values of everything from real estate to stocks and commodities go up in spite of economic logic to the contrary, it is easy to get sucked into the illusion of eternally rising investments. Judging from the list of victims in the Madoff affair, even financial sophisticates can fall into this trap.

Efforts to control "bad" behavior go back to ancient Babylon's Code of Hammurabi. Criminologists and social scientists now identify possible reasons people commit crimes. Some criminals are psychopaths or sociopaths, and others are just consumed by greed, jealously, or revenge. Some people decide to commit a crime and carefully plan every detail in advance. Others start by covering up a petty theft or white lie, and wind up living a life of deceit in which they fall further and further behind. No one yet knows what demons possessed Bernie Madoff.

One of our roles as a firm that serves as an independent custodian for clients' assets is to observe and report suspicious acts perpetrated by advisors. While there is no perfect trap for anyone intent on deception, every custodian has become wary enough to know that we must be rigorous and diligent in observing patterns and suspicious inquiries. If a person wants to commit fraud or theft, it only has to happen once to cause pain. An individual's pedigree, academic background, or reputation is no guarantee that they aren't working angles that could cause harm to clients.

Now amid this horrible economic crisis, every bad decision by the financial services industry may seem like a crime. Whether deliberate or the consequence of not being careful, recent events have put our entire business in a reputational hole. The burden on all of us left standing is to reclaim our industry's position of trust.

The Implications for You and the Profession

One hurdle to overcome is the illusion that independent advisors can completely separate themselves from the reputational taint of the big investment banking firms. How can one explain to clients, after their portfolios declined 20% to 30% or more, that somehow your approach is better? How can you argue that your firm is above reproach even though both are ultimately overseen by the same agency--the SEC? While those of us in the business understand the nuances of one business model over another, we're not the ones who need to be convinced.

Difficult times usually call for dramatic measures, even if they cause discomfort. For example, you may believe that the way in which you individually practice is ethical, disciplined, safe, and in the client's best interest. But how do you feel about all the other advisors in your community, or in the local or national FPA, IMCA, or NAPFA? Is it possible that there are some whose advice you question, or some you even try to compete against by implying your approach is superior to theirs?

When I merged my firm into Moss Adams in 1994, I was exposed for the first time to rigorous safety protocols in business. It was both a part of Moss Adams's culture and a condition of being a firm focused on compliance. The nature of the accounting business is risky because so many people rely on the opinions expressed by the CPAs about the veracity of a financial statement. Many partners felt that they could render opinions and give advice without seeking input from another partner or senior manager in the firm--it was a perceived entitlement of being a partner. In an effort to change this behavior, the chairman of the firm liked to ask the question, "I know you trust yourself to manage risk, but do you trust the other partners to do the same?" The implication, of course, was that the deployment of safety protocols was the responsibility of everyone and we should all be held to the same high standard. Besides, it takes only one boneheaded action by one person in the firm to cost someone their career, if not their company (? la Arthur Anderson).

The larger the advisory firm, the harder it is to monitor behavior--let alone the recommendations and execution of investment strategies. While practices of all sizes have span-of-control, attention-to-detail, and relevance-of-advice issues, most advisory firms do not have a systematic process for peer review, quality control, performance evaluation, or risk management. Many do not perform mock SEC audits annually or even have an independent auditor examine and verify books and records. When was the last time you reviewed your due diligence process for outside managers? For some, the cost to add a layer of control may be prohibitive--and of course there is the argument that no assets are held in custody at the advisory firm itself, so what could such a process reveal?

As you reflect upon all the things that have happened in the financial services industry in the past 10 years, this might be a good time to pursue that question a little more actively with your partners and associates. Indeed, what could an annual audit reveal? Also, what could a systematic process of quality review, compliance examination, and individual risk assessment expose?

Take Control

The implementation of a safety program in your firm can help:

o Prevent bad acts by one of your partners, associates, or yourself--whether intentional or by accident;

o Demonstrate to clients that you take safety and integrity seriously and are willing to open your business to a qualified and reputable independent firm to verify your processes, approach, and honesty.

I could have made this argument without the long-winded preamble, I suppose, because every reader knows what a mess the industry has made of itself lately and all of us who work in it are now regarded lower than Congressmen. But the context is important. Try as you might to separate your firm from the rest, we all have an obligation to deploy standards of practice that will help to rebuild trust, confidence, and respect in a business that in the past year has featured cads, cowards, and criminals.

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