The financial fraud allegedly carried out by New York investment counselor, Bernard L. Madoff is considered the largest financial swindle ever. In all, Madoff’s 30-year-long Ponzi scheme is believed to have caused least $50 billion in losses and one suicide. The founder of the hedge fund Access International Advisors was found dead December 23 after his fund lost as much as $14 billion invested with Madoff.

Also numbering among Madoff’s victims are dozens of charities and non-profit institutions as well as countless numbers of private individuals, including retirees. Some investors have lost everything in their pursuit of unrealistically high profits.

While the deception was enormous, the crux of Madoff’s scheme is nothing new. Investment counselors have been misleading people out of their money probably as long as there has been investments. In 1932, Col E.C. Harwood, founder of AIER, coined the term “Investment Counselor Racket.” Among other things, Col, Harwood wrote: “The firm seems to realize that only speculative profits can justify their fat fee, yet they wish the public to think they are conservative investment counselors.

Sound familiar. Below is the complete text of the Colonel’s essay, “The Investment Counselor Racket.”   

The Investment Counselor Racket
by E. C. Harwood*

Historians have yet to choose a pithy label for the previous decade, but if by chance they choose the “racketeering decade,” professional investment counselors will have to come to terms with their contribution to the decade’s dubious distinction. Born in the early stages of the late bull market, the investment counselor racket flourished in that easy-money era.

Investment counselors are a varied lot. At one end of the spectrum quacks offer their subtle secrets on fancy charts and with graphic forecasts for the next “big move.” At the other extreme move dignified professionals with university degrees and an exploitable economist or two.

To be sure, some legitimate advisory services furnish statistical information, charge a reasonable fee, and offer their estimates of the situation for what they may be worth. Their claims are modest and they make no pretensions to anything more than their own records justify. But for the speculator who wants something for nothing, such services cannot satisfy the demand for “tipster sheets” furnishing daily and weekly incentives to do something in the market.

Even those who pretend to be able to satisfy the desires of such speculators can hardly be taken seriously. As a whole, they give the margin trader a lively run for his money, and society cares little that his losses become the booty of shrewd tipsters.

On the other hand, among professional investment counselors is a class deserving of careful attention. This one has no scruples in choosing its unwitting victims. Posing as professionals, they approach unwary widows, individual trustees, and small institutions, and for a fat fee betray their confidence by leading the unfortunate investor into speculations for elusive quick profits.

An example can be found in the firm of Skotchem, Stickem, and Quack. (This preposterous title conceals the identity of those whose activities are detailed below. The facts, however, are believed to portray a representative situation.) Although such firms seldom make their schemes public, details of their advice given a small life insurance association are available. Because the experience of this client has been no different from that of many others, a brief investigation of the work of Skotchem, Stickem, and Quack will show what is to be expected from their type of service.

Several features of the relationship between the firm and its unfortunate client are of interest. First, the fee collected by Skotchem, Stickem, and Quack approximates $8,000 annually, which is one-half of one percent of the entire fund. Had the association so desired, it could have placed the funds in the care of a corporate trustee. Based on the present income from the fund, the compensation of a corporate trustee would approximate $6,000. The trustee would not only select proper investments, it would also make them, relieving the association of those details. In addition, the corporate trustee would assume definite legal responsibility for care of the funds in accordance with the trust instrument, and would distribute current income according to instructions.

In contrast with those services, Skotchem, Stickem, and Quack assumed no responsibility whatsoever. All the details of making investments, caring for securities and collecting income therefrom remained with the association officials. The investment counselor furnished only advice while collecting a fee nearly fifty percent greater than the cost of employing a corporate trustee.

Second, as anyone who has ever invested funds is well aware, the extra half of one percent return is obtainable only by assuming more risk, or a choice between strictly high-grade bonds and those of lesser rating. Choosing that type of professional investment counsel burdens the investor with an initial handicap. In order to obtain the same return, the client must take a greater risk.

Apparently, Skotchem, Stickem, and Quack knew that the expense of their services could be justified only by larger net return. Presumably in order to provide that justification, they recommended that the small insurance association invest part of its funds in common stocks. At first thought, and since certain states authorize some common stock investments for life insurance funds, this may not seem at all peculiar. In order to appreciate the full significance of the recommendation, however, one must know something of the financial status of the association.

Starting many years ago on an assessment basis, this mutual benefit company later changed to a level premium legal reserve plan. In other words, like all the large insurance companies, it adopted a policy requiring the accumulation of reserves in accordance with American Experience Tables specifications. The process was somewhat slow, and by December 1928 the association had accumulated only 86% of its required reserves. It had no surplus, no capital, and lacked one-seventh of its full legal reserves. The situation called for the utmost conservatism in making investments because they had no contingency fund, surplus, or other sum available to offset investment losses.

In March 1929, the firm of Skotchem, Stickem, and Quack was called in as investment counselor. The firm prepared a report, which is noteworthy for its inadequacy, on the situation as they saw it. Leaving aside technicalities, the results obtained by numerous fire insurance companies were accepted as a guide to the investment policy of this life insurance association. The report showed a failure to comprehend the nature of the business and concluded that the chief weakness of the portfolio was the absence of common stocks. During the succeeding few months, Skotchem, Stickem, and Quack recommended the sale of many high-grade bonds in order to “invest” the proceeds in common stock. By December 1929, approximately one-quarter of the fund was in common stock pur-chased at or near the September highs of the long bull market.

The indulgent reader may feel that the recommendations made were simple errors such as anyone might make in judging the future. Unfortunately for Skotchem, Stickem, and Quack, this excuse is inappropriate. In December 1928, the chief economist in the firm spoke at an open meeting of a group of economists. He particularly warned them that investors purchasing stocks at that time “stood to lose anywhere up to 50 percent of their purchase price.” Just three months later, despite that warning, he urged the Board of Directors of the small insurance association to adopt his firm’s recommendations to purchase stocks at prices well above those existing in December 1928.

The results can be imagined by anyone familiar with the course of the stock market in the last three years. Practically all of the life insurance companies have survived the storm in splendid condition. None of them have defaulted mortgages and bonds that approach the amount of their capital and surplus. Although the bond market has been though a severe panic, the lowest quoted values do not indicate any danger for most insurance companies. (Required reserve is in most cases several times the sum of capital and surplus.) The unfortunate association guided by Skotchem, Stickem, and Quack, however, has no surplus and has now lost nearly 50 percent of its reserve fund.

The serious situation had aroused some policyholders at the last annual meeting. In anticipation of questions from members, the Secretary-Treasurer wrote to Skotchem, Stickem, and Quack asking them to furnish a letter to be published in the Annual Report. This letter, dated January 11, 1932, was written just two weeks after a member of the firm had spoken again before a group of economists. The letter defended the recommendations made by Skotchem, Stickem, and Quack and advised a continuation of the speculative policy.

That the firm of investment counselors was disposed to make allowances for its errors is unsurprising. However, the firm’s economist just fourteen days earlier had publicly stated “I further suggest that life insurance companies might be required to carry all investments in common stocks at 75 percent of their cost, amortized to 100 percent over a ten-year period. I believe that this would dissuade companies with an inadequate surplus from considering common stocks.” Again a member of the firm said one thing in public before a group of economists and something quite different in private. Such paradoxical procedure is understandable. The firm seems to realize that only speculative profits can justify their fat fee, yet they wish the public to think they are conservative investment counselors. That unavoidable speculative risks are the consequence of the attempt to get speculative profits seems not to disturb these modern “con men.”

The conditions shown in this specific example may well cause investors to think twice before entrusting the supervision of their funds to any counselor. Probably trustees handling small estates, widows having funds to invest, and others who cannot afford to take chances would be better off in the long run if they refused to pay more for advice than a corporate trustee would charge for taking entire responsibility. This is not to say that no honest and able investment counselors exist. However, whoever pays a fancy fee for investment advice will find such a fee justified only by the assumption of speculative risks. Judging from the record, the results seldom justify the risks assumed by investment counselors seeking fat fees.

*MIT, (1932) Cambridge, Mass. Condensed by F. C. Harwood, February 1992

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