How To Avoid Falling Prey To The Next Madoff Scam

Bernard Madoff scammed an estimated $50 billion from his investors over a 20-year period. Why was nobody watching? There are countless ways to perform due diligence, but many methods miss the mark. While it's easy to blame the Securities and Exchange Commission (SEC) for missing the signs and accusations, there is a long line of interested parties who also failed to clue in to Madoff's scam.

One lesson to be learned by this event is that due diligence means more than just dropping by for a visit or relying on the opinions of others. It's a methodology that encompasses all aspects of an investment management organization, including investment policy, trading patterns and verification of investment returns. While there is no official handbook or checklist, a skilled due diligence team has the experience and know-how to complete the process. (For more, read the Investment Scams Tutorial.)

Hedge Funds and Fraud
While its easy for the hedge fund community to defend itself by pointing the finger back at corporate America's debacles like Enron and WorldCom, the temptation and accessibility to perpetrate fraud from a hedge fund requires much less coordination. Enron and WorldCom required collaboration from multiple areas in the company and implicated the accounting firms and banks that participated in the success of the company.

The passage of the Sarbanes-Oxley Act of 2002 was designed in part to eliminate that risk of collusion within large organizations and force management to take personal responsibility for the financial statements and opinions. While there is no guarantee this large cases of corporate fraud won't happen again, there are now stronger laws in place to prevent it.

Proper due diligence works well when all of the information is readily available with regulated investment companies. In the case of hedge funds, the rules are quite different. The private offering status of hedge funds excludes them from both SEC registration and frequent reporting. While their reporting requirements are loosely defined, their obligations as fiduciaries are the same as for everyone else in the investment management business.

Hedge funds' lack of reporting requirements has left many opportunities for abuse and scams like Madoff's. With no formal requirement for hedge funds to file audited financials, investors have to perform their own research or rely on third parties like feeder funds to perform the duties. In the Madoff case, it appears that everyone was looking the other way. Madoff had used a small accounting firm, which may have assisted Madoff in cooking the books; Madoff was able to fake the rest himself. (To learn more, see Taking A Look Behind Hedge Funds.)

The SEC's Fumble in the Madoff Case
It's obvious now why investors missed the signs of the Madoff scam: they were relying on third-party opinions about the investment in the Madoff funds. The third parties participated in the profits with commissions and finders' fees. Madoff himself was well-respected in the community and his returns, while seemingly impossible to duplicate, were better than most funds and offered diversification against major asset classes. The opinions and support of the third parties provided a level of security for investors, because these third parties claimed to be conducting frequent due diligence.

As for the SEC, it made a number of visits to the Madoff offices, conducted some forms of their profiled evaluations and even investigated reports or misconduct. Unfortunately, they just did not dig deep enough. Instead, they made assumptions and took Madoff's word on many occasions. They failed to evaluate even the most basic custodial statements which would have easily exposed the fund's actual value. Even a random sampling of trading history would have at minimum raised some red flags. Unfortunately, the only upside of a major scam is to draw attention to lax standards and hopefully force investors to be more proactive in the future. While it's easy to blame the SEC, you can only imagine the arduous task of reviewing and tracking such a large volume of companies with such limited resources. (For more, see our slideshow on Biggest Stock Scams.)

The Origins of Due Diligence
The term "due diligence" is used in many ways and has vague interpretations for many. Due diligence in its basic form is based on a certain standard of care or level of prudence. It can involve the evaluation of a person, a group or a specific act or set of events. It is considered an open format for the party or parties under evaluation, meaning that any segment of the business is open season for review and unfettered access must be granted. Businesses themselves conduct frequent internal evaluations as part of the normal operating procedure usually called internal audit or internal operating business review.

The origins of due diligence in the investment field can be found in the Securities Act of 1933, which used the term due diligence in its description of how a broker dealer would evaluate a security offered to an investor. This early groundwork provides a standard against which the modern business practice of review in the investment and investment banking industry has evolved.

Levels of Investment Research
Whether they realize it or not, individual investors perform their own version of due diligence when they read a prospectus before investing in a mutual fund. While this form is quite after the fact, it relies heavily on the many hands that participated in the process along the way. That's one of the reasons a broker-dealer is required to provide a prospectus to investors before selling an investment to a client. (For more insight, see Don't Forget To Read The Prospectus!)

Broker-dealers themselves perform a form of due diligence on the individual investors who buy in to their funds by evaluating their tolerance for risk and investment time horizon. This process shows that there are a number of due diligence processes occurring at the same time. With its various potential outcomes, it's easy to assume that due diligence is a somewhat casual engagement, but in fact it its not. While there are various formats for due diligence, the evaluation of investment management firms, including hedge funds, follow a commonly accepted general plan and are much more formal.

4 Madoff-Proofing Portfolio Requirements
A robust due diligence plan includes a very comprehensive evaluation of the complete operation of a hedge fund, from the stated investment policy to the audited financial statements. These items would be considered a minimum requirement:

1. A Strategy
   A defined, written investment strategy must be determined. This is usually termed an "investment policy statement" or "investment management agreement" when written for specific clients
   
   
2. Historical Returns
   Your portfolio's historical returns, preferably in the format accepted by the Global Investment Performance Standards (GIPS), should be determined. GIPS is very comprehensive as it includes an accurate representation of a client's historical performance in both relative and absolute returns. The fact that a firm has adopted the standard also suggests its commitment to honest reporting and accountability because doing otherwise would put its credentials are on the line. While there is no guarantee that the performance is 100% accurate, at least there is some transparency for the evaluation party to locate potential gaps.
   
   
3. Audited Financial Statements
   Audited financial statements are required if the fund is registered and regulated by the SEC. Federal laws require companies that register and are regulated by the SEC to submit complete, accurate and truthful statements, which are prepared according to Generally Accepted Accounting Principles (GAAP). It is also important to know who the independent auditor is and to do some research on it as they as well, as its opinions will provide a significant weight in the overall evaluation of the due diligence.
   
   

The Bottom Line
In its purest form, due diligence does work. A methodical, complex review of all aspects of an investment management firm can provide a clear and concise summary of its merits. Hedge funds, on the other hand, require a more robust process of due diligence because they are not subject to the same reporting requirements as registered firms. The SEC has proved to be very effective in its pursuit of investigations, but missed opportunities to close in on the scam taking place right under their noses in the Madoff case. You can be assured that the SEC will be on the lookout for more Bernie Madoffs and will most likely be more proactive in the future. (For more on this topic, see our related article Hedge Fund Due Diligence.)