Due Diligence in New Investment Opportunities
It pays to do your homework before investing and to monitor your investments on an ongoing basis. While not every fraud can be detected, careful diligence can raise red flags that may, at the least, cause you to inquire further before you proceed. Much of this diligence can and should be conducted by counsel and other experts familiar with the investment industry. Among the matters that you and your counsel should consider are:
- Investment strategies and risks. Understand the investment strategies and risks of the products in which you are investing. Investment products have become increasingly complex, and it may be difficult to discern how the products work and what risks they create. The details of Madoff's investment strategy were cloaked in secrecy and, when analysis was done, it became apparent that the strategy could not have operated as it had been described.
- Product structure. Analyze the legal structure of the investment product. Find out whether the investment manager will purchase individual securities, will place your assets in an investment pool (such as a hedge fund), or will invest your account with other managers (perhaps in another hedge fund). Ask for documentation relating to any investment pool, including offering memoranda and agreements. Because of the structure of the investment vehicles used, some investors did not even know their money was being managed by Madoff.
- Financial statements. Ask for the financial statements of each investment manager and any investment pool involved. Make sure they are consistent with what you have been told. Beware of any unusual entries, footnotes or other disclosures. Consider whether the financials and performance information have been audited, as well as the reputation and resources of the auditor. The Madoff entities were audited by a one-man accounting firm that was unregulated and unknown.
- Custody. Determine where your assets will be held and whether the entity holding your assets is reputable, financially stable and independent of the investment manager. Since the assets Madoff managed were held by affiliates, Madoff had unrestricted access to those assets and could alter the statements provided to investors.
- Personnel. Interview and receive regular reports from the investment and other personnel who will be directly responsible for your account. Make sure they tell the same story and have the necessary experience. Visit the offices of the manager. Consider the quality of the manager's outside service providers, including attorneys, administrators and accountants. It is harder to maintain a fraud when there are multiple points of contact.
- References. Ask for client lists and follow up on references. But beware of relying solely on the recommendations of others, particularly on the basis that they are members of an "affinity" group. Madoff preyed on Jewish investors and fellow country club members. And do not place too much significance on registration or regulatory status. The Securities and Exchange Commission failed to detect Madoff's fraud despite a tip from a whistleblower and its own inspections.
- Regulatory filings. Review regulatory filings made with federal and state administrators. Most of these filings are publicly available and contain information about the person's status (including suspensions, regulatory proceedings and investor complaints) and operations (including assets under management, types of clients, fees, investment methods, conflicts and affiliates). The recent Westridge fraud came to light when one of the investors learned that the National Futures Association had suspended the two principals.
- Search engines. Search Google and other databases, such as news services, court dockets and credit bureaus for information about the activities and affiliations of the people to whom you are entrusting your money.
- Other red flags. Beware of unsolicited offers; high pressure sales tactics; guaranteed or uniform returns; unusual fee structures; inconsistencies in oral or written representations; and materials that do not comply with regulatory requirements. One of the hallmarks of the Madoff fraud was the reporting of consistent, positive performance even in down markets. Another was the absence of an advisory fee.
Above all, you should ask questions and expect to receive written answers. If the responses you get are incomplete or don't make sense, you should investigate further. If your questions are rebuffed, perhaps on the basis that the information is proprietary or unavailable, you should think twice about investing. And, if you do go forward, you should continue the same high level of scrutiny throughout the course of your investment. We would be happy to assist you in conducting this diligence.
If you have questions about any of the issues raised in this article, please contact André Brewster or your usual Howard Rice attorney.
