Investors in Bernard Madoff’s company now know the expensive truth about due diligence: it’s no different from good investing. It’s hard work. It takes time. Short-cuts and gimmicks often end in tears.
While we do not know how many of Bernard Madoff’s cheated investors conducted any due diligence into his investment business, we do know that the cheap kind of computer check that passes for due diligence today -- costing as little as $500 -- would have turned up no red flags on Madoff.
Our way of investigating is a little more expensive but much more thorough, and would have turned up enough questionable facts to warrant a much deeper inquiry into Madoff’s business.
Here is how both the cheap and the thorough examinations of Bernard L. Madoff Investment Securities LLC might have proceeded:
Step 1: Search criminal and civil litigation records in New York, Florida and other jurisdictions Madoff and his company occupied. No hits. The investment firm was and is in good standing in New York.
Step 2: Check for regulatory sanctions against Madoff’s company and his auditor: No meaningful hits.
Step 3: Check regulatory records of Madoff’s company and his auditor: six hits, all seemingly normal filings. A quick computer-driven examination might say Madoff’s record is “clean.” We note that according to the SEC’s Inspector General, one SEC attorney who investigated a tip against Madoff received the agency’s highest performance rating after clearing Madoff.
An intelligent investigator looks not only for “hits,” but also for information that is missing. An intelligent investigator would take things a step further and ask a number of extra questions.
Step 1: Is Madoff’s auditor one of the Big Four? Since we always look to see whether a firm has recently changed auditors, we also take note of who the auditor is. If Madoff’s auditor is competent to oversee tens of billions, why is there no evidence of any other large companies audited? And if Madoff is the auditor's only client, then no matter how large, that auditor is captive and therefore suspect.
Follow-up step: open a new investigation-within-an-investigation of the auditor. Note that this is not part of the original assignment to check out Madoff and his funds, but the original assignment is only a starting point, not a task list cast in stone.
Step 2: Madoff’s firm only filed 13F forms on securities ownership to the SEC from 2006, but since that time his filings raise a major question. The manager of tens of billions of dollars consistently reported well under a billion dollars in stocks and options held at the end of each quarter. The idea that he could go in and out of tens of billions so quickly at the turn of each quarter would call for greater scrutiny. The filing also contradicted reports that Madoff claimed to be "all cash" at the end of each quarter.
Step 3: Since the only other incidence of “Bernard L. Madoff” in SEC records occurs in bios of his former employees who work elsewhere, do we have permission from our client to talk to this ready-made source list of people who could have taken us inside the workings of the organization?
Follow-up step: Picking up the phone and talking to human beings is something computer-based due diligence still cannot manage. Former Madoff employees would have been able to tell us about the small-time auditors, the doubts about Madoff’s returns, and the secretive management style in Madoff’s asset management business.
Our kind of due diligence takes longer than a three-hour computer check. We look at the public record both for what investors would expect us to find – convictions for fraud, civil fines, and regulatory sanctions – as well as for what we should find but do not. Most importantly, we talk to people who get us information that will never make it into a government filing.
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