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Madoff Offers Biggest Lesson In Due Diligence at Trader’s Narrative

Madoff Offers Biggest Lesson In Due Diligence

Due diligence has many meanings depending on context. If you pressed me for a definition within finance, I would say it is:

The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship.

If you suffered losses as a result of Madoff’s fraud, then this lesson is extremely expensive. If not, it is probably the biggest gift Madoff has given the world.

As an investor or trader, you have to perform due diligence not on just trades or investments, but also on your broker or prop firm, your bank, your accountant, etc. Each link in the chain is vital. Never assume anything. Check and verify every little detail. As this most recent event has shown beyond a shadow of a doubt, you have to take personal responsibility and can not have the SEC or FBI do it for you.

Madoff’s Ponzi scheme has snared not just wealthy individuals but very large instititutions like Nomura, BNP Paribas, Neue Privat Bank, Santander, UniCredit, Lombard Odier, Royal Bank of Scotland as well as dozens and dozens of fund of funds that allocated portions of their assets under management to Madoff. These institutions supposedly have whole departments full of lawyers and accountants who are given the task of due diligence. Each and everyone of them failed their fiduciary responsibility and will probably be sued by those who experienced losses.

Just out of curiosity, I looked the website for Optimal Investment Services, the hedge fund arm of Banco Santander. Here is a snippet:

optimal hedge fund of fund santander due diligence

Optimal clients were exposed to the tune of 2.33 billion euros or $3 billion US dollars, according to a report from Bloomberg.

What sort of due diligence did they perform exactly? one that didn’t flag a potential problem with Madoff being the broker, custodian and investment manager, all rolled into one? one which missed the fact that a tiny one person accounting firm did their annual audit?

A lot of heads in “due diligence” and “risk management” departments are going to roll.

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8 Responses to “Madoff Offers Biggest Lesson In Due Diligence”  

  1. 1 Declan Fallon

    No doubt these firms had a cadre of Ivy League MBA’s doing their DD research; I wonder how much damage this does to their reputation and the reputation of their schools?


  2. 2 Babak

    Declan, image is everything, perception is reality… until the tide goes out.

  3. 3 Russ Abbott

    It’s a lot easier to pile on now that we know that Madoff was a fraud. Before that, however, it was not so easy. Much of the world, including the investment world, runs on trust and personal relationships. One can’t investigate everything. One has to rely on one’s knowledge of the people you are dealing with. Madoff seemed especially trustworthy. He had been the head of NASDAQ; he had been in business for decades; no one ever had trouble withdrawing money; he was audited in 2001. What more can one do?

  4. 4 Babak

    Russ, the fact that he was the broker/dealer, custodian and investment manager all rolled into one was a red flag. So was the unknown accounting firm that audited a vast and complex financial firm. So was the equity curve. There were people that looked at Madoff and walked away after due diligence. Of course, as you mention, others went on his reputation and stature.

  5. 5 Gary

    There were NOTHING but red flags.

    No name accountant
    Clearing and trades in house.
    Family members as compliance officers.
    A 2001 Barrons article suggesting fraud.
    A simple strategy — easy to test — that shows risk-reward nothing like claimed.

    I strongly suspect that the “fiduciaries” believed that Bernie was front-running. This makes them greedy, unethical and stupid. I hope there are some zealous lawyers in Europe!

  6. 6 Russ Abbott

    It’s SO easy to see red flags in hindsight.

    Let me pose a challenge. Which red flags we are ignoring now, and what should we do about them?

  7. 7 prosse

    How exactly do you do due diligence? I know it’s not enough to check with the SEC, so how far do you go?

  8. 8 Babak

    prosse, this is a good place to start.

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