The Heightened Importance of Thorough Due Diligence in the Current Market Environment By William E. Donnelly, Esq.

I. Introduction

William E. Donnelly is a partner in the Financial Services Group at LeClairRyan in Washington, DC. Mr. Donnelly represents broker-dealers, investment advisers, public companies and individuals on securities matters, has published frequently, and appears regularly on panels concerning securities laws issues.

What began as a minor tempest in the market for subprime mortgage loans developed during 2008 into a full-blown financial typhoon that has swallowed up some of the most venerable institutions on Wall Street and severely damaged the retirement nest eggs of an entire generation. While it is still too soon to predict with certainty all of the long term consequences, it is not too soon to begin to identify some of the causes of this crisis. One of the most salient questions raised by the recent financial market turmoil is “Who was doing the due diligence?” Although commentators have identified a broad range of causes that undoubtedly contributed to the current financial crisis, the failure of many financial intermediaries, including broker-dealers, banks, pension fund trustees and investment advisers (and, in some instances, their lawyers) to perform adequate due diligence was undoubtedly one very important factor. The lack of adequate due diligence has been a particularly serious failing with regard to the several enormous Ponzi schemes that have been uncovered as a result of the current crisis. However, the possible lack of effective due diligence has been reported in other areas as well, ranging from auction rate securities to financial services industry mergers. The first section of this article provides a brief overview of the legal framework that gives rise to the duty to perform adequate due diligence in certain contexts. The second section describes three of the more noteworthy recent Ponzi schemes where failures to perform adequate due diligence have been revealed. The final section sets forth some suggested elements of an effective due diligence program for investment advisers and other financial intermediaries.

II. Legal Framework The source of the legal obligation to perform adequate due diligence depends to a large extent upon the situation in which the obliga©

2009, William E. Donnelly

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tion to perform due diligence arises. Officers and directors of a corporation owe a fiduciary duty of due care to the corporation and its shareholders under state law.1 In certain circumstances, the failure to perform sufficient due diligence on a transaction for the corporation may constitute a breach of the duty of due care. 2 Breach of fiduciary duty claims against corporate officers and directors frequently give rise to derivative lawsuits in which shareholders seek to assert claims on behalf of the corporation. Investment advisers owe fiduciary duties of care and loyalty to their advisory clients.3 The precise contours of that fiduciary duty will depend upon the particular facts and circumstances. For example, if an investment adviser represents that it applied a rigorous due diligence process to any hedge fund before recommending its purchase to advisory clients, the failure to follow that process before recommending a hedge fund could be a breach of fiduciary duty.4 Although broker-dealers generally do not have fiduciary duties to customers for whom they do not exercise discretion, the recommendation of unsuitable investments can be a violation of selfregulatory organization suitability rules. NASD Rule 2310 provides that, in recommending the purchase, sale or exchange of a security, a brokerdealer is required to have “reasonable grounds” for believing the transaction is suitable for the customer. Unless a broker-dealer has performed adequate due diligence concerning a particular investment, especially an investment that does not trade regularly on an established market, it would be very difficult for the firm to prove that it had reasonable grounds for considering the investment to be suitable.

III. Recent Noteworthy Due Diligence Failures Three recent extremely high profile apparent Ponzi schemes within the past six months illustrate the potential adverse consequences of failing to perform adequate due diligence. The three individuals that are at the heart of these Ponzi schemes were Bernard Madoff, Allen Stanford and Marc Dreier.5 In both the Madoff and Stanford cases, the connection between inadequate due diligence and massive investor losses is relatively apparent. The

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Dreier case, on the other hand, is a cautionary tale about how even relatively reasonable due diligence efforts can be thwarted by a sufficiently brazen and clever schemer. A. Madoff Of these three apparent Ponzi schemes, the Madoff scheme was the largest and the longest in duration. On December 11, 2008, Bernard Madoff was arrested on securities fraud charges and sued civilly by the SEC.6 Madoff was the principal of Bernard L. Madoff Investment Securities, a registered broker-dealer and, since 2006, a registered investment adviser. Madoff was also the former chairman of the board of directors of the NASDAQ stock market and a highly respected member of the Wall Street community. Although the precise amount lost in the Madoff scheme may never be determined with certainty, Madoff apparently told his sons on the eve of his arrest that he had lost approximately $50 billion. The victims of the Madoff scheme included numerous prominent individuals and pension funds, as well as a number of charities and other non-profit organizations. As details of the scheme emerged, it became apparent that, while some of Madoff’s victims had invested with him directly, many others had invested through financial intermediaries. In some cases, these financial intermediaries did not disclose that they were investing client monies with Madoff and hence their investors were completely unaware that Madoff was “managing” their money. Most of these financial intermediaries were hedge funds, sometimes referred to as “feeder” funds or “funds of funds.” Madoff represented to clients and prospective clients that he employed an investment strategy referred to as a “split strike” conversion strategy. Madoff claimed that he would invest in a basket of 35-50 stocks that were part of the S&P 100 index.7 Madoff further claimed that these investments would be hedged by using investor funds to buy and sell option contracts related to these stocks, thereby limiting potential losses on the stock positions.8 Madoff also promised clients annual returns of up to at least 46 per cent per year.9 Contrary to the representations he made to clients and prospective clients, Madoff, in classic Ponzi scheme fashion, used most of the investors’

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funds to meet periodic redemption requests of other investors.10 Madoff apparently conducted no trading on behalf of investors. Madoff set up an elaborate “back office” infrastructure to create the impression that he was actually engaged in investing client funds and caused the employees he hired to staff this infrastructure to issue fictitious account statements and trade confirmations.11 Madoff’s scheme, which apparently began as far back as the 1980s, finally collapsed in December 2008 when the pace of redemption requests outstripped Madoff’s ability to attract new investor funds. Madoff made clever use of investor psychology to perpetuate his scheme. One of his most effective techniques was to tightly restrict the ability to invest with him. By cultivating an air of exclusivity, he created the impression among those permitted to invest that they were part of a “secret club.” Madoff also strongly discouraged questions about the details of his investment strategy, stating or implying that anyone who asked too many questions would be denied the opportunity to participate. Madoff’s stature as a distinguished figure on Wall Street also undoubtedly contributed to the success of his scheme. Many of the feeder funds that invested advisory clients’ monies with Madoff have been sued for breach of fiduciary duty. These suits allege that the feeder funds represented that they performed thorough due diligence before placing client funds and failed to do so with respect to investments with Madoff and also collected advisory fees on the basis of the care and diligence they exercised in placing client funds. These suits seek damages for investment losses and the return of advisory fees. In addition, investors who were able to withdraw funds before Madoff ’s scheme collapsed face claims from the court-appointed receiver seeking to “claw back” such payments as fictitious profits. Some prospective investors and market observers were not taken in by Madoff’s scheme. As long ago as 2001, a hedge fund industry publication was reporting that many money managers were questioning the consistency of the returns reported by Madoff.12 Robert Rosenkranz, a principal of Acorn Partners, was quoted in the press as stating: “Our due diligence, which got into both account statements of his customers and the

audited statements of Madoff Securities, which he filed with the SEC, made it seem highly likely that the account statements themselves were just pieces of paper that were generated in connection with some sort of fraudulent activity.13

The lack of adequate due diligence has been a particularly serious failing with regard to the several enormous Ponzi schemes that have been uncovered as a result of the current crisis. In addition, Aksia LLC, an independent hedge fund research and advisory firm, noted in a public letter to clients that it had repeatedly steered clients away from “feeder” hedge funds that invested with Madoff, based upon what it described as a “host of red flags.” The red flags identified by Aksia included the following: that the returns touted for the split strike conversion strategy purportedly followed by Madoff could not be replicated by Aksia’s quantitative analyst; the implausibility of the S&P 100 options market having the capacity to handle the $13 billion in assets that Aksia estimated was in the feeder funds; that the auditor of Madoff Securities was a 3-employee firm with a small office in suburban Rockland County, New York; and that Madoff Securities, through discretionary brokerage accounts, initiated and executed the trades in client accounts and custodied and administered the assets. B. Stanford According to allegations made by the SEC in a civil enforcement action filed on February 17, 2009, Allen Stanford orchestrated a multi-billion dollar fraudulent scheme through controlled companies that were part of the Stanford Financial Group. 14 The scheme allegedly involved the sale of certificates of deposit (“CDs”) issued by Stanford International Bank (“SIB”), an offshore private bank based in Antigua that was part of the Stanford Financial Group. Another element of the scheme alleged by the SEC was the marketing of a fraudulent proprietary mutual fund wrap program.

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The SEC alleged that the CDs issued by Stanford International Bank were marketed by touting, among other things, rates of return that greatly exceeded the rates offered by U.S. commercial banks on comparable CDs.15 According to the SEC, the rates of return on SIB’s investment portfolio set forth in the SIB financial statements used to market the CDs was fabricated.16 The SEC alleged that, by the end of 2008, more than $8 billion in SIB CDs had been sold to investors in the U.S. and in numerous other countries around the world.17 In addition to SIB, the Stanford Financial Group also included an SEC-registered broker-dealer and investment adviser, Stanford Group Company(“SGC”) with 29 offices throughout the U.S.18 The SEC alleges that SIB marketed its CDs to investors in the U.S. exclusively through SGC registered representatives pursuant to a Regulation D private placement.19 The SEC further alleged that the performance data used to market the mutual fund wrap program was also materially false and misleading.20 According to the SEC, these false performance results were used to recruit registered representatives with significant books of business to SGC, who were then incentivized to reallocate client assets to the SIB CDs.21 A temporary restraining order entered at the time that the SEC enforcement action was filed, and extended by the Court upon the application of the court-appointed receiver for the Stanford entities, froze thousands of customer brokerage accounts at SGC. During the period this freeze has remained in effect, it has caused extreme hardship to the affected customers of SGC and to many of the registered representatives that had been recruited to SCG. These customers and registered representatives have no apparent connection to any wrongdoing involving Stanford. Many customers had been using their brokerage accounts to pay living expenses, such as the mortgage and medical bills. 22 Over time, the Court issued a series of orders partially releasing this extremely broad freeze in stages on certain accounts held by customers who were not employees of one of the Stanford entities and did not invest in SIB CDs. However, as of May 21, 2009, the freeze order remained in effect as to a significant number of SGC customer accounts. C. Dreier Of the three large Ponzi schemes described in this article, the most brazen was unquestionably the one

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perpetrated by Marc Dreier, a prominent New York lawyer and founder and managing partner of a law firm with more than 250 attorneys. Dreier pled guilty to federal criminal charges on May 12, 2009, following his arrest in Toronto, Canada on December 2, 2008 for impersonating a lawyer with the Ontario Teachers Pension Plan. 23 Dreier’s scheme reportedly caused investor losses of more than $400 million and led directly to the failure of his law firm.24 Beginning in 2004, Dreier sold fictitious promissory notes purportedly issued by a real estate company to hedge funds and other investment funds.25 Dreier represented that the notes paid interest at rates ranging from 8% to 12%.26 Dreier subsequently expanded the scheme to include fictitious notes purportedly issued by the Ontario Teachers Pension Plan.27 Dreier apparently went to extraordinary lengths to create the appearance that the fictitious promissory notes were authentic. Among the steps he took were to create fictitious financial statements for the development company that purportedly issued the notes and a forged opinion letter from an accounting firm that purportedly audited the fictitious financial statements.28 In addition, when representatives of the investors, as part of their due diligence, sought to speak to someone with the development company, Dreier arranged for other persons to impersonate officers of the development company.29 Dreier undertook similar steps to conceal the fictitious nature of the notes he sold that had purportedly been issued by the Ontario Teachers Pension Plan, including enlisting others to impersonate officials of the Plan in telephone conversations he arranged with investors.30 Dreier used the money he obtained from the sale of the fictitious promissory notes to purchase items for himself, to fund the operations of his law firm, to pay interest and principal to previous purchasers of the notes and to pay co-conspirators.31 Dreier also misappropriated funds from clients of his law firm.32

IV. Effective Due Diligence in a Post-Madoff World The trilogy of high-profile Ponzi schemes described above has underlined the critical importance of effective investment due diligence. As the Stanford case illustrates, due diligence is also critically im-

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portant for financial advisers who are considering changing firms.33 As noted in a recent report on best practices for hedge fund investors: Investors should conduct thorough due diligence in the market place on the reputation, experience and background of hedge fund managers and the key principals in the firm. Investors should employ as broad a range of resources as practicable, including industry contacts references, professional background searches, regulatory registrations, disciplinary history, and other research tools.34 A comprehensive due diligence questionnaire is an essential element of any due diligence investigation. The following are some additional due diligence procedures that were disregarded by many unfortunate investors in these Ponzi schemes and by their advisers. 1. Closely scrutinize investment strategies that purport to provide above-market returns Both Madoff and Stanford purported to provide returns that were well above the norm for the particular class of asset. Madoff also reported returns which were remarkably consistent over an extended period of time, despite significant volatility over the same period in the equity markets in which he claimed to invest. Other money managers found it impossible to replicate the returns reported by Madoff. Returns significantly above market averages, particularly over an extended period of time, are a major “red flag.” No money manager, however clever, will be able to consistently achieve above market returns indefinitely. Even legendary mutual fund manager William Miller, whose fund outperformed the broad market every year from 1991 to 2005, faltered in 2008, with the fund suffering a 58 per cent loss that exceeded the loss in the S&P 500 by 20 percentage points.35 Although it is undeniably a cliché, the old adage, “If it seems too good to be true it probably is” is also generally valid in this context. 2. Review SEC and SRO filings and other public information Information on SEC-registered investment advisers, including the Form ADV, is available from

the SEC’s Investment Adviser Public Disclosure website. Information on broker-dealers and their registered representatives, including disciplinary history, is available on FINRA’s BrokerCheck website. Although there is no guarantee that this information will be accurate or complete, or that an SEC-registered person or entity is not engaged in fraud (both Madoff and Stanford controlled registered broker-dealers and registered investment advisers), this information can provide an important check on information disseminated directly by the entity or individual to investors. In addition to information available from regulators, there is a wealth of information on hedge funds and other investment vehicles publicly available from a variety of sources. Much of this information is available on the internet. While the quality of this information varies widely and obviously must be evaluated carefully, it can provide useful clues. For example, a simple internet search by a prospective Madoff investor would have likely produced the May 2001 industry publication article referenced above questioning his investment returns. 3. Evaluate the Independent Auditor One of the red flags that caused some investors to avoid Madoff was the fact that the independent auditor for this multi-billion dollar investment fund was a 3-person accounting firm located in a strip shopping center. There are hundreds of accounting firms outside of the “Big Four” that are highly competent and professional, and an audit from a Big Four firm is no guarantee against fraud. However, if an accounting firm seems to be too small or too obscure in relation to its audit client that may be at least a warning sign. 4. Evaluate asset custody arrangements Custody of client assets is a key due diligence issue. Investment advisers registered with the SEC that have custody of client assets are required, with certain limited exceptions, to maintain client funds or securities with a “qualified custodian.”36 Under the SEC’s Custody Rule, banks and registered brokerdealers are among the entities that are within the definition of “qualified custodian”, primarily because they are subject to extensive regulatory oversight.37 The SEC has recently proposed to revise this rule to require all advisers with custody

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of client assets to engage an independent public accountant to conduct an annual surprise audit of customer assets.38 The Madoff and Stanford cases provided part of the impetus for this potential regulatory change.39 Some prospective investors avoided the Madoff scheme after they determined that no independent third party custodian maintained possession and control of client assets. 5. Consider retaining a due diligence consultant A number of independent consulting firms specialize in performing due diligence on hedge funds and other investment vehicles. These firms often possess considerable expertise and experience in ferreting out fraudulent schemes or unsupportable claims. If an individual or entity lacks the expertise internally to perform thorough investment due diligence, it may be worthwhile to retain a firm that specializes in that activity. There are also a number of law firms with the capability and experience to perform valuable due diligence investigations on behalf of investors.

6. Verify representations with third parties where possible One of the reasons Dreier was able to sell fictitious promissory notes is that, whenever someone asked to speak with a representative of the issuer of the notes, either Dreier or a co-conspirator arranged to impersonate the issuer representative. Of course, had the prospective investor contacted the issuer directly, rather than through Dreier, the scheme would have likely collapsed immediately. 7. Conclusion The law imposes due diligence obligations on investment advisers and other financial intermediaries when investing client monies. The recent highly publicized Madoff, Stanford and Dreier Ponzi schemes have illustrated the serious consequences of failing to perform effective investment due diligence. The failure of a financial intermediary to perform sufficient investment due diligence can result not only in costly regulatory enforcement actions and litigation with clients but can also cause catastrophic reputational damage.

ENDNOTES 1

2

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8

See, e.g., Gantler v. Stephens, 965 A.2d 695, (Del. 2009) See A Breach of Fiduciary Duty at Bank of America? by Mark T. Williams, Forbes.com, February 26, 2009 SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963) See In the Matter of Hennessee Group LLC, Advisers Act Rel. No. 2871 ( April 22, 2009) Madoff and Dreier have pled guilty to criminal fraud charges. To date, Stanford has only been sued civilly by the SEC and continues to publicly dispute the charges against him. The failure of the SEC to detect and shut down Madoff’s scheme at an earlier date, despite having conducted several investigations that touched on his activities, has been a source of considerable embarrassment to the agency. See the Criminal Information, ¶ 7, United States v. Madoff, 09 Crim 213 (SDNY March 10, 2009) Id.

9 10 11 12

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15 16 17 18 19 20 21 22

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Id. at ¶ 8. Id. at ¶ 9. Id. at ¶ 10. Madoff Tops Charts; Skeptics Ask How, Mar/ Hedge, May 2001. Look at Wall Street Wizard Finds Magic had Skeptics, New York Times, December 12, 2008 See Amended Complaint filed in SEC v. Stanford International Bank, et al., 3:09-cv-0298N (N.D.Tex. February 27, 2009) Id. at ¶ 3. Id. at ¶ 5. Id. at ¶ 3. Id. at ¶ 13. Id. at ¶ 23. Id. at ¶ 6. Id. at ¶ 6 See Judge OKs indefinite freeze of Stanford assets, Reuters, March 12, 2009 See Dreier Pleads Guilty to Fraud, Faces Life in Prison, Bloomberg, May 12, 2009. Id.

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26 27 28 29 30 31 32 33

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36 37 38 39

Indictment, United States of America v. Marc Dreier, (SDNY) Id. at ¶ 3. Id. at ¶ 8. Id. at ¶ 6. Id. at ¶ 7. Id. at ¶ 10. Id. at ¶ 13. Id. The established financial advisers recruited by Stanford over the years to affiliate with his broker-dealer have undoubtedly come to regret that decision. Principles and Best Practices for Hedge Fund Investors/ Report of the Investor’s Committee To The President’s Working Group On Financial Markets (January 15, 2009) at p. 21. See The Stock Picker’s Defeat, Wall Street Journal, December 10, 2008. See Adviser’s Act Rule 206(4)-2 Id. See SEC Release No. IA-2876 (May 20, 2009) Id. at ftn. 11.

This article is reprinted with permission from Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services, Inc. For more information on this journal or to order a subscription to Practical Compliance and Risk Management for the Securities Industry, go to onlinestore.cch.com and search keywords “practical compliance”

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