And just Whose Responsibility is Due Diligence?
I am finding this whole Bernard Madoff scam fascinating. Sad in some ways, instructional in others,
and interesting in most.
I find it especially interesting because back in the 1980’s a
large group of friends in Colorado got hooked into an “investment opportunity” with M & L Business Machines which turned out to be a major Ponzi scam.
To a large extent I think I can imagine Madoff’s roll in
this in the beginning. The desire to be
seen as important, successful, beneficent, etc. I even would bet that originally he had no plans for this to be a Ponzi scam (which is significantly different from the M & L
scam). Madoff wanted to look good and good returns did that. I am fairly sure he was initially planning that “someday
soon" he was going to make "the big one"; the trade or investment that was going to be huge and make up for his losses.
But ego feeds the ego. Once he was on his way to building the image he had always wanted he was never able
to stop playing the game and everyone, himself included, became more and more
trapped. I think he has known it to be a
Ponzi scam for years, even decades, but I wonder if he really thought it was going
to collapse. Denial is a powerful force!
“How could this happen?” is a question rocketing around the
news rooms and internet. I am finding it
fascinating to look at it for myself and in a bigger sense. This is such an “educational opportunity”!
First, just on the practical side of things – there is no
way at all that I believe that Madoff was in this entirely alone. He was the main guy and is the “fall guy” but
there is no way this huge of a scam was accomplished without others in his
company knowing that there was something dreadfully wrong and deciding to play
along. I sincerely wonder if we will
ever know all the players. But the main
interest for me is how it happened in a bigger sense and what I can learn from
it.
The first lesson in Investments 101 is to diversify. Investopedia defines diversification as A risk management technique that mixes a
wide variety of investments within a portfolio. The rationale behind this
technique contends that a portfolio of different kinds of investments
will, on average, yield higher returns and pose a lower risk than any
individual investment found within the portfolio.”
Why did organizations and individuals who know this rule
lose so much in Madoff’s scheme? Two
reasons. The first is that the products
that Madoff’s company offered appeared to be quite diversified. An individual and even a manager could have
put all of their funds into Madoff’s products thinking they had a “diversified
portfolio”.
The second reason is a little more sticky. It involves a responsibility of following
things through in detail, due diligence.
How many people reading this (if anyone is!) truly know
where your IRAs are invested? Yes, back
when I had a retirement portfolio (pre injury) I could have told you that I
used UBS Financial and the name of my financial advisor. I possibly could have mentioned the name of a
couple of the mutual funds too. But
beyond that? I barely took any notice of
what stocks were held and traded within the funds. The returns
were good and I trusted my investment planner. I passed off the responsibility of detailed
due diligence to my investment manager.
In the Madoff case it appears that the responsibility of due
diligence was passed down the line over and over:
Investment firms that did business
with Madoff have also been sued. New York University said it lost $24 million
in investments managed by Madoff, according to a lawsuit filed Dec. 23 in New
York state court in Manhattan against fund manager J. Ezra
Merkin and his Gabriel Capital LP fund and Ariel Fund Ltd. The school
alleged Merkin invested NYU’s money with Madoff without telling investors or
performing proper due diligence.
In a separate proposed class-action
against Merkin, who is also the chairman of auto lender GMAC LLC, Harry Susman,
a lawyer for The Calibre Fund, alleged he misled investors by claiming to have
put investor money in a “diverse portfolio of securities.”
Exactly whose responsibility is it in these above cases? Exactly who did not perform proper due
diligence? When is it okay to pass off
the job of due diligence to someone else? There are going to be many a jury deliberating
just such a topic in years to come!
Okay, so the question of Diversification morphs into the
Responsibility of Due Diligence.
Another lesson to take away from this is that the definition
of Diversification needs to be broadened. Investment
Diversification must also include diversification among fund managers and
companies not just “within the portfolio”.
I think that is the thing that amazes me the most in seeing
some large institutions and charities lose so much money; that they placed all
of their funds – tremendous amounts – in the hands of one single fund manager .
. . who then invested all of it in Madoff.
I think I will end this post here since it has gotten so
long and look at other aspects of “How could this happen?” in some future
posts.