Demand for Change Post-Madoff
Due diligence in a changing economy
ZABRINA T. BARILE and WENDY TORIBIO-TORRES, HEDGEOP COMPLIANCE, AN IMS GROUP COMPANY
The Madoff Investment Securities scandal in 2008 prompted significant reforms to the rules and regulations that govern the investment management industry. One of those major reforms includes the Dodd–Frank Wall Street Reform and Consumer Protection Act signed into federal law by President Barack Obama on July 21, 2010. The goal is to increase transparency in the financial system and hold those accountable who do not abide. As the investment management industry continues to evolve and undergo substantial changes, it is clear that there is a need for money managers to build out robust effective infrastructures and conduct thorough due diligence on many levels including investment and risk management, investigative, operational and more.
A number of administrative proceedings, complaints and litigations recently filed have included allegations related to the investment adviser’s due diligence. Asserting proper due diligence could have prevented investments involving Ponzi schemes, insider trading or other serious frauds. Actions have focused on false and misleading statements in the investment adviser’s marketing materials or offering documents based on the level, scope or quality of due diligence. Others have also noted the absence of well-documented due diligence reports and active monitoring of procedures.
Regulators increased focus on due diligence
The Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations (OCIE) is focusing on investment advisers’ due diligence practices, in both the investment decision-making process and the selection and monitoring of service providers. SEC-proposed rules require that investment advisers disclose findings related to the contractual details, potential conflicts, transparency and oversight of service providers.
In remarks to the industry, Carlo Di Florio, the SEC’s OCIE Director, and OCIE Deputy Director Norm Champ, among others, have included due diligence of underlying investments and managers in their lists of areas of interest and exam topic items. Among the priority focus areas, OCIE mentions “Sales Practice of New or Risky Products,” and one of the particular areas of concern noted was “lack of due diligence performed on underlying investment vehicles/managers and any undisclosed conflicts and/or fee arrangements,” in its 2012 National Exam Overview.
Qualitative and quantitative reviews
Prior to any allocations and even post investment, investors clearly have expectations and are now demanding that investment advisers respond to regulatory compliance requirements and increase the level of transparency and reporting provided. This increase in investor scrutiny has brought forth many operational changes in alternative investments especially with respect to due diligence and governance. Investor reporting has become more standard, operational risk management has been enhanced, and due diligence has become an integral part of investors’ analysis.
The SEC has highlighted the importance of qualitative checks to assess the target fund’s financial stance. Investors should perform reference checks, and assess creditworthiness, unpaid debts, judgments and liens for both the fund of interest and its key investment personnel. In addition, all analytical tools should be exhausted in identifying discrepancies and red flag items.
Further to public record background due diligence checks, the SEC has stressed the importance of developing standard due diligence policies and procedures that include quantitative due diligence checks. Investors must be prepared to review audited financial statements, verify service provider relationships, and confirm that the adviser’s due diligence practices conform to those practices disclosed in its Form ADV, fund offering documents and marketing materials.
In general, the SEC has repeatedly expressed the importance of due diligence performed by potential clients and investors on advisers and funds, and stated that facilitating due diligence is one of the reasons for the enhanced disclosure in publicly available forms such as the Form ADV and ERA filings. The exigent need for disclosure and transparency through data collection and analysis of public filings, offering documents, marketing materials and due diligence questionnaires is meant to enable clients and investors to identify potential misrepresentations by advisers. Releases adopting and implementing changes to the Form ADV and the new ERA filings suggest that having that additional information will help protect potential clients and investors from making bad investment decisions.
Among other information that the SEC deems important for an investor to consider in its due diligence is the census data collected on the private fund’s gatekeepers, including administrators and auditors, along with information about additional business ventures, affiliates, owners and even disciplinary issues.
Key offering terms in supporting offering documents
A critical review of the key offering terms as noted in the supporting offering documents (i.e., private placement memorandums, marketing material, due diligence questionnaires, etc.) is yet another important level of due diligence that should be added to the investment review process. Key terms include fees and expenses, withdrawal/redemption rights, pay-out schedules and negotiable areas where side letters should be contemplated (i.e., liquidity concerns, key man issues and/or unlimited use of private or restricted securities). The following areas of focus should be highlighted:
• Structural anomalies and/or unique operating terms
• Inconsistencies in the description of terms among the various disclosure documents and
• Accordance of terms to industry standards or client guidelines
• Eligibility and threshold requirements
• Potential conflicts of interests
As the industry evolves and expectations for regulatory reforms and oversight increase, developing and maintaining a proper due diligence infrastructure and record-keeping system for potential and ongoing investments will prove fundamental in building towards the level of trust and transparency that investors are looking for. The emphasis should be on the key personnel, methodology, performance and philosophy behind every investment. “Transparency, credibility, reliability, alignment of interests, and low self-orientation are the elements required to foster trusting adviser relationships,” says Ben Stein in his 2011 speech at PwC’s From Black Box to Open Book Alternative Investments Seminar.
The higher the value that is placed on the importance of due diligence and scrupulous background investigations, the less likely the chance of engaging in a bad investment. Hedge funds are lightly regulated in comparison to other investments and fraud may not always be detected by the major regulatory agencies. It is the investor’s fiduciary duty to protect their assets and those of their investor base. We are living in a culture of accountability where due diligence is no longer an afterthought but a preemptive step required by all investors and the financial industry as a whole.
Guidance for Qualitative and Quantitative Reviews
At minimum, research should execute the following preliminary public records background checks:
• Confirm that entities exist, are in good standing and that all required formalities have been adhered to in connection with formation and operation of the fund(s)
• Verify employment and educational histories as related to the key individuals under review
• Review news articles, social and media websites naming or linked to the entities and key individuals being researched
• Conduct public record searches for adverse records such as those relating to bankruptcies, judgments/tax liens, UCC filings, and civil and criminal filings
• Review of key individuals’ assets such as multiple property transactions, foreclosures, etc.
• Verify key individuals’ regulatory and professional licenses and certifications
• Check for any regulatory records, violations or disciplinary issues that have/have not been disclosed
• Ensure that proper securities filings have been made and that any disclosures noted conform to other information that is publicly available
• Run profile searches of the entities and key individuals under review against sanction and Anti-Money Laundering Watch-lists for any potential risks