Monday, 29 December 2008
Asia Markets Suffer Lack of Due Diligence
There has been a lot of finger pointing in the wake of Bernie Madoff’s US$50 billion fraud. The United States Securities and Exchange Commission and other government regulators surely deserve a share of the blame. However, the real question is how so many supposed wizards of Wall Street were taken in by the scam. If a fraud of this scale can be pulled off in the relatively transparent markets of the US, one cringes at the potential scope of the scams moving through Asian markets.
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Asia Markets Suffer Lack of Due Diligence
Samuel Porteous
29 December 2008
There has been a lot of finger pointing in the wake of Bernie Madoff’s US$50 billion fraud. The United States Securities and Exchange Commission and other government regulators surely deserve a share of the blame. However, the real question is how so many supposed wizards of Wall Street were taken in by the scam. If a fraud of this scale can be pulled off in the relatively transparent markets of the US, one cringes at the potential scope of the scams moving through Asian markets.
In Asia and elsewhere, highly successful individuals tend to develop a disturbing degree of overconfidence in their ability to innately, and with little formal third-party assistance, assess individuals and opportunities. This is particularly the case in places like China, where it is often assumed, incorrectly, that useful information on individuals and opportunities is difficult, if not impossible, for outside parties to obtain.
As a result, irresponsible individuals or financial entities are often overly dependent on sometimes important, but always insufficient informal cues such as introductions by mutual acquaintances, common club memberships, or a quick chat with personal sources to assess an individual or opportunity.
Madoff exploited all these weaknesses and survived countless informal non-third party reviews of this nature. However, a methodical review of his firm’s public record coupled with targeted discreet inquiries would have raised several troubling issues. In some instances, street analysts openly questioned whether Madoff’s investment model, involving trading in shares and options, could be successfully executed on the scale Madoff’s accounts would have required.
There were also questions about his engagement of a seemingly inappropriately small audit firm. Others speculated that Madoff’s consistently successful returns could only be the result of access to insider information. Interestingly, this last speculation, reportedly, only encouraged some judgment-impaired investors to work with him.
The above information was apparently there to be had and an adequate due diligence consisting of database and public record checks coupled with targeted inquiries and skilled analysis would have uncovered it. While reasonable persons might disagree on how to assess the information from such an inquiry, few would argue that obtaining this sort of information was not a useful exercise. The question for financial institutions that invested with Madoff will be just what sort of due diligence they subjected his operation to, and whether the assessment of its result was adequate.
Unfortunately, there is very little guidance in the US and Asia with regard to minimum acceptable standards of due diligence. Some financial institutions and entities in Hong Kong and elsewhere engage in serious formal due diligence efforts on every investment, while others do the bare minimum. Currently, the bare minimum in Asia consists of a cheap third-party database check of questionable utility coupled with the financial institution’s deal team’s in-house risk assessment of the project.
These sorts of lax standards no doubt played a large part in the recently disclosed fraud of a Xinghua property entrepreneur, whose recently bankrupted company allegedly raised more than 700 million yuan (HK$793.5 million) from investors by promising to pay monthly returns of up to 10 per cent.
Ideally, what will emerge from the Madoff matter and the resultant lawsuits are a heightened understanding of the importance of significant formal due diligence and some indications of what should be considered to be a reasonable standard of due diligence required of financial institutions and entities making investment decisions.
Investors in Asia and elsewhere can only benefit from such a development.
Samuel Porteous is the Asian managing director of Navigant Consulting
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