Learning the lessons of due diligence

A few months back when the alleged Bernard Madoff Ponzi scheme was first exposed, I remember writing on this blog that the alleged $50 billion fraud was only the tip of the iceberg, and that the recession would result in other scams or alleged frauds being exposed.

Not that I want to beat my own drum, but it doesn't take much to realise that a deep economic recession and tightened credit availability are all it takes to bring suspected frauds that have gone undetected, to light. When banks don't want to lend and investors panic and want to withdraw funds, things start to unravel.

I don't think we can say that the credit crisis is causing fraud to spiral out of control, however, it is resulting in greater levels of discovery. Since Madoff, there has been the $1.5 billion fraud at Indian IT firm Satyam Computers, other Ponzi schemes and dodgy investor scams are being uncovered on a regular basis and now the SEC alleges that Allen Stanford duped investors who bought bonds from his Stanford International Bank in Antigua and claim that he also lied about the performance of their savings and the extent of investors' exposure to Bernard Madoff's alleged Ponzi scheme.

Not only is more fraud likely to be uncovered in trying economic times, but also financial regulators are on the war path, eager to redress the perception that they failed to adequately supervise financial firms when times were good. Now that times are not so good we can expect to see the heavy hand of regulation come down on banks.

In the UK the Financial Services Authority is calling for a sea change in the way commercial banks, investment banks and building societies manage their liquidity. The new liquidity standards, which are scheduled to come into force in October, will also impact US banks with branches in the UK and are designed to try and prevent an event like the Lehman's collapse in the US, spilling over into the UK by forcing bank branches to become self-sustaining when it comes to liquidity.

While managing liquidity is not directly related to fraud, what is perhaps more interesting is that observers believe the FSA is likely to not only make an example of those banks that fail to comply with its new liquidity standards, but they may also "disbar" those company chairman and executive directors of banks that don't measure up.

Corporate governance is back on the agenda again and it is the guys at the top that are likely to take the heat, however one has to question how serious the regulators really are when you read reports that a former disqualified company director was able to foil the FSA merely by changing his name and becoming a director of three companies.

We have all heard the corporate governance rant before - isn't that what Sarbanes-Oxley was all about? Yet financial accounting scandals are still very much with us and some suggest it is only going to get worse as company executives resort to fiddling the books in order to preserve banking covenants, meet analyts' expectations or avoid bankruptcy.

But heightened levels of corporate governance in the form of greater regulatory oversight is not the panacea some think it is. If anything is to be learned from the Madoff and Stanford cases it is the lack of due diligence by investors and investment funds. All the warning signs were there; fly-by-night accountants and a lack of separation of duties; and if anyone had bothered to do their due diligence they would have uncovered enough to raise alarm bells.

However, it seems everyone wanted to believe the unbelievable; market beating returns; and it seems we all want to believe that some of the gold dust will rub off on us, which means a lot of financiers are not subjected to the level of scrutiny that they should be.