The Due Diligence Mess 3 Ways to Protect Investors

By Dale Yeager

Indictments for Ponzi schemes and investor fraud have been increasing every day. While pundits, Congress and financial experts pinpoint problems with regulatory agencies such as the SEC, the real problem centers on what I call the ‘Due Diligence Mess’.

After the sentencing of Bernard Madoff for 11 federal felonies, one of his victims made this statement to USA Today, “My due diligence was the SEC. What greater due diligence can you have than the SEC? They failed us.”

While I agree that the SEC and the SIPC failed to uncover the crimes of Madoff and his affiliates, the initial decision to invest with Madoff was made by the investors and it was their responsibility to make an informed decision. Anyone who seeks to invest in a business or financial product knows that there is risk, and that risk is primarily based on the ethics and competency of the people running the operation.

Ethical, cautious, professional organizations provide safe havens for investments. Those qualities are best discovered through forensic psychology and criminal investigation models.

Just as forensic accounting is a powerful tool in vetting the numbers of an organization, forensic criminal investigation models are just as powerful in vetting the quality and ethics of people leading an organization.

The following is a list of three reasons why I believe financial crimes will continue to occur unless radical changes are made in the due diligence process by attorneys and accountants.

1. The Problem with Databases

With the aggressive rise of the Internet in the mid 1990’s, the use of online databases has become a mainstay in the daily processes of many law firms and accounting firms.

The problem with these databases is their dependence on local, state, and federal agencies to provide accurate and updated information. Our legal services division investigators have found that 40 to 45% of the information that comes through these databases is inaccurate or outdated, even information from the “premier’ providers.

Our investigators also discovered that much of the remaining information cannot be verified, which begs the question: “Why are legal and accounting professionals still depending on these inadequate systems?” The answer is simple they are inexpensive and convenient.

There is nothing inexpensive or convenient about due diligence. In my experience it requires time and professional manpower to collect accurate data, confirm the data and assess the information. “Easy” does not enter into the process of accurate due diligence.

The other problem with databases is that the information must be assessed using criminal forensics. What may seem unimportant to the untrained eye can be a critical element to an investigation. Knowing what to look for and knowing how that information plays into a psychological assessment of a fund manager, business executive or broker comes only from forensic psychology which has the distinct ability to look behind the professional facade of people.

Bottom line: Due diligence is as much a criminal investigation as it is a financial and legal process.

2. Forensic Accountants but not Forensic Investigators?

Over the past 20 years, the use of forensics accountants has become increasingly commonplace in civil and divorce legal cases. Their value as a tool for uncovering financial crimes has become a legal necessity.

However, the use of forensic investigators in due diligence is a legal rarity. This contradiction is troubling.

In most cases cost is the primary factor – “my client doesn’t want to spend the money”. How ironic since the client will be investing a significant amount of money in a business enterprise or handing over a significant amount of money to an investment firm. There is no logic with this kind of thinking.

Rather than explain the value of a proper investigation, some professionals will attempt to do the work “in house.” This is done through their favorite private investigator.

Contrary to popular belief, most private investigators do not have criminal forensics training or financial fraud experience. Their training consists of “experience” which can be inconsistent and unreliable. Also, most federal agents are not trained in these areas. Inexperienced investigators without proper forensics training set the stage for a legal and financial disaster.

3. Data Without Context

Data without context is useless. Since many professionals lack criminal forensics training, they do not understand how to accurately assess data. Because of this limitation, many professionals miss key information that would have saved their client’s great pain.

A perfect example is the correlation between trespassing, breaking, and entering, and sex crimes. I have seen this fact missed many times in background checks and criminal investigations.

What seems like unimportant data can be an indicator of narcissistic activities, embezzlement, or other negative behaviors on the part of the people running an organization.

Bottom line: Either data are accurately assessed, or people will suffer.

The current state of due diligence is woefully inadequate in determining risk. The current focus of such efforts is solely placed on the company being purchased or the organization that will handle the client’s money and not on the people operating these entities.

Professionals and investors alike must understand the need for forensics within this process. Due diligence is about assessing people.