Background Checks and Key Person Risk, Post Madoff

As problems mount during these difficult economic times and lessons are learned from the scandal du jour and the lawsuits making their way through the legal pipeline, one thing is clear. Unearthing information about the individuals who control billions of dollars is fast becoming a critical element of doing one's homework. It's not that background checks are more important than before. To the contrary, investigations remain hugely important to asset allocation procedural prudence. Post Madoff and pay-to-play headlines, it's hard to justify sloppy due diligence. Anyhow, why would attorneys and investment clients take the risk when it is simple enough to write a check to someone who can do the research expeditiously?

Enter Mr. Ken Springer, a former FBI agent and author of Digging for Disclosure: Tactics for Protecting Your Firm's Assets from Swindlers, Scammers and Imposters.

In this December 2010 book, Springer and his co-author, Ms. Joelle Scott, dispel the notion that key person risk is trivial and unimportant. To the contrary, their numerous examples make it clear that a "background check should always be conducted on any person who has an impact on, or control over, the funds and operations of the company." This might include a marquee name trader at a hedge fund, the general partner of a private equity fund, the chief compliance officer at a mutual fund, the lead programmer for an algorithmic portfolio, an internal or external auditor, all of the above or other job functions altogether. These two experts explain that classifying a key person(s) will vary by firm and scope of responsibilities, adding that background checks are "always the ideal way to be on the offensive in terms of fraud detection."

The chapter entitled "Dial 'F' for Fraud" describes the use of a whistleblower hotline as another smart move that requires only a small cash outlay to create. By encouraging board members, investors, employees and/or others to anonymously report wrongdoing, an asset manager, investor and/or counsel has a chance to investigate whether a complaint is legitimate and take corrective action before it's too late.

Since surveys of investment professionals repeatedly cite reputation risk as a major pain point, digging for disclosures before trouble gets out of hand makes sense. Furthermore, bad news can sometimes cost a money manager plenty in the form of reduced assets as existing clients head for the door or new clients refuse to knock. Should litigation occur, lost profit calculations typically incorporate reputation or "brand" considerations as part of the damages. For investors who can prove harm because of lax due diligence on the part of those charged with such duties, damages typically incorporate opportunity costs "but for" key person risk oversight failures.

This hot-off-the-press guide to improving information flow reminds readers that memories are short and it's easy to forget rogues until new ones take their place. Springer and Scott urge investment management professionals to do their own due diligence and take off the blinders. They apply their techniques to "Brazen Bernie," "Stanford's Instabilities," "The Sting of Pang" and Bayou in a final chapter that links survival to awareness.

As Sir Francis Bacon wrote several centuries ago, "Knowledge is power."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.