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Madoff debacle reveals stunning failure of due diligence

awillis@globeandmail.com

It's called due diligence.

It's a process that is so basic to investing that it should never need to be explained. But with clients of some supposedly sophisticated institutions now out somewhere between $17-billion (U.S.) and $50-billion courtesy of their involvement in Bernie Madoff's hedge funds, it seems timely to revisit the concept of this duty owed to clients.

Before delving into what seems to have happened to backers of Bernard L. Madoff Investment Securities LLC and its iconic founder, let's review what's supposed to happen when the likes of Grupo Santander SA or HSBC or any number of financial intermediaries put their wealthy clients' money into a hedge fund.

These investments start with a meeting between the sharp-eyed, skeptical advisers and executives from a money manager such as Madoff Investment. The advisers should ask how the money is managed.

You're not pressing Colonel Sanders for the secret blend of 11 herbs and spices on his fried chicken. You're simply asking hedge fund managers to explain just how they generated the returns they claim. Money managers are expected to offer up detailed, audited results. They may even be politely asked to produce their auditors.

Bernie Madoff never, ever explained just how he was making money. There was vague talk of owning blue-chip stocks and writing covered calls. But most of this business was done on a trust-me basis, by a trader with five decades of experience, credentials such as a stint as Nasdaq's chairman, and a great story of getting started in markets with $4,000 earned as a lifeguard.

Anyone who tried to replicate Mr. Madoff's results, based on the minimal disclosure from his funds, couldn't reverse-engineer his performance. Auditors to Madoff Investment were never made available.

Now we're finding out that Madoff's auditors consisted of two guys working out of a New York City suburb, one of whom is in his 70s, and living in Florida.

There seems to have been a massive failure of due diligence at Madoff Investments. Mr. Madoff's wealthy friends can be forgiven for trusting their buddy.

But professional financial advisers, charged with helping their clients make investment decisions, should never have been doing business with this fund. Madoff Investment failed the most basic of screening processes.

Mr. Madoff, obviously, is ruined if the massive fraud alleged by U.S. regulators is proved. But the real fallout from this scandal will be among those who steered money into these funds, and to the money management industry.

The 70-year-old Mr. Madoff promises to do for hedge funds what Drexel veteran Michael Milken's prosecution did for junk bonds - tar an entire sector. Bank of Montreal economist Sal Guatieri said yesterday: "The fear is that the massive losses could cause a wave of distressed asset sales by investment funds that invested with Madoff [Investment], and could also cause already skittish investors to pull their funds from other hedge funds and investment groups."

There's a small army of what's known as fund of hedge funds selling alternative assets to clients. The good ones, including many Canadian players, have no ties to Mr. Madoff. Those that did do business here, and charged a hefty fee for their services, have a lot to explain to their clients.

BMO TAPS MARKETS

Institutional investors are using this latest round of recapitalization - Bank of Montreal sold $1-billion of common stock yesterday - to build positions in blue-chip companies at substantial discounts.

BMO joined its rivals by selling 33.3 million shares at $30 each, in a bought deal financing led by investment banking unit BMO Nesbitt Burns Inc.

That stock sale came at an 8.4-per-cent discount to where BMO's stock closed on the Toronto Stock Exchange. The discount is in keeping with what's been seen from other financial institutions in recent weeks. Royal Bank of Canada raised $2-billion in a sale priced 6 per cent under the close, the gap was 7.6 per cent at Toronto-Dominion Bank, 5 per cent at Manulife Financial and 7 per cent at Great-West Lifeco.

Now, those who remember slightly more robust equity markets, as recently as a year ago, will recall bought deals being pitched right at the closing price on the stock, or with skinny 2-per-cent discounts. Those days are long gone.

This is a buyers' market. A few dozen Canadian equity fund managers have cash after selling commodity-related holdings. They are willing to put that money to work, but only in just the right situation. The so-called buy side of the Street is using every bit of its leverage to squeeze the best possible terms out of issuers such as BMO.

TRUSTS GO HUNTING

Two income trusts went hunting yesterday, with Crescent Point Energy Trust and Great Lakes Hydro Income Fund announcing acquisitions funded off bought deals.

Crescent Point raised $100-million from investors, and announced that the money is being plowed into a 17-per-cent stake in Wild River Resources, a private company with properties in the Bakken play in Saskatchewan, and another $12.5-million of property acquisitions in the same region.

Crescent Point's financing was led by Scotia Capital, BMO Nesbitt Burns and CIBC World Markets.

Great Lakes Hydro snapped up two wind farms, one in British Columbia and the other in Sault Ste. Marie, Ont., from Brookfield Renewable Power Inc. The acquisitions come with a $130-million price tag, and Great Lakes Hydro is raising $75-million of this amount by selling units.

CIBC World Markets and RBC Dominion Securities led the Great Lakes Hydro bought deal - a form of financing that sees the underwriters purchase equity from a company, and shoulder the risk of selling the securities to investors.

See Andrew Willis's Streetwise Blog at ReportonBusiness.com

© 2007 The Globe and Mail. All rights reserved.

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