As the dust begins to settle around the Bernie Madoff Ponzi scheme it has been revealed that among his list of high society clientele were a number of American pension funds. We all, to some degree, can understand how an individual investor might get duped by a con man, but how does a professional money manager fall for such a scam and why were there no Canadian pension funds amid the victims?

Bernie Madoff wasn’t your typical con artist. Revered on Wall Street for decades as a pioneer of electronic trading in the 80s and chairman of the NASDAQ exchange in the 90s, he commanded the respect of many, including former U.S. Securities and Exchange Commission (SEC) chairman Arthur Levitt, who consulted frequently with Madoff during his tenure.

While these credentials proved to be a siren song for U.S. pension fund managers under pressure to live up to their performance-based compensation packages, to the relief of thousands of Canadian pension fund members, no Canadian funds were involved in the scam. According to Deborah Allen, director of communications with the Ontario Teacher’s Pension Plan, the absence of Canadian funds from Madoff’s client list is attributable to that most basic tenet of investor practice, due diligence.

“Like the majority of the large pension funds in Canada, Teachers’ manages most if its investments in-house and conducts a thorough due diligence process on any potential investment,” she says. “We have a 200-page due diligence manual that we follow, and every two years we visit each fund and fund of fund that we are invested in and perform an audit.” That audit, she explains, includes a review of the investment’s strategic due diligence, trading history and operational due diligence.

So it seems that while being seduced by a charming salesman might pique a Canadian pension fund manager’s interest, it would only be enough to trigger an extensive process that would have detected a number of problems in the Madoff scenario.

“Establishing a personal relationship might be the reason to start the process but it would never be enough of a reason to do business with a particular person or fund,” says John Pierce, vice-president of corporate communications with OMERS. He explains that part of the due diligence process for Canadian pension funds is verification of the back office records and a thorough review of the firm’s back office itself. If the fund cannot verify the information provided to it, they will walk away. It is during this phase of the investment process where most of the red flags would have been raised with Madoff’s fund.

A look at Madoff’s back office would have revealed that the “auditors” consisted of a 3-person accounting firm employing a lone CPA in a tiny office in New York—hardly adequate to monitor a firm that supposedly traded a good chunk of NYSE and NASDAQ volume. In addition, the comptroller of the firm was based in Bermuda, whereas most mainstream hedge fund investment advisers have their comptroller in-house.

A verification of the firm’s trades would also have been a major cause of concern, as Madoff purportedly used a “split-strike conversion” strategy which is known to be extremely volatile. Suffice it to say his company’s consistent year-over-year returns of 10%-12% would have raised more than a few eyebrows. Failing that, the lack of trading verification would have been the smoking gun. It’s tough to provide evidence of trades when you never made them in the first place.

Other red flags for potential investors were paper copies of records provided to clients despite the supposedly highly automated nature of the firm, the degree of secrecy surrounding its activities and the fact that it was run almost exclusively by family members.

Apparently, questions were raised about Madoff’s operation as early as 1992 when the SEC sanctioned three firms that acted as feeder funds for Madoff. Subsequent complaints were brought to the regulator in the late 90’s and early 00’s, but in the end the warning signs were missed or ignored.

The SEC’s embarrassment has spurred regulators in this country to take action. In early February the Ontario Securities Commission began probing hedge fund managers about their operations, and the Investment Industry Regulation Organization of Canada (formally the Investment Dealers Association of Canada) has reportedly circulated an internal memo documenting the warning signs that occurred in the Madoff case.

As the opaque layers that Madoff built over the years are slowly peeled back, retail investors will learn a valuable lesson in due diligence. However, pension fund managers who were caught in this have no excuse. They should have known better.

Philip Dale is a Toronto-based freelance writer.

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