Due diligence? Get serious, Pt. 1

By Steven McCarty

"Due diligence," now that's a quaint term. Since 1933 -- when Congress passed the Securities Act -- financial firms have been conducting research on the companies whose equities they sell. They don't do this out of the goodness of their heart. Rather, they do it as a potential defense. If clients accuse them of not disclosing material information, they could use their due diligence as a shield, even if it didn't uncover the information in question.

After due diligence became a standard practice in the securities industry and other sectors, the term entered the common vernacular as a synonym for "checking something or someone out." Even clients tried to do due diligence before selecting a financial advisor or making an investment... at least some did.

That was then, but what about today? I can only conclude that the concept -- and practice -- of true due diligence is seriously past due. Individual and institutional investors just haven't shined as adequate a light on potential investments as they once did -- and they have suffered huge losses as a result. Two cases in point:

    1. The subprime mess

    As you well know, mortgage brokers and lenders failed to do their due diligence on borrowers who wanted big mortgages with little or no assets. Wall Street financial engineers bought up and repackaged these mortgages without fully understanding their risks, then sold them to entities around the world. Banks, municipalities and pensions funds bought securitized mortgages without enough due diligence -- and lost billions when they blew up in the housing crisis. Because people up and down this chain failed to do their homework -- or deliberately gamed the system -- Wall Street collapsed and the U.S. entered a serious recession.

    2. The Madoff mess

    Not only did major individual investors and charities get trapped in Madoff's $50 billion Ponzi scheme, so did major financial institutions. Austria-based Bank Medici lost $2.1 billion; Banco Santander, $3.2 billion; and the Tremont Group (a subsidiary of MassMutual) lost $3.3 billion. Granted, Madoff's scheme was slick, but surely a little bit of old-fashioned due diligence could have parted the veil.
My point in reminding you of these two sorry spectacles? To encourage you to get your due diligence out of arrears in 2009. Given all of the criminal and unethical conduct we've seen of late, you must subject all of your carriers and marketing firms to a much higher level of scrutiny. Here are a few practical suggestions:

No. 1: Become your own due diligence officer. Don't outsource this key function. Read the fine print yourself. If you don't like what you see, don't do business.

No. 2: Don't place too much weight on any one financial rating agency. Rather, weigh the preponderance of data from multiple sources.

No. 3: Don't give unearned trust to anyone or anything. Make sure that the products you sell have established track records -- and that your carriers and marketing firms have the means to stand behind their promises.

Finally, a prediction: If 2008 was the year of financial calamity, 2009 will be the year of due diligence. In Pt. 2 of this column, I'll discuss what this trend means for you and your clients.