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“Due diligence investigation” is a phrase that varies in meaning among different business organizations and industries.

From the perspective of a venture capitalist or a private equity investment manager, it’s about assessing the business model, conducting market research and talking to the market.

For an accountant, it may be analyzing the books and records.

From an investigator’s perspective, a due diligence investigation is utilized to assess the character, integrity and reputation of potential business partner(s) or key player(s) in a venture before the client enters into a substantial financial relationship.

What is a due diligence investigation?

A due diligence investigation is conducted to assess the qualifications and track records of the people involved in the deal, to identify potential inconsistencies, misrepresentations, omissions or controversies in their backgrounds.

When is a due diligence investigation performed?

These investigations are commonly performed prior to transactions such as a merger or acquisition, formation of a business partnership or strategic partnership, or a significant investment or financing arrangement.

Who requests a due diligence investigation?

Due diligence investigations are typically conducted on behalf of small and medium-size businesses, large corporations, investment banks, private equity firms or other investors. In many cases, the investigation is initiated by a legal team involved with the deal in order to protect the integrity of the information.

What is included in a due diligence investigation?

Information that is typically covered in a due diligence investigation includes the following:

  • Personal and professional history, which includes work history, board memberships and nonprofit affiliations
  • Historical news media research on the individuals and businesses with which they have been affiliated
  • Details of civil litigation and criminal case history, including on-site court research and retrieval, where applicable
  • Regulatory records, professional licenses and government compliance checks
  • Financial history, which includes personal assets, judgments, liens, bankruptcies and U.S. Tax Court cases
  • Corporate affiliations, sex offender registries, driving history records and political contribution records
  • Credit history (with consent)

In addition to the above, a due diligence investigation can include interviews with references, sources or relevant parties.

What kind of information is found in a due diligence investigation?

Some of the more common issues that are revealed in a due diligence investigation include the following:

  • Misrepresentations of employment history or falsified degree information
  • Financial troubles, including bankruptcies, tax liens and foreclosures
  • Accusations in lawsuits, such as harassment or fraud
  • Regulatory issues
  • Past criminal trouble, including drunk driving
  • History of litigiousness
  • Undisclosed corporate affiliations, government scrutiny or a trail of failed companies

Why conduct a due diligence investigation?

In today’s business world, information is power. In the end, the purpose of conducting a due diligence investigation is to gather as much intelligence and information as possible to help you make a more informed decision.

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The “Well-Known Cloud” over JP Morgan’s Head

If living in hindsight was a reality,  there are many of us who would have taken a different path at times during the road of life.  As reported in today’s New York Times, JP Morgan Chase executives reportedly “expressed serious doubts about the legitimacy of Bernie Madoff’s investment business more than 18 months before his Ponzi scheme collapsed, but continued to do business with him.” Unfortunately now for JP Morgan, the path they chose (which encompassed a “Google search with no follow-up”) may cost them $6.4 billion in civil claims.

According to several internal bank documents unsealed yesterday in connection with the Madoff Trustee liquidation proceeding, several high-ranking JP Morgan risk management executives shared communications in 2007 about Madoff’s “Oz-like signals” which were “too difficult to ignore.”

As described in the court filings:

For whatever its worth, I am sitting at lunch with [JPMC Employee 1] who just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a [P]onzi scheme-he said if we google the guy we can see the articles for ourselves-Pls do that and let us know what you find.”

[JPMC Employee 2] warned, “you will recall that Refco was also regulated by the same crowd [SEC, NYSE, NASD] and there was noise about them for years before it was discovered to be rotten to the core. Hopefully this is not the case here but given [JPMC Employee 1’s] view, I think we owe it to ourselves to investigate further.”

Nevertheless, Equity Exotics seemed eager to receive approval, and the further research on Madoff was limited to a Google search with no follow-up. REDACTED [JPMC Employee 8] asked one of her colleagues to “please have one of the juniors look into this rumor about Madoff that [JPMC Employee 2] refers to below.”

The analyst forwarded an article about a proposed change in SEC regulations that would eliminate a loophole in the regulations governing broker-dealers. He speculated the loophole allowed broker-dealers to run “a ‘[P]onzi’ scheme of sorts.” Even though the article made no mention of Ponzi schemes and provided no suggestion as to why Madoff in particular would have had a “well-known cloud” over his head, upon information and belief, no further investigation was conducted—even after [JPMC Employee 2] cautioned, “Mr. Madoff will not allow us to conduct any due diligence on him directly and we are forced to rely on the diligence of third parties. . .

Now getting back to the earlier point of living in hindsight; we are confident that many individual investors and business executives were unfortunately blinded by Madoff’s “well-known cloud” and possibly even ignorant to the subtle red-flags he may have waived.  However, when one of the largest financial institutions in the world considers proper due diligence as “googling the guy” or last “having one of the juniors look into this rumor about Madoff”…something is seriously wrong with the avenue JP Morgan chose to vet Mr. Madoff, possibly even now negligent.

What do you think about JP Morgan’s “due diligence”?  Let us know in the comments.

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One of the most overlooked areas in a private equity transaction is a due diligence background investigation on the key players or principals part of the transaction.  The purpose of the due diligence background investigation is to evaluate the integrity of individuals – both personally and professionally – that you are going to be doing business with. Understanding the personal and professional history of those key players can be the difference between a successful transaction and a complete failure.

People are Assets

In some cases, the key assets that are being acquired as part of an acquisition are hard assets such as a product, factory, patent  or even an idea.  But in other cases, the most important assets are the people that are going to be on board, especially in service related businesses.  If the transaction involves the acquisition of key principals that are going to be the foundation to the future success of the company, among the key issues that need to be answered as part of the due diligence investigation process is the background and reputations of the parties whom you will be doing business with.

Key issues that could be uncovered:

  • Business Interests – Corporate executives engaging in self-dealing or previous business interests that have been the subject of controversy, bankruptcy or sanctions
  • Personal History – Multiple divorce filings with allegations of personal misconduct
  • Professional History – Falsified education credentials or misrepresentations of previous work history
  • Regulatory Issues – Undisclosed regulatory complaints or disciplinary actions taken by state or federal regulatory agency
  • Criminal/Civil Cases – Multiple convictions for driving under the influence of alcohol, allegations of soliciting a prostitute or litigious past
  • Financial Status – Hundreds of thousands of dollars in federal tax liens, credit issues to grievances filed with U.S. Tax Court
  • Assets – Multiple houses and boats which could show someone living beyond their means

In Depth: Anatomy of a Comprehensive Background Investigations [Infographic]

Who should a private equity firm conduct a due diligence background investigation on?

To best answer this question, some of the key questions that you need to ask yourself is: how much capital is at risk, how much reliance is being placed on the key principals of this transaction and the nature of the business (a paper mill and an oil exploration business have two totally different risk profiles). Ultimately, it’s a choice that the private equity firm must make, but at the very least, a due diligence background investigation should be conducted on the key principals as part of the transaction, specifically those individuals whom you have identified during the transaction as keys to the future success to the company.

Final Thought

Having the wrong management in charge can be the  difference between an immediately successful acquisition or a complete failure. The goal of the due diligence background investigation is to identify relevant issues in management’s background and track record to make a well informed business decision that could impact your investment decision.

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An investment fraud can look legitimate in so many ways, but there are many warning signs everyone should be aware of. The key is not only to recognize some of these warning signs, but to act on them.

15 Warning Signs of an Investment Fraud:

1There is Nothing on Google! – Not finding anything on the first few pages of Google might give you some level of comfort.  What you may not know is that a fraudster may have paid someone to bury the results of past discretions. Even so, Google is only the tip of the iceberg as far as the information that you can get.

2Planes, Boats, Yachts – Ponzi schemers love to show their jewelry, vacation homes, cars, planes and yachts. They must  figure that they are going to be caught at some point and should enjoy the fruits of their labor.

3Pedigree – There are certainly a number of successful investors who have come from nowhere, but for the most part, the successful investors have come from prominent firms or have a prominent background in the industry.

4Lofty Credentials – Having a degree from an Ivy League school or having experience at a top flight investment firm instantly gives people credibility. The problem is that the fraudster knows that as well and knows that most people will take their word for it.

5All the trappings of success – In order to get access to people’s money, you have to have their trust, and part of building that trust is acting the part. Making high profile donations to local charities, flying private jets and dressing the part are all ways that a fraudster gives the impression to potential investors that they have all the trappings of success.

6Unverifiable claims – Insider information, patent pending formulas or information that nobody has access to are all examples of things that are either impossible to verify or not verifiable at all.  You can’t always trust people; if it can’t be independently verified, it’s not worth anything more than the paper it’s written on.

7Multiple Aliases – You should always be wary of people that have multiple aliases (John, J. Charles, “Charlie”, “J.C.”, etc.). The fact of the matter is that it’s more difficult to identify issues in someones past if they have multiple aliases.

8Secretive – Bernie Madoff was notorious for his secrecy. Secret, confidential, exclusive clubs of investors may sound tempting, but it should be anything but.

9Verifiable through local regulators? – If local regulatory offices can’t verify the existence of the investment scheme, it’s a big cause for concern.

10“Guaranteed” Returns or “No Risk” Investments – The truth is that no investment strategy is truly “no risk.” The more you are guaranteed the more you should examine what you are being guaranteed against.

11Lack of Transparency – The more transparent that you have to be to investors, the more difficult it is to cover up the fraud.

12It Sounds to Good to Be True? – If it sounds too good to be true, it probably is.

13From a different area – It makes sense not to commit another fraud in the community where they got into trouble before. By moving to a new area, a fraudster may be trying to escape some of his past.

14No name accountant or administrator – The reason for having an auditor and third-party administrator is to have professional/non-biased oversight of the firm, but if that auditor or third party administrator is someone that nobody has ever heard of, there is some good reason to do some extra digging around.

15Too Many Questions – Asking a lot of questions can make an investment fraudster uncomfortable, after all, it’s a sign that someone is doing their homework. Every investor has a right to ask as many questions as they want; it’s their money after all.

What do you do?

If you have recognized any of these warning signs, you can trust your gut instinct and run for the hills, or you can hire a professional private investigator who can help get beneath the surface and find information that can help you make a more informed decision.

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September 2011 Update: Samuel “Mouli” Cohen Trial Set

Hiring a professional private investigator to conduct a comprehensive due diligence investigation on Samuel “Mouli” Cohen would have identified multiple “red flags” that could have saved investors millions of dollars.

On August 9, 2010, federal prosecutors in California unsealed a criminal indictment accusing local businessman Samuel “Mouli” Cohen of defrauding over 55 investors, including actor Danny Glover, out of more than $30 million with claims that his company was about to be acquired by Microsoft Corp. On his website, the Israel-born Cohen describes himself as an entrepreneur, “one of the few to have success in biotechnology and high technology,” and he claims to have “generated well over $3 billion in shareholder value.”

According to the indictment, Cohen allegedly lied to investors with claims that his company, Ecast, was about to be acquired by Microsoft and that once the deal was completed, Cohen’s Ecast shares would be exchanged on a 1-for-1 basis for Microsoft shares of stock, which would have netted investors significant gains. According to a related civil lawsuit that Glover and his affiliate Vanguard Public Foundation filed against Cohen last year, Vanguard “has been effectively destroyed” by Cohen’s activities. Cohen was a persuasive salesman who had “all the trappings of success,” according to Peter Rehon, a lawyer in the civil suit.

Does this sound familiar?

Now we cannot live in hindsight, but we can learn from our mistakes and shortcomings. By hiring a investigator with both the knowledge and experience to conduct a comprehensive due diligence investigation on Mr. Cohen, certain “red flags” would have immediately stood-out:

  • Prior Allegations of Fraud – A review of civil litigation filings where Mr. Cohen either resided or worked identified more than 20 lawsuits against him dating back to the 1990’s. They include two lawsuits from 2003 and 2004 which contained fraud allegations against Cohen that are nearly identical to the recently-filed criminal indictment. A more in-depth review of the those litigation filings would have uncovered allegations that Cohen was not the successful entrepreneur with a self-reported net worth of over $40 million and was Ecast not close to finalizing any merger deals or financing agreements with Microsoft.
  • Failed Business Venture – Over the past several years, Cohen has issued numerous press releases and online posts relating to his many ventures claiming that he was “one of few to have success in biotechnology and high technology” which has “generated well over $3 billion in shareholder value.” However, Cohen failed to disclose that just prior to his affiliation with Ecast he was president and CEO of Playnet Technologies which filed for Chapter 11 bankruptcy in June 1998. According to a 1997 SEC filing, Playnet Technologies had $819,894 in revenues for the period of 1990 through July 1997 and a net loss of $170,561 for that same period.
  • Conspicuous Consumption – In August 2002, the San Francisco Chronicle reported that Mouli Cohen had 30 guests at his multi-million dollar Belvedere residence “to celebrate the completion of his new house.” However, subsequent investigation disclosed that Cohen never actually owned this property. The residence had been owned by a Lawrence and Karen Drebes, founders of desktop.com, since the late 1990’s. In addition, Cohen often self-promoted himself via videos on YouTube discussing fine art and philanthropy painting the “trappings of success.” Cohen also posted various photographs of himself on one of his many social networking websites taking pleasure on yachts, ski vacations, and beautiful beaches all while giving projecting an image of vast wealth to potential investors who may decide to “Google him.”
  • $450,000 Owed in Federal Tax Liens – On October 22, 1998 a $150,627 federal tax lien was filed against Cohen in New York and on February 27, 2001 a $313,592 federal tax lien was filed against Cohen in San Francisco. Additionally, the New York State Tax Commission filed a $40,492 judgment against Cohen on December 2, 1999.
  • “Millionaire Residency” Status – Multiple press releases published by Cohen disclosed that he “was awarded the first-ever ‘Millionaire Residency’ with full citizenship status by President George H. Bush.” Unfortunately for Mr. Cohen, as far as we can tell, there is no such thing as a “Millionaire Residency” status. A simple Google search of the term “Millionaire Residency” does identify multiple results, but upon further review, nearly all of them relate to Cohen and his self-promoting.
  • Inconsistencies in Cohen’s Professional History – There are multiple inconsistencies with Cohen’s self-reported employment history on his LinkedIn profile as compared to his reported work history to the SEC. Specifically, his online profile page indicates that he was Chairman and CEO of “Aristo International” from 1980 and 1982, while SEC filings indicate he was affiliated with Aristo International (which later became Playnet Technologies) from 1990 through 1998. In addition, he self-reports that he was Chairman and CEO of “Lamia Enterprises” from 1982 and 1984, while according to SEC Filings he was affiliated with Lamia from 1989 through 1991. While date inconsistencies with a person’s reported employment history may not necessarily be a clear indication of fraud, numerous and significant inconsistencies do raise a red flag and should be grounds for further inquiry.
  • Multiple Aliases – A review of litigation filings and other publicly-available documentation identified multiple aliases for Mr. Cohen over the past 10 years including: Mouli Cohen, Shmuel Cohen, Shmual Cohen, Schmual Cohen, Samuel Cohen and Moli Cohen. Although the multiple name variations are not significant in and of themselves, it raises the possibility of accusations against other aliases, which he could have been looking to hide.

Note that the information reported above was identified exclusively through the examination of publicly-available documentation.  Additional facts may have also been disclosed via interviews with Mr. Cohen’s former business partners, known associates, legal counterparts or possibly even his ex-wife.

What Does This All Mean?

Fraudsters are now adapting to a new culture whereby potential investors are becoming more aware and skeptical of large promises and guaranteed returns. Unfortunately, some of these skeptics are putting on their own fedora hats and trying to conduct their own investigation through Google or one of the many “fly by night” background checking websites to conduct their own due diligence investigation. As demonstrated by the case of Mouli Cohen, millions of dollars in losses could have been prevented had investors consulted a due diligence investigator to help them avoid a “persuasive salesman who had ‘all the trappings of success.’”

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The Securities and Exchange Commission (“SEC”) has recently initiated a program to educate both first-time investors and seasoned professionals on the identification of various red flags of investment fraud to conduct a “do-it-yourself” due diligence investigation. While the SEC outlines several important ways to avoid falling victim to an investment advisor fraud, (e.g. “pump and dump,” pyramid, ponzi scheme or affinity scheme), an experienced due investigator specializing in due diligence investigations is trained to tap into numerous resources to obtain critical facts which often help investors make more “informed” decisions and help you avoid an investment fraud.

In addition to conducting quantitative due diligence on a potential investment advisor/broker/hedge fund manager (i.e. reviewing financial statements, understanding the investment scheme, etc.), here are some additional tips on how to avoid falling victim to an investment-related fraud from a due diligence investigation perspective:

“Googling” is not due diligence

Did you know that by recent estimates, the surface web (a typical “Google” or search engine) accounts for less than 1% of what is actually on the Internet? Consider that the next time you spend an hour “Googling” a particular person or company and come up empty. It is also important to understand that the more successful and more complicated the particular scheme has become, the more likely the fraudster will “bury” any derogatory or damaging information about themselves into the Internet. (See related post, What You Find on the Internet May Not Be True?)

Value your references, but check it out anyway!

Someone who has been referred to you by a respected member of your community should be treated with the same skepticism as anyone else. There has been an explosion of affinity frauds (investment frauds that prey on an identifiable group) over the last few years, including the now infamous Madoff scandal. Former investors, employees and business associates can provide critical details that you may not be able to find anywhere else.

Verify Credentials

It is common for fraudsters to claim numerous memberships to exclusive organizations or relationships with wealthy families. In addition to finding information to support such claims, attempts should also be made to confirm that the broker or advisor really did receive that “ivy league education” or that they are licensed with appropriate regulatory agencies (e.g. FINRA).

Review Litigation

Historical civil complaints filed by current or former investors are oftentimes the first warning sign that trouble has been brewing. Federal and state litigation searches can also identify potential red flags such as divorce petitions, which often provide evidence of stress/tension or information concerning conflicts with former employees, employers, suppliers or business partners.

“Conspicuous Consumption”

A major warning flag for investors is a “showcase” of wealth. Investment fraudsters driven by greed and power, often camouflage the legitimacy of their investments by purchasing luxury homes, automobiles, yachts and one-of-a-kind items (e.g. artwork). In addition, certain fraudsters will make significant contributions to exclusive charities or organizations, often with a big splash or press release attached.

Review Criminal/DMV Records

Would it surprise you that several high profile fraudsters have had criminal records or a history of alcohol abuse, which could have been easily identified during a routine background check? For example, Sam Israel (Bayou Hedge Fund Group), who defrauded over $400 million from loyal investors, had a history of alcohol abuse. While Nicholas Cosmo (Agape World, Inc.), who is awaiting trial on a separate $400 million Ponzi scheme, previously served more than a year in federal prison for stealing client funds.

Confirm Service Providers

Outside accounting firms and fund administrators, who are “independent” third-party providers, provide an important buffer between the investment managers and their victims. But what if these “independent” providers were not so independent after all and were actually aiding in the scheme? Bernie Madoff used a unusually small two-person accounting firm to manage his billion dollar hedge fund while Sam Israel used an accounting firm run by his CFO. Are these arms-length relationships worth knowing bout beforehand?

Conclusion

As the daily headlines reveal more and more fraudulent investment schemes, individuals and businesses should use all of the investigative due diligence resources available today to avoid becoming another statistic tomorrow.

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