Trust in the business world has taken a beating. Not quite a year since Bernard Madoff's sentencing to 150 years in prison, the role of trust in the marketplace has changed -- perhaps for the better. Investigation and prosecution arising from Madoff's fraud continue, and new regulations and enforcement powers have been proposed to improve protection for the marketplace. Yet laws alone cannot ensure a consistent level of ethical behavior among all or most participants, and the marketplace understands this. Investors are focusing on the following precautions in their investment habits and practices and devoting significantly more time and resources to them.

Due diligence and investigation. Investors are remembering that they have the right to conduct due diligence on prospective investments using best practices. Best practices due diligence should be both qualitative and quantitative. Qualitative diligence includes interviewing managers or executives, conducting background checks on key personnel, evaluating business practices and operations, and similar steps to assess the quality of operations. Individual investors with limited resources can work with a qualified adviser, business and/or legal, who can explain the due diligence practices it uses to evaluate investment opportunities. Investors can seek more guidance at the Securities and Exchange Commission's Web site, particularly in the investor education section.

Independence. Ideally, top-level management or decision-making positions should be held by independent and unrelated persons. This will support oversight of management activities, reduce likelihood of conflicts of interests and ensure maintenance of ethical standards. Independence is a factor in ensuring there is effective internal control and corporate governance. Key positions at Madoff's firm (for example, chief compliance officer, administrator and head trader) were held by immediate family members. This calls into question the independence of those functions. Lack of independence can also take other forms as described below.

Quality service providers. The quality of service providers to a potential investment can also be a red flag. If the service provider of an investment opportunity is not well known, it should be a subject of due diligence by any investor. Being unknown does not mean it is untrustworthy or less than competent. It only merits homework. The outside auditor of the Madoff firm was not known and was comprised of three employees, only one of whom was an active accountant. It is a near impossible task for an accounting firm of that size to service Madoff's business adequately. If it could, it could only do so by sacrificing other clients and being beholden only to one client. Such an arrangement calls into question the independence of the auditor. If you do not recognize the auditor, law firm or investment bank supporting the business, then you should feel free to question the investment opportunity about them, check with other resources regarding such firms and also speak with the firms directly.

Diversification. It seems obvious. One of the fundamental rules of investing is diversification. However and unfortunately, numerous investors forgot this principle and were hurt last year, particularly with Madoff. There are three important takeaways here. There is significant risk in failing to diversify investments. Potential investors must ask questions of the managers or executives to understand the use of the funds. Investors must monitor their investments to ensure that funds are in fact continuing to be diversified or that the use of funds is consistently being executed.

Transparency. How transparent is the investment? Executives or founders of companies or managers of funds should be transparent with their investors. Investors should regard it as a red flag where managers or executives are running their business in a "black box" where the investors cannot find out exactly what the managers or executives are doing. Madoff was known in the industry as being unwilling to answer questions of potential investors. Basic transparency such as regular reports are reasonable conditions to your decision to invest.

In addition to the qualitative and quantitative precautions investors can take in the marketplace, there are other factors equally important to consider. On the other side of the trust coin are the factors that should not be foundations for trust. Successful marketplaces require a level of ethical behavior among the participants, and breaches of ethics diminish trust in the marketplace. Investors often let features or attributes serve as surrogates for ethics and trust despite the presence of red flags. Even the most sophisticated investors put their faith in Madoff despite many apparent warning signs like those mentioned above to do otherwise. The following are examples of influences that are neither qualitative nor quantitative, which work together to lead investors to trust, according to professors Maurice E. Schweitzer and G. Richard Shell in an interview with Knowledge@Wharton, "The Bernard Madoff Case: Trust Takes Another Blow."

Social endorsement. Investment opportunities may point to well-known figures who participate in investments. Many celebrities and famous figures such as Steven Spielberg, Jeffrey Katzenberg and Fred Wilpon (part owner of the New York Mets) invested with Madoff. Prominent or high-profile persons involved in a business often give some investors a sense of comfort or basis for trust. How often have we heard investment opportunities mention what other high-profile persons invested? Yet, what relevance is this? There are no assurances on the level of evaluation and care they exercised when making their investment. The investment decisions of others, however prominent or famous they may be, cannot be a substitute for first-hand diligence and your own evaluation of the investment opportunity.

Influence. Businesses or investment opportunities may tout executive officers, board members or advisory board members who are authorities in the given industry. Such persons may have worked with past companies or organizations with great success or fame. This was the case with Madoff, who served as chair of Nasdaq OMX Group Inc. and other organizations and had an air of authority. Authority figures can exercise a significant amount of influence over us. While the involvement of such people can be relevant, it should not distract from evaluating the actual company or investment product.

Dearth. Businesses may present an aura of scarcity regarding an investment opportunity. "We'll get you into the investment round if we can." "I will keep you in mind if we have room." "We are oversubscribed and closing soon." This can be an effective marketing approach and was the primary technique of Madoff. How often have we heard this approach? It creates the influence or effect on a potential investor of receiving a favor by allowing him or her to invest. Investors should not be motivated to trust and invest by what they were told they could not have or be part of.

Appeal. Many of us make contacts through networking and introductions through others socially, whether through clubs or charitable events. Madoff met many investors through his philanthropic work and through country clubs and was apparently an extremely pleasant person whose company others enjoyed. It is reasonable to presume credibility of an appealing business contact you meet at a philanthropic event or exclusive club, but it should not be a reason to trust.

The desire to believe. Investors want to believe. They want to believe that they can earn excellent returns on a regular basis. Consequently, investors are willing to suspend disbelief and create the reasoning to support the decision to invest. When this factor works together along with the other factors described, the result can be very effective.

The precautions above are not warnings against trust or taking risks. Human relationships and social systems cannot operate without trust, and business relationships and financial systems are no exceptions to this. There are qualitative and quantitative measures to use that are reasonable bases for beginning to establish trust. Using such measures will likely mean more time and some additional cost as part of making any investment decision. The nonqualitative and nonquantitative factors such as influence and social endorsement can be relevant but should be recognized as predominantly socially or emotionally based and therefore not a substantive contributor to the analysis. n

Alisa Won is a corporate partner in Winston & Strawn LLP's San Francisco office who focuses her practice in the corporate securities area.