A Market Premium for Fraud
February 09, 06In the aftermath of the “Certifigate” certification scandal, in which bribes secured “upgraded” grading reports, diamond merchants specializing in larger goods have gradually become aware of the continued presence of quite a number of mostly, or almost exclusively, large diamonds in the market which may still have questionable – or possibly fraudulent -- certification. In efficient markets information travels with the speed of light and market forces set the price and terms-of-trade of all products, including the “price” for diamonds which may have a deficient diamond grading report. In certain instances, these diamonds demand a discount; in others, they are getting premiums. The situation is rather unprecedented – as is the market response.
Let’s first stress the good news: in the market for large diamonds (polished of diamonds above 5 carats) stones with GIA certificates issued after June 2005 are unequivocally accepted as “being o.k.” – doubts only center on certificates which are older, especially those which were issued in the 2000-2005 period. The faith of the market in recently issued certificates underscores the market belief that no new fraudulent certificates are entering the market; that the bribery problem has been solved – or, to say it in a more cautious manner - that it doesn’t seem to be happening now. (Whether this is “temporary” or “lasting” depends on the success of the ongoing investigations and/or reorganization at the GIA.) In any event, newly issued GIA reports are trusted.
Before “Certifigate”, most serious players in the markets of the large goods would implicitly trust their GIA grading reports. Now virtually all buyers are using in-house gemologists and are getting a “second opinion” on the accuracy of the reports. Many companies have also reviewed the older goods in their inventories. This has given rise to the discovery of a quite a large number of possibly deficient certificates. One major European dealer in large polished goods estimates that there still may be between $0.5 - $1.0 billion worth of suspicious certificates in the hands of the dealers today.
It is quite amazing – and even encouraging – that the diamond market is sufficiently sophisticated and mature to have quickly developed ways to “deal” with those problematic goods in the market and we expect that within the next half a year or so, there will be no such “upgraded” stones in the market. The overriding shared self-interest of virtually all players (of both the bribers and their victims) to minimize their own financial and reputational damage (and to ensure continued consumer confidence in our products) are dictating their market behavior. It is possible to identify certain “rules of behavior” by which this market operates – and we, with the greatest caution, want to report on what we have observed and learned recently in the
Detection, Trading and Indicators of Suspicion
(1) In the last few weeks we were alerted to a number of instances in which a potential buyer conditioned deals on getting an updated GIA certificate. If everything is bona fide, the seller doesn’t object. The alarm bell rings when the seller seems to be reluctant to agree to a recertification. The potential buyer knows that there may be a problem. He simply doesn’t complete the deal.
(2) There have been instances involving some large trading companies, in which the potential buyers of individual stones (or of a substantial assortment) insisted that they should be allowed to submit the goods for certification, rather than rely on a submission by the seller. There have been instances reported in which the seller refused to allow the potential buyer to make the submission to the GIA. This has become a deal-breaker. [This underscores that the market “knows” something that we don’t know yet – and the GIA should continue to review the submission procedures.]
(3) We must be very careful not to attribute every instance of “upgrading” to fraud. We must stress the subjectivity of the grading process, the borderline cases, etc. But it goes far beyond that. On the other hand, the market (rightly or wrongly) now understands much better some of the inexplicable phenomena that the market faced in recent years.
For example, a substantial number of “suspect” certificates are dated 2002-
(4) Polished dealers explained to me last week that in the aforementioned period, a few dealers with stocks of large certified goods would slightly repolish their stones (reducing the weight, for example, from 10.10 carats to 10.02 carats) and submit the goods invariably getting at least one higher color and quality grades. The avalanche of upgrades in the market was so significant at the time that it impacted market prices. [I was told at the time of concerns on market impact when “upgrading” would turn into “downgrading”.] Even today, it is unclear why there were so many “upgrades” awarded at that time – and it is unlikely that fraud and bribery were the reason. Today, some traders might jump to the wrong conclusion when looking at these certificates. Having said this, the GIA may well be advised to look again at what exactly happened in that period. [A tip: Look at SI-1’s…]
One thing I remember for a fact: DTC executives attributed the huge volume of upgrades of the GIA certificates as being partly responsible for the high market premiums on the DTC’s rough diamond boxes. This underscores the centrality of the grading consistency and integrity not only on polished market prices, but also on rough diamond prices.
(5) “Suspicion” is an elusive concept. It is clearly subjective at heart and is personal to the individual who may form the suspicion. A dealer discovering suspected certificates in his stock is advised to first put the stone in the market to see reactions. [In this manner, for example, a Swiss dealer holding a D-IF certificate on a 10 carater has discovered that the market would not give him more than $40,000 per carat for a stone that should be trading for well over $50,000 per carat. So he knows he has a problem.] The way this type of problem is being solved is by going back to the supplier. Every single large stone in the market has a father. There is always someone to go back to.
(6) We know of at least a few isolated instances where the dealer holding a suspect certification said to his supplier: “There are two choices: either I am submitting the stones you sold to me recertified or you buy them back from me for at least a 10% premium.” It has now been confirmed to us that some suppliers of stones with suspect certificates are willing to purchase their goods at a premium!
I want to be very careful: an agreement to buy back a stone with a bad certificate doesn’t necessarily mean that the supplier intentionally perpetrated any fraud. He may himself have purchased the stone in the market – and may well refer back to his supplier. There is also a possibility that a genuine grading mistake was made. It does show, however, that such a supplier is sufficiently conscious about his name and reputation and that he feels responsibility for the delivery of a defective product. So an agreement by a supplier to buy back such diamonds and pay a premium doesn’t necessarily mean what it may appear to mean. But, again, the possibility cannot be excluded – and the earlier mentioned 2003 “upgrading” phenomenon was mentioned to stress the possibility of alternative causes.
(7) Suppliers who willfully sold an upgraded stone are most likely to agree to a repurchase. If malfeasance is involved, this will come out in the recertification process. What is likely to happen is that through these buybacks eventually those who did act fraudulently are paying the price and are forfeiting the fruits of their fraud.
There are a number of problematic goods presently being traded and we know of an 80 carater, a 43 carater and a 10 carater. There are many, many more. One might argue whether 10% is the correct compensation for the damage incurred. The answer is yes. When one purchases a 40 carater costing several millions of dollars this is normally done with a credit of 90 days. This gives the buyer a chance to resell the stone. However, if a deficient certificate is involved in such a sale, the buyer will not be able to sell the diamond quickly. While holding the stone, he faces a loss of liquidity, he may have to forgo other purchases, and yes, he does suffer. If a holder of a problematic (suspect) certificate can resell the stone at a premium to his supplier, and if fraud was involved, the supplier escapes justice – and that is in itself regrettable – but the innocent and duped buyer succeeded at least to reduce his damage.
(8) Dealers must develop their own “due diligence” and “Know Your Client” (KYC) scorecard in respect to suppliers of large goods. A few Antwerp diamantaires told us that there are polished suppliers who will not show their large goods to other diamantaires and only sell to consumers, or to people outside the mainstay of the business (such as “new money” individuals in Russia, Dubai, etc.) Though it may simply represent a downstream strategy, some cautioned that this behavior warrants enhanced due diligence. Likewise: if there are manufacturers who consistently hugely overpay for certain rough stones, one should wonder how such company can afford to do so.
(9) A few dealers claimed that auction houses represent a convenient venue to sell large stones with “problematic certification”, as auction houses do not conduct their own independent examinations. We asked the prominent auction houses for comments, though only Sotheby’s was kind enough to reply. In response to our question whether Sotheby’s accepts the information on the certificates, Sandie C. Maylor of the auction house’s
One might take issue with the contention that auction houses are “convenient”, as the buyer doesn’t know the seller. This suggestion is probably unfair. Says Sotheby’s “Auction houses are of course very public places, and our jewelry and stones are thoroughly scrutinized by dealers, private buyers and most importantly diamond professionals who carefully inspect every stone over the several days of exhibitions, as are our catalogues, so fraudulent documentation is not something we frequently see, given the very public nature of our business.”
(10) Any fraudulently upgraded stone resubmitted to the GIA for recertification will likely be identified in the regrading process. And if the stone was a borderline case, it is likely to get the same grade automatically. It is expected that those who are “buying back” large diamonds will slightly repolish and submit the diamonds – getting the grade the stones deserve.
Admittedly, this market behavior may ensure the solving of the problem, minimizing the damage and, at the end of the day, the perpetrators of the fraud escape their day in court. As much as I regret this, there is so much at stake that pragmatism may well have to prevail over justice. Hundreds of millions of dollars have been earned fraudulently. If a large part of the illegal earnings are de facto given back to those who were defrauded this still may be the preferred solution.
(11) The GIA’s grading standards may change over time. Sotheby’s has a sound policy, which deserves to be emulated. “It is our general policy to update the gemological reports on flawless and internally flawless diamonds whose reports are five or more years old,” notes Sotheby’s Sandie Maylor. She further elaborates that it is their “usual policy also to update the reports on colored diamonds that were issued prior to 1996 due to the changes in GIA's colored diamond grading system.”
(12) Is there a “compelling commercial aspect” which might explain why people have been willing to criminalize themselves to turn F colors into D or VVS1 into Flawless? We hate to think that there is anything else beyond simply greed. A dealer noted that consumers who are willing to spend a few millions for a stone want to buy the best. They want to have an F or an IF quality. They wouldn’t buy a stone if it had a lower clarity grade. This is reflected in the market price of the really large goods. Their value drops significantly and sometimes even to half when the clarity or color grades drop. A lot of money is at stake.
What about the Consumers?
This leaves of course the problem of deficient certificates in the hands of unsuspecting consumers. Here the GIA has an obligation to work together with the dealers to find a solution. No consumer has come forward yet. And maybe no one will. But if the dealers and the GIA work together this should be manageable. GIA’s executive chairman
The management of the GIA must, in this respect, think of the unthinkable – and then prepare for it to happen.
Why didn’t we see the willingness by suppliers to repurchase their stones eight months ago when the problem began? Part of the answer lies in the actions of the rough producers. De Beers, BHP Billiton, Rio Tinto and others have made it abundantly clear that they will not tolerate or condone having fraudsters among their clients. A threat to lose one’s sight is now seen as credible, realistic and serious. We still expect that the DTC will take concrete steps (and some people have been warned); we know that BHP Billiton has already taken some action.
It is also because of that specific threat that suppliers are willing to pay a premium in buying back the stones.
Nothing in this article suggests that the scandal is over. I have reason to believe that it has now – rather belatedly -- dawned upon the GIA that the fraudulent upgrading phenomenon has taken place for about a decade and has involved more dealers than may have been thought so far. Those at the GIA who were in a state of “denial” are now facing up to reality. The GIA probably now recognizes that its internal investigation wasn’t as effective as they initially believed it would be.
Though it announced in October that the investigation has been completed, we would urge the GIA to continue in its efforts to get to the bottom – for once and for all. With the cloud of the lawsuit being removed, it is easier for the GIA to address the other issues. I have reason to believe there will be more changes at the Board and Management levels and I also expect that more attention and clarity will be given to the grading system to remove problematic areas. There is, as yet, no complete clarity (no pun intended) on how the Certifigate scenario will eventually play out. The issues are complicated. But as the GIA and the market are having a greater grasp of how Certifigate has evolved – and it sees that the market knows how to respond – it is certainly well positioned to continue to take the steps, which are required.
But this counts for the trade as well. Do your due diligence! A frequent question posed to me is “why do you concentrate on the GIA? Where are your stories on those labs who will give retailers even empty certificates? Where are your stories on appraisals who don’t know prices?” My answer is unequivocal: the GIA is the world’s standards. As this article illustrates again, its behavior can impact the prices in the market. The fraud profoundly affected the rough market as well. The diamond and jewelry business needs an honest, reliable and respected GIA. That’s why it so important that the issues are faced, addressed and get over with. With due respect to other labs, there is no doubt that the GIA is first among equals and above many others. We’ll continue to follow the developments at the GIA very closely.
Allow me one footnote:
Have a nice weekend.