If It’s Not One Thing, It’s Another – Auditors Getting Sued Over Madoff

By • Dec 18th, 2008 • Category: BDO, EY, KPMG, Madoff, PricewaterhouseCoopers, SEC, The Case Against The Auditors


The “victims” of the Bernie Madoff scandal are not taking their losses laying down.  Why are so many suits suddenly being brought against the auditors of the funds that invested on behalf of their clients in the Madoff funds?  

It’s not enough that their world view has been shattered. 
 

“A friend recalled this scene from decades ago: The president of a small Orthodox synagogue in New York had apparently absconded with about $2 million from the congregation, a huge sum in those days. But since he had not yet been formally charged or arrested, he was free to attend Shabbat services. Which he did.

Seeing the alleged scoundrel, another man — a Holocaust survivor — rose and faced his fellow congregants, banged on the bimah table and demanded a judgment from the rabbi before the Torah portion was chanted. “In America, if you are willing to work hard, you can earn a living,” the man said angrily. “You don’t have to steal!”

…there is a gnawing temptation to subject Bernard Madoff to such a ceremony, to publicly point the finger on behalf of the family members, friends, rabbis, business partners, communal leaders and untold numbers of ordinary folk whose lives and good causes have been permanently disrupted by his audacious, unfathomable deceit and say: You didn’t have to steal! You didn’t have to steal from us, your people!…

What’s worse is that those who should be the guardians of the public trust and watchdogs for those who can not watch for themselves were, in the words of one source today, “…either complicit, incompetent or duped.” None of these conclusions is very appetizing.

From the Jewish Daily Forward again:

“…Any doubt that the proper regulatory function of the federal government was stripped bare and impotent during the Bush administration should now be laid to rest. Even the chairman of the Securities Exchange Commission had to acknowledge that his agency was shamefully asleep at the wheel. Congress, too, must work swiftly to undo the mess it helped create on its sprint to deregulate too many sectors of the economy that clearly cannot be left to guard their own hen houses.”

Within the last forty eight hours or so, at least four lawsuits have been brought against audit firms by clients of so called “feeder funds” that invested in Madoff funds.

From The Financial Times:

Top accounting firms were hoodwinked by Bernard Madoff’s alleged $50bn fraud as well as several leading banks and some of the world’s biggest hedge fund investors, according to lists of service providers to Madoff-linked funds.

PwC, KPMG and Ernst & Young, three of the “big four” accountants, and an arm of BDO International, the fifth largest, were all auditors of the feeder funds which channelled money into accounts at Mr Madoff’s New York brokerage.

The New York Law School became the first Madoff victim to target an accountant this week when it named BDO Seidman in a lawsuit alongside Ezra Merkin and his Ascot Partners fund, which invested almost all its money with Madoff and was audited by BDO.

PwC was auditor of Fairfield Sentry, the $7.3bn feeder fund run by New York-based Fairfield Greenwich; of Kingate Global, a $2.75bn feeder fund run by London’s FIM Advisors; and of Gibraltar-based Reliance Management’s $488m Defender fund.

KPMG audited two of Tremont Group’s Rye Select funds, which had $2.37bn invested with Mr Madoff. Other Tremont funds also invested with Mr Madoff, giving clients of the the New York-based manager a total exposure of $3.3bn, according to people familiar with the situation.

Ernst & Young audited at least four feeder funds. Two of them with $2.5bn are from Herald Asset Management, linked to Vienna’s Bank Medici, which is part-owned by Unicredit of Italy. The other two funds with $870m are managed by Pioneer Alternative Investments, a Unicredit subsidiary.

Fairfield itself is now considering suing PwC…”



Separately, in a second lawsuit, Scott Berrie, an investor in Gabriel Partners, another investment partnership managed by Merkin, is suing Gabriel and BDO Seidman, the auditor, for alleged securities fraud and negligence.

And from Business Week:     

“…more than 100 people who have contacted a Long Island (N.Y.) law firm that has filed a class-action suit against Madoff’s investment company…

So far, the list includes Carl Shapiro, a 95-year-old former garment industry executive who reportedly had $400 million of his personal wealth invested with Madoff, as well as $145 million from his family foundation; Irwin Kellner, chief economist for MarketWatch and the lead plaintiff in the class action, who invested more than $2 million; and Lawrence Velvel, 69, dean of the Massachusetts School of Law, who told the Associated Press he and a friend may have lost millions of dollars between them in bad Madoff investments.”

Yesterday, Stephen Grendel of Time Inc.com asked the question, “How Culpable Were The Auditors?”

I spoke to him on Thursday and he told me that the lawsuits so far primarily focus on investors in feeder funds that put substantially all or a very large percentage of their assets in Madoff’s funds. Whereas you may not expect an auditor to verify existence or valuation of underlying assets of a fund that was a non-material asset on another fund’s balance sheet, if Madoff’s funds were the whole balance sheet, the entire portfolio of a foundation of a feeder fund, you would expect their auditors would kick the tires harder, go check out the operation, look for the assets and verify the balances in person. This is especially true given the fact that Madoff’s operation was performing all of the roles – investment advisor, brokerage, trade clearing and asset custodian. This is highly unusual.

And so is the fact that a fund of this size would be audited by a three person firm that no one else had ever heard of.

Despite these obvious warning signs, ones that were enough to turn a few others off, including Société Générale who blacklisted Madoff’s funds,  the Center for Audit Quality, the audit industry lobbying group, says the auditors did everything they are supposed to do.

Cindy Fornelli, executive director of the Center for Audit Quality, which is a Washington-based public-policy organization that represents public-company auditors, contends that all the Madoff case amounts to is a lack of sufficient regulation, not a failure of the accounting profession. “It is not the responsibility of the accountant for a capital-management firm to audit the underlying investments of the firms it invests in,” says Fornelli. “The auditor is not in a position to test the existence of the underlying securities — especially in a fund-of-funds situation.”

Looks like some are already setting up the auditors to use the “I was duped” defense. Probably not a bad idea since being judged complicit or incompetent is not very appealing

And now we find that the hinky-dink firm that was Madoff’s auditor has never submitted to a peer review, even though it is enrolled in the AICPA’s program and it’s only active accountant is a past president of his county’s chapter of the New York State Society of CPAs.

Friehling & Horowitz, is now also being investigated by the American Institute of Certified Public Accountants, the prestigious body that sets U.S. auditing standards for private companies.

The problem: The auditing firm has been telling the AICPA for 15 years that it doesn’t conduct audits. Friehling & Horowitz is enrolled in the [peer review] program but hasn’t submitted to a review since 1993, says AICPA spokesman Bill Roberts. That’s because the firm has been informing the AICPA — every year, in writing — for 15 years that it doesn’t perform audits…

Meanwhile, Friehling & Horowitz has reportedly done just that for Madoff. For example, the firm’s name and signature appears on the “statement of financial condition” for Madoff Securities dated Oct. 31, 2006. “The plain fact is that this group hasn’t submitted for peer review and appears to have done an audit,” Roberts says. AICPA has now launched an “ethics investigation,” he says.

The latest news from The Financial Times, just when you thought it could not get any worse, any uglier… 

It appears that the auditors missed a whole boatload of irresponsible lending by some very large banks. They skipped the step of verifying assets on the books of these large banks, loans made to the feeder funds so they could triple or quadruple their investments in the Madoff funds.  There was no review by the auditors of the underlying assets, the securities supposedly in the Madoff funds which were the collateral for the loans.     

“Leading banks from Britain, France and Japan helped investors treble or quadruple bets on Bernard Madoff by lending billions of dollars to “feeder” funds, which placed their money with the alleged fraudster.

HSBC, Royal Bank of Scotland, Nomura and BNP Paribas lent the money without spotting a fraud, and in at least one case without due diligence teams visiting Mr Madoff’s brokerage, which held the assets.  Banks including Nomura and Spain’s BBVA also helped create special “notes”, structured products that allowed small investors or those barred from investing in offshore vehicles to put as little as $50,000 into Madoff feeder funds….

Bankers said they had done everything they could, including checking the auditor and regulatory reports, and could not have been expected to spot a fraud.

“The lending bank clearly looks at all the data available, looks at the audited material, what the regulators have said, does a site visit to the fund of funds [feeder fund]: they go through everything,” said one bank facing a big potential loss…”


Another are of potential liability for the auditors will develop if it turns out that any Big 4 or next tier firms were hired by feeder funds or banks to do due diligence on Madoff.  Where are those due diligence reports? If these reports do not exist or end up being the sham that it appears the end result implies, then more plaintiff’s claims of complicity, incompetence or “duped-ness” of the auditors are inevitable.

It may turn out that the auditors will experience the latest and perhaps largest, most effective litigation tsunami, not because of the subprime/credit/failure of the capitalist system crisis, but as a result of a scandal hiding in plain sight, hitting them with no warning because the match was put to the rubbish by the fraudster himself.  
Mr. Madoff, it appears, intentionally exuded the message that he deserved trust. He redeemed funds in a timely manner, gave generously to charity and had his family in the “fund.” Those behaviors would have literally injected (the psychological term is induced), beliefs and confidence into the psyche of anyone he dealt with. With that emotional architecture in play, traditional objective decision processes never had a chance.

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15 Responses »

  1. “It is not the responsibility of the accountant for a capital-management firm to audit the underlying investments of the firms it invests in,” says Fornelli.

    Sounds like what PriceWaterhouse was saying back in the 1930’s about the classic McKesson Co. fraud: “auditors can’t be expected to determine the actual existence” of inventories. According to the SEC report on that fraud, when a major portion of business is carried on completely offstage by agents unknown to the auditors, “the reliability of these agents must be established by completely independent methods.” What’s the point of having audits if they can’t spot a $50,000,000,000 swindle?

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  3. “It is not the responsibility of the accountant for a capital-management firm to audit the underlying investments of the firms it invests in,” says Fornelli.

    Actually, that’s generally true Francine. Auditors don’t do that. They typically have confirmations sent out. Most of these cases don’t have a leg to stand on. Now, if these funds of funds invested primarily in Madoff, then I would expect more work to be done.

    You would probably check the audit firm for competence and objectivity. That’s where you would get your warning flag. You would find a three person shop located in a strip mall auditing a multi-billion dollar hedge fund.

    My point, these suits only have a chance if Madoff was a significant part of the investment mix. Otherwise, they are dead in the water.

  4. What a great day for Deloitte… dodging a bullet.

  5. The issues here isn’t that the fund should have had the procedures to do due diligence and the auditors of these funds should have evaluated these procedures as part of the audit. So it’s not so much that the auditors should have uncovered the Ponzi Scheme (other than that guy in New City), but they should have scrutinized the procedures and seen that there may have been risks that warranted disclosure. Other than that, I just don’t see the liability but we will see what happens.

  6. “It is not the responsibility of the accountant for a capital-management firm to audit the underlying investments of the firms it invests in,” says Fornelli. “The auditor is not in a position to test the existence of the underlying securities — especially in a fund-of-fund. s situation.”

    Misleading analogy! Some years ago we had an audit client that invested with a small investment advisor. Our client was invested allegedly 100% invested in FDIC insured CD’s. We had concerns with the size of the investment advisor company so we arranged to confirm the existence, ownership and terms of the CD assets directly with the custodian (a large regional financial institution). It turned out that the custodian didn’t have all the assets that the investment advisor claimed were held. Fortunately, custodian made the client whole.

    Madoff was both the advisor and custodian which (a highly unusual situation). Auditors usually have an obligation to at least consider the financial wherewithal of custodians in this situation. The investors’ audit firms should have at least requested copies of the audit report for Madoff’s company(wonder how many of the investors’ audit firms requested that?) A quick examination of the report and a few telephone calls would have identified the small size and scale of Madoff’s auditor. A followup call to the AICPA to confirm the peer review status of Madoff’s auditor would have quickly uncovered that firm’s true status.

    Fornelli’s statement is misleading in that whether the auditors were or were not responsible to audit the underlying investments is not relevant. Rather, based upon these facts the investors’ auditors should have done something to satisfy themselves as to the viability of the custodian(Uncle Bernie’s Pancake Investment Shop). It will be interesting to hear them tell us exactly what procedures they did perform.

  7. This was a failure on so many levels and I think the banks especially are trying to shift some of the blame for their complacency:

    “Bankers said they had done everything they could, including checking the auditor and regulatory reports, and could not have been expected to spot a fraud.”

    There was a funny comment on NPR this weekend about he surprise of many Madoff investors that they were ripped off when they had thought he was only ripping off other people. I think that many people probably expected something was going on, but hoped that they weren’t the “bigger loser” in the pyramid.

    In terms of the accountants specifically, I think that at least part of it has been the lower standards of regulation. Many clients, especially in good times, would probably complain about the cost of extra audit procedures that might have uncovered something and without a regulatory requirement and in a competitive audit environment the firms may have been hard pressed to argue that such procedures were called for.

  8. Little CPA firm. So what? Which firms audit: Freddie, Fannie, AIG, Citigroup, Goldman, Lehman, Bear, Wachovia, Countrywide, etc.? Three-person shops? Do you think KPMG’s Citigroup audit is worth the paper it is printed on? Who is kidding who? I agree with Been There, at the very least, the custodian should have been contacted. Until more facts emerge, I am agnostic on the large CPA firms liability here. But, if the facts emerge as I expect, let ‘em pay through the nose.

  9. Help me understand, please. I am a CPA disgusted by this scandal.

    Isn’t it true that Mr Madoff wasn’t even registered as an investment advisor until 2006? How does that happen? Why didn’t that cause auditors at the lower tier to ask questions? What CPA works on an audit like this and does ask questions about the reasonable probability of generating these kinds of returns? Have we lost any ability to set aside a checklist and ask a REAL question?

    When I audit a balance sheet and the investment accounts are material to that statement don’t I have an obligation to make sure that I send out a confirmation of the account AND to make sure that the confirmation I receive back is worth something? Even where an account is held by a national bank we still verify that the confirmation has some relationship to the bank statement issued on that date.

    What Mr Madoff did was analogous to the diligent employee who refuses to take a vacation. He controlled every aspect of the investment transactions and all of the reporting related to them. This sounds like a concentration of risk issue. Further, Mr Madoff trying to skip registering in order to remain outside SEC scrutiny is another audit flag. Finally, when some investors tried to bring accountants in to perform due diligence and were denied access that is a huge flag. All of these issues should have been considered by the auditor as a reflection of management of the lower tier investor.

    Large CPA firms don’t necessarily do a better job. They have more resources, but I have seen abysmal work that passes their review process come to my desk.

  10. Been there, you wrote:

    “We had concerns with the size of the investment advisor company so we arranged to confirm the existence, ownership and terms of the CD assets directly with the custodian (a large regional financial institution).”

    What were your procedures for this? I imagine when you are in the fraud realm, standard audit procedures don’t apply. Forged documents would probably be provided.

    I stand by my original statement. The Maddoff investment would have to be pretty big for me to go real in depth.

  11. @ Chicago

    “What were your procedures for this? I imagine when you are in the fraud realm, standard audit procedures don’t apply. Forged documents would probably be provided.”

    I agree. In our case we went one level beyond the small investment advisor and confirmed information with the custodian, a publicly traded financial institution subject to an independent audit. The relative size of the investment advisor to the institution was tiny so the chances of the advisor’s ability to influence the custodian were minimal. The few million dollars invested was large relative to our client but was miniscule relative to the balance sheet of the custodian institution. The additional steps taken weren’t complicated, didn’t take much additional time but would theoretically provide us with a high degree of comfort about the reliability of the response. Ultimately, it also alerted the institution to improprieties taking place involving customers in its trust department.

    In the Madoff situation, since he was both advisor and custodian, my sense is that we would have attempted to do something more formal to confirm the credibility of his firm. This could have included such things as getting a copy of his audited financial statements, which would have led to further questions and concerns. IMHO it’s the same logic (if not the same rules) that underlie the reasoning for requesting copies of SAS 70 reports.

    Then, if we’d gotten the same canned responses from Madoff’s firm as he gave most everyone else, I’d like to think that we would have disclosed the situation in the financials and formally recommended that the client terminate the investment relationship and move its funds elsewhere.

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