re: The Auditors » Madoff

Madoff, MLK, Buddha And Elusive Nature of Self-Interest

Francine — Mon, 16 Jan 2012 08:37:00 +0000

A repost of one of my favorite – and one of my most read – posts in honor of Martin Luther King Day. It was originally published December 24, 2008.

Back home after dropping off my friend at the airport. As those of you who have been following me on Twitter know, I’ve spent the last few days visiting with an old friend from my JP Morgan Latin America days. Kenny recently came out of almost five years of semi-reclusive Buddhist retreat. We hadn’t seen each other during that time, but had been in touch each time he was home in Brooklyn for the holidays or between sessions at the retreat in Northern California.

We worked together in Latin America, primarily Brazil, during the Year 2000 project period. I was JPM’s PMO Director for the project in Latin America. He was implementing a new order entry and trade management/compliance system for their equity options and derivatives business. As calm and serene as he has learned to be when faced with crowds, traffic, schedule changes and chatty friends like me, he is also still human. And he is still my old friend with enormous knowledge of how and why controls and regulations are intended to safeguard investors in financial services industry.

It didn’t take much to get him to talk about the Madoff scandal, the financial crisis, the Big 4 firms, the SEC, and the major players on Wall Street. As much as things should have changed in the seven years since he was actively working in the industry, unfortunately according to him, most things have not. He was up to speed, even more than me in some areas, since he has been catching up the last few weeks by subjecting himself to a heavy daily dose of MSNBC, CNBC and BloombergTV.

I sought his advice on some topics and ideas for posts, but he continuously pulled me back to the human element, the psychology of the issues we discussed.

Why would Madoff do it?

How did he get away with it?

Why do regulators not regulate?

Could the auditors have caught it?

What is the nature of evil and its manifestations such as greed, hubris, unbridled self-interest, lying and cheating even those in your own community, denial of responsibility, unjust blame, and refusal to take action in the face of illegal or immoral acts?

Heady stuff. Fortunately he has not given up drinking or laughing so the heaviness was lightened with caipiroskas, pinot noir, Negra Modelos, and cuba libres.

One of the topics we kept coming back to is the responsibility of “professionals,” those who are licensed and mandated by their states to uphold a code of ethics and professional responsibility that demands action beyond that which does or doesn’t profit one personally. Your first obligation as a professional is to your client, not your firm, your partners, or even your family. If your client is doing something illegal then it is to law enforcement. That may seem harsh, but it’s the code that’s supposed to insure that lawyers and accountants, for example don’t cut corners out of their own self-interest and to the detriment of their client’s interests.

From the AICPA’s Section 50 – Principles of Professional Conduct:

“By accepting membership, a certified public accountant assumes an obligation of self-discipline above and beyond the requirements of laws and regulations.

The Principles call for an unswerving commitment to honorable behavior, even at the sacrifice of personal advantage.

A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession’s public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on certified public accountants…In return for the faith that the public reposes in them, members should seek continually to demonstrate their dedication to professional excellence.

Due care requires a member to discharge professional responsibilities with competence and diligence. It imposes the obligation to perform professional services to the best of a member’s ability with concern for the best interest of those for whom the services are performed and consistent with the profession’s responsibility to the public.”

Too much regulation? Too little regulation? The problem is enforcement? Inadequate budgets? Lazy Boards of Directors? Overzealous plaintiff’s bar? Conflicts of interest? Bush? Democrats in US Congress? Greed? Satan?

Martin Luther King Jr.: “Morality cannot be legislated, but behavior can be regulated. Judicial decrees may not change the heart, but they can restrain the heartless.”

Regulate the immoral. Restrain the heartless.

It’s hard for an external auditor to step up and do the right thing. As I have written in so many other places in this blog, the model of providing this critical public service meant to protect shareholders (the purpose of the audit report) via a profit making private partnership often encourages “behavior that must be regulated” (as the PCAOB was charged to do after Sarbanes-Oxley.)

Many, even the young professionals writing me in earnest for advice, have either never learned or have suppressed the nature of the true auditor-client relationship. The client for audited financial statements is the shareholder, not the company management. The Audit Committee of the Board of Directors, who hires and is supposed to manage the external auditor, represents that shareholder client. Other beneficiaries include bondholders, lenders, employees, vendors/customers who depend on the continued viability of the company, and regulators (whose role is to protect investors and overall capitalist system.)

When they forget or suppress acknowledgement of the true client, an auditor loses the ability to properly structure decisions with moral and ethical implications, let alone those with serious legal and regulatory ones. In the face of potential legal implications of a decision, they seek advice from their own counsel in order to avoid liability. In the face of a moral or ethical dilemma, they look at costs/benefits of looking out for the shareholder versus looking out for their own financial self-interest, at an individual and at a firm level.

Adam Smith Philosopher, 1723-1790:

Man naturally desires, not only to be loved, but to be lovely; or to be that thing which is the natural and proper object of love. He naturally dreads, not only to be hated, but to be hateful; or to be that thing which is the natural and proper object of hatred. He desires, not only praise, but praiseworthiness; or to be that thing which, though it should be praised by nobody, is, however, the natural and proper object of praise. He dreads, not only blame, but blame-worthiness; or to be that thing which, though it should be blamed by nobody, is, however, the natural and proper object of blame.

Human beings, however noble, virtuous and full of integrity in words often fall short in action. We only have to look at the cases of whistleblowers I’ve written about and a new one, Gary Aguirre of the SEC, to see how hard it is to step up. Whistleblowers and those that push unpopular ideas or try to report on wrongdoing often lose their jobs, are vilified by the former employers and sometimes their former colleagues, are often disbelieved and laughed at, attributed with bad attributes and intentions such as revenge, anger, payback, whining, mercenary goals, bitterness, spite, Don Quixote-like tilting at windmills, unreasonable idealism, and impractical expectations.

They are often very right, but often end up being right all alone.

How many times has an external or internal auditor been told when raising concerns or questions about lack of segregation of duties, improper expense reports, lack of proper authorizations for stock options or shady compensation decisions:

“He’s a man of integrity. He lives this company. He is a pillar of the community. He donates to charity. He is an elder statesman of the industry. He has unquestionable, unassailable ethics and cares about this company.”

And maybe they are also told, “How dare you suggest that he would ever do anything to harm his employees, shareholders, business partners…”

Faced with the challenge of questioning someone who everyone else thinks is an icon and may not be, most people back down, question themselves, wonder if they’ve read, seen, or heard what they thought they had. Pressured by the cost of moving forward with potentially imperfect evidence, or with an accusation that shakes the foundations of belief and trust, most “professionals” trust their boss, the lawyers, the advisors, and drop it. Add more pressure over accusations that potentially threaten a lucrative business relationship, a big deal, or an important hire, speaking up is often a career limiting move, threatening your own livelihood.

But auditors, who are inevitably almost always CPAs also, have a higher responsibility. Making the type two error of being right in your suspicions of illegal activity and potentially enormous harm or loss and not acting on them is completely unacceptable. US Attorney Patrick Fitzgerald explained his decision to bring corruption charges against Illinois Governor Blagojevich before all “the t’s were crossed and i’s were dotted” this way:

“…But I was not going to wait until March or April or May to get it all nice and tidy and then bring charges and then say, “By the way, all this bad stuff happened because no one was aware of it back in December.” I think that would be irresponsible. (Cross talk.)

So sometimes, when there’s ongoing criminal conduct — and this is a very different case than what we often see — we will expose the criminal conduct and bring charges to let people know we’re on to it, and to hopefully — to put a stop to it…“

Don’t let anyone ever tell you again, after Madoff and the rest of the cases of hubris we have seen during this ignominious year, that any man or woman is above suspicion. When you’re told, “He’s an icon,” as an auditor you should look even harder, be professionally skeptical, trust your own instincts and judgment as long as they have been educated and are competent and objective. Push hard for truth and justice.

As the guardians, the watchers, those entrusted by the investors with seeing and speaking up when they can not do so themselves, if you don’t do so then history is bound to continue repeating itself.

From The Guardian:

“So how did these exceptionally smart people forget their habits of due diligence? One answer lies in the curious respect Americans have for their leaders, which is something rarely appreciated in Europe. Anyone who reaches the top of the pile in the United States, whether in the law, broadcasting, investment management, business, the church or sport is given unwavering respect.

Their employees and supporters faithfully cluster round and offer up what seems to the European eye to be blind fealty. Pastor or president, you become the Man, at which point followers begin to suspend all judgment. Madoff was the Man and potential clients had to be damn well connected for him even to consider trousering the $1m minimum investment.

This tradition may have something to do with the small groups of pioneers that struck out West and relied on their leaders for their survival, but I prefer HL Mencken’s insight that while Americans see themselves as rugged individualists, they are rather conformist, as well as respectful. “There are no institutions in America, only fashions,” he once wrote.

It is true that Americans are often furiously trying to join something, enroll others or keep them out. The more exclusive a country club, society or nightclub the more desperate they are to gain entry…”

Or avoid being kicked out.

Whistleblowers Are Not Pretty

Francine — Thu, 03 Feb 2011 07:50:11 +0000

This article was originally published at GoingConcern.com on March 3, 2010.

Most don’t wear stilettos, although Cynthia Cooper is fairly attractive for a blond. Harry Markopolos, the Madoff “hero” whose new book is out is being called a whistleblower. I do not see him really warming up to that label or really warming up at all. He did admit that, early on, he was partially motivated in his quest to get the SEC to listen to his theories about Madoff’s fraud by the potential for whistleblower rewards.

From The Boston Globe in January 2009: Markopolos allows that at times he was motivated partly by the opportunity to receive a bounty that the government pays to whistleblowers in successful prosecutions, if the fraud falls within certain categories – the front running issue, for example… Over time, Markopolos concluded that he wasn’t likely to get a whistleblower payment, but he continued nonetheless, spurred on by the pure intellectual challenge of cracking a Wall Street legend…

Now Markopolos works to seek out other whistleblowers and shares in the bounty if they successfully file claims.

From a recent Fortune interview:

You were a whistleblower and you work with them now. What is the profile of the whistleblower’s personality? If you don’t have a strong belief system, you’re not going to be a whistleblower. You have to be crazy-brave. The risks are all weighted to the downside.

Crazy-brave? Yes. You cannot have self-doubt. You just have to go forward and say I believe in this country. I believe in these core values. I know if I get outed and get caught, I’ve committed economic suicide for myself and my family. I’m going to be on the industry blacklist.

Markopolos reminds me of many internal auditors I have known over the years. Many are introverted, not comfortable with the spotlight, anal-retentive but with a pit-bull, black-and-white, judgmental sense of right and wrong. It’s what it takes to do the job.

One of the biggest challenges for the internal audit profession after Sarbanes-Oxley was passed was to live up to the enormous expectations. Internal audit functions were mandated. Controls were front and center. I expected Internal Audit to gain more prominence as Chief Audit Executives began reporting directly to the Audit Committee and started making their own Board presentations instead of hiding behind the CFO.

Unfortunately, as my friend Chuck Eldridge from Korn Ferry told me back in 2003, very few internal auditors at the time were prepared to be “outside guys” instead of inside guys. In fact, it should be suspect if the internal auditor is too cozy with senior executives. We’ve seen internal audit come back again full circle to having to justify their existence via consulting and cost-savings initiatives.

It is hard out there for the internal auditors, external auditors, and accounting professionals, who want to expose fraud and illegalities and still live to work another day. Markopolos said he feared for his life. I know I’ve been more wary about my own safety since November. Cynthia Cooper of WorldCom fame received death threats.

“For me, this has been the most difficult thing I have gone through in my lifetime…There were times when I was scared to death,” Cooper told the audience, adding that she had to dig down to find her courage and push forward.

Few are prepared for the consequences or realize fully how bad they can be. Ideally you are either independently wealthy or so poor that you have nothing to lose. Sticks and stones can’t hurt you.

I know one real-life whistleblower personally. He’s actually a former Chief Audit Executive who is more of an outside guy than usual. He was always active in professional associations like the IIA, was comfortable presenting to outside counsel and the Board of Directors and has the chops to deal with tough issues. When asked to look the other way in a job that was supposed to be a repair and renewal assignment rather than all CYA, he balked. He’s currently working as the CFO of a startup while pursuing his claims.

Suing Audit Firms re: Madoff: The Iguana In The Room

Francine — Sun, 29 Nov 2009 22:26:00 +0000

From Kevin LaCroix’s blog, D&O Diary:

“When I first started tracking the Madoff-related litigation last December, it seemed like a relatively straightforward undertaking. But now the list of Madoff-related lawsuits (which can be accessed here) runs to some 18 pages, and the lawsuits continue to pour in…the most striking thing is what a varied assortment of lawsuits the Madoff scandal has produced. Even though there is a great deal of duplication among the claims, the list encompasses a spread and scope of lawsuits that defied brief summarization.”

Kevin likens the morass of Madoff litigation as reminiscent of one of his favorite films, It’s A Mad, Mad, Mad, Mad World.”

I’d very much like to assess the depth and breadth of claims, especially as they relate to the auditors. Which firms have the most claims? Which firm locations are named most often? Which filings do not name an audit firm and why?

How many name the international audit network umbrella “coordinating” firm? Shouldn’t they all?

But trying to sort it all out is like trying to kiss a bumblebee.

Most of the Madoff feeder funds claims are organized this way:

(I’m going to use the Optimal Strategic US Equity fund claims to illustrate.)

Plaintiffs are an individual or individual representing a class of investors in a particular hedge fund or fund of funds.

Defendants named are one or more of the following actors:

The feeder fund, such as Optimal, which is the ostensible investment manager and may provide other support services to the investors such as selection and review of third-party investment managers.
A bank, such as Santander with regard to the Optimal funds, and/or fund of funds group that sponsors the funds and manages sales of the funds through its global network.
An administrator/custodian, theoretically to provide back office operations to the fund. In the Optimal case, HSBC provided no more than Net Asset Value (NAV) calculations for production of customer statements and was supposed to provide monitoring of custody of assets that had been delegated to Madoff’s firm.
Audit firm. Typically the auditor of the feeder fund is named. In the Optimal case, the auditor is PwC Ireland. However, PwC International - because of its role as an umbrella coordinating organization of the PwC member firms – is named, as well as PwC US and PwC Bermuda because of their involvement in supporting the PwC Ireland audit opinion.

I’m interested in the role of the audit firms in Madoff feeder fund litigation and, in particular, the claims made against the audit firms’ international umbrella “coordinating” organizations. Why do plaintiffs sue the audit firms’ international umbrella “coordinating” organizations? There are several recent cases, adjudicated, pending, and prospective that may help us understand the legal strategies.

On January 28, 2009, Jennifer Hughes of the Financial Times quoted the attorney who brought the case against BDO International to sum up the issues of the Big 4 global networks:

“It makes sense that they want to have a brand just like IBM or Mercedes. But when they get sued, they say ‘that’s not us, it’s someone else’. No-one else gets to do that, why should accounting firms be able to?” says Steven Thomas, the lawyer leading the case against BDO. He claims there is an agency relationship between the international unit and the local, meaning BDOI was responsible. If this is proven, it could be bad news for PwC. Satyam was registered in the US, meaning US investors are likely to look to sue there, not in India.

I put this to Mr Thomas, who pauses, then says carefully: “I believe that there will be direct liability in the US for PwC – and PwC International.”

Later that day, the Wall Street Journal Law Blog reported on an important ruling in the Parmalat fraud case:

New York Judge Puts Possible Bulls-eye on Deloitte Touche

New York federal judge Lewis Kaplan issued a ruling yesterday in the Parmalat securities litigation which could have accountants quaking, and plaintiffs’ lawyers licking their chops. Parmalat, an Italian dairy conglomerate, collapsed in 2003 following the discovery of a massive fraud in which the company allegedly overstated its assets by $16 billion.

At issue in yesterday’s ruling was whether Deloitte Touche Tohmatsu potentially could be held liable for an allegedly defective Parmalat audit by its Italian member firm, Deloitte & Touche, S.p.a. Yes, Kaplan held, in denying a Deloitte Touche Tohmatsu’s motion for summary judgment.

A settlement was recently reached in the above dispute. Grant Thornton International will pay, also. Grant & Eisenhofer, Stuart Grant’s firm, is happy with it, although the dollars awarded are less than I expected.

The class of securities holders will net $15 million if the settlement is approved by U.S. District Judge Lewis A. Kaplan. Deloitte Touche Tohmatsu and its U.S.-based unit Deloitte Touche have agreed to pay $8.5 million to settle allegations of fraud by Italian auditors connected to Parmalat’s 2003 spiral into bankruptcy. Grant Thornton International has agreed to a $6.5 million settlement… “We think it’s a noteworthy settlement because the settlement involves the worldwide coordinating organizations — Deloitte Touche Tohmatsu and Grant Thornton International — who were sued not directly for anything they did, but for audits by their affiliate firms in Italy,” James Sabella of Grant & Eisenhofer PA, lead counsel for the plaintiffs[...] “It’s very rare that any settlements have been achieved involving those organizations rather than the actual member firms who practice in the various jurisdictions,” Sabella said.

In the case of Banco Espirito Santo v BDO International, attorney Steven Thomas was disappointed in June of this year by the judge’s ruling and jury’s decision.

The jury’s finding that BDO International bore no responsibility for the $170 million compensatory damages verdict against BDO Seidman followed Tuesday’s directed verdict for BDO International, which cleared the international of liability for $351 million in punitive damages against BDO Seidman.

“The jury got the case at 3:01 [P.M.] and they returned a verdict at approximately two minutes of four,” said BDO International lawyer Mark Raymond of Broad and Cassel. “The evidence is just overwhelming that there is no control by BDO International of its member firms…”

However, since BDO Seidman, the US firm, is now responsible for the record verdict alone, the wrangling over the money continues.

Espirito Santo Bank may be permitted to perform limited discovery to determine if BDO Seidman is shrinking to make itself poorer while appealing a $522 million award against the accounting firm, Florida’s 3rd District Court of Appeal ruled Wednesday.

The court said Miami-Dade Circuit Judge John Schlesinger misinterpreted state law and a previous ruling, reopening the door to discovery on the narrow issue of whether BDO is dissipating its assets. Schlesinger was ordered to carefully review the discovery question again…The accounting firm asserts the $352 million punitive damages portion of the verdict could bankrupt it, and state law bans court awards that would drive a company out of business. Bank attorney Steven Thomas rejects BDO’s position on its finances.

“BDO Seidman has been making money hand over fist, and they’ve been trying to conceal that from the court,” said Thomas, a partner with Thomas Alexander & Forrester in Venice, Calif. “Their claims of poverty to the court are just false, and you’re not allowed to claim to the court one thing and to the public another.“

Mr. Thomas included BDO International as a defendant in the original case because Florida state law bans a verdict that could bankrupt a defendant. BDO International was an original defendant and then left out of decision, which was later reversed on appeal. But Mr. Thomas also feels strongly about the principles. He told me that night after the BDO International verdict:

“We believe the global audit firms should be held responsible for their advertising, marketing and branding not only as truth in advertising but as a public duty and obligation to deliver quality and standards to their clients across borders.”

Including the international firms as defendants in the large scale claims against the global audit firms that cross borders and involve multiple member firms is a way to bring in member firms as possible funding sources for a judgement in the event the primary defendant can not, will not, or is prohibited from paying. However, there doesn’t need to be an international component or multiple member firm defendants to bring in the “control”and “global brand” arguments. Mr. Thomas is applying his principles in the case against KPMG on behalf of the New Century Trustee. They’ve filed against the US firm in California and against KPMG International in New York.

There’s another case with EY and Akai where the international firm entered into the settlement negotiations for their Hong Kong firm that is said to be more than they can pay alone. EY theoretically would like to maintain a brand presence in that location, albeit not at “any” cost.

Grant & Eisenhofer, who settled the Parmalat litigation, is one of four law firms leading the plaintiff’s litigation in the consolidated claims filed so far in the Pricewaterhouse Satyam fraud. PricewaterhouseCoopers, Satyam and the Indian Directors are currently trying to get the cases filed in New York dismissed on forum non conveniens grounds. In addition, Pricewaterhouse International is trying to wiggle off the hook.

“PricewaterhouseCoopers International Ltd. said it should be dropped from the case because the investors failed to show it had control over its Indian member, Price Waterhouse, as is required by U.S. securities law.”

Issues of control and the issues of the “agency” relationship between the auditors’ international umbrella “coordinating” firms and their member firms figure prominently in the Madoff feeder funds filings that include the international firms as defendants. The plaintiffs attorneys are learning from each experience and there is plenty of learning material out there. They are looking for the strategies, hooks, information and documents that will make these cases better. The language of the filings improves with each filing including amended complaints. The lawyers are attempting to explain to sometimes stubborn or intransigent judges, and the eventual juries, what really goes on behind closed doors in the global audit firms.

The “global brand” reference and an indictment of the “have your cake and eat it too” attitude of the firms last highlighted by Mr. Thomas in the FT…

“It makes sense that they want to have a brand just like IBM or Mercedes. But when they get sued, they say ‘that’s not us, it’s someone else’.

…also appear in the Optimal Strategic US Equity fund claims filing. Let’s look at how the Optimal feeder fund Madoff-related securities litigation brings in PwC International.

IN RE SANTANDER-OPTIMAL SECURITIES LITIGATION CONSOLIDATED AMENDED CLASS ACTION COMPLAINT

(Filed in US District Court, Southern District of Florida entered on the docket October 21, 2009.) pgs 71-74

These four governance bodies (the Network Leadership Team, Network Executive Team, Global Board, and Strategy Council) provide a global governance structure that is housed within PwC International. In effect, the PwC member firms (including PwC Ireland, PwC Bermuda, and PwC U.S.) act as agents of PwC International. PwC International controls its agents through a series of agreements that govern and enforce standards across PwC member firms…The Global Annual Review of PwC is, thus, no different than the annual report of McDonalds, Exxon, Microsoft, or Santander.

When trouble comes, the global audit firms claim to be separate legal entities with global “coordinating” firms that have no control over member firms. But successful branding and seamless delivery of services to multinationals depends on the members firms acting together and upholding certain standards. This was the argument Steve Thomas was making in the BDO International case.

Thomas argued the “agency” argument. BDO International was found not liable for punitive damages because there was no separate tort for gross negligence proved. That was required. For joint liability on the shared damages for the negligence claim, the jury had to find that BDO International exerted control. They did not. They believed the testimony of the BDO International Secretary.

“Why do they have poor Paul Van Elten sitting in the hot seat? He’s only the custodian of the global-size binder clips.”

From a summary of the BDO International trial by Mayer Brown:

The trial [turned] on whether BDO Seidman LLP was an agent of BDO International and whether the Member Firm’s alleged negligence occurred within the scope of the agency relationship.

At closing argument, plaintiff focused on the element of “control.” In particular, plaintiff argued that:

BDO Seidman LLP was required to follow the international audit manual and, thus, its work was controlled by BDO International.

BDO International controlled branding and therefore could “police the brand.”

BDO International had the “right to fire” BDO Seidman LLP by terminating its Member Firm Agreement.

The jury deliberated for about one hour before returning a verdict in favor of BDO International. The first question on the verdict form asked: “Was BDO Seidman an actual agent of BDO International, B.V.?” The jury answered “No.” As a result, the jury did not have to reach the second question, which asked whether BDO Seidman LLP’s actions were within the scope of the agency relationship.

I think the questions of “agency” and “control” are being framed incorrectly in these filings.

The member firm is not the agent of the international firm. The international firm should more effectively be construed, in my opinion, as an agent of the member firms, controlled by a Board of Partners created by the consent and vote of the member firms, that represents the interests of the member firms with regard to the network and “controls” the member firms.

That’s why Steven Thomas should have put the head of the BDO International Board of Partners, Cecil Fleming (1998-2002) and the head of the BDO Seidman firm (who was on the Board of Partners) at the time, not the Executive Director flunky, on the stand. Unfortunately, Mr. Fleming passed away in April of 2009.

Global board

The board is the body responsible for the governance of the PwC network and oversight of the network leadership team. The board is accountable to the PwC member firms and does not have an external role. Board members are elected by all partners in all PwC member firms every four years, with the current board taking up office in April 2009.

A new organisational model for the PwC network was introduced in the last 12 months which has enabled PwC member firms to align more closely their strategy around the world and improve the integrated service offered to clients. As part of that new network structure we have introduced a set of standards and policies with which all PwC member firms are expected to comply. These standards cover existing key areas such as independence and risk management as well as wider areas such as people management and brand and communications. PwC member firms agree to follow this wide range of standards (including quality reviews) in exchange for the right to use the PwC name. The use of the PwC name is very carefully monitored.

We should be judged, not just on the quality and extent of the standards that are applied to all PwC member firms, but on the actions that are taken to maintain these standards and the consequences for member firms that do not live up to them.

PricewaterhouseCoopers International Limited (PwCIL) is a UK private company limited by guarantee in which the various PwC firms are members. PwCIL does not provide services to clients. Its primary activities are to: identify broad market opportunities and develop associated strategies; strengthen PwC’s internal product, skill and knowledge networks; promote the PwC brand; and develop and work for the consistent application of common risk and quality standards by PwC member firms, including compliance with independence policies.

Main Page Photo Credit: Movie Still from Bad Lieutenant: Port of Call, New Orleans

Interior Page Photo Credit

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

Francine — Fri, 19 Dec 2008 03:48:00 +0000

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.

From The Jewish Daily Forward:

“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…”

From the Wall Street Journal Law Blog:

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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Madoff and Blagojevich: Stealing – Easier When No One Is Watching

Francine — Mon, 15 Dec 2008 10:55:00 +0000

Both are accused of being corrupt.

One gentleman has been under a cloud of suspicion for a while. He’s denied it and dared prosecutors to wiretap his conversations, to come and get him. He hid his activities in plain site. As visible as a major state Governor has to be, he also kept a low profile, not talking to his Lt. Governor for over a year. He didn’t even speak at the convention that nominated a fellow Illinoisan to be President.

The other gentleman was a pillar of the financial services business community. He welcomed attention in those areas that burnished his golden reputation for business acumen and philanthropy. He walked the halls of prestigious institutions and government agencies, sitting on Boards and advising others on how to run fair and efficient markets.

“He sat on a committee of academics, regulators and executives formed in 2000 by former SEC Chairman Arthur Levitt to advise the agency on new stock-market rules in response to the growth of electronic trading. Madoff has led the trading committee at the Securities Industry Association, Wall Street’s biggest trade group, and served as chairman of the Nasdaq Stock Market.”

But he also had secrets and held the details of activities that led to his shocking admissions very close to his vest. His painfully obvious suspicious and questionable activities were never fully scrutinized because of his golden history and impeccable reputation,

In both cases, acute circumstances led to the unraveling of their schemes.

For Illinois Governor Blagojevich, it was the spectacular rise of Illinois Senator Barack Obama to the US Presidency. This left a hole that presented the Governor with a “golden opportunity ” to use the power of his office to mitigate the financial pressure his family was under. There had been many years of expensive legal advice. But he was greedy and displayed that avarice in what’s being called a crude and very vulgar attempt to extort. He’s now forced famous US Attorney Patrick Fitzgerald’s hand.

For Bernard Madoff, it was the current “financial crisis” which precipitated sudden large requests for redemptions from his private hedge fund. It turns out, according to Mr. Madoff himself, he was running a “Ponzi scheme.” Everything works fine as long as new money is coming in and no significant funds have to go out. At the end, there’s reportedly only a few hundred million dollars available in cash out of more than 50 billion dollars that had been invested with him in previous years.

You expect that such a large “Ponzi scheme” — in which early investors are paid with money raised from subsequent victims — will prompt lawmakers to review how the U.S. polices brokerages, wealth managers and unregistered advisers, such as hedge funds.

From Yves Smith’s Naked Capitalism:

…The SEC, via its own protocols, should have inspected the Madoff Ponzi operation prior to the end of 2007 and failed to. Why? Evidently, due to Madoff’s good reputation in the industry.

What is particularly curious (if my assumptions are correct) is that Madoff kept his registered status, which meant he would at some point have the SEC knocking on his doors. I am assuming he registered in 2006 because that is when the SEC has an initiative underway to register hedge funds with over $25 million in assets under management. Some evaded it by getting investors to agree to 2 year+ lockups (that put them in a different category).

But the registration requirement was nullified when a hedge fund manager sued successfully, claiming that the SEC was misusing its statutory authority under the Investment Advisers Act of 1940. Most hedge fund then removed themselves from registration; for some reason Madoff did not. Did he somehow think he could bluff the SEC, or did he have a death wish? (Note: I am assuming the Madoff investment operation was considered to be a hedge fund, otherwise, it should have been registered as an investment adviser long ago…)”

There were many other opportunities for suspicions to be raised, followed up on or, at least, for some investors to dig deeper.

I twittered the news as soon as I heard it, on CNBC, December 11, at 3:26 CST.

At that time, the size of the problem was not yet apparent. The next day, Naked Capitalism linked to my post on the PCAOB report with an additional comment:

“With the Madoff scandal, I suspect there will be a renewed focus on the quality of audits (and I have yet to see who was doing his books).”

Friehling and Horwitz does not have a web page. According to Bloomberg News:

“The New City, New York, auditing firm Friehling & Horowitz signed off on the annual financial statement of Madoff’s Manhattan-based investment advisory business through Oct. 31, 2006, according to a copy obtained by Bloomberg News. Friehling & Horowitz included one partner in his late 70s who lives in Florida, a secretary, and one active accountant…

The copy of the four-page annual financial statement, dated Dec. 18, 2006, attested that the financial statements of Madoff’s securities firm were “in conformity with accounting principles generally accepted in the United States.” The financial analysis said Madoff Securities had $1.3 billion in assets, including $711 million in marketable securities and $67 million in U.S. debt. Members’ equity, the firm’s net worth, was $604 million, according to the document.

The firm operates from a storefront office in the Georgetown Office Plaza in New City, New York, sandwiched between a pediatrician’s office and another medical office.”

So why did so many “sophisticated” investors put their money and their faith in an operation that, if you didn’t know Mr. Madoff, threw up all the red flags typical of a scam? In fact, some have claimed that the problem is too much regulation… But then ideologues will grasp at straws to explain the fundamental fact so evident in this an many of the “financial crisis” stories:

Ethical relativism is alive and well. The extreme sense of entitlement and unadulterated self-interest inherent in some of the worst offenders is an example of pure evil.

I see bad people.

“The smart money KNEW Bernie had to be cheating, because the returns he was generating were impossibly good. Many Wall Streeters suspected the wrong rigged game, though: They thought it was insider trading, not a Ponzi scheme.

And here’s the best part: That’s why they invested with him.”

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