The Madoff Securities case was a phenomenal one, in terms of the sheer size of the funds involved, the duration over which the scam took place as well as the stature of the victims affected. In most comparable schemes, the victims are usually those who have a very limited understanding of financial products and such schemes mostly do not last very long. This paper will review the case by determining the regulatory oversight in place at the time of the scandal and reasons why this scheme was not discovered as well as delve into other aspects of the case.
Regulatory Oversight of the SEC
When Bernie Madoff started off his firm in the early 60s’ regulatory oversight at SEC was restricted to ensuring that investment advisers would be registered with the SEC, although advisers with fewer than 15 clients were exempted from this rule. (Collins, 2016, p. 438) The fact that Madoff chose to run his firm in an illegal manner by underreporting the number of clients in his book was clearly a testimony to the SEC’s oversight. The fact that Bernie had started a basic version of his Ponzi scheme since 1965 (and not early 90s’ as the court records indicate) also shows that the SEC had clearly not delved into the workings of his business. (Collins, 2016, p. 438) The fact that hedge fund managers as well as SEC officials who interacted with Bernie could not even figure out that something was missing. The SEC even investigated Madoff twice – once in 1992 and again in 1999 – both times the SEC could not find him guilty of anything. Even worse, when the SEC received two complaints in 2003 and 2004 against Madoff, the agency did not act even when they found out that his firm was not registered with them. (Collins, 2016, p. 444) Instead of taking action against Madoff at that stage, the SEC chose to allow him to quietly register his firm and closed the case. Therefore, in effect, Madoff and his accomplices operated the firm for almost 4 decades without getting caught or without proper registration with the SEC, which indicates either the blatant oversight by SEC or the clout that Madoff had in the markets.
Possible Reasons for the delay in discovering the scam
If one attempts to find out the reasons for SEC not able to unearth the scheme earlier, many reasons come to mind. 1. Firstly, the SEC receives as many as 10,000 complaints against brokers. This coupled with the fact that the SEC at that time was mostly focused on unearthing front-running within brokerages led the SEC to look in a different direction. (Collins, 2016, p. 444), 2. The SEC might possibly have had difficulties understanding the complex nature of Bernie’s operations. 3. It is also possible that the officials gave Bernie a benefit of doubt given his stellar track record with NASDAQ as well as the fact that he had helped SEC with issues in the past. 4. The fact that Bernie never requested a lawyer when talking to SEC officials also may have contributed to their laxity. 5. Although Markopolos made several complaints, the SEC officials and Markopolos had an antagonistic relationship, thus leading the SEC to believe that Markopolos’ complaints stemmed from his desire for the cash reward coupled with his inability to run an organization similar to Madoffs’. (Collins, 2016, p. 445) These could be few possible reasons for the SEC not discovering the scheme earlier.
Audit Procedures
One understands that Audits – both internal as well as external failed to identify that a Ponzi scheme was running within the Madoff firms. If I was an auditor for a firm that had an amount of $10 million invested in Madoff Securities, I would have applied the following procedures. 1. I would have firstly checked the veracity of the internal auditors of the firm as well as their reputation and track record. 2. I would have checked the credential of the funds who were acting as feeder funds. 3. Most importantly, I would have checked the status of the funds in the accounts – a sort of a tally to ensure that the financial statements indeed reflect the true financial position. 4. I would have checked expense allocations to ensure that the firm is spending money in the correct manner. 5. Particularly, I would have checked for suspicious trades within the financial statements as well as the veracity of the trade notes drawn up by the firm to see if the firm indeed was carrying out the trades indicated.
If one or more of this was raising red flags, I would have gone in for a second level audit, including possible a forensic audit. In any case, I would have also officially notified the SEC so as to avoid a liability on my firm.
In fact, a peer review of Friehling and Horowitz would have been enough to uncover the lies and deceit. No one ever found out that Friehling and Horowitz had their offices in a strip mall with only three employees – none of who were qualified auditors, except the two partners and there was only on accountant on their payroll (Gandel, 2008). The fact that the firm wasn’t registered (which did not allow other firms to peer review them), in itself, should have been a very big red flag. Additionally, since the firm made a representation that they were not into performing audits, they weren’t required to register. Such a simple check by a peer firm at the behest of even a single investor would have been enough to expose the sham. But unfortunately no such event took place.
In the entire chain of events Markopolos tried to expose the fraud through repeated complaints to SEC, most of which went uninvestigated and ignored. He even went to Taxpayers against Fraud to get Wall Street Journal to cover the scam, but his plan didn’t work out as he had anticipated. If I was Markopolos, I would have probably utilized a very different strategy. After realizing that the SEC was not going to do much about this, I would have approached the FBI’s White Collar Crimes Division. Additionally, I would have approached the United States Attorney’s office and would have gone ahead with filing an official complaint before the Magistrate Judge of a lower court. The rationale behind this strategy would be ensure that an agency beside the SEC would start the investigation since at the time the SEC seemed a little prejudiced towards Madoff. This strategy would have kick started the legal process from the judicial side and the SEC would have been forced to toe the line.
The audit committee should have most importantly played the role of an entity that does constant due diligence on the activities of Madoff Securities, especially given the highly complex structure of the firm. The audit committee at Madoff was a sham since it either overlooked or played a part in the entire scam by overlooking crucial aspects of the firm. It never even bothered to check if the assets of the firm were in place. The worst part is that even the Top audit firms did a cursory audit of Madoff Securities rather than delving into the details. Clients acted on such information when considering other investments into the fund, which only exacerbated the problem.
The audit committee should have checked the asset quality of the firm as well as the inconsistencies in the track record of the firm. A simple check would have revealed that there were simply no assets underlying the claims made in the statements. The committee should have put in stringent rules in place especially for the feeder funds as well as certain strictures in place to prevent Madoff from routing and rerouting money. The audit committee should have also prevented Bernie and others from using Madoff Securities as their personal piggy bank. The rationale behind this would have been to prevent Madoff from diverting funds to other places. Further, the auditors would have been holding a moral high ground in the whole situation since they would have had first hand information about the whole event. Many investors, as a result, would have been saved from the collapse of the securities firm as well as the end result.
Therefore, one can see that the audit committee was also responsible, in part, for the happenings at Madoff Securities more out of negligence than out of connivance. Auditors hold a fiduciary role towards clients and if they could not understand the structure or felt that Madoff was operating something that was remotely illegal their reports should have reflected the same. No such reporting took place from the auditors side.
Conclusion
In conclusion, one can understand that the Madoff scandal was a combination of dereliction of duty by key legal entities such as the SEC as well as, in part, by the negligence of the auditors and the accountants who oversaw and checked the various processes. The blame also largely goes to the SEC for not investigating any of the earlier red flags that had been raised and categorically ignoring them. Even the auditors involved in the process should have been more diligent rather than take things at face value. As an auditor, they had every right to check the books as well as underlying entries and tally the assets of Madoff securities – something they didn’t bother doing.
Therefore, this incident remains as a lesson for our system.
Reference
Collins, D. (2016). Bernie Madoff’s Ponzi Scheme. Edgewood University. Retrieved from http://collins.faculty.edgewood.edu/pdfdocuments/Madoff%20Case.pdf
Crawford, D & Dugan, I.J. (2009). Accounting Firms that Missed Fraud at Madoff May Be Liable. The Wall Street Journal. Retrieved from http://www.wsj.com/articles/SB123491638561904323
Gandel, S. (2008). The Madoff Fraud: How Culpable were the Auditors? Time Magazine. Retrieved from http://content.time.com
