Bernard Lawrence Madoff was born on April 29, 1938, in New York City. Madoff spent his childhood in a lower middle-class neighborhood in the borough of Queens. After graduating from high school, Madoff enrolled in the University of Alabama but transferred to Hofstra College, now known as Hofstra University, on Long Island at the beginning of his sophomore year. Three years later in 1960, he graduated with a political science degree from Hofstra.

According to a longtime friend, the driving force in Madoff’s life since childhood was becoming wealthy. “Bernie wanted to be rich; he dedicated his life to it.” That compelling force no doubt accounted for Madoff’s lifelong fascination with the stock market. As a teenager, Madoff frequently visited Wall Street and dreamed of becoming a “major player” in the world of high finance. Because he did not have the educational training or personal connections to land a prime job on Wall Street after he graduated from college, Madoff decided that he would set up his own one-man brokerage firm. 

While in college, Madoff had accumulated a $5,000 nest egg by installing sprinkler systems during the summer months for wealthy New Yorkers living in the city’s exclusive suburbs. In the summer of 1960, Madoff used those funds to establish Bernard L.

Madoff Investment Securities LLC, which was typically referred to as Madoff Securities. Madoff operated the new business from office space that was provided to him by his father-in-law, who was a partner in a small accounting fi rm. For nearly five decades, Madoff served as the senior executive of Madoff Securities. During that time, the shy New Yorker, who had an occasional stammer and several nervous tics, would accumulate a fortune estimated at more than one billion dollars. 

Initially, Madoff’s brokerage firm traded only securities of small over-the-counter companies, securities commonly referred to as “penny stocks.” At the time, the securities of most large companies were traded on the New York Stock Exchange (NYSE). The rules of that exchange made it extremely difficult for small brokerage firms such as Madoff’s to compete with the cartel of large brokerage firms that effectively controlled Wall Street. Madoff and many other small brokers insisted that the NYSE’s rules were anticompetitive and inconsistent with a free market economy. Madoff was also convinced that the major brokerage firms kept securities transaction costs artificially high to produce windfall profits for themselves to the detriment of investors, particularly small investors. Because of Madoff’s resentment of the major Wall Street brokerage firms he made it his mission to “democratize” the securities markets in the United States while at the same time reducing the transaction costs of trading securities. “Bernie was the king of democratization. He was messianic about this. He pushed to automate the [securities trading] system, listing buyers and sellers on a computer that anyone could access.”

In fact, Madoff Securities was one of the first brokerage firms to utilize computers to expedite the processing of securities transactions. Bernie Madoff is also credited as one of the founders of the NASDAQ stock exchange that was organized in 1971. The NASDAQ was destined to become the world’s largest electronic stock exchange and the largest global stock exchange in terms of trading volume. In the late 1980s and early 1990s, Madoff served three one-year terms as the chairman of the NASDAQ.

Madoff’s leadership role in the development of electronic securities trading contributed significantly to his firm’s impressive growth throughout the latter decades of the 20th century. By the early years of the 21st century, Madoff Securities was the largest “market maker” on the NASDAQ, meaning that the fi rm accounted for more daily transaction volume on that exchange than any other brokerage. By that time, the fi rm was also among the largest market makers for the New York Stock Exchange, accounting for as much as fi ve percent of its daily transaction volume. This market-making service was lucrative and low risk for Madoff Securities and reportedly earned the firm, which was privately owned throughout its existence, annual profits measured in the tens of millions of dollars.

In 1962, Madoff had expanded his firm to include investment advisory services. For several years, most of the individuals who set up investment accounts with Madoff Securities were referred to him by his father-in-law. Although the fi rm was a pioneer in electronic trading and made sizable profi ts from its brokerage operations, investment advisory services would prove to be its most important line of business. By late 2008, the total value of customer accounts that Madoff Securities managed had reached $65 billion.

The key factor that accounted for the incredible growth in the amount of money entrusted to Madoff’s fi rm by investors worldwide was the impressive rates of return that the firm earned annually on the funds that it managed. For decades, those funds earned an average annual rate of return generally ranging from 10 to 15 percent. Although impressive, those rates of return were not spectacular. What was spectacular was the consistency of the returns. In 2001, Barron’s reported that some of the Madoff firm’s largest investment funds had never experienced a losing year despite significant stock market declines in several individual years. Even when the stock market collapsed in late 2008, individual Madoff funds continued to report net gains for the year-to-date period. Although Madoff would eventually serve as an investment adviser to dozens of celebrities, professional athletes, and other wealthy individuals, most of the money he managed came from so-called “feeder fi rms,” which were large hedge funds, banks, and other investment companies. The individuals who had committed their funds to these feeder firms were typically unaware that those funds had been turned over to Madoff........

Questions

1. Research recent developments involving this case. Summarize these developments in a bullet format.

2. Suppose that a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff Securities. What audit procedures should the investment fi rm’s independent auditors have applied to those assets?

3. Describe the nature and purpose of a “peer review.” Would peer reviews of Friehling & Horowitz have likely resulted in the discovery of the Madoff fraud?
Why or why not?

4. Professional auditing standards discuss the three key “conditions” that are typically present when a financial fraud occurs and identify a lengthy list of “fraud risk factors.” Briefly explain the difference between a fraud “condition” and a “fraud risk factor” and provide examples of each.

5. In addition to the reforms mentioned in this case, recommend other financial reporting and auditing-related reforms that would likely be effective in preventing or detecting frauds similar to that perpetrated by Madoff.