PeregrineTwenty Years of Fraudulent Cash Balances

Russell Wasendorf, Sr., Chief Executive Officer of Peregrine Financial Group (PFG), moved Peregrine from Chicago to the edge of the university town of Cedar Falls, Iowa in 2009. He quickly became an active and respected community leader, donating millions of dollars to the local university and several charities. Three years later, he confessed he had committed fraud for over 20 years (Bunge, Patterson, and Steinberg 2012; Phillips, Leising, and Harris 2012). The confession note stated, I have been able to embezzle millions of dollars from customer accounts at Peregrine Financial Group. Using a combination of Photoshop, Excel, scanners, and both laser and inkjet printers, I was able to make convincing forgeries of nearly every document that came from the bank (Phillips et al. 2012). With this equipment, Wasendorf allegedly fooled regulators through an elaborate scheme that included forged bank statements, faked emails, and a bogus bank account at a post office box (Bunge et al. 2012). Interestingly, Peregrines external auditor was a one-person audit firm based in Glendale Heights, Illinois (Lynch, Stephenson, and Carey 2012). Further, since Peregrine was a registered broker-dealer, it was required to be audited by the Commodities Futures Trading Commission (CFTC). In addition, due to its futures trading, Peregrine was periodically audited by the National Futures Association (NFA). As such, one would expect that both the external auditor and the NFA were interested in examining the validity of Peregrines cash balances and other liquid assets, especially restricted cash in customers accounts. The $215 million fraud, which took place over a 20-year period, was exposed when the NFA sent an audit team to review Peregrines books and pressure Peregrine into participating in a new electronic confirmation system for verifying cash accounts. Interestingly, the fraud was almost discovered by the NFA a year earlier after the regulator received an email from a bank employee on a Friday indicating that Peregrines account for customer balances had less than $8 million. The following Monday, the NFA received an email fax purportedly from the same bank employee with a hand-written note that the account balance was now $218.6 million (Phillips 2012). Apparently, the NFA auditors accepted this correction and did not follow up on how the bank could have made such a large error. A later investigation revealed that the fax was sent by Wasendorf (Huffstutter, Saphir, Polansek, and Sheppard 2012b). WASENDORFS BACKGROUND AND PEREGRINE FINANCIAL GROUPS HISTORY The fraud shocked the small town of Cedar Falls where Peregrine was located, as well as the Chicago financial community. Now known as the Midwest Madoff (Epstein 2012), Wasendorf grew up in eastern Iowa. He was raised by a single mother following his fathers sudden death when Wasendorf was in kindergarten. He studied at the University of Northern Iowa, which he left to pursue a career as a documentary filmmaker. He was introduced to the futures industry in the 1970s through a trading program aimed at farmers. Wasendorf launched a financial advisory boutique in 1980 in the backroom of a barber shop (Huffstutter, Saphir, Polansek, and Sheppard 2012a). A correct bet ahead of the Black Monday market crash of 1987 provided the capital for the launch of Peregrine Financial Group three years later. Wasendorf said, I named the company Peregrine because there is an expression in our business that you are either predator or prey. The firm moved from Iowa to Chicago in 1994 just as the futures industry boomed with the advent of electronic trading. Peregrine moved back to Iowa in 2009, where Wasendorf was known for his restaurants and environmental and philanthropic work (Huffstutter et al. 2012a). Wasendorf built a facility in a wooded area outside of town designed specifically for the operations of the financial firm, with technology accessible throughout the building. A gym, daycare, and cafeteria were available at no charge. The first person he hired for the project was a biologist to ensure that endangered species or woodlands would not be harmed. Now the building sits empty. That property could be vacant for five years, says Jim Benda, a broker at a commercial realtor in Cedar Falls. Its going to be a difficult sale (Louis 2012). The property cost $20 million to construct in 2008, and was sold in 2013 for $3.3 million (Bunge 2013). Peregrines auditor was a one-person shop run out of the accountants home in Glendale Heights, Illinois (Ahmed and Lattman 2012). In the 2010 report, Veraja-Snelling & Co. wrote that there were no material weaknesses involving internal controls and that the corporations practices and procedures were adequate (Lynch and Carey 2012). Details about how the audit was conducted are limited, but given that Peregrines activities involved futures trading, one would expect the auditor to concentrate on examining the validity of its cash and other liquid assets. As noted above, Peregrine was also subject to periodic audits by the NFA. After the fraud was revealed, research indicates that Wasendorf and Peregrine were able to fool the NFA at least three times. In 2004, a Peregrine client sent a letter to the NFA asking that it intervene to prevent the firm from misusing its customers money (Ahmed and Lattman 2012). In 2009, a tipster wrote the NFA asking it to review Peregrines bank account information for accuracy (Ahmed and Lattman 2012). Finally, as mentioned earlier, the NFA failed to investigate an email from a bank employee indicating that Peregrines cash balances were less than $8 million (Phillips 2012). In Wasendorfs court statement, he indicated the scheme began out of financial desperation (Bunge et al. 2012). I had no access to additional capital and I was forced into a difficult decision: Should I go out of business or cheat? I guess my ego was too big to admit failure. So I cheated. Cash from customers accounts is not all that was apparently stolen. When the FBI searched the firms Cedar Falls headquarters, they seized 1,449 sets of silver coins sporting the image of TV cartoon character SpongeBob SquarePants, worth about $375,000 based on the retail price of $259 per set. An additional 304 SpongeBob coins were listed among Peregrines missing assets.

ECHOES OF EARLIER SCANDALS Major frauds tend to imitate those of the past. First Securities Company of Chicago is one of the early significant auditor legal liability cases brought under the 1934 Securities Act. The perpetrator of the fraud, Leston Nay, received funds from friends to invest in an escrow syndicate. In fact, however, the syndicate did not exist and all of the funds were lost. To prevent detection, Nay instituted a mail rule and insisted that only he could open mail addressed to him. The fraud lasted about 30 years. The Peregrine case is similar. To prevent other Peregrine employees from learning about the real bank balances, for 20 years Wasendorf insisted that only he could open mail from the bank. The largest of the financial frauds that were revealed in the aftermath of the 2008 financial crisis involved Bernie Madoff. Like Wasendorf, Madoff apparently could not stop once he started the fraud. Madoffs fraud began in the 1990s, although some believe that it started in the 1980s (Frank, Efrati, Luccetti, and Bray 2009). Similar to Peregrine, Madoff was audited by a small CPA firm, this one a two-person firm with only one practicing CPA (Fuerman 2009; McKenna 2012). No one raised questions for either Peregrine or Madoff as to why a financial services firm with hundreds of millions of dollars under management would employ such a small audit firm. CONFIRMATION OF CASH BALANCES Cash is one of the most basic audit areas, and the audit work is typically performed by new staff auditors. It is said that cash is cashyou either have it or you dont. Faking cash balances does not seem plausible, and cash is rarely central to most major frauds. It is far easier to create fictitious inventory, receivables, or understate accounts payable. However, the fraud at Parmalat, which was revealed in 2003, highlighted the ability of companies to fraudulently overstate significant cash balances supported by fictitious bank confirmations. American Institute of Certified Public Accountants (AICPA) auditing standards (AU-C 500) define an external confirmation as audit evidence obtained as a direct written response to the auditor from a third party (the confirming party), either in paper form or by electronic or other medium (for example, through the auditors direct access to information held by a third party) (AICPA 2009, 2011). Janvrin, Caster, and Elder (2010) identify several problems involving confirmation, including the need to evaluate the reliability of the response. Fictitious responses indicate a need to authenticate responses for balances involving significant risks, while responses involving collusion between the client and customer indicate a need for additional collaborative evidence in addition to confirmations. Confirmation of cash balances is a typical audit procedure performed by many auditors, and the AICPA provides a standard bank confirmation form (see Exhibit 1). The practice is so common that most auditors are surprised to learn that confirmation of cash is not currently required by auditing standards, although the Public Company Accounting Oversight Board (PCAOB) is considering requiring confirmation of cash balances (PCAOB 2009). Auditors typically confirm cash balances directly with the bank. In the Parmalat case, executives sent a forged confirmation to the auditors confirming 3.95 billion euros in a Cayman Island account. Potential fictitious bank balances and confirmations have recently arisen as a problem area in audits of Chinese companies (Rapaport 2011), but have not been a common problem in audits of U.S. companies. Wasendorf supplied the auditor with the address for a post office box that he controlled for the mailing of the confirmations. It was not just the external auditor that he fooled. Peregrine was audited by the NFA in February 2010 and May 2011. NFA President Daniel Roth stated on July 25, 2012 that, The sheer volume of forged documents that were produced as part of this scheme is staggering, and had to occur on a daily basis. Some forms of technology, such as scanners and printers, may be used to facilitate fraud (Caster and Verardo 2007). As such, documentary evidence traditionally relied upon by auditors may be weakened. For example, Wasendorf used Photoshop, Excel, scanners, and printers to conceal his fraud by creating convincing forgeries of bank statements and other bank documents (Phillips et al. 2012).

ELECTRONIC CONFIRMATIONS The process of sending written bank balance confirmations had largely been unchanged for decades until the Parmalat fraud. The forged confirmation in the Parmalat fraud involved an alleged account at Bank of America. Following the fraud, discussions with practitioners indicate the use of electronic confirmations increased when Bank of America informed CPA firms that it would only process confirmations sent electronically through a secure, online, third-party intermediary. An effective electronic bank confirmation service provides a secure network for auditors to communicate with their clients banks. Further, and perhaps most importantly, an effective service ensures that only authorized individuals respond to the confirmation requests. Aldhizer and Cashell (2006) provide details as to how an electronic confirmation service would use encryption and firewalls to ensure the security of all communication between auditors and their clients banks. Aldhizer and Cashell (2006) also indicate the controls that are necessary to authenticate the parties involved in the confirmation process. The lack of authentication is a major weakness in the manual, paper confirmation process. Today, all of the major accounting firms, many smaller audit firms, and most large banks use electronic confirmations. The NFA began using electronic confirmations in the wake of the October 2011 collapse of MF Global Holdings, a company led by former New Jersey governor Jon Corzine. The NFA began to demand that futures brokerages submit to its e-confirmation services in the summer of 2012. After significant pressure, Wasendorf agreed to authorize the NFA to electronically confirm Peregrines cash balances. The next day, he signed a written statement in which he confessed the fraud in detail. EPILOGUE Wasendorf pleaded guilty in September 2012, and was sentenced to 50 years in prison in January 2013 (Isidore 2013). He was also ordered to pay $215.5 million in restitution. However, news reports of the missing assets recovery investigation provide little hope that investors will receive a significant portion of the missing funds stolen over the past 20 years. Thus far, investigators have learned that most of Wasendorfs assets, including his luxury Iowa home, downtown Chicago apartment, and private plane, were highly mortgaged. Further, officials are investigating a $50,000 deposit made by Wasendorf to his new wifes daughter, as well as missing gold valued at $60,000 (Saphir 2012a). Peregrine filed for bankruptcy within a week of Wasendorfs confession note. Over 300 employees are now laid off and 17,000 futures customers and 7,000 trading clients were forced to find alternative trading services (Saphir 2012b).

1. Explain how the auditors could have evaluated both quantitative and quantitative materiality, and used analytical procedures and audit risks (inherent, control and detection risk) in their preliminary planning to identify the material misstatement at Peregrine. (Answer in no more than two pages).