Shenanigans at Bernard L. Madoff Investment Securities

Professionals who sold Madoff investments included lawyers, accountants, bankers, brokers, and even doctors. Many of these veterans thought Madoff had a system to make money. Salespeople for Madoff investments in Europe were well trained and spoke multiple European languages. They were wealthy and well connected. A large proportion of Madoffs business came from well-to-do European investors. Mr. Madoff only had two dozen people working for him in the U.S. hedge fund business and another 28 working for him in his London office (Henriques 2011). A key employee in accounting assisted Mr. Madoff by creating an elaborate phony paper trail and by mailing falsified account statements to customers on a regular basis. His employees, including the sales professionals, were well compensated. They were paid much above the industry norms. Key employees were paid substantial bonuses, as well. Perhaps such exceedingly generous payments should have raised some eyebrows.

Peter Madoff served as the Chief Compliance Officer and Senior Managing Director at BMIS from 1969 to 2008. Peter was in charge of developing compliance policies and procedures and overseeing their implementation. He created a comprehensive compliance manual and annual compliance reports overseen by competent investment professionals. However, it was all an illusion created with the fake filings and fictitious documentation. In June 2012, the Securities and Exchange Commission (SEC) filed a criminal complaint against Peter Madoff in the U.S. District Court for the Southern District of New York alleging:

that in addition to creating false compliance materials, Peter Madoff created false brokerdealer and investment advisor registration applications filed by BMIS. He also failed to implement and review required policies and procedures, and falsified the firms books and records. Peter Madoff was richly rewarded for his misconduct, pocketing tens of millions of dollars through salary and bonuses, fake trades, sham loans, and direct, undocumented transfers of investor funds to himself from the bank account that BMIS used to perpetrate the Ponzi scheme. (SEC 2012)

Peter Madoff was sentenced to ten years in jail for his role in the Madoff fraud in December 2012.

The chief financial officer, Frank DiPascali, was in charge of maintaining the accounting records and financial management at BMIS. A 33-year veteran at BMIS, Frank was the chief lieutenant of Mr. Madoff. Frank was also the director of options trading at the firm. Every three months, BMIS would mail quarterly statements to the firms investors. Many of these statements showed investments in blue chip companies. These statements always showed a positive return of 3 to 4 percent every quarter. In earlier years, if investors requested a liquidation of their investments, a check for the balance was promptly mailed to them. Since most of the investors were individually very wealthy, the refund requests were sporadic. In addition, some investors were charitable organizations and were not seeking the return of their original investment. Mr. Madoff, his brother, and Frank DiPascali formed a tight-knit group that engineered this massive fraud and kept it secret for a long time, to the detriment of thousands of gullible investors.

BMIS claimed to be a private fund and did not register with the SEC. Hence, it was not filing financial information with the SEC on a regular basis for many years. BMIS, however, was audited by Friehling & Horowitz, a small CPA firm in New York City. This accounting firm operated out of a 13 feet by 18 feet office in uptown New York (Abkowitz 2008). The CPA firm consisted of three people, including a secretary. Jerome Horowitz, the senior accountant at the firm, retired in 1991 and moved to Florida. The only active accountant at the firm, David G. Friehling, was a past president of the Rockland County chapter of the New York State Society of Certified Public Accountants and sat on the chapters executive board. David Friehling, a 49-year-old accountant, apparently worked sporadically, according to a nearby worker in the office building (Abkowitz 2008). He was often seen driving a luxury Lexus. Mr. Friehling essentially attested for 17 years that BMIS had a clean audit record. He collected a $250,000 audit fee for just signing the audit report, and performed no audit procedures. Friehling & Horowitz did not submit itself for peer review during the last 17 years (Abkowitz 2008). The firm had been consistently telling the New York State CPA Society that they had not done any audits during those 17 years and, therefore, were not subjected to any peer review. Mr. Friehling was also not registered with the Public Company Accounting Oversight Board (PCAOB). The Madoff Trustee, Irving Picard, sued JPMorgan Chase in December 2010. Picard alleged that the Madoff banker had known that Friehling had neither registered with the PCAOB nor subjected himself to the American Institute of Certified Public Accountants (AICPA) peer review as early as 2006. The Office of the Comptroller of the Currency (OCC) is also unhappy with JPMorgan Chase and is faulting the bank for not conducting due diligence and for failing to report suspicious activity at BMIS.

Fairfield Greenwich Group invested a staggering $7.5 billion with BMIS (see Exhibit 1). In 2008, the Fairfield Fund announced on its website that it was managing $14 billion in assets. More than 95 percent of this $14 billion came from Europe, Asia, and the Middle East. Hence, a little more than 50 percent of the funds were invested with one individual (Mr. Madoff) by Fairfield managers. As a feeder fund, it was Fairfields fiduciary duty to do due diligence about BMIS before investing. It appears that Fairfield failed to perform this duty and did not exhibit enough professional skepticism. Of course, Fairfield was receiving substantial fees from its own clients and from BMIS (Henriques 2011). Red Flags

The SEC received multiple complaints against Mr. Madoff over the years (Scannell 2009). Whenever the SEC made inquiries about the trading practices at BMIS, Mr. Madoff used his charm and manipulative ways to explain away his dealings to the SEC inspection teams. While some of these complaints were anonymous, several were credible and had professional names associated with them. The earliest complaint was in 1992 and was directed at an associate of Mr. Madoff, Mr. Avellino (Berenson 2009). Avellino and Bienes initially had set up an accounting firm in Manhattan in 1977 and soon shifted their focus to raising funds for Mr. Madoff. By 1992, they had raised $441 million from 3,200 clients and had entrusted these funds to Madoff (Berenson 2009). What caught the attention of SEC investigators was the promise made by Avellino and Bienes that they would pay 13.5 to 20 percent annual returns to their clients. This generous promise prompted the SEC to wonder whether Avellino and Bienes were running a Ponzi scheme. When Avellino was questioned by SEC investigators, he told them that the money has been entrusted to Mr. Madoff (Berenson 2009). At that time, Madoffs firm was an influential brokerage house on Wall Street. Once Avellino assured the SEC investigators that he would return the money to investors and paid a small fine to the SEC, the federal investigators concluded the investigation. Avellino and Madoff had been connected for a long time; Mr. Avellino had worked for Mr. Madoffs father-in-law since 1958 as an accountant. The SEC failed to ask the right question in 1992Is Mr. Madoff (not Avellino) running a Ponzi scheme?

Harry Markopolos filed complaints against Mr. Madoff multiple times and put his professional name on the line. He complained to the Boston office of the SEC, suggesting that Madoff was either front running or deceiving his investors by running a Ponzi scheme in 2000. As an example, front running would occur if a stockbroker learns that a large retirement fund has a limit order in to purchase a certain stock, and the broker uses this private information to buy the same stock just before the retirement funds large order is executed. The SEC has banned front running. In an article published in Barrons, Arvedlund (2001) wondered how Madoff was getting such steady returns. She was also critical of the secrecy associated with the Madoff methods to generate the returns. A long memo was sent by Markopolos in 2005 to the SEC detailing why he considered BMIS a fraud. Markopolos (2005) listed 29 red flags in support of his allegation that Madoff had been committing a serious fraud. A few of his red flags are discussed below. He pointed out that BMIS reported only seven small monthly losses in 174 months (14.5 years). This defies logic. This is equivalent to a major league baseball player hitting a 0.960. There were not enough index put option contracts in total in the market to hedge the way Madoff said he was hedging. Several investors believed that Mr. Madoff subsidized down months. Other investors believed that Mr. Madoff could time the market perfectly because of his insider status. This is incredulous. There was a lot of secrecy associated with BMIS operations, and only family members knew the Madoff investment strategy. The feeder fund (Fairfield Sentry) took extraordinary pains to hide the fact that the real money manager was Mr. Madoff. Sometimes the best advice financial advisors can offer their clients is to be conservative and diversify their investments. Many of the financial advisors failed to offer this advice.

The Aftermath

Within a few weeks of his house arrest, Mr. Madoffs customers had confessed that their loss exposure totaled several billion dollars. A CNN (2008) business story reported that several prominent Madoff investors, including Royal Bank of Scotland, BNP Paribas, Banco Santander, HSBC, and others, announced billions in expected losses. A few weeks later, the court-appointed receiver reported that he had recovered a sum of $1.1 billion from several Madoff bank accounts (see: http://www.madofftrustee.com). Some of the big accounting firms were staring at potential lawsuits. Even though they were not the auditors of BMIS, the big accounting firms were the target for the trial lawyers because of their role in auditing the feeder funds (Dugan and Crawford 2009).

Mr. Madoff pled guilty to 11 felony charges (securities fraud, investment advisor fraud, mail fraud, wire fraud, money laundering, false statements, and others) in March 2009. He was awarded the maximum possible jail sentence of 150 years in July 2009 and was asked to pay a restitution of $170 billion (Henriques 2011). Mark Madoff (Mr. Madoffs eldest son) committed suicide in December 2010. Frank DiPascali pled guilty to ten felony charges and is awaiting sentencing. He is cooperating with the government in the investigation. David Friehling pled guilty to felony charges against him and lost his CPA license in July 2010. His sentence has been postponed multiple times, as he is also cooperating with the government. The auditors son, Jeremy Friehling, committed suicide in November 2012. The SEC punished nine employees in November 2011 for their negligent roles in multiple Madoff investigations without firing any of them. These sanctions included pay reductions, suspensions, and counseling memos. In November 2012, Irwin Lipkin, former controller at BMIS, pled guilty to falsifying books and records. The Madoff Recovery Initiative (see: http://www.madofftrustee.com) reports that as of April 2013, the SIPA Trustee has recovered or entered into agreements to recover more than $9.32 billion.

Based upon the reading of this case and other materials suggested by the instructor, answer the following questions.

Case Questions

(1) What are the red flags (fraud risk factors) that are present in this case? Red flags should be grouped under three categories: pressures/incentives, opportunities, and (ethical) attitudes/rationalizations. Please refer to AU-C Section 240 (AICPA 2012).

(2) There are multiple approaches available to make ethical decisions. Describe Utilitarian Theory, Rights Theory, and Justice Theory. Who are all individuals and groups affected by the Madoff Ponzi scheme, and how are they affected?

(3) a What were the weaknesses in the control environment of Bernard L. Madoff Investment Securities LLC?

(3) b What organizational controls, including internal controls, should be put in place to prevent another Madoff fraud from occurring again? Suggest some regulatory controls that can deter another Madoff fraud.

(4) Investors, the auditor, feeder funds, the Financial Industry Regulatory Authority, Inc. (FINRA), SEC inspectorsall should have exhibited professional skepticism. What do you understand by the phrase professional skepticism? Describe it in detail.

(5) Why did the SEC miss the fraud, even after receiving several complaints?

(6) Go to the SEC website or Google it to find and read the Markopolos complaint dated November 7, 2005 (The Worlds Largest Hedge Fund is a Fraud19 pages long), against Bernie Madoff. Please summarize the key points in the complaint in one or two pages of your own writing.