Several prominent audit firms are being
targeted in lawsuits against feeder funds to the largest Ponzi
scheme in US history.

Investors that lost money placed in Bernard L
Madoff Investments Securities (BMIS) have brought a spate of class
actions against hedge funds and their auditors for failing to
detect the fraud.

Madoff was charged with securities fraud after
allegedly confessing to investigators that he directed a Ponzi
scheme that paid off early investors with money from later
participants. The scheme is estimated to have conned investors out
of $50 billion.

KPMG, Ernst & Young, Pricewaterhouse-
Coopers (PwC) firms, McGladrey & Pullen and BDO Seidman all
audited feeder hedge funds that were not part of BMIS but had
significant amounts invested with the brokerage. They will now
defend their actions in courts across the US. Proceedings could
take months, if not years, to progress.

Deep pocket syndrome?

A partner at the London law firm Reynolds
Porter Chamberlain, Jane Howard, believes these cases are an
example of how investors are increasingly attempting to raid the
pockets of auditors, especially in the instances where primary
targets, i.e. the perpetrators of corporate fraud, cannot cover
damages.

“It is inevitable that you are going to get
this second wave just because of the telephone number sums that are
at stake. It is a bit like Parmalat, I guess, where the Italian
auditors very quickly had no money then people started looking
around for other targets,” Howard said.

Complaints have only been filed in the past
few months so it is too early to predict what might or might not
happen. However, it is clear that one of the most important
questions for auditors is whether it is within the scope of their
audit duty to investigate the activities where the actual fraud
occurred.

“Absent special circumstances or knowledge, it
should not be,” Howard added.

Firms named in court filings have argued that
it was not within their scope to probe Madoff’s books and they
conformed to all professional standards in their audits of feeder
fund clients.

Howard said she does not believe it is
reasonable or fair that auditors be held accountable for Madoff’s
activities or for investment decisions.

“I think it does smack of deep pocket
syndrome. The assumption is ‘[the auditors] were on the scene and,
therefore, should have been responsible for pointing everything
out’. I think the auditors would be well advised to argue that it
wasn’t within the scope of their retainer,” she said.

“But until one actually sees the specific
allegations in detail, it’s hard to say, and I’m sure that as these
cases emerge there are going to be particular facts where they will
say there was this particular red flag and, therefore, the auditors
ought to have reported or raised it. I dare say that we might find
that the auditors did and that sometimes they were ignored.”

KPMG’s US firm has been sued by investors of
the large feeder fund Tremont Group Holdings, which had invested
$213 million into the scheme up to December 2007. The derivative
complaint was filed in the New York State Supreme Court by the law
firm Pomerantz and brought by the Tomchin Family Charitable Trust
on behalf of the Rye Select Broad Market XL Fund.

Red flags

The lawsuit claims KPMG should have
investigated a series of red flags as part of its audit of the
fund.

Foremost, the complaint alleges that Tremont
reported the fund’s assets had been solely invested in Treasury
Bills on 31 December each year but this was at odds with Madoff’s
“split strike conversion strategy”, which required the purchase and
sale of a wide array of financial instruments such as stocks and
derivatives. The claim stated that such a volatile investment
scheme should not have yielded consistently smooth returns.

The plaintiff also claimed that KPMG should
have probed further as Madoff “initiated trades in the accounts,
executed the trades and administered the assets, a conflict of
interest”.

Other red flags include a high degree of
secrecy that surrounded the trading of these accounts and the fact
that Madoff family members controlled key positions at the
firm.

Madoff was audited by a tiny three-employee
accounting firm, Friehling & Horowitz. This firm has also come
under the spotlight as it is not registered by the Public Company’s
Accounting and Oversight Board and has not been subject to a
peer-review.

Pomerantz partner Mark Gross explained:
“Tremont collected millions of dollars in management fees from the
fund while turning a blind eye to numerous red flags indicating
that Madoff was a fraud and that the fund’s assets were in grave
danger.

“Tremont could not have done this, however,
without the imprimatur received from the fund’s auditor, KPMG,
which told the fund that there was nothing to worry about and that
its assets were safely invested. We hope this case is a major step
in recovering the fund’s losses caused by these derelictions of
duty.”

KPMG said that its work conformed to all
professional standards.

Ernst & Young (E&Y) was named among
the defendants in a claim brought by Repex Ventures in the US
District Court for the Southern District of New York.

The claim is against Austria’s Bank Medici and
related parties, which invested $3.2 billion in BMIS through three
separate funds, including the Herald Lux US Absolute Return
fund.

Citing similar red flags as the KPMG lawsuit,
the complaint stated: “E&Y were at all relevant times the
accountants for both the Herald and Primeo Funds. E&Y audited
the Herald and Primeo Funds and falsely represented to plaintiff
and the class that their investments were secure and gaining
value.

“E&Y ignored the many red flags which
would have shown that these funds were not safe and growing, but
were instead invested in a Ponzi scheme.”

Firms reject claims

Late last year, BDO Seidman was also named in
a case brought against Ascot Partners fund. A statement from BDO
Seidman at the time said the firm was not and had never been the
auditor of BMIS.

“BDO Seidman’s audits of Ascot Partners and
Gabriel Capital conformed to all professional standards and we will
vigorously defend ourselves,” the statement said.

PwC Canada rejected claims it had been
negligent in the audit of feeder fund Fairfield Greenwich Group.
The firm stated the claim was baseless and reiterated the fact that
it did not audit BMIS “where the alleged fraud occurred”.

PwC Ireland was named among the defendants in
a class action filed in Miami against Optimal Investment Services,
a hedge fund unit of the Spanish bank Santander that lost €2.33
billion ($3.09 billion) in client funds in the Madoff Ponzi scheme.
The suit was launched by lawyers representing two Latin American
investors.

McGladrey & Pullen was accused of
negligence for failing to detect the Madoff fraud in a claim filed
in the Connecticut Superior Court. McGladrey & Pullen audited
Maxam Absolute Fund, which had invested $280 million in assets in
BMIS.

Combined, Madoff lawsuits have targeted five
of the seven largest audit firms in the US and this is a trend that
is likely to continue, warned Howard.

“The amount of money involved just means they
are going to come thick and fast whether they have merit or not,”
she said.

MADOFF FRAUD

At a glance

What: Largest Ponzi
scheme in US history. Investors were duped out of $50 billion.

Who: Bernard L.
Madoff Investments Securities (BMIS)

Orchestrator:
Bernard Madoff (71 years old)

Audit firms targeted in
lawsuits:
KPMG US, Ernst & Young,
PricewaterhouseCoopers Canada, PricewaterhouseCoopers Ireland, BDO
Seidman and McGladrey & Pullen.

Why: Lawyers claim
that auditors of BMIS feeder funds should have detected the fraud
by picking up several red flags. Auditors argue they followed
professional standards and were not responsible for the detection
of fraud and the affairs of a non-client.

Legal viewpoint:

“I think it does smack of deep
pocket syndrome. The assumption is ‘[the auditors] were on the
scene and, therefore, should have been responsible for pointing
everything out’. I think the auditors would be well advised to
argue that it wasn’t within the scope of their retainer.”

Jane Howard, Reynolds Porter
Chamberlain

Source: International Accounting
Bulletin