SEC Focuses On Auditor Risks Following Madoff Fraud

September 15th, 2009

Speaking at a Senate Banking Committee hearing on September 10, 2009, a senior-level SEC official said the Commission is paying “a lot more attention” to auditor risks following the Madoff fraud. The official is John Walsh, Acting Director of the SEC’s Office of Compliance Inspections and Examinations. His remarks were made in response to a question from Senator Jeff Merkley (D-OR) about lessons learned from an in-depth report by the SEC Inspector General on the SEC’s failure to uncover the fraud.

Auditor-related Red Flags

The Inspector General’s report identifies several auditor-related red flags, including:

  1. Reports that Madoff’s auditor was his brother or brother-in-law. (These reports raise concerns about the auditor’s independence or ability to conduct an unbiased, fair and impartial audit).
  2. Reports of Madoff’s excessive secrecy and refusals to allow investors to hire their own auditors to audit his books. (A large international investor was reportedly told that only Madoff’s brother is allowed to audit performance for reasons of secrecy.)
  3. Reports that the audit firm’s capabilities appeared inadequate to handle the billions of dollars that Madoff was managing for investors. The specifics included the audit firm’s relatively small size (three employees), the obscurity of its location (“New City, NY”), and its lack of visibility to those with industry expertise.

Despite these red flags, the SEC staff apparently did not take the time to examine the auditor’s work papers, and the Inspector General concluded that this was a mistake. If they had, the fraud would have been detected earlier. After Madoff confessed to running a Ponzi scheme, the SEC staff requested copies of the auditor’s work papers. Within hours of obtaining the work papers, they were able to determine that no audit work had been done.

Coming Reforms

SEC’s Walsh explained that, “This [auditor inadequacy] is one of the high risk factors that we are looking into to see if there are more problems lurking out there.” In addition, the SEC is adding more specialists and looking at other risk factors that can be identified by specialized industry expertise and analytical procedures. Examples related to the Madoff fraud might include the apparent misrepresentations of trading volume, unusually consistent and non-volatile returns, and the use of an unusual fee structure.

On balance, investors can be encouraged by the list of reforms that Congress and the SEC are putting in place after the Madoff swindle.

  • The SEC’s list of reforms is posted on its website.
  • Other upcoming reforms were described in the testimony of Walsh and Robert Khuzami, the SEC Director of the Division of Enforcement, at the Senate hearing.
  • The US Public Company accounting Oversight Board (PCAOB) has issued new rules. In January 2009 the PCAOB issued a release announcing that financial statements of non-public broker-dealers for fiscal years ending after December 31, 2008 must be certified by a registered public accounting firm. (Madoff’s auditor escaped PCAOB registration and inspections because, at the time of the Madoff swindle, auditors of non-public broker-dealers were not required to register with the PCAOB.)
  • In September 2009, Senator Charles Schumer (D-NY) issued a news release saying that he is drafting legislation that would allow the SEC to keep all of the fees it collects so it can afford to recruit and retain better-trained personnel.

Open Questions

At the top of the list of open questions is one posed by Senator Schumer at the end of the hearing. He asked, “Is a higher standard of criminality needed?”

Schumer posed the question following remarks by Harry Markopolos, the whistle-blower who sent the SEC a long list of red flags indicating that Madoff was likely running a Ponzi scheme. Markopolos’ testimony included this observation: “The law is the lowest form of acceptable behavior, but ethics are a higher standard that the SEC’s securities lawyers seem to ignore time and again.” As one example, Markopolos pointed to mutual fund market-timing. Another example might relate to violations by auditors of applicable ethical standards or codes of conduct.

According to the SEC’s enforcement release, Madoff’s auditor was not subjected to the required inspections in the US for auditors of non-public broker-dealers for years because he made false representations to the American Institute of CPAs (AICPA) about the firm’s involvement in issuing audit opinions. A peer review would have served as an effective safety net for the SEC staff. It is fair that the SEC should shoulder some of the blame for not uncovering the scandal sooner. But, as pointed out in a recent editorial in Investment News, the SEC was not alone is missing the Madoff debacle.

In the aftermath of what has described as “the biggest international swindle of all time,” Schumer’s question is a good one. Is it enough to encourage whistle-blowing to the SEC? Or should stiffer more direct criminal penalties apply to unethical conduct?

Another good question is, “Could better communications to investors help prevent another Madoff scandal?” Clearer communications about such matters as inspections might be a good starting point. It seems likely that some investors misunderstood the meaning of Madoff’s representations that his firm has just been inspected by the SEC. Some may have thought of this as some sort of seal of approval. Others may never have fully understood where to look for an AICPA peer review or what it means that a firm is (or is not) peer-reviewed.

Entry Filed under: Governance

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