Determine the regulatory oversight that was in place while the Ponzi scheme was operating,
and speculate on the main reasons why they did not discover the scheme.
Assume you are an auditor for a firm that had $10 million dollars invested in Madoff Securities.
Determine the fundamental audit procedures that you should have applied to this investment.
Predict the way in which a peer review of Friehling and Horowitz would have uncovered the scheme related to Madoff Securities.
Introduction
Madoff security was founded in 1960 by Bernard Madoff in Wall Street in the US. Madoff
Investment Scandal came to light in December the year 2008 after Bernard Madoff himself
admitted that his entire business was a complex Ponzi scheme (DeStefano, 2009). He was
arrested in March 2009 and sentenced in June 2009 to 150 years and a restitution of $17 billion
after pleading guilty to the charges leveled against him (Glovin, 2009). The fraud was estimated
to be $ 64.8 billion by the prosecutors while his liabilities amounted to US$50 billion (Chad,
2009). Half of the total investors in Madoff securities lost their money while one of his Sons’
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Mark Madoff was reported to have committed suicide in December the year 2010 while the other
known as peter agreed to a prison jail term of ten years.
The regulatory body that was in charge of the general operations and financial management of
the financial institutions at the time of the Madoff Securities scandal was the Securities and
Exchange Commission while the other ones were the Securities Industry and Financial Markets
Association known as the SIFMA and the House Financial Services Subcommittee on Capital
Markets. The Financial Industry Regulatory Authority over saw the activities of stock brokerage
firms.
The major reason that may have prevented the regulatory authority from investigating Madoff
Securities as early as the year 1999 when Securities and Exchange Commission first investigated
Madoff Securities was that Bernard Madoff was a professional broker who had experience in
dealing with stocks and investments besides he chaired the board of NASDAQ at one time hence
he was very influential in financial matters especial on matters that touched on the Capital
markets and other financial markets. These influence prevented anyone who didn’t have factual
information to inquire or order investigation on the activities of Madoff securities (Feuer, 2008).
He created imaginary profits from his illegal operations to woo more investors. The knowledge
and experience that Bernard Madoff had when he was a stock broker made him to successfully
hide his fraudulent activities from the SEC which conducted several investigations again in 2001
but never unearthed any significant evidence against him. Erin Arvelund wrote in one of his
articles that Madoff’s secrecy prevented most of his investors from knowing his exact business
operations while the hedge funds that largely invested in his company were prevented from
naming him as the financial manager on their marketing prospectus ( Arvedlund, 2001). Madoff
managed to sell most of the firm’s holdings for cash at the end of each financial period hence he
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practically avoided filling any forms of disclosures under SEC. Madoff turned down any offers
of internal audit under the guise of company secrecy and ascertained that his brother peter was in
charge of all the financial compliance with the SEC. Most hedge funds use major banks to hold
their portfolios hence it’s easy to verify their total holdings but Madoff securities processed all
its issues and trades while acting also as a broker and dealer.
b) The audit procedures would entail some checks on all cash flows, liabilities and assets. A
hedge fund utilizes equity and also loans to manage and fund its projects. The returns or profits
on the assets known as the investments are used to generate profits. These profits or dividends
are used to pay the equity investors.
To audit the books of account the auditor and all the interested investors should be allowed to
review all the accounting books of a company including inviting a reputable audit firm to review
the books on their behalf. A fund is generally a company. Madoff security was not a fund and he
created a large separation between himself and the investors. He only used manipulated paper
statements and controlled all the company’s financial processes and reports. He also managed all
the brokerage accounts. The accounting procedures of segregating all the critical accounting
functions from one office in order to act as checks and balances for mistakes and
misappropriations should be implemented. The investors and company clients should all be
provided with independent audit results on the financial dealings of the firm. Performance alone
cannot guarantee the integrity of a financial process.
c) The peer review by Friehling and Horowitz would have questioned the secrecy that Madoff
handled all the company’s transactions and the reasons why he required his investors on the
hedge funds not to mention his name as the financial manager on their marketing prospectus
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( Arvedlund, 2001). Friehling and Horowitz should have also enquired why Madoff performed
most of the company functions alone and why a multi-billion fund had only a few employees in
their head office.
All the interested investors should have been allowed to review all the accounting books of a
company and also invited a reputable audit firm to review and audit the books on the books of
Madoff securities. A fund is generally a company and Madoff security was not a fund. It was
only registered in 2006 that’s years after it had been involved in financial mismanagement. He
only used manipulated paper statements and controlled all the company’s financial processes and
reports. He also managed all the brokerage accounts.
c) The secrecy and the large separation between himself and the investors should also have been
investigated by Markopolos. The secrecy meant that he was hiding something from the
regulatory authority. For example, he needed time to manipulate the paper statements.
d) All the interested investors should have been allowed to review all the accounting books of a
company and also invited a reputable audit firm to review and audit the books on the books of
Madoff securities. These actions would have led to discoveries by the different investors on their
investment and dividends returns. Qualified auditors would have noted that Madoff’s security
was not a registered company and it was operating illegally as a hedge fund. Most hedge funds
use major banks to hold their portfolios hence it’s easy to verify their total holdings but Madoff
securities processed all its issues and trades while acting also as a broker and dealer. It was
impossible to verify Madoff’s holdings as he acted alone in most of his transactions and used the
JPMorgan Chase bank as the center of his fraud. The bank was later accused violating the Bank
secrecy Act by failing to report the Madoff’s suspicious activities and its failure to implement
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proper anti-laundering control procedures for fraudulently obtained money. The bank provided a
cover up for his illegal operations.
Finally to conclude, Madoff’s past experiences in financial markets and his large influence in the
capital markets provided him with an edge against his accusers during his early years but when
the fund expanded and more investors invested their monies in the fund it begun to crumble as
the scheme could not service the huge promises that came with the illegal fund.
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References
Feuer, A, H. C. (2008). “Standing Accused: A Pillar of Finance and Charity” . The New York
Times. Retrieved October 27, 2011.
Glovin, D. (2009). “Madoff Prosecutors Get 30 More Days for Indictment” . Bloomberg L.P.
Retrieved February 11, 2009.
DeStefano, A. M. (2009). “Madoff expected to plead guilty in Ponzi scheme” . Newsday .
Retrieved March 7, 2009.
Chad, B. (2009). “Madoff Pleads Guilty to Massive Fraud” . The Wall Street Journal (Dow Jones,
Inc). Retrieved March 12, 2009.
Arvedlund, E. E. (2001). “Don’t Ask, Don’t Tell – Bernie Madoff is so secretive, he even asks
investors to keep mum” . Barron’s May 7, Retrieved August 12, 2009.
