Madoff's brokerage firm initially traded only securities of small over-the-counter companies, securities commonly referred to as "penny stocks." At the time, the securities of most large companies were traded on the New York Stock Exchange (NYSE).
The rules of that exchange made it extremely difficult for small brokerage firms such as Madoff's to compete with the cartel of large brokerage firms that effectively controlled Wall Street. Madoff and many other small brokers insisted that the NYSE's rules were anticompetitive and inconsistent with a free market economy. Madoff was also convinced that the major brokerage firms kept securities transaction costs artificially high to produce windfall profits for themselves to the detriment of investors, particularly small investors.
Because of Madoff's resentment of the major Wall Street brokerage firms, he made it his mission to "democratize" the securities markets in the United States while at the same time reducing the transaction costs of trading securities. "Bernie was the king of democratization. He was messianic about this. He pushed to automate the [securities trading] system, listing buyers and sellers on a computer that anyone could access."²
In fact, Madoff Securities was one of the first brokerage firms to utilize computers to expedite the processing of securities transactions. Bernie Madoff is also credited as one of the founders of the NASDAQ stock exchange that was organized in 1971.
The NASDAQ was destined to become the world's largest electronic stock exchange and the largest global stock exchange in terms of trading volume. In the late 1980s and early 1990s, Madoff served three one-year terms as the chairman of the NASDAQ.
Madoff's leadership role in the development of electronic securities trading contributed significantly to his firm's impressive growth throughout the latter decades of the twentieth century. By the early years of the twenty-first century, Madoff Securities was the largest "market maker" on the NASDAQ, meaning that the firm accounted for more daily transaction volume on that exchange than any other brokerage.3 By that time, the firm was also among the largest market makers for the New York Stock Exchange, accounting for as much as 5 percent of its daily transaction volume. This market making service was lucrative with low risk for Madoff Securities and reportedly earned the firm, which was privately owned throughout its existence, annual profits measured in the tens of millions of dollars.
In 1962, Madoff had expanded his firm to include investment advisory services. For several years, most of the individuals who set up investment accounts with Madoff Securities were referred to him by his father-in-law. Although the firm was a pioneer in electronic trading and made sizable profits from its brokerage operations, investment advisory services would prove to be its most important line of business. By late 2008, the total value of customer accounts managed by Madoff Securities reached $65 billion.
The key factor that accounted for the incredible growth in the amount of money entrusted to Madoff's firm by investors worldwide was the impressive rates of return that the firm earned annually on the funds that it managed. For decades, those funds earned an average annual rate of return generally ranging from 10 to 15 percent.
Although impressive, those rates of return were not spectacular. What was spectacular was the consistency of the returns. In 2001, Barron's reported that some of the Madoff firm's largest investment funds had never experienced a losing year despite significant stock market declines in several individual years. 4 Even when the stock market collapsed in late 2008, individual Madoff funds continued to report net gains for the year-to-date period.
Although Madoff would eventually serve as an investment advisor to dozens of celebrities, professional athletes, and other wealthy individuals, most of the money he managed came from so-called feeder firms, which were large hedge funds, banks, and other investment companies. The individuals who had committed their funds to these feeder firms were typically unaware that those funds had been turned over to Madoff.
The reclusive Madoff and his subordinates disclosed as little as possible about the investment strategy responsible for their firm's success in the stock market. On one occasion, Madoff told an executive of a feeder firm, "It's no one's business what goes on here."5 The Wall Street Journal reported that Madoff commonly "brushed off" skeptics who questioned his firm's investment results by pointing out that those results had been audited and by insisting that his investment strategy "was too complicated for outsiders to understand."⁶
The only substantive information Madoff Securities provided regarding its investment policies was that it employed a "split-strike conversion" investment model. In simple terms, this strategy involved purchasing several dozen blue-chip stocks and then simultaneously selling both put options and call options on those securities.
Supposedly, this strategy ensured a positive rate of return on those investments whether the stock market went up or went down.
Competitors, financial analysts, and academics repeatedly attempted to replicate the success of Madoff Securities' investment strategy. None of those attempts were successful, which only added to Bernie Madoff's stature and mystique on Wall Street.
As one industry insider noted in 2001, "Even knowledgeable people can't really tell you what he's doing."7 A CNN reporter observed that by the turn of the century Madoff was widely regarded as a stock market wizard and that "everyone" on Wall Street, including his closest competitors, was "in awe of him."⁸

Questions
1. Suppose that a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff Securities. What audit procedures should the investment firm's independent auditors have applied to those assets?
2. Describe the nature and purpose of a "peer review." Would peer reviews of Friehling & Horowitz have likely resulted in the discovery of the Madoff fraud? Why or why not?
3. Professional auditing standards discuss the three key "conditions" that are typically present when a financial fraud occurs and identify a lengthy list of "fraud risk factors." Briefly explain the difference between a fraud "condition" and a "fraud risk factor" and provide examples of each. What fraud conditions and fraud risk factors were apparently present in the Madoff case?
4. In addition to the reforms mentioned in this case, recommend other financial reporting and auditing-related reforms that would likely be effective in preventing or detecting frauds similar to that perpetrated by Madoff.