On December 11, 2008, Bernie Madoff was arrested on one count of securities fraud. The arrest came one day after Madoff admitted to his two sons that his entire investment advisory business was just one big Ponzi scheme. In the early part of 2009, Madoff pled guilty to 11 counts of fraud, perjury, and money laundering. As a result, Madoff was sentenced to 150 years in prison. How did Madoff defraud investors out of as much as $65 billion? This case provides an overview of how Madoff was able to commit the Fraud of the Century.

PONZI SCHEME

A Ponzi scheme is any fraudulent investment plan that pays its returns to an investor from either that investor’s own principal or principal paid by future investors, not from legitimate investment returns. To carry out his plan, Bernie Madoff represented to clients and potential clients that he used an innovative “split-strike conversion strategy” to invest their money. In so doing, he claimed to invest their money in “shares of common stock, options and other securities of well-known corporations, and upon request, would return to them their profits and principal.” In fact, Madoff never invested the funds in the securities that had been promised. Rather, the funds were deposited into a bank account at Chase Manhattan Bank, based in New York City. If clients requested to receive “profits earned” or redeem their investment principal, Madoff merely used the money in the bank account at Chase Manhattan Bank that had belonged to either that client or other clients to pay off the requested sum.

SPLIT-STRIKE CONVERSION STRATEGY

Madoff created Madoff Investment Securities in the 1960s with $5,000 that he had earned from installing refrigeration systems and working as a lifeguard. By the late 1980s, Madoff had hired a number of family members and had earned a sterling reputation on Wall Street. By the early 1990s, Madoff began to receive investment commitments from key institutional investors. While he did not promise specific rates of return to clients, Madoff knew that the investors expected that their investment would perform at a level higher than the market average. To meet their expectations, Madoff claimed to have mastered a “split-strike conversion strategy.”

Under his split-strike conversion strategy, Madoff promised clients and prospective clients that their funds would be invested in a “basket of stocks that would closely mimic the price movements of the Standard & Poor’s 100 Index.” He further promised to “opportunistically time these purchases and would be out of the market intermittently, investing client funds during these periods in United States Government-issued securities such as United States Treasury bills.” Madoff also promised to hedge the investments in common stocks “by using client funds to buy and sell options contracts related to those stocks, thereby limiting potential client losses caused by unpredictable changes in stock prices.” Madoff, in reality, never made the investments that he promised to clients.

To help conceal the Ponzi scheme from investors, Madoff created “false trading confirmations and client account statements that reflected the bogus transactions and positions” and then sent them to investment clients. According to Madoff, “The clients receiving trade confirmations and account statements had no way of knowing by reviewing these documents that I had never engaged in the transactions represented on the statements and confirmations.”

SECURITIES AND EXCHANGE COMMISSION

Interestingly, between June 1992 and December 2008, the SEC received several complaints regarding Madoff’s hedge fund, including those from Harry Markopolos, a portfolio manager at Rampart Investment Management in Boston; yet, ultimately the SEC was unable to uncover Madoff’s Ponzi scheme. In May 2000, Markopolos submitted evidence to the SEC that questioned the legitimacy of the returns on Madoff’s hedge fund. In his submission, Markopolos wrote that Madoff’s reported performance, which when charted rose roughly at a 45-degree angle, did not exist in finance.

Markopolos e-mailed a second submission to the SEC on March 1, 2001, in which he presented additional analysis on Madoff’s returns. Markopolos wrote that Madoff reportedly earned more than 15.5 percent a year for more than seven years, with an extremely low standard deviation of 4.3 percent. This was in contrast to the S&P 500, which earned more than 19.5 percent but with an annual standard deviation of 12.9 percent. In addition, Madoff’s fund had only three down months in contrast to the market being down 26 months during the same period. “For example, in 1993 when the S&P returned 1.33%, Bernie returned 14.55%; in 1999 the S&P returned 21.04%, and there was Bernie at 16.69%. . . . His returns were always good, but rarely spectacular. So it wasn’t his returns that bothered me so much—his returns each month were possible—it was that he always returned a profit. There was no mathematical model that could explain the consistency.” “This program earned 80% of the market’s return with only one-third of the risk. Think about it! Is this really possible, or is it too good to be true?” wrote Markopolos.

In October 2005, Markopolos made his third submission, titled “The World’s Largest Hedge Fund Is a Fraud,” to the SEC. Markopolos’s submission included 30 red flags that indicated that it was “highly likely” that Madoff was operating a Ponzi scheme. Each red flag fell into one of three categories: (1) Madoff’s obsessive secrecy; (2) the impossibility of Madoff’s returns, particularly the consistency of those returns; and (3) the unrealistic volume of options Madoff was supposedly trading. Despite all of the warnings, the SEC failed to uncover the Madoff Ponzi scheme on its own.

MADOFF’S AUDITOR

From 1991 through 2008, Bernard L. Madoff Investment and Securities’ (BLMIS) financial statements were audited by the accounting firm Friehling & Horowitz. In March 2009, David Friehling, who was a CPA licensed by the state of New York, was arrested and charged with securities fraud, aiding Madoff with investment advisor fraud, and filing false audit reports with the SEC. The charges brought against Friehling include that he failed to do the following:

• Conduct independent verification of BLMIS revenues, assets, liabilities related to BLMIS client accounts, and the purchase and custody of securities by BLMIS.
• Test internal controls over areas such as the payment of invoices for corporate expenses or the purchase of securities by BLMIS on behalf of its clients.
• Examine a bank account through which BLMIS client funds flowed.

The SEC also filed a civil case against Friehling and his firm Friehling & Horowitz. The AICPA and the New York State Society of CPAs have expelled Friehling from membership. Under the AICPA’s peer review program, auditors are monitored through mandatory peer review every three years. Friehling’s work was not peer-reviewed because, since 1993, he had informed the AICPA that he did not perform audits, and therefore, would not need a peer review. At the time, New York was one of only six states that did not require accounting firms to be peer-reviewed. However, beginning January 1, 2012, New York firms with three or more accounting professionals must be peer-reviewed once every three years.

On November 3, 2009, Madoff’s auditor David Friehling changed his plea from not guilty to guilty for the crimes involving the filing of falsely certified audits and financial statements with the SEC. Although Friehling was initially supposed to be sentenced in 2010, the sentencing was repeatedly postponed due to his cooperation with the government. In May 2015, citing his cooperation with the government, a federal judge sentenced Friehling to one year of home detention and one year of supervised release. Friehling lost his CPA license in July 2010.

1. Refer to the fundamental principles governing an audit. Under the responsibilities principle, auditors are required to exercise due care and maintain professional skepticism throughout the audit. Based on the case information, do you believe that the auditors from Friehling & Horowitz exercised due care and maintained professional skepticism throughout the audit? Why or why not?
2. After the Madoff case, the SEC instituted a number of reforms to its operations. Visit the SEC’s website (www.sec.gov) and search for Post-Madoff reforms. Next, please identify the two reforms that you believe will have the best chance of catching a criminal like Madoff. Make sure to provide justification for your choices.
3. Consider section 24 of the Securities Act of 1933 and section 32 of the Securities Exchange Act of 1934. Based on the case information, do you believe that Madoff’s auditor, Friehling, should be facing criminal charges? Why or why not?

Answer rating: 100% (QA)

1 Refer to fundamental principles governing an audit see chapter 2 Under the responsibilities principle auditors are required to exercise due care and maintain professional skepticism throughout the a... View the full answer