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General News    H3'ed 6/18/10

MADOFF: THE LIABILITY OF THE SEC, FINRA,LARGE BANKS AND FUNDS, AND ACCOUNTANTS

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But though Chase and Morgan knew, or certainly should have known, that the 703 account was being used to perpetrate a fraud, and even that the precise nature of the fraud was that it was a Ponzi scheme, they serviced the account for decades in order to make hundreds of millions of dollars from it. This, I should think, makes them culpable coconspirators in the fraud, and liable to all victims -- all of whose monies went through the Chase and Morgan account.

I now turn briefly to the potential liability of various accountants. The two large accounting firms that have been assailed in major complaints that I've read are Price Waterhouse and KPMG. Both of them audited hedge funds or bank funds that invested with Madoff, with the global Price Waterhouse group being alleged to have audited eight funds having a total investment in Madoff of about 16.5 or 17 billion dollars. The accounting firms are accused of various acts of negligence, but the one which especially caught my eye is the failure to verify that the assets being claimed by the funds actually existed.

It has long been my impression, one confirmed yet again by statements in complaints, that it is a prime responsibility of auditors to take steps and conduct tests demonstrating that claimed assets do in fact exist. (Hasn't this duty been placed on auditors at least since the Billy Sol Estes scam of the 1960s, in which tanks did not contain the claimed salad oil or whatever kind of oil it was?) Yet, instead of verifying that the securities and options allegedly held by Madoff for the funds actually existed, as I believe was their duty, the accounting firms apparently just took Madoff's word for it. They sometimes asked a few simple questions which uncovered nothing, but that was it. Like the SEC, they did not make inquiries that would have uncovered the absence of trading or assets and did not ask Madoff for permission to make inquiries where the permission might have been necessary, e.g., for inquiries at the Depository Trust Company. So, it is my understanding, at least, that they negligently violated a cardinal rule of auditing.

Had they not failed to do their job properly, the whistle would inevitably have been blown on Madoff at least a decade earlier; even if the accountants did not have a duty to notify the government of the discovery of a giant fraud -- and it may be that they did have such a duty -- it is a virtual certainty that word of what was learned would have gotten around, especially since the accounting firms would have been unable to provide clean audits and indeed would have had to withdraw, I believe, from all of their many engagements with Madoff feeder funds.

For their negligent failure to audit properly, the accounting firms should plainly, I think, be liable to their hedge fund or bank fund clients (with whom they had a direct relationship or were in "privity"). But the more interesting question (especially since the accountants might be able to ward off the clients because the latter were themselves negligent) is whether the accountants can be liable to the investors in the funds, with whom they were not in privity but who depended upon the clean audits received by funds as an assurance that the funds had the assets and were making the monies they claimed to have and make. This dependence on auditors -- and particularly on the large accounting firms which do so much of the auditing of major companies, auditing on which tens of millions of investors, and the health of the economy, inevitably depend -- is a fundament of a healthy capitalist system and of the well being of the economy. Businessmen can be crooks, and lots are, but we depend on auditors to be completely honest and to play it straight. When auditors begin to ignore basic tenets of their profession, and thereby open the door to gigantic frauds, an entire economic system can be threatened. (One wonders, for example, why auditors did not uncover early-on that derivatives based on subprime mortgages were constructed of sand, were likely worthless because the assumptions underlying the mortgages were economically disastrous. True, the assets -- the subprime mortgages -- existed, unlike the securities and options in Madoff, but don't auditors have a duty not only to verify the assets' existence, but also that the assumptions underlying their purported value are not nuts? If there is no such duty, why do we have huge accounting battles about the propriety of mark to market versus original cost? Anyway, the overall point here is that the economy will get into enormous difficulty if auditors ignore cardinal tenets of auditing and thereby undermine a basic function, relating to value, on which all businessmen, investors and government officials rely.)

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Lawrence R. Velvel is a cofounder and the Dean of the Massachusetts School of Law, and is the founder of the American College of History and Legal Studies.
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