December 18, 2008

Madoff Upate: If It Sounds Too Good to Be True …..

Well, my speculation that irregularities involving Bernard Madoff go back only a few years was incorrect. It was a guess borne of overconfidence in securities industry oversight — not regulations, which as written are more than adequate, but oversight, which is carrying out the regs.

A Wall Street Journal editorial today notes that:

Since at least 1992, when the SEC sued two accountants peddling Madoff investments while promising sky-high returns, the commission missed opportunities to dig deeper into his operations. In 1999, trader Harry Markopolos wrote that “Madoff Securities is the world’s largest Ponzi Scheme,” in a letter to the SEC. More recently, multiple SEC inquiries and exams in 2005 and 2007 found only minor infractions.

A front-page WSJ article today (subscriber-only unless you include the search engine portion of the URL) goes over what Markopolos did to try to reverse-engineer Madoff’s performance (he and others he consulted couldn’t). In 2001, Madoff supposedly had $12 billion in assets; how much of that was fictitious is apparently unknown. When he was arrested last week, the estimate was up to $50 billion. It’s clear that mostly federal but also state regulators (paging New York’s Eliot Spitzer, whose main interests were ruining others and certain extracurricular activities) should have paid more attention to Markopolos and others, and, even if people such as Markopolos weren’t raising red flags, better exercising the oversight work they have been charged to do.

(Side analogy: People should have paid more attention to mostly-GOP senators and congressmen who were warning about debacles at Fannie Mae and Freddie Mac — also clear failures of oversight — that dwarf what Madoff did.)

The Journal’s editorial notes that the SEC’s budget has tripled since 1999, but it would appear that its effectiveness hasn’t.

Madoff’s “accounting firm” (which is really “one guy“)? I wrote on Monday that if the vast majority of the losses aren’t very recent, “the CPA firm (Friehling & Horowitz) could actually be off the hook. Otherwise, they’re in fatally serious trouble.”

It’s even worse than that, as the firm, i.e., Friehling, has told the American Institute of CPAs for 15 years that it, i.e., he, doesn’t perform audits.

The next line of defense is professional peer review by another CPA firm. But if you don’t do audits, you don’t have to enroll; or if you’re enrolled, as F&H was, you don’t have to be reviewed if you don’t do audits, as this technical language-laced January 2008 guidance from the AICPA states:

(Question) Does My Firm Have to Enroll in a Peer Review Program if the only engagements it performs are Compilations issued with Engagement Letters and without a Report as detailed in SSARSNo. 8? (i.e., not reports that express an opinion on financial statements — Ed.)

(Answer) Under the AICPA bylaws, firms (or individuals in certain situations) are only required to enroll in an Institute-approved practice monitoring program when the engagements they perform are within the scope of the AICPA’s practice-monitoring standards and issue reports purporting to be in accordance with AICPA professional standards.

….. For firms already enrolled (and that stay enrolled) in the AICPA Peer Review Program, these engagements currently would fall within the scope of peer review and would require a firm to undergo a peer review.

So in theory, the AICPA could have forced F&H to go through peer review. But because of the accounting standards compliance workload involved and liability exposure, probably thousands of firms who are in the program who used to do audits or other “attest engagements” don’t do them any more. So how are you going to catch someone who says they aren’t doing audits when they (supposedly) are (or are at least putting their names on audit opinions)?

New York’s legislature has just passed a law making peer review mandatory for CPA firms doing business in the state (if you’re looking for a regulatory failure, that’s it; guess who was Attorney General and seen as a great regulator for most of the past 10 years, and “somehow” didn’t get around to this?). But there isn’t a peer review procedure for “prove that you don’t do audits” when someone says they don’t, and it could be that even under New York’s new law that another F&H could still opt out with the same excuse it used on the AICPA.

That leads back to the SEC, the regulators who presumably got the audit reports but didn’t exercise adequate oversight, even when warned for years by Markopolos and others. It also leads back to other investment firms who used Madoff, very few of whom appear to have asked of F&H, “Who are these guys?”

The Journal editorial’s conclusion, while valid, is quite a bit less than satisfying:

There’s a lesson here for investors and Congress. Instead of shoveling more money and power to the regulators who already had plenty of both, let’s take care not to overregulate the people who actually warned about Mr. Madoff’s miracle returns. Law enforcement is useful in punishing wrongdoers after the fact, which will deter some crooks. But expecting the SEC to prevent a determined and crafty con man from separating investors from their money is no more sensible than putting your life savings with a Bernard Madoff.

Their point is that the supposed security provided by regulators is not an excuse to avoid doing your own due diligence and listening to warning signs, including this one: If it sounds to good to be true, it almost definitely is. But regulators who didn’t exercise the oversight expected of them shouldn’t be getting off the hook.

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UPDATE: You can’t play the “affinity warning” enough, and this Robert Cass column in today’s WSJ goes there quite well, with another “the regulators won’t save you” caution –

The Madoff tale is striking in part because it is like stealing from family. Yet frauds that prey on people who share bonds of religion or ethnicity, who travel in the same circles, are quite common.

….. In each case, the perpetrator relied on the fact that being from the same community provided a reason to trust the sales pitch, to believe it was plausible that someone from the same background would give you a deal that, if offered by someone without such ties, would sound too good to be true.

….. Predictably, the Madoff story has prompted speculation about potential new regulations that might be imposed to head off future problems. Politicians and pundits have called for the adoption of new rules for securities markets in general and hedge funds in particular, even though Mr. Madoff didn’t run a hedge fund and there is no shortage of existing securities rules that were violated by his reported conduct. (Keeping two sets of books suggests his own recognition of that.)

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