Ponzi's Auditors

by Thomas Brom

Financier Bernie Madoff is now serving 150 years for creating the world's biggest Ponzi scheme. His accountant has pled guilty to criminal charges and is cooperating with prosecutors. But some of the thousands of investors who were burned for more than $50 billion still hope to get their money back.

In the chase to locate recoverable assets, plaintiffs have sued Madoff's relatives, his auditor, his banks, his "feeder" hedge funds, and the auditors of those funds. The feeder funds were critical to Madoff's success, pooling investments from individuals, promising due diligence, and offering investors the presumed assurance of audits by major accounting firms.

The question, asked now in pleadings in multiple jurisdictions, is whether those accounting firms had an obligation to look beyond the feeder fund financials to question operations at Madoff's home office - where whistleblower Harry Markopolos famously warned the SEC, "There are not enough index option put contracts in existence to hedge the way [Madoff] says he is hedging!"

The SEC ignored Markopolos's letter in 2005, closing its Madoff investigation in January 2008 with the conclusion, "The staff found no evidence of fraud." That report proved embarrassing, and it provided excellent cover for auditors later accused of overlooking red flags. But the facts were undeniable: Billions of dollars in purported assets didn't really exist, and thousands of reported transactions never occurred.

"Auditing firms are supposed to be evaluating corporate governance, not just acting as bookkeepers," says Francine McKenna, a principal at Chicago-based McKenna Partners who blogs at re: The Auditors (http://retheauditors .com). "There are very thorough fraud checks under [Statement on Auditing Standards No.] 99 designed to spot red flags. This is very basic stuff, unrelated to the internal controls requirements of Sarbanes-Oxley."

The Madoff feeder fund litigation is now beginning to ripen - and not in a good way for investors. In March a federal district court in New York dismissed all claims against KPMG (Meridian Horizon Fund, LP v. Tremont Group Holdings, Inc. (2010 WL 1257567 (S.D.N.Y. motion granted March 31, 2010)). "The standard for pleading auditor scienter is demanding," wrote District Judge Thomas P. Griesa. Citing a recent opinion, he added, "a plaintiff must allege that the accounting practices were so deficient that the 'audit amounted to no audit at all, or an egregious refusal to see the obvious, or investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decision if confronted with the same facts.' " (Citing In re Scottish Re Group Secs. Litig., 524 F. Supp. 2d 370, 385 (S.D.N.Y. 2007).)

Then in May, New York Supreme Court Judge Richard B. Lowe III dismissed claims against BDO Seidman, which had audited the financial statements of a Madoff feeder fund and issued clean opinions on the financials (CRT Investments, Ltd. v. Merkin, No. 601052/09 (N.Y. Sup. Ct., New York County motion granted May 5, 2010)). "The court reached the correct decision," says John H. Eickemeyer, a shareholder at New York's Vedder Price whose firm represents defendants in other Madoff feeder fund suits. Citing Judge Griesa's opinion in the federal case, Eickemeyer adds, "There is no obligation on the accountant's part to audit the underlying Madoff fund."

But Judge Lowe was troubled by his own ruling, noting that "these types of allegations of scienter against auditors of investment funds in these situations appear to be recurring, yet they cannot go beyond the motion to dismiss stage and into discovery under the present state of the law. The inability to explore the alleged wrongdoing any further and potentially hold these parties accountable is frustrating to the court."

Third-party claims against auditors, especially allegations of professional negligence, are notoriously difficult to maintain. Negligence law differs state by state, with jurisdictions generally applying one of several common law theories of recovery. In New York, the near-privity doctrine prevails, which requires a linking relationship between the investor and the auditing firm. Private actions may also be preempted by the Martin Act, which gives the New York attorney general the exclusive authority to assert claims for securities fraud. In California, auditors owe no general duty of care to persons other than the client. An auditor may, however, be held liable for negligent misrepresentation if it is intended that third parties will rely on a report (Bily v. Arthur Young & Co., 3 Cal. 4th 370, 376 (1992)).

"With so many cases now spread through so many jurisdictions, judges have got to say, 'We need to hear the arguments,' " says McKenna, who has worked at two of the Big Four accounting firms. "They can see the smoke, but they can't get to the fire."

So what's a plaintiffs lawyer to do? Last year attorneys in New York and California filed derivative suits - which avoid the privity issue - in New York courts. In March two of the derivative suits that included malpractice claims against Madoff feeder fund auditors became the first in a New York jurisdiction to survive a motion to dismiss (Sacher ex rel. Beacon Assoc. LLC II v. Beacon Assoc. Mgmt. Corp., 2010 WL 1881951 (N.Y. Sup. Ct., Nassau County motion denied April 26, 2010); Hecht ex rel. Andover Assoc. I v. Andover Assoc. Mgmt. Corp., 2010 WL 1254546 (N.Y. Sup. Ct., Nassau County motion denied March 12, 2010)).

"Accountants have a duty to be skeptical," says Charles J. Hecht, the principal in New York's Hecht & Associates. "In Andover, they certified to the existence of assets that did not exist - there were enough red flags that you'd have to be deaf, dumb, and blind not to see them."

Cotchett, Pitre & McCarthy in Burlingame also filed a derivative suit against KPMG in the Madoff feeder fund litigation (Wexler ex rel. Rye Select Broad Market Prime Fund LP v. KPMG LLP, No. 101615/09 (N.Y. Sup. Ct., New York County)). "The auditors always say they have a limited, small job," says Nancy L. Fineman, a partner at Cotchett Pitre who interviewed Madoff in prison last summer. "But in these cases they gave unqualified statements in their audits - and the statements are misrepresentations."

Derivative suits, however, may still prove vulnerable to the doctrine of in pari delicto - Latin for "in equal fault." The equitable defense is most commonly used in courts when relief is being denied to both parties in a civil action because both were involved in wrongdoing. In the derivative context, it would mean that plaintiffs couldn't sue on behalf of a corporate entity if the entity, by imputation, was equally liable for the actions of its officers.

That defense is now at issue in Hecht's cases, and in an unrelated suit brought by a state teachers' retirement system against AIG in Delaware. In April the trial court in the Sacher case denied an auditor's motion to dismiss based on in pari delicto. (See 2010 WL 1881951 at *14.) But in the state teachers' litigation, the Delaware Chancery Court held that once wrongdoing is imputed to a corporation, claims against its auditor are barred as a matter of New York law. On appeal, the Delaware Supreme Court stayed a ruling pending response to this certified question sent to the New York Court of Appeals: "Would the doctrine of in pari delicto bar a derivative claim under New York laws where a corporation sues its outside auditor for professional malpractice or negligence based on the auditor's failure to detect fraud committed by the corporation; and, the outside auditor did not knowingly participate in the corporation's fraud, but instead, failed to satisfy professional standards in its audits of the corporation's financial statements?" (Teachers' Ret. Sys. of Louisiana v. PricewaterhouseCoopers LLP, 2010 WL 728794 at *3).)

If the Chancery Court ruling stands, it may foreclose the derivative suit option in New York. It would send a message that the Delaware Chancery Court looks favorably on foreclosing that option. And - in terms of fleecing the lambs - it would make Bernie Madoff look like a rank amateur.

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