Focus On Accountants:
Bernie Madoff and Auditor Liability—From “A” to Ponzi
Leon A. LaRosa, Jr., CPA, CFE, CFF
EisnerAmper LLP
101 West Avenue, PO Box 458
Jenkintown, PA 19046
(215) 881-8800
Leon.larossa@eisneramper.com
Jonathan S. Ziss
Goldberg Segalla LLP
1700 Market Street, Suite 1418
Philadelphia, PA 19103
(267) 519-6820
jziss@goldbergsegalla.com
Leon A. LaRosa, Jr. is a partner in the litigation services group of EsinerAmper
LLP in Jenkintown, Pennsylvania. He has over 45 years of diversified experience
in the public and private accounting sectors, and academia. Mr. LaRosa has served
both public and privately held companies in the professional service, health care,
wholesale, real estate and other industries. He has also served as an expert witness
or consultant in matters involving financial statement fraud, employee fraud, professional malpractice, related party liability and bankruptcy.
Jonathan S. Ziss is a partner in the Philadelphia office of Goldberg Segalla LLP.
His practice focuses on the representation of accountants in lawsuits brought by
former clients, parties to business combination disputes, banks and other lenders,
creditors and trustees, and other affiliated professionals. Mr. Ziss is frequently asked
to represent accountants in investigations by federal, state and local authorities,
including the IRS, FBI and Department of Labor, and by bankruptcy trustees and
creditors’ committees.
Focus On Accountants:
Bernie Madoff and Auditor Liability—From “A” to Ponzi
Table of Contents
I.Presentation..................................................................................................................................................97
Focus On Accountants: Bernie Madoff and Auditor Liability—From “A” ... ❖ LaRosa and Ziss ❖ 95
Focus On Accountants:
Bernie Madoff and Auditor Liability—From “A” to Ponzi
I.Presentation
Acting upon a tip that his investment advisory business was a fraud, two special agents with the FBI
met with Bernard Lawrence “Bernie” Madoff in his $7 million Manhattan penthouse on December 11, 2008.
According to Special Agent Theodore Cacioppi as set forth in the securities fraud complaint:
After identifying myself, Madoff invited me, and the FBI agent who accompanied me, into his
apartment. He acknowledged knowing why we were there. After I stated, “we’re here to find out
if there’s an innocent explanation,” Madoff stated, “there is no innocent explanation.” Madoff
stated, in substance, that he had personally traded and lost money for institutional clients, and
that it was all his fault. Madoff further stated, in substance, that he “paid investors with money
that wasn’t there.” Madoff also said that he was “broke” and “insolvent” and that he had decided
that “it could not go on,” and that he expected to go to jail.
United States v. Madoff, No. 08 MAG 2735 (S.D.N.Y. Dec. 11, 2008).
So ended what is believed to be the largest Ponzi scheme in history, causing over tens of billions of
dollars in losses to thousands of investors.
As defined by the SEC, a “Ponzi Scheme” is a type of illegal pyramid scheme named for Charles
Ponzi, “who duped thousands of New England residents into investing in a postage stamp speculation scheme
back in the 1920s.” www.sec.gov/answers/ponzi.htm. Though Ponzi is the scheme’s namesake, he was not the
original practitioner. Such schemes are known to date back to at least 1899 when New Yorker William Miller
bilked investors out of $1 million—more than $20 million in today’s dollars. Although Miller and Ponzi set
the standard for Ponzi schemes in the late 19th and early 20th centuries, the schemes did not become prevalent in the US for several decades. It was not until the 1980’s and 1990’s that Ponzi schemes began cropping up
with increasing regularity.
Somewhat incredibly, the fallout from the Madoff scandal has not deterred others from operating
their own Ponzi schemes, nor has it caused the investing public to wise up. Consider the following examples.
In 2008, a federal grand jury in Minnesota indicted Thomas Petters, a Minnesota businessman and
the former CEO and chairman of Petters Group Worldwide, on 20 counts of mail fraud, wire fraud, conspiracy, and money laundering. The government accused Petters of turning his company into a $3.65 billion Ponzi
scheme, in which he fabricated business records to convince investors that they were financing the purchase
of electronic goods that would be resold to big-box retailers. On December 2, 2009, Petters was convicted on
all 20 counts. He is serving a 50-year federal prison sentence.
In June 2009, Texas financier Allen Stanford was charged by federal prosecutors in a 21-count indictment with orchestrating a $7 billion Ponzi scheme centered around the fraudulent sale of certificates of
deposit through a bank he controlled. Allegedly, Stanford funneled the investments into his own businesses
and real-estate ventures. On June 14, 2012, Stanford was sentenced to 110 years in federal prison.
In July 2009, federal investigators arrested several prominent rabbis in a corruption probe into
money laundering and political corruption that is considered New Jersey’s largest corruption sting. The investigation was aided by an informant, Soloman Dwek, who operated a Madoff-style Ponzi scheme amongst
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an insular population, that ultimately led him to a $50 million bank fraud. Following his own arrest, Dwek
turned government cooperator.
On April 1, 2010, Donald “Tony” Young was charged with running a Ponzi scheme in which his
investors lost more than $25 million through his investment advisory business known as Acorn Capital.
According to the indictment, Young preyed on the wealthy polo set in suburban Philadelphia and Palm Beach.
He solicited investors by claiming that he would invest their money in large stable companies. Ultimately,
Young raised more than $95 million from his investors. Instead of investing all of these funds as promised, he
diverted more than $25 million for his own use. Young pled guilty in July 2010 to mail fraud and money laundering. In May, 2011, he was sentenced to 17 years in prison.
There are countless other examples of Ponzi schemers, and statistics suggest that these numbers are
on the rise. Although the SEC does not publicly maintain statistics on Ponzi scheme investigations, it filed
more new cases in 2011 than 2010. By one count, 2011 Ponzi schemers caused alleged damages in excess of
$830 million, which resulted in an average of $139 million in losses every month. See, Brian Willingham, 2011
Ponzi Schemes by the Numbers, www.diligentiagroup.com.
Ponzi scheme victims have taken a variety of approaches in their pursuit of relief. Victims may try
to recover include the Securities Investor Protection Corporation, a member-funded non-profit corporation
that protects investors in certain securities from financial harm in the event of a scheme or other failure. Only
direct investors are eligible. Filing a proof of claim in bankruptcy court is also a standard maneuver. (The
Receiver of a bankrupt Ponzi scheme marshals assets for the benefit of the creditors, which assets are then
used to pay claims in some proportion.)
Litigation, too, is part of the process. Whereas suits against the debtor are stayed (11 U.S.C. §362),
suits by the Receiver and/or by investors as against others are not. So, for example, private lawsuits may be
brought by investors against investment advisors and managers, feeder funds, auditors, and perhaps others.
Theories range from professional negligence to fraud and conspiracy. The Receiver, too, may assert claims
against ancillary professionals, such as the auditors.
Auditors are typically sued on the theory that they failed to detect the fraud due to a negligently
planned and/or executed audit. This calls the question of whether an auditor has a duty to detect fraud in the
first place.
While the authoritative literature is quite clear that there is no such duty per se, auditors in fact have
a duty to consider fraud as they plan and perform their work. This might be seen as a relatively subtle distinction, especially when viewed through the lens of civil litigation. So, whether the failure to detect fraud in a
given instance—say, in the event of a multi-million dollar Ponzi scheme—amounts to malpractice, is a question most auditors would prefer not have to answer.
In the course of an audit, the entity’s internal controls come into sharp focus. As defined in the Generally Accepted Auditing Standards (GAAS), internal control “is a process—effected by those charged with
governance, management, and other personnel—designed to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of
operations, and compliance with applicable laws and regulations.” AU Sec. 314.41. The standards further provide that “[t]he auditor must obtain a sufficient understanding of the entity and its environment, including
its internal control, to assess the risk of material misstatement of the financial statements whether due to the
error or fraud … .” AU Sec. 314.01. Thus, it is incumbent upon the auditor to gain an understanding of how
his/her client actually functions vis-à-vis the reliability of its financial reporting.
98 ❖ Professional Liability Seminar ❖ December 2012
Even more to the point, GAAS requires that the auditor, among other things, be knowledgeable of the
so-called “red flags” of fraud; consider the opportunities and motivation for the occurrence of fraud; discuss
amongst the audit team the risks of material misstatements in financial reporting due to fraud; assess the internal control environment risk factors that may result in a material misstatement due to fraud; assess management’s response regarding the risk of fraud; and communicate to senior management, the audit committee, or
others whether the auditor has determined there is evidence that fraud may exist.. SAS No. 99; SAS No. 113.
Therefore, when defending against allegations of audit negligence, the auditor’s fraud risk assessment
plan and the audit team’s performance of that plan are the centerpieces of the litigation. Quality documentation of the plan and its implementation are paramount. Ideally, the documentation will evidence a specific
awareness and sensitivity of fraud risk in the client’s particular business environment, be it manufacturing,
retail, service, or as the case may be, an investment company. If the auditor can show that he/she truly considered the business from the perspective of the owner, as well as from the perspective of the investor, and that
those perspectives informed the audit plan generally and the fraud risk assessment in particular, the standard
of care may very well have been met. On the other hand, a cookie cutter approach to an audit, one without
nuance or recognition of the peculiarities of the industry or of the actual entity, could be problematic and difficult to defend, especially when viewed in hindsight.
Putting the standard of care to one side, auditors have a potentially potent defense which has virtually nothing to do with the quality of their professional service. By definition, Ponzi schemes are criminal
enterprises. If the auditor can show that its audit client was nothing more than an engine of theft—notwithstanding the auditor’s failure to figure that out—the weight of authority nationwide favors application of the
equitable maxim in pari delicto (potior/melior est conditio possidentis); Latin for “in equal fault (better is the
condition of the possessor).” In short, the law will not assist a plaintiff with unclean hands. As a result, in jurisdictions that recognize this defense, Receivers—who stand in the shoes of the bankrupt/defunct enterprise—
are themselves barred from pursuing the investment company’s auditors for malpractice.
The in pari delicto defense cannot protect the auditors against all claims—those brought by outside
investors and lenders would not trigger the equitable balancing that applies to claims brought by or in the
name of the former client. However, depending upon the jurisdiction, such non-client claims might be barred
by application of the privity rule or other related rules limiting the scope of would-be claimants to those
whom the auditor specifically understood would be relying upon their audit opinion. This is a highly jurisdiction dependent defense.
The case law to date appears to be favoring the defendant auditors. Various investor plaintiffs have
made a number of unsuccessful attempts to recover from auditor defendants, and in the process a strong line
of defense has emerged. However, there is certainly no guarantee that this trend will continue. The opportunity remains for other courts to evaluate the facts and to apply the applicable law to a different result. For
example, as we pass beyond the four-year anniversary of Madoff ’s arrest, we continue to see suits being filed
by ERISA funds and other investors against their own auditors. These cases involve a somewhat more attenuated version of the “failure to detect” theory, but are conceptually equivalent.
Moreover, while claims filed under New York’s Martin Act were previously found to preempt private
claims and thus provided a formidable safe haven for securities defendants, such a defense is now virtually
out of contention in light of the recent decision Assured Guar. (UK) Ltd. v J.P. Morgan Inv. Mgt. Inc., 2011 N.Y.
LEXIS 3658 (N.Y. Dec. 20, 2011). This too may open doors to certain investor plaintiffs. The accounting profession will surely keep a close eye on the number and vitality of these claims arising from the largest Ponzi
scheme in history.
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