Running Head: ” BERNARD L. MA

Running Head: ” BERNARD L. MADOFF INVESTMENT AND SECURITIES: A FOCUS ON AUDITOR’S LEGAL LIABILITY AND DUE CARE”

“Bernard L. Madoff Investment and Securities: A Focus on Auditor’s Legal Liability and Due Care”

XNAMEXXX
New England College
Abstract
Friehling & Horowitz were the auditing firm that “audited” Bernard Bernard L. Madoff Investment and Securities (BLMIS) for over 15 years, while Bernie Madoff ran a Ponzi scheme under their noses. This paper addresses the legal liability of Friehling & Horowitz and their lack of due care, that resulted in billions of dollars being stolen from investors. The following 4 questions will be addressed (1) Did Friehling & Horowitz exercise due care and maintained professional skepticism during any of the Audits? (2) What audit evidence should have been vouched , reviewed to determine whether BLMIS had purchased, sold and maintained proper custody of investment Securities? (3) Are there any mitigating factors to help defend the actions of the auditors? and (4) Should the BLMIS auditor Friehling face criminal charges? Based on case information, I concluded that that the auditor David Friehling was indeed liable for fraud with very little mitigating factors.

Keywords: Professional due care, fraud, Madoff, BLMIS
Question 1: Friehling & Horowitz – Due care and professional skepticism
The AICPA, (American Institutes of CPA’s, 2014) on their website under Professional Responsibilities state ” CPAs are licensed and regulated by their state boards of accountancy. Additionally, all AICPA members are required to follow a rigorous Code of Professional Conduct which requires that they act with integrity, objectivity, due care, competence, fully disclose any conflicts of interest (and obtain client consent if a conflict exists), maintain client confidentiality, disclose to the client any commission or referral fees, and serve the public interest when providing financial services.” ¹
Based on the available case information, Friehling & Horowitz did not exercise due care or maintained professional skepticism during any of the Audits that they signed off on for Bernard L. Madoff Investment and Securities (BLMIS). According to the SEC complaint filed in 2009², Friehling failed to conduct meaningful audits that complied with GAAS and GAAP and failed to conduct any audit procedures as to the internal controls of BLMIS and therefore has no basis to state that the BLMIS financials was free of material misstatements and inadequacies.
Friehling also failed to maintain auditor independence as he clearly indicated later on that he knowingly left a signature stamp and the accounting firm’s stationery at BLMIS and he did knot know when and for what purposes these were used.
1. AICPA, “AICPA Professional Responsibilities”, 2014, retrieved June 8, 2014 from
http://www.aicpa.org/interestareas/personalfinancialplanning/resources/practicecenter/professionalresponsibilities/pages/professionalresponsibilities.aspx
2. U.S. Securities and Exchange Commission (SEC) , “SEC charges Madoff Auditors with fraud”, March 18, 2009 retrieved June 08, 2014 from http://www.sec.gov/litigation/litreleases/2009/lr20959.htm
Bloomberg’s Erik Larson reported in 2003 that Friehling stated “It could be used to put my signature on any document at any time, without my knowledge. I did not object and I agreed to it.³ (Larson, Erik 2013). Furthermore, Friehling failed to conduct independent verifications of the BLMIS assets, securities purchased and sold as well as the custody of these securities, revenues, commissions, liabilities related to client accounts and the bank account with Chase Manhattan NY (SEC 2009)². He never reviewed material sources or tested and verified the existence and validity of any of these transactions nor did he send independent confirmations to the bank through which billions of his clients’ money flowed. (SEC 2009)²
At no point did Friehling test the BLMIS internal controls to determine if there was any and if these controls were sufficient to prevent fraud. The SEC in their complaint (SEC, 2009)² alleged that Friehling did not conduct an Audit, but only pretended to conduct minimal audit procedures of some accounts to make it appear that he has conducted an audit.4
Professional skepticism was lacking as the auditors should have been skeptical of the bank transactions and the “extraordinary results” of Madoff’s split-strike conversion strategy that continuously produced good returns even in a bad market.(Gaffen, David 2008) 5
Therefore, Friehling & Horowitz did not maintain professional skepticism, or performed due care as they failed to gather any material evidence, nor did they objectively
evaluate the evidence, thus they were unable to render an opinion. They failed to fulfill the requirements of the Responsibility Principal under GAAS.

3.Larson, Erik, Bloomberg, “Madoff Ex-Accountant Tells Jury Aide Helped Fudge Taxes”
November 13,2013 , retrieved June 08,2014 from http://www.bloomberg.com/news/2013-11-12/madoff-ex-accountant-tells-jury-aide-helped-fudged-taxes.html
4. Securities Docket, “SEC Charges Madoff Auditors With Securities Fraud, “Pretending” to Perform Audit”, March 18,2009 Retrieved June 08,2014 from http://www.securitiesdocket.com/2009/03/18/sec-charges-madoff-auditors-with-securities-fraud-pretending-to-perform-audit/
5. Gaffen, David, Wall Street Journal, “Madoff’s Not-So-Unique Options Strategy” December 16, 2008, Retrieved June 08, 2014 from http://blogs.wsj.com/marketbeat/2008/12/16/madoffs-not-so-unique-options-strategy/
Question 2: Required Audit Evidence for BLMS Audit
According to AU Section 326 from the AICPA website (AICPA, December 2006, “Audit Evidence AU Section 326” paragraph 01 ) 6 “The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.” and in paragraph 8 indentation 1 “Audit evidence is more reliable when it is obtained from knowledgeable independent sources outside the entity.” 6 (AICPA, December 2006, “Audit Evidence AU Section 326” paragraph 08)
Evidence must be relevant and valid to the entry that is being audited, while the AICPA does not require an auditor to audit every transaction 6 (AICPA December 2006, “Audit Evidence AU Section 326” paragraph 02), in the case of BLMIS, the audit of just one (1) transaction would have brought to light that no investment securities were ever traded.
The quality of audit evidence gathered, is measured by the relevance and the reliability of the evidence. Relevance refers to audit evidence relating to the assertion made on the financial statements, that is being tested and will allow the auditor to reach an conclusion.
Reliability refers to whether the evidence can be trusted and relied upon as an true certification/ indication in the financial statement assertion being tested. Trusted external confirmations are considered more reliable.
“However, because accounting records alone do not provide sufficient appropriate audit evidence on which to base an audit opinion on the financial statements, the auditor should obtain other audit evidence.” 6 (AICPA December 2006, “Audit Evidence AU Section 326″ paragraph 04), The type and the quantity of documentation and evidence would be subject to the professional judgment of the auditor. The greater the possibility of a misstatement the more evidence will be required.

6. AICPA,”AU Section 326 Audit Evidence”, December 15, 2006 Retrieved June 08,2014 from
http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00326.pdf

Thus in order to comply with paragraph 04 of Section 326, (AICPA December 2006), an competent auditor would vouch external documentation when auditing investment securities purchased. Evidence would include, but not be limited to, inspecting the securities, purchase orders and confirmations, bills received(invoices), checks issued or wire transfers, reading the agreements and investment contracts, and confirming the number of shares with the issuer or custodian.
Evidence for investment securities sold, similarly would include invoices issued, cash received in the bank account, statements and reconciliation and confirming the number of shares with the issuer or custodian.
In order to confirm the proper custody of investment securities, while auditing, an independent confirmation letter should be send to the financial institution or issuer that serves as the custodian for the investment security.
Question 3: Auditors Common Law Liability to Third Parties.
There are 3 levels liability that arises out of failure to exercise the appropriate level of professional due care, ordinary negligence, gross negligence and fraud. Ordinary negligence is the failure to perform duties with reasonable due care resulting in an unintentional misrepresentation. Gross negligence is the performing of duties without proper care that it results in others being misled. Fraud is the deliberate misrepresentation of a fact that the person/auditor knows to be false and is done with the intend to defraud.

6. AICPA,”AU Section 326 Audit Evidence”, December 15, 2006 Retrieved June 08,2014 from
http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00326.pdf

The difference between the fraud and gross or ordinary negligence is that with fraud there is knowledge that the representation is false where as with gross and ordinary negligence there are no prior knowledge of the misstatement.
Under common or statutory law auditors will be liable to all 3rd party users of the financial statements. Since the investors relied on these financial statements that were materially misstated and incurred economic losses based on the material misstatements, 3rd parties have a solid case.
The BLMIS auditors, Friehling & Horowitz, failed to conduct an audit, 7 (SEC, 2009). According to the SEC complaint, Friehling pretended to do an audit by producing minimal audit procedures to specified accounts. In addition, being concerned that his work for BLMIS would be subject to a review by his peers, as required, he lied to the AICPA and insisted in writing for at least 15 years, that he did not do any audit work. 8 (Abkowitz , Alyssa, CNN Money, 2008)
The SEC maintained that if an proper audit was done, then the Audit would have shown that BLMIS owed ” tens of billions of dollars in additional liabilities to its customers and was therefore insolvent.”9

7. U.S. Securities and Exchange Commission (SEC) , “SEC charges Madoff Auditors with fraud”, March 18, 2009 retrieved June 08, 2014 from http://www.sec.gov/litigation/litreleases/2009/lr20959.htm
8.Abkowitz , Alyssa , CNN Money, “Madoff’s auditor… doesn’t audit?”, December 19, 2008, Retrieved June 8, 2014 from http://money.cnn.com/2008/12/17/news/companies/madoff.auditor.fortune/
9. U.S. Securities and Exchange Commission (SEC), “SEC charges Madoff Auditors with fraud”, March 18, 2009 retrieved June 08, 2014 from http://www.sec.gov/news/press/2009/2009-60.htm
Based on the fact that no audits were performed, false fillings with the SEC and the fact that Friehling knew Madoff was handing these audited financial statements to potential investors,10 ( Carney, John, 2009), Friehling is definitely guilty of fraud, his actions constituted a deliberate intent to defraud. David Friehling pleaded guilty on November 3, 2009 to charges of securities fraud, investment adviser fraud and obstructing tax law administration. He has been cooperating with the authorities and that allowed him to remain free on bail, while his sentencing hearing remains postponed.
Friehling maintains to this day that he had no idea the Bernard Madoff was involved in a Ponzi scheme, he lost several million of his own and his children’s money in this scheme. This fact and his recent cooperation with the authorities might possibly be the only mitigating factors that could count towards a reduction in his sentence.

Question 4: Should Friehling be facing criminal charges?
Section 24 of the securities act allows for an auditor to be subject to criminal penalties and states: “Any person who willfully violates any of the provisions of this title, or the rules and regulations promulgated by the Commission under authority thereof, or any person who willfully, in a registration statement filed under this title, makes any untrue statement of a material fact or omits to state any material fact required to be stated therein or necessary to make

10. Carney, John,, Business Insider “SEC Charges Madoff Auditor With Fraud Too”, March 18,2009 retrieved June 08,2014 from http://www.businessinsider.com/sec-charges-madoff-auditor-with-fraud-too-2009-3
the statements therein not misleading, shall upon conviction be fined not more than $10,000 or imprisoned not more than five years, or both.”11 (FDIC Law, Regulations, Related Acts, 8000 – Miscellaneous Statutes and Regulations,)
Section 32 of the Securities Exchange Act of 1934, states that to be subject to criminal charges the auditor must have “willingly and knowingly” been aware of the misstatement in the produced financial statements.
In order to be subject to criminal action, the auditor must have “willfully” issued financial statements with a material misstatement and filed these statements. This is not always easy to prove but in the case of the BLMIS auditor, Friehling is was easy to prove as he filed statements showing huge profits and stability while BLMIS was in fact insolvent and owed billions in liabilities.
An auditing firm is engaged to perform an audit to establish that the financial statements are true, accurate and without material misstatements. To remain fair and impartial, and prevent over zealous charging of auditors for the smallest infraction, each case of potential fraud must be evaluated based on the circumstances of the case. If the auditor performed with appropriate level of professional care and skepticism and the fraud goes undetected because of management interference or the sophistication of the fraud scheme, then the auditor should not be held liable as he performed the audit in accordance of the AICPA principals. Should the auditor fail to use due care and professional skepticism, then the auditor should be held accountable together with the management.

11.FDIC, “FDIC Law, Regulations, Related Acts, 8000 – Miscellaneous Statutes and Regulations” Section 24, Retrieved June 08,2014 from http://www.fdic.gov/regulations/laws/rules/8000-6240.html
However in the case of Friehling where there was a blatant disregard for the AICPA principals and no proper audit was ever performed, in fact Friehling lied and intentionally told the AICPA in writing that he did not perform any audits, the belief is that he did this to avoid detection if subjected to peer review.
The NY state and SEC was correct in charging Friehling with fraud. If Friehling performed just one audit during all the years he was the Auditor for BLMIS he could have detected the fraud and saved many investors from losing their life savings. There is no excuse for Friehling not performing the duties he was “hired” for.

References
Abkowitz , Alyssa , CNN Money, “Madoff’s auditor… doesn’t audit?”, December 19, 2008, Retrieved June 8, 2014 from http://money.cnn.com/2008/12/17/news/companies/madoff.auditor.fortune/
Angeli, E., Wagner, J., Lawrick, E., Moore, K., Anderson, M., Soderlund, L., & Brizee, A. (2010, May 5). General format. Retrieved June 08,2014 from http://owl.english.purdue.edu/owl/resource/560/01/
Accounting Web, “Madoff’s accountant: When is an auditor not an auditor?” March 30, 2009 Retrieved June 08, 2014 from http://www.accountingweb.com/topic/watchdog/madoff-s-accountant-when-auditor-not-auditor
AICPA, “AICPA Code of Professional Conduct”, 2014, Retrieved June 8, 2014 from http://www.aicpa.org/research/standards/codeofconduct/pages/default.aspx
AICPA,”AICPA Professional Responsibilities”, 2014, retrieved June 8, 2014 from
http://www.aicpa.org/interestareas/personalfinancialplanning/resources/practicecenter/professionalresponsibilities/pages/professionalresponsibilities.aspx
AICPA, AU Section 326 Audit Evidence, December 15, 2006 Retrieved June 08,2014 from
http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00326.pdf
Carney, John,, Business Insider “SEC Charges Madoff Auditor With Fraud Too”, March 18,2009 retrieved June 08,2014 from http://www.businessinsider.com/sec-charges-madoff-auditor-with-fraud-too-2009-3
FDIC, “FDIC Law, Regulations, Related Acts, 8000 – Miscellaneous Statutes and Regulations” Section 24, Retrieved June 08,2014 from http://www.fdic.gov/regulations/laws/rules/8000-6240.html
Gaffen, David, Wall Street Journal, “Madoff’s Not-So-Unique Options Strategy” December 16, 2008, Retrieved June 08, 2014 from http://blogs.wsj.com/marketbeat/2008/12/16/madoffs-not-so-unique-options-strategy/
Henriques, Diana B, New York Times, “Madoff’s Accountant Pleads Guilty in Scheme” November 3,2009 Retrieved June 08, 2014 from http://www.nytimes.com/2009/11/04/business/04madoff.html
Larson, Erik, Bloomberg, “Madoff Ex-Accountant Tells Jury Aide Helped Fudge Taxes”
November 13,2013 , retrieved June 08,2014 from http://www.bloomberg.com/news/2013-11-12/madoff-ex-accountant-tells-jury-aide-helped-fudged-taxes.html
Louwers, T., et al. (2012). MP Auditing & Assurance Service (5th ed.). Module C pages 633-676.
Securities Docket, SEC Charges Madoff Auditors With Securities Fraud, “Pretending” to Perform Audit, March 18,2009 Retrieved June 08,2014 from http://www.securitiesdocket.com/2009/03/18/sec-charges-madoff-auditors-with-securities-fraud-pretending-to-perform-audit/
Thibodeau, Jay, Freier, Deborah, March 18, 2013 “Auditing and Accounting Cases: Investigating Issues of Fraud and Professional Ethics ” Case 2.7 Bernard L Madoff Investment and Securities: A Focus of Auditors’ Legal Liabilities
U.S. Securities and Exchange Commission (SEC), “SEC charges Madoff Auditors with fraud”, March 18, 2009 , Retrieved June 08, 2014 from http://www.sec.gov/litigation/litreleases/2009/lr20959.htm and http://www.sec.gov/litigation/complaints/2009/comp20959.pdf
http://www.sec.gov/news/press/2009/2009-60.htm
U.S. Securities and Exchange Commission (SEC), “SECURITIES EXCHANGE ACT OF 1934” (page 364 – section 32 Penalties) Retrieved June 08,2014 from https://www.sec.gov/about/laws/sea34.pdf

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“BERNARD L. MADOFF INVESTMENT AND SECURITIES: A FOCUS ON AUDITOR’S LEGAL LIABILITY AND DUE CARE”