Several accountants shared their views about the fallout of the estimated $65 billion Ponzi scheme perpetrated by Bernard L. Madoff. Robert E. Sohr, a retired partner at Deloitte & Touche, said that if you're the auditor of a broker-dealer, or any other specialized industry, it's important to know the industry and the specialized auditing procedures that need to be applied. Looking at an audit of a feeder fund, it's important to know your client. David A. Lifson, a partner at Crowe Horwarth, said that by understanding the tax recovery opportunities, you might be able to help your clients mitigate some of their damages. Tax recovery is an important element to this scheme. Dan L. Goldwasser, shareholder and member of the accounting law practice group at Vedder Prince, said that the area of damage control in the Madoff situation really boils down to two or three things that you can do. The most important thing you can do is to protect your insurance coverage. FULL TEXT

On May 27. 2009, The CPA Journal hosted a breakfast symposium titled "Are CPA's the Next Madoff Victims? The Accountant's Liability." The discussion stemmed foam the cover article in the April issue of The CPA Journal, written by Dan L. Goldwasser and John H. Eickemeyer, both shareholders and members of the accounting law practice group at Vedder Price, P.C. The authors of the article appeared as panelists at the symposium, along with Robert E. Sohr, a retired partner at Deloitte & Touche: David A. Lifson, a partner at Crowe Horwath, LLP: Thomas R. Manisero, a partner at Wilson Elser Moskowitz Edelman & Dicker, LLP; and Ric Rosario, CEO and director of Cantico Mutual Insurance Company.

The panel was moderated by CPA Journal Editor-in-Chief Mary-Jo Kranacher. and featured each panelist speaking from his own area of expertise about the fallout of the estimated $65 billion Ponzi scheme perpetrated by Bernard L. Madoff. Topics included how accountants and auditors could be held hable for not uncovering fraud, what they can do to protect themselves from liligation, how they .should work with their insurance carriers, and what the tax implications could be.

The following is an edited transcript of the panelists" remarks.

ROBERT E. SOHR

The Auditor's Responsibility

There has been an awful lot of news about Madoff. We see the issues that are coming to the fore, but I think in order to frame it properly, we have to look first at the audit of Bernard L. Madoff Investment Securities, LLC [BMIS]. There's a lot of good information that is contained in the allegations in the civil suit that has been filed by the SEC against Madoff's finn and [auditor] Friehling & Horowitz. Friehling avoided the AICPAs peer review program, so claims the SEC. and he falsely represented that he was not engaged to conduct audit work. Friehling and Horowitz both had accounts that were held by BMIS - you don't need to go far to see what's wrong with this.

An auditor should adhere to all ethical standards. Article 1 of the Code of Professional Conduct says that an auditor needs to exercise sensitive and professional judgments. Article 3 [slates that] an auditor has to "perform I all professional responsibilities] with the highest sense of integrity." Article 4 [states that] an auditor has to "maintain objectivity and be free of conflicts of interest" and "should be independent when providing auditing services."

What have we learned from this? If you're the auditor of a broker-dealer, or any other specialized industry, it's important to know the industry and the specialized auditing procedures that need to be applied. According to our Code of Professional Conduct, confidence represents the obtainment and maintenance of the level of understanding and knowledge that enables a member to render services with facility and acumen. In conducting an audit of a broker-dealer, the procedures around custody of a client's assets are key, and if s important to have procedures in place that look at the controls and determine that the entire population of securities exist.

What are the concerns [regarding the feeder funds]? Historically, auditors of feeder funds would rely on confirmations from registered broker-dealers who have custody of assets. They rely on the fact that it's a regulated industry: The broker-dealers are required to be audited. They rely on the independent auditor's report on internal controls that's required by [SEC] rule 17a- 13. In this case, that report was issued with no indication of a material weakness, but one of the red flags here was that the broker-dealer, which had custody of the assets, was a related party to the investment advisor.

Know Your Client

Looking at an audit of a feeder fund, it's important to know your client. In conducting your own client acceptance and continuation procedures, it's important to make sure that you have a good understanding of your client, the feeder fund's investment strategy, and how the placement of assets with other investment advisors helps them achieve that strategy. It's important to understand your client's due diligence procedures on the investment advisors that they use. You should know whether your client has determined that the claimed historical returns make sense based on the strategy of the investment advisors. Also, is there an open channel of communication between the management of your client, the feeder fund, and the investment advisors that they're using?

I would then look to the auditors of the broker-dealer and the investment advisor, and determine if they are competent. If you have any questions about that, and if in fact the investment with the investment advisor is material to the feeder fund. I would go so far as to tell my client that we should discuss the audit of the broker-dealer with their auditors. You need to arrange that, and if necessary, review their workpapers. What if the investment advisor refuses to do that? You need to come to a decision with your client and the feeder fund as to whether you can audit the feeder fund.

Here we had several red flags. You had a related-party custodian. There are some reports that although the Madoff firm was a leader in technology, their broker's statements were manually prepared. They were using a small CPA firm for relatively large broker-dealer operations, and there was a sense of secrecy around the trading operations and the Madoff funds. There were a lot of red flags there, which point out some of the lessons to be learned in audits of the feeder funds.

DAVID A. LIFSON

Tax Implications

Taxes were certainly a subplot within a theft and a fraud that have had massive publicity and repercussions. It [the Madoff scheme] is a little bit like a Shakespearean play where there are these little minor characters that roam around, and I think that's what fascinates us so much about this.

Why is the tax guy up here in the first place? By understanding the tax recovery opportunities, you might be able to help your clients mitigate some of their - and perhaps even your - damages. Tax recovery is an important element to this scheme.

IRS Guidance

The challenge here is that the IRC was not designed for Ponzi schemes, and there have been erratic and inconsistent facts, and sometimes flawed findings, in prior cases. The tax law was in a total jumble when it came to Ponzi. The precedent as it would apply to Madoff and other modern schemes was - and I believe remains - dubious at best. The tension between the IRCs rules about form versus substance sometimes gets in the way of a logical conclusion when it comes to a Ponzi scheme.

In fact, interpreters of many prior Ponzi arrangements struggled between taxing their form or taxing their substance, and there was often no symmetry in these findings for the winners and losers. For example, winners (meaning somebody who got more money out of the scheme than they put in) are generally taxed as investors in a Ponzi scheme, and losers are generally taxed as victims of theft losses. The nature of the theft loss was very challenging in several pieces of precedent, but the IRS finally - after pleas from tax practitioners, the investment community, and even the White House - responded to the rampant confusion about how the tax law would apply to these things.

They responded on March 17 with two key pronouncements. One was a revenue ruling [2009-09] mal rationally summarized their generic position on all Ponzi schemes, and one was a revenue procedure [200920] that could be used by all qualified victims. They came up with this concept of a qualified victim that could use this IRS revenue procedure to resolve all doubt about the tax treatment, and like any revenue procedure, there was something in it for the defrauded investor, but not everybody got everything that they might have wanted as a result.

There were seven key findings in the revenue ruling, which is the iRS's determination about what the law is on how Ponzi schemes will be taxed - or as I like to call it. untaxed, because we're talking about refunds. What is the recovery of the un-tax that investors can get if they're a victim of a Ponzi scheme? The IRS's first and second findings were: "Yes, this is a theft loss, it isn't a capital loss. We will respect the substance of what happened (they stole your money), rather than the form of what happened (they issued a statement that said you bought securities that you never owned)."

The same principle would apply to a Ponzi scheme that was based on notes as opposed to shares of stock in a broker-dealer. They also found that the theft loss was a transaction entered into for profit, or a business transaction, both of which get a slightly elevated recovery status in that there are no $100 or $500 limitations on the loss nor the 10% loss limitation. This was a very taxpayer-friendly finding - that Ponzi schemes are entered into for profit. There was some concern as to whether the IRS could have argued the alternative [to be the case].

Year of Discovery

The IRS also found that the code provides that a theft loss enjoys a special provision. Usually, a loss is deductible only in the year when the loss is incurred, whereas thefts have special treatment: They're deductible in the year they're discovered. That's because if somebody stole something from you many years ago, you might even be beyond the statute of limitations to take a deduction for a theft from three or four years ago, so there is a special relief provision in the code that applies to Ponzi schemes.

They also inferred that this means that you get the deduction in the year you discover the loss, and it precludes many people from amending your return if your entire loss took place during open statute. For example, if you were a two- or threeyear investor in the Madoff scheme, you might find the amount of tax recovery would be significantly higher by amending your returns /or the profits you reported to the government where you were thinking. "They were fictitious. I don't want to pay tax on them." You'd like to do that. but according to the revenue procedure, that isn't how the IRS sees it. They see it as, you gave a guy some money in an investment scheme, and he stole your money.

Amount of Recovery

The ERS also reminded us that the tax deduction you get is the amount you lost, net of estimated recoveries, with a true-up when you have a better understanding of what your recovery is. We know that you could have various types of recoveries. The obvious one in this case is specific: If Madoff had had a bank, it would have been from the FDIC. This scheme could have been just as easily hatched from a bank as a securities finn. It can also be done in an unregulated environment, which was the case in 99% of prior Ponzi schemes. In fact conducting this Ponzi scheme through a bank or brokerage finn with an off-thebooks account is fundamentally all he did. He just opened up a separate bank account to do the Ponzi scheme and had legitimate accounts that everybody audited. They didn't audit him very well, I admit, but it was an off-the-books account, so it's important to note that this Ponzi scheme used a little bit of a new and different technique - the entire integrity of our financial system - to perpetrate the fraud. The IRS said. "Deduct your estimated net loss, net of recoveries, and do a true-up in a couple of years when you find out what you really lost."

The next thing they found is that the losses created a net operating loss if the losses were greater than the business income in the year of deduction. Most people felt that it was the right answer, and some people quickly latched onto the fact that an operating loss is generally more valuable as a recovery tool than an itemized deduction. This helped us out, especially in some estate tax recoveries.

Claim of Right Disallowed

Next to last of all, the IRS found restoration under the so-called claim of right is not allowed and does not apply. They dismissed this key opportunity for recovery by citing two bizarre cases in a struggle to fit a square peg into a clearly round hole. That is their finding and their interpretation - unless somebody challenges it.

Last of all, I think they quite likely confirmed that the mitigation provisions in the code - which say that you have a duty of consistency - are not tools available to the taxpayer in Ponzi loss schemes.

The revenue procedure, which is different from their interpretation of the law, leveraged these findings and said. Fundamentally, if you agree with everything we've just said, you're not allowed to do the claim of right. If you agree not to claim mitigation, if you agree not to file amended returns, if you agree with this whole panoply of findings in the revenue ruling, you can deduct 95% of your loss in the year you discover it as a reasonable estimate of what it will be." You'll still have an obligation to true up later, and if you're going to make third-party claims, then you're only allowed to deduct 75% of your loss. The rationale is that you have more opportunities for recoveries, and therefore, you can only deduct a smaller portion of the loss until you actually find out what your true-up is and the whole situation is resolved. These issues with using the revenue ruling and the revenue procedure are very key.

In most cases that I've examined, there is significant shrinkage in the amount of tax that you actually paid as compared to the tax refund you will recover. The shrink- age occurs because of the macabre design of the Internal Revenue Code, and because of state tax law rules, especially in NewJersey. Connecticut, and somewhat in New York, because New York only allows half of your itemized deductions.

The claim of right should be allowed. I think their finding is false. I think that this is a brave position to take, and it should not be taken without due consideration of the pros and cons of taking it and sacrificing the protection of the revenue procedure. Under the claim of right, which would allow you to fundamentally recalculate your taxes for the last 20 or however many years you were in the scheme, you figure out how much tax you paid as compared to how much tax you should have paid each year - a classic with-and-without calculation - and take that as a credit in your 2008 tax return. That's always going to make you exactly even. Through the claim of right, you get back the taxes that you paid in each past year, dollar for dollar. You also have a second alternative under the claim of right to take a deduction for the amount of loss in the year you're using the claim of right. Under that scenario, you might get back more tax than you paid.

The IRS cleverly did not address clawbacks. A clawback could occur if you took money out of your Madoff account within the last six years, you may have to give it back to the people who lost money. It doesn't quite make sense if you put millions in and took millions out, and they only look at what you took out. There is a lot of controversy in this area. The law is clear that if you are a clawback victim in the Madoff scheme - meaning that you actually have to write a check to restore monies that you had taken out of the account - then you clearly have a right under the claim of right doctrine to get your money through this withand-without calculation. Should you go for the whole hog or just what you get through your clawback? That's an open question. You should first hire an attorney to make sure you don't get "clawed back.

THOMAS R. MANISERO

Basis for Litigation

This situation with Madoff is in many respects not new. We've seen Ponzi schemes time and time again, and we can learn from those prior experiences what kinds of lawsuits will be brought against CPAs and financial advisors. What makes Madoff different, obviously, is the sheer spectacular size of it. and the fact that this was a Ponzi scheme that was conducted through a regulated industry - as opposed to a situation similar to Bennett Funding, which was selling equipment leases that weren't regulated.

A Variety of Claims

The breadth of Madoff is leading to a panoply of different kinds of claims being made against accountants. The most vulnerable are the people who were auditing the constituent members of the scheme. There have already been lawsuits brought against the auditors for the various feeder funds. A lot of the Big Four and the regional firms were involved in doing those audits, and. in that situation. the clear challenge is on the auditor's asset confirmation procedures.

We're seeing similar claims being made and threatened against the auditors of hedge funds - not necessarily feeder funds. Madoff was so special that there were actually hedge funds that were created for the single puipose of allowing investors to get access to Madoff. We hear a lot of stories about people with $2 million or $3 million who want access to this spectacular investment advisor who's bringing these wonderful returns. and they go to him and say. "Bernie. can you take my money?" And he goes. "No. you're too small. I'm only taking minimum investments of $10 million right now." What happens? You get a couple of these guys with $2 million or $3 million, they put their money together and they create their own little sort of investment or hedge fund, and that would get them access to Madoff. Those little hedge funds were themselves audited. Of course, investors don't like losing money, and when they do. what do they do? They look for deep pockets - and CPAs and auditors are generally viewed as deep pockets.

We're seeing claims being made and threatened against the auditors of various charities that were heavily invested with Madoff. These claims are coming through the attorney general's office because, in New York, the attorney general has the authority to regulate and discipline those people who are involved in charities. The investigation starts off by looking at the trustees or the directors of these various charities, claiming that they were recalcitrant in their fiduciary responsibilities of maintaining and protecting the funds that they were entrusted with. Then, collateral claims are brought against the professionals - the lawyers and the accountants - who professedly did not give the directors or trustees proper professional advice.

Claims involving auditors particularly focus on the asset confirmation procedures. The debate is: "I. as an auditor. confirmed with an independent third party. It was a regulated industry. I was provided with a confirmation. It tied out." But one of the things that these auditors received, along with the confirmations that they got from Madoff. was this Friehling & Horowitz internal control letter. For auditors, it gives them a clean opinion on internal controls, which gives them a little extra comfort: "I'm just going to put that in my workpapers and rest easy." The argument now is that this letter should have triggered some thought in the skeptical auditor's mind - namely, how could this tiny firm, operating out of a 150-square-foot office in New City. N. Y.. have any kind of capability to assess the internal controls of an entity like Bernard L. Madoff Securities? I hate to admit it. but 1 think the people on the other side have a pretty good argument. It wouldn't have taken much, and it certainly is going to ring loud to a jury that you had this document. you didn't ask another question, and you were the auditor.

Trustees at Risk

The auditors of the constituent members of this Madoff population all have something to fear. We are seeing a number of heart-wrenching cases in which CPAs were the trusted advisors, who took on the roles of trustees for their clients' estate trusts and living trusts. They've taken on fiduciary responsibil- ities. These trusts were heavily invested with Madoff. and now the beneficiaries of the trusts are looking to the fiducia- ries, to the trustees, and saying, "Hey. you had a fiduciary responsibility. You shouldn't have had all of these trust assets concentrated with one investment advisor." They are taking the "prudent man" rule from trust law, which requires that the investments of the trust be diver- sified, and they're saying that law applies to where the investments are held. It is a bit of a twist, a wrangling of what the prudent man rule is, because if you took a look at one of the Madoff state- ments, what you would see is that they're pretty sophisticated. You would look at it and you would see that there were pur- portedly positions held in a wide vari- ety of public companies - well-respect- ed, well-regarded, well-known public companies. You would see that there were positions ostensibly being held in different kinds of investments. It's hard to believe in looking at these statements that this was completely fictitious.

I spent a weekend looking through a whole bunch of these statements and preparing to produce them. One of my clients received a subpoena from the trustee, and looked at the statements. I went home and I told my wife. "I'm scared. I'm scared because I look at these Statements and I would be perfectly convinced." They didn't look irregular. It made me wonder whether my Fidelity statements are fictitious as well.

The cases against the trustees fall into the category of "no good deed goes unpunished." People assume this role as trustee for the benefit of longstanding clients who they respected, and the claimants are not the clients themselves, but the ne'er-do-well children of the clients themselves who just can't stand the idea that they've just lost their investment, their inheritance. The situation with these investors now consists of trying to decide how they want to approach their loss, worried about whether they're going to be clawed back, what their tax consequences are going to be, what positions they should be taking with SIPC [Securities Investor Protection Corporation], what SIPC claims they have to make. We haven't seen the full rush of litigation yet. This is going to take a long time to unwind. It's going to take a long time for people to gei a full appreciation of what losses - if indeed there were losses - were suffered out there. It's going to be a process, and because of the size of this. I expect the litigation front is going to run on for a number of years."

Investors don't like losing money, and when they do, what do they do? They look for deep pockets- and CPAs and auditors are generally viewed as deep pockets.

DAN L. GOLDWASSER

Damage Control

Risk management is a subject which I divide into two parts. The first part is loss prevention, which encompasses those things that you can do before you're brought into a lawsuit to protect yourself against the possibility of a lawsuit. The second is damage control, which encompasses what you should do after you know that you're likely to be sued. In short, what can you now do to protect yourself? We're largely going to be dealing with the damage control segment because you've already audited your client, you've already done the tax returns for your client, and now your client has discovered that he's a victim of a major scandal.

The area of damage control in the Madoff situation really boils down to two or three things that you can do. The most important thing you can do is to protect your insurance coverage. That is going to be your main line of defense - and hopefully you all have insurance coverage.

Insurance companies are obviously very mindful of their potential exposure from the Madoff scandal. You've got to protect your coverage, and in that regard, you have to think about some of the things that iasur- ance companies do to try to get out from covering your claim. Probably the first thing that they do is they look to see when you may have discovered your potential loss and whether it was under their watch. You've got to report your claim as soon as you feel you have cir- cumstances which may give rise to a claim. That's what the language of your policy will say. You've got to immediately con- sider: "Should we be notifying our insur- ance company right now? What should we be telling the insurance company?" Obviously, there is a dilemma here, because if you say. "1 had 10 clients with total investments of $50 million with Madoff and you send that notice to your insurance company, there's a good chance that your insurance company may say, "I don't want to do business will you anymore," and terminate you as a policy holder. That's a consideration - but I don't think it's a major consideration.

What to Tell Your Insurer

At this point, the only thing that you've got to be concerned with is not whether you're going to be covered next year. It is, "What are we going to do to cover the claims that are likely to come out of this year?" You want to notify your insurance carrier that you have potential Madoff claims. That doesn't mean you have to say, 'I'm positive I'm going to be sued by each and every one of my clients who were victims of the Madoff scheme." But what you should be doing is notifying your insurance company, "I have the following clients. For client A, I did audit services; for client B, I did tax return preparation; for client C, 1 did investment advice, and so on." This way. your insurance company can understand the nature of your insurer's exposure. You should also be telling them the amount that your clients had invested in the Madoff scheme, allowing the insurance company to see the magnitude of the potential loss.

Once you've given your insurance company the parameters of your potential loss, you should also be notifying your insurance company of any other facts which might be relevant. Those facts might be, "1 spoke to my client. My client's very happy, he doesn't blame me," but you want to pass that on to the insurance company nevertheless. On the other hand, you may have a client who has just terminated you, claiming that you're responsible for the losses. That's an important fact that should be passed on to the insurance company. You've got to do the uhings necessary to protect your insurance carrier, say whether claims have been threatened or not, and do this before your policy expires.

Of course, you should not be changing insurance carriers at this time because, if you do, you run the risk of having one carrier saying, "No, 1 don't think it was a claim. When you gave it to me, you didn't say that anybody had threatened you." If the claim came the next year under your new carrier, then you've got two carriers, both of whom are going to be disclaiming lia- bility. You're much better off staying with your carrier, whomever that may be. You won't be able to increase your poli- cy limits at this point - that's a virtual given. I'm not even sure that any insurance companies right now are raising limits for their liability insurance, because it's going to be a very tight market - as a result of the economic decline as well as the Madoff problem.

Those are the things that you've got to do to protect your insurance coverage. I would take the position, at least in the beginning, that you're telling your insurance carrier that these are the facts. There's always likelihood that any one of these may give rise to a liability, but unless you have some reason to believe it is going to be a claim, there's no obligation to say so.

Collect Documentation

Get yourself in a position where you can assist your outside counsel if and when you do get sued. That means you've got to take all your records with respect to any Madoff victim, whether they are e-mails, voicemails, conespondence, or workpapers. Collect every copy of every document that relates to that client and put it under lock and key. That way, if and when you are actually sued, you've got all the evidence ready, because one of the things that plaintiffs like to say is, "Well, you knew that you could potentially have a claim because you wrote your insurance company, but now you don't have all your documents. You have destroyed documents." In legal terms, that's called spoliation of evidence. The courts have gotten very nasty about that, particularly with e-mails. Where they perceive that a defendant has destroyed documents, they are likely to reduce the plaintiffs burden of proof when the liability claim is ultimately asserted. You want to make sure that you don't put yourself into a spoliation situation.

The next question is, "Should we be reviewing this documentation to see what's in there?" Maybe there are some really incriminating things in there that really aren't part of our workpapers, and we would rather they not see the light of day. Can we destroy those and get rid of them? That's always a touchy situation, particularly if there's any possibility of criminal liability, because you could be held to have obstructed justice - Ã la Arthur Andersen in the Enron situation. You've got to be very careful about destroying anything. Also, if you're doing any sort of an audit engagement, review, or even a compilation engagement you've got to be wary of the fact that the [Board of Regents] have rules regarding document retention. You don't want to put yourself in violation of those rules. Chances are you're not going to be able to get rid of very many records. Obviously, innocuous conespondence you can get rid of - but if it's innocuous, why get rid of it anyway?

The best policy is to collect everything and put it under lock and key. Then you should have it reviewed, preferably by somebody who has technical expertise in the area of the engagement. Have the person review what you did to make sure that you did perform the engagement properly, because it's going to be put under a microscope. Anything that you did wrong will be used against you to try and show the jury that you performed your engagement in a slipshod manner. This makes the jury more likely to believe anything the client may say against you.

If there are gaps in your workpapers, you might want to prepare additional workpapers to fill in those gaps. That way, it looks like your job was complete. Obviously, the closer to the engagement that you do this. the greater credibility those new workpapers will have.

Helping Your Client

The last issue to consider is. "What do I do about my client? Should I be talking to my client? Should I not be talking to my client?" The problem with helping your client now is that you run the risk of increasing the statute of limitations. The continuous representation doctrine in New York states that when you find your client has a problem and you try to help your client remedy that situation, you're deemed to have continued your representation, and the statute of limitations ceases to run and is tolled in legal terms. The time that you spend helping your client repair his problems does not count against the statute of limitations. Normally, there is a three-year statute of limitations in New York. If for the next three years you're helping your client recover his monies, that statute of limitations has not even begun to run.

In most cases, what you want to do is help your client recover his losses - because every dollar you recover is one less dollar he's going to be able to claim against you. Also, if you're helping your client, there's probably less likelihood that your client is going to turn around and say. "You're the cause of all my problems."

Tax preparer liability is really a very poor case in the Madoff situation because a tax preparer has no duty to investigate. The only way that a client is going to hold you liable in a Madoff claim is to be able to assert that you had a duty to look deeper and had you looked deeper, you would have found the problem. The likelihood of your being sued in a tax preparer situation is fairly minimal, and even if you are sued, the defense is fairly strong. If you're helping your client out in a situation where the client has a very weak case against you, the chances are pretty good that you'll never be sued. That's the main argument in my mind as to why you should be helping your client.

When you do so. there are a couple of rules that you have to follow: Do not admit that you ever made a mistake. You'll help your client in any way you can. but you should never be saying. "I should have done that. I should have done this." If you do that, you're only opening yourself to potential liability. The second thing is. you should not be telling your client about your insurance coverage. Your insurance coverage is between you and your insurer, and you don't want to give the client the idea that there's a deep pocket lying behind you that he can tap into. Insurance is something that's off the table and not to be discussed with your client.

In most cases, what you want to do is help your client recover his losses- because every dollar you recover is one less dollar he's going to be able to claim against you.

RIC ROSARIO

Insurance Protection

Cantico insures about 50,000 CPAs across the country. That's all we do and we've been doing it for 20-plus years. From my perspective insuring CPAs all these years, the Madoff scenario is not new. The only really big difference is the sheer size and the notoriety. But the fact is. we spend tens of millions of dollars every year defending CPAs. mostly against fraud schemes. Along with the Madoff [scheme]. I've got another half dozen of them sitting around. As human beings, we seem to repeat the same general issues. Those include greed and people not wanting to believe that this kind of thing can happen again, even in a publicly traded environment. In the ZZZZ. Best fraud, basically 80% of the assets were fraudulent. The company was being publicly traded and audited by a Big Eight firm. so. in a regulated environment or unregulated environment, mese things seem to keep repeating themselves. Accountants continue to be blamed for these things, and from an accountant's liability perspective, it - either not detecting an embezzlement or not detecting a fraud - continues to be our biggest problem.

I would really double underline the fact that if you have coverage, you should notify the carrier. There is the backside of the risk in that if you call the carrier they might drop you the next year. Most carriers won't do that There are some carriers that will play that game, but you probably should have figured that out in the first place when you bought coverage, about what kind of carriers treat their policy holders that way.

There is a provision in accountant malpractice policies when professional policy claims are made. It's called a "potential claim." You're obligated to notify the carrier under a claim when someone says, "I want some money." Under a potential claim, it gets a little gray. If you talk to your carrier, it will then hire [a lawyer] to help you work your way through it. This gives the opportunity for the firm, the insurance company. and the lawyer to see what can be done before there's a problem. A lot of times we can solve a problem before it ever turns into a claim.

At Cantico, we get roughly 500 claims a year that I would call "real" claims. We probably get 3,000 potential claims. On all those potential claims, we would work with you and your lawyer, and try to work with the client or the situation. The classic example is tax consider- ations on a tax claim. By putting your head in the sand, hoping the client forgets that you exist, you may create another malpractice problem by not advising the client as to proper tax treatment.

Speak Up About Red Flags

The Madoff scenario is outrageous. Where the heck were the regulators? I get very upset because I have to pay out all this money, and I don't believe the accountants are responsible because they didn't put most of these people into the deal, they were there after the fact. There was an eight-page memo that listed point-by-point in 2003 that Madoff was a fraud, and it was sent to the SEC. The problem is that half the time - and this is very consistent with frauds - no one wants to hear it. That's the outrage, and particularly in this case, very smart people who were in charge of protecting us from these kinds of things totally disregarded it.

We had this one Carnico policy holder who in 2003 was approached by his client. The client came up and said, "I'm thinking about investing in this deal." All the CPA did was the client's tax return. The CPA took a look at the materials and went through the prospectus and in short order called the client back and said. "Do not invest in this thing at all. it is a fraud." The client said. "No way. not at all." Of course we're talking about the Madoff investment. The CPA went through a couple of quick points and said. "It doesn't make any sense. Don't invest in it." It was very clear to the client. What did the client do? Invest in it. When the CPA found out that the client invested in the Madoff deal, he fired the client on the spot in 2003. He did the right thing. The CPA lost money because he didn't get the tax return work anymore. Not only did he fire the client, but in 2003, he picked up the telephone and called Cantico. He said, "I think this thing's a fraud. I fired the client just in case. If this thing ever turns out bad, I want you to make sure I have coverage."

In December 2008, when the Madoff stuff hit. Camico's phones started ringing off the hook - because we train our policy holders to call us the second they smell something. In January, we got several dozen phone calls from CPAs that had Madoff clients, all the way from tax return preparers to auditors of feeder funds. That one CPA who called in 2003 called back in December 2008 and said, "I told you. You have me recorded in the system, right?" He's my Cantico poster child - a good guy who figured it out, did the right thing with his client, and also did the right thing as far as working to let the insurance company know. It's my little glimmer of hope in all the money I'll probably have to spend [defending and paying out claims] over the next decade.

By putting your head in the sand, hoping the client forgets that you exist you may create another malpractice problem by not advising the client as to proper tax treatment.

JOHN H. EICKEMEYER

Possible Legal Defenses

I'd like to talk about some of the defenses that are typically asserted at the outset of some of these actions. Some can be brought on by motions to dismiss. Others may be more appropriate for summary judgment motions. Trying to stop one of these cases at an early stage - before you have to go through the lengthy, expensive, and often excruciating process of discovery - is critical. In addition to controlling legal fees, it will stop the plaintiffs from developing the kind of facts that will either position them to succeed at trial or to be able to increase the price of settlement. These are defenses that, when they work, can really stop the case in its tracks. I think the big question that we will face over the next few months is whether some of those defenses, which have often been very successful for accountants in New York State, will be as successful in Madoff-related cases.

Potential Defenses

One of the defenses that is frequently asserted is the privity defense, in cases where the plaintiff is not a client of the auditor but rather is a nonclient. a third party, who read a financial statement that was audited by the accountant and on which the accountant prepared a report. New York has a rule restricting suits by nonclients against accountants that is as strong as any rule in the country, embodied in the Court of Appeals decision in the Credit Alliance v. Arthur Andersen case about 25 years ago. The key requirement in that case is that there be some linking conduct on the part of the accountant that evidences the accountant's understanding that the plaintiff was going to be using and relying on the work done by the accountant for some purposes of the plaintiff. This is a very lough rule, because it requires the plaintiff to plead that linking conduct at the outset and to plead the facts that would show that the accountant actually understood that the plaintiff would be relying on the accountant's work.

There are a couple of other cases in New York, some of which are older and some much more recent than Credit Alliance that may provide many plaintiffs a way around that very high privity bar. One of them is another Court of Appeals case decided in the 1970s known as White v. Guarente, which has managed to survive Credit Alliance and the many, many cases in which the Credit Alliance doctrine has been repeated and, if anything, strengthened by the New York Court of Appeals over the years.

White v. Guarente involved investors in a limited partnership that was audited by an accounting firm. In that case, the court held that even though the plaintiffs were not clients, they were not the partnership itself; they were limited partners. They were a known group of identifiable users of the financial statements who would be relying on the report, and whose reliance on the report could be foreseen. The court allowed those ostensibly nonclients to maintain an action against the limited partnership's auditor. White v. Guarente continues to have vitality in this state, and I think it is a theory that we will see asserted in many cases by investors in hedge funds or other funds that invested money with Madoff.

It may be important to distinguish in those cases between people who were already in those funds - who will argue: "If only we had known the truth, we would have gotten out of these funds. If the auditors had uncovered the fraud, we could have gotten our money back" - and those other persons who had not yet invested and will allege that they got the financial statements of the funds, looked at them, and said "These funds appear to be invested in good sound investments, including this Madoff thing which had wonderful returns." [The latter] now claim that if only the auditors had blown the whistle, they wouldn't have been involved in Madoff, and they wouldn't have lost all this money. Those persons who were on the outside may not fall within the ambit of White v. Guarente and may not be able to maintain claims. The persons who were already invested may well fall within that decision.

There are other issues, though, for those nonclients to submit in their claims, namely the idea that if there had been some red flag raised, they could have gotten their money out. They all would have rushed for the exits at once, and [it is not clearj whether everybody could have gotten all their money back under those circumstances. It essentially would have been a fire sale. Clawback issues would come into play, and I think those plaintiffs will have some very serious issues trying to prove they are entitled to recover all of their damages. The privity defense has historically been very strong in New York. It's important to bear in mind that this defense only applies to cases brought by nonclients and will not apply in cases brought by clients against their own accountants.

Statute of Limitations

Another defense that has been successful for accountants over the years is the statute of limitations defense. New York has a three-year statute for negligence. In certain cases, this can be extended through the application of the continuous representation doctrine. One way that that can be triggered is by assisting a client going forward in trying to recover some of the losses suffered. That doctrine will probably also be asserted even if continuing assistance wasn't provided by the accountant.

There was a significant decision by the New York Court of Appeals a couple of years ago involving a suit against an accounting finn that had audited a mutual fund for a number of years. The client argued: "I shouldn't be limited just to the last three years. This was a continuing relationship that went back for 15 years, and we should be able to sue for all the bad financial statements."

There were about seven years' worth of financial statements that they thought were incorrect. The Court of Appeals held that the continuous representation doctrine would not extend back in that case because there were a series of discrete one-year engagements to prepare each annual audited financial statement without an expectation that there would be further services going forward. In other words, the client was getting a report every year. The client was going to read it, rely on it for whatever purpuses, and that would be the end of it. This is somewhat distinct from a tax situation where the tax return is issued and then you expect that your accountant will be there years later to assist with issues that may arise out of that tax engagement.

The statute of limitations defense may well continue to be a limitation on damages for negligence-based claims. The fraud statute of limitations in New York is six years. Fraud encompasses not only intentional conduct, but reckless conduct. In many cases, that reckless conduct is construed by the courts to include ignoring the kinds of red flags mentioned by a lot of plaintiffs in the wake of the Madoff revelations. We may see a lot of claims that have just been negligence claims being also asserted as fraud or recklessness claims in an effort to broaden the statute of limitations period and perhaps also to take advantage of the greater likelihood that you can obtain punitive damages in connection with a fraud claim.

Causation is generally a fact issue, but it is one that is not often successful, certainly not at the motion to dismiss stage. At the summary judgment stage, it's the exception rather than the rule. But it can be an important defense because, in fraud cases, it is necessary for the plaintiff to show not only what's known as transaction causation, which is basically a "butfor" test - but for the wrongful conduct by the auditor, I wouldn't have invested in this - but also to establish loss causation, namely that the very fact that it was misrepresented is what caused the loss. That's a two-stage process. Sometimes courts will grant summary judgment, but more often than not, that is going to be a fact issue, and I don't think it's one that is going to be terribly effective for auditors in these cases.

Regarding the standard of care, auditors will argue, "We conform to generally accepted auditing standards [GAASl in doing our work; we should therefore not be held liable." Unfortunately, GAAS is not the gold standard of care according to most courts that have considered the issue. GAAS is strong evidence of what "standard of care" is, but a majority of courts around the country have said that jurors are free to consider other factors in determining what a reasonable auditor would have done under the circumstances. That will be really the test in these cases that do go to a jury: Faced with all of the audit evidence, what would the reasonable auditor have done? The question is not, "Did they check all the boxes according to GAAS?" That's going to create, particularly in cases where you had so many sympathetic plaintiffs and such a huge and pervasive fraud that extended over a period of years, a much greater likelihood that jurors will consider something other than GAAS in deciding whether the auditors ought to be held liable. That is one of the things we really are going to have to watch for as some of these cases ultimately come to trial.

GAAS is strong evidence of what "standard of care" is, but a majority of courts around the country have said that jurors are free to consider other factors in determining what a reasonable auditor would have done. SIDEBAR

HOW THE MADOFF FRAUD COULD AFFECT YOUR CPA PRACTICE

By Stephen Scarpati

With an estimated S65 billion lost from trust funds, retirement plans, pensions, investment funds, inheritance monies, and nonprofit organizations, many people have been adversely affected by the Ponzi scheme perpetrated by Bernard L Madoff. When you combine a lot of lost money with a lot of angry people, the result is a lot of lawsuits. The breadth of those lawsuits will encompass all associated with the affected organizations - including CPAs. Those messages were loud and clear at the May 27, 2009, breakfast symposium "Are CPAs the Next Madoff Victims? The Accountant's Liability," sponsored by The CPA Journal.

The audience at the symposium included CPAs from large, medium, and small firms, industry, and academia. Prior to the start of the event, this author spoke to a number of attendees who spoke excitedly about the importance of this issue to our profession. Some CPAs, from organizations that had invested with Madoff, were directly affected. Other CPAs had clients who lost money in the scandal. The amounts varied from organizations and persons who lost "a lot of money" to those who lost "a little bit." (Nobody mentioned specific dollar amounts.) For those in attendance who were not directly impacted, they knew from the news stories they'd seen about Madoff that the scandai pounded the investment community. All were aware that accountants would come under scrutiny. It quickly became clear to those in attendance, however, that there would be implications that extend beyond the immediate litigation parties. The sheer magnitude of the scandal has brought the accounting profession as a whole into the spotlight.

For many CPA firms, change is already under way. Following are four areas of CPA practice that are specifically affected as a direct result of the Madoff fraud.

Audit Procedures

It has been reported that Friehling & Horowitz, the audit firm for Madoff's operations, was not qualified to conduct the audit. Some people contend that there were sufficient red flags to alert other accounting firms that something was amiss with Madoff's audit firm. Inevitably, there will be finger-pointing at the auditors of the feeder funds, hedge funds, investment organizations, and others who invested with Madoff that they should have checked on the small firm that issued the reports on which they relied.

For CPAs in attestation engagements who rely on the work of other auditors, the alert is now raised. In some situations, additional procedures may be needed to sufficiently rely on the work of other auditors. A number of practitioners in attendance vowed to incorporate this step into their audit plans. What might have been a fairly routine matter in the past will now receive additional scrutiny in future audit engagements.

Advisory Services

It is expected that the Madoff lawsuits will drag in investment advisors, trustees, fiduciaries, and anyone who had some advisoryrelated role to any organization and any person who lost big with Madoff. No one knows how these lawsuits will be resolved, but it is certain that fiduciary standards will be put to the test.

CPAs who perform advisory services, especially investment advisory services, would be well advised to follow these cases closely. In addition, those CPAs who perform trustee and fiduciary roles of any kind should also pay close attention. We can expect that professional standards will be vigorously debated in the courtrooms. Scrutiny must be given to how juries decide standards of professional conduct for various advisory services in these cases.

Practice Management

With all this discussion of lawsuits, now is the perfect time for CPAs to review their professional liability insurance coverage. There are two key questions CPAs should ask themselves:

* Are my coverage limits adequate for the businesses that I am in? This would be a very significant issue if, for example, a CPA firm has expanded the scope of the services that it offers clients since it purchased its current professional liability policy. It may be that the policy does not cover the new business and needs to be updated.

* What is my insurance carrier's reputation for dealing with claims? As the Madoff lawsuits develop and claims get made, it will become apparent which insurers stand behind their policies and which attempt to bail out at the first sign of trouble. If your carrier is among the latter, it may be time to switch insurance companies.

Tax Services

All of the attorneys on the symposium panel assured tax preparers that, under current legal liability standards, they have no obligation to go further than using the information they have been provided to prepare tax returns. Nonetheless, there was a sense of unease among many in attendance. Many CPAs were concerned that opportunistic lawyers and plaintiffs could put this standard in jeopardy. As a result, the topic of engagement letters was raised. Presently, it is not a common practice to utilize engagement letters for tax preparation services. It was pointed out, however, that an engagement letter would help avoid any misinterpretation of the services being provided. Although it is not customary for his firm, at least one practitioner in attendance promised to discuss the matter with his partners to determine if, in fact, there are certain tax engagements where an engagement letter might provide prudent protection.

Going Forward

CPAs should study the events of the Madoff scandal closely, from two perspectives. First is the technical aspect: Which professional standards are being scrutinized? The second is more complex: What does the generai public expect from CPAs in these circumstances? Specifically, how will juries, which represent the general public, apply their own expectation standards to case verdicts? To the extent that either of these aspects is found lacking, the profession will have to learn from those shortcomings and adapt accordingly.

The Madoff breakfast symposium sponsored by The CPA Journal highlighted the fact that many CPA firms, not just those directly associated with litigation, are being touched by the scandal. With claims and lawsuits expected to last years, it is important that dialogues such as this symposium continue and that CPAs follow events closely to ascertain how the Madoff fraud fallout will affect their practice in the future.

Stephen Scarpati, CPA, CLU, ChFC, is an accounting professor at the John F. Welch College of Business at Sacred Heart University, Fairfield, Conn., and a member of the CPA Journal Editorial Review Board.