Will CPAs Become Madoff''s Next Victims?

Copyright 2009 ProQuest Information and LearningAll Rights ReservedCopyright 2009 New York State Society of Certified Public Accountants The CPA Journal

April 2009

SECTION: RESPONSIBILITIES & LEADERSHIP: ACCOUNTANT'S LIABILITY; Pg. 68 Vol. 79 No. 4 ISSN: 0732-8435

ACC-NO: 26131

LENGTH: 3592 words


HEADLINE: Will CPAs Become Madoff's Next Victims?

BYLINE: Eickemeyer, John H; Goldwasser, Dan L.

Dan L. Goldwasser, JD, and John H. Eickemeyer, JD, are shareholders and members of the accounting law practice group at Vedder Price, P.C., New York, N. Y. Goldwasser is a member of "The CPA Journal Editorial Board. Eickemeyer also heads the directors and officers/professional liability litigation practice group at Vedder Price.

ABSTRACT

As the extent of the schemes perpetrated by Bernard L. Madoff continues to unfold, one must ask where it will lead next. CPAs are trained to be skeptical in matters of financial fraud and do not readily fit the profile of a Ponzi scheme victim. The sad fact, however, is that many CPAs are likely to be drawn into the financial black hole created by Madoff's scheme because their clients entrusted their investments to Madoff, either directly or indirectly. CPAs who served as trustees, executors, or administrators of trusts, estates, and foundations that invested with Madoff are in even greater danger of being sued. Faced with the prospect of being another Madoff victim, accounting firms must take precautions to minimize their liability exposure. For most firms, the first and foremost line of defense is their professional liability insurance policy. It is vital that CPAs do not jeopardize their coverage by failing to promptly notify their insurers about actual or potential claims. FULL TEXT

As the extent of the schemes perpetrated by Bernard L. Madoff continues to unfold, one must ask where it will lead next. Are CPAs in line to be victims of Madoff? This seems like a silly question, because Madoff admit- ted he operated a Ponzi scheme estimated at $65 billion; plead- ed guilty to 1 1 counts of fraud, money laundering, and perjury; will be sentenced to up to 150 years in jail; and will never be allowed to reenter the securities business. Moreover, CPAs are trained to be skeptical in matters of financial fraud and do not readily fit the profile of a Ponzi scheme victim. The sad fact, how- ever, is that many CPAs are likely to be drawn into the financial black hole created by Madoff s scheme because their clients entrusted their investments to Madoff, either directly or indirectly. In fact, at least three dozen New York accounting firms and another two dozen individual accountants were identified in court filings as having received account statements from Madoff s investment firm.

The huge losses resulting from the Madoff scheme will no doubt result in an equally huge flood of litigation. Anyone who served as an auditor or professional advisor of a Madoff investor stands a good chance of becoming a defendant and, thus, being added to the list of Madoff s victims. In fact, this process has already begun, as lawsuits have been brought against Ernst & Young, McGladrey & Pullen, KPMG, and BDO Seidman.

Who Is at Risk

The accounting firm most closely tied to the Madoff scheme was Madoff s own auditor, Friehling & Horowitz, which consisted of three people (only one was an active CPA, one was a secretary, and the third was approximately 80 years old and living in Florida) and operated out of a 13' by 18' storefront office in New City, New York. In addition to auditing Madoff s operations, this firm invested in Madoff s fund (further calling into question its audit independence) and also served as the accountant for scores of other Madoff investors.

Beyond this obvious target are the auditors for the numerous feeder funds that invested all or a substantial portion of their investors' monies with Madoff. These audit firms are likely to be sued by their fund clients and their clients' investors for having failed to properly audit the funds' financial holdings. Although auditors are generally able to rely on the audit reports of investee entities such as Madoff, the plaintiffs will undoubtedly allege that the auditors failed to heed numerous "red flags" that something was amiss in Madoff s enterprise. The following are among the red flags that have been alleged in an existing lawsuit:

* Madoff s claimed investment strategy was incapable of delivering the returns he was reporting;

* The options contracts in which Madoff supposedly invested were not reflected in the trading of the options exchanges;

* The value of the reported listed call options was insufficient to allow Madoff to hedge the exposure of the $65 billion in assets which Madoff claimed;

* Madoff operated under a veil of secrecy and did not allow outside audits by significant investors;

* Madoff went to 100% cash every December 31, irrespective of market conditions;

* Investors had no electronic access to their accounts at Madoff; and

* Madoff did not have an independent custodian hold its investment securities.

Entities that invested directly with Madoff will likely also seek to recoup their losses by suing their accountants and auditors. These entities will include educational and charitable organizations, foundations, pension plans, and other benefit funds that invested in Madoff s fund. While their losses are substantially less than those of the feeder funds in absolute terms (which ran as high as several billion dollars), they are devastatingly large to many such investors that placed most, if not all, of their entire investment portfolios with Madoff. These institutional investors will undoubtedly assert that such a concentration of assets with a single fund manager requires much greater scrutiny on the part of the entity's auditors, that the auditors had a duty to disclose the large concentration in a single investment vehicle, or that such concentration was in violation of the fund's stated policy of investment diversification. Whether such blame should fall on the fund managers rather than their auditors is subject to debate.

Also included among Madoff s victims were many thousands of individual investors. Although the vast majority of these investors did not have their financial statements audited, they may have employed accountants to prepare their tax returns or to offer business and investment advice. Many individual investors had copies of their Madoff monthly statements sent directly to their accountants; others simply forwarded those statements to their accountants in order to prepare their tax returns. Those accountants who offered investment advice (regardless of whether they were specifically retained as an investment advisor) will be particularly susceptible to lawsuits by their clients, who will likely claim that the accountants failed to adequately investigate what Madoff was doing. Even those accountants who only performed tax-preparation services are likely to be charged with having failed to notice various irregularities on their clients' monthly statements from Madoff. Although tax preparers rarely assume responsibility for bringing such anomalies to their clients' attention, this is unlikely to deter a defrauded widow from commencing a lawsuit alleging that she relied on her accountant to protect her, or a jury from finding that the accountant had a duty to do so.


CPAs who served as trustees, executors, or administrators of trusts, estates, and foundations that invested with Madoff are in even greater danger of being sued. These accountants would be considered fiduciaries and subject to assessment for their entity's losses. In such cases, plaintiffs need not prove that CPA fiduciaries had a duty to investigate, discover, and report anomalies in the way Madoff conducted his operations, but only that tfiey failed to use reasonable prudence in making their investment decisions. An investment that paid 10% to 15% annual returns might be considered inherently too risky for such entities.

Madoff did not simply rely upon his reputation for high returns to attract the investors necessary to keep his Ponzi scheme alive. Madoff is said to have paid substantial finders' fees to solicit new investors. Any CPA who may have accepted such fees will have a difficult time convincing a jury that he did not compromise his objectivity in advising clients to invest with Madoff. This will be especially trae of any firms that did not advise their clients that they were receiving remuneration from Madoff, with respect to their clients' investments.

Plaintiffs' Burden of Proof

Most of the suits against accounting firms will be brought by the accounting firms' clients themselves. These will normally be asserted on a negligence theory. In such cases, a client will have to allege that an accounting firm had a duty to investigate Madoff s fund and that, had the accounting firm done so, it would have discovered that Madoff was operating a Ponzi scheme. Such a claim poses some fairly high hurdles for plaintiffs, especially considering the number of sophisticated investors and regulatory officials who also failed to detect a scheme that Madoff operated for more than 15 years.

Some suits by CPAs' clients will be brought on a breach of fiduciary duty theory. In these cases, the plaintiff will have the bürden of proving that tiie defendant accountant or accounting firm was a fiduciary with respect to the client. The law is clear, however, that tiie normal auditor-client relationship does not create a fiduciary relationship. Indeed, it has been successfully argued that a fiduciary relationship is incompatible with the independent auditor role. This does not mean that a CPA must manage a client's money or be an executor or trustee in order to be considered a fiduciary. A fiduciary relationship may exist when there is a significant disparity in financial expertise between the client and the professional, where the professional has undertaken to provide advice or other expertise for the client, and where the client is clearly relying upon the professional's greater expertise in making his investments or other business decisions. While it is not unusual for a client to claim that he was wholly dependent upon a professional's financial advice, the determination of whether a CPA owed a fiduciary duty to a client will likely turn on the facts of each individual case.

A breach of fiduciary duty claim is particularly dangerous for accounting firms if a client can surmount the hurdle of proving that the accountant served in a fiduciary capacity. As a fiduciary, an accountant not only would have had a duty to act prudently and with reasonable care, but also to advise a client of matters which come to her attention that could have an adverse impact on the client. This would not only require an accounting firm to disclose any fees which it had received in connection with the client's investment with Madoff, but also to disclose any anomalies that the accounting firm may have noticed in the way the fund conducted its operations such as the steady returns reported when the broader market generally was suffering losses, the fact that Madoff s fund did not publish its financial statements, and that fact that the monthly financial reports sent out by Madoff had various anomalies on their face.

A few accounting firms may also be confronted by class actions brought on behalf of investors in the various feeder funds that invested with Madoff. Because these would not be client suits, the plaintiffs would have to plead and prove that the defendant accounting firm had acted fraudulently or recklessly. This is a heavy burden for any plaintiff to sustain. But it is not an impossible one, especially considering that a jury could easily find that, when it comes to a $65 billion investment company, relying on the audit opinion of a three-person accounting firm is inherently unreasonable. Moreover, the damages likely to be sought in such suits are so high that few accounting firms will be able to risk a jury verdict. Thus, such cases would seemingly have a very high likelihood of settlement if the plaintiffs suit is not dismissed by the court in its earliest stages.

Protecting Liability Coverage

Faced with the prospect of being another Madoff victim, accounting firms must take precautions to ininimize their liability exposure. For most firms, the first and foremost line of defense is their professional liability insurance policy. Accountants who may have exposure to Madoff-related claims should make sure that their coverage remains in place and that their insurer is promptly notified of any potential, threatened, or actual claims. The good news is that most claims that arise out of the Madoff scandal will fall within the coverage of most policies. Claims that are based solely on investment advice may fall within an exclusion contained in some policies. It is likely, however, that most claims will be based on alleged negligence in connection with the provision of tax or audit services, in which case there will likely be coverage or, at worst, the provision of a defense under a reservation of rights by the insurer.

It is vital that CPAs do not jeopardize their coverage by failing to promptly noti- fy their insurers about actual or potential claims. If a lawsuit is received, the insur- er should be notified immediately, as pro- vided in the policy. Accountants should also promptly notify their insurers about threats to bring Madoff-related claims or demand letters directed to the accounting firm. Prompt notice of these incidents not only allows the insurer and the accounting firm to begin to plan a defense at the earliest possible time, but it ensures that the insurer cannot later seek to avoid providing coverage - if suit is eventually brought - on the grounds that the firm did not give notice to the insurer as soon as it learned that a claim might be brought.


CPAs may also receive subpoenas from parties already involved in Madoffrelated litigations or from trustees, receivers, or creditors in connection with bankruptcy proceedings resulting from the Madoff fiasco. Recipients of such a subpoena should promptly notify their insurers and explain in an accompanying letter their involvement with the person or entity involved in the Madoff-related proceeding. Many policies offer some form of coverage for subpoena responses, which can help defray at least some of the related expense. More importantly, notice of the subpoena will generally serve as notice of a potential claim, ensuring that if a suit is subsequently brought against the accounting firm, there will be no grounds for a denial of coverage due to late notice. CPAs who receive subpoenas or informal requests for testimony, documents, or other information pertaining to Madoff-related claims should always consult counsel before responding.

Not surprisingly, liability insurers are already deeply concerned about their potential exposure arising out of Madoff claims and are requesting information in their renewal applications about their insureds' exposure. A failure to respond tmthfully to such inquiries could jeopardize a firm's liability coverage. On the other hand, a firm that reports a large number of clients who sustained losses in the Madoff scandal could find that its insurer has declined to renew its policy.

The best way to respond to such inquiries is to report in detail all Madoff-related suits that have actually been initiated or threatened, or in which a subpoena or other request for documents or testimony has been made. As discussed above, this already should have been done prior to the time of the renewal application. These will constitute "claims" under the firm's existing policy and will have to be covered by the insurer up to the limits of the firm's policy. For the most part, however, accounting firms will not have been sued or even threatened with a lawsuit by clients who invested in the Madoff fund. With respect to these clients, it is recommended that the firm simply list each of these clients, with the amount invested by each and the nature of the services the firm provided. This list should be accompanied by a statement that the firm has not been threatened by any of the listed clients and that the list is simply being provided to allow the insurer to assess its potential exposure.

There is, of course, a risk that some insurers may be frightened by these disclosures and decline to renew a firm's coverage. If this happens, the firm will have difficulty finding a new insurer that will cover claims by the listed clients because a new insurer will likely treat them as existing claims and assert that they are the responsibility of the previous insurer. To protect itself in this situation, an accounting firm will have to make a further submission to its current insurer prior to the expiration of its policy (or the extended reporting period related to the policy), explaining why it believes that claims may arise with respect to each of the listed clients. (In the case of a firm that provides attest services to a client who has invested with Madoff, its independence will likely be impaired by any threat of litigation.) The insurer will have the burden of proving that a claim could not have been reasonably foreseen at the time the policy expired - a very difficult burden to sustain after it has dropped coverage. In this way, an accounting firm can maximize its chances of being covered if a suit is later commenced against it.

Under New York law, an insurer may not terminate coverage on less than 45 days' notice. This is not a lot of time in which to secure replacement coverage, especially coverage for potential Madoff claims. Should an accounting firm receive notice that its insurance will be cancelled or not renewed, it must immediately contact its legal counsel and insurance broker and give serious consideration to purchasing extended reporting - known as tail coverage - on its existing policy.

Other Damage Control Measures

In addition to ensuring that any Madoffrelated claims are covered by their professional liability insurance, accounting firms that may face such claims should also take steps now to assess, and possibly limit, their exposure. For example, firms that have Madoff investors or feeder funds among their clients should carefully collect and review all of their files related to those clients. Attest engagement workpapers are subject to retention requirements - seven years, in the case of New York State Board of Regents Rule 29.10(a)(ll). This provision also requires that any substantive alterations to workpapers made more than 45 days after issuance of the financial statements must be clearly documented and include both the date of and the reason for the alteration. While a review of workpapers may indicate the need for additional documentation, any substantive alterations should be made in strict conformity with the rulé, and may not include the discarding of any portion of the workpapers.

While it may be tempting to discard certain material during this review process, the destruction of any materials at this time - when there are numerous investigations by a variety of governmental agencies under way - could be hazardous and might itself become the subject of investigation. Even if the discarded material never becomes the subject of an investigation, the destruction of any relevant material could be examined in future litigation and construed as harmful to the firm. The emphasis at this time should be on the gathering, preservation, and review of all physical and electronic information related to engagements that could give rise to Madoff-related claims. This material should be placed under the control of a person or small group designated by firm management. Access to the material should be strictly controlled, and the firm's outside counsel should be consulted with respect to any potentially damaging material that is identified.

Of particular importance will be the firm's engagement letter and correspondence with clients. One of the most important issues to be considered by firms whose clients invested with Madoff will be whether the firm undertook to, or did, provide investment advice, regardless of what the nature of the engagement may have been. It will also be important to assess what kind of information the firm received concerning its clients' investments with Madoff - in particular, whether the firm received any Madoff-generated account statements - and whether that information contained anything that could be construed, in hindsight, as a red flag.


In addition, further communications with clients who had Madoff investments should be carefully restricted, and firm personnel should be warned not to make any statement to the client that could be construed as admitting that the firm could or should have detected the Madoff fraud. This will be difficult, because most clients who are Madoff victims will now need the firm's help more than ever. Such communications should be well planned in advance, and the persons engaging in those discussions with the client should be thoroughly familiar with all prior client communications so as to avoid making any admissions against the firm's interests. In such conversations, the client is likely to have a distinct - even if erroneous - recollection of having discussed her Madoff investment with one or more of the firm's professionals.

In any event, accounting firms will undoubtedly have to assist clients in filing for tax refunds and applying investment losses to other taxable income. CPAs may also be asked to help individuals make claims in the Madoff bankruptcy proceeding and defend claims by the bankruptcy trustee to recover any monies that may have been withdrawn from the Madoff fund. A firm that lacks the competence to provide this type of advice should not do so because a client who may not be able to hold his accounting firm responsible for his losses may nevertheless seek to hold the firm responsible for failing to provide the necessary advice to mitigate his losses to the maximum extent possible. SIDEBAR

It is vital Ihat CPAs do not jeopard~e their covelage by failing to pmmptly notify their insuret~ about actual or potential daims.

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LOAD-DATE: April 13, 2009

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