MADOFF AND ENRON: The Common Denominator!

Did The System Fail? Not Necessarily!

Dan Scotto, Whitehall Financial Advisors LLC

THE COMMON DENOMINATOR: The Power of Clout

The investment community was shocked by allegations that Bernard Madoff perpetrated a fraudulent $50 billion hedge fund. Prosecutors and regulators accused the 70-year-old Madoff of masterminding a Ponzi scheme of “epic proportions” through a hedge fund he ran.  Hundreds of individual and institutional investors entrusted Madoff, the former chairman of the Nasdaq Stock Market, with billions of dollars.  The Madoff scheme will clearly go down as one of the largest Wall Street scandals of all time, eclipsing Sam Israel’s $400 million investment at the Bayou Group.  Israel founded Bayou in 1995 with James Marquez. After the company lost money in 1998, Marquez and finance chief Daniel Marino created a sham accounting firm to serve as the company's external auditor.

THE ENRON CONNECTION

As in the Enron case, it is incumbent upon investors to ask the right questions and when the answers “seem” odd, they should either investigate further or move on.  Enron relied on its industry clout to procure investors, much in the same way Madoff used his social connections and reputation to dupe investors.  The harsh reality is “buyer beware.” Had investors questioned the auditing quality in both the Bayou and Madoff investment schemes, in all likelihood, they would not have entrusted their hard earned money with either.  Audited financial statements are critical to any investment decision, it is one of the protections provided by “the system” and the firm preparing such statements should be taken into consideration and, despite the preparer, should be “read for qualifiers.”

HOW FLAWED WERE MADOFF’S INVESTMENT DECISIONS?

Madoff’s investment approach seems to have been to invest in high quality companies, such as Microsoft and straddled the position with puts and calls, a strategy which (... oddly enough) is not unreasonable in this market.  The problem is that this would be a very difficult, if not impossible policy to apply uniformly on a multi-billion dollar portfolio.  In order to execute this transaction, given its size, it would quickly become a market mover thereby running the risk that the trade could lose substantially all of its profit potential.  For a smaller hedge fund or an individual, this investment tactic is likely to succeed.

INDEPENDENT DUE DILIGENCE

On December 11, 2008, Madoff simply told senior employees that his money management operations were "all just one big lie" and "basically, a giant Ponzi scheme." Unlike Enron, which denied allegations of wrongdoing, Madoff seems to have surrendered unceremoniously to Federal agents.  It was just that simple, $50 billion dollars gone! How could it happen? It was easy, investors clearly did not conduct sufficient due diligence on Madoff Investment Securities and his Investment Advisory firm.  The obvious weak link in the Madoff chain was the lack of a reliable outside auditing firm.  Enron investors were less fortunate in that its books were audited by the prestigious accounting firm, Arthur Anderson.  In both cases, auditors did not reveal phantom transactions – illustrating that no single individual or corporation can engage in a ponzi scheme without benefit from “enablers.”  Hence “the system” of checks and balances would have uncovered trading irregularities, regardless of the underlying assets (i.e. energy futures contracts, stocks, options, etc.), if this critical link had not failed.

WHO AUDITS THE BOOKS?

Had investors and/or advisors examined the accounting firm auditing Madoff’s books, which should be a routine part of the due diligence of any hedge fund or investment firm, along with a review of their legal representation, the warning signal should have been triggered.  Madoff’s books were audited by the Friehling & Horowitz (...who?).  A 3 member firm, 2 principals and one secretary, headquartered next to a pediatrician in an upstate New York suburban office building.  According to state records, one of the principals, 80-year-old Jerome Horowitz, actually retired from the firm in 1997 and he now lives in Florida.  In effect, that leaves a one individual, David Friehling responsible for reviewing the transactions of a $50 billion organization (...how many $50 billion firms have a single outside auditor? I don’t know, but I feel confident in saying none or certainly none a prudent investor should consider.)

It is nearly impossible to believe that one person could audit the transactions of a massive, $50 billion investment firm.  Consider the number of transactions and money inflow/outflows such a company would entail.  A private investigator reported to Aksia, a New York based hedge fund consulting firm, that there seemed to be one person working there.  According to press reports Aksia attempted to engage in dialogue regarding Madoff’s accounting policies and procedures.  Reportedly, “phone calls were not returned until someone finally answered and said the firm was not open for business.” (...is there really any need to go further?).

RULE NUMBER 12: Quality of Accounting and Legal Representation

This is such an obvious flaw in the investment decision process that it almost need not be mentioned.  Most hedge funds, even when they are small, use one of four or five big-name accounting firms that are well staffed with accounting professionals.  The big four auditors are: PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG.

However, since so many investors apparently missed it, we are adding it to our list of Guidelines on How To Avoid the Next Enron.  Hence it will become rule number twelve: Professional Representation: does the corporation have well regarded accounting and legal representation.  Has the representation been stable and are opinions clear, not muddled with disclaimers, regardless of the firm issuing an accounting or legal opinion, even an highly “conditioned report” by a prominent accounting or law firm should raise questions and be investigated.

The New York State Education Department, which licenses certified public accountants, says there has never been any disciplinary action against the Friehling or the firm and none is pending (...why do we sense that they may have had only one client, Madoff, who would have no reason to file a complaint.) While State documents indicate that it is a firm engaged in the business of tax preparation, bookkeeping, accounting and auditing, it is unclear how many other clients, if any, Friehling & Horowitz represents.  The firm apparently has a clean record and Friehling is a Certified Public Accountant (CPA) in good standing despite informing the AICPA (American Institute of Certified Public Accountants) every year, in writing – for 15 years that his firm doesn't perform audits. He is a past president of the Rockland County chapter of the New York CPA society and sits on the chapter’s executive board.  Notwithstanding Friehling’s reputation, it should have obvious that the task of auditing a $50 billion enterprise is not a one person task.<

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