Sheep on the Prowl -- Madoff's Victims Go After the Auditors

There’s an ominous if predictable new chapter this week in the saga of Bernard Madoff’s alleged $50 billion escapade: the inclusion of the auditors as recovery targets. As the front page of the normally sensible Financial Times put it on Wednesday, “lawyers say the asset-rich firms are likely to be targeted for legal action.”

The Seidman firm has been sued along with its client Ascot Partners, and threats are percolating against three of the Big Four who audit funds that had fed some $20 billion into the Madoff operation.

The large firms were already on the bubble of survival, awaiting only the return of critical political and regulatory scrutiny later this winter – here. Now, for two reasons, what might once just have been Madoff’s epic re-scaling of the familiar story of a glib and well-connected scamster and his credulous circle of ready victims takes on the potential to rock the already shaky foundations of global financial statement assurance.

The first is that, much as Madoff’s victims might hope for deep pockets to pick, characterization of the large accounting firms as “asset-rich” is thoroughly wrong.

The principal “assets” of the firms appear nowhere on their balance sheets – comprising only their fragile measure of gate-keeper trust, and the professional skills of the partners and their staff that deploy by the tens of thousands. But these structures are highly brittle under stress and threat, as proved by the speed of Arthur Andersen’s post-indictment disintegration in 2002, and they have no monetizable value – to pay lawsuits or otherwise – as shown by their lack of appeal to the world’s investment bankers – here.

On the contrary, under a model developed two years ago in London for the European Commission, the limited capacity of the thinly-capitalized Big Four to withstand a litigation death-blow can be calculated as ranging between $500 million and $2 billion – here -- small fractions of the amounts Madoff apparently sluiced away.

Impelled by fee-motivated lawyers, the blame-seeking Madoff investors are unlikely to be deterred by the absence of a pay-off, of course, which exposes the other reason the auditors should be very worried:

Namely, “failure to detect” cases are easily started, but they are hell’s difficult for the auditors to defend, much less to win.

On the jurisprudence, cases are brought by audit clients in the often accommodating state courts, under garden-variety common law theories of malpractice, negligence and breach of contract, rather than under the stricter standards of fraud required by the federal securities laws.

In addition, defendant auditors face three huge hurdles in the courtroom:

First, human nature cannot resist applying the crystal clarity of hindsight, so juries presented with the inescapable reality of a catastrophe are inexorably drawn to the allocation of blame, rather than a reasoned consideration of ex ante discoverability or prevention.

Second, the very nature of audit execution involves judgment and choice about sampling and the depth and extent of work to be done. After the fact, even for a job perfectly executed, plaintiffs are well armed to second-guess any audit procedures omitted or disregarded – and are abetted in their advocacy by forensic experts hired to focus the jurors’ attention on the hostile arguments of fault.

And third, if the past is future, the nightmarish likelihood is that down deep in the audit papers on the feeder funds, waiting to be unearthed by the plaintiffs’ subpoenas, lurk the worrisome memoranda of alert staff personnel, questioning the legitimacy of Madoff’s operations or fingering its weaknesses – the very smoking guns with which the firms will have to play survival roulette.

Despite the large firms’ formulaic protests that they conformed to applicable standards, and their professed readiness to defend themselves, the future of the Madoff cases can be foretold.

That is, the record already presented by the firms themselves to the US Treasury Department’s Advisory Committee on the Audit Profession – here – is that the large firms cannot afford to go to trial in life-threatening cases – as reinforced by the Seidman firm’s survival on life support as it appeals its $521 million Bankest verdict in Miami -- here.

So, facing a deeply insulted and well-heeled set of investor adversaries, the large firms would be brought to the brink of survival if obliged to take up any share of Madoff’s predations of $50 billion that even approached ten percent.

That thought alone -- passing the gruesome ignominy that a noble profession delivering highly complex and technical service to the world’s capital markets could be brought down by the prosaic activities of a single if grandiose con artist – is enough to mute the level of cheer and festivity at the large firms’ annual holiday parties.

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Comments

[Greg Morrow]

Which firms are exposed to Madoff?

[Jim Peterson]

Greg -- Thanks - good question. The FT flagged PwC (auditor of Fairfield Greenwich), KPMG and E&Y. The effective source for future tracking will be Kevin LaCroix at the D&O Diary -- http://www.dandodiary.com -- which yesterday identified a class action against the Tremont Group and others including E&Y, and a state court action against Fairfield that did not (yet) include PwC. And so it begins.