Unaccountable external auditors

Their roles in the 'Great Economic Meltdown' Part 1 of 2


By Gilbert Geis, PH.D., CFE
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LACHLAN CURRIE, EARL ARENA, CHRISTOPHER STEER, 
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External auditing firms are supposed to provide detailed, accurate and unbiased information about the finances of their clients. However, the author contends that the failures of many external auditors helped contribute to the recent “Great Economic Meltdown.” He says a radical overhaul of the U.S. system of external auditing of corporate financial affairs is necessary. 

Adapted from a chapter in “HOW THEY GOT AWAY WITH IT,” edited by Susan Will, Stephen Handelman and David C. Brotherton. Copyright © 2012 Columbia University Press. Used by arrangement with the publisher. All rights reserved.

The Securities and Exchange Commission (SEC) has been pelted with criticism for its failure to monitor the investment banks and other irresponsible entities whose reckless behavior, shenanigans and financial crimes collectively triggered what become known as the “Great Economic Meltdown” in 2008 and beyond. 

Presumably because of the lack of adequate funding, the SEC failed to stem the self-indulgent excesses of real estate brokers and financial institutions involved in the subprime lending racket and toward Wall Street investment firms that were avidly marketing toxic mortgage derivatives. The peddlers of these polluted and often largely incomprehensible papers, not coincidentally, were reaping extremely high profits.

There were, as well, other corporate and partnership culprits who participated in the affairs leading to the meltdown that have largely remained out of the limelight. One group of these organizations — the external auditing firms that are supposed to provide reliable information about the financial situation of their clients — constitutes the subject matter of this article.

The role of accountants in the economic recession has barely been considered. An exception was an article in the business section of The New York Times that deals with the loose rules promulgated and still defended by professional organizations such as the Financial Accounting Standards Board. The article carries the telling headline “Accountants Misled Us Into Crisis.” The story jumps to a headline inside that may prove prescient if effective remedial measures aren’t put in place. It reads: “It Could Happen Again” (Norris 2009, B4).

In the following article, I provide evidence to support the argument that a radical overhaul in the U.S. system of external auditing of corporate financial affairs is necessary.

THE RAKOFF REMEDY

One of the developments in the meltdown cleanup involved the merger of Bank of America, nudged rather strenuously by the U.S. Department of the Treasury, with a near-bankrupt Merrill Lynch. Bank of America (itself the recipient of a government loan) failed to tell its shareholders, who had to approve the blending of the two companies, that Merrill Lynch would dole out huge — some would call them obscene — bonuses that would reduce its value to its purchaser. In the fourth quarter of 2008, Merrill Lynch suffered losses of $15 billion, yet it allocated $3.6 billion of its funds for executive bonuses. 

The SEC charged Bank of America in civil court for hiding these facts from its stockholders; the corporation agreed to settle the case by paying a $33 million penalty. A federal district judge had to approve it for the deal to be clinched. Judge Jed Rakoff, reputed to be something of a curmudgeon, rebelled. He wanted to know, among other things, why the company was expropriating money from shareholders to pay the fine rather than getting the funds from the lawyers who had failed to mention the bonuses in the proxy statement. Or as Rakoff noted, why not penalize Bank of America executives who either knowingly or negligently let this happen? Rakoff refused to approve the settlement (SEC v. Bank of America 2009).

Five months later, however, Rakoff “reluctantly” agreed to a $150 million settlement, thereby expropriating even more of the shareholders’ money than in the original plan. Conceding that the new agreement was “far from ideal,” he apparently relented because it seemed likely that the New York attorney general would press a criminal case against Bank of America and individuals involved in the merger arrangements. The charges haven’t been forthcoming. 

A pair of investigative reporters maintained that then Secretary of the Treasury Timothy Geithner and then New York State Attorney General Andrew Cuomo had cut a deal not to charge the corporations or their executives criminally because it would roil an already unsettled marketplace (Morgenson and Story 2011b). 

The same two reporters subsequently noted that the Department of Justice had adopted guidelines favoring a “deferred prosecution” approach to white-collar criminals, whereby they would be put on warning to behave thereafter or to face a delayed prosecution (Morgenson and Story 2011a).

Particularly noteworthy was an item in the Bank of America settlement that received no coverage in the media. The parties had agreed to submit proposed bonuses to a nonbinding vote by shareholders within the following three years, and during the same time period to appoint an independent “disclosure counsel” who would report solely to the audit committee of Bank of America’s board of directors on the adequacy of the bank’s public disclosures. Rakoff added a further element to the oversight proposal that was especially interesting:

In order to further strengthen these prophylactic measures, the Court suggested at the hearing on February 8, 2010 that the independent auditor and the disclosure counsel not just be chosen in consultation with the S.E.C. but rather be fully acceptable to the S.E.C. with the Court having the final say if the two sides could not agree on the selection. The parties, by letter dated February 16, 2010, have subsequently agreed to these suggestions, which will therefore need to be incorporated in a revised Proposed Consent judgment to be presented to the Court (SEC v. Bank of America 2010, 3).

Rakoff’s recognition of the key role that can be played by external auditors in scrupulously monitoring the financial affairs of their clients attests to a very significant subplot in both the recent economic meltdown and earlier business scandals.

THE MADOFF MAELSTROM

It was a difficult task for the media, especially television, to get a firm grasp on the ingredients that constituted the Great Economic Meltdown. Arcane financial transactions, such as synthetic CDOs (collateralized debt obligation), do not make for rousing images. Also, no attention was paid to the matter that had moved Judge Rakoff to try to fashion a remedy. Despite flagrant mismanagement and irresponsible risk taking by insurance giants such as the American International Group (AIG) and by investment banks such as Goldman Sachs, Bear Stearns and Lehman Brothers, the question never arose as to why outside auditors hadn’t spotted the accounting chicanery that marked the perhaps illegal and certainly ill-advised corporate activities. Nor were there questions about why they hadn’t alerted government officials and the public to what was occurring.

Bernard Madoff attracted the most intense media and prosecutorial scrutiny in part because the Ponzi scheme he operated was so brazen and simple-minded, and many of its victims were so well known. Madoff himself was a person whose glamorous lifestyle could be depicted in terms vivid enough to satisfy viewers and readers (see, e.g., Arvedlund 2009; Kirtzman 2009; Kotz 2009; LeBor 2009; Markopolos 2010; Oppenheimer 2009; Ross 2009; Sander 2009; Strober and Strober 2009). The Madoff case was the only instance in the meltdown that addressed a basic question: Where were the external auditors while all this was going on?

Madoff allegedly cheated about 8,000 investors in his scheme of somewhere between $15 billion and $65 billion. The exact figure varies with the source. He operated over a span of 40 years, paying off those who sought to cash out with funds secured from new clients, and he sent regular statements to investors detailing their holdings and their illusory high level of profits.

It apparently never occurred to Madoff’s clients to exercise due diligence that would involve checking out the person or organization responsible for auditing his company’s books. Had they done so, they would have learned that the Madoff enterprise was audited by Friehling & Horowitz, a firm that occupied a 13-foot x 18-foot storefront office in the village of New City, about 30 miles north of Manhattan. David G. Friehling, 49, the only professional accountant in the office, had been auditing Madoff’s books since 1991. Jeremy Horowitz, Friehling’s father-in-law and cofounder of the firm, had retired to Florida. He died of cancer on the day that Madoff received a 150-year prison sentence.

Friehling proved an easy target for the authorities. Prosecutors noted that he had signed off on a report to the SEC indicating that Madoff’s firm had $1.09 billion in assets and $425 million in liabilities. The figures were phony. He pleaded guilty in November 2009 to single counts each of securities and investment advisor fraud, four counts of making false filings with the SEC and three counts of obstructing and impeding the administration of the federal tax laws — the last on the grounds that he prepared phony tax returns for Madoff and unidentified others. 

Friehling was fined $3.18 million, the sum representing his fees from Madoff and his investment in the company. He said that at no time had he been aware that Madoff was operating a Ponzi scheme. Friehling sought to support this claim by pointing out that he had lost about $500,000 in personal investments in Bernard L. Madoff Investment Securities. He said that he took the documents that were presented to him from the Madoff operation at face value and rubber-stamped them. For this amiable activity, Friehling was paid between $12,000 and $14,500 monthly from 2004 to 2007. He agreed to cooperate with the prosecution in other Madoff-related cases, and as a result his sentencing was postponed (Bharara 2010). He faces the maximum possible statutory term of 114 years (Bray 2009).

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STANDFORD INVESTMENT BANK

Madoff’s Ponzi peer was Texas billionaire R. Allen Stanford, the 59-year-old head of Stanford International Bank (SIB). Along with his chief financial officer, James M. Davis, Stanford carried out what the SEC described as a massive, ongoing fraud. Like Madoff, he appears to have played fast and loose with auditing activity. The Stanford group is headquartered in St. John’s, the capital of the island-nation of Antigua and Barbuda, a locale that fits the description novelist Somerset Maugham once applied to the French Riviera: “a sunny place for shady people.” 

Antigua has long been considered an attractive site for U.S. citizens who, illegally, pursue off-shore Internet gambling (Pontell, Brown and Geis 2007). It was also the temporary refuge of Robert Vesco, who sought without success to buy the island of Barbuda from Antigua and thereby to avoid extradition to the U.S., where he had been charged with egregious financial frauds (Herzog 1987).

SIB had sold approximately $8 billion of what it called “certificates of deposit” to Central American and North American investors. Stanford was tripped up, ironically, when he claimed to have had nothing to do with Madoff. SEC investigators knew better, because they had learned that Stanford had deposited some of the funds invested with him in Madoff’s company. So careless was Stanford that SIB claimed that its “diversified portfolio” had returned precisely identical results in consecutive years — a claim that an expert hired by the SEC labeled impossible.

Alex Dalmady, an investigative blogger, first exposed SIB in an article published in a Venezuelan financial magazine, Veneconomy Monthly. Dalmady titled the piece “Duck Tales,” playing on the old saw that if something looks like a duck and quacks like a duck — or, analogously if things look decidedly crooked — then the former is a duck, and the latter is a scam. Dalmady pointed out that the SIB auditor was an island firm whose principal was a 72-year-old man who had been examining the company’s books for at least a decade, despite the fact that PwC and KPMG both had offices in Antigua. Dalmady indicated that a Spanish proverb was appropriate to the Stanford situation: “Hecha la ley, hecha la trampa” — if there’s a law, there’s a loophole (Dalmady 2009, 14).

The SEC complaint briefly summarized the auditing farce that characterized Stanford’s operation:

The impossible results are made even more suspicious by the fact that, contrary to assurances provided to investors, at most only two people—Stanford and Davis—knew the details concerning the bulk of SIB’s investment portfolio. For example, its long-standing auditor is reportedly retained based on a “relationship of trust” between the head of the auditing firm and Stanford (SEC v. Stanford International Bank, Ltd. 2009, 2).

 


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