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 th
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
1145A tax audit is an experience every businessperson hopes to avoid. If the IRS does pay your business a visit, however, understanding what an auditor might look for can make the difference between a minor inconvenience and a major hardship.
During a full-fledged audit, an IRS agent maylook at several specific items in your tax return and business records, including:
Income. The IRS will compare your bank statements and deposits to the income you reported. They will also review your invoices, sales records and receipts, along with your general ledger and other formal bookkeeping records. If you received gifts of money or an inheritance, keep records to document how much you received. Without proof, the IRS may classify these as income and tax them as such. They will also classify any exchange of goods or services in lieu of cash (such as barter transactions) as taxable income.
Expenses and deductions. An auditor may compare canceled checks, bills marked “paid,” bank statements, credit card statements, receipts for payment or charitable gifts, and other business records to the expenses and deductions you reported on your return. They may pay special attention to reported debts or business losses; charitable gifts; and travel, meal and entertainment expenses. Keep a log to substantiate travel, meal and entertainment expenses, and be sure to deduct only legitimate business expenses. Read Tax Deductions and Your Small Business for additional information.
1145A tax audit is an experience every businessperson hopes to avoid. If the IRS does pay your business a visit, however, understanding what an auditor might look for can make the difference between a minor inconvenience and a major hardship.
During a full-fledged audit, an IRS agent may
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look at several specific items in your tax return and business records, including:
Income. The IRS will compare your bank statements and deposits to the income you reported. They will also review your invoices, sales records and receipts, along with your general ledger and other formal bookkeeping records. If you received gifts of money or an inheritance, keep records to document how much you received. Without proof, the IRS may classify these as income and tax them as such. They will also classify any exchange of goods or services in lieu of cash (such as barter transactions) as taxable income.
Expenses and deductions. An auditor may compare canceled checks, bills marked “paid,” bank statements, credit card statements, receipts for payment or charitable gifts, and other business records to the expenses and deductions you reported on your return. They may pay special attention to reported debts or business losses; charitable gifts; and travel, meal and entertainment expenses. Keep a log to substantiate travel, meal and entertainment expenses, and be sure to deduct only legitimate business expenses. Read Tax Deductions and Your Small Business for additional information.
Loans and interest. An auditor may review loan paperwork, deposits, bank statements, credit card statements, receipts and canceled checks to verify that you used borrowed money only to cover business expenses. This is important, since you may deduct interest on business-related loans.
Employee classifications. The IRS will review employee classifications on your return and check this data against time cards, job descriptions, benefit plans, invoices, canceled checks, contracts and other business records. Auditors will pay particular attention to independent contractor classifications, since many firms improperly classify regular employees as contractors. For more information about IRS rules, read The Proper Classification of Workers.
Payroll. Auditors will examine canceled checks, tax returns, deposits, business records and other forms to check for completeness, accuracy and timely filing. They will also review records documenting state, federal and Social Security (FICA) withholding, Medicare taxes, advance earned-income credit, unemployment compensation and workers’ compensation premiums. The IRS will also examine salaries and bonuses paid to owners and officers of your business to be sure they are legitimate and within industry standards.
Other records. An auditor can also inspect records from your tax preparer or accountant, bank or other financial institution, suppliers, and customers.
In addition to inspecting your business, an auditor may inspect your personal finances. The IRS may compare your current lifestyle with the income presented on your tax return to determine if they are compatible. An auditor may also talk with others who are knowledgeable about you and your financial situation.
