The Great Unspoken Danger

Yesterday, the U.S. House Committee on Financial Services conducted a preliminary hearing into the investigation of regulatory failure associated with the $50 billion Madoff Hedge Fund fraud.  Among those testifying was Leon M. Metzger, a Yale University professor and expert on hedge fund management.  His commentary included the following:

I wish to stress two things: first, the need for top-notch internal controls and second, that operational risk is the great unspoken danger.   A 2003 study of 100 hedge fund failures over a 20 year period concluded that 50 percent of hedge funds had failed due to operational risk…  When I was interviewed in August 2004 about teaching a hedge funds course at the Yale School of Management, I said that I wanted to emphasize good operational controls, which investors tend to overlook, and are essential to the success of an investment.  I was offered the job, and the importance of those controls is what I stress whenever and wherever I teach.  

Many risk experts fail to recognize the importance of strong internal controls, but they are (to use a football analogy) the “blocking and tackling” of risk management.  Without a solid internal control framework, any hedge fund, financial institution or corporation is likely to suffer a similar demise.  Wheelhouse Advisors can provide a no-cost diagnostic review of your internal control structure.  Visit www.WheelhouseAdvisors.com to learn more.

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About Wheelhouse Advisors
Wheelhouse Advisors LLC is the publisher of The ERM Current™, an online publication and blog dedicated to providing the latest updates on current trends in Enterprise Risk Management & Control. Wheelhouse Advisors provides cost-effective Enterprise Risk Management & Control solutions to both large and mid-size corporations. To learn more about Wheelhouse Advisors, please visit our web site at www.WheelhouseAdvisors.com.

3 Responses to The Great Unspoken Danger

  1. Leah says:

    Sarbanes Oxley is great for publicly traded companies but there still isn’t any way to regulate and hold accountable privately managed companies like Madoff. Practically every financial institution except the big retail banking firms is a private company – an LLC or an LLP. Their financial statements are not signed off by management, no one is obligated to take a look at their internal controls. Maybe I’m missing something?

    • As a follow-up to your comment, see the following from the Wall Street Journal.

      Madoff Auditor Evaded Honor System
      By Suzanne Barlyn
      A DOW JONES NEWSWIRES COLUMN
      NEW YORK (Dow Jones)–Bernard Madoff’s auditor is accused of evading peer reviews that might have spotted irregularities, but auditing experts say the review process is an honor system with significant flaws.

      Lynn Turner, a former Securities and Exchange Commission chief accountant, characterizes the decades-old system as “ineffective.” That, in part, was why a new set of controls were created after the 2001 Enron scandal. The new system had a weakness, too: Privately held brokers were exempted until this year.

      Federal authorities charged accountant David A. Friehling, 49 years old, on Wednesday with securities fraud, aiding and abetting investment adviser fraud, and four counts of filing false audit reports with the Securities and Exchange Commission.

      The SEC’s complaint alleges Friehling only pretended to audit Bernard L. Madoff Investment Securities LLC.

      It says Friehling also told the American Institute of Certified Public Accountants, or AICPA, that he was not doing any audit work. That allowed him to avoid review of his purported audits by others among the AICPA’s 350,000 U.S. accounting professionals.

      The AICPA announced Wednesday that it concluded an ethics investigation of Friehling’s conduct as an auditor of a broker-dealer, and expelled him for failing to cooperate.

      But earlier scrutiny through an AICPA peer review may have helped to expose Madoff’s massive Ponzi scheme. But Turner says the AICPA’s voluntary system “doesn’t work very well.”

      AICPA spokesman Bill Roberts, while declining to comment specifically about the charges against Friehling, confirmed that the peer review program is an honor system.

      The organization, he says, sends letters to 37,000 accounting firms, asking whether they’re engaged in auditing and, if so, the nature of the audits.

      Of those, 6,700 respond that they’re not conducting audits. But the AICPA’s 550-person staff isn’t able to check whether those representations are accurate, Roberts said. “It’s just not feasible.”

      Roberts said he believes the percentage of accounting firms that falsely deny doing audit work is “extremely low – about one in a million.” He said, however, that his office would follow up any tips involving a specific company.

      Turner, now a managing director in the national forensic accounting and litigation consulting practice of Kroll, the global risk management company, cited a particular flaw in the AICPA process: an auditor being reviewed can request which companies does it.

      AICPA’s Roberts confirmed that practice but said there are safeguards, among them a prohibition on reciprocal reviews.

      Turner says deficiencies in the AICPA’s peer review system prompted creation of the Public Company Accounting Oversight Board, or PCAOB, as part of the Sarbanes-Oxley Act of 2002 to oversee auditors of public companies and protect investors.

      But SEC rules, adopted under then-chairman Christopher Cox, exempted the auditors of nonpublic brokers like Madoff from PCAOB oversight. That order, which Turner calls “terrible rulemaking,” finally expired in January.

      He believes a PCAOB inspection of Madoff’s auditor would have certainly exposed the fraud much earlier.

  2. Thanks for the comment. You make a great point. While private and non-profit companies are not legally required to certify to the effectiveness of their internal controls, most do need to have audited financial statements to conduct business. External auditors are required by accounting standards to examine internal control as part of their audit engagement. However, these audits are only as good as the firm who conducts them. As we saw in the Madoff case, his accountant was not following the standards and was not registered with the PCAOB as a public accountant. So, it is certainly buyer beware in the case of private companies.

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