As everybody knows, Bernard Madoff’s investment fund was a huge Ponzi scheme.  Upon discovery of his fraud, people have started suing those with deep pockets, such as the auditors, including BDO Seidman.  These lawsuits are meritless because BDO Seidman’s responsibility pertains to its audit of Ascot Partners; the auditor has no responsibility with respect to an audit of Madoff, even if it is a major investee of Ascot Partners.  Not only is the suggestion that an investor’s auditor should examine the statements of investees without basis in law or professional conduct, but also it is impractical.  How could an enterprise such as (say) Microsoft operate if all of its investors sent their auditors to inspect the books of Microsoft?  In addition, audits in the United States operate by means of a contract between the auditor and the firm being audited.  No contract exists between an investor’s auditor and the investee, allowing the investee to refuse such extra audits.

Several months ago I argued that managers at Ascot Partners have a “due diligence” obligation whenever they examine a potential investment.  It is their responsibility to examine the financial statements of the investee, including the audit report and to determine the utility of the investment.  The managers failed miserably in meeting this due diligence obligation with respect to Madoff’s funds.

I also suggested that investors in Ascot Partners should sue these managers for not performing due diligence with respect to Madoff.  Today there is a lawsuit, but it comes from the trustee for the liquidation of BLMIS.  Yet it will accomplish the same purpose of holding fund managers responsible for the decisions they make with investors’ money.

On May 6, Irving Picard, trustee for the liquidation of BLMIS, filed suit in the U.S. Bankruptcy Court, Southern District of New York.  (Complaint can be found at: http://www.scribd.com/doc/15051912/Trustees-Suit-Against-J-Ezra-Merkin ).  While the suit begins with a complaint against Ezra Merkin and his fund Gabriel Capital Corporation, it extends to funds they managed: Gabriel Capital; Ariel Funds; and Ascot Partners.

The complaint outlines Madoff’s so-called “split-strike conversion” strategy.  This strategy involved the purchase and the selling of S&P 100 firms at appropriate lows and highs.  When out of the market, the funds would be put into Treasury securities.  Simultaneously, Madoff purportedly would acquire options to control the risk from unfavorable price movements.  Even with this strategy, the results Madoff claimed were unrealistically high, too consistent, and had too low volatility.

Plenty of bread crumbs were strewn along the way to point to securities fraud.  These indicia include:

• Unfavorable press reports about Madoff came out as early as 2001.
• Madoff refused to answer questions about his funds; he offered almost zero transparency.
• Madoff did not give customers access to their accounts electronically; instead he supplied paper trading confirmation despite being a leader in computer-based trading.
• Madoff served as manager and custodian of the securities, eliminating an important internal control.
• Ascot Partners had a twelve-year period in which it had negative returns in only four months.  Compared with the stock market and with other funds, these results were too good to be true.
• Annual rates of return ranged from 11% to 16%.  These rates of return were too high for an investment with so little risk.
• Trade confirmations did not coincide with market data.  For example, Ascot Partners’ “October 2003 monthly account statement reported a purchase of 641,718 shares on Intel Corporation (INTC) … at a price of $27.63.  The daily price for Intel [on that date] ranged from a low of $28.41 to a high of $28.95, which made the reported price impossible.”  (The trustee has discovered over 500 instances in which the purported price lies outside of the actual daily price range.)
• Purported options trading also was impossible.  For example, BLMIS allegedly bought 11,967 exchange-traded options on January 23, 2008 for Ascot Partners; actual total volume, however, was only 8,645.
• The compensation arrangement was askew.  Managers of feeder funds were paid excessive amounts for little work.

It seems one must conclude that Merkin and his associates did not perform their due diligence requirements while managing these feeder funds.
Many lawsuits have been filed in the Madoff Mess.  Not too long ago the state of Massachusetts accused Fairfield Greenwich Group of fraud and claimed that managers of this feeder fund failed to fulfill its due diligence with respect to its investments in Madoff.  The state is probably correct in its assertion.  Another example is a lawsuit by Zuckerman, owner of New York Daily News, whose charitable trust lost $25 million.  Zuckerman has sued both Merkin and BDO Seidman.  I think he will win against Merkin but lose against BDO Seidman.

Managers of investment funds have a fiduciary responsibility to their investors.  They must invest the money in a wise manner, and that requires some due diligence on their part with respect to each of the investment possibilities.  When these responsibilities are not properly discharged, society needs to hold these managers accountable for their misconduct.  And quit blaming the accountants for mistakes made by investment managers.

6/9/09 UPDATE: In the first version of this essay, I stated that Ascot Partners had sued BDO Seidman; that is untrue.  The news source I relied upon was in error.