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Madoff and Enron, studies in strategic deception



As the Madoff affair began to unfold, my immediate thought was Madoff’s fund had to be bogus on the face of its size alone, i.e., at 30 to 50 billion dollars, the fund’s putative activities would have visible to all. Consulting a colleague, Michael Sheren, skilled in leveraged syndication, Sheren confirmed the assumption, noting that a half to one billion dollar fund could made discrete investments but that a 50 billion fund would have moved the market, thereby attracting wide attention. Had Madoff been making legitimate trades, he would presumably had to have been making countertrades to try to mask his strategy to those who would attempt to emulate him. There were apparently no such trading patterns, thus Madoff could not have pursued his advertized strategy.


Finding so many structural similarities between Enron and Madoff, I thought to examine Madoff with the strategic deception approach used on Enron. Europe were fascinated by both Enron and Anderson, the resistence of sell-side analysts to see trouble, and the failure of US regulatory agencies, notably the SEC, to intervene prior to Enron’s collapse. The 2002 Enron & Arthur Anderson: to comply is not enough dealt with the deception (spurious signals) by Enron and omissive and comissive behavior by Andersen. Many foreign nationals and not a few US nationals are surprised to learn that the SEC's budget and investigative directions are regularly hamstrung by congressional legislators under lobbying from the finance sector. After Andersen's dissolution, the Final Four did not mend their ways, but rather sought to insulate themselves from similar attack. This author believes that Madoff will again show the audit process as well as many of its practitioners to be flawed.


Red flags beyond number


A brief search revealed warning signs about Madoff's investment securities unit that should have frightened investors and regulators alike (Various sources from bibliography): 

  • Single party client asset management, trading initiation, trade execution, asset custody, produced client statements and paperwork administration
  • Stock broker managing client accounts
  • Clients (through FOFs) unaware of actual manager
  • Portfolio manager outside the hedge fund industry
  • Did not found own hedge fund
  • Hyper secretive black box investment approach
  • Irreproducible financial results from a common, widely known collar approach (Split Strike Conversion)
  • Uninterrupted performance in adverse market conditions
  • Near complete aversion to industry news coverage
  • Did not charge normal incentive fees and percentage of profits (1 and 20 to 2 and 20)
  • Aggressively funds raising at a size that would have hard closed other funds
  • "Special case" admission - false scarcity
  • No prime broker
  • Improper/insufficiently skilled external auditor
  • Family member, insufficiently skilled at that, as compliance officer
  • Full cash positions at quarter-end and year-end
  • High proportion of money raised from overseas sources

It is not yet known when Madoff became a full-fledged Ponzi scheme (Allen believes that Madoff was subsidizing returns from brokerage commissions early on), but 2001 is a reasonable guess: 

Then a watershed event occurred in 2001 from the potent combination of a sustained bear market and decimalization. The broking income probably became insufficient to smooth away the drawdowns... Certainly the divergence between the [Madoff feeder, Fairfield Sentry] and Gateway [GATEX, a mutual fund of similar age running the same split strike strategy] became startlingly wider than the previous just dubious disparity. The anomalous returns were noticed by some who pay attention and it is worth noting that two skeptical articles appeared that year.

Madoff, as Enron, is "essentially a story of executives and auditors deceiving investors about the true state of its business."  The secrecy, exclusivity, black box nature of Madoff’s business and the complexity of Enron's business "created extraordinary opportunity to obfuscate and conceal... The outcome was a substitution of fraud and self-dealing for legitimate growth."


I found it interesting that some investors said that they invested with Madoff because they felt him to be fraudulent, using insider trading, front running, or both to gain his returns. None appear to have assumed Ponzi.
It is reasonable to expect charges of fiduciary breach to be leveled at many; Fairfield Greenwich Group (FGG) may well merit consideration.


Primer on Denial and deception (D&D) present in Madoff and Enron


Deception, be it military, diplomatic, financial or political, has four components:

  • Security (deception demands controlled dissemination of supporting data and suppression of conflicting data)
  • Plausibility (deception must be plausible to the target set)
  • Adaptability (however elaborate, deception must adapt to the changing situation)
  • Integration (deception effort integrated at all levels and with all means)

Deception planning and deception countermeasures commonly applied to military and diplomatic spheres are conspicuously absent in analyzing commercial business endeavors.  These tools can provide advance notice saving investors money that would otherwise fall prey to spoofing and disinformation.


Denial and deception seeks to disrupt

the analyst’s decision cycle (what the military calls Boyd's OODA Loop) to "observe, orient, decide and act." Most people are poor at countering deception without training and rigorous analysis as they fall prey to:
  • Poor anomaly detection (missing contextual cues, or prematurely dismissing as irrelevant or inconsistent with other intelligence)
  • Misattribution (attributing a deception event to collection gaps or processing errors)
  • Failure to link deception tactics to deception hypotheses (noticing anomalies but failing to recognize them as indicators of deception)
  • Inadequate support for deception hypotheses (failing to link an assessment of an adversary's deception tactics and goals to the adversary's strategic goals; i.e., failing to test denial or deception course of actions against the available evidence)
Countering deception is difficult, made worse by the fact that commercial finance/risk managers often exhibit damaging characteristics:
  • Believe that they are well informed even when they are ill informed
  • Not invented here (NIH)
  • Arrogance
  • Inability to distill ("can't analyze what they have")
  • Competitive bad advice

Lapsing into the condition of being "better informed without the ability to act," too many do not "see" the data in first instance, do not see context, do not see relevance, do not see pattern at any time, and do not see patterns maturing over time. They are deprived of a meaningful means of prediction, must less deception awareness.


Frank Stech, MITRE’s head of counter-deception, observes that those being deceived “do not systematically consider alternative explanations for the evidence they observe and incorrectly weigh the evidence they do have.”  As a result, “people often dismiss important evidence, prematurely prune alternative hypotheses, and jump to conclusions.”  This makes “people and organizations easy to deceive.” [email, previously cited].


Designed to “make the enemy quite certain, very decisive, and wrong,” the current deception paradigm of strategic surprise contains these elements: 

  • Signals: legitimate information from or about the adversary
  • “Sprignals” or spurious signals: Information intentionally designed to deceive
  • Noise: Background and environmental information that may be legitimate or from various sources but is ultimately irrelevant and interferes with detection of signals and sprignals

Every deception effort involves a series of sprignals and signals that “hide the real while revealing the false”:

  • Dissimulation (hiding the real): The covert element that conceals truth from the enemy
    • Masking: Using means to evade detection.

    • Repackaging: Altering the appearance of an object to make it look like something else.

    • Dazzling: Confusing the sensory processing abilities of the target with stimuli.

  • Simulation (revealing the false): The overt element that reveals falsities presented to the enemy as truth
    • Mimicking: Creates a replica of reality using one or more distinctive characteristics of the object being mimicked.

    • Inventing: Displays the false by fashioning an alternative reality.

    • Decoying: Offers a distracting or misleading option with the intent of diverting an opponent’s attention away from the real focal point.

The analyst’s task is greatly complicated in a signal, sprignal and noise model as he must go beyond distinguishing between what is signal and noise to the authentication of both, recognizing that the perpetrator may deliberately inject both noise and sprignals.  Authentication validates signals, ensuring that those acted upon are genuine, as it deciphers the intent and method of deception so that warning systems can be tuned to recognize further deception.


Noise, Signals and Sprignals in Madoff:


Background “Noise” factors obscuring analysis


Contributing Factors in background “Noise”:

  • Bull market demanding higher stock performance despite declining fundamentals
  • CEO and senior management compensation disproportionately tied to share price
  • Federal Reserve resistance to non-bank securities regulation
  • Increasingly complex derivatives instruments with poorly understood, underestimated risk
  • New, increasingly opaque business models
  • Credulous acceptance of these models by analysts and investors
  • Conflicts of interest by both sell-side and buy-side analysts
  • Auditors’ weakened oversight
  • Expansion of Fund of Funds (FOF) that masked investors’ ability to assess risk
  • Congressional hobbling of public and private regulatory bodies

Sharing too many factors with Enron, an earlier comment applies now to Madoff: “While the “noise” category also includes invalid assumptions and stereotypes, faulty appraisals and dissemination of information, this author is of the opinion that attributing all of these factors to “noise” is exceedingly charitable in that some of the actions of investment analysts and auditors were contributory sprignals in and of themselves.”


Generating spurious signals that ‘hid the real while revealing the false’


Madoff was spectacularly successful in deception and denial, weaving a fabric of trust, exclusivity and success among primarily unsophisticated investors that continued to grow over time: 

  • Low risk, wealth preservation strategy attractive to those who had endured volatile, high return wealth generation strategies earlier in life.
  • High social trust among A-list investors, government and regulators.
  • Social and political influence via political donations and philanthropy.
  • Exclusivity - false scarcity - of access to funds under Madoff’s control, i.e., investor effort was gaining access, not performing due diligence.
  • Secrecy coupled with threat of expulsion for violation of investment guidelines (implications for both social standing and financial returns)
  • Create international feeder network of A-list personages and FOFs managed by A-list personages, effectively creating an uncritical, unlicensed dealer network.
  • Sufficient securities market presence to silence most critical examiners, i.e., those who would not invest or would withdraw funds already under investment but would not formally report to SEC.
  • Active and passive steps to avoid expanded SEC oversight beyond brokerage activities.
  • Sought investment targets that were not volatile in either withdrawals or payout expectations (retirees, the wealthy, charitable groups).

It remains to be seen how many others were directly involved with Madoff. Any member of Madoff Investment Securities and all adjacent firms on the limited access 17th floor are suspect. While Madoff’s children, who were involved in other practice areas, are said not to be a target of the current investigation, we use the term, ‘IQ of a cactus’ to describe such willful ignorance or incuriosity while in such proximity to Madoff’s core business. It would not surprise us to find an earlier dividend payment, in the Caymans perhaps.


Fund of Funds (FOF) feeder funds to Madoff bear greater culpability that Andersen in their de facto certification of Madoff. In what can only be described as a massive failure of due diligence, these “funds staked their entire competitive advantage on their ability to rigorously evaluate funds [that were] safe for their investors.” [email]


Contrast the inactions of these feeders to the independent hedge fund research and advisory firm, Aksia:

As many of you know, Aksia published extensive reports on several of the “feeder funds” which allocated their capital to Madoff Securities. Our decision to not recommend these feeders was never based on the existence or discovery of a smoking gun; however, there were a host of red flags, which taken together made us concerned about the safety of client assets should they invest in these feeders. Consequently, every time we were asked by clients, we waved them away from the Madoff feeder funds.


On the surface, these feeder funds had all of the makings of institutional quality funds. They had substantial assets under management and were audited by large and respected audit firms. They were managed and marketed by legitimate and registered investment managers. They had long and impressive track records and a roster of professional investors.


As a research firm we are forced to make difficult judgments about the hedge funds we evaluate for clients. This was not the case with the Madoff feeder funds. Our judgment was swift given the extensive list of red flags. Some of these red flags were as follows...

The Securities and Exchange Commission (SEC) and other regulators are classed as sprignal generators by virtue of their serial failure to act against Madoff, thereby continuing to confer legitimacy without which the fiction of stable returns would have collapsed. The lack of regulatory oversight allowed an easily detectable scam (witness those cataloged in this note below who pierced the veil without benefit of subpoena) to continue robbing billions. As noted in the opening comments, a legitimate Madoff would have been the elephant in the room. His trades on the boards would have been seen and processed; had he traded elsewhere, counterparties would have come to the boards to hedge.


The forthcoming congressional investigation should yield some clarity as to why Madoff escaped for so long. Barring causal conditions such as ineptness, absence of continuity, disbelief, complicity and criminality, it is likely that a number of Barrett’s nine auditing failures (see below) - which are far more human characteristics than breaches of statute - will be at play.


Signals suppressed - the incredulous but silent, often skilled traders or funds managers, that did not believe Madoff’s results, did not invest or withdrew investments under their control but did not act, presumably out of fear of reprisal directly or indirectly by Madoff. There is much to be learned here as to why these individuals felt that it was not in their professional best interests to be more vocal.


Who were the skeptics and why?


Despite Madoff’s seeming achievements (consistent, positive monthly returns), the skeptics looked at core fundamentals, performed pattern comparisons of Madoff against industry; were repelled by secretive, irreproducible black box strategies; and deflected the lure of monthly returns.


Doubters (here and here) saw numerous red flags a decade ago, including:

  • Lack of volatility
  • Inability to reproduce results
  • Lower returns from existing entities using similar strategy
  • Market timing
  • Ability to buy and sell underlying stocks without noticeable market affect
  • Willingness to charge mere commissions rather than incentives plus profit %
  • Refusal to establish separate asset management arm
  • Assumption that Madoff was using other stocks and options beyond the S&P 100 collar
  • Proprietary “black box” system
  • Use of FOF capital as “pseudo equity” to support market making activities or provide leverage
  • Secrecy

  • Aversion to publicity

Madoff's performance was indeed startling:


The best known entity using a similar strategy, a publicly traded mutual fund dating from 1978 called Gateway, has experienced far greater volatility and lower returns during the same period. The capital overseen by Madoff through Fairfield Sentry has a cumulative compound net return of 397.5%. Compared with the 41 funds in the Zurich database that reported for the same historical period, from July 1989 to February 2001, it would rank as the best performing fund for the period on a risk-adjusted basis, with a Sharpe ratio of 3.4 and a standard deviation of 3.0%. (Ranked strictly by standard deviation, the Fairfield Sentry funds would come in at number three, behind two other market neutral funds.)

In 2001 Arvedlund encapsulated the persistent failure to remember the recent past and the responses of the unskilled and rigorous investor: 

The lessons of Long-Term Capital Management's [LTCM] collapse are that investors need, or should want, transparency in their money manager's investment strategy... Madoff's investors rave about his performance -- even though they don't understand how he does it. "Even knowledgeable people can't really tell you what he's doing," [said] one very satisfied investor..."People who have all the trade confirms and statements still can't define it very well. The only thing I know is that he's often in cash" when volatility levels get extreme. This investor declined to be quoted by name. Why? Because Madoff politely requests that his investors not reveal that he runs their money.


"What Madoff told us was, 'If you invest with me, you must never tell anyone that you're invested with me. It's no one's business what goes on here,' " says an investment manager who took over a pool of assets that included an investment in a Madoff fund. "When he couldn't explain how they were up or down in a particular month, [I] pulled the money out."

Shirreff’s lessons from the collapse of LTCM are instructive and recommended. Of note is the “value of disclosure and transparency.” It was interesting to read Coffin’s lessons on the 10th anniversary of the collapse of LTCM, and prior to Madoff: 

#1. The secret is that there isn't one

Long-Term's reputation had been built, at least in part, on the notion that it was operating by a unique model that could predict things that others could not. By the time Long-Term was off and running, many Wall Street firms had similar models to Long-Term, and they used them extensively. Because of the high level of mathematical skill of Long-Term's principals, however, they could read their models with greater detail and get more information out of them. But in reality, Long-Term was using the same kind of tools as everybody else. The notion that they had unlocked a secret method of divining market movement was mere fantasy.

With LTCM as well as the present, the SEC and auditors had difficulty in tracking wider risk beyond a discrete set of players: 

The sad truth revealed by [testimony from Richard Lindsey, SEC's director of market regulation division, to the House Committee on Banking and Financial Services on October 1,  1998] is that the SEC and the NYSE were concerned only with the risk ratios of their registered firms and were ignorant and unconcerned, as were the firms themselves, about the market's aggregate exposure to LTCM. Bank of England experts note the absence of any covenant between LTCM and its counterparties that would have obliged LTCM to disclose its overall gearing. UK banks have long been in the habit of demanding covenants from non-bank counterparties concerning their overall gearing, the Bank of England says.

Save for Andersen, the current auditors that were present at LTCM's demise were active thoughout the past decade plus. Many of the same red flags were present with LTCM and Enron were present with Madoff.


Harry Markopolos was the most persistent Madoff investigator who, after being challenged by his employer to produce equal performance, analyzed Madoff's method and found it wanting as early as 1999. Markopolos sent increasingly more detailed submittals to the SEC, first in Boston, then New York, culminating in a 2005 report in which Markopolos laid out, in 29 "Red Flag" arguments with relevant conclusions, the case that Madoff was most likely a Ponzi scheme or, less likely, front-running customer orders. But unlike other public skeptics, Markopolos presented his concerns directly to the SEC largely in part due to safety concerns to himself and his family.


This restricted distribution is sad in that although Markopolous is a competent financial forensic analyst, his red flag arguments are understandable to a reasonably skilled lay reader:


The family runs what is effectively the world's largest hedge fund with estimated assets under management of at least $20 billion to perhaps $50 billion, but no one knows how much money BM [Bernard Madoff] is managing... However the hedge fund isn't organized as a hedge fund by Bernard Madoff (BM) yet it acts and trades exactly like one. BM allows third party Fund of Funds (FOF's) to private label hedge funds that provide his firm, Madoff Securities, with equity tranch funding. In return for equity tranch funding, BM runs a trading strategy, as agent, whose returns flow to the third party FOF hedge funds and their investors who put up equity capital to fund BM's broker-dealer and ECN operations... The third parties organize the hedge funds and obtain investors but 100% of the money raised is actually managed by Madoff Investment Securities, LLC in a purported hedge fund strategy. The investors that pony up the money don't know that BM is managing their money. That Madoff is managing the money is purposely kept secret for the investors...


Red Flag #3: Why the need for such secrecy? If I was the world's largest hedge fund and had great returns, I'd want all the publicity I could garner and would want to appear as the world's largest hedge fund in all of the industry rankings. Name one mutual fund company, Venture Capital firm, or LBO firm which doesn't brag about the size of their largest funds' assets under management. Then ask yourself, why would the world's largest hedge fund manager be so secretive that he didn't even want his investors to know he was managing their money? Or is it that BM doesn't want the SEC and FSA to know that he exists?

Prior to reading the 2005 submittal, I was aware that it had not found traction within SEC and regulatory circles, but after reading The World's Largest Hedge Fund is a Fraud, I found it difficult to believe that any securities specialist could put this document aside without action. One has to read it; just reading trade press about it does not do Markopolos' research justice: 

  • Red Flags 4 and 6 note that the total amount of OEX listed call options are insufficient to generate income on BM's total assets under management, and that BM would "have to be over 100% of the total OEX put option contract open interest in order to hedge his stock holdings as depicted in the third party hedge funds marketing literature."
  • Red Flag 5 shows that BM's put option costs would have put his fund under water during one or more financial crises.
  • Red Flag 7 states the counter-party credit exposures would be too large for credit department approval by firms such as Merrill and UBS.
  • Red Flag 9 speaks to the enormous paperwork involved in tracking putative BM OTC trading as well as the absence of Goldman and Citigroup from clearing BM's trading volume.
  • Red Flag 10 states the mathematic impossibility "for a strategy using index call options and index put options to have [virtually no] correlation to the market where its returns are supposedly generated from."
  • Red Flag 16 debunks Madoff's "perfect market-timing ability," e.g., getting to 100% cash before every market decline.
  • Red Flags 18 and 19 note Madoff's returns are inconsistent with GATEX, the only publicly traded option income fund of equal age to Madoff, and no option income fund IPOs could match BM's high returns.
  • Red Flag 26 notes that BM "goes to 100% cash for every December 31st year-end," where major quarter-end and year-end transactions are a major red flag for fraud.
  • Red Flag 27 again picks up the argument that BM's split-strike conversion strategy cannot "achieve 12% aver annual returns with only 7 down months during a 14 1/2 year time period." (Item 7 on page 5 had already dismantled the split-strike conversion approach said to be used by BM.)
  • Red Flag 29 notes BM's comments to "third party FOF's that he has so much money under management that he's going to close his strategy to new investments" yet an unending number of FOF managers continue to get “special access,” a “special relationship” to Madoff.

An investor merely had to ask for trade tickets, then compare them against the Options Price Reporting Authority (OPRA) time and sales price feed. If the Madoff tickets don’t match OPRA time and sales reporting, the putative trades must be bogus. (OPRA is a “registered securities information processor” pursuant to the Securities Exchange Act of 1934 which collates trading activity of the American Stock Exchange, Boston Stock Exchange, Chicago Board Options Exchange, International Securities Exchange, New York Stock Exchange, Philadelphia Stock Exchange and Nasdaq.)


Markopolos reports that at least one counter-party to an HFOF did just this and “concluded that Madoff was a fraud and pulled significant assets out of the fund.”


After Markopolos’ persistent traffic to the SEC, the SEC halted an investigation of Madoff investment securities (BML) in 2007 with only the superficial violation of correcting BML’s role in Fairfield Greenwich Group (FGG) as investment advisor above and beyond that of executing broker. Left untouched were the trading legitimacy and fraudulent activities of BLM. By positively and ‘willingly’ cooperating with the SEC, Madoff escaped scrutiny of his core fraud.


All this after Madoff had already come to the attention of the SEC in 1992 as the secret investor behind the Avellino & Bienes “unregistered investment company” It is quite possible that Madoff was illegal in the 1980s: 

The best evidence that the returns were very attractive: the size of the pools mushroomed by word-of-mouth, without any big marketing effort by the Avellino & Bienes partnership. The number of investors eventually grew to 3,200 in nine accounts with the Madoff firm. "They took in nearly a half a billion dollars in customer money totally outside the system that we can monitor and regulate..."


In the mid-1980s, one investor says, the limited reports that Avellino & Bienes sent to investors changed, and investors stopped being told in which securities their money was invested. The interest rate on some new notes sold by the accountants was also lowered to 16% or less. One investor who complained about the vaguer reports and lower returns was told that if he didn't like them, he could withdraw his investment. He chose to remain.


Perhaps the biggest question is how the investment pools could promise to pay high interest rates on a steady annual basis, even though annual returns on stocks fluctuate drastically. In 1984 and 1991, for example, the stock market delivered a negative return, even after counting dividends. Yet Avellino & Bienes -- and Mr. Madoff -- maintained their double-digit returns.

HFOFs make a mockery of diversification strategies


Diversification by both strategy and manager is a primary rule of any portfolio, yet investor diversification becomes problematic in a Fund of Funds (FOF) environment in which an investment fund holds a portfolio of other investment funds rather than making direct investments in securities, shares and bonds. Without transparency, the ability of the investor to make reasonable risk assessments become clouded. The problem becomes reentrant as the investor’s portfolio funds make investments in other funds, i.e., a nested FOF environment. Add the secrecy that Madoff demanded of many of his associated feeder funds and an investor’s original diversification strategy can collapse with disastrous results. (Also here)


The failure of audit in particular and due diligence in general


Audit throughout the HFOF chain from Madoff to investor is flawed, and I believe negligent. From the data on offer, it appears that this audit chain never performed a rigorous due diligence at any stage, unlike the venture capital sector where at least the lead investor undertakes rigorous due diligence (which secondary investors too often consume without further investigation):

Though Bernard L. Madoff Investment Securities itself was audited by small firms, questions are arising over how major firms like PricewaterhouseCoopers and KPMG overlooked several red flags related to the operations over a number of years. The big accounting firms are likely to face queries about why they gave their seal of accounting to the astoundingly steady positive returns booked by a fund manager whose investment strategy was nearly completely opaque...


With many of the feeder funds’ managers having taken losses from their own personal exposure to Mr. Madoff’s firm, the accounting firms may be a likely target for investors seeking to recoup at least some of their money...


PricewaterhouseCoopers was the main auditor for Sentry, the largest fund run by Fairfield Greenwich Group, the $14.1 billion investment manager that has lost the most money so far in the Madoff scandal. The accounting firm was tasked with minding Sentry, which had about $7.5 billion invested in Mr. Madoff’s firm...


But the Madoff case presents an unusual situation.... Previous cases focused on the auditors of the firm at the center of the scandal, not the auditors of investment managers one rung removed.

Barrett identified nine symptoms inherent in auditing Enron that this analyst expects to see conspicuously at play with Madoff: Unconscious bias, Ambiguity, Attachment, Approval, Familiarity, Discounting, Excalation, Culture and ineffectual professional standards unit, and Significant conflicts of interest and self-interest.


Analyzing auditor independence in the wake of Enron, O'Connor is recommended for his review of the development of the accounting-audit profession, rise of securities law, private and public regulation of accountants providing audits, and changes in the the business environment for professional services. His summary of Enron confirmed my view that the accounting process is flawed and open to exploitation at will:

The most surprising thing about the recent spectacular collapse of Enron [may] be that this kind of colossal public audit failure did not happen sooner. While greed and power likely played a role in the reasons that the Enron Corporation set up dubious partnerships to hide company debt and assets, the question remains, where were the auditors? The kind of ploys that Enron executives seem to have been involved in are not new: the fact that some corporate officials may not always act in the best of faith was one of the primary reasons why the federal securities laws were enacted in the first place. But it is precisely the public company disclosure and audit procedures created by the securities laws that established a watchdog in the form of accounting firms to certify the books and financial statements of the company to curb rampant abuses by corporate officials. Accordingly, the accounting firms are supposed to be "independent" of the audit client and act on behalf of the public, not the audit client. The problem is that, however well this audit system worked at its inception, it is fundamentally flawed now, such that as a practical matter it is impossible for auditors to be "independent" of their audit clients.

Barrett dispenses with the fiction of operational auditor independence by categorizing the pressures on the audit process within a professional services organization:

Aren't audits supposed to be sign-offs on the appropriateness of a company's financial statements? Not exactly. Before we examine what went wrong in Andersen's audits, we should clarify what an audit hopes to accomplish. In an audit, the auditor evaluates the various representations that an enterprise's management asserts in the financial statements and related notes about the firm's assets and liabilities at a specific date and transactions during a specific accounting period so that the auditor can render a report on (and almost always express an opinion about) those financial statements and accompanying disclosures. Ultimately, the auditor seeks to express an opinion as to whether the financial statements present fairly, in all material respects, the enterprise's financial condition, results of operations, and cash flows in conformity with generally accepted accounting principles. If the examination of the entity's procedures and accounting records allows the auditor to reach an affirmative conclusion, then the auditor will issue an unqualified or "clean" opinion. Even an unqualified opinion, however, does not guarantee the accuracy of financial statements; such an opinion provides only "reasonable assurance" that the financial statements fairly present, in all material respects, the enterprise's financial condition, results of operations, and cash flows in conformity with generally accepted accounting principles...


Unfortunately, even in a properly planned and executed audit, fraud can more easily avoid detection than unintentional errors. As a result, investors set a higher standard for auditors to uncover fraud than to discover errors and their expectations exceed the assurance actually provided. The accounting profession has labeled these misconceptions as the "expectation gap."


To reiterate, an audit provides only reasonable assurance against material misstatements, whether intentional or unintentional, in the financial statement. In reality, an audit does not guarantee that error or fraud has not affected the financial statements. Similarly, even an unqualified report does not offer any assurance that the enterprise presents a safe investment opportunity or will not fail. At the same time, however, then-existing generally accepted auditing standards required an auditor to assess the risk that errors and fraud may cause the financial statements to contain a material misstatement. In addition, the auditor faced a professional obligation to design the audit to provide reasonable assurance that the examination would detect material errors and misstatements, to exercise professional skepticism, and to perform and evaluate audit procedures to attain the required assurance...


So why did Andersen fail to catch the problems at Enron? Although numerous conflicts of interests permeated the relationship between Andersen and Enron, unconscious bias - the propensity to interpret data in accordance with our desires - best explains why Andersen's audits failed. Other explanations include the culture and organizational flaws at Andersen...

From a risk analysis viewpoint, Barrett's list of human and organizational pressures against accurate audit are far more indicative of the accuracy of an audit than are the financials presented:

  • Unconscious bias: Auditor-client relationships, more so in longstanding and financially important relationships, "create significant opportunities for bias to influence auditing judgements. [Three] aspects of human nature - familiarity, discounting, and escalation [amplify] auditors' unconscious biases."
  • Ambiguity: "financial accounting requires various estimates that affect the amounts shown in the financial statements... generally accepted accounting principles often allow alternative treatments for the same transaction or events and may not address a particular situation because business transactions evolve more rapidly than accounting principles"
  • Attachment: "auditor's business interests in fostering a long-term relationship with a client's management encourage auditors to render "clean" audit opinions in an effort to retain any existing engagements and to secure future business. Auditors that issue anything but an unqualified opinion frequently get replaced."
  • Approval: "audit essentially endorses or rejects the accounting choices that the client’s management has made."
  • Familiarity: Resistence to harm individuals that are known as opposed to strangers, more so in considering harm to "paying clients, or individuals they consider paying clients, with whom they enjoy ongoing relationships."
  • Discounting: "Immediate consequences influence behavior more than delayed ones, especially when uncertainty accompanies the future costs."
  • Excalation: Acceptance of "small imperfections in a client’s financial statements" which become material over time. Rather than restating, auditor may escalate "unconscious bias into fraud" by attempts to conceal the problem.
  • Culture and ineffectual professional standards unit: Various means by which revenue generation and revenue stream protection superceded accepted standards of practice. Professional standards unit is gelded, overruled.
  • Significant conflicts of interest and self-interest: Careers and regional offices at risk, "revolving door" employment between auditor and client staff, auditor’s professional standards unit's evaluation of its own consulting unit's services, et al.

The investor is as much or more at the mercy of management’s intent than he is under the protective eye of external audit. Risk analysis must extend beyond the financials into the softer metrics of the guardian-client relationship.


Full bibliography citations in separate note. See: Bibliography for 'Madoff and Enron, studies in strategic deception'


Gordon Housworth

InfoT Public  Risk Containment and Pricing Public  Strategic Risk Public  


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