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Auditing the Audit Firms

This story was co-published with Barrons.

Minnesota businessman Thomas J. Petters is accused of masterminding a $3 billion Ponzi scheme. Auditing firm McGladrey & Pullen is being sued by investors who say the firm was not diligent in auditing Petters's fundsThe Big Four accounting firms are used to embarrassing headlines about their purported misdeeds. After all, the past decade has seen one business catastrophe after another at companies audited by the major firms. Witness the scandals at Tyco, WorldCom and Xerox.

These days of Ponzimania have put the glare on two smaller auditing firms. BDO Seidman, the seventh-largest U.S. auditor in terms of net revenue, has been linked to disgraced financier J. Ezra Merkin and so, indirectly, to the ubiquitous Bernard Madoff. McGladrey & Pullen, the fifth-largest in the field, is under fire for its connection to a $3 billion Ponzi scheme purportedly masterminded by Minnesota entrepreneur Thomas J. Petters.

In investor lawsuits filed in recent months, BDO Seidman and McGladrey & Pullen stand accused of shoddy audits and signing off on the books of fraud-ridden businesses and investment funds. The cases, together with a string of earlier ones involving the two firms, raise unsettling questions about the level of confidence investors can put in financial audits.

The two audit firms say they stand by their work, and there is, in fact, some murkiness about auditors' responsibilities for detecting fraud. The firms are supposed to "obtain reasonable assurance about whether the financial statements are free from material misstatement, including misstatements caused by fraud," according to the Public Company Accounting Oversight Board, the federal entity that supervises auditors of public companies. The gray area centers on what is reasonable, an issue that often plays out in the courts because accounting firms can be one of the only solvent players left when a company goes down.

Before Madoff came along, there was E.S. Bankest LLC. The Florida factoring company went bust after its executives allegedly carried out an elaborate nine-year scheme to steal roughly $170 million from the business while fabricating false financial statements; nine Bankest insiders were convicted of criminal charges in a Florida federal court. BDO Seidman had audited the company and concluded its books were free from material error.

California attorney Steven Thomas, who in 2007 won a $522 million jury award against BDO Seidman stemming from its Bankest audits, says the case reflects the kind of cozy interdependence that helped sink Enron and Arthur Andersen. "Auditors are supposed to have professional skepticism, and that is just inconsistent with the client relationships that they try to preserve to keep the money flowing," Thomas says.

BDO Seidman spokesman Jerry Walsh says the firm is appealing the Bankest verdict and remains "extremely confident that this jury's findings will be overturned."

The firm also is contesting a civil lawsuit from the collapse of Le-Nature's Inc., a Pennsylvania iced-tea producer shuttered in 2006 after allegedly faking $240 million in revenue, according to forensic accounting undertaken by a bankruptcy court. BDO Seidman auditors had certified that Le-Nature's financial statements were free from material error.

"There is a difference between being fooled and putting your head in the sand so you don't see things," says Robert Loigman, a New York lawyer representing Le-Nature's investors who sued (PDF 1, PDF 2). A tour of the company's Latrobe, Pa., warehouse would have made clear Le-Nature's wasn't selling $300 million worth of bottled drinks a year as claimed, he says.

Walsh says his firm "was one of many victims of a collusive fraud at Le-Nature's."

For McGladrey & Pullen, some tough questions have come from Frederick J. Grede, a Chicago bankruptcy trustee who claims the firm's auditors actively participated in the "looting" of Sentinel Management Group, a $1.4 billion investment fund that failed in August 2007.

A lawsuit filed by Grede accuses McGladrey & Pullen auditors of "preparing false footnotes to Sentinel's financial statements," certifying bogus financial statements to federal regulators, "consciously ignoring" serious problems "clearly shown" in the firm's work papers.

The Securities and Exchange Commission and the Commodity Futures Trading Commission are pursuing top Sentinel executives in court, saying they siphoned hundreds of millions of dollars. McGladrey & Pullen declined to comment on the case.

J. Ezra Merkin (Getty Images) The recent Ponzi schemes have touched off another round of litigation. Take the case of J. Ezra Merkin.

According to New York Attorney General Andrew Cuomo, Merkin repeatedly lied to his customers about what he was doing with the $2.4 billion they had given him. In a 54-page civil fraud complaint, Cuomo accuses Merkin, who ran a trio of investment funds, of giving his investors "false" offering documents and quarterly statements. Merkin, according to the suit, consistently deceived investors about the fact that he had entrusted Madoff with their cash, which vanished. Merkin has denied any wrongdoing.

The Merkin funds were audited by BDO Seidman, which attested that the books were free of material error. New York Law School, which lost $3 million it placed with Merkin's Ascot fund, claims BDO Seidman failed to "maintain an appropriate degree of skepticism" or collect sufficient evidence to support its conclusions.

In a lawsuit, the school blames BDO Seidman for not telling investors about Merkin's alleged sleights of hand. Exhibit A: the 2007 audit of Ascot, which lists the fund's assets on a week-to-week basis, but doesn't mention that just one broker, Madoff, held nearly all those assets.

Nancy Kaboolian, an attorney for New York Law School, declined to comment. But New Jersey lawyer Alan Wasserman, who is preparing another case against BDO Seidman on behalf of Merkin investors, says Merkin's heavy reliance on Madoff is a "red flag any accounting firm should have seen" and noted.

Says Walsh: "It is unfortunate that these investors would bring legal action before all of the facts are known and seek to blame others for their own investment decisions."

McGladrey & Pullen, meanwhile, has been targeted in the case involving Petters, who once owned Polaroid.

Before his arrest by federal agents in October 2008, Petters allegedly convinced investment funds to pump billions into a nonexistent TV-wholesaling business. McGladrey & Pullen audited three of those funds, which made a steady stream of high-interest loans to the Petters Company. All three funds were wiped out, and investors are suing McGladrey & Pullen, saying the firm should have noticed that the funds were shoveling vast sums into a business with no real customers.

Petters pleaded not guilty in December to charges of mail fraud, wire fraud, money laundering and conspiracy.

"McGladrey & Pullen stands by the quality of its audits, which are conducted with due care while conforming to professional standards," company spokeswoman Betsy Weinberger says.

In the view of Richard L. Kaplan, a law professor at the University of Illinois, a diligent auditor should go to source documents to verify the financial statements it is scrutinizing. If a fund claims it has cash in a bank account, auditors should get records directly from the bank, he said.

Kaplan has advocated tougher oversight of accounting firms. Still, he acknowledged there are limits. "A very determined crook," he said, "will deceive virtually any auditor."

The auditing companies must regain public trust, otherwise they would have to disappear.

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