Ernst & Young faulted for relying on Madoff’s word, audits

Ernst & Young LLP erred by taking Bernie Madoff at his word when it signed off on audits of a fund that helped feed the biggest Ponzi scheme in U.S. history. The firm then stumbled by trusting the con man’s now-disgraced ex- accountant, a jury in the first trial of its kind was told.

FutureSelect Portfolio Management Inc., which lost $112 million in its investment in the feeder fund, claims that Ernst & Young was reckless in its review. The accounting firm would have known that the fund’s purported assets didn’t even exist had it not relied on audits done by Friehling & Horowitz, Madoff’s auditor in a strip mall in the New York City suburbs, a lawyer for FutureSelect said in closing arguments on Monday.

“If you’re going to use someone’s work and rely on it, you have to check them out,” lawyer Steven Thomas told jurors.

The case in state court in Seattle tests whether Ernst & Young should have detected Madoff’s fraud through its scrutiny of feeder funds. Ernst & Young audited Rye Funds, which were managed by Tremont Group Holdings Inc. The accounting firm audited Rye from 2000 to 2003 and performed surprise audits of Tremont from 2000 to 2008, FutureSelect said in court documents.

Reasonable audits

“The first truth is that Ernest & Young in fact did its job in this case,” James Bennett, a lawyer for the accounting firm, said Monday in closing arguments. “The second ultimate truth is that Bernard Madoff is the reason we are here.”

The company has maintained from the start of the trial that its sign-off was reasonable based on generally accepted auditing standards and that no audit of a Madoff-advised fund could have detected the Ponzi scheme.

FutureSelect invested about $195 million from 1998 to 2007 in feeder funds. The company sued Ernst & Young in 2010 along with Tremont and its parent Oppenheimer Acquisition Corp., which later reached confidential settlements.

FutureSelect claims Ernst & Young failed to perform audit procedures that tested the existence of assets on Rye’s financial statements. Rye “outsourced everything” – from investment decisions to record keeping – to Madoff, according to court documents.

Peer review

Ernst & Young never inquired about Friehling & Horowitz’s professional reputation as required by generally accepted auditing rules, Thomas said. Had the accounting firm done so, Thomas said, it would have found out that the firm wasn’t peer reviewed, as required by industry standards, and the American Institute of Certified Public Accountants last reported on the concern in 1993, five years before FutureSelect’s first investment.

Bennett countered in his closing arguments that criticism of the company’s audits is “all based on hindsight.” The argument that Ernst & Young somehow failed to follow the rules by not investigating Friehling is “based on a flat out misreading of EY work papers and a flat out misreading of the rules,” Bennett told jurors.

Feeder fund

Madoff is serving a 150-year prison term for stealing billions of dollars from thousands of investors. David Friehling, Madoff’s accountant for more than 20 years, pleaded guilty to fraud in 2009 and was sentenced to two years’ probation after cooperating with prosecutors.

Tremont was the second-biggest feeder into Madoff’s multibillion-dollar fraud after Fairfield Greenwich Group. Tremont and the liquidator of Madoff’s brokerage agreed in 2013 to a $1 billion settlement, freeing up money to repay some investors. FutureSelect, based in Redmond, Washington, opted out of that deal and pursued its own case.

FutureSelect’s lawsuit was dismissed by a trial judge before being reinstated by an appeals court in August 2013. The case made its way to the Washington State Supreme Court, which ruled last year that a trial judge must determine whether Ernst & Young’s acts substantially contributed to FutureSelect’s decision to continue investing in the funds.

The case is FutureSelect Portfolio Management Inc. v. Ernst & Young, 10-2-30732-0, Superior Court of the State of Washington for King County (Seattle).