Madoff's 2007 Audit Report Contains Red Flags

WASHINGTON - Today, Congressman Paul E. Kanjorski (D-PA), the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, pressed forward in his congressional examination of the frauds allegedly committed by Mr. Bernard L. Madoff in his estimated $50 billion Ponzi scheme.  Chairman Kanjorski wrote to U.S. Securities and Exchange Commission Chairman Christopher Cox after scrutinizing the 2007 audit report of Bernard L. Madoff Investment Securities.  Publicly available in the Commission's reading room, the report should have raised red flags within the Commission about the operations of Mr. Madoff's company.  Chairman Kanjorski will use the responses received from Chairman Cox about the Commission's existing policies, procedures, and operations when drafting new laws to govern the securities markets and to protect investors.  The Commission's Inspector General, Mr. H. David Kotz, received a copy of the letter and the audit report in order to aid in his investigations related to the Commission's failure to detect the Madoff Ponzi scheme sooner.

The text of Congressmen Kanjorski letter to Chairman Cox follows:

Dear Chairman Cox:

As you know, I am very concerned about the failure of our regulators to detect in a timely manner the $50 billion Ponzi scheme allegedly perpetrated by Mr. Bernard L. Madoff, which is now the subject of several investigations.  In this regard, I write to bring your attention to the annual audited report (Form X-17A-5) filed by Bernard L. Madoff Investment Securities (BMIS) with the U.S. Securities and Exchange Commission on December 20, 2007, for the fiscal year ending on October 31, 2007.

On initial review, this document appears to offer several red flags that could have helped the Commission to find this sizable investor problem earlier and, at least, prevented the losses for those individuals who invested their funds with Mr. Madoff in 2008.  The document also raises a number of policy concerns and questions that the Commission should promptly answer in order to assist the Congress in rewriting our federal securities laws.

For your convenience, I have enclosed a copy of this form, which is publicly available in the Commission's reading room.  As I understand, BMIS filed similar annual audited reports with the Commission for almost 30 years, and the enclosed document is fairly representative of the firm's other submissions.

With respect to the red flags and other matters that cause me concern, the document specifically requires Mr. Madoff, by his signature, to attest to the validity and truthfulness of the financial statement and supporting materials contained in the document.  It seems highly probable that this annual financial statement and prior submissions are most likely inaccurate, especially given press reports that Mr. Madoff maintained a separate set of books.  Because Mr. Madoff signed this document, he may also be subject to additional violations of federal securities laws and regulations.  To help me ascertain whether this assumption is correct, please advise me as soon as possible whether or not the known signing of an annual audited report of a broker-dealer containing false information could lead to sanctions under our securities laws and, if so, what types of sanctions are possible.

Additionally, while the preparer and signatory accountant checked a number of boxes on the enclosed form, the information supposedly attached cannot be found within the public submission.  Moreover, it appears that no amendments to the form were filed.  Among other things, these documents should include an income statement, a statement of cash flows, a statement detailing the changes in stockholders' equity or sole proprietors' capital, and an independent auditors' report on internal accounting controls.  On its face, the form therefore appears to fall short of meeting the Commission's filing requirements because the additional material is not attached even though the boxes are checked.  A cursory review of these documents by the Commission's staff would have likely detected these discrepancies.

As you know, the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises is engaged in a review of our federal securities laws and procedures as part of the Committee's broader efforts to write new laws to reform the regulation of the financial services industry.  It would therefore be helpful to learn as soon as possible whether Commission staff reviews each annual audited report of a broker-dealer as it comes in.  If so, please describe the general procedures used by the Commission to review these materials.  If the Commission does not typically review these documents or only analyzes a sampling of them, it would be helpful to know the reasons why the Commission decided to implement these alternative procedures and what those procedures are.

In addition, internal controls are supposed to help ensure the accuracy of audited financial statements.  As noted above, Mr. Madoff appears to have maintained two sets of books.  An effective set of internal controls verified by a competent independent auditor would likely have allowed for the earlier detection of the purported scam at which Mr. Madoff now sits at the center.  Please therefore advise me as to the Commission's compliance and inspection policies and its regulations as they relate to internal controls for broker-dealers and their auditors.

Moreover, please detail the reasons why the Commission decided against extending the exemption from registration with the Public Company Accounting Oversight Board (PCAOB) for the auditors of broker-dealers.  This exemption expired at the end of 2008, shortly after it became widely known that BMIS used an auditor that was not registered with the PCAOB.  While the Commission has remained generally silent on these matters, the PCAOB has advised me that it needs statutory authority to inspect and take enforcement actions against the registered auditors of non-public broker-dealers.  I am already working on legislation to fix this loophole, and I would appreciate receiving the Commission's thoughts on the need for and suggested content of such legislation.  I would also like an explanation as to why the Commission has not publicly called on the Congress to take this action.

Additionally, the annual audited report indicates that a computation of net capital for BMIS should be attached, but there appears to be none in the submission.  Instead, there is a general discussion on the last page of the document that BMIS used the "alternative method" for determining the firm's net capital standards.  There is no detailed explanation as to how the firm arrived at this figure, and without documentation it appears to have come from thin air.  There may be some reason to explain this discrepancy, but the lack of clarity and transparency as to how the net capital level was developed causes me considerable concern.

This is not the first time that capital standards for entities regulated by the Commission have raised concerns.  Just last year in the wake of the downfall of Bear Stearns and Lehman Brothers, many criticized the Commission for a failure to ensure that investment banks held adequate capital reserves for purposes of maintaining liquidity.  In an effective regulatory system, the capital that a company must hold ought to affect its decisions related to risk.  It can limit leverage.  Capital can also serve as a buffer to protect investors and shareholders alike.

Accordingly, please provide me with details about why and when the Commission allows for deviations from its standard practices to allow the use of alternative methods for computing the net capital requirements of broker-dealers.  Moreover, please advise me as to how the Commission ensures that broker-dealers have properly calculated their capital requirements.

In making the aforementioned requests, please understand that I am very mindful about the need to avoid interfering with the Commission's ongoing investigations related to Mr. Madoff, BMIS, and potentially others.  The Commission must move expeditiously in bringing to justice those individuals who have violated our securities laws.  The Congress, however, must also move quickly -- and simultaneously -- in developing new laws to govern the securities markets.  To do so, we need the assistance of the Commission.

In this letter, I have therefore opted to use the Madoff investigation and the red flags contained in the annual audited report of BMIS as a road map for guiding our efforts to obtain general information about the Commission's compliance procedures, broker-dealer net capital standards, inspection policies, enforcement practices, and penalties, among other things.  As a result, I would not view the answers to these posed questions as prejudicing the investigations now underway related to Mr. Madoff's alleged extensive Ponzi scheme.  In short, your prompt responses to these policy questions would greatly facilitate the work of the Financial Services Committee, but should not affect the Commission's ongoing investigations.

In closing, even though you are soon leaving the Commission, I would request that you personally provide answers to my questions as soon as possible, but no later than Wednesday, January 28, 2009.  These are serious matters, and I would appreciate learning of your perspective on them as the Chairman of the Commission.  I am sure that you will agree that we must act quickly and together to restore trust in our capital markets.

Sincerely,

Paul E. Kanjorski

Member of Congress

Enclosure:         Bernard L. Madoff Investment Securities X-17A-5 Filing on December 20, 2007

cc:                    Mr. H. David Kotz

Inspector General

U.S. Securities and Exchange Commission

100 F Street, NE, Room 2742

Washington, DC 20549

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Click here to view a copy of the 2007 audit report of Mr. Madoff's company.