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    Auditing controls

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    3.6 Madoff Investment and Securities: Understanding the Client's Business and Industry
    Synopsis During 2008, Bernie Madoff became famous for a Ponzi scheme that defrauded investors out of as much as $65 billion. To satisfy his clients' expectations of earning returns greater than the market average, Madoff falsely asserted that he used an innovative "split-strike conversion strategy," which provided the appearance that he was achieving extraordinary results. In reality, he was a fraudster. Madoff was arrested on December 11, 2008, and convicted in 2009 on 11 counts of fraud, perjury, and money launder- ing. As a result, Madoff was sentenced to 150 years in prison. Not a Typical Hedge Fund In 2001 Madoff Securities had 600 major brokerage clients and over $7 billion in assets under management in its hedge fund portfolio.1 By the end of 2005 the company had assets under management estimated at $20 billion.2 Interest- ingly, Madoff had not registered with the SEC as an investment advisor until September 2006, following an SEC investigation into his business.3
    Unlike a typical hedge fund, Madoff Securities did not charge a fee on the money it managed. It only earned money by charging commissions on trades ex- ecuted for the accounts of its third party hedge funds. "We're perfectly happy to just earn commissions on the trades," said Madoff in an interview in 2001.4 In so doing, Madoff Securities was operating differently than largely all other hedge funds. To some observers, it was shocking that "Madoff was voluntarily giving up huge profits. Nobody anybody of us ever knew in the industry voluntarily left money on the table - except for Bernie."5 In addition, while the third party hedge funds (referred to as "feeder funds") obtained the investors, 100% of the money raised was actually man- aged by Madoff. Interestingly, investors were unaware that Madoff was actu- ally managing the funds. In fact, the feeder funds were not allowed to name Madoff as the actual money manager in their marketing literature or perfor- mance summaries.6 A typical hedge fund uses a network of third-party providers, including an in- vestment manager, one or several brokers to execute trades, and some custodians to hold the investment positions. Typically, these providers are independent of one another to reduce the risk for fraud. In Madoff's firm, all of these functions were performed internally with no independent oversight by any third-party provider. Instead of providing electronic access to their accounts, Madoff mailed his feeder funds paper statements showing account activity. Sometimes, the

    3.7 Waste Management: Understanding the Client's Business and Industry

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    Are all investment advisors required to register with the SEC? How the investing public can discover whether an investment advisor has violated SEC regulations?

    The investment advisors that must register with the SEC are those who manage $100 million or more in client assets. Investment advisors who manage less than $100 million are required to register with with the state securities agency in their state, which represents the principal place of their business.

    The investing public can discover whether an investment advisor has violated SEC regulations by carefully examining the "Form ADV", which consists of two parts. The first part of the form contains information about the adviser's business, and most importantly for the public, it details whether they've had problems with regulators or clients.

    Inherent risk assessment and three specific factors about Madoff Securities business model that might cause you to elevate inherent risk if an auditor were conducting an audit at Madoff Securities.

    Because Madoff kept the assets in its own custody and relied upon a small tiny auditing firm to sign off on his company books, these were specific inherent risks that the auditor who was auditing Madoff Securities should have focused upon. There were many red flags including the the most basic red flag, unbelievably consistent and high returns as well as whistleblowers who the SEC refused to give credence to such as Harry Markopolos.

    Changes brought on by the Dodd Frank Act to the hedge fund industry. Did this Act change the industry enough?

    Some of the changes that the Dodd Frank Act initiated included the Registration and Regulation of Private ...

    Solution Summary

    Auditing controls is examined.