Jury Holds Ernst & Young Liable For Madoff Losses

A Washington jury has found accounting firm Ernst & Young ("E&Y") liable for at least $10 million of losses suffered by a Washington investment company that invested in Bernard Madoff's infamous Ponzi scheme through a "feeder fund" audited by the firm.  FutureSelect Portfolio Management ("FutureSelect"), a Washington-based financial firm, obtained a total verdict of $20 million resulting from what it alleged were more than $129 million in losses suffered from its exposure to Madoff's scheme through a Madoff feeder fund, Tremont Partners.  The verdict is significant not only because of the large amount of damages but also because such verdicts have been relatively rare against accounting or auditing firms in Ponzi scheme litigation.  It is expected that E&Y will appeal the verdict.

Background

FutureSelect managed several investment funds, and was approached by a representative of Tremont in 1997 regarding an investment in the Rye Funds.  Tremont served as the general partner of the Rye Funds, which was one of the prime feeder funds that funneled investor funds into Bernard L. Madoff Investment Securities ("BLMIS").  During those discussions, FutureSelect was told it was being given a "rare, and potentially fleeting" opportunity to invest with Madoff and was provided with audit opinions from auditing firm Goldstein Golub Kessler.  Based on these opinions and representations from Tremont about its oversight and constant monitoring of Madoff, FutureSelect invested nearly $200 million in the Rye Funds from 1998 to 2007.  E&Y audited several funds comprising the Rye Funds from 2000 to 2003, and also conducted "surprise" audits of Tremont from 2000 to 2008.  In 2008, Madoff's fraud came to light and estimated victim losses were pegged at nearly $20 billion.  FutureSelect's net loss was estimated at nearly $130 million.

Tremont reached a $1 billion settlement with Irving Picard, the bankruptcy trustee appointed to liquidate BLMIS, who had accused the firm of ignoring red flags associated with Madoff.  The settlement allowed claims asserted by several Tremont funds to proceed in the bankruptcy proceeding, providing an avenue for those funds to compensate their investors who were excluded from Picard's claim proceeding due to their status as "indirect" investors.  Claimants with allowed losses in the Madoff bankruptcy have recovered over 50% of their losses to date and are expected to recover most, if not all, of their losses when the bankruptcy proceeding concludes.  However, FutureSelect opted out of the settlement with the intent of pursuing other parties for its losses.  

FutureSelect filed the suit against E&Y, Goldstein, and others in 2010, asserting negligence claims and violations of Washington's State Securities Act.  A trial court dismissed the complaint, but an appeals court subsequently reinstated the suit in 2014.  FutureSelect settled its claims against Goldstein and was compelled to arbitrate its claims against another firm, KPMG, so E&Y was the only defendant left standing to face trial.

The Trial

Trial began in mid-October, with E&Y pinning its defense on the claim that it had done its job and that it was only one of many who failed to detect Madoff's fraud.  E&Y defended its actions, saying it had "scrupulously" followed generally accepted accounting principles in auditing one of the many funds that had used Madoff as its investment adviser.  Lawyers for FutureSelect scoffed at these claims, claiming that E&Y had simply relied and signed off on audits performed by a little-known firm, Friehling & Horowitz ("Friehling").  (editor's note: David Friehling, the principal of that firm, was referred to by Madoff as the "dumb auditor" and was the first to be charged criminally for his role in auditing Madoff's books.  He ultimately received a sentence of probation.)  

FutureSelect argued that E&Y blindly accepted and relied on Friehling's audits of BLMIS and that a simple review would have demonstrated that the firm's purported assets did not exist.  Indeed, if E&Y would have looked into Friehling, it would have discovered that the nondescript firm was not peer reviewed and was in violation of industry standards.  E&Y countered that the accusations were "all based on hindsight" andthat "no audit of a Madoff-advised fund could have detected this Ponzi scheme." 

FutureSelect ultimately sought approximately $200 million from E&Y.  The jury deliberated several days after closing arguments earlier this week and ultimately returned a verdict with mixed findings on the WSSA counts but finding against E&Y on the negligent misrepresentation claims.  The jury awarded damages of $20.3 million, with E&Y liable on half that amount.  Lawyers for FutureSelect estimate that E&Y could be on the hook for nearly $25 million when factoring in prejudgment interest.  

Rare Recovery

While rare, recoveries from  accounting firms for their role in failing to detect Ponzi schemes are on the rise.  Many liken the firms as gatekeepers between investors and fraud-feasors and argue that they should be held accountable along with other gatekeepers such as lawyers.  While the recovery against E&Y is noteworthy because it represents a jury finding against an auditing firm, the recovery is not unprecedented in Ponzi-related litigation against auditors.  A Florida CPA firm paid $3.5 million in 2007 to resolve claims of inadequate auditing relating to its work for a massive insurance Ponzi scheme. Another Florida-based accounting firm, Kaufman Rossin, paid nearly $10 million in 2010 to settle claims (without admitting liability) brought regarding the firm's work surrounding the Thomas Petters Ponzi scheme.  An Indiana firm, DeWitt & Schrader, paid $1.8 million last year over its accounting work for a $9 million Ponzi scheme.  And BDO USA LLP paid $40 million earlier this year to settle claims for its auditing of several entities connected to the massive Ponzi scheme masterminded by Allen Stanford.