The Madoff scandal has been a cataclysmic event for the funds industry, even though Madoff was not running a hedge fund. The failure of the regulator to spot the fraud has prompted a serious review of procedures and regulations in the US. Elsewhere it has highlighted the need for thorough due diligence as well as the importance of third party independent administrators and auditors.
The KPMG team believes the Madoff affair has re-enforced the importance of robust audit procedures concerning existence and ownership of fund assets.
Barry Winters and Garrett O’Neill at KPMG in Dublin think a number of key lessons should be learned from Madoff. One is the importance of understanding the investment strategy in which an investor investors. Madoff was supposedly using a complex trading system to generate returns, a strategy he dubbed the ‘split-strike conversion strategy’. The risk manager who first alerted the US Securities and Exchange Commission (SEC) to the alleged Madoff fraud in 1999 to no avail ran a similar strategy and could not match the returns or see any legitimate way Madoff could.
The importance of the auditor, concludes Winters and O’Neill, is clear. Madoff’s books were being audited by a small, virtually unknown auditing firm. For this reason, more investors are looking to known names as fund auditors.
The importance of due diligence, say the pair, has also been highlighted. Madoff’s reputation was substituted for the careful questioning of methodology, risk and return that investors should have undertaken.
Another lesson emerging from the scam is the need of investors to diversify. It does not take a fraud to expose the risk of concentrating too many assets in one place, cautions Winters and O’Neill.
A further lesson to be learnt is not to rely too much on advisors is another lesson; another is the importance of transparency. Madoff was able to execute his fraud because he operated behind a curtain. Investors should not accept the answer ‘it’s proprietary’ in relation to strategy or tactics, say the pair.
Segregation of duties and independent service providers are a must, note Winters and O’Neill. Investors should ensure that assets are held in custody by a reputable third-party institution and that their assets are administered by an independent administrator.
Anthony Pace and Noel Mizzi at KPMG in Malta note that a report issued by David Kotz, the US Securities and Exchange Commission (SEC)’s inspector general, described how the SEC failed to detect the Madoff fraud during the audits conducted. Partly as a result of this, the SEC plans to issue post-Madoff audit rule changes for investors that self-custody.
Under Maltese regulation, say Pace and Mizzi, fund investments must always be held under third-party custody and in the case of some professional investment funds, a prime broker is considered sufficient.
Although some comfort is provided by the regulator and the custodian, Pace and Mizzi say they generally seek to obtain assurance from the auditors of the service providers as well. They say it is mainly the responsibility of the auditors of the fund manager, administrator and custodian to ensure the necessary controls and procedures are in place.
As part of their auditing process, the pair evaluates the reliability or otherwise of the service organisation auditor and review the results of the procedures performed by obtaining a SAS70 report.
The week on Risk.net, December 9–15 2017Receive this by email