U.S. watchdog adopts Madoff-inspired reforms for auditors of brokers

By Sarah N. Lynch

WASHINGTON (Reuters) - The U.S. audit watchdog adopted new standards on Thursday that would force auditors to scrutinize securities brokerages more closely, finalizing a long-awaited reform that came about in the wake of Bernard Madoff's $65 billion Ponzi scheme.

The Public Company Accounting Oversight Board, which polices public company auditors, won new powers under the 2010 Dodd-Frank Wall Street reform law to write standards, routinely inspect and discipline the auditors of broker-dealers.

Under the new PCAOB rules, auditors of brokerages that hold custody of client money will be required to conduct reviews of those brokerages' internal controls, make sure the brokerages are complying with federal net capital rules and make sure customer money has not been misappropriated.

The PCAOB also adopted a new standard that applies to auditors of brokers who do not have custody of customer funds, as well as a third standard laying out requirements for how auditors should review "supplemental information" that brokerages often provide to regulators.

Madoff managed to get away with duping investors for so many years in part thanks to his auditor, David Friehling of Friehling & Horowitz, who operated his audit firm out of a strip mall in New City, New York. Friehling pleaded guilty in 2009 to fraud charges but claimed he did not know that Madoff was running a Ponzi scheme. He is awaiting sentencing.

"The new standards will enhance consumer protection by strengthening performance standards for the audit of brokers and dealers in important areas relating to financial soundness and compliance with legal requirements," PCAOB board member Lewis Ferguson said.

The PCAOB was unable to approve the new standards immediately after the enactment of the Dodd-Frank law because it had to wait for the Securities and Exchange Commission to complete related new rules for brokerages.

The SEC's rule, which was adopted in July, requires broker-dealers to file certain reports with regulators and hire an independent public accountant.

The toughest new requirements in the SEC's rule apply to brokers who, like Madoff, have custody of their clients' money, a factor that raises the risk for fraud or misappropriation of funds.

The SEC's rule requires brokerages that have custody of assets to file a "compliance report" with the SEC to verify they are following the agency's capital requirements and customer protection rules. Under the PCAOB's new standard, auditors will be required to scrutinize that document closely.

Brokerages without custody must file an exemption report, and outside auditors must review that report to help verify it under the PCAOB's new standards.

Although the PCAOB adopted the new audit standards only on Thursday, it has been operating an interim inspection program for two years to check auditors' work.

During that time, the PCAOB uncovered widespread flaws and issues with auditors failing to check properly for accounting fraud risks or test controls over customer funds.

In its second annual report released in August, the PCAOB said it uncovered problems in 95 percent of the 60 audits it checked - similar to its findings the prior year.

"We have seen significant compliance problems," PCAOB Chairman Jim Doty said on Thursday. "It is clear many firms will need to significantly improve their work under any set of standards to meet the SEC's requirements and more importantly, the public's expectations."

The PCAOB's standards must be finalized by the SEC before they take effect.

Until then, the PCAOB will continue to run an interim inspection program for broker-dealer auditors until rules for a permanent program can be completed. A rule proposal for a permanent inspection program is expected to be unveiled in 2014 at the earliest.

(Reporting by Sarah N. Lynch; Editing by Karey Van Hall and Dan Grebler)

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