CASE 2.5
LIPPER HOLDINGS, LLC
Synopsis
Media reports described Kenneth Lipper as a “bon vivant” and “renaissance man.” Lipper, the
son of a shoe salesman, grew up in a modest working-class neighborhood in the South Bronx. A
childhood friend of Al Pacino and a contemporary of Bernie Madoff, Lipper made a name for
himself on both Wall Street and in Hollywood. Lipper served as a partner of Lehman Brothers and
Kenneth Lipper’s reputation as a Wall Street maven was dashed in February 2002 when his
company, Lipper Holdings, LLC, reported that the collective market values of the investments held
by three hedge funds that it managed had been grossly overstated. The hedge funds were
subsequently liquidated resulting in huge losses for many of Lipper’s prominent investors.
Investigations by regulatory and law enforcement authorities revealed that the market values of the
hedge funds’ investments had been intentionally overstated by one of Lipper’s top subordinates who
had served as the portfolio manager for those funds.
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146 Case 2.5 Lipper Holdings, LLC
Lipper Holdings, LLC—Key Facts
1. Kenneth Lipper, the son of a shoe salesman, was raised in a modest working-class neighborhood
in the South Bronx community within New York City.
2. In addition to establishing a prominent Wall Street investment firm and serving several years as
4. One of Lipper’s top subordinates, Edward Strafaci, served as the portfolio manager for the three
Lipper hedge funds.
6. Following Strafaci’s sudden and unexpected resignation in January 2002, an internal
investigation revealed his fraudulent scheme.
8. The SEC’s investigation revealed that PwC had collected considerable evidence indicating that
the collective market values of the three hedge funds’ investments were materially overstated.
10. The SEC suspended the former partner who had supervised the Lipper hedge fund audits after
ruling that he had been a “cause” of their violations of federal securities laws.
Case 2.5 Lipper Holdings, LLC 147
Instructional Objectives
1. To identify audit risk factors posed by sophisticated financial services clients such as hedge
funds.
Suggestions for Use
As the opening prologue for this case suggests, hedge funds are easily among the most
controversial investment vehicles in today’s capital markets. They are also among the most
mysterious and least understood Wall Street “creatures.” For those reasons, alone, I believe this case
will pique your students’ interests. Consider having a student or group of students provide a five–
minute in-class report on the “state of the hedge fund industry.” By the time you discuss this class,
there may have been important changes in the regulatory environment for hedge funds that would
have at least indirect implications for those entities’ independent auditors.
Suggested Solutions to Case Questions
1. The three categories of fraud risk factors discussed in AU Section 316, “Consideration of Fraud
in A Financial Statement Audit,” in the PCAOB’s Interim Standards are “incentives/pressures,”
“opportunities,” and “attitudes/rationalizations” (of course, collectively these three categories of
fraud risk factors are often referred to as the “fraud triangle.”) The appendix to AU 316 provides
numerous examples of fraud risk factors in each category. Listed next are examples of specific fraud
risk factors faced by the PwC auditors assigned to the Lipper hedge fund audits. (Note: AU-C
Section 240, “Consideration of Fraud in a Financial Statement Audit,” is the section in the clarified
AICPA Professional Standards that corresponds with AU Section 316 in the PCAOB’s Interim
Standards.)
Incentives/pressures:
148 Case 2.5 Lipper Holdings, LLC
Opportunities:
—“Assets, liabilities, revenues, or expenses based on significant estimates that involve
subjective judgments or uncertainties that are difficult to corroborate” (as noted in a footnote
to the case, many of the hedge funds’ investments were in “thinly-traded” securities that
Attitudes/rationalizations:
—“Known history of violations of securities laws or other laws” (as noted in the case, Kenneth
Lipper had been previously accused of aiding and abetting violations of federal securities
laws)
How should PwC have responded to these and other risk factors posed by the audits of the
Lipper hedge funds? By making proper adjustments in the audit NET for those audits, that is, the
nature, extent and timing of the audit procedures to be applied during those engagements. Granted,
in some cases audit firms may simply choose not to be associated with an audit client for which an
extensive number of fraud risk factors is present.
2. Paragraph 11 of PCAOB Auditing Standard No. 15, “Audit Evidence,” identifies five
management assertions that are relevant to independent auditors. The “audit objectives” on audit
Case 2.5 Lipper Holdings, LLC 149
of the AICPA Professional Standards presented those five assertions for the first time. See AU-C
Section 315.A114 for a list of the 13 “new” assertions.]
Audit objective: Audit objectives related to “assertions about the valuation of derivatives and
securities address whether the amounts reported in the financial statements through measurement or
disclosure were determined in conformity with generally accepted accounting principles.” AU
332.26
Audit objective: Audit objectives related to “completeness assertions address whether all of the
entity’s derivatives and securities are reported in the financial statements through recognition or
disclosure.” AU 332.22
Example of a relevant audit procedure: The auditor should request “counterparties or holders who
are frequently used, but with whom the accounting records indicate that there are presently no
derivatives or securities, to state whether they are counterparties to derivatives with the entity or
holders of its securities.” AU 332.22
3. Listed next are examples of specific factors that may have contributed to the alleged flaws in the
audit procedures applied by the PwC auditors while testing the year-end market values of the Lipper
hedge funds’ investments.
—Kenneth Lipper’s prominence and influence in the hedge fund industry and the investment
community (History has proven that auditors are sometimes prone to give prominent audit clients or
150 Case 2.5 Lipper Holdings, LLC
—Inadequate supervision (This was one of the specific allegations levied against Stoler by the SEC.)
—Lack of proper expertise on the part of members of the audit engagement team (Hedge funds are
just one example of a type of audit client that almost certainly requires that one or more auditors
assigned to the engagement team have specific “industry” expertise or knowledge.)
—Inadequate time budgets (There was no indication that this factor was relevant to the Lipper hedge
fund audits; nevertheless, this factor appears to have been a contributing factor to many alleged audit
failures.)