The arrest of Bernard Madoff’s accountant highlights the peril posed by bogus auditors at the heart of Ponzi schemes that have bilked investors out of billions of dollars.

David Friehling’s arrest for securities fraud yesterday followed at least four other cases this year in which money managers accused of defrauding clients created sham auditors or hired accountants not up to the job. Investors may have avoided about $74 billion in losses if they had examined, or just tried to shake hands with, accountants supposedly verifying the books.

“Due Diligence 101 should demand that you check out the auditing firm and find out if it exists,” said Richard Dietrich, an accounting professor at Ohio State University in Columbus. “Then, you have to find out if they are qualified.”

The auditor for James Nicholson, the hedge-fund manager arrested in February for conning investors out of as much as $900 million, was a mail drop in Manhattan. Phones rang unanswered when regulators called R. Allen Stanford’s auditor in Antigua. Friehling was sole proprietor of Friehling & Horowitz, an accounting firm run from a 13-by-18-foot storefront in the New York City suburb of New City.

The roster of cases reveals a hole in the anti-fraud strategy the U.S. government pursued following scandals at Enron Corp. and WorldCom Inc. The Sarbanes-Oxley law of 2002 created the Public Company Accounting Oversight Board to inspect auditors of public companies. It doesn’t require money managers to hire regulated auditors.

SEC Considering Changes

“Too many Larry, Moe & Curly accounting firms” are now auditing money managers, said James Cox, a law professor at Duke University in Durham, North Carolina. “While we made progress with accounting for reporting companies, we have not with investment advisers.”

The Securities and Exchange Commission is working on a proposal, first disclosed last year, that may force hedge funds to identify their auditors and brokers, said Robert Plaze an associate director in its investment management division. U.S. Representative Paul Kanjorski, a Pennsylvania Democrat, introduced legislation last month to let the PCAOB inspect and discipline the auditors of brokerages like Madoff’s. The measure would fix a “loophole” that lets auditors avoid PCAOB supervision, he said.

Drive-By Inspection

Money managers should be required to disclose to regulators who audits their books, handles their trades and has custody of their assets, Cox said. Fund managers typically disclose those details privately to investors, who may try to independently verify them. Many don’t.

Friehling, Madoff’s accountant, operated from an office in the Georgetown Office Plaza, sandwiched between a medical practice and a pediatrician’s office. Prosecutors and the SEC said Friehling, 49, vouched for Madoff’s books without taking meaningful steps to verify them.

To avoid becoming victims of such Ponzi schemes, investors should “at the very least drive by the auditors’ buildings and see what kind of facilities they have, or hire someone to do it,” said James Ratley, president of the Association of Certified Fraud Examiners in Austin, Texas.

Bogus Audits

A week after Madoff’s arrest, Georgia currency trader James Ossie tried to reassure clients in a letter, claiming outside accountants verified his books every 90 days. It wasn’t true, the SEC said in a January lawsuit accusing him of running a $25 million Ponzi scheme. Ossie falsely told some clients he was audited by Robert Half International Inc., a Menlo Park, California-based recruiting company, the agency said. His attorney, William Leonard in Atlanta, declined to comment.

New York hedge-fund manager Grant “Gad” Grieve created two “sham” firms to vouch for his profits, the SEC said in a February lawsuit. Grieve sent at least one investor an audit report on letterhead from one of the fictional firms, for which he had arranged an Internet address, the agency said. He has left the U.S., the SEC says. Joel Schneck, a New York attorney listed in court documents as representing the firm Grieve managed, didn’t return calls.

Stanford falsely claimed the bank’s statements were audited by Antiguan regulators, the agency said. Instead, the books were overseen by “a small local accounting firm” called C.A.S. Hewlett & Co., picked because of a “relationship of trust” Stanford had with its chief, the SEC said. The head of the firm, Charlesworth Hewlett, died in January, and nobody answered calls by Bloomberg.

Hedge fund operator Nicholson defrauded clients at his firm in Pearl River, New York, by overstating assets, according to claims filed by the SEC and prosecutors at federal court in New York. He allegedly said his books were audited by a firm called Havener and Havener on East 41st Street in Manhattan.

‘Virtual’ Office

When an FBI agent visited the address last month, he discovered Nicholson had signed a lease in 2004 with a company that provides “virtual” office space, letting customers use it as a mailing address, prosecutors said. For some time, Nicholson even arranged for the leasing company’s answering service to take calls to the auditor, forwarding messages to him.

Prosecutors said at a Feb. 25 hearing that Nicholson’s alleged fraud may have cost clients as much as $900 million. Erika McDaniel Edwards, a New York lawyer representing him, didn’t respond to a call seeking comment.

People burned by frauds sometimes don’t look for warning signs because it conflicts with what they want to believe, said Stephen Greenspan, professor emeritus of educational psychology at the University of Connecticut and author of the 2008 book “Annals of Gullibility: Why We Get Duped and How to Avoid It”

Greenspan speaks from experience: He invested more than $250,000 with Madoff.