The town of Fairfield, Conn., has filed a lawsuit against KPMG and an investment advisor after its employee retirement programs lost an estimated $40 million in two hedge funds that invested all their assets with Bernard Madoff.

One of the hedge funds, American Masters Broad Market Fund, retained KPMG to audit its 2005 and 2006 financial statements. The lawsuit charges that KPMG should have done a due diligence investigation of Madoff’s investment firm as part of the audits and noted, “there was no independent verification of Madoff’s investments for AMBMF since Madoff purported to maintain the investments at a broker-dealer that he owned rather than at an independent broker-dealer company.” A KPMG spokesman declined to comment.

The lawsuit also refers to the three-person auditing firm, Friehling & Horowitz, which functioned as Madoff’s auditor and should have aroused suspicion. “Madoff’s broker-dealer company was still audited by an unusually small and unqualified accounting firm and thus offered inadequate assurance of the broker-dealer’s representations concerning the investments it purportedly was holding on behalf of AMBMF,” said the lawsuit.

The plaintiffs also claimed that KPMG failed to do a proper risk assessment and examine on a test basis the evidence supporting the amounts and disclosures in AMBMF’s financial statements.

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