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FRM Part II · FRM Exam Part II · Madoff: A Riot of Red Flags

A feeder fund allocator is comparing four operational setups for a manager. Which setup best addresses the governance weaknesses highlighted by the Madoff case?

The best setup uses independent parties for each key function: a third-party custodian or prime broker, an independent administrator calculating NAV, a reputable auditor, and an independent board. This separation provides checks and balances that Madoff's structure lacked.

  1. AManager acts as its own custodian and administrator, with an annual internal compliance review
  2. BIndependent prime broker as custodian, independent administrator calculating NAV, a reputable independent auditor, and a board with independent membersCorrect
  3. CIndependent auditor only, with the manager retaining custody and NAV calculation
  4. DIndependent administrator only, with the affiliated broker holding assets and the auditor chosen by the manager's founder

Explanation

Madoff's failures were concentration of functions and absence of independent oversight. Independent custody, NAV administration, auditing and board oversight together create checks and balances. The other setups leave at least one critical function, custody or NAV, under the manager's control.

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