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

A pension fund's investment committee is reviewing why the SEC failed to uncover Bernard Madoff's fraud despite several examinations and tips. Which of the following best describes a lesson for institutional investors drawn from this regulatory failure?

Investors must carry out their own independent due diligence, because regulatory registration and examination did not uncover Madoff's fraud even after repeated warnings. Regulatory oversight is not a guarantee of integrity, so it cannot replace an investor's own verification of strategy, custody, auditors and operations.

  1. ARegistration with the SEC and periodic regulatory examination can be relied on as a substitute for independent due diligence
  2. BInvestors must perform their own independent due diligence because regulatory oversight cannot be assumed to detect fraudCorrect
  3. CRegulatory failures matter only when the fund uses leverage, so unleveraged funds need less scrutiny
  4. DInvestors should rely mainly on the auditor's opinion, since auditors are more effective than regulators at detecting fraud

Explanation

The Madoff case showed that regulators received credible warnings and examined the firm yet missed the fraud. Investors therefore cannot outsource their diligence to regulators. The first option is the opposite of the lesson. The auditor option fails because Madoff's auditor was a tiny, unqualified firm.

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