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FRM Part II · FRM Exam Part II · Case Study: Financial Crime and Fraud

An investment firm has a fund whose manager also serves as the chief executive, chief compliance officer and custodian-liaison. The auditor is an unknown three-person firm, and clients receive only paper statements generated in-house. Returns are steady at about 1% per month in all market conditions. Which single control change most effectively mitigates the structural weakness that allowed fraud in cases like Madoff?

Appointing a reputable independent custodian and administrator that verifies assets and issues client statements is the best fix. The fraud risk comes from one party controlling trading, custody and reporting, and independent third-party verification breaks that concentration of control.

  1. AAppoint a reputable independent custodian and administrator that verifies assets and produces client statements directlyCorrect
  2. BIncrease the frequency of in-house statements to weekly
  3. CAsk the manager to publish a strategy description in more detail
  4. DAdd a second in-house reviewer who reports to the manager

Explanation

The core weakness is that the manager controls both asset custody and reporting, with no independent verification. An independent custodian and administrator confirms assets exist and generates statements outside manager control. More frequent or in-house reviews, or more narrative, leave the same conflict in place.

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