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

An investor allocates to a manager because the manager is SEC-registered and has been inspected. A risk committee member argues this offers limited comfort. Which statement most accurately supports the committee member's view in light of Madoff?

Registration and inspection do not guarantee integrity because examinations are sample-based and may not verify asset existence, custody or independence of service providers. Madoff was registered and examined yet ran a fraud, so investors must independently confirm custody, trading and auditor quality.

  1. ARegistration involves the regulator verifying the existence of every reported asset
  2. BRegistration implies the regulator has certified the strategy's reported returns
  3. CRegistration and inspection are not guarantees of integrity, since examinations are sample-based and may not test custody, existence of trades or independence of service providersCorrect
  4. DRegistered advisers are barred from self-custody, so fraud cannot occur

Explanation

Examinations are periodic and risk-based, and may not verify that assets and trades exist or that service providers are independent. Madoff's combined advisory, brokerage and custody functions with a tiny auditor evaded detection. Registration is not certification of returns.

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